Question

An acquired company has an unsettled lawsuit, in which it is the defendant. The expected present value of the obligation is $5,000,000, and the lawsuit meets the requirements for recognition at acquisition date. No changes in the reported value are made until the lawsuit is settled, 18 months after acquisition, for $3,000,000. In the year of settlement, the effect of the settlement is to report the $2,000,000 change in the value of the lawsuit as:

1) $2,000,000 gain
2) $2,000,000 loss
3) $3,000,000 gain
4) $3,000,000 loss

Answer 1

Upon settlement of the lawsuit for $3,000,000, which was $2,000,000 less than the recognized liability of $5,000,000, the company would report a $2,000,000 gain in its financial statements for the year of settlement.

Step-by-step explanation:

The student's question pertains to how the settlement of a lawsuit should be reported in the financial statements of an acquired company. When the company was acquired, an expected present value of the obligation due to the lawsuit was $5,000,000. This amount was recognized on the acquisition date, as it met the necessary requirements for recognition. Eighteen months after the acquisition, the lawsuit was settled for $3,000,000.

The effect of the settlement in the year it occurred is that the company will report a gain, since the settlement amount ($3,000,000) is less than the amount that was initially recognized as a liability ($5,000,000). This results in a difference of $2,000,000, which is reflected as a gain on the company's financial statements.

The correct answer to the question is:

1) $2,000,000 gain.