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M&A Accounting for Lawsuit Contingencies Revoked

Expert Witness: Fulcrum Inquiry
An accounting pronouncement highly criticized by the legal profession was formally revoked this month, putting back in place rules that the lawyers have known for years. The requirement of disclosing in the financial statement footnotes the range of expected outcomes for a recognized contingency at the acquisition date is similarly eliminated.

An accounting pronouncement highly criticized by the legal profession was formally revoked this month. The Financial Accounting Standards Board (FASB) issued FSP FAS 141(R)-1, “Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies”. As described in our previous article, the “old” rule (which was effective starting in 2009) required lawsuits to be valued at their “fair value”. The revision effectively guts this requirement, and returns the accounting to what previously existed. FSP FAS 141R-1 also eliminates the FAS 141R requirement of disclosing in the footnotes
to the financial statements the range of expected outcomes for a recognized contingency at the acquisition date.

Because of the change, if the fair value of lawsuit contingencies are not probable and cannot be reasonably estimated, then acquirers should not recognize these contingencies as of the acquisition date. Instead, acquirers should account for lawsuits in subsequent periods by following other applicable GAAP (specifically FASB Statement No. 5, Accounting for Contingencies).

The revision finalizes the September 2008 FASB announcement that it would rethink the new requirements. This past summer the FASB received over 235 comments, the vast majority of which were not supportive of the FASB’s change. The opposition largely came from lawyers and preparers of financial statements, while users (i.e., investors and financial analysts) were generally supportive.
The FASB acknowledged that they were under pressure to make the change. Specifically:

“B6. After the issuance of Statement 141(R), preparers, auditors, and attorneys raised a number of application issues about the requirements in that Statement related to assets and liabilities arising from contingencies. In particular, preparers and attorneys were concerned about providing auditors with evidence to support the recognition and measurement of liabilities related to certain litigation-related loss contingencies assumed in a business combination under Statement 141(R), because disclosure of such information could be prejudicial.

B7. Preparers and attorneys were concerned that information provided to an independent auditor about whether it is more likely than not that a litigation-related contingent liability exists under Concepts Statement 6 could lose its privileged status and be subject to discovery. Attorneys indicated that if an acquirer recognizes a liability arising from a litigation-related contingency because it has concluded that it is more likely than not that a liability exists under Concepts Statement 6, the acquirer could be perceived as admitting guilt (even though the law may be highly uncertain in the relevant area). The result could be prejudicial to the acquirer. The American Bar Association’s Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests for Information does not require a client’s attorney to comment on whether it is more likely than not that a contingency arising from litigation gives rise to a liability as defined in Concepts Statement 6. Attorneys indicated that they could not reconcile fulfilling their professional responsibilities to their clients and providing auditors with audit evidence that states that their client is more likely than not liable in a given case.”

There is mixed case law about whether providing information to a client's auditor is a waiver of attorney-client privilege and work product rights. The better view is that there is a "common interest" waiver protection, but there are contrary cases. Since the underlying estimates and evaluations for the proposed additional disclosures would be obtained from counsel, waiver will also be claimed for the financial statements disclosures themselves.

ABOUT THE AUTHOR: David Nolte - Fulcrum Inquiry
Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.

Fulcrum Inquiry performs litigation damages analysis, and financial investigations.

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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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