Proposed Amendment to FASB Statement No. 5, Accounting for Contingencies,
Raises Significant Concerns
July 9, 2008
On June 5, 2008, the Financial Accounting Standards Board (FASB) issued an exposure draft that proposes amendments to FASB Statement No. 5, Accounting for Contingencies (FAS 5). The amendments would redefine the disclosure requirements in FAS 5 for certain unrecognized loss contingencies that meet the definitional criteria of amended FAS 5, including potential losses from pending and threatened litigation. If adopted, the new requirements will be effective for fiscal years ending after December 15, 2008. FASB has stated that the proposed amendments stem from a concern that disclosures about loss contingencies under the existing FAS 5 standards do not provide adequate information to assist users of financial statements to assess the likelihood, timing, and amount of future cash flows associated with loss contingencies.
The proposed amendments raise significant concerns, including potentially requiring disclosure of key elements of a company's litigation strategy, the possible waiver of attorney-client privilege and attorney work-product protection, and that the increased disclosure may itself be the source of additional litigation. In addition, the new disclosures may embolden plaintiffs to continue what otherwise may be problematic litigation and also may increase amounts paid in settlement. Clients who would like to comment on the proposal should note that comments in writing are due on this proposed amendment by August 8, 2008.
FAS 5 established three categories of loss contingency: "probable," "remote," and "reasonably possible." Under FAS 5, "probable" means that the future event is likely to occur, "remote" means that the chance of the future event occurring is slight, and "reasonably possible" means that the chance of the event occurring is more than remote but less than likely. A company must accrue for loss contingencies, such as pending or threatened litigation, when the loss is probable and the amount of loss can reasonably be estimated. If there is no accrual because both of these two conditions are not met, then disclosure of the loss contingency must be made in the financial statement notes when there is at least a reasonable possibility that a loss may have been incurred. The disclosure should set forth the nature of the loss contingency and the range of probable loss if reasonably estimable; however, if the range of probable loss cannot be estimated, then an estimate of loss does not have to be disclosed.
As a practical matter, because the standards for judging a loss contingency to be either probable or remote are so high, most loss contingencies fall into the category of reasonably possible. In addition, it is uncommon for legal counsel to estimate a loss or range of probable loss in responding to auditors' requests for information because the applicable standards require that the attorney conclude that the probability of inaccuracy of the estimate is slight. Therefore, significant litigation usually is disclosed in the financial statement notes on a factual basis limited to describing the nature of the claims with no qualitative assessment and no estimate of loss or range of probable loss.
The proposed amendments to FAS 5 would require companies to disclose substantially more information about their litigation loss contingencies and would lower the disclosure threshold in some instances. The amendments do not change the threshold for accrual of a liability on the financial statements (i.e., the loss must be probable and the amount of the loss must be reasonably estimated). With respect to pending or threatened claims, the exposure draft requires disclosures of all loss contingencies within its scope, except for those claims that are remote and unasserted claims that either will probably not be asserted or where, if asserted, the likelihood of a loss is remote. In addition, even remote loss contingencies must be disclosed if they are "expected to be resolved in the near term" (i.e., within one year of the date of the financial statements) and could have a "severe impact" (i.e., a "significant financially disruptive effect") on the company's financial position, cash flows, or results of operations. The requirement to disclose even remote contingencies in these circumstances is a change from the present standards.
If the disclosure threshold is met, a company would be required to include both quantitative and qualitative information about the contingency in the notes to its financial statements. The quantitative disclosures would include the amount of the claim or assessment, or, "if there is no claim or assessment amount, the entity's best estimate of the maximum exposure to loss." The company may report its estimate of the possible range of loss if the amount of the claim or assessment is not representative of the actual exposure. The qualitative disclosure would include "a description of the contingency, how it arose, its legal or contractual basis, its current status, and the anticipated timing of its resolution; a description of the factors that are likely to affect the ultimate outcome of the contingency along with their potential effect on the outcome; the entity's qualitative assessment of the most likely outcome of the contingency; and significant assumptions made by the entity in estimating the amounts disclosed." In addition, a company would be required to disclose a qualitative and quantitative description of the terms of relevant insurance or indemnification arrangements that offset any of the possible loss.
Concerns regarding Proposed Amendments
The proposed amendments raise a number of concerns.
Although the basic disclosure thresholds in FAS 5 have not been changed, the content of the required disclosures has increased substantially. Where disclosure is required, companies will have to disclose the nature of the litigation, their best estimate of the maximum exposure, a qualitative assessment of the most likely outcome, and the significant assumptions underlying their estimates. These required disclosures are likely to require a company to reveal elements of its litigation strategy, as well as quantify and disclose its potential maximum exposure. This information is typically very carefully protected in an adversary proceeding. Also troubling is that the required disclosures may be admissible in evidence against the company in the proceedings that are the very subject of the disclosure (i.e., an admission against self-interest). As a result, the required disclosures may embolden plaintiffs because they signal that the company considers the litigation exposure to be both credible and serious. The disclosures also may serve to frustrate settlement negotiations and/or result in higher settlement amounts or jury awards due to the disclosed estimates of the maximum exposure. In addition, the requirement to disclose even remote loss contingencies under certain circumstances could make even dubious cases less likely to settle or just fade away.
Furthermore, since the required disclosures may be based on confidential communications between a company and its counsel, there is a risk that the required disclosures may result in the waiver of attorney-client privilege and attorney work-product immunity. In addition, since auditors are likely to want to test the qualitative analysis and loss estimates as part of their audit work, there may be increased pressure for them to seek privileged information in order to test the disclosures, which also could further erode attorney-client privilege.
Lastly, since litigation assessments are inherently uncertain, the proposed amendment itself threatens to become a source of securities litigation. Assessments of pending and threatened claims, particularly those involving litigation, are inevitably uncertain and subject to factors outside the control of any of the parties. As a result, the required disclosures and estimates may be sources of additional claims and litigation in the event that they prove to be inaccurate.
Wilson Sonsini Goodrich & Rosati believes that the proposed standards in the exposure draft are inconsistent with the current standards in the "treaty" between the American Bar Association and the American Institute of Certified Public Accountants governing lawyers' responses to auditors' inquiries. As discussed above, it is uncommon for legal counsel to estimate a loss or range of loss in responding to auditors' requests for information because of guidelines in the ABA Statement of Policy Regarding Lawyers' Responses to Auditors' Request for Information. As a result, significant litigation usually is disclosed in the financial statement notes on a factual basis limited to describing the nature of the claims with no qualitative assessment and no estimate of loss or range of loss. The new standards clearly will put pressure on legal counsel to provide additional qualitative analysis as well as loss estimates when responding to auditors' requests, which will put lawyers in a very difficult position with their clients regarding the disclosure of this very sensitive information.
The FASB proposal specifically recognizes that for certain loss contingencies—such as pending or threatened litigation—disclosure of certain information about the contingency may be "prejudicial to an entity's position" in the litigation. In that event, the proposal provides that disclosures may be aggregated or reported at a higher level, or in "rare instances," omitted altogether. In such cases, the company must disclose "the fact that, and the reason why, the information has not been disclosed." Because the FASB has expressly indicated that the relief is only available in "rare" circumstances, it may have a chilling effect on the willingness of a company to utilize this exception.
Comments in writing are due on this proposed amendment by August 8, 2008, and FASB plans to host an open forum on the proposed amendments at which those who have submitted comments may testify. Comments may be sent by email to firstname.lastname@example.org, File Reference No. 1600-100. The firm understands that the American Bar Association (including the ABA Attorney-Client Privilege Task Force and the Business Law Section's Law and Accounting Committee), business trade associations, and investor groups are focusing on the significant issues presented by the proposed amendments.