Valuation of contingent liabilities: some risk management considerations for lenders

Finding little information upon valuating contingencies beyond FASB's Statement of Financial Accounting Standards No. 5--Accounting for Contingencies, the author, a California attorney, went upon to tackle the problem for himself and now shares that information with Journal readers.

Lender at least the singles I know, seem to part with a great deal of time, effort, and cash evaluating the asset section of their borrowers' balance sheets. They will not seldom retain appraisers to provide values of of that kind significant assets as:

* Furniture.

* Fixtures.

* Machinery.

* Equipment.

* Inventory.

* Accounts receivable.

* Patents.

* Trademarks.

* Copyrights.

* Customer lists.

* Real estate.

* Leasehold interests.

* Motor vehicles.

* Rolling stock.

Those lender also attempt to determine the nature, amplitude and validity of the borrower's liabilities, particularly accounts payable, accrued operating charges accrued salaries, other employee benefits, and whatever other the borrower or its accountants have chosen to state upon the balance sheet.

However, I question the amount of attention devot to the valuation of contingent liabilities--in particular, pending, threatened, and distantly potential litigation and governmental action--based upon the lack of information available to assess their risks. The starting point for my analysis of this question at issue is the only writing of any substance I have base on the subject:

Statement of Financial Accounting Standards No. 5--Accounting for Contingencies, promulgated by dint of the Financial Accounting Standards Board of the Financial Accounting Foundation.

Statement of Financial Accounting Standards No. 5 defines a contingency as an existing condition, situation, or put of circumstances involving uncertainty as to possible gain or los to an enterprise. The uncertainty factor would ultimately be resolv when single or more future events meet the eye or fail to occur. SFAS No.5 defines three classes of contingencies: probable (likely to occur) reasonably possible (more than distant but less than likely), and distant (slight chance of occurrence). Although SFAS5 teaches in what manner to identify and report contingencies, it does not provide a standard for valuation of los contingencies that can be used through a lender, nor does existing literature or law shed any light upon such standards.

more [i]or[/i] less contingencies quickly become unwieldy and difficult to assess: expropriation of assets and catastrophes caused by the agency of weather, earth movements, plagues, famine, locusts, frog and other incidents of biblical proportions. Therefore, this article is confined to an exploration of the valuation of risks attendant to litigation and governmental action.

A Hypothetical Borrower

Question of Balance, Inc. (QBI) was formed 10 years ago by dint of a group of high-net-worth engineers who had invented a vehicle that could operate upon a combination of salt water, inflammable air methane, and oxygen. After years of research and unfolding work, QBI developed a prototype vehicle that could move 50 miles per hour for 10 hours at a time without refueling. The small vehicle held single the driver; chemical tanks and equipment used all remaining space. However, QBI was certain that with a certain quantity of additional R&D work, the size and passenger capacity could be increased and demand for the vehicle would be overwhelming.

thus certain was the firm that it retained investment bankers to initiate an initial public offering (IPO) of its stock, engaged dealers in 20 states for its soon-to-be-produced four-passenger QBIMobile, and applied to Little Bank of Detroit (the Bank) for a $25 million loan to be repaid from the advances of the impending IPO.

While the loan application was being complet the Securities & Exchange Commission (SEC) raised regards about the disclosures in the Registration Statement filed in connection with the IPO and threatened to bring action against the company and its principals. The attorneys general of 18 of the 20 states where the of recent origin dealers were located raised bear upons and threatened to conduct investigations about potential violations of the states' franchise investment laws. When the Federal Trade Commission (FTC) got wind of those state activities, it make opened an investigation regarding possible violations of federal franchise investment laws. Those actions received in like manner much press that the federal Environmental Protection Agency (EPA) and similar agencies from 10 states uncloseed investigations regarding possible violations of air pollution laws resulting from the exhaust emitted by dint of the QBIMobile. Meanwhile, four female employee filed suit against the company and four of its principals for sexual harassment resulting from activities following the celebration held to introduce the QBIMobile general [i]or[/i] abstract notion car to the motoring public.

Preparing to Assess the Risk

QBI submitted with its loan application an audited balance sheet prepared by dint of its regular outside CPAs. The liability section of the balance sheet disclosed the actions of the governmental agencies and throw backed the pending harassment litigation. QBI also provided reasonably detailed footnotes to the statement; however, no dollar value was assigned to these contingencies. The assets of the company consisted principally of machinery and equipment with a fair market value of $18000 a commercial building with equity of $7 million, and intellectual attribute valued at $50 million. The stated liabilities of $400000 consisted of accounts payable and an accrued amount owed to the company's employee benefit plan. There were no tax liabilities shown nor were there any loans to or from officers or other insiders. The principals agreed to guaranty the Bank's loan and confident their guaranties with improved real attribute located in major markets.