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 ....


Related Posts (on one page):

  1. When Should a Firm Recognize a Possible Litigation Liability?
  2. Accounting Standards and Litigation Contingencies: