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    Are Revisions to SFAS No. 5 Needed?
    research summary posted February 19, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.03 Impact of New Accounting Pronouncements 
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    Title:
    Are Revisions to SFAS No. 5 Needed?
    Practical Implications:

    The findings generally support FASB (2008) Exposure Draft assertions that there is often insufficient timely information about litigation available to users. Specifically, the authors find that in an unexpectedly large proportion of the cases they investigate, companies do not disclose lawsuits until a loss occurs. The authors also find a relatively high incidence of companies not providing estimated losses or ranges of losses prior to resolution. For a substantial number of cases, accruals for estimated losses are not made (or are at least not disclosed) prior to the realization of the loss. Further, the authors find a relatively high degree of disclosure of the items called for in the FASB’s (2008) Exposure Draft, suggesting that users already demand at least some of them.

    For more information on this study, please contact Ray J. Pfeiffer.

    Citation:

    Desir, R., K. Fanning, and R. Pfeiffer. 2010. Are revisions to SFAS No. 5 needed? Accounting Horizons 24 (4): 525-545.

    Purpose of the Study:

    Setting financial reporting standards, like most regulatory activities, requires decision-making under uncertainty.  In a typical standard-setting issue, standard setters receive information — typically in the form of (often unsupported) assertions — that there is some deficiency in existing Generally Accepted Accounting Principles.  For those alleged deficiencies that exceed a threshold, the Board and Staff of the FASB initiate a standard-setting project.  In their work on projects, Board and Staff members must make difficult judgments about the nature of guidance likely to resolve the deficiency while anticipating any indirect consequences of the contemplated new guidance.

    Empirical academic research has the potential to play a useful role in the standard setting process to the extent that it can be used to reduce the inherent uncertainty facing Board members. Ex ante empirical evidence is particularly desirable because it enhances the likelihood that new guidance is actually warranted and that any new guidance achieves its intended purpose.

    This paper reports the findings of an example of such ex ante empirical research.  The issue in question is the allegation that firms tend to provide insufficient and insufficiently timely disclosures of contingent legal obligations.  This assertion was an explicit part of the rationale underlying the FASB’s Exposure Draft, “Disclosure of Loss Contingencies” (FASB 2008b).  This paper has two intended contributions:  (1) to report the findings of empirical research about the extent of the alleged insufficient disclosure problem; and (2) to serve as an example of how empirical academic research can be informative to the FASB Board and Staff.

    Design/Method/ Approach:

    The authors assembled a representative random sample of unfavorable settlements and adjudications of lawsuits in firms’ 10-Q and 10K filed during the first half of 2007. For each resolved lawsuit, the authors coded characteristics of the disclosure in the period of resolution as well as in all prior periods where disclosure existed prior to resolution. The descriptive evidence of litigation-related disclosure was from financial statement notes and required SEC disclosures in the 10K or 10-Q. 

    Findings:
    • The authors find that firms did not disclose 7.8% of the lawsuits in their sample in the quarter immediately preceding resolution, or in any period prior to resolution.
      • Twenty percent of the cases involving large losses (i.e., greater than 5% of pretax income) and 14% of the cases involving core operations fail to disclose the lawsuit in the quarter prior to resolution, suggesting this non-disclosure is not driven by lawsuits involving small dollar amounts or that are unrelated to core operations.
    • The authors find that firms provided estimates of the loss or range of possible loss (or explicitly stated that an estimate could not be made) in only 47.1% of the resolved lawsuits in their sample.
    • The authors find that companies accrue for such losses (or at least disclose that an accrual has been made) in 60.8% of cases.
      • For those cases that are larger (i.e., greater than 5% of pretax income) the accrual rate is 55%. For those cases related to core operations, the accrual rate is 59.1%, suggesting larger losses and losses related to core operations are not necessarily accrued more often.
    • The authors find a relatively high degree of disclosure of the items called for in the FASB’s (2008) Exposure Draft.
    Category:
    Standard Setting
    Sub-category:
    Impact of New Accounting Pronouncements