The Volokh Conspiracy - When Should a Firm Recognize a Possible Litigation Liability?

A guest post from Professor Robert Bloomfield, Cornell management professor and director of the Financial Accounting Standards Research Initiative, posing this as a question to the Volokh Community. My thanks to Professor Bloomfield, and his post follows below (including below the fold):

As a big fan of the Volokh Conspiracy, I was very happy to see your recent posts about accounting. The posts are serendipitously timed, as this week I have been thinking of posing a question to the bloggers at VC that is relevant to my work as director of the Financial Accounting Standards Research Initiative (FASRI), an organization funded by the Financial Accounting Standards Board (the organization that sets accounting standards for the US).

The question concerns one area in which law becomes very relevant to accountants: when should firms recognize a liability due to possible litigation? Firms face a number of loss contingencies, and FAS 5 has long required firms to recognize a loss in their financial statements (and a corresponding liability) if a loss is probable and estimable, and disclose the possibility of a loss in a footnote if a loss is reasonably possible.

Recently, the FASB proposed strengthening those rules, requiring disclosure in any case when the loss will be severe, or when the loss will be resolved soon.

These requirements generated little controversy for most types of losses. For example, just about everyone agrees that if you sell an item under a warranty, it is appropriate to recognize some warranty expenses and a warranty liability. Matters get trickier, however, if the loss in question arises from litigation.

The FASB received a number of comment letters from lawyers, arguing that "loss contingencies created by litigation are unique in several respects." This comment letter from an organization called Lawyers for Civil Justice is typical (full letter at the link). In summary, Lawyers for Civil Justice argues, first, that losses due to litigation are unusually hard to predict. This strikes me as unlikely; many losses are hard to predict, and juries aren't the only fickle parties in the world. But the letter's second argument seems more plausible: that the "adversarial nature requires that internal evaluations of the claim be kept confidential."

There thus seems to be a real tension between good lawyering and transparent accounting. Reporting internal assessments about a judgment or settlement in financial statements may be detrimental to the firm-as-defendant. On the other hand, not providing that information to investors leaves financial reports far short of the transparency investors would like ....

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Aware of this type of concern, the FASB did include some accommodations for litigation:

Exemption from Disclosing Prejudicial Information

11. For certain contingencies, such as pending or threatened litigation, disclosure of certain information about the contingency may be prejudicial to an entity's position (that is, disclosure of the information could affect, to the entity's detriment, the outcome of the contingency itself). In those circumstances, an entity may aggregate the disclosures required by paragraph 7 at a level higher than by the nature of the contingency such that disclosure of the information is not prejudicial.

In those rare instances in which the disclosure of the information required by paragraph 7, when aggregated at a level higher than by the nature of the contingency, or of the tabular reconciliation would be prejudicial (for example, if an entity is involved in only one legal dispute), the entity may forgo disclosing only the information that would be prejudicial to the entity's position. In those circumstances, an entity shall disclose the fact that, and the reason why, the information has not been disclosed. In no circumstance may an entity forgo disclosing the amount of the claim or assessment against the entity (or, if there is no claim amount, an estimate of the entity's maximum exposure to loss); providing a description of the loss contingency, including how it arose, its legal or contractual basis, its current status, and the anticipated timing of its resolution; and providing a description of the factors that are likely to affect the ultimate outcome of the contingency along with the potential impact on the outcome.

Despite this accommodation, Lawyers for Civil Justice still expresses concern in its comment letter that:

Prudence demands that a litigation defendant evaluate all potential legal theories and arguments that could be asserted by the plaintiff. Disclosure of this internal evaluation would prejudice the defendant's litigation position in several ways: (I) it may suggest legal theories and arguments to the plaintiff that the plaintiff had not considered; (2) the plaintiff could try to use the internal evaluation as an admission of liability or damages; and (3) the plaintiff could use the internal evaluation as leverage in settlement discussions.

So, against that backdrop, here are my questions to the Volokh Conspiracy community:

First, does Lawyers for Civil Justice overstate its case, or does the FASB's exemption for prejudicial information seem adequate?

Second, leaving accounting standards to one side and focusing on legal ethics, would a requirement to disclose internal estimates of liability violate other laws, or lawyers' professional standards?

Finally, any suggestions or ideas how the FASB might address this basic tension between good legal practice and transparent reporting?

(You can read a little more about this at the FASRI blog, particularly: http://fasri.net/index.php/2009/05/office-hours-contingent-fas-5-revisited/ http://fasri.net/index.php/2009/05/research-ideas-fas-5-contingencies/.

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	[Kenneth Anderson, September 10, 2009 at 12:05pm] Trackbacks When Should a Firm Recognize a Possible Litigation Liability? A guest post from Professor Robert Bloomfield, Cornell management professor and director of the Financial Accounting Standards Research Initiative, posing this as a question to the Volokh Community. My thanks to Professor Bloomfield, and his post follows below (including below the fold): As a big fan of the Volokh Conspiracy, I was very happy to see your recent posts about accounting. The posts are serendipitously timed, as this week I have been thinking of posing a question to the bloggers at VC that is relevant to my work as director of the Financial Accounting Standards Research Initiative (FASRI), an organization funded by the Financial Accounting Standards Board (the organization that sets accounting standards for the US). The question concerns one area in which law becomes very relevant to accountants: when should firms recognize a liability due to possible litigation? Firms face a number of loss contingencies, and FAS 5 has long required firms to recognize a loss in their financial statements (and a corresponding liability) if a loss is probable and estimable, and disclose the possibility of a loss in a footnote if a loss is reasonably possible. Recently, the FASB proposed strengthening those rules, requiring disclosure in any case when the loss will be severe, or when the loss will be resolved soon. These requirements generated little controversy for most types of losses. For example, just about everyone agrees that if you sell an item under a warranty, it is appropriate to recognize some warranty expenses and a warranty liability. Matters get trickier, however, if the loss in question arises from litigation. The FASB received a number of comment letters from lawyers, arguing that "loss contingencies created by litigation are unique in several respects." This comment letter from an organization called Lawyers for Civil Justice is typical (full letter at the link). In summary, Lawyers for Civil Justice argues, first, that losses due to litigation are unusually hard to predict. This strikes me as unlikely; many losses are hard to predict, and juries aren't the only fickle parties in the world. But the letter's second argument seems more plausible: that the "adversarial nature requires that internal evaluations of the claim be kept confidential." There thus seems to be a real tension between good lawyering and transparent accounting. Reporting internal assessments about a judgment or settlement in financial statements may be detrimental to the firm-as-defendant. On the other hand, not providing that information to investors leaves financial reports far short of the transparency investors would like .... (show) Aware of this type of concern, the FASB did include some accommodations for litigation: Exemption from Disclosing Prejudicial Information 11. For certain contingencies, such as pending or threatened litigation, disclosure of certain information about the contingency may be prejudicial to an entity's position (that is, disclosure of the information could affect, to the entity's detriment, the outcome of the contingency itself). In those circumstances, an entity may aggregate the disclosures required by paragraph 7 at a level higher than by the nature of the contingency such that disclosure of the information is not prejudicial. In those rare instances in which the disclosure of the information required by paragraph 7, when aggregated at a level higher than by the nature of the contingency, or of the tabular reconciliation would be prejudicial (for example, if an entity is involved in only one legal dispute), the entity may forgo disclosing only the information that would be prejudicial to the entity's position. In those circumstances, an entity shall disclose the fact that, and the reason why, the information has not been disclosed. In no circumstance may an entity forgo disclosing the amount of the claim or assessment against the entity (or, if there is no claim amount, an estimate of the entity's maximum exposure to loss); providing a description of the loss contingency, including how it arose, its legal or contractual basis, its current status, and the anticipated timing of its resolution; and providing a description of the factors that are likely to affect the ultimate outcome of the contingency along with the potential impact on the outcome. Despite this accommodation, Lawyers for Civil Justice still expresses concern in its comment letter that: Prudence demands that a litigation defendant evaluate all potential legal theories and arguments that could be asserted by the plaintiff. Disclosure of this internal evaluation would prejudice the defendant's litigation position in several ways: (I) it may suggest legal theories and arguments to the plaintiff that the plaintiff had not considered; (2) the plaintiff could try to use the internal evaluation as an admission of liability or damages; and (3) the plaintiff could use the internal evaluation as leverage in settlement discussions. So, against that backdrop, here are my questions to the Volokh Conspiracy community: First, does Lawyers for Civil Justice overstate its case, or does the FASB's exemption for prejudicial information seem adequate? Second, leaving accounting standards to one side and focusing on legal ethics, would a requirement to disclose internal estimates of liability violate other laws, or lawyers' professional standards? Finally, any suggestions or ideas how the FASB might address this basic tension between good legal practice and transparent reporting? (You can read a little more about this at the FASRI blog, particularly: http://fasri.net/index.php/2009/05/office-hours-contingent-fas-5-revisited/ http://fasri.net/index.php/2009/05/research-ideas-fas-5-contingencies/. (hide) Related Posts (on one page): When Should a Firm Recognize a Possible Litigation Liability? Accounting Standards and Litigation Contingencies: