Ed Trott, a former member of the Financial Accounting Standards Board, agrees. He says that the low end of the range is the “least meaningful” measurement that companies could disclose. “Many accountants like to argue that they want conservative rules,” says Trott. “But FAS 5 is the opposite of conservative. FAS 5 is an embarrassment.”
At one point even the SEC seemed to agree. “In practice, zero may arguably be the low point of the range in many cases, resulting in no liability being reflected,” the SEC staff wrote in a 2005 report to Congress on off-balance-sheet accounting. But, “the Staff has long believed that the application of SFAS No. 5 by issuers should be improved.” (The SEC did not respond to repeated requests by CFO for a comment on its current position.)
Indeed, attorney Rogers believes FAS 5 actually forces company management in an awkward spot, both by encouraging a lowball disclosure and by discouraging efforts to openly obtain more-detailed estimates that might force them to hike the number. A low liability estimate can also prevent companies from pursuing other strategies, such as transferring the liability to insurers, which naturally would charge a higher figure. “People get locked into this pattern and can’t change,” says Rogers. “Auditors know this is kind of bogus, but the standard is kind of bogus, too.”
Last year, FASB proposed tightening FAS 5 so that companies would have to disclose all but “remote” loss contingencies and provide a full range of estimates. But the move triggered a storm of protest from attorneys, who feared that companies facing lawsuits would be forced to provide privileged information, and that the disclosures might reveal their defense strategies to plaintiff’s lawyers. Many cited a 1975 treaty between the American Institute of Certified Public Accountants and the American Bar Association that states that attorney-client privilege trumps auditor scrutiny. Much of The Brattle Group’s work for companies is stamped “Prepared at the request of counsel,” notes Koch, which effectively extends legal privilege to internal reports on environmental costs.
The protest appears to have killed FASB’s proposal, although at press time the standard-setter was officially still reviewing public comments. Among the minority who commented in favor of modifying FAS 5, most said unequivocally that the peculiar math of the standard and the ability of companies to shield contingent liabilities behind attorney-client privilege leave investors with far less information than is actually available. In his letter, Standard & Poor’s chief global accountant said the rating agency is regularly privy to inside information about contingencies that could affect cash flows, an effect “difficult to discern and quantify [using] public disclosures.”
More Cleanup Needed
Despite the criticism leveled at FAS 5, FASB seems unlikely to change it in the near future. The equivalent international rule, IAS 37, currently requires that firms provide investors with the midpoint, rather than the bottom, of a probable range of costs, a difference that would likely cause the environmental liabilities at American companies to soar if the United States converts to international accounting.