Financial Reporting Alert 11-1, SEC's Focus on Compliance With Loss Contingency Disclosures
The SEC has recently renewed its focus on registrants’ compliance with existing disclosure requirements under ASC 450-201 in connection with litigation contingencies. This Financial Reporting Alert highlights certain aspects of loss contingency disclosures that will be subject to heightened scrutiny by the SEC and the FASB this reporting season.
On January 28, 2011, Wayne Carnall, chief accountant in the SEC’s Division of Corporation Finance, and Michael Young, former member of the Financial Accounting Standards Advisory Council to the FASB, met with members of the New York City Bar Association to discuss litigation contingency reporting under ASC 450.2 The meeting was in response to requests by users of financial statements for more timely and transparent disclosures about loss contingencies.
In July 2010, the FASB issued a proposed ASU3 that would (1) expand loss contingency disclosures to include certain remote loss contingencies and (2) increase the amount of quantitative and qualitative information that entities are required to disclose. In comment letters to the FASB, constituents expressed concerns about many of the proposed disclosures. Accordingly, the FASB directed its staff to do the following before the Board begins redeliberations: (1) understand efforts by the SEC and PCAOB to improve compliance with existing disclosure requirements in ASC 450-20 and (2) review 2010 Form 10-K filings for calendar-year-end reporting entities and determine whether the SEC’s and PCAOB’s efforts resulted in improved disclosures about loss contingencies.
ASC 450-20 requires the following:
- For probable loss contingencies, entities should:
- Record an accrual when the loss is probable and can be reasonably estimated. The best estimate of loss within a range should be accrued; however, if no estimate in the range is better than any other, the minimum amount should be accrued.
- Disclose the nature of the accrued loss contingency.
- Disclose, in some circumstances, the amount accrued if such disclosure is necessary for the financial statements to not be misleading.
- For reasonably possible loss contingencies, entities should:
- Disclose the nature of the loss contingency.
- Disclose the estimate of the possible loss or range of loss or a statement that such an estimate cannot be made.
Disclosure should also be made for a reasonably possible loss in excess of the amount accrued. For example, if it is probable the contingency will result in a $100 loss, but it is reasonably possible the loss could be $500, the entity should disclose the nature of the loss contingency and:
- Accrue $100, disclosing the amount accrued if necessary for the financial statements to not be misleading.
- Disclose the estimate of the $400 reasonably possible loss.
SEC Comments and Observations
Loss contingency disclosures were discussed at the June 2010 CAQ SEC Regulations Committee Joint Meeting With the SEC Staff (“Joint Meeting”), at which the SEC staff reiterated its expectation that registrants comply with ASC 450 from both a recognition and disclosure perspective. In particular, the SEC staff noted a situation in which a registrant did not disclose an estimate for a possible loss or range of loss (or a statement that such an estimate could not be reasonably made) when there was a reasonable possibility that realized losses would exceed amounts accrued.
The meeting highlights note that the staff “would expect that disclosures about a loss contingency would be updated as additional information becomes available. With the passage of time, there is a greater presumption that it would be possible for the company to provide quantitative information.” The highlights also note that “the disclosure can be aggregated in a logical manner vs. separate disclosure for each asserted claim . . . the staff has also recently issued comments when there was a large settlement with little or no disclosure in earlier periods — e.g., why wasn’t there disclosure?”
Mr. Carnall’s remarks to the New York City Bar Association echoed many comments made previously by the SEC staff, including those stated at the June 2010 Joint Meeting and the 2010 AICPA National Conference on Current SEC and PCAOB Developments (“AICPA Conference”). Note that the comments and observations discussed below are not meant to be all-inclusive; entities should be mindful of the reporting and disclosure requirements in ASC 450-20.
Timing of Accrual
- Mr. Carnall noted that when a settlement is disclosed in a registrant’s filing, the SEC staff will review prior-period filings to ensure that the disclosures leading up to the settlement were adequate. ASC 450-20-25-2 requires an accrual when the loss is probable and can be reasonably estimated.
- The staff will question whether an accrual is made in the appropriate period. Mr. Carnall stated that a defined event triggers the loss and that it is therefore not appropriate to “spread” a probable loss over multiple periods. For example, it would not be appropriate to book $25 million of a $100 million probable loss each quarter for four quarters; rather, the $100 million should be accrued when facts and circumstances indicate the loss is probable and can be reasonably estimated.
- When a loss is probable and can be reasonably estimated, an accrual should be made of the best estimate (or at least the minimum amount of loss in the entity’s estimate) even if the upper end of the range is not known.
Estimate of Possible Loss (or Range of Loss) or Statement That Estimate Cannot Be Made
- Mr. Carnall indicated that registrants should try to quantify the reasonably possible loss or range of loss. The SEC does not believe there is a basis in ASC 450 for quantified disclosures to be omitted because the possible loss or range of loss cannot be determined with “precision and confidence.”
- There may be situations in which an estimate of the possible loss or range of loss cannot be made; however, the SEC staff may question this assertion. Further, asserting that an estimate of the possible loss or range of loss cannot be made will be more difficult as litigation progresses.
- Registrants sometimes assert that because a loss contingency is not material, they therefore do not need to provide quantitative disclosures. Mr. Carnall noted that such registrants should consider the difference between “not material to the balance sheet” and “not material.” If a loss could be material to any one of the financial statements (i.e., balance sheet, income statement, statement of cash flows), the SEC staff would still expect quantified disclosures.
Classification of Loss Contingency as Probable, Reasonably Possible, or Remote
- ASC 450-20-55-18 through 55-21 illustrate how different aspects of a claim may be evaluated differently and satisfy different classification criteria (i.e., probable, reasonably possible, and remote). The paragraphs state:
An entity may be litigating a dispute with another party. In preparation for the trial, it may determine that, based on recent developments involving one aspect of the litigation, it is probable that it will have to pay $2 million to settle the litigation. Another aspect of the litigation may, however, be open to considerable interpretation, and depending on the interpretation by the court the entity may have to pay an additional $8 million over and above the $2 million. . . . In that case, paragraph 450-20-25-2 requires accrual of the $2 million if that is considered a reasonable estimate of the loss. . . . Paragraphs 450-20-50-1 through 50-2 require disclosure of the nature of the accrual, and depending on the circumstances, may require disclosure of the $2 million that was accrued. . . . Paragraphs 450-20-50-3 through 50-8 require disclosure of the additional exposure to loss if there is a reasonable possibility that the additional amounts will be paid.
Preparation of the Contingency Footnote
- Registrants are expected to update their disclosures as additional information becomes available, as noted in the June 2010 Joint Meeting remarks.
- Preparation of the litigation footnote should be a collaborative process between accountants and lawyers. At the 2010 AICPA Conference, Mr. Carnall noted that management needs to “take back the financial statements” from the lawyers with respect to litigation disclosures.
- Lawyers’ responses to audit inquiry are subject to the ABA Statement of Policy4 (“ABA Statement”), under which legal counsel is cautioned not to provide auditors with quantitative estimates unless counsel believes that the probability of inaccuracy is “slight.” However, this policy is inconsistent with the requirements of ASC 450-20 (as discussed above) regarding loss contingencies. Mr. Carnall stressed that the ABA Statement is not part of the FASB Accounting Standards Codification and is not a defense against complying with GAAP.
- In response to concerns by preparers that the requirements in ASC 450-20 may result in prejudicial information, the SEC has indicated that it does not object to registrants’ providing disclosures (particularly quantified disclosures) in the aggregate.
Scope of Loss Contingencies
- ASC 450 incorporates all contingencies, which may include regulatory actions brought by the SEC, the U.S. attorney general, etc. The SEC’s expectations about disclosures related to regulatory actions are similar to its expectations about litigation contingencies.
Consistency of Information
- When different registrants are parties to a claim (i.e., one registrant is a defendant and another is a plaintiff), the SEC may review the counterparty’s filings and ask questions if the information is not consistent.
- The SEC staff has also challenged registrants that have disclosed in the footnotes that the outcome of a contingency is not expected to materially affect their financial statements but indicated in the risk factors section of the filing that the same contingency’s outcome could materially affect their financial results. Registrants have been asked to explain such inconsistencies or revise their disclosures accordingly.
- The SEC views the disclosure requirements under ASC 450 and SEC Regulation S-K, Item 103,5 differently, noting that while Item 103 requires a factual discussion, disclosures under ASC 450 should be more analytical and may sometimes require registrants to make a quantified assessment. The SEC will continue to look for a registrant’s compliance with both ASC 450 and Item 103. At the September 2010 Joint Meeting, the staff noted that “attempts to satisfy both objectives through an integrated set of disclosure often result in lengthy factual recitations rather than focusing on the underlying loss contingency, the related exposure and the likelihood of a loss.”
Mortgage and Foreclosure-Related Activities or Exposures
In addition to public comments and observations, the SEC staff has issued guidance reminding registrants of the disclosure requirements under ASC 450. In October 2010, the SEC’s Division of Corporation Finance posted to its Web site a sample “Dear CFO” letter on accounting and disclosure issues related to potential risks and costs associated with mortgage and foreclosure-related activities or exposures. The letter instructs registrants to consider enhanced disclosures about the impact, obligations, and potential losses as a result of representations and warranties to purchasers of whole mortgage loans or through a securitization (as part of asset-backed securities). Purchasers would include government-sponsored entities, private-label mortgage-backed security investors, financial guarantors, and others.
The letter does not replace or amend existing GAAP requirements; however, the SEC believes that the considerations outlined in it will prompt registrants to make clearer and more transparent disclosures about (1) their obligations related to the various representations and warranties made in connection with securitization activities and whole loan sales and (2) the implications of any foreclosure review, including potential delays in completing foreclosures, if applicable.
Next Steps for FASB’s Loss Contingency Project
As noted, the FASB will evaluate the impact of the SEC’s efforts before beginning redeliberations on its loss contingency project. The FASB staff will perform this analysis as well as additional outreach during the first half of 2011. The Board plans to begin redeliberations during the second half of 2011.
The following Deloitte publications contain additional information on loss contingency disclosures:
- SEC Comment Letters — Including Industry Insights: A Snapshot of Current Themes (November 2010 update).
- December 16, 2010, Heads Up, “Highlights of the 2010 AICPA National Conference on Current SEC and PCAOB Developments.”
- October 29, 2010, Financial Reporting Alert 10-10, “SEC Advises Registrants to Enhance Disclosure About Mortgage and Foreclosure-Related Activities or Exposures.”
- July 20, 2010, Heads Up, “FASB Proposes Guidance on Expanded Disclosures for Certain Loss Contingencies.”
1 FASB Accounting Standards Codification Subtopic 450-20, Contingencies: Loss Contingencies.
2 FASB Accounting Standards Codification Topic 450, Contingencies.
3 Proposed FASB Accounting Standards Update, Disclosure of Certain Loss Contingencies.
4 American Bar Association Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests for Information (December 1975) (“ABA Statement of Policy”) (see AICPA and PCAOB Professional Standards, AU Section 337C). As noted in the ABA Statement of Policy, a “lawyer should not be asked, nor need the lawyer undertake, to furnish information to the auditor concerning loss contingencies except as contemplated by [the ABA Statement of Policy].”
5 SEC Regulation S-K, Item 103, “Legal Proceedings.”
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