Confrontation looms over accounting for legal bills

Attempts to replace account­ing rules for sensitive and costly legal actions
are facing resistance from Europe and the US, with calls for current proposals
to be scrapped.

The International Account­ing Standards Board (IASB) last week extended the
comment period for changes on how to measure and record court cases and other
non-financial liabilities, reflecting growing angst surrounding the standard
known as IAS 37.

The proposals aim to improve how companies measure non-financial liabilities
such as court cases. These difficult-to-value liabilities have uncertain
outcomes, but can significantly affect the value of a company.
The standard is causing headaches at the IASB and could now prove a stumbling
block as it converges with US accounting standards.

At the heart of the changes is how companies measure their non-financial
liabilities, such as court actions, which, particularly for the litigation-prone
tobacco or pharmaceutical industries, can add up to billions of pounds in
liabilities each year.

At present, companies record a liability if the chances of losing a case, or
having to pay out funds, is greater than 50%. The value recorded in the
financial statements represents the company’s “best estimate” of this liability.

However, “best estimates” vary widely according to the IASB which instead
wants companies to record a weighted average of all potential outcomes. Under
the model companies would assign a probability to each possibility and combine
these to arrive at a value.

Both the current and proposed models may prove incompatible with current US
rules. Under US standards companies disclose court-related liabilities further
along in the litigation process than their counterparts using international
accounting rules.

The US Securities and Exchanges Commission (SEC), which is yet to decide
whether to adopt international account­ing rules for US companies, said there
remained “serious concerns” about the IASB’s general approach to the issue.

In a 2 March statement the SEC said it will give “careful consideration of the
impact of litigation contingency account­ing and disclosure requirements” as it
decides whether to make the transition to international accounting standards.

In the litigious US environment it’s also feared the IASB’s rule may
prejudice court cases or erode attorney-client privilege.

European Financial Report­ing Advisory Group (EFRAG), the body which advises
the European Commission, believes the current rules do not need to change.
“We are not persuaded
that the application of the current measurement guidance in IAS 37 is a source
of significant problems for preparers; nor does it create serious com­parability
issues to users of the financial statements,” said Stig Enevoldsen, chairman of
EFRAG, in a draft comment letter.

The model is also drawing criticism from some of the IASB’s staunchest
supporters.

“The ICAEW has supported IASB through thick and thin. That loyalty is about
to be tested severely,” said Andy Simmonds ICAEW’s Financial Reporting Faculty
chair, in January.

The issue has caused division within the IASB itself with six of the 13
member board voting down some technical elements of the plan. The approaching
June departure of two of the proposal’s advocates – Bob Garnett and Jim
Leisenring – has heightened the need to have the standard resolved.
Kathryn Cearns, technical accountant with law firm Herbert Smith, said the IASB
should leave the standard as it is and concentrate on other issues.

“The IASB has got more important matters to deal with than this,” she said.
“There is no real problem to fix.”

IN OUR VIEW

Given the host of other issues affecting accounting in the credit crunch and
recession, the issue of how to treat potential legal bills is an odd one to get
stuck on. The IASB and FASB have to keep their eyes on the prize – effective
convergence of US and international standards. There should be no sense in which
the issues surrounding IAS 37 should come to present a threat to that prize. All
it needs is some careful management.

Further reading:

iasb.org