When a company determines that a potential legal claim is probable and the amount can be reasonably estimated, how should it record this event in its journal entries?

• A. Debit a revenue account and credit a liability account
• B. Debit a liability account and credit an expense account
• C. Debit an expense account and credit a liability account
• D. No journal entry is required until the claim is settled

Answer: (C)

Verified step by step guidance

1. Understand the concept of contingent liabilities: A contingent liability is a potential obligation that may arise depending on the outcome of a future event. If the liability is probable and the amount can be reasonably estimated, it must be recorded in the financial statements.
2. Identify the correct accounts to use: When recording a probable legal claim, the company should recognize an expense to reflect the cost associated with the claim and a liability to show the obligation to pay in the future.
3. Determine the journal entry structure: The expense account is debited to increase expenses, and the liability account is credited to increase obligations. This follows the double-entry accounting principle.
4. Write the journal entry: The journal entry would be formatted as follows: Debit the appropriate expense account (e.g., Legal Expense) and Credit the appropriate liability account (e.g., Legal Claims Payable).
5. Understand why no entry is required until settlement if the claim is not probable or cannot be reasonably estimated: If the legal claim is not probable or the amount cannot be reasonably estimated, it is disclosed in the notes to the financial statements rather than recorded as a journal entry.