What is the “value” of litigation?

Placing a value on litigation — that is, determining the probable outcome and its potential financial impact on a party — is important for several reasons. For instance, it not only can help you weigh the relative costs and benefits of various litigation strategies, but it’s also relevant for business valuation and financial reporting purposes.

The value of litigation is particularly significant in light of the Financial Accounting Standards Board’s (FASB’s) proposed changes in the way loss contingencies are accounted for and disclosed in a company’s financial statements. These changes raise some concerns regarding potential disclosure of litigation strategies and other confidential information.

Accounting for contingencies

Accounting for litigation and other contingencies has always been a challenge. But FASB’s proposed changes raise significant concerns for parties and their counsel, particularly from the defendant’s perspective.

Under current standards, contingent assets, such as a plaintiff’s potential recovery, generally aren’t recorded on a company’s financial statements until they’re recognized — in other words, until the litigation is completed and the contingency is resolved.

Contingent losses, on the other hand, such as a defendant’s potential liability, may need to be recorded or disclosed in the financial statements. Loss contingencies are classified as “probable,” “reasonably possible” or “remote.” Companies must accrue contingent losses that are probable, provided the amount of the loss can reasonably be estimated.

If a loss isn’t accrued, it must be disclosed if there’s at least a reasonable possibility that a loss has been incurred. The disclosure should describe the nature of the loss contingency and, if reasonably estimable, the range of probable losses.

FASB’s proposed changes would require companies to disclose more information about potential litigation losses. Among other things, the proposal would require disclosure of remote contingencies if their near-term financial impact would be “severe” if they came to fruition.

The proposal would also require disclosures to include both qualitative and quantitative information about contingent losses — including loss estimates — that critics fear could reveal litigation strategies, disclose privileged information or attorney work product, or affect settlement negotiations.

Litigation as an investment

When making litigation-related decisions (such as to settle a case or bring it to trial), it’s helpful to view litigation as an investment. Valuation experts can use a variety of techniques — including decision trees, real options analysis and discounted cash flow analysis — to determine the potential “return on investment” of various litigation outcomes.

For example, if trying a case would cost $500,000 and the probability of recovering more than that amount is slim, then pursuing this strategy would be an unwise investment.

Impact on business valuation

From a business valuation perspective, pending litigation can have a big impact on what a hypothetical willing buyer would pay for a business; pending litigation increases a business’s risk, which in turn has an adverse effect on its value. Valuators must work closely with counsel and management to assess the probability that pending or potential litigation will result in a gain or loss and to place a monetary value on that probability. Both the potential gain (or loss) and potential attorneys’ fees must be considered.

In some contexts — such as valuations for gift or estate tax purposes — valuators must rely on their experience and professional judgment to estimate the impact of litigation contingencies on business value. In other cases, however, such as the sale of a business or marital dissolution, the parties may be able to avoid the uncertainties inherent in litigation by agreeing to adjust the terms of a transaction or settlement once the litigation has been resolved.

Teamwork pays off

By working as a team, attorneys and their financial experts can assess the probability of various litigation outcomes and estimate the value of litigation for a variety of purposes. After FASB has finalized new standards for loss contingencies, consult your experts to discuss how the new standards will affect your clients’ financial statements and litigation strategies.