IMPORTANT FACTORS TO CONSIDER IN INTERACTION BETWEEN ACCOUNTANTS, AUDITORS, AND COUNSEL

MARCH 15, 2016

LITIGATION AND CORPORATE LAW FORUMS

PARAMETERS FOR SETTING LITIGATION RESERVES

PANEL Kevin Davis – kdavis@navigant.com - 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 – pbrennan@jenner.com – 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 – ken.reiss@ng.com – 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 450-20-

25-2(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 VIEWS AND COMMENTS SEC 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 SCENARIOS SAMPLE 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. $3,000,000

B. Zero

C. $10,000,000

D. 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. Zero

B. $7,500,000

C. $10,000,000

D. 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. Zero

B. $10,000,000

C. $5,000,000

D. 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. Zero

B. $7,500,000

C. $10,000,000

D. 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

STANDARD 2505 RELEVANT AUDITING

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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