Disclosure of contingent legal liabilities

J. Account. Public Policy xxx (2013) xxx–xxx

Contents lists available at ScienceDirect

J. Account. Public Policy

journal homepage: www.elsevier .com/locate/ jaccpubpol

Disclosure of contingent legal liabilities

0278-4254/$ - see front matter � 2013 Elsevier Inc. All rights reserved.http://dx.doi.org/10.1016/j.jaccpubpol.2013.10.005

⇑ Tel.: +1 (405) 325 5743; fax: +1 (405) 325 7348.E-mail address: [email protected]

Please cite this article in press as: Hennes, K.M. Disclosure of contingent legal liabilities. J. Account. Publi(2013), http://dx.doi.org/10.1016/j.jaccpubpol.2013.10.005

Karen M. Hennes ⇑University of Oklahoma, 200E Adams Hall, Norman, OK 73019-4004, United States

a b s t r a c t

There has long been user dissatisfaction with firm’s disclosure ofcontingent legal liabilities, and the FASB, IASB, and SEC have allconsidered compliance issues and standard amendments on thistopic in recent years. This study uses a sample of employment dis-crimination cases to provide evidence on the extent to which cur-rent contingent legal liability disclosures provide usefulcontingency evaluations. Consistent with legal concerns influenc-ing reporting decisions, I find that current disclosure practices pro-vide limited quantitative detail regarding the magnitude of theexpected loss. However, the text of the disclosures does providequalitative indicators of the probability of loss. I find evidence thatstatements about the inestimable nature of the loss and statementsabout the firm’s willingness to consider a settlement are related tohigher probabilities of loss and higher loss amounts. I also find evi-dence that statements regarding an existing accrual for losses andwarnings about materiality reflect a higher likelihood of a nontriv-ial loss. These results emphasize firms’ strong resistance to quanti-tative disclosures of legal contingencies but suggest that existingSFAS 5 disclosures do contain qualitative information useful forevaluating the loss contingency.

� 2013 Elsevier Inc. All rights reserved.

1. Introduction

The threat of litigation pervades nearly every aspect of the contemporary US business environment,and the magnitude of potential losses from litigation can be substantial. Even ignoring the indirectcosts associated with lawsuits, litigation can represent a multi-million- or multi-billion-dollar chargeagainst the firm. Despite the prevalence of litigation, many financial statement users have complainedthat existing disclosures are ‘‘inadequate or ineffective’’ (FASB, 2007, p. 1) in assisting financial

c Policy

http://dx.doi.org/10.1016/j.jaccpubpol.2013.10.005

mailto:[email protected]


http://www.sciencedirect.com/science/journal/02784254

http://www.elsevier.com/locate/jaccpubpol


2 K.M. Hennes / J. Account. Public Policy xxx (2013) xxx–xxx

statement users in assessing the likelihood, timing, and amounts of loss contingencies, including thoserelated to litigation. In a recent speech, Wayne Carnall, the chief accountant for the SEC’s Division ofCorporate Finance, similarly criticized some companies for ‘‘pages of disclosures’’ on contingent liabil-ities that ‘‘say little.’’1 In response to such concerns, the FASB released exposure drafts (FASB, 2008,2010) of a proposed amendment to SFAS 5 (part of Topic 450 in the codified standards) that would re-quire increased disclosure for loss contingencies.2 In comment letters on the proposed amendment, audi-tors and lawyers have expressed serious concern about expanding the reporting for litigationcontingencies, and the American Bar Association (ABA) notes that there is limited empirical evidenceon the inadequacy of existing litigation contingency disclosures. Although the FASB and the IASB’s con-current loss contingency projects were delayed by focus on the joint convergence projects and issues re-lated to the recent financial crisis, questions remain about the need to make significant changes to thedisclosure requirements for loss contingencies. Working within the existing standards, the SEC’s Divisionof Corporation Finance recently stated their intention to increase their scrutiny of legal contingency dis-closures (Nilsen, 2011).

In this study, I examine the content of a sample of litigation contingency disclosures under existingaccounting rules for any signals of management’s assessment of the expected loss. This provides evi-dence on whether current contingent legal liability disclosures provide any useful evaluation of thecontingency for investors or if the legal environment drives firms to provide formulaic disclosureswith little or no useful information. This information on the current disclosure practice for litigationcontingencies is relevant to standard-setters and other stakeholders evaluating potential incrementalchanges to the reporting for contingencies as well as to statement users attempting to parse the exist-ing disclosures.

I analyze the 10-K disclosures of 212 firms with now-resolved employee discrimination lawsuits.Thirty-one percent of the sample firms disclose the total damages claimed (and another 20% explicitlyindicate that the claim does not specify a dollar amount) but eventual realized losses are a small frac-tion (11%) of these disclosed claims. Despite the generally small expected payout, less than eight per-cent of the sample firms disclose an estimate (point, range, or aggregate) of the magnitude of thepotential loss; another 21% explicitly state that the expected loss cannot be estimated; and 71% makeno comment on the expected loss amount.

The eventual loss realizations are generally small for the median firm in my sample, but at the 75thpercentile of firms with any payout amount, losses are material at more than 8% of net income (or 5%of operating cash flow). In the extreme, a few firms see bankruptcy-inducing loss realizations (33% oftotal assets in the max case). These significant losses demonstrate why litigation contingency informa-tion is important to investors. At the same time, the bulk of cases in my sample result in fairly imma-terial losses. The challenge to investors (and preparers) is to try to distinguish between these differentcontingencies ex ante.

Analyzing the contingency disclosures in my sample, I find that the text of the disclosures does pro-vide some qualitative clues about the probability of loss despite their limited quantitative detail. Morespecifically, I find evidence that statements about the inestimable nature of the loss and statementsabout the firm’s willingness to consider a settlement are related to higher probabilities of loss andhigher loss amounts. I also find evidence that statements regarding an accrual for losses and warningsabout materiality reflect a higher likelihood of a nontrivial loss. I find no evidence that additional com-mon textual components or statements indicating a remote likelihood of loss relate to the eventualrealization of loss. Overall, these results emphasize firms’ strong resistance to quantitative disclosuresof legal contingencies but suggest that a portion (but not all) of firms’ qualitative disclosures do reflectthe probability of realizing a loss. To the extent that my study suggests that there are specific state-ments firms make that are correlated with a larger ex post loss realizations, my results could help astatement user wade through some of the boilerplate to identify which legal contingencies, if any,warrant further information gathering.

1 Comments from speech at NYSSCPA conference on September 27, 2010 as quoted by Leone (2010).2 Under IFRS, loss contingencies are governed by IAS 37 (IASC, 1998), and the IASB released exposure drafts of a possible

amendment to IAS 37 in both 2005 (IASB, 2005) and 2010 (IASB, 2010) that call for similarly increased disclosure.

Please cite this article in press as: Hennes, K.M. Disclosure of contingent legal liabilities. J. Account. Public Policy(2013), http://dx.doi.org/10.1016/j.jaccpubpol.2013.10.005


K.M. Hennes / J. Account. Public Policy xxx (2013) xxx–xxx 3

2. Accounting for contingent legal liabilities

SFAS No. 5 Accounting for Contingencies (FASB, 1975) is currently the primary standard governingthe reporting of potential losses from pending litigation. SFAS 5 divides loss contingencies into threegroups based on the likelihood that the loss will be realized: probable, reasonably possible, and re-mote. SFAS 5 dictates that material loss contingencies that are probable and reasonably estimablemust be accrued on the balance sheet.3 Loss contingencies that are deemed reasonably possible or prob-able must also be disclosed, even if an inability to estimate the potential losses prevents accrual. SFAS 5specifies that this disclosure should indicate the nature of the loss contingency and provide a point orrange estimate of the amount of loss. If the potential loss cannot be estimated, a statement to that effectis required.

The most recent FASB exposure draft (2010) retains the general three bucket probability frame-work of SFAS 5 but provides more explicit disclosure requirements. Overall, application of the pro-posed standard would continue to involve considerable judgment, but there would be two majorincremental quantitative requirements. The first is a requirement to quantify the amount of the as-serted claim (or an estimate of maximum exposure if a numerical claim not specified in the suit)for all contingencies above the disclosure threshold. Although many firms protest that the assertedclaim amounts are misleading or irrelevant, the more controversial proposed change relates to the‘‘probable’’ losses: the exposure draft calls for a tabular reconciliation of any litigation contingencyaccruals. This proposed requirement is either praised or disparaged by various stakeholders for itstransparency or impossibility. Although the exposure draft attempts to increase quantitative disclo-sures of loss contingencies, it faces the same application obstacles in the legal contingency arena asthe existing standard.

The literature on SFAS 5 suggests that two problems often arise in the the application of SFAS 5 tolitigation contingencies. The first issue is that there is variation in the interpretation of ‘‘probable,’’‘‘reasonably possible,’’ and ‘‘remote’’ across firms, which hampers the comparability of all types of losscontingency disclosures.4 Litigation contingencies are subject to an additional reporting tension: audi-tors are generally not experts at evaluating contingent legal liabilities and must rely on information frommanagement. As acknowledged in SAS 12 (AICPA, 1976) and discussed in depth by Carmichael (1973)and Harrison and Pearson (1989), lawyers’ responses to auditor inquiries are generally the auditor’s onlymeans of corroborating management’s statements concerning litigation, claims, and assessments. Theseresponses from counsel are guided by an American Bar Association (ABA) Statement of Policy (ABA,1975) that limits their information content.

The ABA policy statement suggests that lawyers refrain from expressing judgment on the outcomeof a claim except in rare cases where the client’s prospects of success or prospects of failure are‘‘slight’’ or ‘‘extremely doubtful.’’ Given this criterion, the ABA anticipates that counsel’s response let-ter should generally not include an assessment of expected outcome for most cases and auditors oftenreceive only ‘‘unable to express an opinion’’ disclaimers from legal counsel. The ABA policy statementadvises counsel not to be more forthcoming to the auditor because it could actually be detrimental tothe client firm to do so. Although information about potential claims and pending litigation discussedbetween the firm and legal counsel is protected by attorney-client privilege, the disclosure of suchprivileged information to a third-party (including the auditor) can constitute a waiver of privilege

3 As clarified in FIN 14 (FASB, 1976), if only a range of potential losses is estimable and no point value is better than another,firms should accrue the minimum of the range and disclose the potential for additional loss exposure up to the maximum of therange.

4 Experimental studies report mean estimates of the ‘‘remote’’ to ‘‘reasonably possible’’ threshold (i.e., the probability level atwhich disclosure is first required) ranging from 15% (Reimers, 1992) to 40% (Schultz and Reckers, 1981) and mean estimates of the‘‘reasonably possible’’ to ‘‘probable’’ threshold (i.e., the probability level at which accrual is first required) ranging from 67%(Reimers, 1992) to 75% (Brackner, 1985). Other studies, including Lewis (1980), Raghunandan et al. (1991), Amer et al. (1995), andHackenbrack and Nelson (1996), also note that experimental participants’ interpretation of SFAS 5 thresholds vary withcharacteristics of the client and of the type of contingency being evaluated.




on that communication or even on that entire subject matter. Information compiled by auditors orcommunicated to auditors may be open to discovery by claimants.5

The revelation of internal litigation assessments to a plaintiff’s attorney could compromise legalstrategy by providing previously unknown facts or evidence to the opposing counsel, and the ABA ar-gues that the revealed estimate of loss or of the litigation reserve could also be treated an implicitadmission of culpability. Such an admission could increase the odds of an unfavorable as outcome,encourage follow-on suits, or raise the floor for a potential settlement amounts.6 The indirect costsof transparent litigation disclosures can thus be quite high, and the risks associated with less than fullytransparent disclosure appear to be fairly low in the current environment.7 Given these economics, it isnot surprising that some firms may choose to provide relatively uninformative disclosures.

In early research on SFAS 5 litigation disclosures, Dennis and Keith (1981) examine the footnotes of198 NYSE firms in 1977 and 1978 and find that a large number of firms fail to clearly indicate the nat-ure of a given case, the current status of the case, or an inability to estimate the loss when no estimateis given—all of which are disclosures required by SFAS 5. Fesler and Hagler (1989) compare litigationdisclosures from 1982 to 1983 with eventual case outcomes. They judge 43% of their sample to haveprovided no or insufficient warning regarding the legal liability and conclude that there is a lack ofconsistency and compliance in this area. Thompson et al. (1990) examine the litigation disclosuresfor 100 Fortune 500 firms over 1983–1987 to document the percentage of firms disclosing specific lit-igation cases and related quantitative loss estimates. They conclude that the lack of advance disclosureand limited quantitative information may make it difficult for users to draw valid conclusions aboutpossible losses. Despite the passage of times since these studies, these negative conclusions are echoedby some statement users today and are the type of concerns that prompted the FASB to reconsiderSFAS 5.

Focusing on the existence of a contingency disclosure alone rather than the content, Little et al.(1995) investigate the firm’s decision to disclose a specific case at all. Little et al. (1995) identify103 hazardous waste lawsuits filed between 1977 and 1986 and search for subsequent firm 10-K dis-closures on these cases. They find that only 53 of the 103 cases are mentioned in the firm’s financialstatements and investigate whether the market reaction to the lawsuit filing is correlated with thefirm’s decision to disclose the case. Little et al. (1995) fail to find evidence that the market assessmentof the loss (measured as the market return around the suit filing) is correlated with the firm’s assess-ment of the expected loss (measured as the decision to disclose the lawsuit in the financial state-ments). The authors assert that the missing disclosures could reflect proprietary costs, managementdeception, or ambiguities in SFAS 5.

In a more recent study, Desir et al. (2010) describe 51 disclosures of adverse litigation outcomesfrom 2007. They find that 8% of their samples makes no reference to the litigation in the financialstatements in the period prior to the loss announcement. For those firms with advance disclosure,most sample firms describe the nature of the claim but less than half discuss the anticipated amountof loss (even to state that is is inestimable). Overall, Desir et al. (2010) conclude that there is relativelyhigh disclosure of some components required by SFAS 5 (or the new Exposure Draft) but fairly lowdisclosure of other desired components.

Litigation contingencies are just one variety of loss contingency, and there is considerable existingliterature on other types, particularly environmental loss contingencies. Barth and McNichols (1994),Lawrence and Khurana (1997), and Campbell et al. (1998), for example, investigate disclosures ofSuperfund liabilities, and Gamble et al. (1995) and Campbell et al. (2003) provide evidence on disclo-sure patterns for a broader range of environmental liabilities. Barth et al. (1997), Walden and Schwartz(1997), and Cormier et al. (2005) are among those who study the determinants of the environmentaldisclosure decision in specific industries. A number of studies (including Cormier and Magnan (1997),

5 See Hodel and Burke (1991), Shalit (1994), Rothschild and McKenna (1997), Sharp and Stanger (2000), and Reach(forthcoming) for case examples.

6 For these reasons, the FASB is considering a prejudicial exemption clause in their revision to SFAS 5 but expects this clause willrarely apply. The ABA disagrees (ABA, 2008).

7 Searches of EDGAR and Lexis-Nexis during the sample period reveal no successful securities fraud lawsuits over inadequatedisclosure as long as the existence of a pending lawsuit against the firm is disclosed even minimally.




Hughes et al. (2001), Patten (2002), and Clarkson et al. (2008)) also consider the relation between thefirm’s level of environmental disclosure and the firm’s environmental performance. Although thereporting situation for environmental loss contingencies differs from non-environmental loss contin-gencies on a number of important dimensions (e.g., increased FASB and SEC disclosure requirements,decreased materiality thresholds, differing regulatory and legal penalties, the existence of outsideinformation sources such as EPA reports and the Superfund database, and strong industry concentra-tions), the literature on environmental loss contingencies suggests that there can be informative con-tent in brief or even vague contingency disclosures.

Environmental loss contingency disclosures frequently contain limited quantitative information, somany studies in this area consider the qualitative textual components of the disclosures. Clarksonet al. (2008), for example, develop a content analysis index for environmental and sustainabilityreporting, and they include a number ‘‘soft’’ disclosures for assertions firms might make without sub-stantiating details or credibility. Cho et al. (2010) also find that both the degree of quantitative infor-mation and the degree of optimism in the non-quantitative environmental disclosures is related toenvironmental performance. There is thus certainly a precedent in research on environmental issuesfor considering aspects of the textual disclosures beyond specific quantitative financial information.Although my study focuses on litigation contingencies rather the environmental contingencies, I sim-ilarly consider more qualitative disclosure components in addition to any quantitative disclosures.

Overall, the consistent conclusion from prior studies on litigation contingency disclosures is thatfirms provide fairly limited information on the estimated loss amount. It should certainly be acknowl-edged that predicting the outcome of even the most straightforward claim against a corporation canbe difficult considering that differences in the case facts, trial location, and the identities of the plain-tiff, judge, lawyers, and jurors all introduce uncertainty. However, management and counsel certainlymake some evaluations about prospective trial outcomes when considering settlement options or de-fense strategies and should generally be in a position to provide a better-than-random assessment ofthe likelihood and magnitude of loss. The question is what sort of disclosures (both quantitative andqualitative) best balance SFAS 5 directives with the legal concerns associated with transparent disclo-sures. In this study, I examine whether the variation in the language and content of firm’s litigationcontingency disclosures offers any meaningful insight into management’s ex ante expectation of loss.

3. Model Specification

I collect a sample of firms who identify themselves in their 10-K as defendants in pending employ-ment discrimination litigation (e.g., age, gender, or race discrimination) as this type of lawsuit has sev-eral desirable sample characteristics. Unlike environmental claims, there are no specialized reportingrequirements for this type of legal contingency, and employee claims are unlikely to be concentratedin only a few industries. In contrast to patent or licensing disputes that impact future business deci-sions, the damages paid in employment discrimination cases are a reasonable estimate of most of thedirect costs of an adverse outcome. Firms are also less likely to have (potentially undisclosed) insur-ance for this type of litigation than for other types of claims that might be covered under a generalliability or worker’s compensation policy (Bales and McGhghy (2002) and Duncan (2005)).8

I search 10-Ks filed during the period 1996–2010 and identify 212 unique, publicly-traded firmsreporting pending (but now resolved) employee discrimination lawsuits.9 I examine the last 10-K dis-closure before the lawsuit is resolved to see if any components of the disclosure reflect management’sassessment of the expected loss and could thus be used to form predictions regarding the case outcome(win/loss). I use the following general form:

8 Excdiscrimuniquenon-liti

9 Lawfor the

Please(2013

luding the possibility of differential insurance coverage, I have no reason to think that disclosures of pending employmentination litigation are not representative of a broader range of contingent legal liability disclosures. However, given thelegal tensions inherent in this setting, I would not necessarily expect inferences from this study to extend to other types ofgation loss contingencies.suit filings exhibit cyclical trends over time as legislation and precedent evolve. This time period contains the peak years

most recent wave of employment discrimination filings (Clermont and Schwab, 2004).

cite this article in press as: Hennes, K.M. Disclosure of contingent legal liabilities. J. Account. Public Policy), http://dx.doi.org/10.1016/j.jaccpubpol.2013.10.005


Table 1Variable definitions.

Variable Definition

Accrual 1 If the disclosure suggests that the firm has accrued a litigation liability; 0 otherwiseBigLoss 1 If Damages Paid/Total Assets is above the median value of the sample; 0 otherwiseCautionary 1 If disclosure contains additional cautionary language; 0 otherwiseClass

Action1 If case is a certified class action; 0 otherwise

Damages Damages paidDamages% Damages paid/total assetsDefense 1 If disclosure contains a statement about strength or strategy of firm’s defense; 0 otherwiseInestimable 1 If the disclosure of the potential loss cannot be estimated; 0 otherwiseLoss 1 If damages paid are greater than zero; 0 otherwiseMaterial 1 If firm indicates that the lawsuit could have a material impact on financial performance or financial

condition; 0 otherwisePunitive 1 If case involves a request for punitive damages; 0 otherwiseRemote 1 If disclosure contains a statement indicative of remote possibility of loss in AICPA interpretations of SAS 12;

0 otherwiseSettleRef 1 If disclosure contains reference to possibility of settlement; 0 otherwiseTA Natural log of total assets

Notes: Examples of specific disclosure components and classifications are provided in Table 2. Variables are described in furtherdetail in Section 3.

10 See


Please(2013

Outcome ¼ aþ bðDisclosureCharacteristicsÞ þ cðControlsÞ þ e ð1Þ

I measure the dependent variable Outcome in several ways in an attempt to capture the different typesof information that financial statement users might be concerned about. First, I consider actual dam-ages paid both in absolute magnitude (Damages) and scaled by prior period’s total assets (Damages%).Given the limited quantitative information in the disclosures, I also construct two dichotomous out-come measures: Loss and BigLoss. I define Loss as equal to one if the firm had a non-zero payout on thelawsuit and zero otherwise. In the world of litigation, however, the line between winning and losingmay not be that simple. Firms often consider small settlements to be a cost-effective defense, so smallpayouts may be viewed by management as ‘‘wins.’’ To capture this concept, the final dependent var-iable BigLoss is a dichotomous variable indicating whether the firm did or did not realize a nontrivialloss in a particular legal case. To determine BigLoss, I evaluate the distribution of total damages paidscaled by prior period’s total assets across my sample firms. BigLoss equals one for relative lossamounts above the median and equals zero for relative loss amounts below the median. Althoughnot as straightforward as a pure win/loss indicator, this measure should result in trivial losses beingmore appropriately classified as ‘‘wins’’ without having to subjectively distinguish between trivial andnontrivial losses.10

As my question is whether the litigation contingency disclosures are related to the case outcome, Ilimited my possible disclosure variables to information contained in the financial statement notes. Ireviewed litigation contingency disclosures from a hold-out sample with various types of pendinglawsuits. For each disclosure, I eliminated sentences that contained only factual case information(location, dates, parties involved, etc.) and then evaluated all the remaining sentences for any lan-guage that could potentially reflect managements’ expectation of loss. I created the variables Accrual,Inestimable, Material, Remote, Defense, SettleRef, and Cautionary for components of litigation contin-gency disclosures that I observed across multiple firms. The disclosure characteristics are measuredas dichotomous variables based on textual statements made within the contingency footnote. Theyare described in more detail below and summarized in Table 1. Examples of contingent legal liabilitydisclosures are provided in the Appendix, and examples of each type of textual component are alsoprovided in Table 2.

Section 6 for a discussion of alternate measures and post-verdict appeals.



Table 2Examples of disclosure components.

Variable Value Statement

Accrual 1 ‘‘We have accrued $5 million related to this claim.’’1 ‘‘We have accrued as necessary for this case.’’1 ‘‘Management believes the liability will not exceed existing accruals.’’0 ‘‘This liability is not represented on the consolidated balance sheet.’’0 ‘‘We make no reserves for this claim.’’

Inestimable 1 ‘‘We are unable to estimate the potential loss that could result from this claim.’’Material 1 ‘‘An adverse outcome could have a material impact on the firm’s liquidity and financial condition.’’

0 ‘‘We do not believe the outcome of this case will have a material impact on financial performance.’’Remote 1 ‘‘We believe the plaintiff’s case has no merit.’’

1 ‘‘We believe the action will not result in a liability to the firm.’’Defense 1 ‘‘We intend to defend these charges vigorously.’’

1 ‘‘We believe we have meritorious defenses in this case.’’SettleRef 1 ‘‘We may agree to a settlement if we feel it is in the best interest of our shareholders.’’

1 ‘‘Arbitration hearings have been scheduled, and we hope to reach a satisfactory settlement in thismatter soon.’’

Cautionary 1 ‘‘Litigation is inherently uncertain and difficult to predict.’’1 ‘‘No assurances can be given that this matter will be resolved as expected.’’

Notes: Example statements are representative of phrasings used for classification but are not exhaustive. All variables areassigned values of zero if there is no relevant statement within the legal contingency disclosure.


Accrual is an indicator variable set equal to one if the disclosure suggests that the firm has accruedan expected loss and is set to zero otherwise. Firms that explicitly disclose the contingency accrual orprovide an aggregate accrual number for a set of cases including the sample case are assigned Ac-crual = 1 as are firms stating they have ‘‘accrued as necessary.’’11 Firms that explicitly indicate they havenot accrued any amount or who make no comment on the accrual status are coded Accrual = 0. If firms’references to accrued status are unreliable or not meaningfully different from the absence of such disclo-sures, there should be no relation between Accrual and the likelihood of loss. A lack of association be-tween Accrual and the likelihood of loss would be consistent with firms’ concerns about the discoveryof privileged material driving them to avoid a reference to the accrual in the disclosure even in situationswhere an accrual has in fact been made. If, however, firms adhere to the accrual requirements of SFAS 5(at least above high some probability threshold) and disclose this transparently, then the disclosure ofthe existence of an accrual will be positively related to the likelihood of loss.

The variable Inestimable is set equal to one if the disclosure explicitly states that the potential losscannot be estimated and is equal to zero otherwise. If this type of statement is used strategically byfirms as a way to disclose lawsuits with higher chances of loss but without having to reveal quantita-tive accrual information that may damage their legal position, I expect Inestimable to be positively re-lated to the probability of loss.

Material is set equal to one if the firm indicates there is a chance that the lawsuit will have a mate-rial impact on either the firm’s financial performance or financial condition and is set equal to zero forthose cases where management makes no comment on potential materiality or indicates that the out-come is expected to be immaterial. Although SFAS 5 does not require firms to disclose contingenciestruly expected to be immaterial, such disclosures are observed in practice. The ‘‘immaterial’’ assertionsmay not be credible, or they may be a public acknowledgment of a lawsuit that received abnormallyhigh levels of media attention but that the firm truly believes is immaterial. The firm may also believethat disclosing immaterial cases is preferable to no disclosure for the small chance that the case turnsout to involve an unexpected material loss.

To the extent that materiality warnings can suggest the order of magnitude of the estimated loss,legal concerns about increasing settlement floors or attracting follow-on suits provide incentives for

11 Conclusions are similar if I restrict Accrual = 1 to the clearly explicit accrual cases and combine any more ambiguous ‘‘accruedappropriately’’ or ‘‘accrued as necessary’’ disclosures with the no accrual group.




firms to avoid informative materiality statements. If firms’ materiality warnings are unreliable or notmeaningfully different from the absence of such disclosures, there should be no relation betweenMaterial and the likelihood of loss. As firms are only required to disclose material contingencies, itis possible that all disclosed cases exceed the materiality threshold regardless of whether the potentialmateriality is explicitly noted or not. If, however, concerns about shareholder litigation or regulatoryaction prompt the firm to provide more explicit warnings when the odds are less favorable, then thesewarnings will reflect a higher probability of loss assessment and Material will be positively related tothe likelihood of loss.

Litigation disclosures in the 10-K often include qualitative statements regarding the case or man-agement’s defense (e.g., ‘‘We feel the plaintiff’s case has no merit,’’ ‘‘We believe we have strong argu-ments in this case,’’ etc.). An AICPA interpretation of SAS 12 (see AU §9337) discusses to what extentauditors can infer the likelihood of loss from statements like these if received in the lawyer’s responseto the inquiry letter. The AICPA concludes that certain phrasings imply that the likelihood of loss isremote (e.g., ‘‘We feel the plaintiff’s case has no merit,’’ ‘‘We believe the action will not result in a lia-bility,’’ ‘‘We believe we can defend this action successfully,’’ and similar statements). Remote is equalto one if the disclosure contains one of these statements that the AICPA has equated with a remotelikelihood of loss and is equal to zero otherwise. As firms are not required to disclose contingencieswhere the probability of loss is truly remote, there is no reason to expect these statements to be reli-able given that the case is being disclosed. However, if other factors drive these disclosures and thesestatements are used in a manner consistent with the AICPA interpretation, I expect Remote to be neg-atively related to the likelihood of loss.

Statements regarding the firm’s legal defense (e.g., ‘‘We believe we have a strong defense in thiscase,’’ ‘‘We believe we have strong arguments in this case,’’ ‘‘We intend to defend these charges vig-orously,’’ etc.) are frequently observed in litigation disclosures and presumably are intended to conveysome positive sentiment. The indicator variable Defense is set equal to one for disclosures containingthese assertions about the quality of the firm’s defense. As such statements for are not considered suf-ficiently clear indicators of probability under SAS 12 and the ABA statement explicitly notes that com-ments like these should not be viewed as expressing an opinion about the likelihood of success, thepredictive ability of these statements is unclear.

The variable SettleRef is set equal to one if the firm explicitly indicates a willingness to settle (e.g.,‘‘Although we deny the allegations, we may agree to a settlement if we feel it is in the best interest ofour shareholders’’) or discloses that settlement negotiations are scheduled or in-process. Consideringthe high settlement rate in the US, the majority of all disclosed cases are likely to end in settlement,and a reference to a potential settlement could convey little real information. Legal anecdotes, how-ever, suggest that a premature reference to the possibility of settlement can damage the firm’s legalposition and that a reference to a possible settlement concedes a higher probability of realizing a loss.If not just part of a boilerplate disclosure, a discussion of a potential settlement implies an expectationof at least some level of payment, so SettleRef is predicted to be positively related to the probability ofrealizing a loss.

Many firms insert additional caveats or cautionary language (e.g., ‘‘Litigation is inherently uncer-tain’’ or ‘‘Although no assurance can be given. . .’’) into the pending litigation paragraph. The indicatorvariable (Cautionary) is set equal to one for those firms with this type of additional cautionary lan-guage and is equal to zero otherwise. Although this text may be nothing but a standard template, thisadditional language could also reflect increased uncertainty or could be used to provide a warning awithout disclosing an accrual and inviting the related risks. I predict that the use of this additional cau-tionary language is positively correlated with management’s estimate of the probability of loss.

The pending litigation disclosure in the 10-K often also provides factual information about the caseincluding the plaintiff’s identity, the complaint, the legal venue, and the types of damages requested.As my objective is not to build a legal model that predicts the suit outcome using all available datasources but instead to see if the 10-K disclosure predicts the outcome, I do not consider any special-ized legal variables based on case details or precedent that would not be common knowledge to theaverage statement user. I do, however, construct two additional control variables from the disclosedclaim information: ClassAction and Punitive. ClassAction equals one if the firm discloses that the casehas been certified as a class action suit and zero otherwise. Punitive equals one if the firm discloses



Table 3Sample selection.

Firms

Disclose employee discrimination suit 419First disclosure is after case resolution (46)Disclose pending employee discrimination case 373Resolution missing and insufficient detail to track (83)Firm deregistered/bankrupt/acquired before resolution (66)Explicitly confidential settlement (12)Final Sample 212

Notes: Firms disclosing an employment discrimination suit are identified using regular expressions to search all 10-Ks, 10-K405s, and 10-KSBs available on EDGAR and originally filed between 1996 and 2010. If a firm has multiple employee dis-crimination suits, the earliest suit is selected. I search for case resolution information in subsequent SEC filings, Lexis-Nexis, andWestLaw. Firms are also eliminated for missing data or confounding events as detailed above. Cases where the discriminationcharge is part of a series of suits and countersuits between the firm and a former executive are also excluded, as are cases stillunresolved through FY12.

Table 4Descriptive statistics.

Mean 25% 50% 75% Max

Firm characteristicsBook value of equity 1363.1 4.6637 45.145 626.92 47,289Total assets 8132.2 16.7890 133.673 1717.67 602,843Current assets 4664.8 7.5405 57.339 585.69 585,755Net income 243.41 �5.3150 0.830 3.45 22,071Operating cash flow 449.86 �0.6425 6.144 191.49 23,100

Case outcomes: all casesDamages paid 5.8797 0 0.01001 0.4000 192.50Damages/total assets 0.0093 0 0.00012 0.0053 0.33Damages/current assets 0.3531 0 0.00018 0.0107 66.91Damages/|net income| 0.2089 0 0.00220 0.0292 12.47Damages/|operating cash flow| 0.1643 0 0.00247 0.0315 18.61

Case outcomes: non-zero paymentsDamages paid 8.0941 0.0010 0.0640 3.800 192.50Damages/total assets 0.0128 <0.0001 0.0085 0.010 0.33Damages/current assets 0.4861 <0.0001 0.0025 0.027 66.91Damages/|net income| 0.2876 0.0009 0.0118 0.085 12.47Damages/|operating cash flow| 0.2262 0.0005 0.0099 0.059 18.61

Notes: All variables are measured in millions of dollars, and all firm characteristics are measured at the date of the last 10-Kbefore the case resolution. Damages capture the total dollar amount owed by the defendant under the terms of the settlementor verdict. If the terms require the defendant to reimburse the plaintiff’s legal fees, then this amount is included; the defendant’sown legal costs are excluded. Non-zero payouts present the 154 cases (out of 212) with positive payouts to the plaintiff.


that the plaintiff has requested punitive damages and zero otherwise. The disclosure of these attri-butes of a case may suggest higher potential damages even to a financial statement user with no legalbackground. Lastly, I also include the natural log of total assets (TA) to control for potential effects offirm size on the magnitude of damages or on the likelihood of payout. The primary model is thus:

Please(2013

Outcome ¼ aþ b1Accrualþ b2Inestimableþ b3Materialþ b4Remoteþ b5Defense

þ b6SettleRef þ b7Cautionaryþ b8ClassActionþ b9Punitiveþ b10TAþ e ð2Þ

This model will be repeated for each measure of Outcome. The actual implementation of the model willvary between OLS and logistic regression, consistent with the form (continuous or dichotomous) of thedependent measure being used. Alternate specifications are discussed in Section 6. Correlations be-tween the primary variables of interest are presented in Table 5.



Table 5Correlation of disclosure characteristics.

Accrual Inestimable Material Remote Defense SettleRef

Inestimable �0.02053Material 0.04285 0.02759Remote �0.07597 �0.03031 �0.11506*

Defense �0.06823 �0.00356 0.02854 0.18180***

SettleRef 0.26478*** �0.01334 0.08136 �0.13831** �0.15039**

Cautionary 0.06253 �0.04559 0.18998*** 0.04050 0.02473 �0.06907

Notes: Variables are defined in Table 1. This table presents the Phi coefficient of correlation for the binary disclosurecharacteristics.* Indicate significance at the 10% level (two-tailed).** Indicate significance at the 5% level (two-tailed).*** Indicate significance at the 1% level (two-tailed).


4. Descriptive Information

The initial sample contains 419 publicly-traded firms that disclose a specific employment discrim-ination suit in a 10-K filing between 1996 and 2010.12 Observations that are strictly ex post disclosuresof resolved cases are eliminated, as are those with missing data or confounding events as detailed in Ta-ble 3. Information about trial verdicts, dismissals, and settlements are collected from subsequent 10-Ks,Lexis-Nexis, and Westlaw. It is interesting to note that only 46 firms (11%) are eliminated because thefirst disclosure was after the case resolution. This level of ex-post-only disclosure is considerably smallerthan the 35% and 63% reported in an earlier period by Fesler and Hagler (1989) and Thompson et al.(1990), respectively, which suggests that firms now disclose specific lawsuits earlier in the litigation pro-cess. The decrease in ex post only examples in my sample is comparable to the rate found by Desir et al.(2010). This trend could reflect the broader increase in disclosure over recent decades or may be drivenby a desire to avoid comment letters from the SEC over surprise settlement announcements (Zion et al.,2011).

Among the 212 firms in the final sample, 65 firms (31%) disclose the dollar amount of damages re-quested by the plaintiff (the mean disclosed request is $30.7 million), and 43 firms (20%) explicitlyindicate that the plaintiff has not specified the amount of damages requested. The remaining 104 firms(49%) are silent on the amount of the claim. One of the FASB’s proposed changes includes a require-ment that firms quantify the assessed claim or their maximum exposure for all disclosed cases with-out accrual information. When the case has no specifically quantified damages claim, it is unclear howwilling or able firms will be to provide exposure estimates, but my sample suggests that a consider-able number of firms would be impacted by this additional disclosure requirement. For those 65 caseswhere the firm disclosed the plaintiff’s claimed damages in the 10-K, the actual realized loss averaged11% (ranging from 0% to 124%) of the disclosed claim amount. This less than perfect correlation be-tween the asserted claimed and the actual loss realization is one potential argument against requiringnumerical claim disclosures as they may do little to hone investor expectations.

The lawsuits in the final sample average 2.3 years from suit filing to resolution, with durationsranging from less than one year to more than twenty years. On average, cases in my sample first ap-pear in a 10-K filing 1.1 years after the lawsuit is filed, and the last forward-looking 10-K disclosure isabout 6 months before the case resolution. In the final sample, most (208) firms reported the outcome(win, lose, settle, etc.) of the previously disclosed case in a subsequent SEC filing. Among these 208firms, 144 also self-report the dollar amount of the realized loss. The majority (148 cases or 70%) ofcases in the final sample are settled, which is consistent with the high settlement rates reported byClermont and Schwab (2004), Kotkin (2007), and Nielson et al. (2010). A fraction of the cases (44 casesor 21%) are dismissed via pretrial motions, and only 19 cases (9%) proceed to trial (with 9 bench trialsand 11 jury trials).

12 It should be noted that the sample selection method will not detect firms with no disclosure of the case at any point—eitherbefore or after the resolution.



Table 6Disclosure characteristics by outcome.

Total Loss = 0 Loss = 1 Chi-Square Big Loss = 0 Big Loss = 1 Chi square

Accrual 0.1934 0.1034 0.2273 4.1411** 0.1321 0.2547 5.1103**

Inestimable 0.2123 0.1724 0.2273 0.7583 0.1698 0.2547 2.2850Material 0.3962 0.3448 0.4156 0.8817 0.3396 0.4528 2.8393*

Remote 0.3160 0.3966 0.2857 2.3945 0.3302 0.3019 0.1964Defense 0.6981 0.6897 0.7013 0.0271 0.6698 0.7264 0.8057SettleRef 0.1651 0.0345 0.2143 9.8818*** 0.0755 0.2547 12.3538***

Cautionary 0.3302 0.2931 0.3442 0.4965 0.3302 0.3302 0.0000N 212 58 154 106 106

Notes: Variables are defined in Table 1. Mean values of disclosure variables are provided in the ‘‘Total’’ column and reflect theproportion of firms with a value of one for the relevant disclosure type across all firms. Frequency proportions and Chi-squaretests of difference in frequency across Loss and BigLoss are also provided.* Indicate significance at the 10% level (two-tailed).** Indicate significance at the 5% level (two-tailed).*** Indicate significance at the 1% level (two-tailed).


As reported in Table 4, the mean damages paid over all cases in the sample is $5.9 million (0.9%of total assets or 21% of net income). Excluding dismissals and verdicts for the defense, the meandamages paid among cases with a non-zero payout is $8.1 million (1.3% of total assets or 29% ofnet income). A few firms realize extreme losses (with damages representing more than 30% of totalassets in the most extreme case) that emphasize the potential importance of loss contingency dis-closures, but a substantial portion of the disclosed cases result in immaterial loss realizations.Although the disclosures regarding the immaterial cases were irrelevant to most investors ex post,it is unclear whether investors or preparers could identify the more material cases more narrowlyex ante.

The disclosure of a multitude of lawsuits, many of which are expected to be immaterial, makesit that much more difficult for a statement user to focus in on the most relevant cases. As reducingunnecessary and overly lengthy disclosure is a goal of the FASB (FASB, 2012), this evidence on theimmateriality of many disclosed litigation contingencies suggests that additional consideration andguidance on disclosure thresholds might be helpful in reducing the number of cases disclosed.Guidance from standard-setters, however, is unlikely to eliminate these disclosures without corre-sponding support from regulators. To the extent that the SEC penalizes firms when they reveal arealized material loss that was not disclosed as a contingency (Zion et al., 2011), firms are encour-aged to defensively disclose multitudes of immaterial suits as protection against the chance of alow probability high magnitude adverse outcome. The challenge for financial statement users isthus not only the limited information provided for each case but also the wide range of casespresented.

Only 11 firms (5.2%) disclose a quantitative estimate of the potential loss for the specific samplecase, and five additional firms (2.4%) disclose an aggregate accrual for a set of cases including the sam-ple cases. Of the 11 firms with quantitative estimates for the specific case, eight had point estimatesand three provided a range. Four of the point estimates appear to be based on plaintiff-rejected orcourt-rejected settlement offers that the firm believed suggested a non-zero minimum loss (althoughrejected settlement offers are not always interpreted this way). One point estimate exactly matchesthe settlement announced in the subsequent period, suggesting that the settlement negotiations weresubstantially complete (albeit undisclosed) at the time of the 10-K filing. Two of the range estimatesdisclose contractually-specified severance payments that would be owed for termination withoutcause as a possible upper bound for the loss but do not address any related damages that might beawarded. No support is provided for the remaining quantitative estimates, all of which differ substan-tially from the eventual actual damages realized. Although this sample of quantitative estimates is toosmall for meaningful statistical analysis, the low rate of quantitative estimates is consistent with ear-lier research and user complaints. It also appears that any quantitative estimates of loss that are pro-vided have limited relation to eventual realized losses.



Table 7Disclosure-outcome OLS regression.

Outcome = a + b1Accrual + b2Inestimable + b3Material + b4Remote + b5Defense + b6SettleRef + b7Cautionary + b8ClassAction+ b9Punitive + b10TA + e

Pred. Sign Damages Damages%

Intercept �5.2359 0.0147**

(3.8640) (0.0065)Accrual + �0.4059 0.0011

(3.5305) (0.0060)Inestimable + 4.8034* 0.0160***

(3.2951) (0.0056)Material + �0.0880 0.0003

(2.8361) (0.0048)Remote � 1.0863 �0.0013

(3.0345) (0.0051)Defense �1.2942 0.0035

(3.0223) (0.0051)SettleRef + 8.5901** 0.0148**

(3.9461) (0.0067)Cautionary + �2.4056 �0.0021

(2.9458) (0.0050)Class action + 12.4028*** 0.0018

(4.2825) (0.0072)Punitive + �2.9969 0.0069*

(2.8298) (0.0048)TA 1.8405*** �0.0031***

(0.4990) (0.0008)N 212 212R2 0.2040 0.1211Adjusted R2 0.1644 0.0773

Notes: This table presents estimate of OLS regressions with Damages and Damages% as the dependent variables. All variables aredefined in Table 1. Coefficient estimates are provided with standard errors in parentheses.

* Indicate significance at the 10% level (one-tailed if a sign is predicted, two-tailed otherwise).** Indicate significance at the 5% level (one-tailed if a sign is predicted, two-tailed otherwise).*** Indicate significance at the 1% level (one-tailed if a sign is predicted, two-tailed otherwise).


5. Results

Table 6 provides information on the proportion of firms in the total sample with each textual dis-closure characteristics as well as Chi-square tests for the difference in frequency across the value ofLoss and BigLoss. In the total sample, 19.34% of the firms suggest that they have made an accrual,21.23% state that the loss amount is inestimable, 39.62% warn that the loss could be material,31.60% suggest the likelihood of loss is remote, 69.81% have a statement regarding the strength oftheir defense, 16.51% indicate a potential willingness to settle, and 33.02% include additional caution-ary language. Focusing on the partitioning by BigLoss, there is evidence that an indication of an accrual,explicit materiality warnings, and references to a willingness to settle are all more common in thefirms that eventual realize a relatively larger loss. There is no (two-tailed) evidence of a differencein Inestimable, Remote, Defense, or Cautionary across the partitions.

The results of the OLS regression of the disclosure variables on Damages and Damages% are pre-sented in Table 7, and results of the logistic regression of the disclosure variables on Loss and BigLossare presented in Table 8. Unsurprisingly, the categorical disclosure characteristics are better predictorsof the binary BigLoss than of the magnitude of the realized loss (i.e., Damages).

The coefficient on Accrual is positive and significant for both the BigLoss and Loss models (albeitweaker for the Loss measure). The positive association between Accrual and the likelihood of a nontriv-ial loss suggests that references to an accrual are indicative of higher managerial assessments of theprobability of loss, consistent with appropriate application of SFAS 5 recognition requirements abovesome threshold. More interestingly, the significant coefficient on Accrual also suggests that disclosuresreferencing an accrual relate to different likelihoods of loss than those silent on the accrual status. The



Table 8Disclosure-outcome logistic regression.

Outcome = f(a + b1Accrual + b2Inestimable + b3Material + b4Remote + b5Defense + b6SettleRef + b7Cautionary + b8ClassAction+ b9Punitive + b10TA + e)

Pred. Sign Loss Big Loss

Intercept 0.6937 �0.3058(0.4561) (0.4332)

Accrual + 0.6864* 0.7440**

(0.5009) (0.4151)Inestimable + 0.4308 0.6500**

(0.4173) (0.3803)Material + 0.2157 0.6036**

(0.3488) (0.3240)Remote � �0.4196 0.0047

(0.3553) (0.3397)Defense 0.2793 0.3674

(0.3703) (0.3501)SettleRef + 1.8358*** 1.2385***

(0.7737) (0.5000)Cautionary + 0.2853 0.0222

(0.3601) (0.3343)Class Action + 0.6892 1.8360***

(0.9162) (0.5492)Punitive + 0.1198 0.1945

(0.3483) (0.3264)TA �0.0853 �0.1873***

(0.0611) (0.0607)N 212 212Likelihood Ratio 20.9297** 40.3957 ***

Percent Concordant 69.3

Notes: This table presents estimates from the logistic regressions with Loss and BigLoss as the dependent variables. All variablesare defined in Table 1. Coefficient estimates are provided with standard errors in parentheses.* Indicate significance at the 10% level (one-tailed if a sign is predicted, two-tailed otherwise) based on residual Chi-squaretests.** Indicate significance at the 5% level (one-tailed if a sign is predicted, two-tailed otherwise) based on residual Chi-squaretests.*** Indicate significance at the 1% level (one-tailed if a sign is predicted, two-tailed otherwise) based on residual Chi-squaretests.


absence of a comment regarding an accrual does not just reflect less transparency than a firm reveal-ing the accrual but rather suggests a lower probability of loss for these ‘‘no comment’’ firms. This isconsistent with firms both accruing and disclosing the existence of the accrual for cases where theprobability of a nontrivial loss is sufficiently high enough to overcome legal discovery concerns relatedto the accrual rather than firms accruing appropriately but failing to disclose the existence of theaccrual.13

The coefficient on Inestimable is positive and significant in three models suggesting that these typesof statements are more likely in cases where the loss ultimately realized is higher in relative magni-tude. As discussed in Section 4, only a small number of firms provide a numerical estimate of the po-tential loss, and the remainder of the sample firms either explicitly claimed an inability to estimate orremained completely silent on their estimate. This result suggests that, in the current reporting envi-ronment, the explicit ‘‘unable to estimate loss’’ disclaimer is actually a worse indicator than the si-lence, possibly because ‘‘inestimable’’ firms are more likely to have assessed the likelihood of lossas above the ‘‘probable’’ threshold.

The positive relation between Material and BigLoss suggests that warnings about the possibility ofan adverse outcome having a material impact on firm performance or financial condition are more

13 Alternatively, the disclosure of a loss accrual could be positively related to a realized loss because the accrual itself damagesthe firm’s legal position. This would require firms to feel compelled enough by the SFAS 5 requirements and related enforcementrisk to make an accrual despite the potential legal repercussions.




common when the probability of a larger loss is higher, which is consistent with an ‘‘expected value’’application of SFAS 5. Although a strict reading of SFAS 5 implies a sequential decision process wherepotential materiality is considered first before the probability assessment is made, Newton (1977),Reckers and Stagliano (1979), Lewis (1980), and Schultz and Reckers (1981) report that some practi-tioners claim to consider both the possible dollar loss and the probability of such a loss simultaneouslywhen determining materiality. Using this type of approach, materiality should be positively correlatedwith the likelihood of loss. The significant coefficient on Material also suggests that disclosures withmateriality warnings are distinguishable in terms of the odds of loss from disclosures with no suchwarnings, despite the fact that the firms have no obligation to disclose cases except those consideredmaterial. The evidence in this study suggests that many of the disclosed cases do not end in materiallosses, so users should not assume materiality solely because a case is mentioned but should insteadlook for an explicit comment on materiality.

The variable SettleRef is also significantly positively related to all four of the of the loss measures. Areference to the possibility of settlement in the 10-K disclosure the reflects a higher probability of loss,which is consistent with the high (although not perfect) correlation between a disclosed willingness tosettle and an eventual resolution via settlement (with its related realization of loss). Despite theknown fact that most cases end in settlements, legal counsel likely discourages any reference to thepossibility of a settlement except in cases where the internal decision to seek a settlement has alreadybeen made. The positive relationship between a settlement reference and the absolute or relativemagnitude of the realized loss to the firm also reflects the firm’s increased desire to settle larger caseswhere the potential costs of a trial are correspondingly higher. Contrary to my predictions, I find noevidence that statements equated with a remote probability of loss (Remote) in a lawyer’s responseletter similarly indicate a reduced probability of loss when used in the financial statement footnote.I also find no evidence that statements exalting the firm’s defenses (Defense) or extra caveats (Caution-ary) are related to eventual case outcome.

Overall, I find evidence that statements about the inestimable nature of the loss and statementsabout the firm’s willingness to consider a settlement are both related to higher probabilities of lossand higher loss amounts. I also find evidence that statements regarding any accrual for losses andwarnings about materiality to reflect a higher likelihood of a nontrivial loss. Despite all of the criticismleveled at the current application of SFAS 5 and the real legal concerns firms have regarding these kindof disclosures, these results suggest this type of disclosures does still have some ability to predict theprobability of realizing a material loss.

6. Additional analyses

The primary analyses use the initial case resolution (settlement, dismissal, or trial verdict), but Ifurther investigate the 19 cases with completed trials for evidence of appeals by either party. I findappeals in 11 cases: six unsuccessful appeals, two appeals still pending, and three appeals that alteredthe amount of damages assessed. Results are insensitive to replacing the three original trial lossamounts with post-appeal amounts.

In the main analysis, the dependent variable BigLoss is assigned a value based on the distribution oftotal damages paid scaled by prior period total assets. In sensitivity analyses, I consider a variety ofalternatives. I construct the first alternative measure of BigLoss using book value of equity (positivevalues only) as of the date of the last 10-K. Untabulated results using this alternate scalar are compa-rable to those presented. The median damages paid scaled by prior period total assets (or book valueof equity) is used as the cutoff for classifying BigLoss in the primary results, but I also investigate alter-native cutoffs. There do not appear to be any obvious breaks in the distribution that would be prefer-able to the median nor evidence that the median in inappropriate; partitioning at the 75th percentileyields comparable results. Lastly, as measured, both continuous dependent variables (Damages andDamages%) have a lower bound of zero. Untabulated tobit results are consistent with those presented.

Although the damages paid in my sample average less than 1% of the firm’s total assets, there aretwo observations where the damages assessed represent more than 20% of the firm’s total assets.These observations provide anecdotal support for the importance of the disclosure of pending




litigation despite the generally small average expected payout. I repeat all analyses excluding thesevalid but far outlying observations, and inferences are unchanged. I also test an alternative class actioncontrol variable that expands the class action variable to include lawsuits that threaten class actionstatus but are not certified as such; this change has no impact on my original conclusions.

In some areas of law, the specific legal venue can be a significant factor in the plaintiff’s odds ofsuccess. Although the circuits are less divided on employment discrimination issues than many othertypes of cases, the legal venue could affect the probability of loss or the market’s expectation. Reeves(2008) suggests that the dynamics of employment discrimination litigation in the Eleventh FederalCircuit (Alabama, Georgia, and Florida) differ from those in the rest of the country. Although it isdoubtful that the average statement user is aware of specific venue implications, I do construct a con-trol variable for cases filed in this locale. Further analysis of the venues for cases in my sample alsosuggests that there is a disproportionate number of observations filed in the state of California (44of 212 cases, with 35 states represented in all), so I construct and test an indicator variable for suitsfiled in California as well as a control for the involvement of the Equal Employment Opportunity Com-mission. In untabulated analyses, I find some evidence that the Eleventh Federal Circuit is associatedwith larger unscaled damage amounts (Damages). All of these control variables are otherwise insignif-icant in all other models, and primary results are unchanged for all specifications. The inclusion of anadditional control for overall reporting complexity (proxied by the number of reporting segments)also has no effect on inferences.

Disclosure classifications for the primary results are based on the last 10-K filed before the case isresolved, but for a subsample of firms I also classify relevant disclosures in preceding 10-Ks back to thelater of the first 10-K after the lawsuit filing date or ten years before the case was resolved. I notechanges in a firm’s discussion of the case across multiple filings. Interestingly, less than 20% of thefirms reviewed have changes to even one of the collected disclosure variables over the case lifetime.This pattern is not inconsistent with long periods of waiting during the litigation process followed byfairly swift resolution once more information is revealed. Many firms provide factual timeline updates(e.g., ‘‘in discovery’’ then ‘‘awaiting trial’’ or ‘‘hearing to be held on X’’), but there is limited updating ofinformation that directly comments on changes in the likelihood or magnitude of loss. The small num-ber of changing disclosures precludes analysis of the meaning of any observed change in disclosure,but I repeat all analyses on this subsample using variables constructed from the first available disclo-sure for each firm (rather than the last 10-K). Consistent with the small number of disclosure changesover the life of the cases, the results (untabulated) are comparable to those presented. It is interesting,however, to note that firms rarely update their disclosures regarding the likelihood or magnitude ofthe expected loss even as the case progresses.

Litigation contingency disclosures have been frequently criticized as nothing but boilerplate. To theextent that stock language is suggested by the auditor, the textual components of the litigation con-tingency disclosure could be more reflective of the external auditor than of the case itself. In supple-mental analyses, I investigate whether any of my accounting disclosure variables of interest arecorrelated with the use of specific large auditing firms. I find some evidence that the additional cau-tionary language is less prevalent in firms audited by Ernst & Young than in firms audited by other BigN auditors. It also appears the explicit materiality warnings are more common for firms audited byArthur Andersen and less common for firms audited by Deloitte & Touche, but the relatively smallnumber of observations in some cells limits any strong conclusions on specific auditor influences. Fur-ther research will be required to determine if the predictive or ‘‘boilerplate’’ nature of various litiga-tion disclosure statements varies with the external auditor.

7. Conclusion

I investigate whether current contingent legal liability disclosures provide useful contingency eval-uations to investors or if the legal environment drives firms to provide formulaic disclosures with littleor no useful information. Using a sample of 212 firms that disclose now-resolved employee discrim-ination lawsuits in their 10-Ks, I test whether the components of these disclosures convey informationabout the eventual outcome of the litigation.




I find that current disclosure practices provide limited quantitative detail regarding the magnitudeof the expected loss, even for a type of case where the expected payout is fairly small. Thirty-one per-cent of the sample firms disclose the total damages claimed (and another 20% explicitly indicate thatthe claim does not specify a dollar amount) but eventual realized losses are a small fraction (11%) ofthese disclosed claims. Less than eight percent of the sample firms disclose an estimate (point, range,or aggregate) of the magnitude of the potential loss; another 21% explicitly state that the expected losscannot be estimated; and 71% make no comment on the expected loss amount. Despite this limitedquantitative detail regarding the magnitude of the expected loss, I find that the text of the disclosuresdoes provide some qualitative clues about the probability of loss. More specifically, I find evidence thatstatements about the inestimable nature of the loss and statements about the firm’s willingness toconsider a settlement are related to higher probabilities of loss and higher loss amounts. I also findevidence that statements regarding an accrual for losses and warnings about materiality reflect a high-er likelihood of a nontrivial loss. I find no evidence that additional common textual components orstatements indicating a remote likelihood of loss relate to the eventual realization of loss. To the ex-tent that my study suggests that there are specific statements firms make that are correlated with alarger ex post loss realizations, my results could help a statement user wade through some of the boil-erplate to identify which legal contingencies, if any, warrant further information gathering.

Despite the criticism of poor disclosure in this area, I also observe a large number of firms reportinglitigation contingencies where the ultimate loss realization is immaterial (and sometimes is explicitlypredicted to be so). Given the concerns of academic researchers and standard setters regarding infor-mation overload and ever increasing 10-K lengths, this study suggests that additional considerationand guidance on disclosure thresholds might be beneficial. Regulators face a difficult balance encour-aging compliance with SFAS 5 in ways that do not encourage firms to defensively disclose multitudesof generally immaterial suits. Although predicting litigation outcomes is inherently difficult and thefew large losses (more than 20% of total assets) in my sample reiterate the importance of transparentloss contingency disclosures, limiting the number of cases disclosed could be one way to reduce bothreport length and the legal community’s concerns about the cost of compliance. Enforcement actionsregarding ex post only disclosures may encourage firms to provide brief acknowledgement of a widenumber of cases despite ex ante expectations of immateriality, but this creates extra text for investorsto process.

The results in this study suggest that although the costs and legal ethics associated with disclosureof legal contingencies deter firms from disclosing quantitative contingency information, the observedcompromise between legal incentives and existing reporting requirements under GAAP does containsome qualitative information relevant and useful for evaluating the loss contingency. Future revisionsto SFAS 5 might focus on enhancing these qualitative disclosures that firms seem willing or able toprovide. Overall, whether improved litigation contingencies disclosures are demanded by regulatorspursuing increased compliance with the existing SFAS 5 requirements or through eventual amend-ments to current GAAP, it is important for both regulators and standard-setters to consider how thetension between transparent reporting and legal strategy highlighted in this study will continue toinfluence reporting in this area.

Acknowledgments

This paper is based on part of my dissertation completed at Penn State University, and I am gratefulfor the guidance of my committee: Jim McKeown (chair), Andy Leone, Amy Sun, and Marie Reilly(Dickinson School of Law). This paper also benefits from anonymous discussions with the CFO of a firmwith material pending litigation, corporate legal counsel, and a Big 4 audit partner as well as com-ments by Walid Al-Issa, Robert Bird, Christine Cheng, Bob Lipe, Brian Miller, Kristy Schenck, Han Yi,Teri Lombardi Yohn, multiple referees, the editor (Martin Loeb), and seminar participants at Connect-icut, Drexel, Georgia Tech, Iowa, Massachusetts, Michigan State, North Texas, Oklahoma, Oregon, PennState, Purdue, Rochester, Southern Methodist, Temple, and Washington-St. Louis. I thank Bryan Brock-bank, Matt Cobabe, and Xuerong Huang for research assistance.




Appendix A

A.1. Examples of contingent legal liability disclosures

A.1.1. Coastal Corp‘‘In October 1996, the Company, along with several subsidiaries, was named as a defendant in a suit

filed by several former and current African American employees in the United States District Court,Southern District of Texas. The suit alleges racially discriminatory employment policies and practicesand seeks damages in the amount of least $100 million and punitive damages of at least three timesthat amount. Plaintiffs’ counsel are seeking to have the suit certified as a class action. Coastal vigor-ously denies these allegations and has filed responsive pleadings.

Although no assurances can be given and no determination can be made at this time as to the out-come of any particular lawsuit or proceeding, the Company believes there are meritorious defenses tosubstantially all of the above claims and that any liability which may finally be determined should nothave a material adverse effect on the Company’s consolidated financial position, results of operationsor cash flows.’’

A.1.2. Florida Power‘‘Age Discrimination Suit – Florida Power and Florida Progress have been named defendants in an

age discrimination lawsuit. The number of plaintiffs remains at 116, however, four of those plaintiffshave had their federal claims dismissed and five others have had their state age claims dismissed.While no dollar amount was requested, each plaintiff seeks back pay, reinstatement or front paythrough their projected dates of normal retirement, costs and attorneys’ fees. In October 1996, thecourt approved an agreement between parties to provisionally certify this case as a class action suitunder the Age Discrimination in Employment Act. On August 10, 1998, Florida Power filed a motionto decertify the class, and the plaintiffs filed their response in opposition on September 30, 1998. Ahearing date for the motion has not yet been set. Florida Power has entered into settlement discus-sions with the plaintiffs. In December 1998, plaintiffs alleged damages of $100 million. Company man-agement, while not believing plaintiffs’ claim to have merit, offered $5 million in an attemptedsettlement of all claims. Plaintiffs rejected that offer. As a result, management has identified a prob-able range of $5 million to $100 million with no amount within that range a better estimate of prob-able loss than any other amount; accordingly, Florida Power has accrued $5 million. There can be noassurance that this litigation will be settled, or if settled, that the settlement will not exceed $5 mil-lion. Additionally, the ultimate outcome, if litigated, cannot presently be determined.’’

References

Amer, T., Hackenbrack, K., Nelson, M.W., 1995. Context-dependence of auditors’ interpretations of the SFAS No. 5 probabilityexpressions. Contemporary Accounting Research 12 (1), 25–39.

American Bar Association (ABA), 1975. Regarding Lawyers’ Responses to Auditors’ Requests for Information. Statement of Policy,Chicago, IL.

American Bar Association (ABA), 2008. Comment on ‘‘Disclosure of certain loss contingencies: An amendment of FASBStatements No. 5 and 141(R)’’. Comment Letter No. 280.

American Institute of Certified Public Accountants (AICPA), 1976. Inquiry of a Client’s Lawyer Concerning Litigation, Claims, andAssessments. Statement on Auditing Standards No. 12, New York, NY.

Bales, R.A., McGhghy, J., 2002. Insuring Title VII violations. Southern Illinois University Law Journal 27 (1), 71–102.Barth, M.E., McNichols, M.C., 1994. Estimation and market valuation of environmental liabilities relating to Superfund sites.

Journal of Accounting Research 32 (Supplement), 177–209.Barth, M.E., McNichols, M.C., Wilson, G.P., 1997. Factors influencing firms’ disclosures about environmental liabilities. Review of

Accounting Studies 2 (1), 35–64.Brackner, J.W., 1985. How to report contingent losses in financial statements. Journal of Business Forecasting 4 (2), 13–18.Campbell, K., Sefcik, S.E., Soderstrom, N.S., 1998. Site uncertainty, allocation uncertainty, and Superfund liability valuation.

Journal of Accounting and Public Policy 17 (4), 331–366.Campbell, K., Sefcik, S.E., Soderstrom, N.S., 2003. Disclosure of private information and reduction of uncertainty: environmental

liabilities in the chemical industry. Review of Quantitative Finance and Accounting 21 (4), 349–378.Carmichael, D.R., 1973. Representation letters from a company’s legal counsel—auditing and reporting considerations. Journal of

Accountancy 136 (5), 76–85.Cho, C.H., Roberts, R.W., Patten, D.M., 2010. The language of us corporate environmental disclosure. Accounting, Organizations,

and Society 35 (4), 431–443.


http://refhub.elsevier.com/S0278-4254(13)00092-6/h0005


















Clarkson, P.M., Li, Y., Richardson, G.D., Vasvari, F.P., 2008. Revisiting the relation between environmental performance andenvironmental disclosure: an empirical analysis. Accounting, Organizations, and Society 33 (4–5), 303–327.

Clermont, K.M., Schwab, S.J., 2004. How employment discrimination plaintiffs fare in federal court. Journal of Empirical LegalStudies 1 (2), 429–458.

Cormier, D., Magnan, M., 1997. Investors’ assessment of implicit environmental liabilities: An empirical investigation. Journal ofAccounting and Public Policy 16 (2), 215–241.

Cormier, D., Magnan, M., VanVelthoven, B., 2005. Environmental disclosure quality in large German companies: economicincentives, public pressures or institutional conditions? European Accounting Review 14 (1), 3–39.

Dennis, D.M., Keith, R.M., 1981. Are litigation disclosures inadequate? Journal of Accountancy 151 (3), 54–60.Desir, R., Fanning, K., Pfeiffer, R.J., 2010. Are revisions to SFAS No. 5 needed? Accounting Horizons 24 (4), 525–545.Duncan, E.E., 2005. Insurance coverage for sexual harassment in the workplace. Practical Lawyer 51 (2), 51–63.Fesler, R.D., Hagler, J.L., 1989. Litigation disclosures under SFAS No. 5: a study of actual cases. Accounting Horizons 3 (1), 10–20.Financial Accounting Standards Board (FASB), 1975. Accounting for Contingencies. Statement of Financial Accounting Standards

No. 5, Norwalk, CT.Financial Accounting Standards Board (FASB), 1976. Reasonable Estimation of the Amount of a Loss. FASB Interpretation No. 14,

Norwalk, CT.Financial Accounting Standards Board (FASB), 2007. Accounting for Contingencies. Board Meeting Handout, Norwalk, CT.

<http://www.fasb.org/boardhandouts/09-06-07.pdf>.Financial Accounting Standards Board (FASB), 2008. Proposed Statement: Disclosure of Certain Loss Contingencies: An

Amendment of FASB Statements No. 5 and 141(R). Exposure Draft, Norwalk, CT.Financial Accounting Standards Board (FASB), 2010. Proposed Accounting Standards Update: Contingencies (topic 450):

Disclosure of Certain Loss Contingencies. Exposure Draft, Norwalk, CT.Financial Accounting Standards Board (FASB), 2012. Disclosure Framework. Discussion Paper, Norwalk, CT.Gamble, G.O., Hsu, K., Kite, D., Radtke, R.R., 1995. Environmental disclosure in annual reports and 10Ks: an examination.

Accounting Horizons 9 (3), 34–54.Hackenbrack, K., Nelson, M.W., 1996. Auditors’ incentives and their application of financial accounting standards. The

Accounting Review 71 (1), 43–59.Harrison, K.E., Pearson, T.C., 1989. Communications between auditors and lawyers for the identification and evaluation of

litigation, claims, and assessments. Accounting Horizons 3 (2), 76–84.Hodel, M.A., Burke, C.A., 1991. The argument against discovery. Los Angeles Lawyer, vol. 14 (1), pp. 23–25, 45–47.Hughes, S.B., Anderson, A., Golden, S., 2001. Corporate environmental disclosures: are they useful in determining environmental

performance? Journal of Accounting and Public Policy 20 (3), 189–266.International Accounting Standards Board (IASB), 2005. Proposed Amendments to IAS 37: Provisions, Contingent Liabilities and

Contingent Assets. Exposure Draft, London, UK.International Accounting Standards Board (IASB), 2010. Proposed Amendments to IAS 37: Provisions, Contingent Liabilities and

Contingent Assets. Exposure Draft, London, UK.International Accounting Standards Committee (IASC), 1998. Provisions, Contingent Liabilities and Contingent Assets.

International Accounting Standard No. 37, London, UK.Kotkin, M.J., 2007. Outing outcomes: an empirical study of confidential employment discrimination settlements. Washington

and Lee Law Review 64 (1), 111–164.Lawrence, C.M., Khurana, I.K., 1997. Superfund liabilities and governmental reporting entities: an empirical analysis. Journal of

Accounting and Public Policy 16 (2), 155–186.Leone, M., 2010. What’s on the SEC’s radar? CFO.com, September 29.Lewis, B.L., 1980. Expert judgement in auditing: an expected utility approach. Journal of Accounting Research 18 (2), 594–602.Little, P., Muoghalu, M.I., Robison, H.D., 1995. Hazardous waste lawsuits, financial disclosure, and investors’ interests. Journal of

Accounting, Auditing and Finance 10 (2), 383–398.Newton, L.K., 1977. The risk factor in materiality decisions. The Accounting Review 52 (1), 97–108.Nielson, L.B., Nelson, R.L., Lancaster, R., 2010. Individual justice or collective legal mobilization? Employment discrimination

litigation in the post civil rights United States. Journal of Empirical Legal Studies 7 (2), 175–201.Nilsen, K., 2011. Renewed focus on loss contigency disclosures. Journal of Accountancy 211 (4), 37–39.Patten, D.M., 2002. The relation between environmental performance and environmental disclosure: a research note.

Accounting, Organizations, and Society 27 (8), 763–773.Raghunandan, K., Grimlund, R., Schepanski, A., 1991. Auditor evaluation of loss contingencies. Contemporary Accounting

Research 72 (2), 549–569.Reach, D.M., 2011. Keep your friends close but your auditors closer: corporations risk waiver when independent auditors

request work product. University of Florida Journal of Law and Public Policy, forthcoming.Reckers, P.M.J., Stagliano, A.J., 1979. Accounting for uncertainties. Louisiana Certified Public Accountant 38, 39–45.Reeves, L., 2008. Pragmatism over politics: recent trends in lower court employment discrimination jurisprudence. Missouri

Law Review 73 (2), 481–558.Reimers, J.L., 1992. Additional evidence on the need for disclosure reform. Accounting Horizons 6 (1), 36–41.Rothschild, G.F., McKenna, K., 1997. Dealing with accountants and auditors: Avoiding sanctions in complex cases. Defense

Counsel Journal 64 (3), 401–407.Schultz, J.J., Reckers, P.M.J., 1981. The impact of group processing on selected audit disclosure decisions. Journal of Accounting

Research 19 (2), 482–501.Shalit, M.D., 1994. Audit inquiry letters and discovery: protection based on compulsion. Cardozo Law Review 15 (4), 1263–1311.Sharp, M.J., Stanger, A.M., 2000. Audit-inquiry responses in the arena of discovery: protected by the work-product doctrine.

Business Lawyer 56 (1), 183–211.Thompson, J.H., Smith, L.M., Williams, J.R., 1990. An evaluation of the reporting standards for litigation: some empirical

evidence. Research in Accounting Regulation 4, 43–57.














http://www.fasb.org/boardhandouts/09-06-07.pdf







































Walden, W.D., Schwartz, B.N., 1997. Environmental disclosures and public policy pressures. Journal of Accounting and PublicPolicy 16 (2), 125–154.

Zion, D., Varshney, A., Burnhap, N., 2011. Accountingfest 2011: Key Takeaways from the AICPA Conference on SECDevelopments. Credit Suisse Technical Report.





Documents

Disclosure of contingent legal liabilities