The FASB recently issued an Exposure Draft of a Proposed Statement, Disclosure of Certain Loss Contingencies - an amendment of FASB Statements No. 5 and 141(R). The objective of the amendments is to assist the users of financial statements with information about the risks the loss contingencies pose to the entity, and their potential and actual effects on the financial position, cash flows and results of operations. The proposed Statement significantly expands disclosures about certain loss contingencies and requires detail information on the likelihood, timing, and amounts of cash flows associated with loss contingencies. The new standard will have significant implications for companies, as well as their legal counsel and independent auditors. The recognition and measurement guidance currently in FASB Statement No. 5, Accounting for Contingencies (FAS 5), will not be changed by the proposal (but will be re-considered by the FASB in the future). The Exposure Draft is available at http://www.fasb.org/draft/ ed_contingencies.pdf. The deadline for public comments was August 8, 2008.
Key Highlights For The Proposed Amendments
Effective Date - The proposed Statement will be effective for annual financial statements issued for fiscal years ending after December 15, 2008 and subsequent interim and annual periods. Accordingly, companies with calendar year-end (i.e., December 31) would be required to comply with the new standards for their December 31, 2008 financial statements.
Scope - The proposed Statement will not apply to the following, as they are covered under other existing literature: (1) asset impairment (i.e., allowance for doubtful accounts and impaired loans receivable), (2) guarantees, (3) accounting and disclosure of liabilities for insurance and reinsurance entities (however, loss contingencies that are either self-insured or unrelated to insurance or reinsurance contracts are within the scope of FAS 5 and therefore subject to the proposed disclosure requirement), and (4) liabilities for employment-related costs, including pensions and other postemployment benefits. Obligations resulting from the withdrawal from a multiemployer plan for a portion of the unfunded benefit obligation would also be subject to the proposed new requirements.
Population of Loss Contingencies Required To Be Disclosed - Currently, an entity is only required to disclose loss contingencies that meet the at least reasonably possible threshold in FAS 5. Such practice often resulted in the lack of full disclosures of existing potential loss contingencies to investors. The proposed Statement significantly expands the population of loss contingencies that are required to be disclosed to include the entire population of loss contingencies except those contingencies that meet certain narrow criteria. Furthermore, under the proposed requirement, an entity would disclose remote loss contingencies if the contingency or contingencies: (1) are expected to be resolved within one year from the date of the financial statements; AND (2) could have a severe impact on the entity's financial position, cash flows, or results of operations (i.e., a significant financially disruptive effect on the normal functioning of the entity).
Detail Quantitative and Qualitative Information - An entity will be required to disclose the amount of the claim or assessment against it, including damages, or if there is no claim or assessment, its estimate of the maximum exposure to loss. If the entity believes the claim or assessment, or the estimate of maximum exposure to loss, is not representative of the actual exposure, the entity may disclose its best estimate of possible loss or range of loss. Qualitative information about the contingency shall include, at a minimum, the following:
• a description of the contingency (including how it arose, its legal or contractual basis, its current status, and the anticipated timing of its resolution);
• a description of the factors that are likely to affect the ultimate outcome of the contingency along with their potential effect on the outcome;
• the company's qualitative assessment of the most likely outcome of the contingency; and
• the significant assumptions made by the entity in estimating the amounts disclosed and in assessing the most likely outcome.
In addition to the above, a qualitative and quantitative description of the terms of relevant insurance or indemnification arrangements and expected recoveries should also be included.
Under the new rule, the option to only state that "an estimate of the possible loss or range of loss cannot be made" will be rare. Instead, the entity will be required to provide the reasons why an estimate cannot be made and supplement with a robust qualitative description.
Tabular Reconciliation Of Recognized Loss Contingencies
One of the notorious changes in the proposed Statement is the requirement of a tabular reconciliation of the aggregated amount of loss contingencies recognized in the statement of financial position at the beginning and end of the period. The reconciliation shall include at a minimum:
• increase for loss contingencies recognized during the period;
• increase resulting from changes in estimates of amounts of loss contingencies previously recognized;
• decreases resulting from changes in estimates or derecognition of loss contingencies previously recognized; and
• decreases resulting from cash payment (or other settlement) for loss contingencies.
In addition, an entity would be required to provide a qualitative description of the significant activity in the table. All loss contingencies recognized in a business combination would be shown separately in the reconciliation, while other loss contingencies that arise and are resolved within the same period would be excluded from the reconciliation. Finally, the amount of any recoveries shall be disclosed.
Exemption For Prejudicial Information
To alleviate the concern that certain information may be prejudicial to an entity's position with respect to the outcome of a contingency, the proposed Statement provides an exemption that would allow an entity to aggregate the required disclosure at a level higher than by the nature of the contingency such that disclosure of the information is not prejudicial. In rare circumstances, an entity may forgo disclosing the prejudicial information (for example, where there is only one material loss contingency) and instead disclose the fact that, and the reason why, the information has not been disclosed.
• Subsequent events - In the case of a loss arising after the financial statement date, the same information must be disclosed as for unrecognized loss contingencies, and if the amount of the liability incurred can be reasonably estimated, an entity may supplement the historical financial statements by disclosing pro forma financial data giving effect to the loss as if it had occurred at the date of the financial statements.
• Convergence with IFRS - Currently, IAS 37, Provisions, Contingent Liabilities and Contingent Assets , does not require disclosures for remote loss contingencies regardless of the timing of resolution or potential severity of the contingency. The International Accounting Standards Board (IASB) is discussing potential changes to IAS 37 but has not yet proposed any substantive changes to disclosure requirements. As the IASB deliberates further changes, it is expect to consider potential convergence opportunity with the proposed FAS 5 Statement.
• Contingencies assumed in a Business Combination - The noncontractual contingency, as defined by FASB Statement No. 141(R), shall be assessed whether it is more likely than not , as of the acquisition date, that the contingency gives rise to an asset or a liability. If that criterion is met as of the acquisition date, the asset or liability shall be recognized at that date and measured at its acquisition-date fair value. Subsequent accounting for the asset or liability would be within the scope of FAS 5 when new information is obtained. A liability will be measured at the higher of its acquisition-date fair value or the amount that would be recognized if applying FAS 5. An asset will be measured at the lower of its acquisition-date fair value or the best estimate of its future settlement amount. It should also be noted that, the current FAS 5 has its probable recognition threshold which is a higher threshold than more likely than not (used in FAS 141(R)). FAS 5 also includes a second recognition criterion such that a contingent loss is only accrued when the amount of loss can be reasonably estimated.
• Reactions from legal counsels - A significant unknown in the implementation of the proposed amendments will be how preparers, independent auditors, and the legal community address the differences in the probability of occurrence as well as the measurement of the contingencies that arise from the business combination. The current guidelines governing attorney-auditor communications were a result of extensive discussions between American Institute of Certified Public Accountants (AICPA) and the American Bar Association (ABA). The proposed Statement would require similar discussions and exchanges between the two professional bodies so that meaningful information can be supplied to the preparers as well as their auditors to satisfy the proposed disclosure requirements. Furthermore, the proposed Statement raises significant concerns that disclosing certain information could result in judicial findings of waiver of attorney-client privilege and attorney work product immunity that would otherwise protect such assessments from use against the entity in litigation. Further, such disclosures would impose upon the preparers (and their counsels) the difficult task of estimating losses, particularly in the early stages of legal actions or complex judicial matters where estimates may not be reasonably determinable.
Unasserted claims and assessments - The proposed Statement retains substantially the existing guidance in FAS 5 on unasserted claims or assessment against the entity. The disclosure of a loss contingency related to an unasserted claim or assessment is not necessary unless it is probable that a claim or assessment will be asserted and the likelihood of loss (if the claim or assessment were to be asserted) is more than remote.
Yan Zhang is a Director in Eisner's technical services group. For more information, you can contact her at (212) 891-6070.