When a Judge in Mexico ruled against Yahoo with a massive $2.7 billion judgment, the Internet company may have lost more than the case; it also lost some credibility on its financial reporting.

Yahoo announced in late November that it was facing the massive penalty as a result of lawsuit in Mexico it lost against a yellow pages listing service company. To be sure, companies win and lose lawsuits all the time, and Yahoo is unlikely to shell out anywhere near that figure, as it plans to “vigorously defend itself” during the appeals process. The real problem, however, was the fact that the case exposed holes in Yahoo's loss contingency disclosure policies.

Contingencies are unresolved issues, such as lawsuits or environmental clean-ups, which represent liabilities on the balance sheet. Companies are required to disclose in their financial statements when they are facing such possible liabilities and to state or estimate what the final cost will be if it can be determined.

Both the Financial Accounting Standards Board and the Securities and Exchange Commission have made such disclosures a top priority in recent years, after complaints from investors about large legal settlements with little or no warning in the financial statements. While FASB abandoned its five-year-old project to change the existing rules last summer, it reiterated the need for the SEC to keep a close watch on loss contingencies.  “The SEC has done a very good job saying that they don't want to see surprises like this; that companies should keep their investors apprised of how litigation is progressing,” says Keith Peterka, a shareholder with audit firm Mayer Hoffman McCann.  “This is another reason for the SEC to keep it front and center.”

The litigation was filed about a year ago, according to Carlos Bazan-Canabal, who is a partner in and legal representative of the two Mexican firms suing Yahoo. In an e-mail, Bazan-Canabal said the case went through the Mexican court system over the course of the year, with Yahoo hiring international law firm Baker McKenzie to defend its interests before the judge.  During that time, the Internet giant never dropped a hint about the existence of the lawsuit in its filings with the SEC, and accordingly, never estimated any probable losses or accrued for them as required by Generally Accepted Accounting Principles.

While Yahoo has not responded to requests for comment, legal experts reason that the company may have believed that the case would never lead to any losses. In general, “if you are very confident of victory in a litigation, you can make a judgment call to not disclose it at all,” says Michael Young, a partner with the law firm of Wilkie, Farr & Gallagher.

Along the same lines, it may have appeared that any penalty wouldn't rise to the level of materiality, since Yahoo does not generate enough revenue in Mexico to merit breaking out its results for the region.  According to press reports of the legal documents, though, the Mexican company filing the lawsuit asserted that it had entered into agreements with Yahoo that would have allowed it to expand into countries around the world, creating over $2 billion in lost opportunities.

“The SEC has done a very good job saying that they don't want to see surprises like this; that companies should keep their investors apprised of how litigation is progressing.”

—Keith Peterka,
Shareholder,
Mayer Hoffman McCann

Companies have long struggled with the requirements around litigation and loss contingency disclosures imposed by GAAP. The most controversial and difficult aspect is usually considered to be the need for companies to estimate and accrue for any probable losses they will face due to litigation. That puts legal departments in the position of having to forecast their odds of winning any given lawsuit, which effectively “tips their hand to the other side,” notes Peterka. As a result, most companies simply decline to put out such numbers with the assertion that outcomes and any damages are not reasonably estimable.

More, More, More

Such pushback hasn't deterred regulators, though. The SEC has asked approximately 7 percent of the 3,264 companies it has sent comment letters to so far this year for more disclosure on pending litigation, according to data supplied by Audit Analytics. In some cases, it has asked for multiple revisions and clarifications on the topic.

HB Fuller, a $1.6 billion maker of adhesives and sealants, went back and forth with the SEC three times this past year before the regulator stopped asking for additional information about pending asbestos and other legal claims. Similarly, after two rounds of letters with Texas Capital Bancshares about a case it had lost in court but was planning to appeal, the SEC staff came back a third time to say “we remain unclear as to why you have not accrued a liability for the $65.4 million verdict amount under the guidance in ASC 450-20-25-2. Please provide us with … additional information to support your conclusion that it is not probable the verdict amount will become an actual liability.” That request generated another 12 paragraphs of explanation, but no accrual, since TCB reiterated the fact that, despite the “reasonable possibility of a loss,” there was no way to forecast what that loss would ultimately be.

SEC scrutiny is not always just related to dollar amounts, either. When Alcoa explained why it could not estimate possible damages from a group of pending lawsuits by giving the details of where each one stood, the SEC deemed the information “helpful” for investors and asked Alcoa to provide “similar insights” in future filings.

As a result of both Yahoo's unexpected results and the SEC's ongoing push, “companies sometimes find themselves disclosing more than they're comfortable with, simply because they want to comply with the rule,” says Young.

YAHOO ANNOUNCEMENT

Below is Yahoo's announcement of the judgement in the Mexico lawsuit.

SUNNYVALE, Calif.--(BUSINESS WIRE)--Yahoo! Inc. (NASDAQ: YHOO) today reported that the 49th Civil Court of the Federal District of Mexico City has entered a non-final judgment of U.S. $2.7 billion against Yahoo! Inc. and Yahoo de Mexico, S.A. de C.V. in a lawsuit brought by plaintiffs Worldwide Directories S.A. de C.V. and Ideas Interactivas, S.A. de C.V. Yahoo! believes the plaintiffs' claims are without merit and will vigorously pursue all appeals. The plaintiffs alleged claims of breach of contract, breach of promise, and lost profits arising from contracts related to a yellow pages listings service.

Source: Yahoo.

At the same time, the sudden appearance of previously undisclosed litigation reveals how hard it is for outsiders to get the information any other way. Such disclosures “are one of the toughest areas of the financial statements to audit,” says Peterka. Auditors try to match legal invoices with litigation, and then often rely on attorney's letters to ensure the company has covered all necessary cases. Those letters, however, are typically filled with boilerplate language and few real details.

Yahoo's surprise also highlights how difficult it can be for multinational companies to deal with litigation outside their home countries. “It's hard enough to make predictions about litigation outcomes in the United States; it's exponentially more difficult in non-U.S. courts where everything from legal procedures to rules of evidence are different and often hard to fully understand,” notes Young.

Getting sued in a foreign location often forces a company to find new legal counsel in an unfamiliar place, and it's not always obvious what the ideal choice may be. “It really comes down to finding the best possible attorney, whether it's through a big law firm or a local practitioner, to handle that particular case,” Young says.

While Yahoo has not disclosed any SEC response to its Nov. 30 8-K so far, many expect that the agency will further scrutinize the decision-making process at the $5 billion company. If Yahoo is not successful in getting the judgment overturned, or at least scaled back, the penalty would represent a big hit to the $7.6 billion in cash it had on hand as of its most recent 10-Q.