FASB on Contingencies; IASB on Hedging

The Financial Accounting Standards Board is backpedaling its plans to update rules on accounting for contingencies in business mergers to address an underlying problem: how to account for contingencies generally.

Contingencies are potential liabilities, such as lawsuits, that add an element of uncertainty to financial reporting because the ultimate outcome of the event is not known. In considering feedback to its proposed new accounting for business combinations, such as a merger or acquisition, FASB took to heart criticisms that its proposed approach to accounting for contingencies in the context of a business combination contradicted existing rules regarding how to account for contingencies outside of a merger.

As such, the Board decided to throttle back its planned pursuit of mark-to-market accounting for contingencies in its proposed Financial Accounting Standard No. 141R, Business Combinations. At the same time, FASB decided to look anew at FAS 5, Accounting for Contingencies, to determine if the approach on the books since 1975 needs revisiting. FASB has opened a new project to research the possibility and consider its options.

Dodyk

FAS 5 says contingencies should be reported when the uncertain event is probably going to occur and when the economic consequences of that event can be estimated, according to Larry Dodyk, a partner with PricewaterhouseCoopers. FASB’s plans for a business combination called for a contingency to be recorded at fair value at the time of the acquisition and then to be marked to market value each reporting period until the contingency was resolved.

John Formica, also a partner with PricewaterhouseCoopers, says FASB’s intended approach drew criticism because of the difficulty in valuing an uncertain outcome and because it likely would cause earnings volatility.

Formica

“This is not an area where the valuation community has a lot of experience, and there’s not a lot of objective evidence of how to value that,” he says. “People were concerned about valuation methodologies and about the volatility. Every time there’s a change in value, it would result in an adjustment that would go through to earnings.”

Given the conflict between FASB’s planned fair value approach and existing rules for accounting for contingencies, FASB decided to drop its plan to pursue mark-to-market accounting for contingencies—at least for now, says Chris Roberge, a FASB project manager who will oversee the new project on contingencies.

For purposes of proposed FAS 141R on business combinations, FASB plans to require that companies measure contingent liabilities both under FAS 5 and at fair value at the time of acquisition, then book the bigger number. For contingent assets, the same two yardsticks would be used, but companies would book the lower number.

That would result in a conservative approach, says Georgia Saemann, an accounting professor at the University of Wisconsin at Milwaukee. “It doesn’t mean you intentionally understate assets or overstate expenses,” she says. “It means if you’re not sure which way the wind is going to blow, you go with the answer that makes you look less good.”

Roberge says the decision to open a project on contingencies wasn’t based entirely on feedback to the business combinations proposal. “The Board has been receiving feedback on the guidance in FAS 5 for years, and the IASB is in the midst of trying to revise their guidance,” Roberge says. “The recognition criteria in FAS 5 results in delayed recognition of liabilities that relate to contingencies, and users of financial statements are concerned that disclosures being made by companies as they relate to contingencies are not timely.”

Roberge says FASB’s decision to step back from subsequent period valuation of contingencies for purposes of business combinations doesn’t signal a change of heart. “Some of the Board thought until we address what the guidance for all contingencies should be, it wouldn’t be time to make the leap to require subsequent measurement of these contingencies at fair value,” he explains. “It is our goal to try to address the concerns around disclosures as quickly as possible because investors are quite concerned that they don’t really receive robust and timely disclosure of contingencies.”

IASB Proposes Stop-Gap Hedge Rules

The International Accounting Standards Board has issued a proposed revision to its controversial standard on hedge accounting to clarify what can be designated as a hedged item and specify the risks that qualify for designation as hedged risks.

The proposed revision to International Accounting Standard No. 39, Financial Instruments: Recognition and Measurement, would clarify when an entity may designate a portion of the cash flows of a financial instrument as a hedged item. IASB said the proposal is intended to respond to requests for additional guidance on what qualifies as a hedge item under IAS 39. Meanwhile, IASB says it is working on a more comprehensive replacement of IAS 39, but that project is in its early stages.

Tom Rees, a director at FTI Consulting, says the guidance doesn’t advance the cause of convergence or try to make International Financial Reporting Standards and U.S. Generally Accepted Accounting Principles more alike. “It’s more of a stop-gap until they can do a more comprehensive revision of IAS 39,” Rees says. “It doesn’t really change anything, but it’s trying to clarify the requirements.”

The proposed guidance departs somewhat from the typical approach in international accounting standards to issue principles-based directives. “This proposal is specific and rule-based,” Rees says.

IAS 39 has been debated heavily in the European Union, where regulators adopted international standards for all companies listed on EU markets but established some exceptions under this particular accounting rule. The carve-outs focused on IAS 39’s provisions for hedge accounting and the fair value option.