In an effort to enhance company disclosures with more information for the investing public, the Financial Accounting Standards Board (FASB) is in the process of updating Accounting Standards Codification Topic 450 (ASC 450) with respect to disclosure requirements of certain loss contingencies.
On June 5, 2008 FASB issued an Initial Exposure Draft1 regarding disclosure of certain loss contingencies. After soliciting comments, the FASB decided not to adopt that proposal. Instead, it updated its proposal by eliminating certain disclosure requirements and exemptions and, on July 10, 2010, issued an update,2 again inviting public comment. The public comment period closed on September 20, 2010 with more than 246 letters including one from the Association of Corporate Counsel signed by more than 150 legal officers.3 After considering comment letters received on the July update, the FASB decided to redeliberate and make changes as appropriate. If adopted, the July update will not be effective for the 2010 calendar year-end reporting period. The FASB will decide on an effective date at a future meeting, currently expected in the second half of 2011.
While the July 2010 update responds to many concerns regarding disclosure requirements in the earlier proposal, critical issues remain. By forcing companies to reveal historically protected information about their potential liability, legal strategies and insurance coverage, the proposed disclosure requirements carry with them the potential for unintended negative consequences including to the very disclosure process that the FASB seeks to improve.
The Current ASC 450 Disclosure Requirement
Currently ASC 450 requires companies to assess the degree of probability of an unfavorable outcome before reporting a loss contingency. ASC 450 classifies the range of possible losses as “probable,” “reasonably possible” or “remote” and requires a company to report a loss contingency when the loss is probable (event likely to occur) or reasonably possible (chance of event less than probable but more than remote). Companies are required to disclose the nature of the contingency and give an estimate of the possible loss or range of loss or state that such an estimate cannot be made. Under the current ASC 450 standard, a loss is accrued when such loss is probable and the amount of loss can be reasonably estimated.
In accordance with the existing ASC 450 standard, companies normally disclose the nature of their loss contingencies and their general position concerning the matter in question, but often do not provide estimates of their loss exposures because of the complexities in ascertaining a specific loss figure.
The Proposed Disclosure Requirements (July 10, 2010)
Consistent with ASC 450’s existing standards, the proposed disclosure requirements would continue to require companies to report all probable or reasonably possible losses. However, under the proposal, even a remote loss contingency must be disclosed if it could have a “potential severe impact,” defined as one that has a “significant financially disruptive effect on the normal functioning of an entity.” In determining whether loss contingencies due to pending and threatened litigation must be disclosed, it is recommended that a company consider the potential impact of the litigation on operations, cost of defense, and the amount of effort and resources management may have to devote to resolve the loss contingency; possible recoveries from insurance or indemnification arrangements should not be considered.
In addition to broadening the types of contingencies that must be disclosed, the July update expands the scope and detail of the required disclosures whether or not there has been an accrual, proposing the required disclosures described below.
A company must disclose “[q]ualitative information to enable users to understand the loss contingency’s nature and risks.” During the early stages of litigation, this information would include the contentions of the parties (for example, the allegations forming the claim and the amount of damages sought by the plaintiff, and the asserted bases for the company’s defense or a statement that the company has not yet formulated its defense). In subsequent reporting periods, the qualitative disclosure would be more extensive, including such matters as the anticipated timing of, or the next steps in, the contingency’s resolution, if known.
Companies would be allowed to aggregate disclosures about “similar” contingencies provided the basis for aggregation is also disclosed. To determine what contingencies are sufficiently similar to be included in one class, a company should evaluate the nature, terms and characteristics of the disclosures (including jurisdiction, individual versus class-action litigations and the specific type of litigation).
To the extent aggregate disclosures are not possible, individually material contingencies would require the disclosure of the following qualitative information:
- The name of the court or agency in which the proceedings are pending;
- The date instituted;
- The principal parties to the proceedings;
- A description of the factual basis alleged to underlie the proceedings; and
- The current status of the litigation contingency.4
A company must disclose the following quantitative information for all loss contingencies that are at least reasonably possible:
- Publicly available quantitative information. For example, in the case of litigation contingencies, the amount claimed by the plaintiff or the amount of damages indicated by the testimony of expert witnesses.
- If it can be estimated, 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) why.
- Other nonprivileged information that would be relevant to financial statement users to enable them to understand the potential magnitude of 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 by either the plaintiff or a regulatory agency, or it relates to a recognized receivable for such recoveries. If the insurance company has denied, contested, or reserved its rights related to the entity’s claim for recovery, an entity shall disclose the fact.5
For remote contingencies that could have a potential severe impact, the same quantitative information must be disclosed except companies are not required to report estimated possible losses and the amount accrued or a statement explaining why an estimate cannot be provided.
For all accrued loss contingencies, the July update proposes that financial statements include a tabular reconciliation of the total amount recognized for the contingencies at the beginning and end of the reporting period. The tabular reconciliation must include:
- Carrying amounts of accruals at the beginning and end of the period;
- Amount accrued during the period for new loss contingencies recognized;
- Increases for changes in estimates for loss contingencies recognized in prior periods;
- Decreases for changes in estimates for loss contingencies recognized in prior periods; and
- Decreases for cash payments or other forms of settlements during the period.6
Effect and Unintended Consequences of the Proposed Disclosure Requirements
With its July update, FASB sought to improve disclosure of certain loss contingencies to provide users of financial reports with more useful and timely information that would assist with assessing the nature, likelihood, timing and magnitude of future cash outflows associated with loss contingencies. Instead, this update now includes provisions that may harm the very process it seeks to improve due to various unintended consequences of its proposed amendments. Some of the noteworthy consequences with respect to litigation contingencies, as identified during the comment period, are described below.
Concerns for Preserving Attorney-Client Privilege and Work-Product Protection
Determining accrual amounts and the information relevant to financial statements is based largely on the advice and analyses of counsel. The new disclosure requirements would potentially chill communications between companies and their counsel as companies might elect to refrain from sharing information because of the risk of disclosure. Disclosures about accruals may therefore become more limited and less reliable by failing to include counsel’s full analyses of risks and exposures.
The new disclosure requirements may also affect the relationship between the legal and accounting professions. Currently, to protect clients against the waiver of attorney-client privilege in communications by the company’s counsel to outside auditors regarding litigation and claims, certain guidelines exist as to what information counsel may provide and the auditor may expect. The new disclosure requirements add information not covered by the guidelines governing counsel’s disclosures to auditors, leaving open the question of whether this expanded information could increase the risk that such communications would effect a waiver of attorney-client privilege or work-product protection. This could result in companies electing to refrain from responding to auditors or responding in a more limited manner.
Disclosure About Accrual Amounts Would Prejudice a Company’s Legal Position
Without a doubt, the new disclosure requirements, which demand predictive disclosures, average settlement amounts, litigation loss contingency accruals, recovery source information and updated tabular reconciliations every period, would tip the scale in favor of opposing parties. This result is inevitable, largely because the July update does not provide that accrual amounts need only be reported if necessary to avoid misleading investors (which exists under the current standard) and eliminates the explicit exemption for the disclosure of prejudicial information (included in the June 2008 proposal).
The risks are many. For example, once a company has disclosed the specific amount accrued for a litigation contingency, that disclosure may effectively establish the floor in any settlement discussions because the company’s self-evaluation would be made public. Likewise, ongoing adjustments to tabular reconciliations provide plaintiffs’ counsel with a window into the company’s evolving position on a litigation contingency, potentially making it more difficult to settle a case. Furthermore, disclosure of particularly large loss contingency accruals, insurance coverage or other recovery sources could encourage other potential plaintiffs or counsel to file a claim, unnecessarily exposing a company to additional litigation.
Forcing Speculative and Inaccurate Disclosures
The new disclosure requirements expand the information that must be reported for probable and reasonably possible, and even remote, loss contingencies. Because probable and reasonably possible do not mean “certain,” requiring such expanded qualitative and quantitative information may effectively render a company’s financial disclosures misleading by including premature estimates. Likewise, requiring a company to report on “remote loss contingencies with a potentially severe impact,” without allowing any consideration for likelihood of success, will force a company to report speculative disclosures that will cause confusion instead of providing useful information to financial statement users. Furthermore, in disclosing estimated amounts, the proposal requires disclosure of the amount claimed by the plaintiff or the amount of damages indicated by the testimony of expert witnesses – even before Daubert and similarly authorized challenges to the reliability of such expert testimony have been addressed. Accordingly, the resulting disclosures may be misleading as plaintiffs often inflate the amount of damages sought in their claim (if only to add some bulk to any eventual settlement), and expert testimony is often one-sided and subject to legitimate challenges to limitation or exclusion.
If the July update is adopted companies will no doubt struggle to find a balance between disclosing sufficient information and preserving attorney-client privilege and work-product protections. Because this effort, under the new terms, will have new challenges, companies may make disclosures based on limited information replete with disclaimers and unintentionally expose themselves to liability by disclosing loss contingency amounts later perceived to be erroneous with the benefit of hindsight. Such a result does not further the FASB’s goals of assisting financial statement users.