LITIGATION AND CORPORATE LAW FORUMS
PARAMETERS FOR SETTING LITIGATION RESERVES
IMPORTANT FACTORS TO CONSIDER IN INTERACTION BETWEEN
ACCOUNTANTS, AUDITORS, AND COUNSEL
MARCH 15, 2016
PANEL
Kevin Davis – [email protected] - 202.481.7340
Kevin is a Director in Navigant’s Washington, D.C. office’s Disputes and Investigations
practice. He has over 25 years of experience as an accountant, auditor and consultant.
Kevin provides services on GAAP, financial reporting, SEC, and GAAS/auditing issues,
and advises audit committees, company executives and legal counsel relating to
independent financial investigations and litigation matters. Prior to joining Navigant, Kevin
spent over 18 years with two international accounting firms. He is a Certified Public
Accountant.
Peter Brennan – [email protected] – 312.923.2614
Peter is a litigator in Jenner & Block’s Chicago. He has served as lead counsel for Nissan
North America for the last decade in courts through throughout the country. His litigation
matters include class action defense, trade secrets and patent disputes, and a variety of
other commercial litigation. He also has recently served as appellate counsel to clients in
matters before courts ranging from the New York Court of Appeals to the Federal Circuit.
Ken Reiss – [email protected] – 703.280.4085
Ken is a Corporate Director and Assistant General Counsel for Northrop Grumman
Corporation. He is responsible for all legal disputes arising in the Eastern U.S. Region,
Europe and Middle East, including government contracts, bid protests, False Claims Act,
commercial contracts, intellectual property, employment, environment, toxic tort, personal
injury, real estate and tax. He advises senior management on contingency loss
accounting reserves and SEC disclosures and recommends strategies to reduce legal
risk.
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ACCOUNTING FOR AND DISCLOSURE OF LITIGATION
RESERVES
• Development of counsels knowledge of why accountants need
assistance related to accounting for and disclosures of litigation
reserves.
• Specifics of what accountants need.
• Timing of accountants need for information.
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ACCOUNTING FOR AND DISCLOSURE OF LITIGATION
RESERVES
• In performing proper accounting for litigation related obligations, two
areas must be considered:
- Relevant accounting literature and guidelines
- SEC views and comments regarding proper financial reporting
• In supporting the balance sheet accrual for litigation reserves and the
related disclosures contained in the financial statement, accountants
place reliance on the legal opinions of company counsel (internal and
external).
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RELEVANT ACCOUNTING LITERATURE:
ACCOUNTING STANDARDS
CODIFICATION 450 - CONTINGENCIES
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ACCOUNTING STANDARDS CODIFICATION 450
• The Accounting Standards Codification is the source of generally accepted
accounting principles (GAAP) recognized by the Financial Accounting
Standards Board to be applied to nongovernmental entities.
• Accounting Standards Codification (ASC) 450 sets forth the authoritative GAAP
for contingencies.
• Contingencies are defined as “[a]n existing condition, situation, or set of
circumstances involving uncertainty as to possible gain or loss to an entity that
will ultimately be resolved when one or more future events occur or fail to
occur.”
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ACCOUNTING FOR LOSS CONTINGENCIES
ASC 450-20-25-2
“An estimated loss from a loss contingency shall be accrued by a
charge to income if both of the following conditions are met:”
• “[I]t is probable that an asset had been impaired or a liability had
been incurred at the date of the financial statements.”
• “The amount of loss can be reasonably estimated.”
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PROBABILITY OF LIABILITY
The first criteria to record an accrual is, “[I]t is probable that an asset
had been impaired or a liability had been incurred at the date of the
financial statements.”
The probability or likelihood of future events is classified as:
• Probable – when the future event is likely to occur.
• Reasonably Possible – when the chance of the future event or
events occurring is more than remote but less than likely.
• Remote – when the chance of the future event or events occurring is
slight.
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DETERMINATION OF WHAT AMOUNT TO ACCRUE
ASC 450-20-30
The second criteria to record an accrual is, “[t]he amount of loss can be
reasonably estimated.”
When an accrual can be reasonably estimated, entities should accrue
the amount that reflects the best estimate within the range of loss.
However, if no amount in the range is a better estimate than another,
the minimum of the range should be accrued.
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WHAT TO DISCLOSE?
ASC 450-20-50
Disclosure requirements for probable loss contingencies that are
reasonably estimable and accrued:
“Disclosure of the nature of an accrual…and in some circumstances
the amount accrued, may be necessary for the financial statements
not to be misleading.”
Disclosure requirements for all other probable and reasonably
possible loss contingencies:
• Nature of the contingency.
• Estimate of the possible loss, range of loss or a statement that
such an estimate cannot be made.
• An exposure to loss exists in excess of the amount accrued, if
applicable.
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ACCOUNTING FOR FUTURE EVENTS – LITIGATION
RELATED OBLIGATIONS
The probability of a future event dictates what accounting action must be
taken as illustrated in the chart below.
What is the
Probability of
Event?
Is the Loss
Reasonably
Estimable?
Financial
Reporting for the
Event
Probable
Yes
Accrue & Disclose
Probable
No
Disclose
Reasonably
Possible
Either
Disclose
Remote
N/A
None
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SUBSEQUENT EVENTS – ACCRUAL OR DISCLOSURE?
ASC 450-20-55 & 450-20-50
Accrual and Disclosure:
• “Accrual may be appropriate for litigation, claims, or assessments whose
underlying cause is an event occurring on or before the date of an entity's
financial statements even if the entity does not become aware of the existence
or possibility of the lawsuit, claim, or assessment until after the date of the
financial statements.”
• “If those financial statements have not been issued or are not yet available to be
issued, accrual of a loss related to the litigation, claim, or assessment would be
required if the probability of loss is such that the condition in paragraph 450-2025-2(a) is met and the amount of loss can be reasonably estimated.”
• Accordingly, accrual for events or conditions whose underlying cause occurred
prior to the date of the financial statements would be required, if reasonably
estimable.
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SUBSEQUENT EVENTS – ACCRUAL OR DISCLOSURE? –
CONTINUED
ASC 450-20-55 & 450-20-50
Disclosure Only:
• “Disclosure of a loss, or a loss contingency, arising after the date of an entity's
financial statements but before those financial statements are issued,…may be
necessary to keep the financial statements from being misleading if an accrual
is not required.”
• Knowledge and assessment of impact should be disclosed for new potential
loss contingencies which occur and are identified after the balance sheet date.
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SEC SEC
VIEWS
AND COMMENTS
VIEWS
AND COMMENTS
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SEC VIEWS SINCE 2011
2012 AICPA National Conference on Current SEC and PCAOB
Developments*:
•
One topic of an SEC staff presentation was “Loss Contingencies – Frequent Areas of
Comment”. The areas noted were, surprise disclosures and accruals, reasonably
possible range of loss, third party recoveries, policy for legal fee accrual, and clarity of
disclosures.
•
The SEC Staff mentioned that it is aware that recognition and disclosure of
contingencies requires judgment, which makes it important that registrants ‘tell their
whole story” in their disclosures.
•
The SEC staff reminded registrants that disclosures related to loss contingencies should
evolve over time as the contingency progresses.
•
The SEC staff said that even though the FASB removed the loss contingency project
from its standard-setting agenda, the way the SEC staff treats loss contingency
disclosures in its reviews will be unaffected.
*Sources include: 1) EY’s “Compendium of significant accounting and reporting issues” publication regarding the 2012
conference. 2) SEC “Slide Presentation: Remarks before the 2012 AICPA National Conference on Current SEC and
PCAOB Developments.”
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SAMPLE SAMPLE
SCENARIOS
SCENARIOS
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SCENARIO NUMBER ONE
Your company is named as a defendant in a lawsuit and you conclude
that on balance you will lose $10 million if a judgment is obtained by
plaintiff. However, you also think that there is only a 30 percent chance of
losing. In such a case, your company’s reserve should be:
A.
B.
C.
D.
$3,000,000
Zero
$10,000,000
None of the above
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SCENARIO NUMBER ONE – SUGGESTED ANSWER
B.
Zero
or
D.
None of the Above
 30% is generally not considered probable
 However, settlement negotiations may lead to accrual
 The need for disclosure should be evaluated
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SCENARIO NUMBER TWO
Your company is named as a defendant in a lawsuit and you conclude that
on balance you will lose $10 million if a judgment is obtained by plaintiff
You also think that there is a 75 percent chance of losing. In such a case,
your company’s reserve should be:
A.
B.
C.
D.
Zero
$7,500,000
$10,000,000
None of the above
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SCENARIO NUMBER TWO – SUGGESTED ANSWER
C.
$10 million
 75% — most would consider probable
 Need to accrue full amount and include disclosure in footnotes to the
financial statements
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SCENARIO NUMBER THREE
Your company is named as a defendant in a lawsuit and you conclude that
on balance you will lose $10 million if a judgment is obtained against the
company. You are unable to evaluate your company’s chance of success
if the case goes to trial. In such a case, your company’s reserve should
be:
A.
B.
C.
D.
Zero
$10,000,000
$5,000,000
None of the Above
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SCENARIO NUMBER THREE – SUGGESTED ANSWER
A.
Zero
 If you can’t evaluate, then not remote. So disclosure likely if material
 In-house counsel should expect pressure to evaluate chance of
success
 Difficult to stay with/unable to evaluate position for a long period of time
 However, settlement negotiations may lead to accrual
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SCENARIO NUMBER FOUR
Your company is named as a defendant in a lawsuit and you think that
there is a 75 percent chance of losing, but are unable to estimate the
amount of the loss (it could fall anywhere between zero and $10 million).
In such a case, your company’s reserve should be:
A.
B.
C.
D.
Zero
$7,500,000
$10,000,000
None of the Above
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SCENARIO NUMBER FOUR – SUGGESTED ANSWER
A.
Zero
• Record at best estimate in range
• If no estimate is better than any other, record at the lower end of the
range
• Disclosure still required, if material
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RELEVANT AUDITING
LITERATURE
– AUDIT AUDITING
RELEVANT
STANDARD
2505
LITERATURE
– AUDIT
STANDARD 2505
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PCAOB AUDIT STANDARD - AS 2505
• The Public Company Accounting Oversight Board (PCAOB) is a
nonprofit corporation established by Congress to oversee the audits of
public companies in order to protect investors and the public interest by
promoting informative, accurate, and independent audit reports.
• PCAOB Audit Standard 2505 (AS 2505) relates to the “Inquiry of a
Client's Lawyer Concerning Litigation, Claims, and Assessments.”
The corresponding standard for non-public entities is the AICPA’s “AU
Section 337”.
• The AICPA establishes auditing standards for non-public entities.
PCAOB and AICPA auditing standards are largely the same in the case
of lawyer’s letters.
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AUDIT CONSIDERATIONS
AS 2505.04
With respect to litigation, claims, and assessments, the independent
auditor should obtain evidential matter relevant to the following
factors:
a. The existence of a condition, situation, or set of circumstances
indicating an uncertainty as to the possible loss to an entity arising
from litigation, claims, and assessments.
b. The period in which the underlying cause for legal action occurred.
c. The degree of probability of an unfavorable outcome.
d. The amount or range of potential loss.
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WHY LEGAL COUNSEL’S OPINION IS NEEDED?
AS 2505.06
“An auditor ordinarily does not possess legal skills and, therefore,
cannot make legal judgments concerning information coming to his
attention. Accordingly, the auditor should request the client's
management to send a letter of inquiry to those lawyers with whom
management consulted concerning litigation, claims, and assessments.”
• Lawyer’s response should be directed to the independent auditor.
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WHAT IS NEEDED FROM LAWYER’S LETTERS?
AS 2505.09
The letter of audit inquiry is to include a “list prepared by
management (or a request by management that the lawyer prepare
a list) that describes and evaluates pending or threatened
litigation, claims, and assessments…” In regards to this list, the
lawyer is requested to furnish:
• A description of the nature and progress of each matter, and the
action the company intends to take(i.e. contest, settle, etc.) for
matters assigned to them.
• An evaluation of the likelihood of an unfavorable outcome and
an estimate, if one can be made, of the amount or range of
potential loss.
• An identification of the omission of any pending or threatened
matters, or a statement that the list of such matters is complete.
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DATE/TIMING OF THE LAWYER’S LETTER
Auditing Interpretations (AI) of AS 2505 - AI 17
• “Auditor’s should request the client to specify, in his audit inquiry letter to
a lawyer…the date by which the lawyer's response should be sent to
the auditor.”
• The interpretation also notes, “[o]rdinarily, a two-week period should be
allowed between the specified effective date of the lawyer's response
and the latest date by which the response should be sent to the auditor.”
• “[T]he latest date of the period covered by the lawyer's response (the
"effective date") should be as close to the date of the auditor's report as
is practicable in the circumstances.”
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THANK YOU
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