(updated from April 11, 2007)
Determining when and how to account for loss contingencies is an important decision for companies that have been sued. Reserving funds for possible litigation losses may significantly affect reported earnings. Worse, failing to book appropriate reserves may lead to restatements of earnings, which could invite an SEC investigation or shareholder litigation. Apart from reserves, the mere decision whether to disclose pending litigation in financial statements can also have major financial and legal ramifications. Moreover, both public and nonpublic companies are affected because both must properly account for and disclose litigation loss contingencies to comply with Generally Accepted Accounting Principles (GAAP).
Unfortunately, setting loss reserves is not as easy as following simple steps or plugging numbers into a formula. The accounting standards are muddled and applying them requires a great deal of discretion and judgment. Even the disclosure rules are fraught with peril.
When Is a Litigation Loss Reserve Required?
Under Accounting Standards Codification, Topic 450-20, “Loss Contingencies” (ASC 450-20) (formerly Financial Accounting Standard No. 5 (FAS 5)), a company must create a litigation loss reserve if (1) a loss is probable and (2) the amount of the expected loss is material and reasonably estimable.
Is a Litigation Loss “Probable”?
The first challenge is to figure out when a loss is “probable.” ASC 450-20 identifies three categories of likelihood: “probable,” “reasonably possible” and “remote.”
Probable. A future event is “probable” if it is “likely to occur.” ASC 450-20 does not define “likely,” except to say that “probable” does not infer “virtual certainty.” Formal definitions aside, “probable” is interpreted in practice as meaning “highly likely.” As a general rule of thumb, remote is typically 10% or less, probable 70-80% or more, and reasonably possible somewhere in between those ranges.
In evaluating the probability of an unfavorable litigation outcome, factors to consider include: (a) the nature of the litigation, claim or assessment; (b) the progress of the case; (c) the opinions of legal counsel and other advisers; (d) the experience of the company and others in similar cases; and (e) any decision by management as to how the company will respond to the lawsuit. Determining whether a loss is probable requires considerable judgment, and the assessment may change as the litigation progresses.
Reasonably Possible. If the “chance of the future event or events occurring is more than remote but less than likely,” the adverse outcome is deemed “reasonably possible.” A loss reserve is not required, but disclosure may be (see below).
Remote. If the chance of an adverse outcome is slight, the event considered is “remote,” and that ends the analysis. No reserve or financial statement disclosure is required. Periodic re-assessments of pending and threatened litigation may be necessary, however, to determine whether a loss that once seemed remote is now probable or reasonably possible.
If a Loss Is Probable, Is the Amount of the Loss Reasonably Estimable?
If a company determines that a loss is probable, it next must consider whether the amount of the loss will be material and if it can be estimated. If the loss is not material or cannot be reasonably estimated, no reserve is required, but Topic 450 makes clear that a company may not delay accrual of a loss until only a single amount can be reasonably estimated. If it is impossible to estimate the exact amount of probable loss, a company should attempt to estimate the range of possible losses. If no amount within the range appears to be the best estimate, reserve the low end of the range and then disclose the remaining amount, up to the high end of the range, as a “reasonably possible” loss. Setting the range requires subjective judgment, but factors to consider may include settlement negotiations, expert damage analyses, past experience, and input from legal counsel.
When Is Disclosure Required?
If a company determines that a loss is only “reasonably possible” or that a loss is “probable,” but the amount is not reasonably estimable, the company need not establish a reserve, but it still must disclose the nature of the possible loss and give an estimate of the possible loss or range of loss. The key is to ensure that the financial statements are not misleading. At a minimum, disclose the nature of the claims asserted and amount of damages sought. If the litigation is in its early stages, it may be appropriate to state that an estimate of reasonably possible loss cannot be made. As the litigation progresses, disclose a range of possible loss, possibly aggregated with other loss contingency disclosures. Keep in mind that the SEC has increasingly taken the position that it is not enough that a possible loss or range of loss cannot be determined “with precision and confidence,” and has indicated that it may ask companies to provide support for an assertion that an estimate cannot be made, particularly as litigation progresses.
The following chart illustrates the decision process:
In addition to the disclosure requirements of ASC 450-20, public companies may be required to provide information under SEC Regulation S-K Item 103, which requires disclosure of material legal proceedings in both the annual report (on Form 10-K) and the quarterly report (on Form 10-Q). SEC Reg. § 229.103. Claims that represent less than 10 percent of the company’s current assets on a consolidated basis are not “material” and need not be disclosed. If Item 103 requires disclosure, the company must give a brief description of the legal proceeding, including the name of the court or agency in which the proceedings are pending, the date instituted, the principal parties, a description of the factual basis alleged for the claims and the relief sought.
The following chart illustrates the decision process:
Companies that either fail to establish sufficient litigation loss reserves or overstate litigation loss reserves (so that the company can “manage earnings” by releasing reserves into income in bad years) have faced private litigation and SEC enforcement actions. The following tips may help avoid common pitfalls.
Tip 1: Establish a company reserve policy and apply it consistently. A written and consistently applied reserve policy may help a company defend a decision not to book a reserve. Establishing and following the policy helps the company avoid appearing opportunistic in setting and maintaining reserves.
Tip 2: Err on the side of disclosure where there is any chance that a litigation loss could be considered “reasonably possible.” Failing to disclose the possibility of a material litigation loss can result in lawsuits and enforcement actions if it later becomes clear that reserves were inadequate and company executives knew or should have known that a material loss was reasonably possible.
Tip 3: Book a reserve only where a loss is probable and the amount of loss can be reasonably estimated. A reserve should not be booked unless both ASC 450-20 requirements are satisfied. The SEC views creation of reserves for an improbable amount of loss to be a form of earnings management. If a loss is only reasonably possible, the company should disclose the nature of the contingency and an estimate of the possible loss or range of loss (or state that such an estimate cannot be made).
Tip 4: Reverse a reserve only where a change in facts makes the reserve (or a portion of the reserve) unnecessary. The SEC looks unfavorably on a company’s release of reserves into income where no specific development or change justifies the release. Reversing a reserve in a bad year is particularly likely to be viewed as opportunistic.
Tip 5: Do not create general reserves to cover unspecified claims. Litigation reserves should be determined on a case-by-case basis and should not be created for general future litigation costs and expenses.
Tip 6: Periodically reassess pending and threatened litigation to determine the adequacy of reserves. The probability of a loss and the ability to estimate the amount of the loss will likely change as the litigation progresses. A litigation loss considered remote when the suit was filed may later become reasonably possible or probable if dispositive motions are unsuccessful or discovery reveals damaging facts. It is also important to reassess the amount of existing reserves. If the underlying case settles, for example, the reserves must be reversed into income.