Taking Another Look at Legal Contingencies

3/3/2011

By David J. Bayens, CPA

For years there has existed an understanding among companies, their attorneys and the auditors regarding legal contingencies- both the transmission of information between parties and the financial statement disclosures. In the past several years, questions have arisen about the adequacy and completeness of the disclosures.

The crux of the controversy is the ongoing quest by the SEC, FASB and others for greater transparency in financial statements versus companies’ desires to keep sensitive legal information confidential. For example, disclosing in a publicly-available financial statement that, “… The Company expects to lose $10 million as a result of this litigation…” could damage the Company’s case in court and potentially establish a baseline for damage awards.

Here’s some background:

For over 30 years, an agreement has existed between and the accounting and legal professions (called “the treaty”) which worked out a structure for dialogue between the two parties in a way that preserved attorney-client privilege. In representation letters to outside auditors, lawyers are cautioned not to make predictions about the outcome of litigation, especially the range of potential loss, unless they believe the odds of being wrong are slight.

Existing requirements for financial statement disclosures are based on probabilities of unfavorable outcomes. For probable loss contingencies, requirements include recording an accrual when the loss is probable and it can be reasonably estimated. For reasonably possible contingencies, disclosures include the nature of the contingency and, if possible, the potential range of loss. Disclosures would also include the reasonably possible loss in excess of the amount accrued.

Generally, these disclosures were vague enough to hide potentially damaging information. However, at a recent bar association conference, Wayne Carnall, Chief Accountant for the SEC’s Division of Corporate Finance, told the audience that they should be careful not to lean too heavily on a long-standing treaty between lawyers and accountants when deciding what to report about litigation contingencies in financial statements.

The SEC has observed inadequate or improper handling of legal contingency accounting and reporting. They have questioned certain registrants’ assertions that estimates of potential losses cannot be made. Also, they have pointed out inconsistencies between registrants’ financial statements that state that the outcome of litigation is not expected to have a material effect and the “Risk Factors” section of the filing that indicate that a negative outcome of such litigation could materially affect the company.

In 2010, FASB issued its second exposure draft on this topic. It proposed expanded disclosure requirements, including discussions of certain remote contingencies, and an increase in the amount of quantitative and qualitative information. In its summary of responses to this exposure draft FASB observed:

The majority of respondents do not support the proposed Update. These respondents are concerned that the enhanced disclosures … would impose significant costs, force an entity to waive attorney-client privilege … and provide prejudicial information to litigation adversaries that would hinder the entity’s defense in litigation. [Respondents defined as] Users [of financial statements] generally support the proposed Update and commend the Board’s efforts for striking an appropriate balance between providing users with adequate information to assess the potential cash flows from loss contingencies and protecting entities from providing prejudicial information to current and future claimants.

FASB did not conclude deliberation on this issue. It directed its staff to work with the SEC and PCAOB to understand their efforts in addressing investor concerns though increased focus on compliance with existing rules and the effect of those efforts on improving disclosure about loss contingencies in 2010 calendar year-end financial statements. FASB plans to redeliberate this topic later in 2011.