Improving Transparency of Expected Losses from Pending Litigation

Abstract

The passage of the Sarbanes-Oxley Act in 2002 has added a new dimension to transparency in financial reporting of publicly help companies. As a result of the Sarbanes-Oxley Act, CEO's and CFO's are required to personally certify to disclosure/internal control and to the material accuracy and completeness of their companies' financial statements. This paper addresses the disclosure issue for expected losses from pending litigation. Companies rarely accrue losses from pending litigation even if a company's legal counsel believes that it is highly likely the defendant company will lose the case. Failure to accrue contingent losses that are judged to be probable and can be reasonably estimated violates the principle of full disclosure. Lack of disclosure of contingent losses would understate a company's debt position and overstate its earnings per share. The lack of disclosure could mislead investors and creditors in their decision making processes. However, attorneys view the legal profession as a qualitative rather than a quantitative discipline and have been reluctant to use quantitative information. Attorneys have also expressed a concern that disclosing an estimate for an expected loss would be interpreted by the plaintiff as an admission of guilt. The legal profession is also concerned that disclosing confidential information to third parties, such as the client's auditor, may result in loss of the "confidentiality" that is necessary to maintain the attorney-client privilege by creating a subject matter waiver. The purpose of this paper is to demonstrate how a user friendly probabilistic model based on the beta probability distribution can estimate expected losses from pending litigation cases that will not infer an admission of guilt nor jeopardize the attorney-client privilege by creating a subject matter waiver.