Proposed Guidance for Loss Contingencies
By Alan Markowitz, Partner - Assurance Services &
On July 20, 2010, the Financial Accounting Standards Board (FASB) issued its proposed guidance to expand the disclosures related to certain loss contingencies. The FASB’s proposal is the culmination of an extended study following its 2008 proposal to amend the standards regarding loss contingencies. As proposed, the guidance in FASB accounting standards codification 450 (“ASC 450”) would be amended to expand the scope of loss contingencies subject to disclosure to include certain remote contingencies. Under the propose guidance, both quantitative and qualitative disclosures in the financial statements would be expanded. The amendments in this proposal would apply to both public and nonpublic companies, however nonpublic companies would not be required to provide a tabular reconciliation of accrued loss contingencies. This proposed standard resulted from concerns of investors and other users of financial reporting that loss contingencies under the existing guidance of ASC 450 do not provide adequate and timely information to assist them in assessing the likelihood, timing and magnitude of future cash outflows associated with loss contingencies. The current guidance for accounting for contingencies has substantially been in place since Financial Accounting Standard No. 5, Accounting for Contingencies was adopted in 1975.
ASC 450 governs the accrual and disclosure of loss contingencies in a company’s financial statements. ASC 450 as currently in place requires companies to categorize loss contingencies as "probable" (likely to occur), "reasonably possible" (less than likely but more than remote) or "remote" (slight). ASC 450 further requires a company to accrue a loss contingency when the loss is probable and the amount of the loss "can be reasonably estimated." When the standards for accrual are not met, the company still must disclose the loss contingency if there is at least a reasonable possibility that the loss will occur. A disclosure of a loss contingency must describe "the nature of the contingency" and provide an estimate of the possible loss, if one can be made.
Under the existing ASC 450 standard, reporting companies typically do not disclose an estimate of their loss exposure due to the difficulty of developing an accurate estimate of the loss. Companies frequently describe the basic relevant facts and procedural history of the litigation or claim, and indicate the company’s general position regarding the matter (e.g., the company will defend its interests vigorously).
The proposed accounting standard would replace the disclosure requirements applicable to "certain loss contingencies" within the scope of ASC 450, including pending and threatened litigation. ASC 450’s existing standards for accrual and measurement of contingencies would continue to apply. Also consistent with the current ASC 450, the proposed amendments would continue to mandate that all loss contingencies be disclosed, regardless of whether they are accruable, unless the chance of loss is remote — with one exception. Under the proposed standard, even a remote loss contingency must be disclosed if, due to its nature, potential magnitude or potential timing (if known), it could have a "potentially severe impact." The FASB defines a "severe impact" as a "significant financially disruptive effect on the normal functioning of an entity," which is a higher threshold than "material”.
Additionally, the proposed amendment would establish the following disclosure objective. The entity shall disclose qualitative and quantitative information about certain loss contingencies to enable financial statement users to understand the nature of the loss contingencies, their potential magnitude and their potential timing (if known).
To achieve the above objective, an entity would consider the following principles in determining disclosures that are appropriate in light of its individual facts and circumstances. (a) During the early stages of a loss contingency’s life cycle, an entity would disclose information that is available to enable users to understand the loss contingency’s nature, potential magnitude and potential timing (if known). Available information may be limited and, therefore, disclosure may be less extensive in early stages of a loss contingency. In subsequent reporting periods, disclosure would be more extensive as additional information about a potential outcome becomes available.
(b) An entity may aggregate disclosures about similar contingencies (i.e. by class or type) so that the disclosures are understandable and not too detailed. If an entity provides disclosures on an aggregated basis, it would disclose the basis for the aggregation.
When assessing the materiality of loss contingencies to determine whether disclosure is required, an entity would not consider the possibility of recoveries from insurance or other indemnification agreements.
The proposed amendments would require disclosure of publicly available quantitative information, other relevant non-privileged information, and in some cases, information about possible recoveries from insurance and other sources. In addition, a public entity would be required to provide tabular reconciliations of recognized (accrued) loss contingencies that present the activity during the reporting period.
The following transactions are excluded from the scope of this subtopic because they are addressed elsewhere in the codification:
a.) Stock issued to employees
b.) Employment-related costs, including deferred compensation contracts (with some exceptions).
c.) Uncertainty in income taxes
d.) Accounting and reporting by insurance entities
In determining the appropriate classes or types of loss contingencies for disclosure purposes, an entity would evaluate whether contingencies are sufficiently similar to be included in one class primarily on the basis of their nature, terms and characteristics. For example, it might not be appropriate to aggregate amounts related to product warranties issued in an entity’s normal course of business with amounts related to warranties that are subject to litigation, or to aggregate contingencies related to environmental contingencies with product liabilities, warranties or other loss contingencies that are dissimilar. Similarly, it might not be appropriate to aggregate amounts related to individual litigation with those related to class-action lawsuits or to aggregate litigations in jurisdictions that have legal characteristics that could affect the potential timing or the potential magnitude of the loss. Furthermore, it may not be appropriate to group together in one class, loss contingencies that have significantly different timings of expected future cash outflows.
To determine the appropriate level of aggregation, an entity would exercise judgment and strike a balance between obscuring important information as a result of too much aggregation and overburdening financial statement users with excessive detail that may not assist them in understanding the nature, potential magnitude and potential timing (if known) of the entity’s loss contingencies.
For public entities, the new guidance would be effective for fiscal years ending after December 15, 2010, and interim and annual periods in subsequent fiscal years. For nonpublic entities, the new guidance would be effective for the first annual period beginning after December 15, 2010, and for interim periods of fiscal years after the first annual period.
Special thanks to article contributor Kim Lamplough