Public companies often struggle with their disclosures about contingent liabilities -- possible losses that may or may not occur, and which, for that reason, may be quite difficult to quantify. However, the SEC and the accounting profession have both focused on these types of potential liabilities, for even a small risk of a significant loss may be extremely important to investors. The long-standing accounting guidance for loss contingencies, FASB Statement No. 5 (FAS 5), has been challenged by investor groups and others as driving inadequate disclosures. Recently, the Financial Accounting Standards Board (FASB) sought to revise FAS 5 to expand disclosures. This effort, Proposed Statement of Financial Accounting Standards, Disclosure of Certain Loss Contingencies an amendment of FASB Statements No. 5 and 141(R) (the Exposure Draft), which has been extremely controversial, would have replaced the FAS 5 disclosure requirements and also addressed disclosure applicable to loss contingencies recognized in a business combination under FASB Statement 141(R). The Exposure Draft, however, was met with great resistance that has led the FASB to reconsider its approach.
FASB proposed the amendments to address concerns from investors and others that disclosure under the existing guidance did not provide adequate information for them to assess the likelihood, timing and amount of future cash flows associated with loss contingencies. The proposed amendments did not have a direct balance sheet impact but would have increased disclosure requirements substantially. The amendments would have both expanded the population of loss contingencies that are disclosed and required the disclosure of specific quantitative and qualitative information about loss contingencies. FASB also provided a narrow exemption from disclosing certain required information if disclosure would be prejudicial to the company’s position in a dispute.
The Exposure Draft elicited almost 250 comment letters.1 Members of the legal and accounting professions expressed serious reservations about the proposal, including concerns that providing such disclosure would be prejudicial to the disclosing party and would cause waivers of the attorney-client privilege. Many letters were also received in support of the proposal, particularly from those in the investor community such as pension funds. In response to the comments, FASB decided, in late September 2008, to field test two different disclosure models, one that is based on the Exposure Draft and an alternative model designed to address the concerns raised by commentators. FASB expects to hold public roundtable discussions in March 2009 to review the results of field testing and then to re-deliberate on its proposal. The final statement is expected to be issued during 2009 and may incorporate elements from both the Exposure Draft and the alternative model. It will not be effective sooner than for fiscal years ending after Dec. 15, 2009.
This memorandum discusses the loss contingency disclosure regime, including some of the concerns raised about proposed amendments.
Principal Disclosure Requirements Related To Contingencies
Management’s Discussion and Analysis
The Management’s Discussion and Analysis section is at the heart of a public company’s financial disclosure. The MD&A is intended by the Securities and Exchange Commission to provide readers with a view of the company through the eyes of management. This includes identifying known trends, demands, commitments, events and uncertainties that would be reasonably likely to materially increase or decrease the company’s liquidity or that would cause reported financial information not to be necessarily indicative of future operating results or financial condition, as well as any known material trends in the company’s capital resources.
In the context of the MD&A disclosures, “material” means there is a substantial likelihood that a reasonable investor would attach importance to the information in determining whether to purchase securities of the company. SEC guidance has long provided that information is material if there is a “substantial likelihood” that a reasonable investor would view such information as altering the total mix of information available. In the specific context of disclosing trends and uncertainties in the MD&A, the SEC has provided guidance that an event that is “unlikely” to occur would not be material or require disclosure. 2 However, if a company cannot conclude that a loss contingency is “unlikely,” then, if the impact of the event, assuming occurrence, would be material, a company would be required to discuss and analyze the contingency in its MD&A, providing enough quantitative and qualitative information to allow an investor to understand its potential impact on the company.
Current Status of FAS 5 Accounting for Contingencies
Currently, FAS 5 requires that a company book a loss contingency on its balance sheet if the probability of the contingency occurring is both “probable”3 and “reasonably estimable.” 4 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 need 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.”5
Proposed Amendments to FAS 5
FASB’s proposed amendments to FAS 5 would have required all loss contingencies to be disclosed unless (i) the company has determined that the likelihood of loss is remote or (ii) the potential claimant has not shown an awareness of a possible claim or assessment, unless it is probable that a claim will be asserted and, if the claim were to be asserted, the likelihood of loss is more than remote. This would not be a change from the threshold for disclosure under the current FAS 5, which requires disclosure of a contingency that is at least reasonably possible, because “reasonably possible” means more than remote but less than likely. As such, if the probability of loss is more than remote, current FAS 5 also requires disclosure. However, the proposed amendment differs in its bias, because it would create a presumption in favor of disclosure with possible exceptions, rather than a threshold that first must be met before disclosure is required.
The proposed amendment would have significantly expanded the population of loss contingencies that must be disclosed because it would require disclosure of certain contingencies even if their probability is remote. Specifically, if a loss contingency is expected to be resolved in the near term, meaning within a year from the date of the financial statements, and the contingency could have a “severe impact” on the company’s financial position, cash flows, or results of operations, then it would have to be disclosed regardless of probability of loss and even if the risk of it happening is remote. “Severe impact” means a significant financially disruptive effect on the normal functioning of the company. Though severe impact is a significantly higher threshold than materiality, it does include impacts that are less than catastrophic.
If a company must disclose a loss contingency, the Exposure Draft required specific quantitative and qualitative information about the company’s loss exposure to be disclosed in the footnotes to the financial statements. A company would be permitted to aggregate this disclosure by the nature of the loss contingency, such as products liability and antitrust matters.
Quantitative information required to be disclosed by the proposal included the amount of the claim or assessment, including damages, or, if there is no claim or assessment amount, the company must disclose its best estimate of its maximum exposure to loss. A company may also disclose its best estimate of the possible loss or range of loss if it believes the amount of the claim or assessment or maximum exposure to loss otherwise disclosed is not representative of its actual exposure. If disclosure is required, a company must provide qualitative information about the contingency that would be sufficient for users to understand the risks faced by the company, including a description of the factors that are likely to affect the ultimate outcome of the contingency as well as their potential effect on the outcome, the company’s qualitative assessment of the most likely outcome of the contingency, the anticipated timing of its resolution, and the significant assumptions made in estimating the amounts disclosed and in assessing the most likely outcome. Companies would also be required to provide a quantitative and qualitative description of the terms of relevant insurance or indemnification arrangements that could lead to a recovery of some or all of the possible loss.
The Exposure Draft’s proposed amendments provided a limited exemption from the disclosure requirements. If a company determined that the required disclosures would be prejudicial to the company’s position in a dispute, the company could aggregate the qualitative and quantitative disclosure at a higher level than nature of the contingency. In the “rare” instances that disclosing even aggregated information would be prejudicial, the company would be permitted to forgo disclosing the prejudicial information.6 In that case, the company must disclose that certain information has been omitted because disclosure would be prejudicial to the company. This disclosure could, of course, also be prejudicial to the company as investors worry about the concealed risks. Furthermore, certain disclosures would still be required, including a description of the factors that are likely to affect the outcome of the contingency along with the potential impact on the outcome.
Other than the requirement to disclose even remote loss contingencies if they are expected to be resolved within the year and could have a severe impact on the company, the general threshold for disclosure of loss contingencies under the proposed amendment would not have differed significantly from the current approach. The primary changes arise only when disclosure is required, in which case the proposed amendments to FAS 5 would have prescribed specific disclosures that are significantly more extensive than currently required. The requirement to quantify the potential loss and to qualitatively discuss and analyze the loss contingency is similar to the disclosure the SEC has long prescribed be included in MD&A, but would define much more specifically the type of information that must be disclosed.
Concerns With Proposed Amendments To FAS 5
Opponents of the Exposure Draft raised concerns that the required disclosures called for information that is not readily available or reliable, are irreconcilable with the litigious United States legal environment and constitute an assault on the attorney-client privilege.
Quantification of Loss Contingencies
The Exposure Draft assumed that loss contingencies are generally quantifiable, particularly in the form of plaintiff claims for a specified amount or estimates of maximum loss exposure. In many states, however, claimants do not have to demand a specific amount and, given the inherent uncertainty of disputes, estimates of maximum or expected loss exposure are often unreliable. Such unreliable estimates would be extremely difficult to audit and therefore of limited usefulness to investors.
The increased disclosures called for by the Exposure Draft reflect investors’ desire for full, transparent disclosure. However, the Exposure Draft failed to recognize that the expanded disclosures conflict with a company’s interests as a party to a dispute. By requiring detailed disclosure about a dispute, including estimates of loss, sources of recovery and assessments of outcome and timing, a company itself could be forced to provide a roadmap to its litigation strategy to the benefit of its adversary. Furthermore, claimants could seek to use the assessments as admissions of liability or of the amount of damages. This information could hurt the company’s ability to defend against the contingency and could also increase judgment amounts or the cost of settlement. In addition, the disadvantages faced by companies in disclosing these loss contingencies may induce companies to resolve disputes before filing deadlines. This potential time pressure could provide claimants with an advantage in settlement discussions and encourage the filing of more claims with limited merit.
Potential Waivers of Privilege
Companies generally look to their lawyers to help draft the 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. This type of information is customarily kept confidential, and disclosing such information in a company’s financial statements or to its auditors could be considered a waiver of attorney- client privilege or work-product privilege with respect to the attorney’s entire file on the matter. Such disclosure may lead to an increase in disputes over privilege matters or inhibit companies from communicating freely with their counsel. There has long been a “treaty” between the lawyers and the accountants regarding FAS 5 disclosures that the lawyers may make without a waiver of the privilege. The proposed amendments, which expand the required disclosure, would have taken us well beyond the treaty into areas where a potential waiver would be a real concern. If, however, the company’s counsel does not discuss the contingencies with the company’s auditor and the accountants are unable to substantiate disclosure included in the financial statement footnotes, the auditors may only be able to give the company a qualified audit opinion. Therefore, to allow for clean opinions, companies, their auditors and their accountants may feel pressured to share information and risk waiver of the associated privileges.
FASB has developed an alternative model to the Exposure Draft, but it consists of a collection of ideas to be field-tested, rather than an integrated disclosure model.7 Though FASB did publish a presentation about the alternative model, the model itself will not be publicly distributed or made available for public comment. FASB has indicated that the alternative model is designed to address the key objections to the Exposure Draft, i.e., that certain of the information required to be disclosed would be prejudicial, speculative and unreliable, and could constitute a waiver of the work product or the attorney-client privileges. The alternative focuses on disclosing factual qualitative and quantitative information about contingencies. A company would be required to disclose material claims against the company and its response, a qualitative description of the potential effect of a negative outcome on operations and liquidity, and, in the case of class action securities litigation, information about the class period. Though the alternative model would not strictly require disclosure of claim amounts or an estimate of maximum loss exposure, it would require quantitative disclosure providing the reader with “a sense of the potential magnitude” of the loss contingency. In addition, if disclosure would not be prejudicial, the alternative model would require disclosure of information about the likely outcome of the contingency, factors affecting the outcome and related assumptions. FASB has indicated, however, that it expects that this sort of disclosure about ongoing litigation generally would be prejudicial, and thus, disclosure could be omitted. This exemption for prejudicial disclosure is broader than the Exposure Draft’s limited exemption, which would only have permitted omission of required disclosure in those “rare” circumstances when aggregating disclosure would be prejudicial and would still require the company to disclose, among other things, a description of the factors that are likely to impact the contingency’s outcome.
FASB expects to hold public roundtable discussions on the Exposure Draft, the alternative model and the results of field testing during March 2009, with internal re-deliberations to follow shortly thereafter. FASB plans to issue a final proposal during 2009, which may incorporate elements from both the Exposure Draft and the alternative model.
FASB proposed the FAS 5 amendment to address concerns from investors that the current disclosure regime is not sufficient and investor groups were generally supportive of the Exposure Draft. However, the serious concerns voiced by the accounting and legal professions during the comment process persuaded FASB to reconsider its proposal. Though FASB is taking into account the concerns about prejudicial disclosure and waiver of the work-product and attorney-client privilege as it reconsiders its proposal, any proposed amendment will likely expand FAS 5 disclosure. Companies should look to the Exposure Draft for guidance about what type of quantitative and qualitative information is important to investors and prepare to expand the disclosure of their loss contingencies in their MD&A to more fully address the needs of financial statement users.