The SEC’s Focus on Accounting for Contingencies – Comments and Enforcement
By George Wilson
The SEC reinforced its focus on accounting for contingencies in an August 24, 2021 enforcement case against Health Care Services Group, Inc. Accounting Standards Codification Topic 450 requires that loss contingencies be recorded when it is probable that a loss will be incurred, and the amount can be reasonably estimated. Contingencies frequently involve high stakes and appropriate accounting requires complex and subjective judgments. Contingencies are lightning rods for SEC review and enforcement.
In the Health Care Services Group case the SEC found that the company failed to record loss contingencies surrounding private litigation against the company in the proper periods. The Enforcement Division found that the company, by failing to record loss contingencies in the appropriate period, managed its earnings to meet analyst’s estimates for several quarters.
A fascinating aspect of this case is that, according to Enforcement Division Director Gurbir Grewal, the company “reported EPS that met analyst estimates for multiple quarters as a result of accounting violations that were uncovered by the Division of Enforcement's ongoing EPS Initiative," Mr. Grewal also said:
"As today's actions demonstrate, we will continue to leverage our in-house data analytic capabilities to identify improper accounting and disclosure practices that mask volatility in financial performance, and continue to hold public companies and their executives accountable for their violations."
Accounting for contingencies is not a new theme in SEC enforcement. In 2007 the SEC fined Cardinal Health $35 million for engaging in a four-year long accounting fraud that, among other misstatements, involved manipulation of a number of reserve and contingency accounts creating misstatements of over $65 million. The company also accrued $22 million of expected proceeds from a litigation settlement before recognition under GAAP was appropriate. As you would suspect, these steps helped Cardinal meet earnings estimates.
BorgWarner provided another example of the SEC’s ongoing focus on accounting for contingencies. This case is more complex. It is based on ASC 450’s guidance about when to record a contingent liability. It started with this comment the company received on its December 31, 2016 Form 10-K in a May 11, 2017 comment letter:
Note 14: Contingencies
Asbestos-related Liability, page 95
1. We note your disclosure that you have made enhancements to the management and analysis of asbestos-related claims, including the engagement of new national coordinating council and new local counsel panels, outsourcing administration and claims handling, implementing improvements in processing, and increasing audits and compliance reviews of counsel handling asbestos-related claims. You state that this has resulted in improvements in both the quantity and quality of information available and an increased ability to reasonable forecast the number of potential future claims that may be asserted.
You also state that you hired a third party consultant in the third quarter of 2016 to further assist you in the analysis of potential future asbestos-related claims. It appears that with the assistance of this external consultant and the updated data and analysis resulting from your claims review process, you determined that your best estimate of the aggregate liability both for asbestos-related claims asserted but not yet resolved and potential asbestos-related claims not yet asserted, including an estimate for defense costs, is $879.3 million as of December 31, 2016, which is $770.8 million higher than the prior year.
Please tell us your consideration of accounting for this as a correction of an error in previously issued financial statements rather than as a change in estimate. Refer to ASC 250- 10-20.
The key issue in this comment is the timing of recording the contingent liability related to potential asbestos claims. Given the material increase in the accrual in 2016, it is logical to ask if the amount was “probable” and capable of reasonable estimation in an earlier period. In its lengthy response, the company included this language:
In connection with the preparation of its annual financial statements for 2016, the Company was able to determine for the first time that its potential liability for asbestos-related claims not yet asserted was capable of reasonable estimation. That determination became possible at such time for several reasons:
during 2016, the Company was able to identify and verify trends in the Company’s claims data which indicated that the Company’s claims experience was stabilizing, becoming less volatile, and becoming consistently related to industry trends in the tort system generally, which led to the Company’s belief that extrapolation from its past claims experience could, for the first time, form the basis for a reasonable estimate of potential future claims,
the Company’s handling and processing of asbestos-related claims (as noted by the Staff in the May 11 letter) collectively improved the quantity and quality of information available to the Company respecting those claims, which in turn increased the real-time visibility to the Company and its senior professionals regarding the handling and resolution of individual asbestos-related claims. This information has been used by the Company in its litigation and settlement efforts to determine better how to resolve individual claims, resulting in more consistent litigation and settlement efforts respecting asbestos claims as a whole and more stable settlement and defense costs,
changes implemented by courts in certain jurisdictions in which the Company is most often named as a defendant in asbestos-related litigation, which were incorporated into the Company’s litigation and settlement efforts, allowing for greater litigation and settlement consistency and predictability in the Company’s claims projections,
co-defendant bankruptcies and the magnitude and timing of bankruptcy trust payments to claimants became more consistent, and information as to both was increasingly required to be made available by claimants, which affected the value of claims asserted against the Company, and
the number of asbestos-related claims faced by the Company was significantly reduced as a result of the Company’s ongoing efforts to eliminate many claims that had become dormant as a result of the passage of time or otherwise capable of being dismissed, which allowed the Company greater ability to forecast outcomes respecting potential claims not yet asserted.
The culmination of all of the foregoing factors in 2016 led the Company to consider, as part of its ongoing review process, that it had become possible to make a reasonable estimate of its potential liability for asbestos-related claims not yet asserted. The Company engaged a third-party consultant in the third quarter of 2016, as the Staff notes in the May 11 letter, to assist the Company with its evaluation of such potential liability. The consultant prepared its analysis during the third and fourth quarters of 2016, and presented its final analysis to the Company in the first quarter of 2017. The Company reviewed the analysis and made its own assessment in connection with the Company’s preparation of its annual financial statements for 2016 that the best estimate of the aggregate liability both for asbestos-related claims asserted but not yet resolved and potential asbestos-related claims not yet asserted, including an estimate for defense costs, was $879.3 million, and adjusted its liability on its consolidated balance sheet in accordance with ASC 450-20-25-2.
The Company does not consider this additional reserve to be a correction of an error in prior financial statements because no error was made. There were no mistakes in the application of GAAP, mathematical errors or oversight or misuse of facts in previously issued financial statements. The Company was diligent in its efforts to monitor and track available information to measure the potential liability for future asbestos-related claims, and appropriately recorded a reserve when information sufficient to support a reasonable estimate became available. The Company followed generally accepted accounting principles - specifically, ASC 450-20-25-2 - in only accruing a liability once such amount was capable of being reasonably estimated.
After this response by BorgWarner, the SEC issued this follow-up comment:
1. We note your response that you concluded your revised estimate for asbestos-related claims is a change in accounting estimate rather than a correction of an error in previously issued financial statements because the quarter ending December 31, 2016 is the first time that the liability attributable to potential asbestos-related claims not yet asserted could be reasonably estimated. You state that prior to the quarter ending December 31, 2016, you concluded claims data was too volatile, and the circumstances in which future asbestos-related claims would be resolved too uncertain, to support a reasonable estimate of the liability for potential claims not yet asserted.
Based on your response, it appears you believed a liability for potential claims not asserted was probable prior to the quarter ending December 31, 2016, but that such liability was not recognized because it could not be reasonably estimated. Please confirm whether our understanding is correct.
Regarding periods prior to the quarter ending December 31, 2016, please tell us whether you (1) attempted to estimate a liability for potential claims but concluded the resulting estimate of loss (or range) was not reasonable or (2) did not attempt to estimate a liability because you believed you could not develop a reasonable estimate. If the former, please tell us the results of your estimation including your estimated liability (or range thereof) as of December 31, 2015 and why you did not believe the estimate(s) to be reasonable.
The back and forth continued and ultimately resulted in a restatement by BorgWarner to record the contingent liability for the asbestos-related claims in earlier years, as you can see in this
As each of these three cases demonstrates, the SEC carefully scrutinizes the accounting, disclosures and judgments surrounding contingencies. This is a reminder that we should carefully make and document judgments surrounding contingent liabilities.
As always, your thoughts and comments are welcome!