Litigation expenses

What Are Litigation Expenses?

Litigation expenses refer to the costs incurred by individuals or entities when involved in legal disputes, whether as a plaintiff or a defendant. These costs fall under the broader category of business finance and typically encompass attorney fees, court costs, expert witness fees, discovery costs, and settlement payments or judgments. For businesses, litigation expenses are significant because they directly impact a company's profitability and can affect its financial health. Unlike regular operating expenses such as salaries or rent, litigation expenses are often unpredictable and can be substantial, sometimes classified as non-operating expenses depending on their nature and recurrence.

History and Origin

The concept of litigation expenses is as old as legal systems themselves, evolving alongside the complexity of commerce and societal regulations. As businesses grew and transactions became more intricate, so did the potential for disputes. Early forms of legal costs involved payments to advocates and court officials. In modern corporate history, the rise of regulatory bodies and consumer protection laws, particularly in the 20th century, significantly increased the frequency and scale of corporate litigation. Landmark cases, such as large product liability lawsuits or antitrust actions, highlighted the potentially enormous financial burden these legal battles could impose on companies. For instance, the multi-billion-dollar settlements in opioid litigation against pharmaceutical companies and distributors illustrate the immense financial scope that such legal disputes can entail, involving significant legal fees and settlement costs.⁶

Key Takeaways

• Litigation expenses include a broad range of costs associated with legal disputes, from attorney fees to settlements.
• These expenses are often unpredictable and can have a material impact on a company's financial statements.
• For businesses, certain litigation expenses may be considered tax deductions if they are ordinary and necessary for business operations.
• Publicly traded companies are often required to disclose material litigation in their financial reports to inform shareholders.

Interpreting Litigation Expenses

Interpreting litigation expenses requires understanding their context within a company's overall financial health. High or recurring litigation expenses can signal underlying operational or corporate governance issues, such as problems with product quality, compliance, or employment practices. Analysts often scrutinize these expenses on a company's income statement to gauge the potential for future liabilities or ongoing legal risks. Significant litigation costs can erode earnings per share and affect investor confidence. Conversely, a company with historically low or well-managed litigation expenses might indicate effective risk management practices.

Hypothetical Example

Consider "TechInnovate Inc.," a fictional software company facing a patent infringement lawsuit from a competitor. To defend itself, TechInnovate hires a law firm, incurring substantial legal fees for attorney hours, paralegal support, and document review. The case proceeds to discovery, requiring TechInnovate to pay for electronic data discovery (e-discovery) services and expert witness testimonies. After months of negotiation, the company decides to settle the lawsuit to avoid a prolonged trial, paying a settlement amount to the plaintiff.

Throughout this process, TechInnovate's finance department records these outflows. The attorney fees, e-discovery costs, and expert witness fees are recorded as litigation expenses in the period they are incurred. The final settlement payment is also accounted for as a significant litigation expense. These costs negatively impact TechInnovate's cash flow and reduce its net income for the year.

Practical Applications

Litigation expenses manifest in various areas of finance and business:

• Financial Reporting: Companies record litigation expenses on their income statement, often within selling, general, and administrative (SG&A) expenses, or as a separate line item if material. They are also considered when assessing contingent liabilities on the balance sheet in accordance with Generally Accepted Accounting Principles (GAAP).
• Taxation: Businesses may be able to deduct litigation expenses from their taxable income if these expenses are considered "ordinary and necessary" for the operation of the business, as outlined by tax authorities such as the Internal Revenue Service (IRS).⁵ This often includes legal fees for contract disputes, employment issues, or tax advice related to business operations. For details on deductibility, businesses often refer to official tax guidance from the IRS.⁴
• Valuation and Investment Analysis: Investors and analysts assess a company's past and potential future litigation expenses when performing due diligence. High or unpredictable litigation costs can deter investors, as they represent a drain on resources that could otherwise be allocated to growth initiatives or returned to shareholders.
• Legal Budgets and Provisions: Companies often allocate budgets for potential legal costs and may set aside provisions (reserves) in their financial statements for anticipated litigation losses, especially if a negative outcome is probable and estimable.
• Regulatory Compliance: Publicly traded companies are required by regulatory bodies like the Securities and Exchange Commission (SEC) to disclose material legal proceedings that could significantly affect their financial position or operations. The SEC provides guidance on what constitutes material litigation and how it should be disclosed to ensure transparency for investors.³

Limitations and Criticisms

One of the primary limitations of litigation expenses, from a financial reporting perspective, is their inherent unpredictability. It can be challenging for companies to accurately estimate the ultimate cost of a lawsuit, especially in its early stages. This uncertainty can lead to adjustments in financial provisions, impacting reported earnings in subsequent periods.

Furthermore, the treatment of litigation expenses in non-GAAP financial measures has faced scrutiny. Some companies may adjust certain litigation-related charges out of their non-GAAP earnings figures, labeling them as "non-recurring" or "unusual," to present a more favorable view of their core operational performance. However, regulatory bodies like the SEC have provided guidance on such adjustments, emphasizing that it is improper and misleading to classify ordinary, recurring legal costs as non-recurring.² Critics argue that this practice can obscure a company's true financial picture, particularly if significant legal issues are an ongoing part of its business. For instance, industries prone to frequent lawsuits, like pharmaceuticals or chemicals, may incur substantial legal costs that, while variable, are a predictable component of their business operations. Treating these as exceptional can misrepresent sustained financial performance or distort capital allocation decisions.

Litigation Expenses vs. Legal Fees

While often used interchangeably, "litigation expenses" and "legal fees" have distinct although overlapping meanings. Legal fees are specifically the charges billed by attorneys for their services, including hourly rates, retainers, and contingency fees. They are a component of the broader category of legal costs. Litigation expenses, on the other hand, encompass legal fees but also include a wider array of costs directly associated with a lawsuit or legal dispute. This broader category covers court filing fees, deposition costs, expert witness fees, e-discovery expenses, settlement payments, and judgment awards. Therefore, while all litigation involves legal fees, not all legal fees are necessarily incurred in the context of active litigation (e.g., legal fees for drafting contracts, mergers and acquisitions due diligence, or routine regulatory compliance advice would be general legal fees but not strictly litigation expenses unless a dispute arises).

FAQs

Q1: Are litigation expenses always tax deductible for businesses?

No, not all litigation expenses are always tax deductible. Generally, only those expenses that are considered "ordinary and necessary" for conducting your trade or business can be deducted. Personal legal expenses are typically not deductible. It's important to consult tax guidelines or a tax professional for specific situations.¹

Q2: How do litigation expenses appear on a company's financial statements?

Litigation expenses are usually recorded on a company's income statement, often as part of selling, general, and administrative (SG&A) expenses. If the amount is significant or relates to an extraordinary event, it might be presented as a separate line item. Additionally, potential future litigation losses that are probable and estimable are typically disclosed in the notes to the financial statements and may involve setting up a liability on the balance sheet.

Q3: Do investors care about a company's litigation expenses?

Yes, investors pay close attention to a company's litigation expenses. High or recurring litigation costs can signal operational problems, reduce a company's profitability, and potentially lead to significant financial liabilities, impacting future earnings and shareholder returns. They are often a key factor in assessing a company's overall risk management and financial stability.

Q4: Can litigation expenses be considered a capital expenditure?

In some specific cases, legal fees incurred to acquire, perfect, or defend title to property or intellectual property may not be immediately expensed but rather added to the cost basis of the asset. This means they are treated as capital expenditures and recovered over time through depreciation or amortization, rather than being fully expensed in the year incurred.

Q5: What is the SEC's role regarding litigation expenses?

The SEC requires publicly traded companies to disclose any material legal proceedings that could have a significant impact on their financial condition, operations, or business prospects. This ensures that investors are informed about potential financial risks stemming from litigation. The SEC also provides guidance on how companies should report and, in certain cases, discuss litigation expenses, particularly in the context of non-GAAP financial measures.