FASB Puts Tougher Contingency Accounting on Hold

The Financial Accounting Standards Board, faced with strong criticism of its plans to change how companies report cash reserves set aside for loss contingencies, has decided to come up with a contingency plan of its own.

The board has postponed implementation of its proposed changes for contingency losses at least until after next spring’s annual reporting season, the latest in a series of delays over the last three years. Some are hoping this extension might last long enough to head off changes completely, by demonstrating that the existing rules are working just fine.

Contingencies are potential future financial gains or obligations—lawsuits, environmental liabilities, or similar events—where a company can’t pin a precise outcome or exact dollar figure on them by the financial reporting date, but must still prepare investors for the possibility. FASB says investors complain that too often they are blindsided by big legal settlements with no forewarning. Accounting Standards Codification 450, Contingencies, requires companies to disclose a possible loss and set up a reserve for it if the company considers the loss probable and if it can be reasonably estimated.

Corporate lawyers, not surprisingly, hate the idea of disclosing possible dollar values for legal settlements—and that has been the crux of FASB’s struggles with contingencies since 2008. It first proposed a new accounting standard that year to lower the bar on disclosure requirements substantially, and ultimately withdrew its plans after they were roundly panned. Critics claimed it would violate attorney-client privilege and force companies to reveal their legal strategies to adversaries.

FASB put forth a second version last July, with an eye to implementing the new standard in time for 2010 annual reports. Again the board received a flood of comments, most of them saying the disclosure could still let plaintiff lawyers decipher how much money they could wring out of a lawsuit. Critics also called on FASB to make its case more clearly for why the rules need to be changed in the first place.

Commenters also cried foul that FASB allowed only 30 days to comment at a time when a number of major new standards were being proposed, which prompted the board to grant another 30 days to the comment process. Finally, FASB acknowledged recently that the proposed rule still requires enough reworking that it won’t be ready in time for 2010 year-end reporting.

Malionek

The deferral is not a wholesale retreat, however, and does not mean that companies should put aside all plans they may be developing to beef up contingency reporting in response to the new rule, says Robert Malionek of the law firm Latham & Watkins. In fact, he says, now may be the perfect time for a close examination of contingencies and to be as forthright as possible.

“When the economic conditions are down and people are losing money, they’re looking for someone to blame.”

—Bridgette Hodges,

Partner,

Grant Thornton

“The pressure is still on companies to make sure they are providing appropriate disclosures. And now more than ever to demonstrate that the current rules ain’t broke,” he says. “If the disclosures are robust and appropriate now, there is less need for FASB to change the regime.”

The SEC Is Watching

While FASB might have put tougher contingency accounting measures on hold, the Securities and Exchange Commission is keeping up its own pressure for companies to make appropriate disclosures regarding contingencies. At a September meeting of the SEC Regulations Committee of the Center for Audit Quality, Wayne Carnall, chief accountant for the Division of Corporation Finance, told committee members that the SEC staff is keenly focused on whether companies are adequately complying with the current rules.

Carnall

Carnall said the staff is looking closely at whether companies disclose the amount or range of reasonably possible losses that exceed what they’ve already reserved. He said the staff also notices when a company announces a material settlement and looks back at prior period reports to see if it was properly disclosed in advance.

John Formica, a partner with PwC, says the SEC has been issuing comment letters to companies regarding their compliance with existing requirements, especially but not exclusively to companies in the financial services sector. The SEC also mentioned contingency disclosures in a recent open letter to all CFOs warning them to be sure they adequately disclose any risks they may face related to ongoing problems with mortgages and foreclosures.

Formica

PWC POINT OF VIEW

The following excerpt was taking from the PwC Point of View Newsletter on disclosure of loss contingencies:

Highlights

1. The U.S. legal system provides certain protections to lawsuit defendants. The additional disclosures being proposed must be balanced against possible prejudicial impacts that could unfairly and adversely affect a company and its investors.

2. Addressing these concerns before finalizing a new standard may take significant time and effort. Even if prejudicial and other concerns can be addressed, we believe any improvement in reporting over the current standard would be marginal.

3. Given the already challenging standard-setting agenda, further work on this proposal should be deferred, pending completion of more important new standards. Does the proposal strike the right balance?

Accounting standard setters are, at times, faced with determining an appropriate balance between transparency for investors and respecting a company’s legal rights and proprietary strategies. This proposal is a prime example of the importance of that objective.

Preparers and members of the legal community have voiced concerns that the proposed disclosures could adversely affect the outcome of litigation against a company. Examples cited include disclosure of amounts accrued for potential losses and descriptions of why those amounts increased or decreased. Such disclosures could provide plaintiffs with insight into management’s thinking about litigation.

Another element of balance that is needed is appropriate communications between attorneys and auditors. These communications are designed to provide auditors with information supporting contingency accruals and disclosures without compromising attorney-client privilege or other legal protections. The proposal may require a reassessment of previous, carefully-constructed agreements between the legal and accounting professions before the proposal is finalized.

Aside from the prejudiced concerns expressed, we have other concerns with the proposal, such as the requirement to disclose certain remote contingencies. By definition, matters that are remote are unlikelly to occur. We question whether disclosures of remote contingencies are relevant to financial statement users and whether such disclosures would make the analysis of a company’s potential losses cumbersome.

Source

PwC Newsletter on Loss Contingencies (2010).

“The existing standard is not particularly prescriptive, but it does require companies to disclose an estimate of the possible loss or a range of loss, if known and if it’s reasonably possible the loss would occur,” he says. “That’s where the SEC has placed a lot of focus. If you can’t determine the possible range of loss, you must indicate that you’re unable to determine the range.”

The SEC has long paid attention to compliance with existing contingency requirements, but the focus has been heightened in recent years at least partly because of the financial crisis and general economic conditions, says Bridgette Hodges, a partner with Grant Thornton. “The SEC is looking at situations where at the end of a reporting period there is a huge settlement of some loss contingency, but historically, either nothing was accrued or nothing was disclosed,” she says. “And they are asking, ‘How can that be?’”

Hodges

Hodges says the SEC is scrutinizing the analysis behind the disclosures. “How was it determined that it wasn’t reasonably possible there would be a material loss?” she says. “Once there’s a settlement, they want to bridge that gap between the period you settled and the period there was an unasserted claim.”

In the current economic environment, the conditions are ripe for an increase in legal claims that might give rise to contingencies, Hodges says. “When the economic conditions are down and people are losing money, they’re looking for someone to blame,” she adds.

Richard Stuart, a partner with McGladrey & Pullen, says the SEC has always had some concern around the tension between investors’ demand for information about potential losses and companies’ concerns about disclosing privileged information. He says FASB still has a lot to address in reconciling those concerns with a workable standard.