FASB Tries Again on Disclosure of Contingencies

Accounting rulemakers are poised to propose a new method for how companies disclose the possible cost of lawsuits—but rest easy, companies will have ample time to express their thoughts on the always controversial subject.

The Financial Accounting Standards Board is putting the finishing touches on its proposal, which would update Accounting Standards Codification Topic 450, Contingencies. Those contingencies could be any number of issues where a company might face some liability or gain in the future, but lawsuits have emerged as the most sensitive one: Investors want more advanced warning about their possible costs, while companies worry such disclosure might tip their hands to opposing litigants.

The current methods for accounting for contingencies have been around for decades; ASC 450 traces its roots to Financial Accounting Standard No. 5, Accounting for Contingencies, which was adopted in 1975. Investors have complained, however, that the current rules don’t give enough warning that a looming liability might be large, says Peter Bible, a partner at auditing firm Amper Politziner & Mattia. Aside from lawsuits, contingency bombshells also come in the form of environmental cleanup costs, warranty obligations, collection of receivables, and more.

Bible

“There were a lot of people saying—and arguably rightfully so—that in one quarter out of the blue there would be a massive litigation settlement,” Bible says. “There was no forewarning it was coming, and it would be material. People are asking, ‘How could that happen?’ We need a longer runway of disclosure regarding these things.”

FASB first tried to craft a new standard addressing that worry in June 2008, when it published a proposal that would have required companies to disclose contingencies with some broad predictions about the possible outcomes. It drew nearly 250 comment letters—a large number for typical FASB proposals—and almost all were negative. “To say it was not well received would be an understatement,” says Chuck Evans, a partner with Grant Thornton.

At the time, companies and audit firms alike said FASB’s approach would trample attorney-client privilege and compromise a company’s ability to defend itself by forcing it to disclose legal strategies or arguments. Lawyers railed that required disclosures, with ranges of possible dollar-figure outcomes, would be speculative at best and used by legal adversaries as benchmarks for extracting a settlement.

CONTINGENCIES DISCLOSURES

The following excerpt is based on FASB’s summary of decisions reached at its April 14, 2010, meeting and also incorporates and updates the tentative decisions reached at the August 19, 2009 meeting:

Disclosure Objective

An entity shall disclose qualitative and quantitative information about loss contingencies to enable financial statement users to understand their nature, potential timing, and potential magnitude.

Disclosure Principles

To achieve the above objective, an entity shall consider the following principles in determining disclosures that are appropriate for its individual facts and circumstances:

During early stages of a contingency’s life cycle, an entity shall disclose information (even though its availability may be limited) to help users understand the nature and potential magnitude of a loss contingency. In subsequent reporting periods, disclosure shall be more extensive as additional information becomes available.

An entity may aggregate disclosures about similar contingencies (for example, by class or type) so that the disclosures are understandable and not too detailed. If an entity provides disclosures on an aggregated basis, it shall disclose the basis for aggregation.

Disclosure Threshold

The Board decided to maintain the existing requirement to disclose asserted claims and assessments whose likelihood of loss is at least reasonably possible.

The Board also decided that disclosure of certain remote loss contingencies, due to their nature, potential timing, or potential magnitude, may be necessary to inform users about the entity’s vulnerability to a potential severe impact. An entity will need to exercise judgment in assessing its specific facts and circumstances to determine whether disclosure about remote contingencies is necessary. Factors that an entity may consider in making this determination include any of the following:

The potential effect on the entity’s operations

The cost to the entity for defending its contentions

The amount of efforts and resources management may have to devote to resolve the contingency.

The plaintiff’s amount of damages claimed, by itself, does not necessarily determine whether disclosure about a remote contingency is necessary although it could be one of the factors to be considered in this determination.

When assessing the materiality of loss contingencies to determine whether disclosure is required, the entity shall not consider the possibility of recoveries from insurance or other indemnification arrangements.

Qualitative Disclosures

For all contingencies that meet the disclosure threshold, disclose the following:

Qualitative information to enable users to understand the nature and risks of a contingency or group of contingencies.

During early stages of asserted litigation contingencies, disclosure shall include, at a minimum, the contentions of the parties (for example, the basis for the claim and the amount of damages claimed by the plaintiff and the basis for the entity’s defense or a statement that the entity has not yet formulated its defense). In subsequent reporting periods, disclosure shall be more extensive as additional information becomes available, for example, as the litigation progresses toward resolution and/or if the likelihood and magnitude of loss increase. Furthermore, if practicable, an entity shall disclose the anticipated timing of, or the next steps in, the resolution of individually material asserted litigation contingencies.

For individually material contingencies, the disclosure shall be sufficiently detailed to enable financial statement users to obtain additional information from publicly available sources such as court records. For example, an entity shall disclose the name of the court or agency in which the proceedings are pending, the date instituted, the principal parties thereto, a description of the factual basis alleged to underlie the proceeding, and its current status.

When disclosure is provided on an aggregated basis, an entity shall disclose the basis for aggregation and information that would enable financial statement users to understand the nature, potential timing, and potential magnitude of loss.

Quantitative Disclosures

For all contingencies that are at least reasonably possible, disclose the following:

Publicly available quantitative information, for example, in case of litigation contingencies, the amount claimed by the plaintiff or the amount of damages indicated by the testimony of expert witnesses

An estimate of the possible loss or range of loss and the amount accrued, if any

If the possible loss or range of loss cannot be estimated, a statement that an estimate cannot be made and the reason(s) therefore

Other non-privileged information that would be relevant to financial statement users to enable them to understand and/or assess the possible loss

Information about possible recoveries from insurance and other sources only if, and to the extent that it has been provided to the plaintiff(s) in a litigation contingency, it is discoverable either by the plaintiff or by a regulatory agency, or it relates to a recognized receivable for such recoveries. If the insurance company has either denied or contested the entity’s claim for recovery, the entity shall disclose that fact.

Source

Summary of FASB’s Latest Decisions (April 14, 2010)

Investors, on the other hand, generally loved the idea; they called for even more disclosure of the most remote loss contingencies that could have a severe effect on the company. FASB went back to the drawing board.

Evans

Now FASB plans to issue an exposure draft of a new proposal in May. This one generally steers clear of predictive disclosures, but does require more disclosure of more remote contingencies, Evans says. He described the new model as “more factual, trying to deal with pure facts as opposed to predictions.”

Companies would start by disclosing whatever limited information they may have even on an early-stage contingency, and then provide more detail in subsequent periods as it becomes available. They would also be allowed to make generalized disclosures about aggregated or grouped contingencies—say, after a product recall spawns a flock of lawsuits in many jurisdictions, or a business discovers a subsidiary polluted many locations—as long as the company explains its logic for grouping them.

One key difference between the proposed standard and current practice is that companies would need to say more about contingencies they consider remote, if those contingencies have the potential for some meaningful effect on company operations. “That part will probably still be controversial,” Evans says. “There are still a lot of people who don’t believe remote contingencies should be disclosed.”

The new proposal also tilts disclosure more in favor of publicly available information, he says, which should help allay concerns over attorney-client privilege and exposing legal strategy.

Rogers

Greg Rogers, an environmental lawyer with the law firm Guida, Slavich & Flores, says the new proposal more closely reflects a long-standing agreement between the legal and audit professions regarding what information auditors can see to back up assertions in financial statements. The American Bar Association and the American Institute of Certified Public Accountants inked that policy statement in the mid-1970s, but FASB’s original proposal seemed to set it aside, he says.

“The heart of the issue is whether the Big 4 can audit this or not,” Rogers says. If attorneys won’t provide evidence for the sort of predictive disclosures FASB originally demanded, auditors can’t give a sound opinion on those disclosures. “That was an oversight in the whole standard development process,” he says.

The new standard’s disclosures would not rely on legal analysis that might be protected by attorney-client privilege, Rogers says: “Auditors don’t have to look to lawyers to verify publicly available information.”

Scanlon

Still, there’s likely to be some grumbling about the new standard, warns Michael Scanlon, a partner at law firm Gibson, Dunn & Crutcher. He says companies and their legal counsel might not be thrilled with some of the qualitative disclosures, because “it really does come very close to disclosure of litigation strategies … particularly around potential settlements,” he said.

Scanlon says companies would be wise to watch for the exposure draft and have their legal departments give it attention. FASB is targeting May for publishing the exposure draft to issue, so the standard can be finished in time to take effect with the 2011 reporting year for calendar-year companies.