Friday, January 19, 2007

The Ontology of FAS 5 - Thoughts Provoked by the E-Mail from RateMyProfessor.Com

Posted by Jeff Lipshaw

I confess to something of a recurring ontological crisis about the creation of business value, something that got aggravated this morning when I received notice from "" that has been sold to MTV Networks, owners of among other things, VHI and Comedy Central, no doubt for an ungodly sum of money.  (Disclosure:  I have looked to see if any student has ever rated me on RMP out of what can be no more than a strange prurient interest.) 

Here is the question at the heart of the crisis.  Does the value of a business have "being" such that you can lie about it?  Is it real?  Can you touch or feel the value of  I have Cratchitstarted to read some of the vociferous debate between advocates of historical accounting methodology (no doubt employed by Mr. Cratchit, left), on one hand, and advocates of forward-looking finance theory, on the other, as to which best captures the inherent value of a business.  Historical financial statements purport to "fairly represent, in all material respects, the financial condition of the business according to generally accepted accounting principles consistently applied."  But we only need look at the gap between the book value of the net assets (or, more colloquially, the net worth) and the market capitalization of almost any company to know that net asset value does not equal market value.  (On Wednesday, my research assistants and I randomly picked Merck, which had a net asset value on its financial statements as of the end of 2005 - determined by accounting - of something like $17 billion, and an enterprise value - determined by the market - of something close to $100 billion.)

Since my impromptu talk at the AALS, I have been thinking about accounting (particularly when the word precedes "fraud"), and what precisely the lie in more complex cases might be.  It is one thing to have a case in which management gets a number in the roll-up of the quarterly financial reports, doesn't like it, erases it, and arbitrarily substitutes another.  But what about all the judgment calls along the way - rates of depreciation, capitalizing versus expenses, bill and hold, etc?

How lawyers factor into this metaphysical mess below the fold.

I want to focus on one microcosm of the issue here (cobbled in part from my article The Bewitchment of Intelligence, 78 Temp. L. Rev. 99 (2005)).  There is a dialogue that goes on between auditors and lawyers about when a contingent liability, like a claim in a lawsuit, moves into the footnotes, and then from the footnotes to an actual accounting charge as a liability.  And the words "probable," "reasonably possible," and "remote," as, in the lawyer's view, they apply to that contingent liability, are critical.

Under the Statement of Financial Accounting Standards No. 5 (“FAS 5”, issued by the Financial Accounting Standards Board), part of the definition of generally accepted accounting principles (“GAAP”), auditors use the word “probable” to indicate one of three different states of likelihood – the other two are “reasonably possible” and “remote” – that future events will confirm the incurrence of a liability. If an event is probable and the amount of the loss is reasonably estimable, FAS 5 requires that the obligation be booked as an accrual (an expense, and hence a charge to earnings) on the income statement and a liability on the balance sheet. “Probable” is defined as “[t]he future event or events are likely to occur.” Telling an auditor one has a better than even chance of losing a case in which the amount of the loss can be estimated is tantamount to incurring the expense.

Lawyers, on the other hand, use loose language of probability to convey a sense of the outcome to their clients on a regular basis. “Your odds of winning are 50-50, 60-40, one in ten, etc.” The ABA has attempted to cover these conflicting uses of language in its Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests for Information

Concepts of probability inherent in the usage of terms like “probable” or “reasonably possible” or “remote” mean different things in different contexts. Generally, the outcome of, or the loss which may result from, litigation cannot be assessed in any way that is comparable to a statistically or empirically determined concept of “probability”. . . . Lawyers do not generally quantify for clients the “odds” in numerical terms; if they do, the quantification is generally only undertaken in an effort to make meaningful, for limited purposes, a whole host of judgmental factors applicable at a particular time, with any intention to depict “probability” in any statistical, scientific or empirically-grounded sense.

So if the lawyers tell the accountants the likelihood of a loss is remote, the item never hits the financial statements at all.  If it is reasonably possible, it shows up in the footnotes.  And if it is probable, then GAAP requires that the lowest probable outcome be booked.

Financial statements are a mathematical model of some other independent reality (whatever it is).  By just a touch of lawyerly judgment, we can impact the model significantly (and who is to say whether that judgment is in good faith or not?) If we are not lying about what would generally be considered to be a piece of independent reality incorporated into the financial statements ("we shipped 10,000 widgets in the month of December"), but are manipulating the model (grossly or mildly), are we lying?

Law & Business, Law & Society, Lipshaw | Permalink

TrackBack URL for this entry:

Listed below are links to weblogs that reference The Ontology of FAS 5 - Thoughts Provoked by the E-Mail from RateMyProfessor.Com:


I blogged earlier today about the International Financial Reporting Standards degrees of likelihood. FAS 5 has a mere 3 levels. Under the IFRS, on the other hand, there are 27 different terms to describe likelihood or degrees of certainty.

Posted by: Allison Garrett | Jan 30, 2007 4:33:25 PM

Post a comment