“Disclosure of Certain Contingency Losses” Exposure Draft Critique

Contingencies refer to existing conditions, situations, or sets of circumstances involving uncertainty as to possible gains or losses to an entity that will ultimately be resolved when one or more future events occur or fail to occur (ASC Glossary). The Financial Accounting Standards Board (FASB) issued an exposure draft in July 2010 relating to additional disclosures relating to certain loss contingencies. FASB argues the necessity of this proposal arises from concerns of investors and other financial statement users relating to disclosures about loss contingencies under the existing guidance. Proponents argue that existing guidance does not provide adequate information to assist users in assessing the likelihood, timing, and magnitude of future cash outflows associated with loss contingencies (Exposure Draft, 1). Although the exposure draft intends to improve financial statement transparency, the balance between “issuing an improved standard must be maintained against possible prejudicial impacts that could adversely affect a company and its investors” (pwc.com)

The first issue of the exposure draft relates to amounts that must be disclosed based on expert testimony. The exposure draft proposes the requirement of disclosing estimated amounts of reasonably possible and remote losses based on the testimony of an expert witness (Chadbourne and Park LLP). This disclosure is flawed and may be misleading considering such testimonies are often imprecise, speculative and subject to cross-examination. Because financial statement users rely on the information provided therein, it is essential to provide the most reasonable information available. Unless preparers gain comfort and confidence over the amount disclosed through evidentiary support, the amount provided by expert testimony should not be a required disclosure.

In addition, the proposal requires disclosure of a possible loss or range of loss and the amount accrued for a particular contingency. The FASB should consider the issue arising from this disclosure and the potential disadvantages this puts companies in during litigation. While the attempt is to provide additional transparency, this disclosure may effectively “provide a bar below which it would be difficult for the company to settle.” Furthermore, plaintiffs are enabled to “track the changes by the tabular reconciliation of accrued loss contingencies” provided in the financial statements. Plaintiffs have the tools to “determine the company's current thinking on a particular contingency's resolution, thus placing the company at a further disadvantage in settlement negotiations. Although such disclosure may be aggregated for all loss contingencies, a significant contingency would still dominate the numbers” (Chadbourne and Park LLP).

The wording of some requirements of the exposure draft raise question to the costs required to implement. One example is the disclosure of “other nonprivileged information that would be relevant to financial statement users to enable them to understand the potential magnitude of the loss” (Exposure Draft). “The reference to “other nonprivileged information”” is vague and will be subject to varying interpretations.” The information required may be highly pejorative and speculative that is expensive to acquire. With this in mind, “this provision will be difficult and costly to implement, especially for remote contingencies with potential severe impact” (AICPA Comment Letter).

The American Bar Association expresses another significant operational issue: the attorney-client privilege may be threatened. Appropriate communications between attorneys and auditors are essential in regards to loss contingencies. “These communications are designed to provide auditors with information supporting contingency accruals and disclosures without compromising the attorney-client privilege or other legal protections” (pwc.com). If this is not addressed, outside legal counsel has to the power to “cite the current AIPCA-American Bar Association treaty as a reason to refuse to provide the information requested for certain disclosures” (AICPA Comment Letter). The proposal may require a reassessment of previous, carefully-constructed agreements between the legal and accounting professions before the proposal is finalized” (pwc.com)

As with all proposals, a cost-benefit analysis should be constructed to determine whether or not the adoption of the proposal in question should occur. Accounting standard setters are often faced with determining the appropriate balance between transparency for investors and respecting private strategies. The objective surrounding this proposal is enhanced disclosures on litigation contingencies. “If finalized, the guidance in the proposed Accounting Standards Update would (1) expand the scope of loss contingencies subject to disclosure to include certain remote contingencies; (2) increase the quantitative and qualitative disclosures entities must provide to enable users to assess the nature, potential magnitude, and potential timing (if known) of loss contingencies; and (3) for public entities, require a tabular reconciliation for changes in amounts recognized for loss contingencies” (deloitte.com). Although the Update’s intentions and goals of transparency align with the goals of financial statements information, this exposure draft is not ready to be accepted in US GAAP.