If you’ve been at a registered company for at least three years, then the SEC has reviewed your disclosures during that time. While this might sound ominous, under Sarbanes-Oxley, the SEC is required to review all registered companies at least once every three years (with some lucky winners reviewed every year!). During 2015, the SEC reviewed 51% of registrants.
As part of these reviews, the SEC may submit comment letters to the registrants regarding issues with the company’s disclosures. Of the registrants reviewed during FY 2015, 8% received a comment letter relating to commitments and contingencies, including legal reserves. In a study on these comment letters by EY, the team noted that the SEC has increased its examination of contingencies in recent years.
While the above statistics show the importance of proper accrual and disclosure of loss contingencies, there are also important reasons to focus on the contingencies themselves. Whether you’re a CEO, general counsel, or auditor, uncertainties like pending litigation and related legal reserves can impact your business.
In last week’s post, we introduced legal reserves and discussed their importance. Today we’ll focus on the financial reporting aspects of loss contingencies, including when disclosure or accrual is required. Next week we’ll touch on the importance of proper legal reserve estimation and tracking for both internal and external purposes.
Financial Statement Disclosure and Accrual
As we discussed in our introductory post, ASC 450 defines a contingency as “[a]n existing condition, situation or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an entity that will ultimately be resolved when one or more future events occur or fail to occur.” A loss contingency exists when this uncertainty relates to the impairment of an asset, or the incurrence of a liability.
Per ASC 450, the first step in determining how to treat a contingent loss is to establish the likelihood that the company will incur a material loss. We’ll discuss how to determine whether a loss is material in the next section, but generally you’ll work with your internal audit team or external auditors to establish a materiality threshold.
There are three possible ranges of likelihood:
- Probable: the future event is likely to occur.
- Reasonably possible: the likelihood falls in the range between remote and probable.
- Remote: the chance of the future event is slight.
For better or for worse, FASB has no bright-line guidance as to exact probabilities included within each range. The likelihood determinations “are not intended to be so rigid that they require virtual certainty before a loss is accrued. Instead, the [probable condition] is intended to proscribe accrual of losses that relate to future periods.”
Most companies establish a 10% probability ceiling for a “remote” chance, and between 70-80% for “likely,” with “reasonably possible” falling between the two. It is important for entities to apply these probabilities consistently across all contingent losses.
If the probability of a material loss is remote, no disclosure or accrual is required. Companies should continue to monitor the matter to determine whether new information, or future changes, would require a reassessment.
If the loss is reasonably possible, but not probable, the company should disclose the contingency, but not record an accrual. If the amount is estimable, the company must disclose the nature of the contingency and provide an estimate of the amount or the loss (or at least a possible range). If the amount is not estimable, then the company must disclose the nature of the contingency and describe why it is unable to estimate the amount of the loss or the range of loss.
If the likelihood is probable, the next step is to determine whether the loss is reasonably estimable. If the amount of the loss is reasonably estimable, then the company is required to accrue either:
- The company’s best estimate of the potential loss within a range; or
- When no amount within the range is a better estimate than any other amount, the minimum amount within the range. Although the minimum amount in the range is not necessarily the amount of loss that will be ultimately determined, it is unlikely that the ultimate loss will be less than this amount.
Meanwhile, if the amount of the loss is not reasonably estimable, the company must disclose the nature of the contingency, and describe why it is unable to estimate the amount of the loss. FASB provides some particularly useful but lengthy guidance.
- The reasonably estimable condition “is intended to prevent accrual in the financial statements of amounts so uncertain as to impair the integrity of those statements.”
- Additionally, the reasonably estimable condition “shall not delay accrual of a loss until only a single amount can be reasonably estimated.”
- Finally, “to the contrary, when the [loss is probable] and information available indicates that the estimated amount of loss is within a range of amounts, it follows that some amount of loss has occurred and can be reasonably estimated. Thus, when the [loss is probable] and the reasonable estimate of the loss is a range […] an amount shall be accrued for the loss.”
We’ll be dedicating an entire post to the topic of updating estimates for legal reserves, but for now we would simply like to remind you of the importance of maintaining accurate assessments of matters that may result in a contingent loss. Setting reserves or accruals or developing disclosures is not a “one and done” exercise, but should be updated as facts and circumstances change.
As we mentioned in the previous section, ASC 450 rules regarding disclosure and accrual only apply to material contingent losses. Many organizations define materiality using a percentage, such as percentage of net income. For purposes of ASC 450, materiality is determined under SEC Staff Accounting Bulletin 99 (SAB 99). While a percentage may be appropriate as a preliminary assessment tool, SAB 99 states that “[a] matter is “material” if there is a substantial likelihood that a reasonable person would consider it important.”
Materiality may vary when determined for other purposes, such as some SEC regulatory filings, like 8-Ks. Issuing companies must comply with materiality thresholds under Regulation S-K Items 103 (relating to legal proceedings) and 303 (relating to general MD&A uncertainty disclosures).
Now that you know how to determine whether disclosures or accruals are necessary for possible losses, we’ll move on to why you should care. Contingent losses for matters like pending litigation, class action suits, or governmental investigation can impact your business’s operations and financials. In addition to meeting reporting requirements, giving appropriate attention to contingent losses and legal reserves will provide your company with valuable planning opportunities.