The cigarette industry is subject to litigation for health hazards posed by its products. The industry has been in an ongoing process of negotiating a settlement of these claims with state and federal governments. As the CFO for Altria Group, the parent

Question

company of Philip Morris, one of the larger firms in the industry, what information would you report to investors in the annual report on the firm's litigation risks? How would you assess whether the firm should record a liability for this risk, and if so, what approach would you use to assess the value of this liability? As a financial analyst following Philip Morris, what questions would you raise with the CEO over the firm's litigation liability?

Answer 1

The litigation risks that Philip Morris faces are reported as contingent liabilities defined in SFAS 5 . Contingent liabilities arise from events or circumstances occurring before the balance sheet date, here the filling of lawsuits against Philip Morris, the resolution of which is contingent upon a future event, the court ruling or a potential settlement.
The accounting treatment for Philip Morris' pending litigation depends on the likelihood that it will lose or settle the lawsuit and whether the amount of damages the firm will be liable for is reasonably estimable. Accounting rules on required disclosure for these types of liabilities depend on whether the loss is probable, reasonable possible, or remote.
Probable – If it is probable that Philip Morris will lose the lawsuit and the loss can be reasonably estimated, the estimated loss should be reported as a charge to income and as a liability. If the loss is probable but no specific reasonable estimate can be agreed upon, rather only a range of possible losses can be estimated without any amount being more reasonable than the other, the amount that should be accrued by Philip Morris is the minimum amount in the range. Note that this contradicts the conservatism principle of accounting.
Reasonably possible – Where the likelihood that Philip Morris will lose the lawsuit is reasonably possible, no amount needs to be accrued as a liability but the nature of the suit needs to be disclosed in the footnotes of the annual report.
Remote – Where the likelihood that Philip Morris will lose the lawsuit is remote, no amount needs to be recorded as a liability nor is any disclosure required in the footnotes of the annual report.
The CFO of Philip Morris faces a dilemma. It is widely recognized that the company faces huge potential litigation costs. It is therefore important that the CFO confront these issues in the annual report, explaining the nature of the suits, the amount of the claims against the company, and the company's plans for responding to the suits. To fail to provide adequate disclosure about these issues, potentially leads investors to fear the worst, reducing the value of the firm's stock. However, the CFO also has to be careful not to make statements that could undermine the company's legal position or its negotiating position with the claimants.
As a financial analyst following Philip Morris I would push the CEO for as much information as possible about the likelihood that the company will lose the lawsuits or come to a settlement with the claimants. This requires that the analysts understand the law and case history for the industry. It also requires information on the company's plans to either take the cases to trial or to settle, as well as the costs of a legal battle, the company's assessment of its chances of victory, and the costs of a potential settlement.
In addition, given that the company's stock is depressed due to fears of losing these suits, analysts can probe management on what actions the company is considering to increase the stock price and maximize shareholder value. For example, is Philip Morris considering spinning off the Kraft food division? What is the firm doing to maintain employee moral and retain Kraft executives that might be inclined to accept jobs with similar food companies not tied to tobacco products? Is Philip Morris considering raising the annual dividend payment to compensate shareholders for lower stock prices?