Question

Ethics

ABC Company has been named as a defendant in a lawsuit claiming that they contaminated a local stream that runs behinds one of its factories. The lawsuit is asking for environmental remediation and is asking for $10,000,000 in damages.

ABC’s in-house legal counsel thinks there is a strong possibility that the firm would likely lose a potential trial and has suggested settling the case. However, at this time management has not determined what they may offer as a settlement. It is February 2020 and the company’s fiscal year ends on March 31, 2020. It is unlikely that a settlement agreement will be reached by the time the firm issues its annual financial statements.

Management of this publicly-traded firm is concerned that recording this charge to income in 2020 would have a significant impact on reported earnings per share and would result in a material decline in stock prices. As such, they have elected to not accrue this loss as of March 31, 2020 and have instead disclose the nature of the lawsuit.

Q: Comment on the application of Generally Accepted Accounting principles and if you think there has been an ethical breach in this circumstance.

Answer 1

As per GAAP, if it is probable ( likely to occur) that a payment will be required to fulfill an obligation, and the amount of the payment can be reasonably estimated, a loss contingency should be recognized.

In the given situation, ABC's in-house legal counsel is of the view that it is probable that the firm would lose a potential trial. Even though settlement agreement might not be reached during the current reporting period, the amount of the payout involved can be reasonably estimated. Therefore, ABC should recognize the loss, and make an appropriate disclosure in the notes.

But the management of ABC has elected not to accrue this loss, rather they have decided to only disclose the nature of the lawsuit, the reason being that the reported earnings are going to fall if the loss were recognized, and would have an adverse effect on the stock price. Therefore, the management wants to maintain the current stock price by concealing a material fact from the investors of the company, thereby impairing their ability to make rational decisions about their investment. This is an ethical breach. The relevant law (GAAP) requires a loss accrual, but there is a conflict of interest.