Samsung's Failure to Warn of Legal Loss Raises Accounting Questions

The recent victory for Apple in its patent suit against Samsung netted the iPhone maker $1 billion and sent shock waves through the technology sector.

Yet despite accounting rules that require companies to keep investors informed of big potential litigation rulings and settlements, there was hardly a hint in accounting statements from either company about the possibility of a big payday for Apple or a payout for Samsung.

Under Generally Accepted Accounting Principles in the United States, Apple is required to keep the public apprised of litigation that is nearing resolution only if management has reason to believe the company may face a material loss. Since Apple was the pursuer of patent violation allegations in its case with Samsung, it wouldn't have been expected to report that it was facing a possible gain—even a big one—if it won the suit. Apple also was the target of Samsung, however, in a countersuit, but management apparently didn't believe it could lead to a loss that warranted disclosure to investors, since it didn't report any loss contingency estimates related to the countersuit.

Over the past several months, the Securities and Exchange Commission has increased its focus on accounting for loss contingencies, especially on rules that require companies to disclose progressively more information leading up to legal settlements or verdicts. The SEC stepped up its enforcement after the Financial Accounting Standards Board and the International Accounting Standards Board met considerable resistance to their efforts to upgrade their existing standards and decided to hold off on issuing new rules.

In Apple's most recent financial report for the quarter ended on June 30 (before winning its $1 billion patent verdict in a U.S. District Court in San Jose, Calif.), the company said it is subject to various legal proceedings and claims arising in the normal course of business. It listed three cases settled in the quarter that “did not individually or in the aggregate have a material impact,” but made no mention of the case with Samsung or the countersuit. Even if Apple had lost a $1 billion verdict to Samsung, would it have been material? Morgan Stanley Analyst Katy Huberty noted in press reports following the verdict: “The $1.05 billion in damages the jury awarded Apple is relatively insignificant compared to Apple's nearly $120 billion of cash and investments.”

Samsung, on the other hand, is listed on the Korea Stock Exchange and submits its financial statements under International Financial Reporting Standards as adopted in Korea. According to a recent analysis of differences between GAAP and IFRS performed by the SEC, companies reporting under IFRS have a lower disclosure threshold than companies reporting under GAAP. That means they are under more pressure to readily disclose when they might face a material loss in a lawsuit.

Both standards require companies to recognize a contingency, or a circumstance where a loss is possible but not yet determined, when it deems it as “probable” and reasonably estimable. Yet the word probable is defined differently under each standard. Under IFRS, “probable” means more likely than not to occur,” and in practice that's come to be understood as any probability greater than 50 percent, says Ellen Odoner, a partner with law firm Weil, Gotshal & Manges. Under GAAP, however, probable is defined as “likely to occur.” Says Odoner, “there's no one percentage, but many people think it's in the area of 70 percent to 75 percent.”

Management at Samsung evidently didn't believe it was probable or reasonably estimable they'd lose $1 billion in court to Apple over the patent dispute. In its most recent filing, covering the first half of 2012, Samsung made only a passing reference to the Apple lawsuit: “The company has been involved in various claims and proceedings during the normal course of business with numerous companies, including Apple Inc.” Samsung says the financial outcomes of the matters are uncertain, but management believes they will not have a material effect on the financial condition of the company.

“Litigation is the hardest contingency to report. At the end of the day, no one knows what a jury is going to do.”

—Nancy Reimer,

Shareholder,

LeClairRyan

Keith Peterka, a shareholder with audit firm Mayer Hoffman McCann and a former Big 4 auditor in Hong Kong and Europe, says he's not surprised Samsung would have little to say about a possible loss to Apple. “Culturally, I wouldn't have expected to see that disclosure,” he says. “It's different. Things are applied differently, interpreted differently. Unless you have a global body or a global regulator interpreting it the same, that's the real issue here.”

Comparability is one of the big concerns raised by the staff of the Securities and Exchange Commission in its reports to commissioners on the possible adoption of IFRS in the United States. In addition to pointing out lingering differences between GAAP and IFRS, SEC staff also have pointed out diversity in how IFRS is applied across countries and industries, leading to comparability problems even among companies that report under IFRS.

Heaped on top of the difference in accounting standards and how they are applied, disclosures related to unresolved litigation are inherently difficult for any company reporting under any standard, says Nancy Reimer, a litigation expert with law firm LeClairRyan. “Litigation is the hardest contingency to report,” she says. “At the end of the day, no one knows what a jury is going to do.” A company must assess not only what they expect the outcome to be, but also whether it will be material. “A billion dollars is a hell of a lot of money, but Samsung made 8 or 9 billion on the Galaxy phone,” she says. “Is that material? It's almost like playing with Monopoly dollars.”

CONTINGENCIES COMPARISON

The excerpt below from the SEC's staff paper comparing U.S. GAAP and IFRS explains how contingencies are treated under both standards:

IAS 37, Provisions, Contingent Liabilities and Contingent Assets, and ASC Topic 450, Contingencies, both require that loss contingencies are recorded when a future economic outflow is probable. However, the term “probable” is defined differently between the two standards. IAS 37 defines “probable” as “more likely than not to occur,” which we understand is widely understood to be anything more than 50 percent. ASC Topic 450 defines “probable” as “the future event or events are likely to occur,” which generally is interpreted to be a percentage somewhat greater than 50 percent.

If a loss contingency is to be recorded, the measurement requirements under IFRS and U.S. GAAP differ in some regards. Specifically, IFRS requires that the “best estimate” of the expenditure is recorded, while U.S. GAAP requires that “if some amount … appears … to be a better estimate than any other amount …, that amount shall be accrued.” Both IFRS and U.S. GAAP provide guidance for circumstances in which a range of possible outcomes exists. IAS 37 defines “best estimate” as “expected value,” which is the midpoint of the range for situations in which a continuous range of equally possible outcomes exist. In similar situations, U.S. GAAP requires that the minimum amount in the range is accrued when no amount within the range is a better estimate than any other amount. The approach required under U.S. GAAP is based on the fact that “even though the minimum amount in the range is not necessarily the amount of loss that will be ultimately determined, it is not likely that the ultimate loss will be less than the minimum amount.”

IFRS also contains requirements related to contingencies for which there are no explicit requirements under U.S. GAAP. For example, IFRS requires that liabilities are discounted at a pre-tax rate that encompasses risks specific to the liability; U.S. GAAP generally does not allow discounting. IFRS also has an explicit requirement to recognize a provision for an onerous contract. U.S. GAAP generally does not allow such provisions to be recognized—although the revenue and lease joint standard-setting projects may result in standards that require liabilities to be recorded for some onerous contracts. Further, IFRS contains more detailed disclosure requirements than U.S. GAAP.

Source: SEC.

Reimer says she often receives letters from auditors asking for status updates on unresolved litigation for financial reporting purposes. “I always use hedging language,” she says. “Nothing is certain out there. We use language like ‘more likely than not,' and it's gray. It drives people crazy. The courts haven't said what ‘more likely than not' means, but we know it means kinda in the middle.”

Other companies that are now facing Apple suits, like Google, might have to take the Samsung verdict into account when considering their own future disclosures, Reimer says. That might lend weight to the notion that a company facing a similar set of circumstances should brace itself for losses. “If you're a U.S. company [facing a similar patent lawsuit], you're probably going to have to disclose that there's the potential out there for a liability,” she says.

However, Reimer also points out that a Tokyo court recently sided with Samsung, not Apple, in a similar patent dispute in Japan. She says it raises all sorts of plausible reporting scenarios for companies facing similar concerns in the United States, Asia, and Europe, reporting under different sets of accounting rules. “This is what drives litigators crazy,” she says.

Angie Moss, a partner with audit firm Sanford, Baumeister & Frazier, says companies routinely resist predicting outcomes when it comes to litigation, regardless of what country they are in or what accounting standard they follow. “They really don't want to give the other side any more information than they have to,” she says. “Whatever is put into a report could potentially put you in a worse situation, particularly if you're the defendant. I can see why Samsung wouldn't want to disclose a range of possible losses.”