Earlier this July, the Financial Accounting Standards Board published an exposure draft for comment, Contingencies (Topic 450): Disclosures of Certain Loss Contingencies. (Most of us know this as Financial Accounting Standard No. 5.) This is the board’s second attempt at addressing contingencies; its previous attempt in 2008 received 241 comment letters—mostly unsupportive.
The board added this project to its agenda based on a perceived sentiment by investors and other users that current disclosures about loss contingencies—that is, losses a company might suffer, but the outcome is still uncertain—don’t provide adequate and timely information to assess the likelihood, timing, and magnitude of future cash outflows associated with the loss.
The funny thing is, less than 10 percent of the comments FASB received last time around came from actual users; more came from law firms, unhappy with possible disclosure of litigation costs. In fact, one comment letter came from professors Joseph Grundfest and Laura Simmons, who reported that based on their academic research, it wasn’t clear that “the investing public is, in any systemic sense, materially ill-informed or systemically unable to assess the implications of litigation-related events on stock price valuation.” They suggested that FASB undertake further research. So determining whether this “user” demand is truly universal isn’t easy.
Many other respondents noted that enforcement of existing disclosure requirements might be more effective and helpful than requiring new ones. And since contingencies aren’t one of FASB’s many topics to converge with International Financial Reporting Standards, other commenters wondered why FASB was spending time on this in the first place.
After FASB issued that original draft, staffers reviewed the comment letters, held roundtables, and attempted to do some field-testing. (That testing proved difficult because it exposed companies to significant legal risks, such as waiving attorney-client privilege.) Finally FASB compiled a revised draft that reflected many of the concerns commenters had raised, and the board decided to re-expose the document for more comment. That’s where we are today.
The proposed amendments would retain existing disclosure requirements for loss contingencies, but enhance them with additional required disclosures. The stated goal is disclosure that would enable users to understand the nature of loss contingencies, their potential magnitude, and their potential timing (if that’s known).
Details about a contingency would be disclosed if there is at least a reasonable possibility (that is, more than a remote possibility) that a loss may have been incurred, regardless of whether the company has accrued for a potential loss. Companies might also need to disclose information about remote contingencies as well, depending on the contingency’s specific nature, potential magnitude, and possible timing, as well as whether the contingency could have a potentially “severe impact.” (“Severe impact” is defined as having “a significant financially disruptive effect on the normal functioning of an entity,” a higher threshold than material.)
The IFRS alternative, IAS 37, seems to offer a nice compromise between what we currently do under U.S. Generally Accepted Accounting Principles and FASB’s new proposal.
All this means FASB’s proposal expands the population of loss contingencies that will need to be disclosed, particularly those related to pending or threatened litigation. Accounting executives will need to exercise judgment in assessing the specific facts and circumstances to determine whether disclosure about a remote contingency is necessary. When determining whether disclosure is required, a company would not consider the possibility of any recovery that might be achieved from insurance or other indemnification arrangements. But information about possible recoveries from insurance and other sources could be disclosed if it is discoverable by either the plaintiff or a regulatory agency, or it relates to a recognized receivable for such recoveries.
The proposed disclosure for certain remote contingencies could cause problems for companies, and was one of the areas that most preparers and law firms disliked in FASB’s original document. After all, if the company has already determined that the outcome is remote, it probably hasn’t expended much time or energy to consider that outcome. The new requirement might force companies to divert time and thought to those highly unlikely outcomes, rather than other more pressing needs.
Required disclosures would include publicly available quantitative information, including the amount of the claim, if available. The proposal does drop an earlier requirement to estimate the amount of the claim if no amount was specified; that’s the good news for lawyers. But the proposal still requires disclosure of an estimate or a range of possible loss for all loss contingencies that are reasonably possible. Those estimates can be aggregated with similar contingencies, as long as the basis for aggregation is also disclosed.
In another nod to the legal department, FASB also noted that during early stages of litigation, there might be little information available to disclose. In that case, the required disclosures would include the basis for the claim and the amount of damages claimed by the plaintiff, plus the basis for the company’s defense or a statement that the defense has not been formulated. You’ll also need to provide sufficient detail so that users can obtain additional information from publicly available sources (court records and the like).
For public entities, every annual and interim report should include disclosure of reconciliations, by class in a tabular format, of recognized (accrued) loss contingencies to include all of the following:
Carrying amounts of the accruals at the beginning and end of the period;
Amount accrued during the period for new loss contingencies recognized;
Increases or decreases for changes in estimates for loss contingencies recognized in prior periods;
Decreases for cash payments or other settlements during the period.
And where is convergence in all this? Well, the proposed disclosures are similar (but not identical) to those required by International Financial Reporting Standards No. 37, Provisions, Contingent Liabilities and Contingent Assets. The International Accounting Standards Board is currently deliberating broader changes to IAS 37, including initial recognition and subsequent measurement in addition to improving disclosures. So even as FASB issues this proposal as a final standard, it may or may not be ultimately aligned with IFRS.
The proposal would be effective for fiscal years ended after Dec. 15, 2010—that is, the end of this year for calendar year-end companies!
Will This Work?
FASB’s revised proposal did recognize many of the concerns initially raised, and changed some of the provisions accordingly. Still, some issues remain. The current standard has been in place for more than 30 years; everyone involved in financial reporting (preparers, auditors, lawyers, investors) understood its requirements, and the accounting and legal professions knew how to handle auditor inquiries about loss contingencies that bumped up against attorney-client privilege. The new requirements, while not as onerous as previously proposed, may still raise attorney-client privilege issues. Current procedures don’t contemplate additional disclosures of remote losses that could have a “severe impact.”
Many believe that disclosing information about loss contingencies that are remote could mislead investors more than it would enlighten them. Estimates, including ranges, could be little more than guesses, and may get more credence than they deserve. (Especially since the company has already determined that any loss is highly unlikely to occur!) And if the company’s estimate is way off, would that create even more litigation risk? This could also result in lengthy boilerplate disclosures that mirror the “risk factors” discussion in the 10-K.
Disclosing the amount of the claim may create an environment where we may see increases in demands, because the plaintiffs know that the company will be required to disclose them. Again, this may give the amounts more credence than they deserve. It might also force early settlements (that might not be in the best interest of the shareholders) so that disclosure does not have to be made. The aggregation may also create misleading information if the cases have different exposure risks, fact patterns, timing, and so forth. Additionally, by requiring information to be disclosed quarterly, the aggregation may inadvertently provide privileged information.
The IFRS alternative, IAS 37, seems to offer a nice compromise between what we currently do under U.S. Generally Accepted Accounting Principles and FASB’s new proposal. Given the huge consequence of other standards being proposed jointly by the IASB and FASB (revenue recognition, lease accounting, financial statement presentation, financial instruments, to name just a few) why wouldn’t we table this until the Securities and Exchange Commission makes its decision on mandating IFRS for U.S. companies?
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