Proposed standard complaints

By its August 8, 2008 deadline, FASB had received more than 200 letters commenting on its new, proposed standard for loss contingency disclosure requirements. The proposed standard is FASB’s Disclosure of Certain Loss Contingencies, released on June 5, 2008 as an exposure draft, File Reference No. 1600-100. It amends the loss contingency disclosure requirements of FAS 5 and FAS 141R.

Tim Reason reported in CFO.com on August 18, 2008, that the majority of the comments were negative, with “many arguing that the proposal should be scrapped in its entirety.” The Wall Street Journal (WSJ) opined in an editorial on August 7, 2008, that the proposed standard was “a wealth transfer from corporations to trial lawyers, [with] FASB doing no favors to the investors it claims to represent.”

It is not clear, however, that the WSJ editorial staff carefully read either the proposed standard or the primary standard it amends, FAS 5, Accounting for Contingencies, before composing its criticism. The WSJ editorial expressed concern, for example, that companies must set about calculating the fair value of uncertain contingencies, when actually the proposed standard imposes no new measurement requirements (measurement of historic costs under FAS 5 still applies) and the words “fair value” are no where in its text.

Separate from the proposed standard, it is FAS 141R, Business Combinations (Revised), that does require measurement of loss contingencies at fair value. FAS 141R pertains to the surviving entity in mergers and acquisitions, applies only to their acquired properties, and, as planned for the proposed standard, is effective beginning in 2009. It is FAS 141R, not the proposed standard, that requires measurement of those loss contingencies at fair value. What the proposed standard requires is that companies expand the information they disclose about those loss contingencies.

The WSJ editorial also asserted that under the current system (of FAS 5 requirements), a company discloses the potential cost of a contingency, such as a lawsuit, “only when the [company] believes it is ‘probable’” to result in a liability. (WSJ, 2008) In fact, under FAS 5, a company must disclose an estimated loss if a liability is at least reasonably possible, not just probable, or state that such an estimate cannot be made.

There clearly is some distress and uncertainty about the proposed standard’s requirements for loss contingency disclosure. Uncertainty appears to extend, as well, to correct application of the existing standard FAS 5.

[For more information, see Raymond Rose's "Expanded Disclosure Distress and Two Classes of Loss Contingencies," Environmental Claims Journal, Corporate Environmental Disclosure Column, Vol. 20, Issue 4, Oct-Dec 2008.]

Expanded disclosure distress

There is the view that many, if not most, public companies disclose in their financial statements fewer loss contingencies than exist and lower loss contingency costs than are realistic, including for environmental loss contingencies. Investors holding this view contend this under-representation of loss contingencies leaves them unable to evaluate company liabilities sufficiently. FASB, acknowledging this view, has proposed a new standard on disclosure of loss contingencies for companies to implement beginning in 2009.

The new, proposed standard is FASB’s Disclosure of Certain Loss Contingencies, released on June 5, 2008, as an exposure draft, File Reference No. 1600-100. It amends the loss contingency disclosure requirements of FAS 5 and 141R. FASB has scheduled it to be effective for annual financial statements issued for fiscal years ending after December 15, 2008, and for interim and annual periods in subsequent years. This would be beginning in calendar year 2009 for most companies. Under the proposed standard, companies must expand disclosure about their loss contingencies beyond what has been sufficient under FAS 5.

Detractors contend that developing the expanded information will add to the compliance burden that companies already face. They also contend that companies will be vulnerable to subjective and risky judgments they must make about their loss contingencies in order to meet the proposed standard’s information requirements, vulnerable because such judgments can prove wrong.

In fact, for prior compliance with FAS 5, companies already have made their loss contingency determinations. Under the proposed standard, they simply must disclose the basis on which they reached those conclusions. The proposed standard essentially moves information investors need about loss contingencies from company files into investor’s hands.

So, it is not necessarily true that companies will have additional information to develop. Nor is it necessarily the case they will become more vulnerable to the consequences of their judgments as a result of having to provide more information about those judgments.

Distress among companies about compliance with FASB’s proposed standard, as currently written, may derive, at least in part, from prior misapplication of FAS 5 disclosure requirements, wherein companies may have avoided identification of loss contingencies that already should have been indicated in financial statements. This would be consistent with the view that loss contingencies historically have been under-represented in number and estimated cost.

It could well mean that the proposed standard, if it proceeds to finalization, has the messy job—beyond its specific scope—of bringing companies into correct application of FAS 5 recognition and measurement requirements in addition to new implementation of this standard's disclosure requirements.

[For more information, see Raymond Rose's "Expanded Disclosure Distress and Two Classes of Loss Contingencies," Environmental Claims Journal, Corporate Environmental Disclosure Column, Vol. 20, Issue 4, Oct-Dec 2008.]