Academic journal article Texas Law Review

Mind the GAAP: Moving beyond the Accountant-Attorney Treaty*

Academic journal article Texas Law Review

Mind the GAAP: Moving beyond the Accountant-Attorney Treaty*

Article excerpt

I. Introduction

Imagine an investor considering a company's stock. Before buying, the investor diligently examines the company's financial statements and Securities and Exchange Commission (SEC) filings. These documents mention a handful of pending lawsuits and lay out the bare facts of the suit. They simultaneously assure the investor that the company has a number of good defenses and is diligently defending the suits. The financial statements similarly mention the litigation in a footnote but go on to say any potential loss cannot be reasonably estimated. Though these disclosures have perhaps given the investor some pause, a lack of legal expertise and knowledge of the company's operations prevents the investor from gleaning much from the disclosures. With these concerns in mind, the investor acquires a stake in the company, trusting that any reliable disclosure system would require more substantive discussion if the lawsuits were truly presented major problems for the company. Soon, however, the company is slammed with a judgment that will bankrupt it (or settles for a startling sum), and much, if not all, of the investment is lost.

Given the current reporting regime and the generally accepted accounting principles (GAAP) for loss contingencies, this story is hardly a fantasy. Such an event should not be acceptable in a system that focuses on transparency and disclosure. If regulators are to fulfill their mission of providing ample, high-quality information so that investors can make informed decisions,1 the disclosure of contingent liabilities in the litigation context must be strengthened. Indeed, the Financial Accounting Standards Board (FASB)-the body tasked with articulating GAAP2-unsuccessfully attempted to reform this area beginning in 2008.3 Among the reforms most quickly rejected was a provision requiring companies to report settlement valuations of certain pending litigation.4 Due to the overwhelmingly negative response to any reform in this area, the reporting of settlement valuations received inadequate attention as a viable approach. This Note recognizes and develops the viability of a system of disclosure based on settlement value and its potential to satisfy warring factions of attorneys and accountants. The proposed disclosure system would require dollar amounts offered by disclosing companies in settlement negotiations to form the baseline for quantifying losses that may not otherwise trigger current disclosure requirements because the potential losses cannot be reasonably estimated.

Part II of this Note will examine the existing reporting system for litigation contingencies and its current inadequacy. Part III will outline a proposed reform to meet this issue that focuses on disclosure of the value of settlements offered by the reporting company. Part IV will examine the practical obstacles and objections the proposed reform would have to overcome. Part V will briefly conclude.

II. Examining the Problem

A. Existing Reporting Requirements

The existing regime for reporting litigation contingencies originates in both SEC rules and the accounting standards that establish the rules for preparing financial statements. This information is disclosed in mandated periodic filings with the SEC and made available to the investing public via forms 10-K (annually) and 10-Q (quarterly).5 Regulation S-K is the most basic toolkit for SEC disclosure filings and explains to reporting companies what must be included in disclosure documents.6 The primary provision relating specifically to potential litigation losses in Regulation S-K is Item 103, which requires disclosure of various factual information regarding litigation falling outside of "ordinary routine litigation."7 The instructions to Item 103 clarify that suits claiming damages of less than 10% of the company's assets need not be disclosed.8 These limitations on disclosure are presumably to keep the reporting burdens on companies manageable. …

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