Editor's Note: The following synopsis is based on a transcript of a program presented at the New York City Bar Association on January 28, 2011 regarding the controversial and high-profile issue of reporting on litigation contingencies in financial statements. The Editor relied entirely on the transcript for this editorial content.
Michael R. Young, Willkie Farr & Gallagher partner and former member of FASB's Financial Accounting Standards Advisory Council, and Wayne Carnall, Chief Accountant, SEC Division of Corporation Finance, addressed a group gathered at the New York City Bar Association.
The speakers addressed the subject of the FASB exposure drafts and SEC scrutiny of litigation contingency reporting.
Mr. Young opened his remarks with the background that ASC 450 (formerly FAS 5) involves two basic concepts. One is accrual. The other is disclosure. As a general matter, if a company believes that a loss from litigation is "probable" and the amount of the loss can be "reasonably estimated," the company is called upon to accrue for the loss. If those two criteria are not met, but the company nonetheless believes that a loss is still a "reasonable possibility," the company is called upon to disclose "the nature of the contingency" and "an estimate of the possible loss or range of loss" or to state that "such an estimate cannot be made."
For the last couple of years, FASB has been receiving criticism of this existing standard, principally from investors seeking earlier and better information regarding quantification of the risk of litigation loss that a company may be facing. Investors, primarily through the newly-formed Investors Technical Advisory Committee or "ITAC," have expressed dissatisfaction based on a perception that large settlements take them by surprise. FASB views investors as the customers for financial information, and seeks to be attentive and responsive to investor concerns.
A consequence was an exposure draft seeking to revise ASC 450 that appeared in June 2008. Upon its appearance, it immediately became a source of great controversy. The most significant controversy resulted from the exposure draft's requirement, under some circumstances, that a company provide its "best estimate of the maximum exposure to loss" and also its "qualitative assessment of the most likely outcome of the contingency." In other words, companies were called upon to predict whether they would lose a litigation, the amount of the anticipated loss, and then to publicly report that information in their financial statements.
An obvious problem was that such information would be available to everyone, including the plaintiffs in the litigation itself. Such information could be expected to immediately establish a floor in any settlement discussions. More than that, it might be viewed as self-created evidence that could be used against the company at trial.
Upon release of the exposure draft, representatives of the bar sought a meeting with representatives of FASB. That meeting ended up taking place in mid-June 2008. What became clear at the meeting was that, at root, the problem involved two completely commendable, but nonetheless conflicting, cultures. One was the culture of transparency in financial reporting. The other was the culture of our adversary system of justice, which is inconsistent with transparency. The fundamental problem was that those two cultures simply did not go together. The question for FASB was to reconcile the two in a way that both provided investors information about the risk while not prejudicing the company in the underlying litigation itself. To their credit, the FASB representatives immediately understood the problem with the exposure draft.
After the meeting, discussion between the bar representatives and FASB staff continued, ultimately culminating in "roundtable" discussions that took place in Norwalk in March 2009. Participating in the roundtable discussions, which were public, were representatives of various perspectives of the financial reporting community, including investors, companies, auditors, lawyers, rating agencies, the SEC, the PCAOB, the AICPA, as well as FASB and FASB staff.
One focus of the discussions involved whether there was a need to mandate predictions or whether investor objectives could be satisfied through more robust disclosure of historical information and the contentions at issue in the litigation. By the conclusion of the roundtable discussions, a broad consensus had been formed around the following principle: "Disclosures about litigation contingencies should focus on the contentions of the parties, rather than predictions about the future outcome."
Thereafter, in July 2010, FASB published a new exposure draft. Consistent with the consensus of the roundtable discussions, the exposure draft sought to focus less on predictive information and more on historical information and the contentions of the parties. However, one aspect of the exposure draft required companies to explicitly disclose "the amount accrued, if any." Since any such accrual would be based upon a belief that a loss was probable and that the amount could be reasonably estimated, the exposure draft to that extent perpetuated the problem of the previous exposure draft - such predictive disclosure could harm the company in the underlying litigation. It is this exposure draft that remains on the table. It is currently under discussion.
Three takeaways from the chronology of happenings at the FASB are:
1. The proposed changes are being driven by investor discontent. FASB regards investors as its customers for financial information and therefore tries to be responsive.
2. The main source of investor discontent is the perception of surprise that results from a settlement in the absence of earlier disclosure regarding quantification.
3. A laudable goal would be to seek to give investors some sense of the amount of money at stake in litigation. That obviously will not always be possible. But some level of quantification, where possible, could go a long way to addressing investor objectives.
Wayne Carnall observed that, basically, ASC 450 contemplates that contingencies will be analyzed in terms of three different buckets: (1) losses that are probable; (2) losses that are reasonably possible; or (3) losses that are remote. If a loss is probable and can be reasonably estimated, you accrue it. If you do not satisfy the requirements for accrual, ASC 450 nonetheless contemplates disclosure if a loss is still reasonably possible. Where disclosure is required, the standard calls for an estimate of the possible loss or range of loss or a statement that such an estimate cannot be made.
Litigation contingency reporting is a subject of renewed emphasis by the SEC staff. Some companies report pages and pages of disclosure with factual information. But there does not seem to be as much disclosure of quantified information about reasonably possible losses. The staff has therefore started asking a number of questions.
In particular, the staff has asked questions where it sees a settlement but doesn't see a disclosure about that issue in prior filings. What the staff has done in such instances is to go back and look at what the prior filings say. The staff has focused on whether the company has earlier said anything about the issue. The staff has focused in particular on what the company has earlier said about the reasonably possible loss.
Where companies have had a settlement for a fairly large amount, the staff has raised the question as to when an amount was first accrued. In that regard, there should be a defined event that triggers the loss. If the loss is going to be $200 million in two years, it's not appropriate to book $25 million a quarter. You have to look at the event that triggers a loss. Some have raised the concern, "Until you know exactly the amount that you should record - let's not record anything." That's not what the standard says.
A lot of the focus this past year has been on reasonably possible losses. There are situations where there has seemed to have been very little disclosure historically. The staff has had a number of conversations with companies about that. Some companies have said, "Well, I can't determine this number with confidence, with precision." And companies might try to suggest that the reason they cannot disclose a number or range of numbers is that they cannot determine the exact number. There is not a basis in the standard to require that degree of precision or confidence as justification for not providing the required information.
There have also been situations, ironically, where the SEC itself has been the source of the contingency. The SEC will be on the other side so the staff actually has inside information in that regard. In such instances, the staff may consider when the company started booking an accrual.
The standard does not get into the issue about whether you have to describe each estimate individually or whether you can describe them in the aggregate. The staff has not objected to companies providing estimates in the aggregate.
A company may make an assertion that any amount beyond what's been accrued is not material to the financial statements. That is a form of quantification. But a company may say that a loss is not material to the balance sheet, when it could well be material to the income statement or the statement of cash flows. That is not providing the quantification required by the standard.
The staff also expects companies to update their information as the litigation progresses and events change. As time goes on, the staff will become more skeptical of an inability to assert a reasonably possible loss.
In terms of the ABA treaty regarding lawyer interaction with auditors on litigation contingencies, the treaty is not part of the accounting codification. It is between two private organizations. The company has an obligation to comply with the federal securities laws and has an obligation to file financial statements that comply with GAAP. If a company has not provided disclosure that would be required by GAAP, the treaty would not be a defense. The company has an obligation to comply with GAAP. And the auditors have a requirement to audit such financial statements.
Companies would be well served to take a fresh look at disclosure in 2011, taking care to put information in context and seeking to make the disclosure as meaningful as possible.
Click Here for a complete transcript of the program.
Published April 3, 2011.
