Question

Lobo, Inc., a construction contractor, has asked for your advice on the following:

New City filed suit against Lobo at the end of 2018 seeking $10 million in civil penalties and injunctive relief based upon violation of the New City construction code pertaining to green building standards.   New City alleged that Lobo had violated the code in various projects undertaken over the past two years. At the end of 2019, the parties had engaged in discovery and begun settlement negotiations. Lobo offered to settle for $500,000. New City rejected this amount and countered with $6 million. Lobo's attorney advised that the ultimate settlement would probably be $3.5 to $5 million based on the information learned in discovery, the settlement negotiations thus far, and the risk and expense of a lengthy trial. Lobo's attorney explained that no amount within that range was better estimate than any other amount. New City follows U.S. GAAP.

Required:

1. What amount (if any) did Lobo make at the end of 2019 (make the entry) to accrue a loss?   Why (what conditions must be satisfied for such an accrual)? Was any disclosure required? If so, be specific as to any amounts that should be disclosed and feel free to draft the disclosure note. (You also must cite the applicable provisions of the ASC).

2. Now assume that Lobo properly made an accrual as a litigation loss of $4.3 million in 2019. In late-2020, Lobo entered into a full settlement with the City for a total of $2 million to cover the cost of the violation. What journal entry (if any) should Lobo make at the end of 2020? Why? Hint: What kind of change is this?

Answer 1