Contingencies from foreign subsidiary 2718
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 ??
kymike last edited by
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.
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 sec.gov 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 sec.gov (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
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.
My 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) ?’ %0AI understood the original question to primarily concern the need for disclosure (on the balance sheet or in the notes) and whether non-disclosure would be a violation of the Sarbanes-Oxley Act. The question of materiality and likelihood are subquestions that arose during the discussion and they are related to the question dealing with the need for disclosure.%0AWhile I did not explicitly state that the location (foreign or US) of the consolidated subsidiary is not relevant for the question of the need for disclosure, I implied this by focusing on the question whether the amount would be material for an investor.%0AThe poster later come up with additional information about different estimates of the likelihood, however this information did not change the fact that a disclosure would be required if the amount turns out to be material.%0ASo by addressing c., I explicitly covered a. and implicitly b. (by not stating that this would permit non-disclosure). Finally I did cover d. through mentioning internal control over financial reporting and disclosure controls and procedures (including any voluntary sub-certifications submitted by subsidiaries).%0AI am still not sure whether the poster still included the non-recurring part of the tax issue (i.e. a lump sum payment for taxes relating to past years if the tax authorities considers certain expenses to be non tax-deductible or because the tax authorities increases revenues by considering old transfer prices as too low) in the total amount that he expressed as a percentage of consolidated EBIT that was above 5%. From his earlier posts and my questions about recurring and non-recurring effects it seems that the recurring effect would be lower than 5% of EBIT and that subtracting the non recurring effect from the enterprise value (or from equity) would result in a decrease in the equity value (or share price) of below 5% of the old equity value (and would thus be immaterial from the point of view of an investor). As I explained in my earlier posts one cannot include non-recurring effects in calculations as a percentage of an income statement or cash flow statement item because commonly used valuation techniques imply that the equity value is derived from income statement or cash-flow items that recur in the future. Negative one-time effects either need to be added to net financial debt (and thus result in lower equity) or need to be directly subtracted from equity. The intuitive reasoning is that an investor cares more if 6% of the EBIT is lost EVERY year in the future (i.e. 6% per year) than if 2% of the EBIT is lost every year and the remaining 4% need to be paid only once but not again in the future.