Handling of Litigation Contingency Disclosure Facing Greater SEC Scrutiny

The SEC appears to be increasing its scrutiny of compliance with financial statement disclosure rules regarding potential court losses. The heightened attention is intersecting with a three-decades-old treaty for lawyers and accountants forged by the AICPA and the American Bar Association.


The JofA spoke with attorney Michael Young, chair of Willkie Farr & Gallagher LLP’s Securities Litigation & Enforcement Practice Group, about the issue. Young is a former member of FASB’s Financial Accounting Standards Advisory Council and recently appeared with Wayne Carnall, chief accountant for the SEC’s Division of Corporation Finance, in a program discussing compliance with GAAP in litigation contingency reporting. Willkie Farr is one of the AICPA’s outside counsel. The following are excerpts from the JofA's conversation with Young:


JofA : Carnall has recently been talking about what’s known as “the treaty” regarding litigation contingencies and has suggested it will not be a defense for companies that do not comply with Accounting Standards Codification (ASC) Topic 450, Contingencies. What’s going on here?


Young: The answer is a bit complicated, so let me start with just a little bit of history. Historically, there has been a tension between auditors who, to their credit, want to learn a lot about pending litigation and companies, who are understandably concerned that disclosure to the auditor will compromise the attorney-client privilege and result in prejudice in the litigation.


About 35 years ago, the accounting profession and the legal profession got together and worked that out and put in place a structure for auditor-lawyer dialogue. The document capturing that structure has informally become known as “the treaty.”


One of the things that the treaty suggests, to reconcile the conflicting objectives, is that lawyers should not offer predictions about the outcome of litigation to auditors unless the odds of being wrong are slight. That understandably can act as a chill on the lawyer-auditor dialogue.


The treaty is still there. It’s still operative. It’s still being used. It still provides the script for much of the auditor interaction with the company counsel.


The point that [Carnall] has apparently sought to make involves the fact that, under ASC Topic 450, a company would need to consider such things as whether a loss from litigation is probable, whether the amount of loss can be reasonably estimated, and whether an estimate of the possible loss or range of loss can be made.


And, of course, if the standard requires that those things be evaluated, then there would presumably be some back and forth with the auditor about the company’s determinations.


The chief accountant seems to be making the point that companies need to do what it takes to see that those things are properly evaluated and properly reported in the financial statements. His main point seems to be that the treaty is not part of generally accepted accounting principles, and it’s generally accepted accounting principles that have the last word. And if a company does not fairly present its financial statements because the treaty has impeded dialogue with the auditor—that is not something the SEC will look favorably on.


JofA : Why is litigation contingency reporting suddenly surfacing as a hot topic?


Young: What’s going on is a bit of a clash of cultures to which FASB and the SEC are now paying a lot of attention. One culture is the commendable culture of transparency in financial reporting. The other culture is our adversarial system of justice, which is inconsistent with transparency in financial reporting.


Both FASB and the SEC have been raising a concern that the present system is broken or, if not broken, not working optimally when it comes to financial statement presentation of litigation contingencies. From FASB’s perspective, they are looking at whether they need to revise the standard. From the SEC’s perspective, they are looking at whether compliance with the present standard should be enhanced. And it so happens that all of this is coming together in this financial reporting season.


Here’s the nut of the problem. FASB, to its credit, wants investors and other users to get the best possible information that financial statements can convey. But when it comes to reporting on litigation, the company can do itself a lot of damage if it’s too transparent.


If, for example, a company says in its financial statements, “We expect to lose this case, and we expect the jury to award damages of $50 million to the plaintiff,” that’s information that would, if candidly presented, be available to the world at large including the plaintiff.


It would immediately establish a floor in settlement discussions and could potentially be used as self-created evidence against the company that prepared the financial statements. That’s the core problem.


JofA : What does the current standard require?


Young: The actual terms of the standard are pretty basic. If you are in a situation where you should disclose litigation, the standard asks for an estimate of the possible loss or range of loss or a statement that such an estimate cannot be made.


The standard also asks the preparer to evaluate the probability of losing and to reasonably estimate, if possible, the amount that would be lost. The key thing about all of that is that it involves forward-looking predictions as to how litigation would come out. Predicting the outcome of litigation can be horrifically difficult. And it creates even more of a problem if such forward-looking predictions become available to the other side in the litigation.


JofA : What’s the current status of this at FASB?


Young: There’s an exposure draft on the table. It is generally viewed as an improvement over an earlier exposure draft though not yet perfect. FASB has received more than 380 comment letters , and the FASB staff is working through them. (FASB has produced a podcast outlining the proposed changes.)


JofA : How does the pending exposure draft intersect with all this?


Young: There is a feature of the pending exposure draft which has caused a fair amount of angst. And that feature calls upon companies to disclose the amount accrued, if any, in connection with a litigation contingency.


The reason that is causing such angst is that an accrual in this context is a forward-looking prediction and, if a company has accrued, then it has presumably come to a determination that it is probably going to lose and that the amount of its loss can be reasonably estimated. And the biggest problem that lawyers are having with the exposure draft is that, in calling for disclosure of that accrual, the exposure draft is basically asking companies to publicly confess in their financial statements that they believe they will lose and to set forth the amount that they expect to pay.


JofA : Who needs to be paying attention to this?


Young: Pretty much all companies that use accounting. As a practical matter, that will include several groups of individuals.


One is the accounting department within the company. Another is in-house lawyers at the company. Beyond that, outside lawyers will want to pay attention because they are often called upon by the auditor to provide information regarding litigation contingencies. And on top of that, auditors of financial statements will want to pay attention. The SEC is saying, “We’re going to be taking a hard look at litigation contingency reporting this season,” and of course the auditors will want to evaluate the financial reporting’s conformity to GAAP.


It’s probably a bigger problem for public companies because public companies face a greater likelihood of massive class-action litigation, but the standard applies to both public companies and private companies, so it’s an issue for everyone.


The downsides of noncompliance can be significant. And that’s a big reason why companies now are working so hard to get it right.


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