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More Lawsuits May Go on the Books

As FASB debates the best way to improve accounting for contingent liabilities, one thing is clear: potential lawsuit losses are more likely to show up on company balance sheets.

Helen Shaw, CFO.com | US
May 5, 2006

Imagine if Revenues Were Subject to the Same Treatment

Although only one element of the possible change in contingent liability measurement, I took particular interest in the discussion as it pertains to the IASB approach. The IASB notion of recording liabilities under an "expected value" paradigm is interesting but, problematic in my view. The problem comes not from liability estimation, but rather the income statement effects of this approach.

Background: The move to fair value accounting has, in general, lead to a certain degree of apples to oranges accounting. The end result is a system that can lead to perverse results. For example, a highly material portion of revenues reported by Energy Conversion Devices in 2005 was due to the application of the Black-Scholes method of valuing options forfeited by a strategic partner in connection with the transferral of certain rights to the partner. (Oddly, the company did not report stock option expense under the fair value method last year.)

However, I am more concerned about the notion of using an "expected value" paradigm. On its surface, expected value accounting may sound reasonable with regard to liabilities/expenses. But, if the method has merit, then logically, it should also be applied to assets/revenues as well. Here is where the use of "expected value" accounting fails. I make my point via a hypothetical example. Assume that XYZ Software Inc sells complex software products that, under present practice, requires customer acceptance prior to revenue recognition. Can you imagine the implications if the firm were allowed to recognize software revenue based on "expected value" accounting? Imagine what that might be like. I can envision the following sentence in the MD&A section of XYZ Software Inc:

“Management has determined that there is a 50% chance that the software we shipped at the end of the quarter will be accepted by our clients. So we recognized 50% of end of period software shipments as top line revenue this quarter.”

So, do we (in the U.S.) really want to recognize liabilities under an expected value framework, as the IASB currently does???

Posted by Donn Vickrey | May 08, 2006 04:11 pm

IASB Math

Mr. Hefferlin's point that not all lawsuits are litigated is a valid one; some do settle.

However, the example in the article notes that according to the IASB's thinking, companies should book the liability at fair value: $10 million (just 10 percent of the $100 million when there is a 10 percent chance of losing). Not $100 million. This is the IASB's standpoint on the issue.

The example and the math came from the conference materials (the author of the materials is unknown but the materials were presented during a panel at which representatives from FASB, PwC, Time Warner, and Bear Stearns spoke).

Posted by Helen Shaw | May 08, 2006 02:14 pm

Do the rest of the math

In 'More Lawsuits Go on the Books' by Helen Shaw, you need to do the rest of the math. OK, so there is a 10% chance you will lose (it might be interesting to see how one comes up with this, but another time, perhaps). $10 mil. OK, now what is the average settlement of a $100 mil. suit of this kind? Probably a lot less than $100 mil. $25 mil? Then you book $2.5 mil. Jonathan R. Hefferlin, Managing Director, Management Recruiters, Dana Pt.

Posted by Jonathan Hefferlin | May 08, 2006 01:42 pm

Disclosing v. Booking Lawsuits

More properly, when speaking of FAS 5, we should be discussing booking losses that are more probable than not. Disclosure obligations are covered by Item 103 of SEC Regulation S-K. Disclosure under Item 103 is triggered by a somewhat complicated test that is basically a ten percent of assets test. For environmental liabilities, though, the trigger is $100,000.

Posted by Allison Garrett | May 08, 2006 01:33 pm

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