Questions

1.What journal entry would OI have made to record the additional $285 million of asbestos liability? You can ignore income tax effects.

2.Explain why OI?s treatment resulted in an increase to the earnings for 2015, 2014, and 2013.

3.Based on OI?s disclosures in the 10-K prior to restatement, was it clear that the firm was using a three year period to estimate asbestos litigation?

4.Briefly summarize the effect of the restatement on the following financial statements. What accounts were affected? By how much? What other disclosures were impacted? Note 1 in the restated 2015 10-K describes the changes.

a.The income statement.

b.The balance sheet.

c.The statement of cash flows.

d.The statement of stockholders? equity.

5.The discussion between the SEC and OI was extensive and interesting. Appendix A shows all of the correspondence between the two and links to the letters. The following questions are based on those letters and the information in the case.

a.What are the pros and cons to OI?s original treatment of the asbestos liability?

b.What are the pros and cons of the SEC?s approach?

c.Which approach do you find preferable and why? You can choose either OI or the SEC but your analysis needs to be based on something other than the SEC prevailed or OI did not.

6.Appendix B contains additional information about the number of asbestos cases OI has dealt with over the eleven-year period ending in 2015. How is OI?s experience with asbestos litigation similar to Garlock?s? How is it different?

How a Product Last Sold Almost 60 Years Ago Resulted in a Current Financial Statement Restatement Introduction The city of Toledo, Ohio is often called the \"Glass City\" because it is where much of the glass industry began. One of the firms that began the glass industry is Owens-Illinois or OI as it is commonly called. The company was originally founded in 1903 as Owens Bottle Machine Company based on Michael Owens' invention of the first completely automated glass bottle making machine. His invention meant that standardized glass bottles could be manufactured for a variety of products including food, beverages and alcohol. In 1929, the company merged with Illinois Glass Company to become OwensIllinois. Currently OI has over six billion dollars of annual sales and remains a world-wide leader in the manufacturing of glass containers. OI manufacturers approximately one out of every two glass containers in the world. While OI currently focuses exclusively on glass manufacturing that has not always been the case. Repercussions from a product that OI last sold almost 60 years ago resulted in the firm restating its financial statements for the year ended December 31, 2015. That product was called Kaylo and OI sold approximately $40 million of it from 1948 to 1958 and has accrued almost $5 billion of liability related to it OI 2015 10-K/A). Kaylo was used as an insulating material for pipes and boilers. OI became involved with manufacturing this product because the raw materials used in it were similar to those used in the manufacture of glass with the addition of asbestos (Expansion, Ecology and Energy: O-I During the 1950s-1970s.). Asbestos is a mineral that can be separated into thin durable fibers that are extremely resistant to heat, fire and chemicals. Those properties made asbestos a very attractive material that was used in almost 3,000 products in a wide range of industries such as the commercial and residential construction, shipbuilding, and automotive industries (Asbestos Exposure and Cancer Risk.). The U.S. Navy actually required that all of the Kaylo it purchased from OI had to contain asbestos (Krik v. Crane Co., et al.). However, exposure to asbestos is potentially harmful to health. It can cause malignant diseases such as mesothelioma or lung cancer and non-malignant diseases such as asbestosis which results in shortness of breath due to scarring in the lungs. Beginning in the 1970s (which was more than a decade after OI sold the Kaylo line of business), the use of asbestos was restricted by several acts by the Environmental Protection Agency and the Consumer Product Safety Commission and the use of asbestos was phased out by most companies. Interestingly, asbestos has still not been completely banned in the U.S. and there are still products sold that contain asbestos (U.S. Federal Bans on Asbestos.). The Disagreement Between the SEC and OI The Securities and Exchange Commission (SEC) initially contacted OI in June of 2015 about the firm's 10-K for the year 2014 (SEC letter2015). The SEC questioned OI about three issues. Two of the issues were quickly resolved. However, the SEC and OI were unable to resolve their disagreement over the firm's estimation of asbestos related contingent liabilities. After almost a year of dialogue, OI concluded in a letter dated April 29, 2016, \"that its previous method for accruing probable losses for asbestos claims not yet asserted was not consistent with ASC 450 because it treated each annual period separately for purposes of estimating total future claims, estimated disposition costs and estimated related legal costs for its asbestos-related liability.\" A few days later OI filed an 8-K summarizing the disagreement and indicating that the firm would change its approach to estimating the asbestos related liability. OI stated in the 8-K that the new approach to estimating asbestos litigation would increase the liability by $295 million and that the firm would restate its financial statements for the years 2015, 2014, and 2013. The issue that led to OI's restatement was how the firm estimated unasserted claims regarding asbestos litigation. In OI's 10-K for 2014, the firm had disclosed (in note 13 regarding contingencies) that \"The Company believes that a reasonable estimation of the probable amount of the liability for claims not yet asserted against the Company is not possible beyond a period of several years.\" OI had made similar disclosures in previous financial statements. Unasserted claims are a type of contingency. Applicable professional guidance (ASC 450) uses a two-step process where the first consideration is whether a claim will be asserted. If the answer to that question is \"yes\" then the claim is treated as asserted and evaluated as a contingent loss. So, an unasserted claim that is likely to be made would be accrued if loss is evaluated as probable and the dollar amount can be reasonably estimated. OI's use of the several year time frame seemed to be based on the firm's concerns about making reasonable estimates of the number of lawsuits and the dollar amount of the settlements. The SEC, in its letter dated June 8, 2015, asked for clarification about the specific time frame used given OI's \"...extensive claims experience.\" In its response dated July 7, 2015, OI stated that the time frame used to estimate unasserted claims was three years. OI indicated that \"...the Company's position is that it cannot reasonably estimate a liability for claims not yet asserted for the period beyond the next three years because the amount of loss cannot be reasonably estimated.\" OI also noted that applicable professional guidance \"...is intended to prevent accrual in the financial statements of amounts so uncertain as to impair the integrity of those statements.\" Ultimately, the SEC (letter dated October 9, 2015) disagreed with OI's contention that unasserted asbestos claims could not be reasonably estimated beyond three years. The SEC indicated that \"We understand that the precision of an estimate may become less precise over longer time periods; however, we note that ASC 450 does not require estimation with certainty, since an estimate is inherently an approximation that is uncertain. Based on your history with asbestos claims, it seems unlikely that the low end of your range of probably losses for time periods beyond three years is zero.\" Why is Estimating Liability regarding Asbestos Litigation so Difficult? Estimates related to asserted litigation are difficult due to their subjective nature but making reliable estimates about litigation that hasn't happened compounds that difficulty. Furthermore, predicting the outcome of litigation related to asbestos is probably the most difficult area of all. Opinions on asbestos litigation range widely. One view is fairly critical of the companies that exposed people to asbestos. This statement by Inselbuch (2016) reflects that view: ...asbestos disease is the longest-running public health epidemic in our history. Asbestos exposure kills thousands of Americans every year and it will continue to do so for many decades to come. For more than eighty years, corporations that produced and distributed asbestoscontaining productsand their insurance companieshave attempted to avoid responsibility for the deaths and injuries of millions of American workers caused by those products. Since before 1930, these corporations have hidden the dangers of asbestos and lied about their knowledge of those dangers, lobbied to make it harder for workers to sue for their injuries, and fought to weaken protective legislation.\" While most would agree that people harmed by exposure to asbestos are entitled to compensation, the outcome of asbestos litigation often doesn't seem to link harm with the companies that caused that harm. One outspoken critic of asbestos litigation is Brickman who has called asbestos litigation \"a massive civil justice system failure\" (2005) that will eventually be considered similar to \"great American scandals as...WorldCom and Enron\" (2004). Brickman (2014) also reflects the lack of linkage between causality and asbestos litigation settlement in his statement: By 2047, when this scourge will have mostly run its course, several hundred thousand deaths will have resulted from asbestos exposures. The litigation spawned by these exposures has no counterpart in our history. Over 10,000 corporation have been names as defendants, leading to nearly 100 bankruptcies (and counting). The bankruptcies have led to the creation of a dual system for compensating claims. Personal injury lawsuits continue to be brought against a dwindling number of solvent defendants... The views expressed in these two quotes illustrate a number of the issues that make estimating the outcome for asserted or unasserted asbestos litigation difficult. One issue that is evident in both Inselbuch and Brickman's statements is that asbestos related illness or death have been ongoing for several decades and are expected to continue for several more decades. One reason for this is the latency period which refers to the length of time between exposure to asbestos and illness. For asbestos, the latency period is twenty to forty years (Brickman 2014). The latency period affects both the employees who manufactured or worked with products containing asbestos and others indirectly affected such as their family members. For example, in a lawsuit decided in 2013 (Grigg et. al. v. Allied Packing & Supply Inc. et al.), OI was sued by a woman who alleged that she was exposed to asbestos by handling and washing her ex-husband's clothes. They had divorced in 1965 and she contracted mesothelioma in 2011 so the latency period for her illness was over 40 years. The jury award to her from OI was $27.3 million. The view expressed in Inselbuch's statements that corporations and insurance companies conspired to withhold information is consistent with the findings from Borel v. Fibreboard (1973). This was a pivotal case that effectively opened the door to asbestos litigation. The Borel case established that some companies (such as Johns-Manville but not OI) had deliberately withheld information from employees about the health effects of asbestos exposure. Since then, plaintiffs have alleged that other companies in the industry must have also known what the effects of asbestos were. For example, in a 1999 suit (McClure et al. v. Owens Corning Fiberglass Corporation et al.), the plaintiffs attempt to connect OI to Johns Manville by showing that OI's actions were \"similar\" to Johns-Manville's because both firms produced products containing asbestos. Prior to the Borel decision, employees had filed workmen's compensation claims for their illnesses related to asbestos. As a result of the Borel decision, those claims became product liability (Brickman 2004). Typically, with product liability litigation, the plaintiff has to prove harm from a particular product. Because many of the employees who dealt with asbestos had come into contact with numerous products containing asbestos and it is impossible to tell which product caused illness, the courts relaxed the standards for proving that a specific product caused the employee's illness (Brickman 2014). It is also impossible to tell whether an illness such as lung cancer was caused by asbestos or something else such as smoking. The result of the relaxed standards combined with the latency period of asbestos means that plaintiffs initiating litigation are recalling which products they were exposed to decades after their actual exposure. As the previous quote by Brickman mentions, approximately 100 firm have been bankrupted by asbestos litigation. Part of the bankruptcy proceedings for these firms is to fund a trust that will be used to compensate future plaintiffs in asbestos litigation. However, what has happened is that after a firm goes bankrupt, plaintiffs are much less likely to remember using one of that company's products and more likely to remember using products from a non-bankrupt company (Dixon and McGovern 2015). Why would this happen? Brickman (2014) speculates that it is because continuing to make claims against the trusts of the bankrupt firms would have reduced and delayed the payment received compared to what could be obtained from a non-bankrupt firm. A recent case involving a company named Garlock helps to illustrate these issues. For about thirty years until the mid-1970s, Garlock produced gaskets that contained asbestos. In the realm of companies producing products containing asbestos, Garlock was a relatively minor producer (Brickman 2014). However, as other firms with asbestos liability declared bankruptcy, Garlock found that it was being sued more frequently (Brickman 2014) and that the average cost of settling a mesothelioma suit increased from about $10,000 in 1999 to nearly $80,000 by 2010 (O'Brien 2016). In 2010, Garlock declared bankruptcy to resolve its current and future (i.e. unasserted) asbestos claims. The firm's bankruptcy hasn't been finalized yet but it will involve setting up a trust for the asbestos claims. At the hearing to determine how much Garlock should contribute to the trust, experts for plaintiffs' attorneys asked for $1.0 to $1.3 billion. The judge presiding over the bankruptcy agreed with Garlock's expert who estimated the liability at $125 million. Quite a difference. The judge indicated that the analysis by the plaintiff's experts' was erroneous because it was based on Garlock's settlement history from 2005 to 2010 and post-bankruptcy the average claim will be much less (Brickman 2014 and In re Garlock Sealing Technologies). To analyze Garlock's estimate, the judge ordered that 15 cases be reviewed. In all 15, it was determined that the plaintiffs had withheld evidence. For example, when suing Garlock, plaintiffs would allege that Garlock's gaskets were the only product containing asbestos that they had ever been exposed to. After settling with Garlock, the same plaintiffs would sue other trusts indicating that they had been exposed to other products (Brickman 2014). Interestingly, one of the attorneys representing the plaintiffs in the Garlock case was Inselbuch (Frankel 2014). A final interesting aspect of the Garlock case is that another company facing asbestos litigation is using the evidence from the 15 cases examined by Garlock to sue plaintiff's attorneys based on the Racketeer Influenced and Corrupt Organizations Act (O'Brien 2016). The Resulting Restatement Due to its resolution with the SEC, OI modified its approach for estimating unasserted claims and included projections for more than three years in the future. OI calculated an additional $295 million of asbestos liability at December 31, 2015 and restated the firm's financial statements. While the restatement resulted in an overall increase in liabilities and expenses related to asbestos litigation, when the changes were reflected in annual fiscal periods, net income for the years of 2015, 2014, and 2013 increased by a total of $431 million. This was a significant increase for these years that more than tripled reported net income. As reflected in the revised statement of stockholders' equity, net income for the years before 2013 decreased by $726 million (Owens-Illinois 2015 10-K/A). OI also provided extensive disclosures about the restatement. The first risk factor addressed in Item 1A was the asbestos related liability. The management discussion and analysis also addressed the restatement. Finally, note 12 about contingencies addressed the restatement (Owens-Illinois 2015 10K/A). Questions 1. What journal entry would OI have made to record the additional $285 million of asbestos liability? You can ignore income tax effects. 2. Explain why OI's treatment resulted in an increase to the earnings for 2015, 2014, and 2013. 3. Based on OI's disclosures in the 10-K prior to restatement, was it clear that the firm was using a three year period to estimate asbestos litigation? 4. Briefly summarize the effect of the restatement on the following financial statements. What accounts were affected? By how much? What other disclosures were impacted? Note 1 in the restated 2015 10-K describes the changes. a. The income statement. b. The balance sheet. c. The statement of cash flows. d. The statement of stockholders' equity. 5. The discussion between the SEC and OI was extensive and interesting. Appendix A shows all of the correspondence between the two and links to the letters. The following questions are based on those letters and the information in the case. a. What are the pros and cons to OI's original treatment of the asbestos liability? b. What are the pros and cons of the SEC's approach? c. Which approach do you find preferable and why? You can choose either OI or the SEC but your analysis needs to be based on something other than the SEC prevailed or OI did not. 6. Appendix B contains additional information about the number of asbestos cases OI has dealt with over the eleven-year period ending in 2015. How is OI's experience with asbestos litigation similar to Garlock's? How is it different? References \"Asbestos Exposure and Cancer Risk.\" http://www.cancer.gov/about-cancer/causesprevention/risk/substances/asbestos/asbestos-fact-sheet. Borel v. Fibreboard. 493 F.2d 107. N.d. Brickman, Lester. 2004. \"On the Theory Class's Theories of Asbestos Litigation: The Disconnect Between Scholarship and Reality.\" Pepperdine Law Review. Vol. 31:33. Brickman, Lester. 2005. \"Ethical Issues in Asbestos Litigation.\" Hofstra Law Review. 833. 1-56. Brickman, Lester. 2014. \"Fraud and Abuse in Mesothelioma Litigation.\" Tulane Law Review. Vol. 88:107. 1070-1152. Dixon, Lloyd and Geoffrey McGovern. 2015. Bankruptcy's Effect on Product Identification in Asbestos Personal Injury Cases. Santa Monica, CA: RAND Corporation. Available at http://www.rand.org/pubs/research_reports/RR907.html. \"Expansion, Ecology and Energy: O-I During the 1950s-1970s.\" Available at https://www.utoledo.edu/library/canaday/exhibits/oi/OIExhibit/expansion.htm. Frankel, Alison. 2014. \"Asbestos plaintiffs lawyers: Garlock is the bad guy, not us.\" June 6. Available at http://blogs.reuters.com/alison-frankel/2014/06/06/asbestos-plaintiffs-lawyers-garlock-is-the-bad-guynot-us/. Grigg et. Al. v. Allied Packing & Supply Inc. et al. Case number RG12629580. Superior Court of the State of California, County of Alameda. In re: Garlock Sealing Technologies, LLC, No. 10-31607, W.D. N.C. Inselbuch, Elihu. 2016. \"The Need for Transparency in the Asbestos Trusts.\" Testimony to the Senate Judiciary Committee Hearing. Krik v. Crane Co., et al. United States District Court Norther District of Illinois Easter Division. N.d. Case No. 1:10-cv-07435. McClure Et Al. v. Owens Corning Fiberglass Corporation Et Al.),. N.d. Available at http://www.illinoiscourts.gov/opinions/supremecourt/1999/october/opinions/html/86118.htm. O'Brien, John. 2016. \"Despite Garlock Settlement, Asbestos Lawyers Can't Shake Racketeering Claims Yet.\" Forbes, Jun 6. Owens-Illinois Form 8-K dated April 28, 2016. Available at https://www.sec.gov/Archives/edgar/data/812074/000110465916116698/a16-10325_18k.htm. Owens-Illinois Form 10-K for the year ended December 31, 2014. Available at https://www.sec.gov/Archives/edgar/data/812074/000104746915000716/a2222968z10-k.htm. Owens-Illinois Form 10-K/A for the year ended December 31, 2015. Available at https://www.sec.gov/Archives/edgar/data/812074/000155837016005950/0001558370-16-005950index.htm. Owens-Illinois letter dated April 29, 2016. Available at https://www.sec.gov/Archives/edgar/data/812074/000110465916115639/filename1.htm. Securities Exchange Commission letter dated June 8, 2015. Available at https://www.sec.gov/Archives/edgar/data/812074/000000000015030395/filename1.pdf. \"U.S. Federal Bans on Asbestos.\" Available at https://www.epa.gov/asbestos/us-federal-bansasbestos#notbanned. Appendix A Correspondence Between the SEC and OI on Contingency Date June 8, 2015 From SEC July 7, 2015 OI August 14, 2015 September 14, 2015 SEC October 13, 2015 SEC December 21, 2015 OI April 18, 2016 SEC April 29, 2016 OI May 27, 2016 SEC OI Summary Initial questions about: Results of operations, Equity method investments, and Contingencies Response to three issues raised. Five of the seven pages relates to contingencies. Additional clarification sought about contingencies Seven-page response describing the firm's approach to estimating contingencies. Questions why estimates are not made beyond three years from the date of the financial statements and why the amounts recorded are in the 3rd and 4th quarters. Indicates that the firm has estimated losses over a three-year period because that is the time frame where the firm can make a reasonable estimate. Continues to question the use of three years as the period for estimating asbestos losses Agrees to estimate losses from asbestos litigation beyond the three-year time frame. State that the filing review has been completed Link https://www.sec.gov/Archives/edgar/data/812 074/000000000015030395/filename1.pdf https://www.sec.gov/Archives/edgar/data/812 074/000110465915050105/filename1.htm https://www.sec.gov/Archives/edgar/data/812 074/000000000015041637/filename1.pdf https://www.sec.gov/Archives/edgar/data/812 074/000110465915064924/filename1.htm https://www.sec.gov/Archives/edgar/data/812 074/000000000015049339/filename1.pdf https://www.sec.gov/Archives/edgar/data/812 074/000110465915086008/filename1.htm https://www.sec.gov/Archives/edgar/data/812 074/000000000016072495/filename1.pdf https://www.sec.gov/Archives/edgar/data/812 074/000110465916115639/filename1.htm https://www.sec.gov/Archives/edgar/data/812 074/000000000016078366/filename1.pdf Appendix B Summary of Ten Years of Asbestos Litigation Experience for OI 2005 2006 2007 18,00 0 13,00 0 9,000 Pending at the beginning of the year 35,000 Disposed Filed 12,000 9,000 32,00 0 21,00 0 7,000 Pending at the end of the year 32,000 18,00 0 14,00 0 347.1 13,00 0 26,70 0 Asbestos-related payments (from the SCF) 171.1 Cases disposed 12,000 162.5 21,00 0 Average cash payment per settled case 14,258 7,738 2008 2009 Year 2010 2011 2012 2013 2014 2015 7,000 5,900 4,600 2,610 2,620 2,260 4,000 3,000 4,500 3,200 4,400 2,400 1,700 1,710 1,830 1,470 1,460 1,280 8,000 5,000 11,00 0 10,00 0 6,000 11,000 7,000 6,000 4,600 2,600 2,620 2,260 2,080 210 179 170 165 158 148 138 8,000 190 10,00 0 4,000 4,500 4,400 1,700 1,830 1,460 26,250 19,00 0 44,750 37,77 8 37,50 0 92,941 80,87 4 94,521 14,000 OI Asbestos Cases by Fiscal Period 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 2005 2006 2007 2008 2009 2010 2011 Disposed Pending at the end of the year 2012 2013 Filed 2014 2015