Contingencies from foreign subsidiary 2718

  • Sirs,%0AI have a question for anybody that could help. I will first describe the case in terms. %0ALet’s take a multinational company, with headquarters in Europe. They have several branches (local companies around the world) and they publish a consolidated balance sheet (part of ‘investor kit’). They also have huge operations and a corporate headquarter in the US and they are listed at NYSE.%0AIn one of their foreign branches (a local company), outside the US and outside Europe, they have a huge tax litigation which, alone, constitute a contingency representing over 10% or global EBIT.%0AMy question is … this contingency should appear in the consolidated balance sheet (at least as a note, since the litigation’s success is scored as ‘possible’) ? And if yes, is it a SOx infraction in case it should be omitted, alleging that it comes from a foreign branch (thus not under US laws) ?%0AWe have a huge discussion on this issue here, and would like opinions from ‘neutral’ professionals.%0AThanks for any reply.

  • a huge tax litigation which, alone, constitute a contingency representing over 10% or global EBIT.’%0ADo you mean that there is a lawsuit by the tax authority of the country where this non-US and non-European subsidiary is located and that the amount for which they sue represents 10% of the consolidated EBIT in the consolidated financial statements of the group (i.e. the issuer that is listed on the NYSE) and that tax lawyer’s say that it is at least possible that the tax authorities win?%0AAs far as I know, both US GAAP and IFRS require the disclosure of material amounts of contingent liabilties in the notes to the consolidated financial statements.%0AKeep in mind that materiality is a concept of securities law and materiality is viewed from what is perceived as material by an investor. If you are familiar with how securities analysts and investors value a security, you will see that the impact of an amount on the value of a share depends whether the amount is a one-time occurrence or whether it occurs every year in the future. One valuation technique is to take the stock price (market capitalization for 100% of the equity) of listed companies in the same industry, to add the net financial debt and to divide the result by the EBIT. You can then multiply this EBIT-multiple with the EBIT of your issuer and subtract its net financial debt to arrive at the value of its equity. You could also use the market cap of the same company as of the end of the year, add the net financial debt of the same company and divide it by the latest available analyst consensus estimate of EBIT for this year or take the EBIT of last year. Apply the potential non-recurring effect to the net financial debt and the recurring to EBIT and then compare the equity values. If the difference is 5% or more, you can argue that it is material.%0AWhat is the magnitude of the contingent tax liability as a percentage of total assets? Have they already changed their tax practices in this jurisdiction or do they still follow the same tax practices that caused the tax authorities to initiate the lawsuit? If they have to change their tax practices, this may lead to a higher average income tax rate at this subsidiary and this will have a recurring effect in the future (i.e. every year).%0AWhat is the control deficiency? Is their information gathering system for lawsuits ineffective and they did not know of the lawsuit at the corporate headquarters? Or did they know of it, but they assessed the amount as immaterial and decided not to disclose it in the notes? In both cases, investigate the root cause of the problem (lack of training in the accounting standard and the assessment of materiality, lack of competence, etc.) and check whether they also forgot or incorrectly assesssed other contingent liabilities or other footnote disclosure that are not mere details of items in the income statement, balance sheet or cash flow statement. In other words the symptom may be small, but the deficiency may have the potential to generate more problems or may have already caused more problems.

  • gmerkl,%0Afirst of all thanks for your answer. %0AYes I mean that this company has a huge litigation representing around 10% of 2008 EBIT running in a non-US non-EU country. There are 2 tax law offices taking care of it. One says that the chance of tax authorities win in 10% the other says it’s 49%. As far as I know the 49% (whicn means at least possible) should be taken in account based on conservatorism.%0AI am not familiar with securities valuation, but I’ll try to make the calculation you suggested to try to understand if it is material or not. If you could be as ‘step by step’ didactic as possible in this calculation this would help me a lot … %0AAnyway, in general terms, that huge contingency is accumulated over around 9 years (reaching 10% of EBIT in 2008). This contingency continues to grow yearly since the company continues to apply the contested tax calculation method relying on a future litigation success (which would clear the contingency)… thus every year this contingency grows (let’s say around 1-2% of global EBIT every year).%0AAs a percentage of total assets (as stated in global consolidated balance) the contingency in 2008 represented a bit less that 2%.%0AWe believe that there has been a misassesment coming from the subsidiary, which wanted to represent this contingency, to their headquarters, as ‘under full control’, while it is not. They took in account the 10% unsuccess instead of the 49% and they cut off the ‘pessimistic’ lawyer impeding him to report to auditors his point of view.

  • Here is the promised step-by-step guide for an even easier method.%0A1) Check out how many classes of equity securities the company has issued (i.e. common shares, preference shares) and how many shares have been issued for each class of equity security). The quantities are usually used for the calculation of earnings per share.%0A2) obtain the price per security as of the end of the financial year from the stock exchange and multply the price with the quantity. This will give you the market value of 100% of the equity securities (i.e. the old equity value).%0A3) obtain the analyst consensus for net financial debt (= interest bearing debt less cash and short-term investments) as of the end of the financial year. If not available take it from the most recent financial quarter before year end or from the accounting records, but keep in mind that the investors that made the stock prices at the end of the year did not know the actual net financial debt yet because the financial statements had not been issued back then.%0A4) obtain the analyst consensus for profit ater tax (i.e. net earnings) as of the end of the financial year. If not available, take it from the last available quarter or from the records as above.%0A5) calculate the price earnings ratio = (equity value + net financial debt) / profit after tax%0A6) The amount for which the tax authorities sue is a one time-effect.%0A The amount of a yearly increase in the average income tax rate of the%0A local subsidiary that would be applied to the local profit before taxes of%0A the subsidiary is a recurring effect that effects all future years.%0A7) now calculate the new equity value = (profit after tax that you are auditing - recurring tax increase) * price earnings ratio from above - (net financial debt + one-time effect of tax claim).%0A8) calculate (new equity value / old equity value) - 1%0A9) if the result is 5% or higher, you can argue that the impact on the share price is material.%0AThis calculation usually uses EBITDA or EBIT instead of profit after tax, but I think it should work.

  • Ok … thank you. I partly used a shorter path … I found an official source for the PE ratio, equity value and profit (after tax and EBITDA), then calculated the net financial debt mathematically (using your formula backward). %0AI made the calculation using both EBITDA and Profix after tax. In both cases it gives around 3,5% of difference in share price … less than the 5% you stated.%0ADoes this mean that they are right (under SOX rules) to omit this contingency in they consolidated balance sheet … and not even mention it’s existance in a note ??%0AI specifically refer to FAS-5 articles 10, 37 and 39 which states that a legal contingency should be at least disclosed in a note when it is classified as ‘possible’…%0AAlso, how does the materiality concept deal with the fact that they report much lower legal contingencies (both acrruing and discolsing in notes) but not this one … is it possible to apply different parameters to similar contingencies within the same balance sheet ?

  • Did you use both the one-time effect of the litigation amount (which increases net financial debt) and the recurring effect of the increase in the tax rate if they lose the litigation in order to arrive at the 3.5% difference in the share price?%0AWhat was the source of your profit after tax, EBITDA and net financial debt? The analyst consensus for the financial year of the financial statements as of the end of the financial year? If there is a difference between what the analysts estimated and the actual results in the unpbulished financial statements, this could also have an effect.%0AMy web acess to the codification of US GAAP does not work currently, but I believe that the concept that only material information needs to be disclosed also applies to the disclosure of contingent liabilities in the footnotes to the financial statements. Unless you can clearly demonstrate that the amount is material, you will have a problem. However, they should explain why they disclose other contingent liabilities with non-material amounts if they think that the materiality limit is that high.%0AWhat is your role in this? Are you preparing the financial statements for the company, are you an internal auditor or are you the company’s public accountant? If you work for the company have you checked with the public accountant what materiality amount they use for audit planning purposes for income statement and balance sheet items? Does the public accountant already know about this contingent liability issue? If yes, they will also make an individual materiality assessment for this issue and will have to consider both the non-recurring and the recurring effect. In my opinion the footnote disclosure should include information on the amount of the potential annual tax increase if the company loses the litigation and has to change its tax practices.

  • GMERKL,%0Ayes I used all the rules you suggested using both one-time and recurring effects… The source for data I used (EBITDA etc…) are analisys published by financial sites based on official numbers.%0AMy role in this is that of a frauds investigator working on behalf of a group of investors and third parties interested in assessing the company’s health.%0ABased on your inputs, I went a bit deeper on the issue. Indeed FAS-5 (part of US-GAAP) defines when contingencies must be accrued and discoled and sets the materiality question (i.e. just material issues need to be disclosed/accrued). On other side SEC and other sources (US Supreme Court) says that an issue is material when a reasonable investor would be influenced by it in its decisions, without setting any ‘numeric’ limit to this. I also researched the 5% rule, which indeed exists in practice, even if it’s not formalized in any law/document. As far as I’ve seen it states that an issue should be considered material if it represents 5% or more of the Net Income … without any other consideration (much simplier than your calculation). In my case, based on 31/12/2008 balance sheet and echange rates this contingency represents around 6,5% of net income … %0AThe only doubt i still have is abount the process of consolidation of a balance in case of such a multinational company. As far as I know consolidate a balance means (more or less) taking ALL accounts from sources (subsidiaries) balances and sum them into a single one. Somebody told me that in certain cases to consolidate a balance they just need to take final results from subsidiaries balances and not other issues like contingencies etc… anyway this seems to me quite redutive and contrary to SOx spirit. Any comment on this. Do you know anything in this sense ??

  • SOX is not the issue here as much as US GAAP, if reporting in the USA or local GAAP if reporting elsewhere.
    I believe that US GAAP would have you disclose the fact that there is a contingent liability, but you are not required to disclose the range of potential liability. You are required to accrue a liability at the low end of the range. If this is deemed to be zero by management, then non-accrual of cost is appropriate.

  • kymike, in our case there is not a range of liability. Or they win and they do not pay the tax, or they lose and they’ll have to pay the full tax (ie full contingency). No mid term result is possible against government.%0AIn my analisis, according to FAS-5, they do not have to accrue the contingency, since they have a legal opinion (from lawyers) setting the chance of losing at 49% (thus possible, but not probable). They anyway have to disclose the contingecy (since it is a fixed value, and not a range, they have to do this with full contingency value). This is we consider the issue ‘material’. That’s the point now … is it material ??%0AAccording to all what I’ve found we may believe it is. Even the informal 5% rule states that an issue is material if it represents at least 5% of net income, and our contingecy represents over 6% of 2008 net income (growing every years at around 1,5% of net income rate).%0AThe fact that the contingency comes from a non-us non-eu subsidiary, in my opinion, means nothing since by consolidating the balance they must consolidate results but also contingencies.%0AWhat do you think about this analisys … is it correct ??

  • You make this sound like an ‘all or nothing’ contingency. If that is the case, I agree that there must be a disclosure, but not necessarily noting the contingent amount. %0AI am not certain that I would agree that this is material to the company. While it is 6% of 2008 net income, what percentage is it to total assets? Would losing this case have a material impact on the balance sheet and the company’s ability to stay in business or just on one year’s financial statements?%0AI agree that the location of the contingency is not meaningful when it comes to potential disclosures.

  • kymike,%0Aexactly … This is definitely a ‘all or nothing’ contingency. But since it deals with tax calculation it’s result (win/lose) has also a recurrent effect.%0AIn the case, taking in account the total consolidated assets (2008) this contingency represents around 1,9%, as said it represents over 6% of 2008 consolidated net income and, in case of losing the litigation, it could severely affect (both for the one-time payment and for the reucrrent effect of new tax calculation) the subsidiary operation, possibly taking to it’s closure or strong redimensioning … we can say that local subsidiary (one of top 10 most important markets for the company, and one of top 5 for personnel) would be severely impacted in it’s ability to stay in business.%0AJust one question. You said that you believe they should discolse but not report the contingent amount. Isn’t it unsuseful to disclose a huge contingency without giving a quantification to it ??

  • Disclosing an amount would be what every investor would want to see. However, there may be reasons to not disclose the amount. You should ask management what their reasons are for not disclosing.
    I don’t know that I have ever heard of a tax position where losing it would put the subsidiary out of business. That would be a bad move for the local government entity as they would assure themselves of no future tax revenue from this entity.
    In the end, management needs to be able to justify non-disclosure of something that you feel should be disclosed. They may not see things the same as you do and may have information that you do not have. I am not trying to support either side, rather suggest that you discuss specific concerns with management and expect to get valid responses from them. They need to support their interpretation of US GAAP.
    Good Luck.

  • kymike,%0Afirst of all thanks you very much for the inputs you provided me.%0AJust to give you an idea of how strong could be the impact of this issue on the subsidiary you must know that at present the contingency represents around 120% of 2008 EBIT (local), and losing the litigation will also carry a recurring impact of around 20% of EBIT yearly.%0AThe problem is that the management relied on a very risky business model in order to grow quickly in the market. %0AThanks again for your help.%0ABest regards

  • The US courts have interpreted the concept of material information in US securities law to be something that could change an investor’s investment decision. This is why I have suggested using a valuation technique in order to see how much non-recurring and recurring effects change the value of a share. Percentages of net profit, profit before taxes or total assets are just rules of thumb that auditors have developed (partly out of laziness to use something more sophisticated). Anything that uses a percentage of an income statement item assumes a recurring effect because investors value shares as a multiple of profit or use the income statement numbers to make estimates of the cash flows or future years and then discount them. If the recurring effect only is over 5% of net profit then it is definitely material. If not, it could be material and you need to discuss it. Ultimately the effect on the share price and thus on the investor’s decision is what counts. I do not know the impact on the value if you would use discounted cash flows and whether future increases in the business of this subsidiary would then result in higher absolute tax amounts and what the impact on the total share value would be.%0AA company that has securities registered with the US Securities and Exchange Commission (which is the case if it is listed on the NYSE) has an obligation to maintain both internal control over financial reporting (relates to the the consolidated financial statements including the notes with contingent liabilities) and disclosure controls and procedures (relates to all financial and non-financial information that potentially needs to be disclosed to the SEC). If you look at the definition of disclosure controls and procedures (check out item 15 on form 20-F on in EDGAR for your issuer), you will see that they need to have a system that collects financial and non-financial information from their subsidiaries that allows the management at headquarters to make decisions whether they need to disclose it or not. If the local guys did not even transmit it to their headquarters, then there is already a weakness in the system. Both the CEO and the CFO have filed certifications with the annual report where they confirm their responsibilities and that they have disclosed assessments of the effectiveness of those controls in the annual report. Important decisions about materiality are up to the headquarter. Consolidation is the collection of information from subsidiaries and then treating the company as a single economic entity by eliminating any intragroup transactions. This includes information in the notes or outside the financial statement section of the annual report. Since the contingent liability is towards a third party (i.e. the tax authority) and not towards another entity in the same group it is not eliminated during consolidation.

  • gmerkl,%0Aagain, thank you very much for your great and illuminating inputs. %0AThe fact is that evidences are arising that somebody at the local subsidiary hid informations that may have misleaded headquarter’s evaluations. In particular it seems that they hid a report from one of the lawyers (there are 2 law offices dealing with this litigation) saying that it was possible to lose the litigation (49% chance), and only presented the report of the other office which said it was remote (10% chance) to lose it. As far as I know, in such a case they should have applied prudence and conservatorism and taken the less optimistic estimate… this considering, among the rest, that the whole market orientation (all their their competitors) estimates as probable the chance to lose it and for this reason did not follow the litigation path (they’re the only ones on this path). FAS-5 (par.36) says that market trends (together with specialist/lawyers reports) is one of the elements to be used to estimate the possibility/probability of a contingency.%0AAnswering to kymike about disclosing value of a contingency. FAS-5 (par. 10) says that when discolsing a contingency they must define a value or range of values for it, besides it’s nature. Since in this case there is not a range but a ‘all or nothing’ situation I believe they could not avoid disclosing the full amount of the contingency. Is it right ?

  • I do not know the US GAAP standard for contingencies by heart, but I do no think that it contains a percentage threshold of what is considered as a ‘remote’ probability. I think 10% is definitely above the ‘remote’ threshold so that an amount, if it is material, needs to be disclosed.%0AA range of values would only make sense if they think that a settlement is likely where the settlement value could be below the value for which the tax authority is suing. But if they have said that they do not plan to settle and want to litigate in court, then you have only one value.%0ASome companies require written sub-certications by the general manager and/or the finance director of subsidiaries in which they confirm that all information has been transferred to the headquarter and that they have evaluated the effectiveness of their local disclosure controls and procedures. Those sub-certificates are not legally required by US securities law. If yes, you can nail them with it and say that they have not followed the company policies. In addition, at the consolidated level there are legally required certifications by the CEO and CFO, which also cover that they have evaluated the EFFECTIVENESS of their disclosure controls and procedures and their conclusion about its effectiveness. This can be a violation the regulations of the SEC (i.e. of US securities law) with sanctions for the company and for the individuals who signed the certifications. Those certifications are filed as exhibits to the annual reports on form 20-F in the EDGAR system at (usually there is a hyperlink to the exhibits at the end of a form 20-F). Willfully failing to disclose a material fact (i.e. material concerning the consolidated information for the whole group) can be punished with criminal penalities (i.e. imprisonment and monetary fines) by the US Department of Justice.

  • Apologies for coming to this late, but I can’t see how non-disclosure of this contingency could be justified.%0AThat it is in a non-US, non-EU subsidiary is irrelevant, the standard is whether it is material to the parent company. Contingent liabilities that are material to the group require disclosure in the group accounts. In addition, under IFRS (IAS37) this would disclosable in the parent company accounts in Europe as well.%0AThat the amount and probably of success are not known is what makes it a contingent liability rather than a regular provision.%0AIn essence under IAS37%0A-and-gt;50% probability - amount should be included in provision%0A-and-lt;50% - it’s a contingent liability%0ADisclosure requirements are:%0A- description of the nature of the CL%0A- an estimate of it’s financial effect%0A- an inidication of the uncertainites%0A- the possibility of any reimbursement

  • To add to this, the US GAAP requirements on contingent liabilities are almost completely converged with IFRS i.e. information about a contingent liability, whose occurrence is more than remote but did not meet the recognition criteria to be included in the P-and-L/BS, should be disclosed in the notes to the financial statements.

  • Denis: thanks for your posts, but the discussion was primarily about evaluating the materiality (i.e. the amount in relation to the consolidated financial statements) and possible calculations of materiality and not about the likelihood that the contingent liability arises.
    In my opinion, the only reason for non-disclosure of a contingent liability in the notes under either IFRS or US GAAP in a case where the tax authority has already started enforcement proceedings (i.e. the likelihood of occurrency is more than remote) could be that the amount is not material in relation to the consolidated financial statements.

  • gmerkl - maybe I misunderstood but I thought the original poster was confused on multiple grounds 😉
    a. materiality
    b. applicability of foreign contingency to US filing
    c. need for disclosure
    d. SOX impact of non-disclosure
    You covered materiality pretty comprehensively and I principally addressed b and c.
    The answer to d is that a failure in the process that resulted in a failure to identify material contingent liabilities would be a control deficiency that could potneitally be material or significant, but a difference of opinion on if and how an identified CL should be disclosed would not be.

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