An Alarming Trend in Financial Reporting for Loss Contingencies Corporate Counsel Series May 2006 Corporate Counsel Series May 2006.

An Alarming Trend in Financial Reporting

for Loss Contingencies

An Alarming Trend in Financial Reporting

for Loss Contingencies

Corporate Counsel SeriesMay 2006

May 2006 2

AgendaAgenda

• Existing Rules

• Uncertain Tax Positions

• Environmental Liabilities

• Other Loss Contingencies

• Strategies for Compliance

• Existing Rules

• Uncertain Tax Positions

• Environmental Liabilities

• Other Loss Contingencies

• Strategies for Compliance

May 2006 3

An Alarming Trend in Financial Reporting for Loss Contingencies


Existing RulesExisting Rules

May 2006 4


• FASB Stmt No. 5 – Accounting for Contingencies

– Gain Contingencies: usually not recognized

– Accrual of Loss Contingencies• If claim is unasserted, it must be probable that a claim will be

asserted; • It must be probable that future events will confirm that a loss

(liability or asset impairment) has been incurred; and• The amount of loss can be reasonably estimated (If estimated

loss is a range and no one best estimate, accrue the low end of the range and disclose the range in the footnotes)

– Disclosure of Loss Contingencies• Accrued Loss: only necessary information• No Accrued Loss: if there is a realistic possibility of a loss (or

additional loss), disclose the potential loss (or additional loss)

• FASB Stmt No. 5 – Accounting for Contingencies

– Gain Contingencies: usually not recognized

– Accrual of Loss Contingencies• If claim is unasserted, it must be probable that a claim will be

asserted; • It must be probable that future events will confirm that a loss

(liability or asset impairment) has been incurred; and• The amount of loss can be reasonably estimated (If estimated

loss is a range and no one best estimate, accrue the low end of the range and disclose the range in the footnotes)

– Disclosure of Loss Contingencies• Accrued Loss: only necessary information• No Accrued Loss: if there is a realistic possibility of a loss (or

additional loss), disclose the potential loss (or additional loss)

May 2006 5


• Perceived Deficiencies in Existing Rules

– High threshold for accrual (probable standard), and

– Low end of the range convention for estimation

– Limited disclosure

Result = systematic underreporting of liabilities

• Recent Trend– Recognition of liabilities when obligating events occur

– Measurement of liabilities at fair value taking into account uncertainties regarding existence, amount, or timing of loss

– Disclosure of all material information

• Perceived Deficiencies in Existing Rules

– High threshold for accrual (probable standard), and

– Low end of the range convention for estimation

– Limited disclosure

Result = systematic underreporting of liabilities

• Recent Trend– Recognition of liabilities when obligating events occur

– Measurement of liabilities at fair value taking into account uncertainties regarding existence, amount, or timing of loss

– Disclosure of all material information

May 2006 6



Uncertain Tax PositionsUncertain Tax Positions

May 2006 7


• Enron

– Engaged in tax shelter transactions for purpose of recognizing financial earnings

– Failed to recognize any loss contingency accrual with respect to underlying tax positions

– Limited or no disclosure

• Enron

– Engaged in tax shelter transactions for purpose of recognizing financial earnings

– Failed to recognize any loss contingency accrual with respect to underlying tax positions

– Limited or no disclosure

May 2006 8


• SEC Response

– Demanded that FASB “fix” the tax accounting rules

– Proposed that tax positions not be recognized in financial statements unless it is probable they will be sustained

• FASB Response

– Presume audit detection of all tax issues (no “audit lottery”)

– Recognize tax benefit only if more likely than not that position will be sustained (probable standard rejected)

– If recognition criteria met, measure the benefit at the amount that has a cumulative probability of more likely than not of being realized (e.g., through settlement)

• SEC Response

– Demanded that FASB “fix” the tax accounting rules

– Proposed that tax positions not be recognized in financial statements unless it is probable they will be sustained

• FASB Response

– Presume audit detection of all tax issues (no “audit lottery”)

– Recognize tax benefit only if more likely than not that position will be sustained (probable standard rejected)

– If recognition criteria met, measure the benefit at the amount that has a cumulative probability of more likely than not of being realized (e.g., through settlement)

May 2006 9


• Implications and Concerns

– Conclusive presumption that unasserted claims will be asserted

• Creates risk of perpetual liabilities (e.g., nexus issue)

• How to measure potential liability (e.g., transfer pricing issue)?

– Documentation that positions meet MLTN standard

– Documentation of settlement probabilities

– Documentation creates “roadmap” and privilege concerns

• Implications and Concerns

– Conclusive presumption that unasserted claims will be asserted

• Creates risk of perpetual liabilities (e.g., nexus issue)

• How to measure potential liability (e.g., transfer pricing issue)?

– Documentation that positions meet MLTN standard

– Documentation of settlement probabilities

– Documentation creates “roadmap” and privilege concerns

May 2006 10


• Conclusion

– Presumption of liability for tax loss contingencies will produce significant overstatements of tax liabilities; irrational rules and bad accounting driven by tax shelter outrage

– Goes well beyond recent trend with respect to recognition and measurement of loss contingencies; creates special rules for tax loss contingencies

– Not a likely blueprint for treatment of other loss contingencies

– Does indicate FASB/SEC leaning toward more comprehensive accrual and disclosure of loss contingencies

• Conclusion

– Presumption of liability for tax loss contingencies will produce significant overstatements of tax liabilities; irrational rules and bad accounting driven by tax shelter outrage

– Goes well beyond recent trend with respect to recognition and measurement of loss contingencies; creates special rules for tax loss contingencies

– Not a likely blueprint for treatment of other loss contingencies

– Does indicate FASB/SEC leaning toward more comprehensive accrual and disclosure of loss contingencies

May 2006 11



Environmental LiabilitiesEnvironmental Liabilities

May 2006 12


• FASB Statement No. 143 – Asset Retirement Obligations (FAS 143)

– Recognize the fair value of an asset retirement obligation in the period in which it is incurred or, if later, when a reasonable estimate is possible

– Fair value generally = probability weighted expected cash flows discounted at credit adjusted risk free rate

– Accounting: Capitalize estimated retirement cost and record offsetting liability; then amortize the capitalized cost using a “systematic and rational method”; remeasure each period

– Disclosure: Description and reconciliation of beginning and ending amounts

• FASB Statement No. 143 – Asset Retirement Obligations (FAS 143)

– Recognize the fair value of an asset retirement obligation in the period in which it is incurred or, if later, when a reasonable estimate is possible

– Fair value generally = probability weighted expected cash flows discounted at credit adjusted risk free rate

– Accounting: Capitalize estimated retirement cost and record offsetting liability; then amortize the capitalized cost using a “systematic and rational method”; remeasure each period

– Disclosure: Description and reconciliation of beginning and ending amounts

May 2006 13


• FASB Interpretation No. 47 (FIN 47)

– Clarifies application of FAS 143 to “conditional asset retirement obligations” (obligations as to which the timing or method of settlement is conditional on a future event or is not within the entity’s control)

– All examples involve environmental liabilities• Example 1: removal of chemically treated utility poles• Example 2: replacement of contaminated kiln bricks• Examples 3 and 4: factory containing asbestos

– Recognition of a liability hinges on:• Existing obligating events, and• Ability to reasonably estimate present value of costs

• FASB Interpretation No. 47 (FIN 47)

– Clarifies application of FAS 143 to “conditional asset retirement obligations” (obligations as to which the timing or method of settlement is conditional on a future event or is not within the entity’s control)

– All examples involve environmental liabilities• Example 1: removal of chemically treated utility poles• Example 2: replacement of contaminated kiln bricks• Examples 3 and 4: factory containing asbestos

– Recognition of a liability hinges on:• Existing obligating events, and• Ability to reasonably estimate present value of costs

May 2006 14


• GASB Proposed Statement

– Replaces FAS 5 standards for pollution remediation obligations of governmental entities related to existing pollution (e.g., hazardous waste cleanup obligation)

– Could have implications for non-governmental entities

– Approach

• Identify sites known or reasonably believed to be polluted

• Determine if “obligating events” have occurred (recognition)

• Estimate the expected outlays for various components of remediation activities (measurement)

• Disclose nature and source of obligation, amount and method of estimating liability, potential for changes, potential recoveries

• GASB Proposed Statement

– Replaces FAS 5 standards for pollution remediation obligations of governmental entities related to existing pollution (e.g., hazardous waste cleanup obligation)

– Could have implications for non-governmental entities

– Approach

• Identify sites known or reasonably believed to be polluted

• Determine if “obligating events” have occurred (recognition)

• Estimate the expected outlays for various components of remediation activities (measurement)

• Disclose nature and source of obligation, amount and method of estimating liability, potential for changes, potential recoveries

May 2006 15


• Conclusion

– FAS143/FIN 47 and GASB Proposed Statement represent the current trend in financial reporting for loss contingencies

• Recognition based on obligating events• Measurement using probability weighted expected cash flows• Disclosure of more information

– Ability to estimate fair value will be pivotal to financial reporting

– Concerns• Accrual = admission of liability?• Disclosure of settlement estimates?

– FAS 5 remains applicable to many environmental liabilities

• Conclusion

– FAS143/FIN 47 and GASB Proposed Statement represent the current trend in financial reporting for loss contingencies

• Recognition based on obligating events• Measurement using probability weighted expected cash flows• Disclosure of more information

– Ability to estimate fair value will be pivotal to financial reporting

– Concerns• Accrual = admission of liability?• Disclosure of settlement estimates?

– FAS 5 remains applicable to many environmental liabilities

May 2006 16



Other Loss ContingenciesOther Loss Contingencies

May 2006 17


• IASB Exposure Draft on Contingent Assets and Liabilities

– Eliminates concept of “contingent liability”

– Recognition: Recognize all present obligations arising from past events (a/k/a obligating events)

– Measurement: uncertainties regarding amount or timing of payment are reflected in the measurement of the liability; measure at present value of probability weighted expected cash flows

– Disclosure: disclose amount, description, reconciliation, timing, uncertainties, and potential recoveries

• IASB Exposure Draft on Contingent Assets and Liabilities

– Eliminates concept of “contingent liability”

– Recognition: Recognize all present obligations arising from past events (a/k/a obligating events)

– Measurement: uncertainties regarding amount or timing of payment are reflected in the measurement of the liability; measure at present value of probability weighted expected cash flows

– Disclosure: disclose amount, description, reconciliation, timing, uncertainties, and potential recoveries

May 2006 18


• Examples

– Example 1 – Lawsuit:• A lawsuit is an obligating event* that gives rise to an

unconditional obligation to stand ready to pay whatever damages might be awarded by the court. Any uncertainty regarding whether and to what extent damages might be awarded is taken into account in measuring the liability.

• The act giving rise to the lawsuit could be the obligating event

– Example 2 – Warranty:• The issuance of a warranty contract is an obligating event that

creates a present obligation to stand ready to perform under the terms of the contract, and any uncertainty over whether and to what extent costs will actually be incurred to satisfy a warranty claim is a matter of measurement.

• Examples

– Example 1 – Lawsuit:• A lawsuit is an obligating event* that gives rise to an

unconditional obligation to stand ready to pay whatever damages might be awarded by the court. Any uncertainty regarding whether and to what extent damages might be awarded is taken into account in measuring the liability.

• The act giving rise to the lawsuit could be the obligating event

– Example 2 – Warranty:• The issuance of a warranty contract is an obligating event that

creates a present obligation to stand ready to perform under the terms of the contract, and any uncertainty over whether and to what extent costs will actually be incurred to satisfy a warranty claim is a matter of measurement.

May 2006 19


• FASB Invitation to Comment

– Notes that IASB proposed approach is consistent with FIN 47

– Seeks comments on whether constituents agree• with the IASB’s analysis of contractual liabilities (warranty

example) as stand-by liabilities• that IASB has appropriately applied the stand-by liability analysis

to non-contractual liabilities (lawsuit example)• with omitting the probability criterion for recognition of a liability• with IASB’s proposed expected value approach for measurement

of liabilities

– Implication is that FASB supports the IASB proposal, but comment letters were generally critical

• FASB Invitation to Comment

– Notes that IASB proposed approach is consistent with FIN 47

– Seeks comments on whether constituents agree• with the IASB’s analysis of contractual liabilities (warranty

example) as stand-by liabilities• that IASB has appropriately applied the stand-by liability analysis

to non-contractual liabilities (lawsuit example)• with omitting the probability criterion for recognition of a liability• with IASB’s proposed expected value approach for measurement

of liabilities

– Implication is that FASB supports the IASB proposal, but comment letters were generally critical

May 2006 20


• Conclusion

– FASB seems inclined to replace FAS 5 rules for loss contingencies generally with rules similar to FIN 47, the GASB Proposed Statement, and the IASB proposals

– Raises same concerns as FIN 47• Accrual = admission of liability?• Will the new rules compromise the company’s settlement

positions and right to assert privilege?• Will the requirements to accrue and/or disclose unasserted

claims invite lawsuits?

– Similar concerns under FAS 5, but less pronounced

– Ability to estimate the liability will be a critical factor

• Conclusion

– FASB seems inclined to replace FAS 5 rules for loss contingencies generally with rules similar to FIN 47, the GASB Proposed Statement, and the IASB proposals

– Raises same concerns as FIN 47• Accrual = admission of liability?• Will the new rules compromise the company’s settlement

positions and right to assert privilege?• Will the requirements to accrue and/or disclose unasserted

claims invite lawsuits?

– Similar concerns under FAS 5, but less pronounced

– Ability to estimate the liability will be a critical factor

May 2006 21



Strategies for ComplianceStrategies for Compliance

May 2006 22

Strategies for ComplianceStrategies for Compliance

1. Keep risk assessment and accounting compliance separate

• Risk Assessment: privileged investigation to identify and evaluate loss contingencies

• Accounting Compliance: workpapers supporting accounting positions and conclusions; should not include or reveal counsel’s privileged advice and analysis

2. Avoid, defer, or minimize accrued liabilities based on uncertainty of existence, timing, or amount of loss

• Resist pressure for probability weighted outcome estimates

3. Increase disclosure of those matters that are known to adversaries or that do not adversely affect settlement

1. Keep risk assessment and accounting compliance separate

• Risk Assessment: privileged investigation to identify and evaluate loss contingencies

• Accounting Compliance: workpapers supporting accounting positions and conclusions; should not include or reveal counsel’s privileged advice and analysis

2. Avoid, defer, or minimize accrued liabilities based on uncertainty of existence, timing, or amount of loss

• Resist pressure for probability weighted outcome estimates

3. Increase disclosure of those matters that are known to adversaries or that do not adversely affect settlement

May 2006 23



QuestionsQuestions

May 2006 24



• Sources

– FASB Project on Uncertain Tax Positions• www.fasb.org/project/uncertain_tax_positions.shtml

– FAS 143 – Accounting for Asset Retirement Obligations• www.fasb.org/pdf/fas143.pdf

– FIN 47 – Conditional Asset Retirement Obligations• www.fasb.org/pdf/fin%2047.pdf

– GASB Project on Pollution Remediation Obligations• www.gasb.org/project_pages/

pollution_remediation_obligations.html

– FASB Invitation to Comment• www.fasb.org/draft/itc_assets_liabilities_with_uncertainties.pdf

• Sources

– FASB Project on Uncertain Tax Positions• www.fasb.org/project/uncertain_tax_positions.shtml

– FAS 143 – Accounting for Asset Retirement Obligations• www.fasb.org/pdf/fas143.pdf

– FIN 47 – Conditional Asset Retirement Obligations• www.fasb.org/pdf/fin%2047.pdf

– GASB Project on Pollution Remediation Obligations• www.gasb.org/project_pages/

pollution_remediation_obligations.html

– FASB Invitation to Comment• www.fasb.org/draft/itc_assets_liabilities_with_uncertainties.pdf

An Alarming Trend in Financial Reporting for Loss Contingencies Corporate Counsel Series May 2006 Corporate Counsel Series May 2006.

Documents

potential loss

loss liability

accrued loss

estimated loss

accrual of loss contingencies

loss contingencies strategies

additional loss slide

timing of loss disclosure