An Alarming Trend in Financial Reporting for Loss Contingencies

1
An Alarming Trend in Financial Reporting for Loss
Contingencies

• Corporate Counsel Series
• May 2006

2
Agenda

• Existing Rules
• Uncertain Tax Positions
• Environmental Liabilities
• Other Loss Contingencies
• Strategies for Compliance

3
An Alarming Trend in Financial Reporting for
Loss Contingencies

• Existing Rules

4
Existing Rules

• 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)

5
Existing Rules

• 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

6
An Alarming Trend in Financial Reporting for
Loss Contingencies

• Uncertain Tax Positions

7
Uncertain Tax Positions

• 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

8
Uncertain Tax Positions

• 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)

9
Uncertain Tax Positions

• 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

10
Uncertain Tax Positions

• 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

11
An Alarming Trend in Financial Reporting for
Loss Contingencies

• Environmental Liabilities

12
Environmental Liabilities

• 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

13
Environmental Liabilities

• 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 entitys 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

14
Environmental Liabilities

• 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

15
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

16
An Alarming Trend in Financial Reporting for
Loss Contingencies

• Other Loss Contingencies

17
Other Loss Contingencies

• 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

18
Other Loss Contingencies

• 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.

19
Other Loss Contingencies

• FASB Invitation to Comment
• Notes that IASB proposed approach is consistent
  with FIN 47
• Seeks comments on whether constituents agree
• with the IASBs 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 IASBs proposed expected value approach for
  measurement of liabilities
• Implication is that FASB supports the IASB
  proposal, but comment letters were generally
  critical

20
Other Loss Contingencies

• 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 companys
  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

21
An Alarming Trend in Financial Reporting for
Loss Contingencies

• Strategies for Compliance

22
Strategies for Compliance

• 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 counsels privileged advice and
  analysis
• Avoid, defer, or minimize accrued liabilities
  based on uncertainty of existence, timing, or
  amount of loss
• Resist pressure for probability weighted outcome
  estimates
• Increase disclosure of those matters that are
  known to adversaries or that do not adversely
  affect settlement

23
An Alarming Trend in Financial Reporting for
Loss Contingencies

• Questions

24
An Alarming Trend in Financial Reporting for
Loss Contingencies

• 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/fin2047.pdf
• GASB Project on Pollution Remediation Obligations
• www.gasb.org/project_pages/pollution_remediation_o
  bligations.html
• FASB Invitation to Comment
• www.fasb.org/draft/itc_assets_liabilities_with_unc
  ertainties.pdf