Pay Close Attention to Financial Reporting About Litigation
by Steven F. Stanton and Michael J. McConnell
The Financial Accounting Standards Board ("FASB") has issued several proposals that would require companies to include expanded disclosures about potential losses from litigation and other contingencies. These proposals were in response to concerns raised by investors and other users of financial statements that the existing rules do not provide adequate and timely information to assist them in assessing the likelihood, timing, and magnitude of potential losses. The original proposal was issued in June 2008, but was criticized by preparers of financial statements as costly and requiring judgments that are more predictive and speculative in nature rather than factual. In response to the criticism, the FASB continued its study of disclosure requirements, which culminated in a July 2010 revised proposal that contained less additional disclosure requirements. This proposal was originally was to have been effective for calendar year end companies in 2010, but the implementation was delayed and is being reconsidered by the FASB.
Even though no new requirements have been implemented, the debate has put more focus on the topic and thus, companies should give close attention to their disclosures and compliance with the existing rules.
The additional disclosures proposed by the FASB include qualitative and quantitative information about loss contingencies to enable financial statement users to understand all of the following:
- The nature of the loss contingencies
- Their potential magnitude
- Their potential timing (if known)
Specifically, the current proposal would require disclosure of publicly available quantitative information (such as the claim amount for asserted litigation contingencies), other relevant non-privileged information, and, in some cases, information about possible recoveries from insurance and other sources. Furthermore, a public entity would be required to provide tabular reconciliations, by class, of recognized (accrued) loss contingencies that present the activity in the account during the reporting period. This table would show what is commonly referred to as a "roll-forward", which consists of the accrual as of the beginning of the year, amounts paid during the year, additional amount accrued or reversed, and the ending accrual balance. Additionally, this proposal also requires the disclosure of certain remote loss contingencies, which are not required to be disclosed under the existing standards.
Companies and other parties raised significant concerns about the proposed changes which caused the FASB to decide that a final standard would not be effective for 2010. The FASB staff will be working with the SEC and PCAOB to understand their efforts in addressing investor concerns about these disclosures through increased focus on compliance with existing rules. The FASB will also be reviewing registrants' filings to determine if those efforts have resulted in improved disclosures about loss contingencies. The FASB plans future re-deliberation of this proposal.
The SEC has expressed concern about the sufficiency and clarity of litigation disclosures made by companies under the current standards. The SEC staff have indicated that they plan to look closely at disclosures companies have been making, both in their financial statements and within the Legal Proceedings section of periodic filings to assess whether the disclosures comply with Generally Accepted Accounting Principles ("GAAP") and the requirements of Regulation SK, Item 103. In public speeches members of the SEC staff have stated that they may question lack of historical disclosure when material settlements are disclosed in future periods. In addition to questioning disclosure prior to material settlements, the SEC staff also sent "Dear CFO" letters to publicly traded companies with potential contingencies related to mortgage loan repurchase demands asking them to consider providing certain additional disclosures. This increased focus on contingencies raises the prospect that external auditors and users of financial statements will give this area more scrutiny than may have occurred in the past. You should also anticipate that plaintiff's attorneys, both those with active cases against your company and the securities class action bar, will be closely reading your disclosures.
The existing accounting and disclosure rules for loss contingencies have been in place for decades and are enumerated in FASB Accounting Standards Codification Topic 450 - Contingencies (ASC 450), formerly Statement of Financial Accounting Standards No. 5, Accounting for Contingencies. When there are potential losses that could be material to the company's financial statements, management needs to assess whether the likelihood of loss is remote, reasonably possible or probable, as defined in ASC 450. [These terms are defined in AC 450 as follows: Probable. The future event or events are likely to occur; Reasonably possible. The chance of the future event or events occurring is more than remote but less than likely; Remote. The chance of the future event or events occurring is slight.]
If a company is a party to litigation where it believes the likelihood of a material loss is remote no accrual of the loss is needed and no disclosure is required. At the other end of the spectrum, if the likelihood of material loss is probable, an estimate of the loss needs to be accrued by a charge to income. For probable contingencies consideration should be given to disclosing the nature and the amount of the accrual in the notes to the financial statements and, where applicable, an indication that it is at least reasonably possible that a change in the estimate could occur.
For matters where the likelihood of loss is deemed to be reasonably possible, no accrual is recorded, but disclosures should be made about the nature of the contingency and an estimate of the possible range of loss or a statement that such an estimate cannot be made. The SEC staff has noted that they are seeing a lack of disclosure regarding these types of reasonably possible loss contingencies and is concerned that some companies may be too readily taking the position that a reasonable estimate of the loss cannot be made in order to avoid disclosing that information. The SEC staff has stated in recent speeches that the existing standards require disclosure of the loss, or range of loss, if it can be reasonably estimated, but does not require that the estimate of the loss be determined with precision.
Companies face a difficult balancing act in drafting loss contingency disclosures. On one hand, they need to comply with accounting rules and SEC reporting requirements, and need to provide full and fair disclosure for investors. However, estimating the likelihood of litigation losses is often a subjective and predictive affair, and doing so with precision can be difficult or impossible, especially in the early stages of litigation. Negative consequences can flow not only from understating the likelihood of a loss, but also from over or underestimating the potential amount of loss. Given that the estimates of both likelihood and amount are inherently subjective and imprecise, the inclusion of an estimate or a range of loss may unintentionally suggest a level of reliability that could be construed to be misleading.
Companies and their attorneys should also be wary of disclosing confidential information, including strategy or assessments about litigation, to outside auditors or in public filings. Public filings are, of course, available to opposing parties, so the company's position in ongoing litigation can be harmed if legal strategy is revealed and settlement negotiations can be affected by disclosure of an estimated loss amount. Auditors are considered outside parties, so companies should also be mindful of the dangers of arguably waiving attorney client privilege or work product protections. Furthermore, company counsel should be familiar with the 35-year-old "treaty" between auditors and attorneys embodied by the 1975 American Bar Association "Statement of Policy Regarding Lawyers' Responses to Auditors' Requests for Information," which discusses the protection of attorney client privilege and largely sets the structure for dialogue between auditors and lawyers.
Attorneys representing publicly traded companies, as well as companies' management and directors, should be sure they are well informed about litigation and other contingencies and understand the process their clients or companies use to determine the accounting and disclosures for litigation and other loss contingencies while being careful not to undermine the litigation position. We suggest the following:
- Ensure that the company has effective processes and controls for identifying and evaluating loss contingencies;
- Make inquiries of in-house counsel, outside counsel and external auditors about potentially material loss contingencies. For particularly significant matters, management and directors should consider having status reports at each board meeting;
- Focus closely on these disclosures when reading drafts of public filings, especially on disclosures of reasonably possible loss contingencies where loss amounts are not reasonably estimable and thus amounts are not disclosed; and,
- Be sure you are satisfied that the company is striking the right balance between complying with the accounting rules, the desire to provide full and transparent information to the investing public while not jeopardizing attorney-client privilege or damaging the company's competitive or litigation position.
Steven F. Stanton, CPA, CFF is a Managing Director in the Disputes & Investigations practice of Navigant in Washington, DC. Mr. Stanton has 30 years of experience as an accountant, auditor and consultant, and specializes in forensic accounting investigations, litigation consulting and expert witness testimony. Mr. Stanton can be reached at (202) 481-8430 or email@example.com.
Michael J. McConnell, a partner in the Securities Litigation and SEC Enforcement practice of Jones Day based in Atlanta. Mr. McConnell has 26 years of experience handling complex litigation matters with a particular concentration on shareholder litigation. Mr. McConnell can be reached at (404) 581-8526 or firstname.lastname@example.org.
The views set forth herein are the personal views of the author(s) and do not necessarily reflect those of the law firm or organization with which he is associated.