Are Revisions to SFAS No. 5 Needed?

Abstract

SYNOPSIS: In the Financial Accounting Standards Board’s (FASB) project, “Disclosure of Certain Loss Contingencies,” a central issue underlying the debate is whether existing implementation of FASB Accounting Standards Codification Topic 450-20 (previously Statement of Financial Accounting Standards No. 5) provides sufficient and timely information to financial statement users. The Exposure Draft explains that constituents’ assertions of inadequate disclosures are the primary motive underlying the FASB’s re-examination of this issue (see, for example, page v of the Exposure Draft). However, little actual data are available to indicate the extent of the alleged problem. This manuscript presents the results of a study undertaken to provide such data. For a sample of litigation-related losses, we find a surprisingly large incidence of non-disclosure of contingent losses that cannot be readily explained. Moreover, even where there is disclosure, we find many cases where firms do not provide estimates of expected losses, presumably under the permitted exception for cases where firms claim to be unable to estimate the magnitude of expected losses. On the other hand, we find relatively frequent disclosure of the items called for in the Exposure Draft, consistent with the conjecture that at least some of these items are being demanded by users.

Auditor Experience and the Timeliness of Litigation Loss Contingency Disclosures*

“…For a sample of 212 employment discrimination lawsuits, Hennes (2014) documents that the majority of sample defendant firms do not disclose plaintiffs' claim amounts, and few firms provide estimates of probable losses. For a sample of 51 cases, Desir et al (2010) provide evidence of non-disclosure of the lawsuit until the loss occurs. Moreover, even when there is a disclosure, previous research suggests many firms do not provide estimates of expected losses.…”

Unintended Consequences of Lowering Disclosure Thresholds: Proposed Changes to SFAS No. 5

“…Recently, the quality of firms" loss contingency disclosures has been criticized by investors, and a debate has developed about whether or not SFAS 5 should be amended (Desir et al 2010). Investors have asserted that disclosures under SFAS 5 do not adequately allow them to predict and assess the likelihood, amount, and timing of future cash flows (FASB 2008;Desir et al 2010).…”

“…Recently, the quality of firms" loss contingency disclosures has been criticized by investors, and a debate has developed about whether or not SFAS 5 should be amended (Desir et al 2010). Investors have asserted that disclosures under SFAS 5 do not adequately allow them to predict and assess the likelihood, amount, and timing of future cash flows (FASB 2008;Desir et al 2010). Investors further allege that too often firms are not disclosing loss contingencies until a material loss has been incurred, leaving them unable to appropriately incorporate contingencies into their judgments, which could lead to a suboptimal allocation of investors" resources (Cheney 2008;Desir et al 2010).…”

“…Recently, however, investors have asserted that too often firms are not disclosing loss contingencies until the loss has already been realized, leaving them unable to appropriately assess the risks that companies are facing due to pending litigation (FASB 2008;Desir et al 2010). In response to investors" assertions, the FASB issued an Exposure Draft (FASB 2008) which proposes to lower the probability threshold for disclosure from "at least reasonably possible" to "more than remote."…”

Litigation-Disclosure Modifications in the 10-K: Large-Sample Evidence

“…ASC 450 requires a company to (a) record an accrual of loss contingency amounts along with related disclosures, and (b) when an accrual is not required but a loss is ''reasonably possible,'' disclosures must provide an estimate of the possible loss or an estimate of the range of possible loss, or a statement that such an estimate cannot be made. Therefore, audited ASC 450 is to provide the recognition of loss contingencies and an evaluation of the likelihood a loss contingency will result in an unfavorable future outcome (Desir et al, 2010).…”