FASB proposes new Statement No. 5

By Cydney Posner

In June, the FASB issued a new exposure draft proposing significant amendments to Statement No. 5, Disclosure of Certain Loss Contingencies, that has deservedly created quite a stir among companies, as well as legal and accounting professionals. The proposal would expand both the number and type of loss contingencies that are required to be disclosed and the extent of disclosure of specific quantitative and qualitative information about those loss contingencies. The exposure draft is designed to address the concerns of investors and others that the disclosures about certain loss contingencies under existing guidance do not provide sufficient information in a timely manner to assist them in assessing the likelihood, timing and amounts of loss contingencies. However, the proposed new FAS 5 would have potentially dramatic implications in the contexts of litigation and public reporting, as well as in our audit letter practices. If adopted, new FAS 5 would be effective commencing with fiscal years ending after December 15, 2008.

Currently, FAS 5 requires that a company accrue a liability in its financial statements for loss contingencies, such as pending or threatened litigation and claims, where the losses are (i) probable and (ii) can be reasonably estimated. Even if no loss accrual is required, a loss contingency must nevertheless be disclosed under the current standard if the loss is "at least reasonably possible," that is, the chance of the loss' occurring is more than remote, but less than likely. The new standard would turn this threshold on its head and require disclosure unless the likelihood of a loss is "remote," that is, the chance of the loss' occurring is slight. Moreover, the company must disclose a loss contingency, regardless of the likelihood of loss, if the contingency (i) is expected to be resolved in the near term (that is, within one year) and (ii) "could have a severe impact" on the company's financial position, cash flows or results of operations. A "severe impact" means "a significant financially disruptive effect on the normal functioning of an entity. Severe impact is a higher threshold than material....[but] less than catastrophic." Although the meaning of "could" in this analysis is not entirely clear, it may even require a "worst case" analysis.

Under the current FAS 5, disclosure of the potential loss is not required if the company believes and states that "an estimate of the possible loss or range of loss cannot be made." However, investors have apparently complained that this option is "exercised with such frequency" that investors "often have no basis for assessing an entity's possible future cash flows associated with loss contingencies." To address this concern, the exposure draft would require the company to disclose (i) the amount of the claim or assessment against the entity (including damages, such as treble or punitive damages), if applicable or (ii) if there is no claim or assessment amount, the entity’s best estimate of the maximum exposure to loss. If the company believes that the amount of the claim is not representative of its actual exposure, the company may also disclose its best estimate of the possible loss or range of loss. In addition, the company must disclose qualitative information about the contingency sufficient to enable users to understand the risks, including:

• 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 company's qualitative assessment of the most likely outcome of the contingency; and
• significant assumptions made by the company in calculating the estimated amounts disclosed and in assessing the most likely outcome.

The company must also provide a qualitative and quantitative description of the terms of relevant insurance or indemnification arrangements, including any caps, limitations or deductibles that could affect the amount of recovery.

A special exception could be made in cases where disclosure may be prejudicial (that is, it could detrimentally affect the outcome of the contingency itself). In all circumstances, regardless of whether the disclosure is prejudicial, the disclosures may be aggregated by the nature of the loss contingency (for example, product liability or antitrust matters). Where disclosure may be prejudicial, the company may aggregate the disclosures at an even higher level to avoid the prejudice. And, in "rare" instances (which the exposure draft takes pains to make clear is not intended to mean "never") when even aggregating at a higher level is not effective (for example, if a company is involved in only one legal dispute), the company may omit disclosure of any prejudicial information (such as the company's assessment of the likely outcome of the case), except that it may not omit the amount of the claim or assessment (or, if there is no claim amount, an estimate of the company's maximum exposure to loss); a description of the loss contingency, including how it arose, its legal or contractual basis, its current status and the anticipated timing of its resolution; and a description of the factors that are likely to affect the ultimate outcome of the contingency along with the potential impact on the outcome. In those instances where the company has omitted information under this special exception, the company must disclose the fact that, and the reason why, the information has not been disclosed.

As noted above, the exposure draft has been highly controversial, raising a variety of concerns. The increase in the population of loss contingencies that must be analyzed and disclosed, even where the possibility of loss is truly remote, will create arguably unnecessary additional burdens in time and expense. In addition, the exposure draft's requirement that a company provide its estimate of its exposure (where no amount has been claimed) and its estimate as to the timing of resolution of the litigation could adversely affect a company's liability in litigation or settlement talks (for example, where the company's adversary may have underestimated the full potential of the claim). Disclosure of the required qualitative information could also compromise a company's litigation or settlement position, particularly in light of the different complexion of information presented in different contexts: for example, a company's typically conservative assessment of the potential outcome in a periodic report might not be consistent with its more optimistic assessment in the course of arguing its case and might be used against the company in the course of settlement negotiations. In addition, it is unclear whether the proposed "aggregation" antidote will provide effective camouflage from a company's legal adversaries or others, given the extent of additional information that must be provided, or whether the narrow option to omit some aspects of disclosure will in practice be too limited in its application or altogether too unsettling for a risk-averse accounting profession to accept. Concerns have also been raised that the disclosures present the risk of waivers of the attorney-client or work product protections. It has been reported that both the ABA and the Association of Corporate Counsel are preparing letters expressing their views on the exposure draft.

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