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New Rules for Disclosing Environmental and Other Loss Contingencies
June 17, 2008
Environmental disclosures under the U.S. securities laws are about to change materially as a result of a proposed new standard from the Financial Accounting Standards Board. FASB has just issued for public comment a major revision of the iconic FAS 5 standard governing the disclosure of loss contingencies. For companies facing environmental loss contingencies,1 the proposed new standard poses significant challenges. We outline the key changes below, and then we offer some thoughts on the challenges ahead.
The Existing FAS 5 Standard
FAS 5 has governed accruals and disclosures of loss contingencies since 1975. It holds that a charge to income must be accrued if (a) current information indicates that a loss contingency is probable and (b) the amount of loss can be reasonably estimated. FAS 5, para. 8. Even when an accrual is not mandated, disclosure of the loss contingency is required if there is at least a reasonable possibility that a loss or additional loss will occur. FAS 5, para. 10. Disclosure is not required if the loss contingency is an unasserted claim that the potential claimant appears to be unaware of, unless the loss contingency is probable and an unfavorable outcome is a reasonable possibility. Id. In practice, these requirements have led many companies to disclose limited information about environmental loss contingencies, given the uncertainties that often surround the probability and magnitude of environmental losses. Critics2 have repeatedly argued for expanded environmental disclosure requirements, but without much success to date.
The Proposed New Standard
FASB now proposes to require expanded disclosure of certain loss contingencies, starting in fiscal years ending after December 15, 2008 – thereby capturing Form 10-Ks filed for calendar year 2008. The proposal does not rescind FAS 5, but it "replaces the disclosure requirements in Statement 5" for loss contingencies that are recognized under FAS 5, as well as for those that exist but currently would not need to be recognized under FAS 5. The proposal addresses only loss contingencies that are "liabilities," leaving unchanged the disclosure requirements under FAS 5 for loss contingencies arising from the impairment of assets. Since environmental loss contingencies fall overwhelmingly into the category of "liabilities," the proposed rule – not FAS 5 – will set the disclosure standard for environmental loss contingencies.
The most important changes called for in the new standard are:
- FAS 5 would no longer be the standard governing the disclosure of loss contingencies that are liabilities. The new standard would govern such disclosures while leaving FAS 5 as the governing standard for loss contingencies that are asset impairments.3
- Qualitative disclosure obligations would be greatly extended to include, "at a minimum," a description of the contingency, how it arose, its legal basis, its current status, the most likely outcome, the timing of the outcome, the factors affecting the outcome, key assumptions in analyzing the outcome, and the qualitative and quantitative aspects of rights to recovery through insurance or indemnity.
- A tabular array of aggregated loss contingencies would need to be provided with every statement of income to show the increase/decrease in loss contingencies, payouts, estimates, recoveries from insurance, etc. over the reporting period.
- Significant aspects of the tabular reconciliation would need to be discussed, and companies would be required to identify the line items in the statement of financial position in which loss contingencies are recognized.
- Disclosure would be required even for a loss contingency liability that is not reasonably possible, if it is expected to be resolved "in the near term" (one year or less) and it "could" have a "severe" impact on the company.
- Even when disclosure would be prejudicial to the outcome of the contingency itself (e.g., disclosure of unasserted claims against the company), it must be disclosed in an aggregated (higher level) format such as the tabular reconciliation unless, in a "rare" instance, even aggregated disclosure would be prejudicial, in which case only the specific information that would be prejudicial may be withheld.
Responding to these new disclosure requirements is complicated by the proposed effective date, which captures the next Form 10-K season. FASB staff had recommended an effective date a year later, allowing companies time to adjust, but the FASB advanced the date. It remains to be seen whether the FASB will stand by its schedule after public comments are received.
Meeting the Challenges Ahead
The new standard works major change in the breadth and detail of information that would need to be disclosed and discussed starting next 10-K season. While many companies have the relevant information at hand, most will need to adapt their disclosure protocols and practices to capture the relevant information and prepare it in a format that works with the new standard. In addition, the company's disclosure team should be briefed and, as necessary, trained in the new emphasis on qualitative disclosure. Finally, companies should consider carefully how to use the remaining 10-Q opportunities in 2008 to lay some foundation for the new information to come early next year, to avert a sense of surprise among shareholders and investors.
1 The proposal, like FAS 5, is not limited to environmental loss contingencies, and it does not establish a higher or different standard for environmental loss contingencies compared to other loss contingencies.