Assignment ContentWrite a 260- to 350-word summary of this week’s readings.Describe major concepts you learned.Explain how you can apply what you learned to your current or future workplace.
A
& A U D I T
international accounting
C C O U N T I N G
I N G
Loss Contingencies Face Controversy
in Convergence
Amendments to SFAS 5 and IAS 37 Are Rethought Amid Criticism
By Anthony D. Holder and
Khondkar E. Karim
A
s part of their short-term convergence project, FASB and the
International Accounting Standards
Board (IASB) are currently reviewing their
accounting for loss contingencies. Statement
of Financial Accounting Standards (SFAS)
5, Accounting for Contingencies, acts as the
primary accounting guidance for the accrual or disclosure of loss contingencies.
Similarly, International Accounting Standard
(IAS) 37, Provisions, Contingent Liabilities
and Contingent Assets, prescribes the recognition, measurement, and disclosure requirements for such items. Few convergence topics have generated as much controversy or
discussion as this one. This article discusses the viewpoints of both standards-setting
bodies, summarizes respondents’ reactions,
articulates the controversies, and illustrates
the practical implications of these findings.
ed with loss contingencies. The proposed
amendments will enhance the current qualitative disclosures by requiring disclosure
of publicly available quantitative information (such as the claim amount for assert-
by Rosemond Desir, Kirsten Fanning, and
Ray Pfeiffer (“Are Revisions to SFAS No.
5 Needed?” Accounting Horizons, vol. 24,
no. 4, pp. 525–545, December 2010). This
research project was undertaken while one
ed litigation contingencies), other relevant
nonprivileged information, and, in some
cases, information about possible recoveries from insurance and other sources.
Likewise, according to the IASB, the
proposed amendments to IAS 37 (ED 1)
will enhance the current qualitative disclosures by requiring additional disclosures.
For example, in the case of litigation contingencies, the new rules will require disclosure of the parties’ contentions and the
ways that users can obtain additional information about the litigation.
of the authors was a FASB research fellow,
and the results of the study were given to
FASB staff prior to the issuance of a second
exposure draft in 2010. According to Desir
et al., this situation is novel because it is
one of the few instances where academic
research contributes to policy making ex
ante. This is “more desirable because it
enhances the likelihood that new guidance
is actually warranted based on the data and
that such new guidance achieves its intended purpose of improving the information
available to financial statement users.” At
FASB’s request, the authors looked at
whether there was any validity in constituents’ assertions that SFAS 5 led to inadequate disclosures.
The First Exposure Drafts
In June 2005 and June 2008, the IASB
and FASB, respectively, published exposure drafts to expand disclosures about certain loss contingencies in the scopes of IAS
37 and SFAS 5. These projects were undertaken jointly by FASB and the IASB to
help reduce the differences in accounting
for contingent liabilities between
International Financial Reporting Standards
(IFRS) and U.S. GAAP.
According to FASB, the proposed
changes in the first exposure draft (ED 1)
result from the perception among investors
and other users of financial information that
disclosures about loss contingencies are
inadequate, primarily because existing
FASB guidance does not achieve its stated purpose of providing sufficient information to assist users of financial statements in assessing the likelihood, timing,
and amount of future cash flows associat-
34
Related Research
There are relatively few research papers
in this area. One notable exception is a study
JANUARY 2012 / THE CPA JOURNAL
The study examined a sample of litigation-related losses and documented characteristics of the disclosures that firms made
prior to reporting the unfavorable outcome.
The authors interpreted their results as indicating a surprisingly large incidence of
nondisclosure of contingent losses, which
they were unable to explain. In some cases,
the authors found that even when there was
disclosure, there was a relatively high incidence of companies not providing estimates of expected losses; however, this result
was attributed to the permitted exception for
cases where companies are unable to estimate the magnitude of expected losses.
Alternatively, the authors did find several
cases where companies disclosed items that
are not yet required, but will be if the proposed changes in the exposure draft are
accepted. The latter result was interpreted as
suggesting that this information is being provided at users’ request.
On the other side of the coin, there is a
quite a bit of anecdotal evidence suggesting that companies will be severely
affected by the proposed changes. For
example, a 2010 Financial Times article
noted that the proposed changes have led
to a backlash from 140 of the biggest
U.S. businesses, including AT&T, Bank of
America, Citigroup, Coca-Cola, Ford
Motor, General Electric, Google, HewlettPackard, Intel, and McDonald’s (Jean
Eaglesham, “U.S. Groups Warn on
Lawsuit Proposals,” www.ft.com/cms/s/0/
2f720eea-c410-11df-b827-00144
feab49a.html#axzz1JQNXu8QG). Many
affected companies are concerned that the
proposals could trigger litigation against
businesses that make inaccurate estimates
of future losses. These companies are also
concerned that the proposed changes will
stimulate class-action lawsuits and make
shareholder-friendly settlements more challenging. The article claims that “the only
folks who benefit from this are people on
the plaintiffs’ bar, who would love more
information about what companies deem
the value of litigation may be,” and it notes
that the companies fear that the proposed
changes would open up a new front in
the ongoing war between U.S. corporations
and class-action attorneys, who specialize
in lawsuits that are often settled for a tiny
proportion of the initial claim.
In fact, SFAS 5 is often referred to as a
“treaty” between the accounting and legal
JANUARY 2012 / THE CPA JOURNAL
professions (M. Barrett, “Opportunities for
Obtaining and Using Litigation Reserves and
Disclosures,” Ohio State Law Journal, vol.
63, no. 5, pp. 1017–1106, 2002). But in June
2008, FASB effectively announced its reconsideration of the “treaty” by issuing ED 1,
the proposed Accounting Standards Update
(ASU) 450, Contingencies: Disclosure of
Certain Loss Contingencies, which recommended changes to SFAS 5. On the other
hand, much of the impetus for the proposed changes underlying IAS 37 is driven
by the SEC’s proposed road map, which sug-
Many affected companies
are concerned that the proposals
could trigger litigation against
businesses that make inaccurate
estimates of future losses.
gests that FASB and the IASB continue to
work toward the convergence of standards
through 2011 (Katie Rahr, Khondkar E.
Karim, and Robert W. Rutledge,
“Transitioning to IFRS: What Should CPAs
and Accounting Firms Be Doing?” The CPA
Journal, pp. 6–9, March 2010). The
Financial Accounting Standards Advisory
Council (FASAC) defines convergence as
follows: “[The IASB and FASB] rejected
the dictionary definition of convergence,
moving toward union or uniformity, as an
end in itself, agreeing instead to focus on
convergence as described in the 2002
Norwalk Agreement—the development of
high-quality compatible accounting standards
that could be used for both domestic and
cross-border financial reporting” (FASB,
Memorandum of Understanding: The
Norwalk Agreement, 2002, www.fasb.org/
news/memorandum.pdf; FASB, FASB and
IASB Agree to Work Together Toward
Convergence of Global Accounting
Standards, October 29, 2002).
Consequently, it is somewhat interesting
that the changes in the proposed SFAS 5
ED 1 are similar, but not identical, to those
proposed for the IAS 37 ED 1, which
seems instead to work against the stated
convergence agenda.
Comment Letters
The IASB and FASB received numerous comment letters on the proposal to converge the guidance in IAS 37 with SFAS
5. Respondents included preparers,
accounting firms, several accounting bodies, and some individuals. On July 20,
2010, FASB issued a second exposure draft
(ED 2) to expand disclosures about certain
loss contingencies, primarily because of
highly critical feedback in the original comment letters.
For this article, the authors obtained the
IASB’s ED 1 and FASB’s ED 1 comment letters directly from the boards’
respective websites. For the analysis of the
formal direct participation of constituents
in FASB’s and the IASB’s due processes,
the authors examined 125 comment letters written in response to FASB’s original ED 1 and 80 comment letters written
in response to the IASB’s ED 1, dating
from June 2005 to August 2008.
FASB. According to the original comment letters, the proposed changes will
have a generally negative impact on companies and will not improve the quality of
financial reporting. Specifically, the
changes will—
I lead to less accurate and less useful
information for investors,
I threaten the attorney-client privilege
and the attorney work-product doctrine, and
I unnecessarily provide damaging information to potential claimants and force corporate defendants to disclose privileged
information to plaintiffs.
Many commentators also argued that the
proposed disclosures will require companies to make public their internal litigation strategies to the very entities
involved in the lawsuits against them.
Furthermore, the changes will increase
the compliance effort necessary to create
the expanded disclosures, and they will
encourage plaintiffs to file claims with
extraordinary demands in order to force
companies to settle lawsuits earlier to elim-
35
inate disclosure. Thus, many respondents
believe that financial statement readers will
not be better served by the enhanced disclosure rules.
Other respondents, however, noted that
the changes proposed by ED1 represent an
important step in providing investors with
improved disclosures. These letters suggest
that the current guidance for the disclosure
of loss contingencies does indeed fail to “provide adequate information to assist users of
financial statements in assessing the likelihood, timing, and amount of future cash
flows associated with loss contingencies.”
According to this group of constituents,
FASB is accurate in its assessment that the
existing SFAS 5 has failed to produce this
“adequate information to assist users of
financial statements.”
IASB. In general, most respondents disagreed with the proposals and suggested
that the IASB has not made a sufficiently
compelling case for the changes arising
from its consideration of contingencies.
The consensus viewpoint expressed by this
group is that there are insufficient flaws
in the current IAS 37 to warrant changes;
therefore, they raised questions about
whether the amendments will actually
improve the relevance and consistency of
financial reporting. Furthermore, the proposed changes will fundamentally change
the accounting concepts applied to the
recognition and measurement of all nonfinancial liabilities. Although some in this
group welcomed the IASB’s decision to
reconsider the concepts underpinning the
recognition and measurement of nonfi-
nancial liabilities, many of these same
respondents suggested that changing IAS
37 at this stage is premature.
An alternative argument expressed by
several writers was that making these
changes to IAS 37 before amending the
Conceptual Framework is inadvisable,
because the changes may ultimately
impair the authority of the framework.
This group of respondents encouraged the
board to use the response to the ED 1 in
a similar fashion as FASB, as input into
the Conceptual Framework Project. Yet
many note that FASB has so far used
the concept of a stand-ready obligation
only in limited cases. Respondents, therefore, commented that one unintended consequence of the amendments may be to
create major additional differences
EXHIBIT 1
Timeline of Proposed Changes to Accounting for Loss Contingencies
FASB Timeline
March
1975
SFAS 5
Issued
June
2008
August 2008/
December 2008
ED 1
Issued
ED 1
Comment Letter
Deadline/
Effective
Date
July
2010
August
2010
ED 2
Issued
ED 2
Comment Letter
Deadline/
Effective
Date
January
2010
April
2010
ED 2
Issued
ED 2
Comment Letter
Deadline/
Effective
Date
IASB Timeline
September
1998
IAS 37
Issued
36
June
2005
October 2005/
January 2007
ED 1
Issued
ED 1
Comment Letter
Deadline/
Effective
Date
JANUARY 2012 / THE CPA JOURNAL
between U.S. GAAP and the short-term
convergence project. Finally, a pervasive
theme expressed by some respondents was
that the IASB should continue its joint
work with FASB.
The Second Exposure Drafts
On July 20, 2010, FASB released a second exposure draft, Accounting Standards
Update: Contingencies (Topic 450):
Disclosures of Certain Loss Contingencies
(ED 2) that reflected certain changes to
its proposal on accounting for contingencies after considering the comments
received on ED 1. Like ED 1, ED 2 also
revolves around the enhanced disclosures
on litigation contingencies. Largely because
of the critical feedback received in the original comment letters for ED 1 (litigation
contingency disclosures in particular),
FASB conducted additional outreach—
including field tests and a public
roundtable—before issuing ED 2.
In January 2010, the IASB also published
a second exposure draft that modified its proposed guidance on accounting for contingencies. (See Exhibit 1 for a timeline of
FASB and IASB exposure drafts.) As with
FASB’s ED 2, the IASB’s ED 2 also
addressed the perceived shortcomings of ED
1. In general, IASB respondents expressed
frustration with the inherent ambiguity in the
language used in ED 1. For example, respondents were confused about terms such as
“settle” and ”transfer”: What does the term
settle mean? Does it mean cancel or fulfill?
What if the amount to settle the obligation
differs from the transfer amount? At which
of the two amounts should the liability be
measured? What if the entity is unable to
transfer a liability to a third party? Should
an entity be expected to measure a liability
at an amount that it may never have to
actually pay?
the entity’s financial position, cash flows,
or results of operations. IAS 37, on the
other hand, does not require disclosures for
remote loss contingencies, regardless of the
expected timing of resolution or potential
severity of the contingency. FASB also
noted that the IASB is expected to evaluate the disclosure requirements in this
proposed guidance when it reconsiders the
IAS 37 disclosure requirements.
One of the IASB’s primary reasons for
issuing the proposed amendments to IAS
37 is its short-term convergence project.
The objective of this project, undertaken
jointly with FASB, is to reduce the relatively minor differences between IFRS and
U.S. GAAP that can be resolved in a fairly short period of time. The IASB further
notes that one aspect of the joint short-term
convergence project requires that the two
boards consider each other’s recent
standards. Thus, it is interesting that
the boards’ proposed changes appear to be
similar, but not identical, to each other.
Exhibit 2 offers a comparison of the exposure drafts.
Current Status and Controversies
The SFAS 5 ED 1 proposal resulted in
significant concern and commentary: More
than 240 comment letters were received, and
FASB held two roundtables to elicit further
feedback from companies, auditors, and
attorneys. The July 2010 proposal, ED 2, is
the culmination of these discussions. But the
revised amendments still raise significant
concerns among respondents and other interested observers, including the potential
required disclosure of key elements of a
company’s litigation strategy, the possible
waiver of attorney-client privilege and
attorney work-product protection, and the
creation of a potential source of additional
litigation. In addition, the new disclosures
could embolden plaintiffs to continue what
would otherwise be problematic litigation
and potentially increase the amounts paid
in settlement.
Rationale for Accounting Changes:
FASB vs. IASB
According to FASB, the proposed
changes to SFAS 5 would require disclosures about a broader population of contingencies than those required by IAS 37.
Specifically, the proposed changes would
require disclosures about loss contingencies, regardless of the likelihood of loss,
if the contingencies are expected to be
resolved in the near term and if the contingencies could have a severe impact on
JANUARY 2012 / THE CPA JOURNAL
37
Some commentators also note that, because
the standards for judging a loss contingency
to be either probable or remote are so high,
most loss contingencies would fall into the
category of “reasonably possible”; however,
it is rare for companies to make an estimate
of loss contingencies deemed reasonably possible because of the inherent uncertainties in
litigation. Furthermore, legal counsel generally refrains from giving an estimate of loss
or range of probable loss when responding
to auditors’ requests for information,
because the American Bar Association’s
(ABA) “Statement of Policy Regarding
Lawyers’ Responses to Auditors’ Request for
Information” cautions lawyers against making estimates where the likelihood of inaccuracy is other than slight.
Constituents also assert that the proposed
changes may conflict with the SEC’s litigation disclosure standards under Item 103
of Regulation S-K. Item 103 requires a
brief description of “any material pending
legal proceedings, other than ordinary routine litigation incidental to the business,”
but it does not require disclosure of “any
proceeding that involves primarily a
claim for damages if the amount involved,
exclusive of interest and costs, does not
exceed 10 percent of the current assets”
of the company.
Some respondents believe that the relative burden and additional costs placed on
EXHIBIT 2
Comparison of Original Guidance with Proposed Amendments
Standard Original Guidance
SFAS 5
I Loss contingencies that are
“probable” to occur require the
quantitative accrual of a liability in
the financial statements.
I All other contingent losses
involving “at least a reasonable
possibility that a loss … may
have been incurred” must be
disclosed in a note to the financial
statements that sets forth the
nature of the loss contingency
and the range of probable loss,
if it is estimable.
I If the range of probable loss
cannot be estimated, it does not
have to be disclosed. Loss
contingencies that are deemed
“remote” do not have to be
disclosed at all.
Standard Original Guidance
IAS 37
38
I IAS 37 requires that a
provision be recognized only if a
present obligation (legal or
constructive) has arisen as a
result of a past event (obligating
event), payment is probable
(“more likely than not”), and the
amount can be estimated reliably.
A constructive obligation arises
if past practice creates a valid
expectation on the part of a third
party. A possible obligation
(contingent liability) is disclosed
but not accrued; however,
disclosure is not required if
payment is remote.
ED 1
ED 2
I The ED 1 amendments would
“replace and enhance the disclosure
requirements” in SFAS 5 for loss
contingencies that are recognized
as liabilities in a financial statement
and for certain unrecognized loss
contingencies that meet the
definitional criteria.
I Among the loss contingencies
included in SFAS 5 are potential
losses from pending and threatened
litigation, claims, and assessments.
I The amendments would also apply
to loss contingencies recognized in a
business combination accounted for
under SFAS 141(R), Business
Combinations.
I The amendments would include more
robust qualitative disclosures in situations
in which quantitative disclosures are
limited—for example, because of the
inherent uncertainties about the final
resolution of litigation contingencies.
I ED 2 requires that entities ignore the
possibility of recoveries from insurance
or other indemnification arrangements.
I It eliminates the requirement to
disclose the entity’s estimate of its
maximum exposure to loss.
I It requires that quantitative disclosures
be based on nonprivileged or publicly
available quantitative information
I ED 2 does not provide a prejudicial
exemption.
I ED 2 does not require disclosure of
settlement offers.
ED 1
ED 2
I The proposed amendment would
eliminate the terms “contingent
asset” and “contingent liability.” It
would also reconsider the application
of the probability recognition criterion.
I The IASB published ED 2 in response
to questions and issues raised by
respondents to ED 1. Consequently, ED 2
provides guidance on the following
questions:
I What does the term ”settle” mean?
To cancel or fulfill?
I What if the amount to settle an
obligation differs from the amount to
transfer it? At which amount should
the liability be measured? What if the
entity could not transfer the liability to
a third party? Should the entity
measure the liability at an amount that
it might never pay in practice?
I In general, the other proposed
changes in ED 2 were semantic or
relatively minor.
JANUARY 2012 / THE CPA JOURNAL
small businesses in complying with the
proposed changes is more onerous than
those placed on larger companies. This
charge stems from the fact that the costs
to comply are essentially fixed; when compared to companies’ revenue base or available liquidity, this will result in a proportionally higher cost to comply for smaller
companies than for larger corporations.
This may place small companies at a distinct competitive disadvantage.
Representatives of small companies also
note that on February 4, 2008, the SEC
amended its disclosure and reporting requirements to expand the number of companies
that qualify for its scaled disclosure requirements. Under these amendments, smaller
reporting companies were given relief from
the extent of disclosure that is required in
certain circumstances. According to the SEC,
these recommendations were designed to
update and improve federal securities regulations that significantly affect smaller companies and their investors in today’s capital
markets. In the SEC’s words:
It is expected that the amendments will
promote capital formation for smaller
reporting companies and improve their
ability to compete with larger companies for capital. For example, we believe
capital formation will be improved by
providing flexibility to more smaller
reporting companies to tailor their disclosure to their investors’ needs. In addition, the cost to raise capital may be
reduced to the extent compliance costs,
but not benefits, are reduced as a result
of the scaled disclosure requirements.
If smaller reporting companies allocate
the capital they raise and save as a result
of our scaled disclosure requirements
to business development in an effective
manner, these companies will be more
competitive. More companies will be
able to take advantage of more scaled
disclosure item requirements, such as
those contained currently in Items 310
and 402 of Regulation S-B. Smaller
reporting companies that avail themselves of the scaled disclosure will provide tailored disclosure that may better
meet the needs of their investors.
(SEC Release 33-8876; www.sec.gov/
rules/final/2007/33-8876.pdf)
Finally, FASB’s Private Company
Financial Reporting Committee (PCFRC)
has deferred recommendations to the
JANUARY 2012 / THE CPA JOURNAL
amendment to SFAS 5, expressing concerns that the additional disclosure requirements mandated by the proposed amendments “could provide opposing counsel
with a road map” to be used in litigation.
Practical Implications
As suggested by many comment letters, the motivations for the proposed
EDs are not clearly articulated. A stated
aim of both FASB and the IASB is to
respond to user demands for more explicit disclosure of the loss contingency risks
that companies face. It appears, however,
that the inherent ambiguity in the proposed
changes will necessitate a significant
amount of additional resources to compile,
analyze, report, and audit the additional
required information. For example, most
dissenting commentators suggest that while
the EDs include specific disclosure requirements that may result in the dissemination of more data, more information may
not necessarily be better. In other words,
the new data may provide little additional
meaningful information for reasoned
decision making.
Inaccuracies in early estimates potentially expose companies to significant associated liability. The litany of information
called for in the new ED requirements
compels the disclosure of the fundamental elements of a reporting company’s
litigation strategy and has the potential to
distort the outcome of the underlying proceedings by significantly and unfairly prejudicing the reporting company’s litigation
or settlement positions by providing a road
map for opposing counsel. This potential
to distort is opposed to the notion that
accounting information should be “free
from bias.”
In the authors’ opinion, it is also possible that the proposed changes may
adversely affect certain industries more
than others. For example, consider the
healthcare industry, where the requirement
to disclose information about a contingency if there is at least a reasonable
possibility (i.e., more than remote possibility) that a loss may have been incurred
would place an inordinate burden on the
industry due to the sheer volume of claims
or potential claims. The added effort to
review each claim independently to ascertain appropriate disclosure will not be costeffective. The ability to effectively audit
this information might be impaired due
to the very subjective nature of certain loss
contingencies. In addition, the sheer volume of the information that will be
required to be reviewed and audited will
result in higher fees from both attorneys
and auditors. Attorneys and other experts
may be unable or unwilling to provide
appropriate auditable evidence. Moreover,
attorneys’ responses to auditor inquiries
could result in unintended waivers of the
attorney-client privilege. As noted above,
as FASB and the IASB progress toward
convergence, they will, where feasible and
cost-effective, value financial reporting
transparency. Well-crafted transparency
should increase the usefulness of financial
information in a user’s decision-making
processes.
It is fair to say that four of the practical
implications of the research findings are as
follows:
I The entire convergence project may be
more difficult and lengthier due to the
observed strong objections of preparers,
particularly due to the more litigious U.S.
climate, as evidenced here concerning loss
contingency disclosure.
I The IASB must devote sufficient
resources to effectively deal with this different U.S. climate.
I FASB must also factor this effect into
its efforts on convergence.
I If these EDs are evidence of short-term
convergence projects, then the current timeframe for convergence may be unrealistic.
In addition, while loss contingency disclosures are particularly controversial, the
two standards-setting entities need to
remain mindful that the ultimate justification of external financial reporting is its
ability to aid various user groups in making informed decisions concerning the allocation of scarce economic resources.
With respect to the accounting profession,
reporting requirements should also pass a
K
cost-benefit evaluation.
Anthony D. Holder, PhD, is an assistant
professor of accountancy at the
Weatherhead School of Management at
Case Western Reserve University,
Cleveland, Ohio. Khondkar E. Karim,
PhD, CPA, is a professor of accounting at
the Manning School of Business at the
University of Massachusetts Lowell.
39
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