If you are teaching an accounting class, here's a simple and timely (I'll explain why, later) assignment for your students:
Facts: Company XYZ is a manufacturer that is being sued by a person claiming that she was injured from using one of XYZ's products. XYZ has retained outside counsel for the purpose of mounting a legal defense, which is expected to take at least two years.
Question: How should the legal defense costs be accounted for by XYZ: (A) record the legal costs as an expense when they are incurred; or (B) accrue the total legal costs expected to be incurred over the duration of the litigation as of the date the claim has been incurred?
When I was teacher, I would ask my students to forget about rules to start with, and to consider only what general principles would suggest as the most appropriate accounting treatment. Consequently, if one believed that it would be a cardinal sin to accrue a liability if the conceptual definition of a liability were not met, and expected future legal costs don't meet that definition, then the appropriate accounting for the above fact pattern should be fairly obvious—Option A, from above.
Unfortunately, you don't get to that answer under GAAP for public companies. Back in the late 90's, the Emerging Issues Task Force was asked to consider roughly the same fact pattern as the one above, and they declined to provide an answer—to a question that well-trained Accounting 101 student should be able to answer. However, the "SEC Observer" did deign to enter the following comment into the EITF's meeting minutes:
"The SEC Observer noted that the SEC staff would expect a registrant's accounting policy to be applied consistently and that APB Opinion No. 22, Disclosure of Accounting Policies, requires disclosure of material accounting policies and the methods of applying those policies.
In other words, 'Take your pick between Option A and Option B; but if you should ever decide to change, you'll need to pay your auditor for a preferability letter.'
This is my reconstruction of the events that caused such a silly state to come to be. First, the EITF knew that if they were to add the issue to their agenda, their only non-ridiculous response would have been to disallow accrual of future legal costs (Option B); but that would have gored a whole herd of oxen, so they decided to take a pass.
Second, the SEC Observer, could not let sleeping dogs lie, because the SEC's policy is to provide interpretive guidance to registrants when they have legitimate questions about the accounting for legitimate fact patterns. Notwithstanding its willingness to provide assistance, the Staff operates under a self-imposed constraint; it must avoid infringing upon the FASB's franchise to make new GAAP. Thus, the Staff Observer had little choice but to merely state the obvious, which is that absent specific guidance in GAAP, the treatment of litigation costs is an accounting policy choice.
That's Old News. Here's What's New
The reason I have raised this question now is because the pot has been stirred once again. During the EITF's recent deliberations on some other health care-related issue, the question of legal costs of malpractice claims arose. The problem to be dealt with was that, some time ago, the AICPA issued an Audit and Accounting Guide for health care entities, which provided that expected future legal costs must be accrued at the time of a malpractice claim (i.e., Option B). How it came to pass that the AAG would change the accounting for health care entities only, I'm not sure. But it eventually found its way into the Accounting Standards Codification (954-450-25-2).
So, the EITF came to be faced with three choices: (1) let it be; (2) make it right—i.e., give a principles-based response; or (3) grant health care companies the same options for managing their financial statements that any other entity has. There is no way that I would be writing this post if the EITF settled on (1) or (2). They chose (3), of course, as formally issued in an Exposure Draft (Proposed ASU No. EITF100F), Health Care Entities (Topic 954): Accounting for Legal Costs Associated with Medical Malpractice and Similar Claims (a consensus of the FASB Emerging Issues Task Force).
It is often the case that the "basis for conclusions" section of an exposure draft is more revealing for the absence of discussion than its presence as regards to key points of contention. I regret to report that this is one of those cases. The basis for conclusions section has a few hundred words to it, but they say absolutely nothing about how the conclusions reached are justified by the supporters of the exposure draft. Specifically, there is nothing about whether the definition of a liability is met under Option B, and there is nothing about whether providing a free choice to health care companies enhances the quality of industry GAAP or GAAP in general.
And, if you are wondering how the ED would affect convergence with IFRS, there is nothing about that either. That's because the provisions of the exposure draft would actually move GAAP further from IFRS.
Each exposure draft issued nowadays contains a separate section entitled, "How Do the Proposed Provisions Compare with IFRS?" This one states:
"IFRS does not provide any specific guidance on the accrual of legal fees." [italics supplied]
The word "specific" is critical to the truthiness of that statement, because IFRS clearly does not permit Option B, even though there is no "specific" statement to that effect. Unlike the FASB's concepts statements, which are explicitly not GAAP, the IASB's conceptual framework is an integral component of IFRS. Since the definition of a liability in the IFRS framework is virtually identical to the FASB's definition, the treatment of legal costs from defending a malpractice claim is clear: charge to expense as incurred (i.e., Option A).
So that, boys and girls, is how accounting standard setting really works. No accounting problem is simple once the EITF gets its hands on it. But, perhaps there is some consolation to be derived from the fact that two of the FASB's members (Bob Herz and Leslie Seidman) have noted their dissent from the exposure draft. Unfortunately, they did so only on the grounds that more free choices to issuers is the kind of thing the Board has been trying to curtail.
Even the courageous dissenters could not bring themselves to acknowledge the elephant in the room: that discretionary legal costs expected to be incurred in the future do not meet the conceptual definition of a liability.