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An Alarming Trend in Financial Reporting for Loss Contingencies Corporate Counsel Series May 2006 Corporate Counsel Series May 2006.

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Presentation on theme: "An Alarming Trend in Financial Reporting for Loss Contingencies Corporate Counsel Series May 2006 Corporate Counsel Series May 2006."— Presentation transcript:

1 An Alarming Trend in Financial Reporting for Loss Contingencies Corporate Counsel Series May 2006 Corporate Counsel Series May 2006

2 2 Agenda Existing Rules Uncertain Tax Positions Environmental Liabilities Other Loss Contingencies Strategies for Compliance Existing Rules Uncertain Tax Positions Environmental Liabilities Other Loss Contingencies Strategies for Compliance

3 May An Alarming Trend in Financial Reporting for Loss Contingencies Existing Rules

4 May 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) 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 May 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 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 May An Alarming Trend in Financial Reporting for Loss Contingencies Uncertain Tax Positions

7 May 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 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 May 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) 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 May 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 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 May 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 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 May An Alarming Trend in Financial Reporting for Loss Contingencies Environmental Liabilities

12 May 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 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 May 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 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 May 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 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 May 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 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 May An Alarming Trend in Financial Reporting for Loss Contingencies Other Loss Contingencies

17 May 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 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 May 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. 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 May 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 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 May 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 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 May An Alarming Trend in Financial Reporting for Loss Contingencies Strategies for Compliance

22 May Strategies for Compliance 1.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 2.Avoid, defer, or minimize accrued liabilities based on uncertainty of existence, timing, or amount of loss Resist pressure for probability weighted outcome estimates 3.Increase disclosure of those matters that are known to adversaries or that do not adversely affect settlement 1.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 2.Avoid, defer, or minimize accrued liabilities based on uncertainty of existence, timing, or amount of loss Resist pressure for probability weighted outcome estimates 3.Increase disclosure of those matters that are known to adversaries or that do not adversely affect settlement

23 May An Alarming Trend in Financial Reporting for Loss Contingencies Questions

24 May An Alarming Trend in Financial Reporting for Loss Contingencies Sources –FASB Project on Uncertain Tax Positions –FAS 143 – Accounting for Asset Retirement Obligations –FIN 47 – Conditional Asset Retirement Obligations –GASB Project on Pollution Remediation Obligations html –FASB Invitation to Comment Sources –FASB Project on Uncertain Tax Positions –FAS 143 – Accounting for Asset Retirement Obligations –FIN 47 – Conditional Asset Retirement Obligations –GASB Project on Pollution Remediation Obligations html –FASB Invitation to Comment


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