Hart Corporation is a chemical company that produces cleaning fluids of different types; it is the main employer in a small town. Stan Hart has been the company president for 15 years and is paid a salary plus a 10% bonus based on pretax income; he is also the major stockholder. After treatment to remove pollutants, Hart Company has been draining the waste water from its production process into a nearby river for many years. Over the past year (2007) there have been several “fish kills” in the river and at the end of 2007 the Environmental Protection Agency (EPA) filed a $1 million lawsuit against Hart for violation of pollution control laws.
You are an accountant for the firm that is auditing Hart’s 2007 financial statements. Preliminary calculations show that Hart earned a pretax income of $600,000 for 2007, before considering the effects of the lawsuit. In a discussion with Stan Hart and Bob Brandt, the company’s attorney, you raise the issue of whether or not to report the lawsuit in the company’s 2007 financial statements. Stan says, “I’ve been president of this company for long enough to know that we didn’t cause the fish kills; it must be something else. Furthermore, I don’t want anything included in the income statement that would jeopardize the company’s well being; the town depends on us. If we shut down, the town will die.” Bob replies “I generally agree with you. But you need to be realistic. I don’t expect the outcome of the lawsuit to be determined for a couple of years. However, there is a pretty good chance the company will lose. If that happens, then there is a 60 percent chance the loss will be $400,000 and a 40 percent chance the loss will be $1 million.” Stan replies “Okay, then let’s put it in a note to the financial statements.”

Required
From a financial reporting and ethical standpoint, prepare a written report that recommends how to account for the lawsuit.