Bar Fight: Accounting for Lawsuits

FASB's chairman defends a recent proposal after a scathing Wall Street Journal editorial, but corporate opposition to increasing disclosure about potential losses from litigation also runs high.

Financial Accounting Standards Board Chairman Robert Herz, in a letter to the Wall Street Journal today, defended FASB’s controversial proposal to require more company disclosure about potential lawsuit liabilities.

Herz’s letter was a direct response to a sharply critical editorial, “FASB’s Lawyer Bonanza,” that the paper ran on August 7, saying that “by organizing a wealth transfer from corporations to trial lawyers, FASB is doing no favors to the investors it claims to represent.” But the proposal is hardly lacking for other critics. The public comment period for the proposal, which closed earlier this month, drew a bumper crop of 226 responses, most of them negative, and many arguing that the proposal should be scrapped in its entirety.

In his letter, Herz said the Journal had mischaracterized the proposal as mandating an accounting change, rather than additional disclosure. He also responded to the Journal’s argument that the proposal would force a company to “[show] its hand to plaintiffs’ attorneys.” Herz noted that the proposal allows companies to aggregate claim amounts, so that plaintiff’s attorneys cannot identify special cases, and also contains an exemption for “clearly prejudicial” disclosure situations.

The proposed new standard would overhaul FAS 5, Accounting for Contingencies. Under the proposed rule, companies would have to disclose “specific quantitative and qualitative information” about loss contingencies. The new rule will also affect the contingent losses companies must disclose under FAS 141, which applies in the wake of mergers and acquisitions.

Under current accounting rules, companies are only required to take a financial charge for a contingent loss if it appears probable that the loss has occurred and its amount can be reasonably estimated. If those conditions are not met, companies must still disclose the loss contingency, but only if there is a reasonable possibility that a loss has occurred.

Under the new rule, companies would have to disclose all loss contingencies unless their likelihood is remote. And companies also would be required to disclose any contingency — no matter how remote — that is expected to be resolved within a year, and could have a severe impact on the company’s financial position, financial results, or cash flow. That’s a change that would put substantially greater detail about potential lawsuit liabilities into the footnotes of corporate financial statements.

That is the part of the proposal that has many companies upset. Credit Suisse Group “believes that the newly proposed guidance will result in disclosing a laundry list of unsupportable claims which in no way would provide investors with a better ability to assess a realistic impact to future cash flows,” Rudolf Bless, chief accounting officer of Credit Suisse, wrote in his comment to FASB.

“Plaintiffs might be encouraged to make wildly excessive claims forcing companies to enter into quick settlement or risk disclosure,” wrote Thomas S. Timko, chief accounting officer and controller of Delphi.

Under the proposal, companies would be required to state the amount of the claim against them, including, in the case of lawsuits, the possibility of treble or punitive damages. In cases where no specific claim exists, companies would have to provide their best estimates of their maximum losses, though they may also provide a different estimate if they think their actual exposure is lower.

“Many suits filed against Netflix and other companies do not set forth a specific amount of claimed damages but have significant theoretical damages. However, as demonstrated by Netflix’s litigation experience, many of these suits are won outright by the defendant ompany or settled for a fraction of the theoretical damages because they have little or no merit. Disclosing the ‘maximum exposure’ in such lawsuits would be extremely misleading,” wrote Netflix senior corporate counsel Reg Thompson.

As Herz noted in his letter, the rule as proposed would, in “rare” cases, allow a company to keep certain information secret — an exemption intended to keep the accounting rule from actually exacerbating the potential loss to shareholders by tipping a company’s hand in litigation or settlement negotiations. But this part of the proposal appeared to satisfy no one, with those in favor of more disclosure noting that the exception would be likely to be abused, while those opposed said it was not sufficiently broad.

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