Case Introduction
Danle Corporation (Danle), a public company engaging in vehicles manufacturing business used asbestos in the past three years. In fiscal year 2008 and 2009, Danle received two similar complaints about mechanics suffered severe illness due to the exposure to asbestos from the parts manufactured by Danle. Danle disclosed neither of the lawsuits litigations in the 2008 & 2009 Form 10-K, even though the external counsel offered evidence showing the potential possible liability for Danle in Dec 2009. For the three Fiscal Year 2010’s Form 10-Qs (1st, 2nd & 3rd quarters), Danle disclosed related information about the potential loss in the footnotes and consolidated financial statements in 2010’s Form 10-K.
Question 1: Disclosure Issue 2009
In 2009, the conclusion reached by Danle’s management after further assessment of the evidence discovered led the company determined not disclosing anything about the matters in its Form 10-K for the year end Dec 31,2009.
However, we have totally different conclusions. According to FASB definitions for Probable, Reasonably Possible and Remote are as follows: 1. Probable: The future event or events are likely to occur; 2. Reasonably Possible: The chance of the future event or events occurring is more than remote but less than likely. 3. Remote: The chance of the future event or events occurring is slight.
In December 2009, evidence discovered by Danle’s external counsel concluded that Danle could potentially, but not probably, be liable for a percentage of recovery sought by the claimants in those matters, which is matches the definition of Reasonably Possible but not Remote.
FASB ASC 450-20-50-3 states: Disclosure of the contingency shall be made if there is at least a reasonable possibility that a loss or an additional loss may have been incurred and either of the following conditions exists: a. An accrual is not made for a loss contingency because any of the conditions in paragraph 450-20-25-2 are not met. b. An exposure to loss exists in excess of the amount accrued pursuant to the provisions of paragraph 450-20-30-1.
Further example for illustrations better confirms our conclusion. FASB ASC 450-20-55-31 for “Case C: Trial Is Incomplete but Unfavorable Outcome Is Reasonable Possible” states: Assume the same facts as in Case B, except the entity had assessed the verdict differently (for example, that an unfavorable verdict was not probable but was only reasonably possible). The condition in paragraph 450-20-25-2(a) would not have been met and no amount of loss would be accrued. Paragraphs 450-20-50-3 through 50-8 require disclosure of the nature of the contingency and any amount of loss that is reasonably possible.
The two historical examples exist related to the similar asbestos lawsuits litigated is half- half in favor of the manufacturers fits the external counsel’s estimation, which is an unfavorable outcome and can be reasonable possible for the company to lose money for the compensation. And according to the FASB ASC 450-20-50-4, the disclosure in the preceding paragraph shall include both of the following: a. The nature of the contingency. b. An estimate of the possible loss or range of loss or a statement that such an estimate cannot be made.
Based on the analysis, the omission of disclosure of the facts relating to the litigation was inappropriate due to the reasonably possibility the compensation will happen and the nature of the contingency shall be disclosed in the footnote in Danle 2009’s 10-K.
Question 2: Disclosure Issue for Form 2010 10-K
Danle may expect to receive comments from SEC’s Division of Corporation Finance for its 10-Q that the disclosure is well-written as whole; inappropriate terms is used; and more detail assumptions and judgments about the change of the nature of two class-action lawsuits should be provided. And comments may also give the company advice for its safety environment.
For the disclosure, according to FASB ASC 450-20-25-2, “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 before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. Date of the financial statements means the end of the most recent accounting period for which financial statements are being presented. 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.” The company did believe that unfavorable outcomes of two claims are probable (the company use “probable loss” in the note) and it estimated the range of possible loss which properly applying the code. And the company did describe the nature of the contingencies and recorded the estimated amount which satisfied FASB ASC 450-20-50-1 and FASB ASC 450-20-50-2.
The SEC Staff Guidance FASB ASC 450-20-S99 provides their response, “The SEC Observer noted that the SEC staff would expect a registrant's accounting policy to be applied consistently and that APB Opinion No. 22, Disclosure of Accounting Policies, requires disclosure of material accounting policies and the methods of applying those policies”. However, the word “reserve” used in the company’s note is inappropriate. According to FASB ASC 450-20-50-1, “The term reserve shall not be used for an accrual made pursuant to paragraph 450-20-25-2; that term is limited to an amount of unidentified or unsegregated assets held or retained for a specific purpose,” Since the company accrued the loss, the term “reserve” should not be used here. Instead, the company should record estimated liability in the note. What’s more, the nature of litigation and recognizing the amount contingency liabilities related to two lawsuits are changed. The company disclosed $0 for probable loss for 2009 in its 2010’s 10-Q. But there is no disclosure of loss in its Form 10-K for the year ended 2009. The company should provide more detail information why it changed its assumptions and judgments about two claims. Furthermore, since 2008, almost 150 mechanics suffered severe illness because of exposure to asbestos from the company’s automobile parts, it is reasonably for the company to check its working environment and improve it to reduce similar claims.