Financial Accounting and Reporting-CPA Practice Exam

How does Smith Corporation report income from a lawsuit settlement in Year 2?

1. Smith recognizes income of the probable settlement amount immediately.

2. Smith defers all income recognition until the cash is received.

3. Smith recognizes a total gain equal to the cash received from the settlement.

4. Smith records income in Year 1 when the suit is filed.

The correct answer is: Smith recognizes a total gain equal to the cash received from the settlement.

Smith Corporation recognizes a total gain equal to the cash received from the settlement because, under generally accepted accounting principles (GAAP), income from a lawsuit settlement is recognized when it is realizable and earned. Realization occurs when the income is likely to be received, and it requires that the amount can be measured reliably. In the case of a lawsuit settlement, the income is typically recognized in the period when the settlement is finalized, and the cash is either received or a firm commitment for payment is established. This means that the actual receipt of cash is a critical trigger for recognizing the income in the financial statements. Prior to the cash being received, any estimates of the potential settlement amount may not be recorded as income to avoid prematurely recognizing revenue. Therefore, recognizing the total gain equal to the cash received aligns with the revenue recognition principle, where income is matched with the actual economic benefits received, providing a clear and accurate reflection of the company's financial position. This approach helps ensure that the financial statements are reliable and that stakeholders have an accurate understanding of the company's performance.