Proposed Changes to SFAS 5: Take Two
October 27, 2008
Copyright 2008. All rights reserved.
The Financial Accounting Standards Board (FASB) issued SFAS 5, Accounting for Contingencies, in March 1975 to address accounting for loss contingencies including potential losses from pending or threatened litigation. Recently, certain constituents expressed concerns that disclosures under SFAS 5 do not provide sufficient guidance and transparency as to the likelihood, timing and amounts of cash flows associated with loss contingencies. In September 2007, FASB decided to start a project with a goal to revise SFAS 5 in such a manner as to address the concerns of these constituents.
Release of New Exposure Draft
FASB issued an Exposure Draft titled "Disclosure of Certain Loss Contingencies" on June 5, 2008. This Exposure Draft proposed amendments to FASB Statements No. 5 and 141(R) that are primarily related to disclosures in company financial statements including potential losses from pending and threatened litigation. The Exposure Draft received over 250 comment letters. Many of the letters expressed some concerns; however, some of the letters supported the Exposure Draft.
A common theme of the letters expressing concerns was that implementation of the proposed amendments may create unintended inequities in the litigation process, for example:
- Defendants would be required to report their "best estimate" and "maximum exposure" to loss, possibly even before a plaintiff would make such a disclosure;
- Expanded litigation disclosures could become admissible evidence;
- Litigation disclosures may be argued to be a waiver of attorney/client privilege and work product;
- Potentially lead to increased securities litigation if the estimates are incorrect, and;
- Is inconsistent with the Current Statement of Policy between the ABA and AICPA as set forth in the AICPA Professional Standards (AU Section 337C)
In late September 2008, FASB held a Board meeting and subsequently issued the following statement regarding the Exposure Draft:
"The Board decided on a plan for redeliberations of its Exposure Draft, Disclosure of Certain Loss Contingencies. The Board directed the staff to prepare an alternative model that will attempt to address the concerns that certain constituents raised about the Exposure Draft. This alternative model will be field tested along with the model in the Exposure Draft. The Board also decided that any final Statement on this topic will be effective no sooner than for fiscal years ending after December 15, 2009."
Three key facts should be taken from this statement by the FASB:
- It appears that the FASB will be making a change or amendments to SFAS 5;
- A new model will be developed that is different from the current Exposure Draft; and
- Both models, the current Exposure Draft and the Redeliberated Model, will be field tested.
We do not know the "redeliberations" which FASB is considering. However, since the FASB appears to be intent on modifying SFAS 5 and will field test the current Exposure Draft, the primary purpose of this article is to outline the changes that the FASB proposed in the Exposure Draft and point out the ramifications of such changes. Examination of the Exposure Draft will give some indications of the areas of concern that the FASB is attempting to address. The relevant type of loss contingency that will be focused on in the remainder of this article is pending or threatened litigation.
The Existing SFAS 5
SFAS 5 describes the framework by which contingencies should be handled in company financial statements. A contingency is defined as "an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (hereinafter a ‘gain contingency') or loss (hereinafter a ‘loss contingency') to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur."
Accrual of Loss Contingencies
SFAS 5 states that an "estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:
- a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
- b. The amount of loss can be reasonably estimated."
Disclosure of Loss Contingencies
SFAS 5 states that "if no accrual is made for a loss contingency because one or both of the conditions in paragraph 8 (probable and reasonably estimated) are not met, or if an exposure to loss exists in excess of the amount accrued...disclosure of the contingency shall be made when there is at least a reasonable possibility that a loss or an additional loss may have been incurred. The disclosure shall indicate the nature of the contingency and shall give an estimate of the possible loss or range of loss or state that such an estimate cannot be made."
Currently, many loss contingencies fall into the category of a reasonable possibility instead of probable. Therefore, significant litigation is usually disclosed in the notes to the financial statements by describing the nature of the litigation and stating that an estimate of possible loss or range of losses cannot be made.
Proposed Amendments to SFAS 5
Based on the Exposure Draft that was set forth, it appears that the FASB is content with the standards for accrual of loss contingencies, but is concerned about disclosures of loss contingencies that do not meet the criteria necessary for accrual of the loss.
Accrual of Loss Contingencies
The criteria by which loss contingencies should be expensed and accrued in the financial statements under the Exposure Draft remains largely unchanged. An estimated loss should be accrued in the financial statements if the loss is both probable and can be reasonably estimated.
Disclosure of Loss Contingencies
Under the Exposure Draft, an entity would not have had to disclose a loss contingency if the entity has made an assessment and determined that the likelihood of a loss is remote. This "remote" standard is a lower bar than the possible standard currently under SFAS 5 and was not defined in the Exposure Draft.
However, under the Exposure Draft an entity would have been required to disclose a loss contingency, or a combination of loss contingencies, regardless of the likelihood of a loss, if both:
- a. The contingency or contingencies are expected to be resolved in the near term (a period of time not to exceed one year from the date of the financial statements); and
- b. The contingency or contingencies could have a severe impact on the entity's financial position, cash flows, or results of operations. Severe impact is defined as a "significant financially disruptive effect on the normal functioning of an entity." Severe impact is a higher threshold than material. Severe impact includes matters that are less than catastrophic. (For example, bankruptcy would be catastrophic.)
If the above two standards are met, than an entity would have been required to disclose the following information about loss contingencies:
- a. Quantitative information about the entity's exposure to loss from the contingency including the amount of the claim or assessment against the entity (including damages, such as treble or punitive damages). If there is no claim or assessment amount, then the entity must make its best estimate of the maximum exposure to loss. An entity may also disclose its best estimate of the possible loss or range of loss if it believes that the amount of the claim or assessment or the maximum exposure to loss is not representative of the entity's actual exposure.
- b. Qualitative information about the contingency. This information should include, at a minimum, a description of the contingency, including 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 disclose.
- c. A qualitative and quantitative description of the terms of relevant insurance or indemnification arrangements that could lead to a recovery of some or all of the possible loss, including any caps, limitations, or deductibles that could affect the amount of recovery.
The Exposure Draft indicated that the above disclosures could have been aggregated by the nature of the loss contingency (for example, product liability or antitrust matters).
In addition to the above disclosures, an entity would have been required to provide a reconciliation, in tabular form, of the total amount recognized in the aggregate for loss contingencies in its statement of financial position at the beginning and end of the period as well as the total amount of recoveries from insurance or indemnification in the financial statements.
These new disclosure requirements appear to be at the center of the issues which the FASB is attempting to address as it works to amend SFAS 5. Namely, a greater level of information regarding likelihood, timing and amounts of cash flows associated with loss contingencies especially as it relates to litigation.
Exemption from Disclosing Prejudicial Information
However, even in the Exposure Draft, the FASB acknowledges that for certain contingencies, such as pending or threatened litigation, disclosure of certain information about the contingency may be prejudicial to an entity's position (disclosure of the information could affect, to the entity's detriment, the outcome of the contingency itself). Therefore, the FASB had added an exemption in the Disclosure Draft for those situations and stated that an entity may aggregate the disclosures set forth above at a level higher than by the nature of the contingency such that disclosure of the information is not prejudicial.
Further, the FASB stated that in "those rare instances in which the disclosure of the information...when aggregated at a level higher than by the nature of the contingency, or if the tabular reconciliation would be prejudicial (for example, if an entity is involved in only one legal dispute), the entity may forgo disclosing only the information that would be prejudicial to the entity's position...In no circumstances may an entity forgo disclosing the amount of the claim or assessment against the entity (or, if there is no claim amount, an estimate of the entity's maximum exposure to loss)..." or a qualitative description of the loss contingency.
Concerns Related to the Proposed Amendments
Currently, SFAS 5 requires that an entity give an estimate of the possible loss or range of loss or state that such an estimate cannot be made. The new amendments would have required an entity to provide quantitative information about the entity's exposure to loss even if the amount of claim against the entity is not known. That would have required entities to give their "best estimate" of maximum exposure to loss. That may have forced a defendant to disclose a potential maximum exposure before a plaintiff had done so and may have provided plaintiffs with an advantage. Further, the expanded disclosures could have given opponents valuable information, such as the defendants' litigation strategy, that could be used against the entity.
These expanded disclosures may have ended up as admissible evidence and may have influenced the outcome of the proceedings by altering the direction of settlement discussions or jury awards. In addition, differences between an entity's estimates that are disclosed in financial statements and a testifying expert may have affected the credibility of the expert.
These expanded disclosures could have led to increased securities class action litigation if the estimates turned out to be incorrect and plaintiffs alleged that disclosures were fraudulent. Further, an entity may have decided not to disclose information based on the entity's consideration of the prejudicial information exemption. Potential securities class action plaintiffs may have questioned an entity's interpretation of what constitutes prejudicial information.
Disclosure of the entity's assessment of likely losses and outcome may have been challenged by opposing counsel to be a waiver of the attorney/client privilege and work product protection that normally would protect such assessments from disclosure during litigation. The proposed standards may have put pressure on legal counsel to provide additional qualitative analysis and estimates. Further, auditors would have likely wanted to test the entity's estimate and would have requested detailed information from attorneys that may have led to further attorney/client privilege risks.
The Exposure Draft requirements also appeared to be inconsistent with the current Statement of Policy between the American Bar Association and the AICPA as set forth in the AICPA Professional Standards (AU Section 337C). The Statement of Policy includes the following:
"In view of the inherent uncertainties, the lawyer should normally refrain from expressing judgments as to outcome except in those relatively few clear cases where it appears to the lawyer that an unfavorable outcome is either ‘probable' or ‘remote'..."
"Therefore, it is appropriate for the lawyer to provide an estimate of the amount or range of potential loss (if the outcome should be unfavorable) only if he believes that the probability of inaccuracy of the estimate of the amount or range of potential loss is slight."
"The considerations bearing upon the difficulty in estimating loss (or range of loss) where pending litigation is concerned are obviously even more compelling in the case of unasserted possible claims. In most cases the lawyer will not be able to provide any such estimate to the auditor."
"...it must be concluded that, as a general rule, it should not be anticipated that meaningful quantifications of ‘probability' of outcome or amount of damages can be given by lawyers in assessing litigation."
The Statement of Policy sets forth the difficulty in estimating loss where pending litigation is concerned, yet the proposed new amendments would have required entities to estimate maximum exposure to a potential loss.
The FASB has not withdrawn the desire to amend SFAS 5, but has only temporarily withdrawn its first Exposure Draft and asked that a redeliberated model be created. Since the FASB is field testing both the Exposure Draft as issued and the redeliberated model, portions of the current Exposure Draft may still be included in the new Exposure Draft.
Therefore, it is important to understand the concerns raised by the Exposure Draft and be aware of how these concerns will be addressed by the FASB in the new Exposure Draft, which is due to be redeliberated and released in April or May 2009.
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