If you’ve been at a registered company for at least three years, then the SEC has reviewed your disclosures during that time. While this might sound ominous, under Sarbanes-Oxley, the SEC is required to review all registered companies at least once every three years (with some lucky winners reviewed every year!). During 2023, the SEC reviewed 49% of registrants.

As part of these reviews, the SEC may submit comment letters to the registrants regarding issues with the company’s disclosures. Interestingly (though maybe just to me), comments on contingencies dropped from the top ten most common comment letter topics in 2023. (In case you’re curious, the most commented area was the use of non-GAAP financial measurements.)

Financial Statement Disclosure and Accrual

ASC 450 defines a contingency as “[a]n existing condition, situation or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an entity that will ultimately be resolved when one or more future events occur or fail to occur.” A loss contingency exists when this uncertainty relates to the impairment of an asset, or the incurrence of a liability.

The first step in determining how to treat a contingent loss is to establish the likelihood that the company will incur a material loss. There are three possible ranges of likelihood:

• Probable: the future event is likely to occur.
• Reasonably possible: the likelihood falls in the range between remote and probable.
• Remote: the chance of the future event is slight.

Most companies establish a 10% probability ceiling for a “remote” chance, and between 70-80% for “likely,” with “reasonably possible” falling between the two. Remember that accounting under IFRS uses a different threshold: a provision is required if the probability is “more likely than not” (i.e., a greater than 50% chance).

If the probability of a material loss is remote, no disclosure or accrual is required. If the loss is reasonably possible, but not probable, the company should disclose the contingency, but not record an accrual. If the likelihood is probable, the next step is to determine whether the loss is reasonably estimable.

If the amount of the loss is reasonably estimable, then the company is required to accrue either:

• The company’s best estimate of the potential loss within a range; or
• When no amount within the range is a better estimate than any other amount, the minimum amount within the range.

If the amount of the loss is not reasonably estimable, the company must disclose the nature of the contingency, and describe why it is unable to estimate the amount of the loss.

(If you’d prefer a video explanation, I gave a talk on this at the Fin(Legal)Tech Conference.)

Modifications

Setting reserves or accruals or developing disclosures is not a “one and done” exercise, but should be updated as facts and circumstances change.

Materiality

For purposes of ASC 450, materiality is determined under SEC Staff Accounting Bulletin 99 (SAB 99). While a percentage may be appropriate as a preliminary assessment tool, SAB 99 states that a “matter is ‘material’ if there is a substantial likelihood that a reasonable person would consider it important.”

Materiality may vary when determined for other purposes, such as some SEC regulatory filings, like 8-Ks. Issuing companies must comply with materiality thresholds under Regulation S-K Items 103 (relating to legal proceedings) and 303 (relating to general MD&A uncertainty disclosures).

Board Considerations

While many board implications were covered in our previous post, there are two additional areas board members should focus on regarding legal reserves:

By focusing on these areas, board members can enhance their oversight of legal reserves, ensuring they’re not just compliant, but strategically managed.

What’s Next?

Now that you know how to determine whether disclosures or accruals are necessary for possible losses, we’ll move on to why you should care. Contingent losses for matters like pending litigation, class action suits, or governmental investigation can impact your business’s operations and financials. In addition to meeting reporting requirements, giving appropriate attention to contingent losses and legal reserves will provide your company with valuable planning opportunities.