The Financial Accounting Standards Board (FASB) has once again waded into the sensitive subject of disclosure of loss contingencies by proposing new standards for required disclosures of possible losses and liabilities (the 2010 Exposure Draft). The Exposure Draft, Proposed Accounting Standards Update, Contingencies (Topic 450), Disclosure of Certain Loss Contingencies, is available at http://tinyurl.com/FAS450. As we discussed in an earlier memorandum (available at http://tinyurl.com/DBR-LossContingencies), the longstanding accounting guidance for loss contingencies, ASC 450-20 (formerly FAS 5), has been challenged by investor groups and others as requiring disclosure about potential liabilities that is often inadequate. FASB’s previous attempt in 2008 to expand disclosure elicited controversy and significant resistance from commenters. In general, the 2008 Exposure Draft was broadly criticized for requiring disclosure that relied on information that may not be readily available or reliable, was irreconcilable with the litigious U.S. legal environment and constituted an assault on the attorney-client privilege. As a result, FASB conducted extensive re-deliberations before releasing the 2010 Exposure Draft, which it has indicated was designed to address both investor needs for information and the practical concerns raised about the 2008 Exposure Draft.
The proposed amendments do not have a direct balance sheet impact, but would both expand the types of loss contingencies required to be disclosed and mandate the disclosure of specific quantitative and qualitative information about loss contingencies. FASB solicited comments to the 2010 Exposure Draft and extended the due date for comments from August 20 to September 20, 2010. If adopted in its current form, the disclosure requirements would be applicable to public companies for fiscal years ending on or after December 15, 2010, and to private companies for fiscal years beginning on or after December 15, 2011.
Current Requirements under ASC 450 (Contingencies)
Currently, ASC 450 requires that a company book a loss contingency on its balance sheet if both the probability of the contingency occurring is “probable” (likely to occur) and the loss is reasonably estimable. If, however, the loss contingency does not meet both of these conditions, but is “reasonably possible” (meaning more than remote but less than likely), the company does not book the loss, but must disclose the loss contingency in the footnotes to the financial statements. The footnote disclosure must include the nature of the contingency and an estimate of the possible loss, or a statement that an estimate cannot be made. No footnote disclosure is required if the probability of loss is “remote” (slight).
Under current standards, when public companies disclose information about litigation loss contingencies that are not required to be reserved for on the balance sheet, they usually do not disclose an estimate of their loss exposure, and they often limit the discussion of material litigation to basic facts, procedural history and status. FASB has said that its objective for the 2010 Exposure Draft is to provide users of financial statements with information that helps them assess various possible outcomes of a loss contingency before it is settled. Furthermore, FASB has stated that it has been motivated by investor concerns that disclosures under the current guidance do not provide adequate and timely information to assist users in assessing the likelihood, timing and magnitude of future cash outflows associated with contingencies.
2010 Exposure Draft – Proposed Amendments to ASC 450
The 2010 Exposure Draft would not change the standard for recording a liability in connection with a loss contingency and, for the most part, would retain a similar disclosure threshold. A company must disclose information about a contingency if there is at least a reasonable possibility (more than a remote possibility) that a loss may be incurred, regardless of whether the company has accrued a reserve for the loss. FASB would also retain the current standard for unasserted claims. Generally, a company is not required to disclose a loss contingency involving an unasserted claim if there has been no manifestation by a potential claimant of an awareness of a potential claim, but disclosure is required if it is both probable that a claim will be asserted and there is a reasonable possibility that the outcome will be unfavorable.
The Exposure Draft would, however, expand required disclosures to include even remote loss contingencies that “due to their nature, potential magnitude or potential timing” could have a “severe impact.” FASB defines “severe impact” as a significant financially disruptive effect on the normal functioning of a company. It intends that this would be a higher threshold than “material” but would include matters that are less than catastrophic. Though some events are material to an investor because they affect the company’s stock price, a change in the stock price alone, without a corresponding impact on the company itself, would not necessitate disclosure under this standard. A company would not be permitted to consider the availability of insurance or other indemnification arrangements when assessing the materiality of a loss contingency, which many commenters expect to lead to an increase in the number of contingencies companies are required to disclose.
Quantitative and Qualitative Information Requiring Disclosure
When the standards of the 2010 Exposure Draft require disclosure of a contingency, a company must disclose information in the notes to the financial statements sufficient to enable readers to understand the nature of the loss contingency, its potential magnitude and, if known, its potential timing. The 2008 Exposure Draft was criticized because it called for management to predict the outcome of a disclosure contingency, so in the 2010 Exposure Draft, FASB attempted to address this issue by instead requiring enhanced disclosure of the known facts and the contentions of the parties. For example, in the early stages of litigation, the company must disclose, at a minimum, the contentions of the parties, including the basis of the plaintiff’s claim, the damages claimed by the plaintiff and the basis for the company’s defense or a statement that it has not yet formulated its defense. As the matter progresses and the information becomes available, the company would be required to disclose publicly available quantitative information, such as the amount of damages indicated by expert witness testimony and, for individually material contingencies, sufficiently detailed information to enable the reader to obtain additional information from publicly available sources such as court records. If the possible loss or range of losses can be estimated, disclosure of the estimate would be required, and if it cannot be estimated, the company would be required not only to state that it cannot be estimated but also the reasons it cannot be estimated. If known, the company would be required to disclose the anticipated timing of the resolution of the contingency or other next steps.
The 2010 Exposure Draft would also require the disclosure of other nonprivileged information that would be “relevant” to understanding the “potential magnitude of the possible loss.” Information about possible recoveries from insurance and other sources must be disclosed if discoverable by the litigation plaintiff or by a regulatory agency, or if the recovery is related to a recognized receivable. A company would further be required to disclose if an insurer has denied, contested or reserved its rights related to the company’s claim for recovery.
Public (though not private) companies would also be required, during each financial reporting period, to provide a table that reconciles the carrying amounts of accruals for loss contingencies as of the beginning and end of the period, the amount accrued for new loss contingencies during the period, changes in the estimates for prior period loss contingencies and decreases for payments or other forms of settlement. The tabular disclosure could be presented on an aggregated basis for loss contingencies of the same class or type. In deciding how to aggregate the accruals, the company would be required to exercise judgment to strike a balance between obscuring important information and overburdening financial statement users with excessive detail.
No Exemption for Prejudicial Information
The 2008 Exposure Draft included a limited exemption from disclosure of information that may be prejudicial to the company, but the 2010 Exposure Draft does not include such an exemption. FASB has specifically, through the public comment process, requested that interested parties provide feedback as to whether a prejudicial information exemption is necessary, but noted that it did not include an exemption in its proposal because it believed that it had eliminated the need for such an exemption by changing the disclosure requirements to focus on publicly available and discoverable information.
Concerns with Proposed Amendments
FASB has demonstrated a commitment to change the loss contingency disclosure requirements in its effort to help users of financial statements make more informed assessments about the possible outcomes of loss contingencies and has made an obvious effort to address and resolve many of the serious concerns expressed about its 2008 Exposure Draft. Nevertheless, the 2010 Exposure Draft has raised renewed concerns about its potentially prejudicial impact, waivers of privilege and the usefulness of the information disclosed.
The expanded disclosure requirements may have been motivated by a desire for transparency, but the consequences of that disclosure demonstrate a significant conflict with a company’s interest as a party to a dispute. By requiring detailed disclosure about a dispute, including anticipated timing of developments and a tabular reconciliation of changes in accruals from period to period, the 2010 Exposure Draft could force a company to provide a roadmap of its litigation strategy to the benefit of the company’s adversaries. Disclosure of specific quantitative information, such as amounts accrued, estimates of loss and potential insurance recoveries, is widely expected to set a floor for plaintiffs in settlement negotiations. It may additionally encourage plaintiffs to press claims with very limited merit, particularly if companies become required to disclose loss contingencies that are considered “remote,” both because companies may feel pressure to settle cases before being required to disclose them and because the amounts disclosed may encourage other plaintiffs to assert similar claims.
Motivated by concerns about the prejudicial impact of disclosure of individual contingencies, FASB would allow companies to present quantitative information about accruals on an aggregated basis. Aggregation will be of limited value in mitigating the potential prejudice for many companies, however. For instance, a company may have only a few significant litigation matters, may not have a sufficient basis for aggregating multiple claims, or may have one or a few large claims that dominate the others. In these cases, quantitative disclosure could reveal information about individual accruals, which may be most useful to the company’s adversary, whereas the shareholders may be more interested in the overall impact of all loss contingencies and accruals on the company’s financial results.
In response to earlier criticisms that the 2008 Exposure Draft would require the disclosure of information that was not readily available and may be speculative and unreliable, FASB’s approach in the 2010 Exposure Draft is to require disclosure of known facts and information that are otherwise publicly available. As currently drafted, however, disclosure of “discoverable” insurance coverage or indemnification agreements would be required. In addition to setting a floor for settlement negotiations, disclosing potential sources of recovery in the financial statement footnotes may provide a company’s adversary with access to this information earlier in the process than it would otherwise be obtained or require public disclosure of information that might otherwise only be discoverable in court subject to strict confidentiality restrictions. As a result, disclosure would provide an advantage to plaintiffs to the prejudice of defendants, which may encourage plaintiffs to file lawsuits with the goal of recovering insurance proceeds and could also increase the cost of insurance coverage.
As currently drafted, the lack of any exemption from disclosing information that would be prejudicial to a company makes these concerns all the more troubling.
Potential Waivers of Privilege
Companies generally look to their lawyers to help draft disclosures relating to pending or threatened litigation contingencies, including the factors likely to affect the outcome of the contingency and the assessment of the most likely outcome. The information and analysis needed to prepare this disclosure is generally kept confidential and is subject to attorney-client privilege or work-product privilege. In light of this, the American Bar Association (ABA) and the American Institute of CPAs (AICPA) have agreed to The ABA Statement of Policy Regulating Lawyers’ Responses to Auditors’ Requests for Information. This “treaty” addresses the information lawyers can share with their clients’ auditors without waiving the privilege. The 2010 Exposure Draft would require more extensive disclosure, for which auditors would typically turn to the company’s lawyer for corroboration and an assessment of the need for disclosure, such as whether certain remote contingencies meet the disclosure threshold, whether relevant information is or is not privileged, and whether insurance recoveries are “discoverable.” This type of information is beyond the scope of the treaty because it requires more than facts and procedural status about a matter and instead calls for legal determinations and a legal evaluation of the case. Requiring this disclosure will increase the tension between the need to maintain the confidentiality of information so as not to waive privilege and the need to provide sufficient audit evidence and may chill open communication between lawyers and clients.
In the 2010 Exposure Draft, FASB stated that it will continue to work with the ABA, the AICPA and the Public Company Accounting Oversight Board to identify and address the potential implications of the new disclosure standards on the treaty. On the other hand, FASB has not indicated that it is willing to delay effectiveness of the amendments until agreement is reached on modified guidelines.
Usefulness of Quantitative Disclosure
The 2010 Exposure Draft would also require the disclosure of certain information that many believe will be of limited usefulness to investors. For example, the amount of a plaintiff’s claim or the amount of damages supported by expert testimony (of one or more parties) may bear limited relation to a company’s actual loss exposure. Additionally, certain disclosure items, such as an estimate of loss, are inherently uncertain and rely on complex judgments. Other new requirements may lead to inconsistent disclosure approaches. For example, discovery standards vary across jurisdictions, so discoverable information that is required to be disclosed will vary from company to company and may even vary among different matters for the same company. As a result of the increased and potentially confusing disclosure requirements, companies may also feel pressure to expand their disclosure, for example, to discredit expert testimony or to explain why the amount claimed by the plaintiff is not an appropriate reflection of an expected loss. It is also expected that companies will include extensive caveats and other disclosure to explain the uncertainties of their estimates. Not only will this involve presenting legal analysis and insight into the cases, it may lead to lengthy disclosure of detail that requires the reader to spend more time attempting to discern what contingencies are more likely to occur and what the impact is expected to be.
FASB proposed the amendments to ASC 450 (formerly FAS 5) to address concerns from investors that the current disclosure regime is not sufficient. It has dedicated significant time and resources to addressing concerns raised about its 2008 Exposure Draft. Its revised proposal, however, continues to raise significant concerns about the prejudicial impact of disclosure to the disclosing company, waivers of attorney-client and work-product privilege and the actual usefulness of the information it will require to be disclosed. FASB has indicated a willingness to consider the insight and feedback of commenters, including by extending the public comment period from August 20 to September 20, 2010, but it is clear that FASB sees a need to expand the disclosure requirements.
FASB received well over 200 comment letters to the 2010 Exposure Draft, many expressing concerns similar to those raised about the 2008 Exposure Draft. Many commenters to the 2010 Exposure Draft have also voiced a concern that a December 2010 effective date is much too soon, and given the extension of the comment period, it is possible that FASB will postpone the effective date. While FASB is expected to consider those comments, the commitment it has demonstrated to revising the loss contingency disclosure requirements strongly suggests that it will amend the requirements in some manner, and it may do so soon. Companies should start assessing what changes may be needed to their disclosure controls and procedures to address the new disclosure standards and begin to gather the information.