Litigation risk is the risk that a legal action might be taken against the company soon. The litigation risk analysis provides the assessment to determine whether there is a chance that a legal action will be taken against the company in the future. This risk analysis also determines the possibility of litigation risk arising for the company from a certain contract or a transaction.
Eradication of litigation risk
Once it is established that a litigation risk can arise from a contract or a transaction, necessary measures are taken to eradicate that litigation risk. It does not matter whether the risk originally arises or not. It is incorporated, nonetheless, in the company’s account. To avoid the litigation risk, it is usually a good practice to leave that specific contract or transaction to avoid any unnecessary complications.
The accounting of the litigation risk
According to the generally accepted accounting practice (GAAP) and International Accounting Standards (IAS), it is necessary for the companies to create a provision for the litigation risk and incorporate it in their financial statements. This practice helps the stakeholders of the company in acquiring a true and fair view of the company’s financial accounts along with all the disclosures. As this is a necessary disclosure and may alter the decision of a potential investor, it is a legal requirement for the companies to disclose these risks.
Litigation risks for auditors
The frequent occurrence of litigation risk is often found in the auditing companies. Since these companies are to provide reasonable assurance on the accounts of a company, there is always a probability that a potential stakeholder of the company sues the audit company for the negligence. Therefore, it is very important for the auditing companies to assess the litigation risk in the contract before finalizing it. If the company is aware of the occurrence of the fraudulent activities within a company, it is usually a good practice to reject the contract.
Litigation risk assessment
Litigation risk assessment provides the management of the company with the early assessment of the potential risk of a legal action and costs that the company will have to bear in the process. In the format of a litigation risk assessment, following components are generally included:
- Nature of litigation and related course of action
- Status of the case
- Assessment of related legal issues and analysis
- Projected legal budget of the case
- Strength and weaknesses of the company’s legal position
- Projection of the result of the case
- Debt ratios
- Liquidity ratios
- Profitability ratios
- Asset management ratios
- Cash Flow Indicator Ratios
- Market value ratios
- Financial analysis
- Business Terms
- Financial education
- International Financial Reporting Standards (EU)
- IFRS Interpretations (EU)
- Financial software