Dealing with loss contingency

The Financial Accounting Standards Board (FASB) is not a group often associated with controversy. In 2008, however, when FASB brought out its recommendation for a revision of SFAS 141 – which deals with how loss contingencies are handled – a storm of protest arose. As a result, earlier this year an important change was made: items that had attracted the most criticism were rolled back, quickly containing much of the furore.

Was it a tempest in a teapot? That may be the wrong question: not only did FASB do a quick change of its first revision, but the atmosphere in which the revisions were first suggested also shifted dramatically.

As one observer puts it: ‘There are no mergers and acquisitions anymore.’ That’s obviously a dramatic overstatement, but it reflects the mood this year among the thousands of players who find themselves with much less to do in a market sent reeling by the credit crisis that erupted a year ago.

M&A activity, a major focus of the new loss reporting rules, is down to piddling numbers compared with its lofty levels a couple of years ago. Coupled with the fact that the most onerous part of the proposed changes were pulled back, this means most companies have simply had to adjust to reporting changes instead of dealing with what many saw as a major business upheaval.

No small matter
The sharp and sudden reversal by FASB led many observers to suggest the capitulation was politically motivated, although few are complaining. The storm was far from a small matter, however. It represented real concerns about the thorny issue of handling loss contingencies, which FASB has been struggling with for some time. In fact, Deloitte Financial Advisory Services says a March survey of more than 2,000 executives shows some 44.3 percent of executives felt the overall situation then in place would cause them to rethink deal strategy and/or affect planned deal activity. That’s a 10.5 percent increase since executives were asked the same question in February 2008 and a 40.6 percent increase since June 2007, before the rule took effect, according to Deloitte.

‘FSP FAS 141(R)-1 simplified things a bit, going back to the way things were handled earlier,’ explains John Hepp, a partner in the accounting principles group at Grant Thornton in Chicago. ‘But there is a different way of doing things that both user and preparer are going to have to get used to.’

To help struggling companies, the SEC in June issued updated guidelines for public firms that incorporate the April changes. Essentially, the FSP (FASB Staff Position) fixed some of the more problematic changes that had gone into effect with SFAS 141(R), which became effective for business combinations on or after December 15, 2008. The April revision made it easier for companies to account for contingent assets and liabilities, such as litigation claims acquired in business combinations, without having to disclose potentially prejudicial information about these claims in financial statements, a matter that attracted scores of complaints and comments.

Disclosing the unknown
SFAS 141(R) had required financial statements to show contingent assets and liabilities at their acquisition-date fair value if the contingency was ‘contractual’, or if it was ‘non-contractual’ but was ‘more likely than not’ to give rise to an asset or liability. It required this even if the event was not probable and/or the amount of contingency could not reasonably be estimated.

A net effect of the April rollback was to bring many of those requirements back to, or make them consistent with, the status prevailing under SFAS 5, FASB’s Accounting for Contingencies standard. Or, as one issuer put it in its 10Q filing: ‘FSP 141(R)-1 addresses application issues raised by preparers, auditors and members of the legal profession on initial recognition and measurement, subsequent measurement and accounting, and disclosure of assets and liabilities arising from contingencies in a business combination.’

That confusion followed all this is very clear, and not just because of such structurally challenged footnotes for average investors. Legal and accounting groups across the country have carried out a wide series of webinars and conferences aimed at getting people in the professions up to speed on just what needs to be done under the new regime.

There were additional effects of FSP (141)R that came into those discussions, affecting everything from the income statement to the handling of research and development, along with accounting for income tax expenses. The far-reaching effects of those shifts may even upset lending arrangements as M&A picks up again, partly because the low level of activity means fewer professionals have been paying attention to the new environment.

Gone but not forgotten
It’s the legal matters that have dominated inquiries to the experts, however. After the FASB staff rollback calmed corporate and industry waters considerably, the board brought the wider subject back to its formal meeting agenda in mid-August, saying it would look at the topic with more intensity.

Attorney Mark Plichta of Foley & Lardner in Milwaukee has followed the issue closely. He says the process will likely take a long time to resolve, as there are so many interests to be looked after, including those of shareholders, the companies and their industries, lawyers, accountants and many others. FASB, for its part, has considered the many comments generated by last year’s first proposal and exposure draft and has since run a major roundtable bringing all interested parties together.

Looking at the board notes on its August meeting, Plichta says FASB is trying to be cognizant of all parties’ interests and that each of those parties is well-intentioned. ‘The standards group would like to respond to demand for more disclosure, but it doesn’t want to cause attorney-client privilege or attorney work product doctrines to come into play, or for companies to be disadvantaged in litigation by their disclosure,’ he says.

Favoring investors
A look through the comment letters makes it clear that attorneys and preparers were not enthusiastic, says Hepp. Much of the pressure for disclosure came from investors, but Hepp still echoes Plichta’s observations: ‘There is a normal tension in financial reporting. You want FASB to balance that tension, and I believe it’s moving nicely in that direction. This is the value-added of standards groups; they can reconcile tough issues.’

That can be a long and arduous process, however, as the industry is experiencing. FASB set out to ‘improve the completeness of information about a business combination’, which is all well and good, but it has gone rather far out on the side of investors without taking a good look at the effects of greater disclosure on the management of businesses to the best advantage of those investors, or the responsibilities of lawyers to their clients.

Some also point out that a demand for estimates of the value of potential contingencies could put companies at a disadvantage in the marketplace, not to mention the significant degree of difficulty that arises when trying to come up with a price tag before all factors can be weighed.

FASB has acknowledged the input of all participants but the input of the legal community, as demonstrated in the list of top concerns, would appear to have had the most significant impact. FASB stated in its April revision that the action was considered temporary and that it would revisit the issue under its project looking at all contingencies. True to its word, in August the board said redeliberation of disclosure requirements for loss contingencies would start with an initial focus ‘on loss contingencies associated with litigation’. Other types of loss contingencies will be looked at in future meetings.

To focus its approach on litigation-loss contingencies, the board declared an objective on disclosure, as follows: ‘An entity shall disclose qualitative and quantitative information about the loss contingency to enable a financial statement user to understand the nature of the contingency and its potential timing and magnitude.’ It then set forth three primary principles for disclosures, which Plichta notes were not previously expressly declared as key issues, as was the case in the board’s August declaration.

The first principle calls for disclosures about litigation contingencies to focus on the contentions of the parties, rather than predictions about the future outcome. The second says disclosures about a contingency ‘should be more robust as the likelihood and magnitude of loss increase and as the contingency progresses toward resolution.’ Plichta says this seems an approach few would disagree with conceptually, but it remains to be seen what the staff does with it in practice.

Finally, the board stated that disclosures should provide a summary of information that is publicly available about a case and indicate where users can obtain more information. This could be anything from court papers – which might be hard for an average investor to deal with – to press releases or other public documents designed to be more easily comprehended.

While matters related to these principles and a number of other technical issues will get staff attention before board deliberation takes place, the board issued a couple of decisions in August. One states that companies will not be required to disclose information they consider to be confidential or potentially prejudicial. The board also decided against requiring disclosure of settlement negotiations.

All of this marks real progress, but much is yet to be determined. FASB says it cannot rule out putting additional standards in place to affect companies whose fiscal year ends after December 15, 2009, but industry observers expect no great rush. As Hepp says: ‘It won’t be a crushing priority.’ 

All in the details

According to Mark Plichta of Foley & Lardner, the most heavily emphasized concerns with the revisions to SFAS 141 proposed in 2008 are:

• Disclosing potentially prejudicial information in financial statements such as management’s assessment of the viability and possible range of outcomes for a contingent claim without compromising the company’s position in litigation
• Supporting the recognition and measurement of liabilities arising from legal contingencies without disclosing attorney-client privileged information to the company’s auditor and potentially waiving the company’s privilege by making such disclosure
• Determining the acquisition-date fair value of a litigation-related contingency if the contingency was not reasonably estimable
• Distinguishing between a contractual and a non-contractual contingency
• Making the more likely than not determination, which constitutes a lower threshold than FAS 5’s probable threshold.