Risk Management

It’s Your Loss. (Maybe.) Now Explain It.

Companies will have to disclose more detail about potential future losses — notably from lawsuits — under a proposed new accounting rule.
Tim ReasonJune 9, 2008

The Financial Accounting Standards Board has proposed substantially increasing the amount of information that companies are required to provide to investors about potential future losses. The new rule could have a dramatic impact on how companies disclose potential liabilities in their financial reports, particularly when it comes to lawsuits.

The proposed new accounting standard, which was released for public comment last Thursday, would overhaul FAS 5, Accounting for Contingencies. Under the proposed rule, companies would have to disclose “specific quantitative and qualitative information” about loss contingencies. The new rule will also affect the contingent losses companies must disclose under FAS 141, which applies in the wake of mergers and acquisitions.

In addition to pending litigation — the most obvious example of a corporate loss contingency — other types of contingencies include collectability of receivables, obligations related to product warranties and product defects, risk of loss or damage to the company’s property through fire or other hazards, threat of expropriation of assets, and other actual or possible claims or assessments against the company.

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Under current accounting rules, companies are only required to take a financial charge for a contingent loss if it appears probable that the loss has occurred and its amount can be reasonably estimated. If those conditions are not met, companies must still disclose the loss contingency, but only if there is a reasonable possibility that a loss has occurred.

Under the new rule, companies would have to disclose all loss contingencies unless their likelihood is remote. And companies also would be required to disclose any contingency — no matter how remote — that is expected to be resolved within a year and could have a severe impact on the company’s financial position, financial results, or cash flow. That’s a change that would put substantially greater detail about potential lawsuit liabilities into the footnotes of corporate financial statements.

For example, companies would be required to state the amount of the claim against them, including, in the case of lawsuits, the possibility of treble or punitive damages. In cases where no specific claim exists, companies would have to provide their best estimates of their maximum losses, though they may also provide a different estimate if they think their actual exposure is lower. Companies are also required to include a written description of the contingency, “including how it arose, its legal or contractual basis, its current status, and the anticipated timing of its resolution,” as well as what they think will be the most likely outcome.

As proposed, the rule would, in “rare” cases, allow a company to keep certain information secret — an exemption intended to keep the accounting rule from actually exacerbating the potential loss to shareholders by tipping a company’s hand in litigation or settlement negotiations. However, companies would be required to publicly assert their claims to the exemption and would still have to provide some information about the nature of the claims against them.

Companies would also have to provide a table outlining loss contingencies and reconciling changes in the aggregate amount from the beginning to the end of the reporting period. That disclosure must include a written description of any significant changes, and must disclose the balance sheet line items that include loss contingencies.

Attorney Greg Rogers, president of consulting firm Advanced Environmental Dimensions, says the new standard may raise eyebrows among investors, since the maximum loss disclosed by companies in the footnotes will likely be much higher than what they actually book as line items in the balance sheet. Rogers, who consults with companies on managing their environmental liabilities, says FASB appears to be responding to historic frustration among investors about the lack of transparency surrounding contingencies.

He also believes that the new standard is “just another step on the road to fair value for everything. FASB’s just taking a baby step.” He says that the amount of information required by this disclosure moves companies closer to the sorts of disclosures required by fair value, in which companies must explain how they arrived at their estimates. Indeed, an exposure draft to overhaul IAS 37, the International Accounting Standards Board’s equivalent of FAS 5, would essentially require that all contingencies be marked to market — a move that has many worried.

In fact, one reason FASB may be taking small steps is the thorny issue of putting a price on the outcome of a lawsuit. Late last year, the general counsels of thirteen major companies addressed a letter to the chairmen of both FASB and IASB, warning that “litigation is inherently unpredictable” and noting that trying to put a value on litigation contingencies would not only be “flawed and misleading,” but could also result in unintended consequences, including “abuse by adversaries seeking to take advantage of the financial impact a lawsuit could have on a company.”

The public has until August 8 to comment on the rule. The new rule would go into effect for fiscal years ending after December 15, meaning that most companies with a calendar fiscal year would have to begin reporting the additional information at the end of this year.