A liability may be sometimes be disputed. If so, a business will need to go through a standard regimen of investigating the situation and negotiating a reasonable outcome. The main steps are as follows:

Confirm the details associated with the liability, to ensure that you have all the necessary facts for reaching a resolution. This will involve a review of all communications from the other party, as well as your own internal documents.
Discuss the matter with the other party, both to see if they have additional facts pertaining to the case, and to see if they are amenable to a negotiated solution.
If necessary, have an attorney review the situation and recommend how to proceed. This may involve a proposed settlement, mediation, arbitration, or the initiation of a lawsuit.

During the course of these steps, account for the outcome in your accounting system. The most appropriate accounting will depend on the probability of payment, as described next.

When to Recognize a Loss Contingency

The accounting for a disputed liability is known as a loss contingency. You should recognize the expense when you can reasonably estimate the amount of the loss and it is probable that a liability has been incurred at the date of the financial statements. Do not delay accruing an expense until there is complete certainty regarding its amount. Instead, accrue some amount as soon as the expense can be estimated within a range. If there is a range of potential expenses associated with the loss contingency, accrue that amount that appears to be a better estimate than any other amount within the range. If no amount within the range appears better than another, accrue the minimum amount in the range.

If a loss contingency is related to litigation, there may be no clearly defined point at which to record an expense. Consider the following factors when determining whether to record the expense:

The degree of probability that the outcome of the litigation will be unfavorable (based on the progress of the case, the views of your attorney, the company's experience with similar cases, and how management plans to respond to the lawsuit, such as with an out-of-court settlement).
Your ability to make a reasonable estimate of the amount of the prospective loss.

You should disclose the existence of the litigation if it is reasonably possible, but not probable, that there will be an unfavorable outcome, or if you cannot determine the amount of the loss.