For the good of investors, FASB should withdraw its loss contingencies disclosure draft

by Kurt Schulzke on October 20, 2008

I have long suspected that “protecting” America’s financial statement users from “bad” financial statements is a futile task.  The FASB’s efforts at revamping its Statement 5, on loss contingencies, confirms the suspicion.  It’s not that we have too many bad financial statements.  It’s that the users — including some who hold advanced business degrees and certifications — lack common sense.  Common sense may also be in short supply at the FASB.

At it’s September 24 meeting, the Financial Accounting Standards Board conceded that its contingent liabilities disclosure proposal had met with serious resistance among financial statement preparers and their attorneys.  Users, however, wanted even more than the truly outlandish disclosure concessions embodied in the Exposure Draft.

The end result was that the FASB scheduled a “redeliberation” of the proposal to give FASB staff time to develop and test an “alternative” that “attempts” to respond to the concerns raised by preparers and their attorneys.  We can only hope that today’s pro-market-regulation hysteria will subside between now and next year when the FASB meets to reconsider this misguided proposal.

Some of the user comment letters reveal a staggeringly simplistic mindset.  One Chartered Financial Analyst with a Yale economics PhD who serves as Executive VP of a Boston asset management firm unbelievably wrote:

We believe that FAS 5 should require companies to disclose all known severe threats whether or not they are expected to be resolved within a year.

Seriously.  “All known severe threats.”  The writer, however, generously allowed she didn’t mean that all of these threats should be quantified:

Recognizing the need to ensure that disclosures are made in a cost-effective manner, [my company] would like to suggest that “remotely probable” risks that are not expected to be resolved within one year be described in a narrative form, but would not need to be quantified other than to specify that they may be severe.”

Maybe they don’t teach game theory to Yale PhDs.  But do you really need game theory to realize that if a company broadcasts a complete narrative description of all known severe threats regardless of how remote they are in time, that competitors and short sellers will exploit that information to hurt the company’s current shareholders?  If an airline broadcasts the departure time and location of a jet that has only one of two engines operating, what should we expect Al Qaeda to do?

Even if we dialed back the disclosure obligation to say, “Quantify all known severe threats expected to be resolved in one year,” — essentially what the current proposal would require — we would be handing enormously prejudicial information to opposing litigants and competitors.  The FASB’s proposal provides a so-called “exemption” from disclosing prejudicial in limited circumstances but even that exemption holds that

In no circumstance may an entity forgo disclosing the amount of the claim or assessment against the entity (or, if there is no claim amount, an estimate of the entity’s maximum exposure to loss); providing a description of the loss contingency, including how it arose, its legal or contractual basis, its current status, and the anticipated timing of its resolution; and providing a description of the factors that are likely to affect the ultimate outcome of the contingency along with the potential impact on the outcome.

Forcing a company to disclose its “maximum exposure to loss” is tantamount to exposing its bottom line in a negotiation.  Why would an investor who cares about the company ever want it to reveal such sensitive information?

Investors should reject this proposal because (a) it is likely to provide highly unreliable information about the disclosing entity (until litigation is finally resolved, no one really knows what’s going to happen); and (b) the very disclosure of such information can change the outcome of pending litigation or negotiation.  It is likely to do more harm than good to the very companies in which investors have invested their funds.