By C. Richard Baker

The SOP is one year old.

What lessons were learned?

In Brief

Implementing SOP 94-6

SOP 94-6, Disclosure of Certain Significant Risks and Uncertainties, requires disclosures in four areas:

* Nature of operations.

* Use of estimates in the preparation of financial statements.

* Certain significant estimates.

* Vulnerability due to certain

concentrations.

The first two requirements do not present a major problem.

Where certain significant estimates have been made in preparing the financial statements, additional disclosures may be required if is reasonably possible the estimates will change in the near term and the change would be material to the financial statements. The problem here is defining the term reasonably possible.

Additional disclosures may be required if concentrations in a entity's activities expose it to risk of a near-term severe impact, the occurrence of which is reasonably possible. This requirement contains the additional definitional problem of the meaning of the term severe impact.

In their financial statements for the year ended December 31, 1995, General Motors chose to include these disclosures in several notes while Coca Cola Bottling Co. made the disclosures in one note on risks and uncertainties.

A

cSEC SOP 94-6, Disclosure of Certain Significant Risks and Uncertainties, became effective on December 15, 1995. The focus of this article is on some issues raised in implementing SOP 94-6 and an analysis of some recent examples of disclosures made in conformity with the SOP that appeared in financial statements for the fiscal year ended December 31, 1995.

Implementation Issues Raised by SOP 94-6

Some aspects of SOP 94-6 have not caused any significant problems in implementation. For example, the first two requirements of the SOP, which deal with disclosures concerning the nature of the entity's operations and inclusion of a footnote discussing the use of estimates in the preparation of financial statements, have not been difficult to implement. Other aspects of the SOP have raised some challenging implementation issues.

New Definitions. SOP 94-6 introduced several new terms to the accounting literature. In addition, the SOP relied significantly on some terms previously defined by SFAS No. 5, Accounting for Contingencies. Because of the importance of these previously defined terms to understanding SOP 94-6, the definitions are repeated here.

Probable. The future event or events are likely to occur.

Reasonably Possible. The chance of the future event or events occurring is more than remote but less than likely.

Remote. The chance of the future event or events occurring is slight.

Although these definitions have been part of GAAP for over 20 years, there has been considerable discussion and debate concerning the precise meaning of these terms. The principal difficulty is a lack of agreement concerning boundaries between the terms remote, reasonably possible, and probable.

Figure 1 presents a conceptual understanding of these terms. These terms can be arranged on a line of subjective probability that ranges from zero to 100%. An event said to be remote would normally be assigned a probability of occurrence somewhere close to zero, whereas an event said to be probable would be assigned a probability of occurrence much greater than zero but something less than certain. Exactly where on the spectrum of subjective probabilities these terms lie is undefined in the accounting literature. Table 1 shows some of the variability in the subjective probabilities that have been found to exist through empirical research.

Because people have some experience in dealing with the meaning of these terms, the SOP does not actually increase the level of difficulty posed by making judgments of this nature, but merely extends the challenge to some new areas.

A more difficult problem is that SOP 94-6 introduced two new terms to the accounting literature. These new terms are as follows:

Near Term. A period of time not to exceed one year from the date of the financial statements.

Severe Impact. Used in reference to the vulnerability of the entity to certain concentrations. A severe impact is defined as a financially significant disruptive effect on the normal functioning of the entity. Severe impact is a higher threshold than material. Matters that are important enough to influence a user's decisions are deemed to be material, yet they may not be so significant as to disrupt the normal functioning of the entity. Some events are material to an investor because they might affect the price of an entity's capital stock or its debt securities, but they would not necessarily have a severe impact on, or disrupt, the enterprise itself. At the same time, an event could have a severe impact but be less than catastrophic. Events that are catastrophic are those that could destroy the entity financially, such as bankruptcy.

In essence, the SOP established a spectrum of judgments concerning materiality ranging from items that are immaterial through those that are material to those having a severe impact and finally to those that are catastrophic. In a manner similar to Figure 1, Figure 2 indicates there is a spectrum of subjective probabilities associated with the terms severe impact and catastrophic in relationship to the terms material and immaterial and these terms may be viewed as distributed along of line of subjective probability ranging from zero to 100%, depending on the decision maker's view of materiality. Since these terms have been recently introduced into the accounting literature, there has been no empirical research addressing the interpretation of these terms in relation to subjective probabilities. Preparers and auditors must therefore use professional judgment in deciding on their meaning.

The Nature of Operations

Although there have been relatively few implementation problems associated with the SOP 94-6 requirement for disclosure concerning the nature of an entity's operations, there have been some questions about the best way to disclose this information. In addition, there have been questions about the relationship between the disclosures required by SOP 94-6 and those of SFAS No. 14, Financial Reporting for Segments of a Business Enterprise. In issuing SOP 94-6, AcSEC felt financial statements should include a description of the major products or services a business sells or provides and its principal markets, including the locations of those markets. If a company operates in more than one business, the disclosure should also include the relative importance of its operations in each type of business and the basis for the determination--for example, assets, revenues, or earnings. SOP 94-6 indicates that disclosures concerning the nature of operations do not have to be quantified. The relative importance of the operations can be indicated through the use of terms such as predominately, about equally, major, and other. The use of terms such as these can result in differences of opinion regarding the precise meaning of these terms similar to that described previously in relation to the terms remote, reasonably possible, and probable. The required disclosures concerning nature of operations are similar to those required by SFAS No. 14 (see Table 2). SFAS No. 14 requires a public company to disclose the major types of products and services that generate revenues (i.e., the nature of its businesses) even if the company operates in only one industry segment. The required disclosures include a description of the types of goods or services provided, operating revenues, operating income or loss, net income or loss, net working capital, and total assets for each segment. Nonpublic entities are not required to disclose this type of
information.

Some critics of SOP 94-6 have expressed concern that the SOP conflicts with SFAS No. 21, Suspension of the Reporting of Earnings per Share and Segment Information by Nonpublic Enterprises. However, even though the information required to be disclosed by SOP 94-6 concerning the nature of operations duplicates in certain respects the information required to be reported under SFAS No. 14, it is different in other respects. Therefore, AcSEC did not believe SOP 94-6 conflicts with SFAS No. 21. AcSEC noted that, for public business enterprises, SOP 94-6 requires additional disclosures about the nature of their operations. The disclosures required by SOP 94-6 focus on a company's principal markets, including their locations. Segment information for business enterprises, in contrast, focuses on the nature of the segments' operations and their identifiable assets and the geographic location of assets outside the enterprise's home location. Disclosure of the locations of a business entity's principal markets provides information useful in assessing risks and uncertainties related to the environments in which it operates. The risks and uncertainties associated with selling products and services in various geographic regions may differ significantly. Knowing the environments in which an entity sells its products or provides services helps users of financial reports assess certain risks based on day-to-day national and world events. Table 2 compares the information required of public companies by SFAS No. 14 with paragraph 10 of SOP 94-6.

Certain Significant
Estimates

Various accounting pronouncements have previously required disclosures concerning risks and uncertainties. In particular, SFAS No. 5 requires disclosures concerning contingencies that exist at the date of the financial statements. In contrast, SOP 94-6 requires some new disclosures concerning estimates used in the determination of the carrying amounts of assets or liabilities and gain or loss contingencies. The SOP requires disclosure about estimates when both of the following criteria are met:

* It is at least reasonably possible that the estimate of the effect on the financial statements of a condition, situation, or set of circumstances that existed at the date of the financial statements will change in the near term due to one or more future confirming events.

* The effect of the change would be material to the financial statements.

The disclosure should state the nature of the uncertainty and include an indication that it is at least reasonably possible that a change in the estimate will occur in the near term. As discussed previously, the determination of whether a change in estimate is reasonably possible to occur is the most challenging aspect of implementing the SOP. The judgments of both preparers and auditors play a significant role in determining whether the occurrence of something is reasonably possible. It is likely that there will be differences of opinion regarding what constitutes a reasonable possibility.

If the estimate involves a loss contingency covered by SFAS Statement No. 5, the disclosure should also include an estimate of the possible loss or range of loss, or state that such an estimate cannot be made. Disclosure of the factors that cause the estimate to be sensitive to change is encouraged by the SOP but is not required. SOP 94-6's disclosure requirements are separate from and do not change the disclosure requirements of SFAS No. 5. The
disclosures required by SOP 94-6
supplement the disclosures required
under SFAS No. 5 in the following ways:

* If an estimate (including estimates that involve contingencies being covered by SFAS No. 5) meets the criteria for disclosure under SOP 94-6, the SOP requires disclosure that it is at least reasonably possible that a change in the estimate will occur in the near term. SFAS No. 5 does not distinguish between near-term and long-term contingencies.

* An estimate that does not involve a contingency covered by SFAS No. 5, such as estimates associated with long-term operating assets and amounts reported under profitable long-term contracts, may meet the disclosure criteria of SOP 94-6.

Whether an estimate meets the criteria for disclosure under SOP 94-6 does not depend on the amount reported in the financial statements, but rather on the materiality of the effect that using a different estimate would have on the financial statements. Simply because an estimate resulted in the recognition of an immaterial financial statement amount, or no amount, does not mean disclosure is not required under SOP 94-6.

Vulnerability Due to Concentrations

Vulnerability from concentrations arises because an entity is exposed to risk of loss greater than it would have had if it had mitigated its risk through diversification. These types of risks manifest themselves differently, depending on the nature of the concentration. Financial statements should disclose the concentrations described below if, based on information known to management prior to issuance of the financial statements, all of the following criteria are met:

* The concentration exists at the date of the financial statements.

* The concentration makes the enterprise vulnerable to the risk of a near term severe impact.

* It is at least reasonably possible that the events that could cause the severe impact will occur in the near term.

Examples of SOP 94-6 Disclosures

General Motors. The first example of SOP 94-6 disclosure is from the financial statements of General Motors (GM) for the year ended December 31, 1995. In these statements, GM made no specific reference to SOP 94-6. There were, however, a number of instances in the financial statements where it appears that the disclosures required by the SOP were being implemented. Exhibit 1 contains extracts from the notes to the financial statements of GM for the year ended December 31, 1995. Certain passages from these extracts have been highlighted in bold. The first instance where the disclosures required by SOP 94-6 appear to be included in the financial statements of GM occurs in Note 1 under the caption: USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS. In this case, the recommended wording of the SOP was adopted virtually verbatim.

The second instance where SOP 94-6 disclosure occurs in the GM financial statements is also contained in Note 1 under the caption: ENVIRONMENTAL LIABILITIES. This disclosure conforms to the requirement of the SOP dealing with the disclosure of certain significant estimates when it is reasonably possible that those estimates could change in the near term and the effect of the change in estimate would be material to the financial statements. In this case, the reader is put on notice that the estimates used in the measurement of environmental liabilities may be subject to change and the effect would be material to the financial statements. This disclosure is a bit ambiguous in that it is not clear whether the management of GM believes it is reasonably possible the estimates could change in the near term. However, the SOP does not specifically require the words reasonably possible be used when making this type of disclosure.

The third type of SOP 94-6 disclosure occurs again in Note 1 under the caption: LABOR FORCE. In this case it appears this disclosure is intended to conform to the requirement of the SOP regarding disclosure about concentrations in labor supply. The disclosure provides information about the percentage of the labor force covered by a collective bargaining agreement and the percentage of the labor force covered by a collective bargaining agreement that will expire within one year.

The next instance of conformity with the requirements of SOP 94-6 occurs in Note 6: UNITED STATES, FOREIGN, AND OTHER INCOME TAXES--DEFERRED AND PAYABLE. This note discusses the realizability of deferred tax assets and indicates that the amount of the deferred tax asset realized could change in a material manner in the near term if the estimated amount of future income is not realized. This type of disclosure conforms to the requirements of the SOP regarding disclosure of certain significant estimates.

The next instance of conformity with the SOP occurs in Note 16: COMMITMENTS AND CONTINGENCIES. This disclosure conforms to the SOP because it discloses the existence of a gain contingency. Prior to SOP 94-6, this
type of disclosure would not
necessarily have been made under
the provisions of SFAS No. 5.

The final example of conformity with the requirements of the SOP occurs in Note 21 under the caption: INDUSTRY SEGMENTS. This disclosure deals with the nature of GM's operations. It might be expected this disclosure would be placed toward the beginning of the notes. It may have been felt, however, this type of disclosure could be combined more efficiently with the segment disclosure required by SFAS No. 14. The difference between the disclosures required by SFAS No. 14 and the disclosure contained in Note 21 lies principally in the greater degree of disclosure concerning the types of industries and lines of business in which GM operates rather than merely disclosing the business segments as defined by SFAS No. 14. In addition, there is some disclosure concerning the location of the markets in which GM operates. Given the worldwide nature
of GM's operations, however, this
disclosure is not very detailed or specific.

Coca Cola Bottling Company. In a manner similar to GM, the financial statements of Coca Cola Bottling Company (Coca Cola Bottling) for the year ended December 31, 1995 do not mention SOP 94-6. The implementation of the SOP in the financial statements of Coca Cola Bottling was handled differently from GM (see Exhibit 2). Apparently, Coca Cola Bottling management decided to include the new disclosures in one footnote rather than attempting to address the various aspects of the SOP throughout the notes. Note 15 addresses two of the four areas of disclosure required by SOP 94-6 (i.e., the use of estimates by management, and the existence of concentrations). The lack of disclosure concerning the two other areas of the SOP may be because management of Coca Cola Bottling believed there were no circumstances in which there were estimates made by management that might have a reasonable possibility of changing in the near term that would be material to the financial statements.

Implications of SOP 94-6

For many companies, the disclosures required by SOP 94-6 do not require significant amounts of additional preparation time because similar types of disclosures have been required by certain SFAS and SEC pronouncements for some time. Nevertheless, preparers and auditors should make sure the required disclosures of SOP 94-6 are properly made. Exhibit 3 contains a checklist that can be used by auditors and preparers to evaluate compliance with SOP 94-6. For auditors of public companies, the disclosures required by the SOP may necessitate some revisions to audit programs, particularly in the area of auditing for the use of estimates and the assessment of vulnerability due to concentrations. In some cases, the SOP 94-6 disclosures have caused the information to move from the area of supplemental disclosure outside of the audited financial statements to footnote disclosure within the audited financial statements.

Nonpublic companies and not-for-profit organizations may need to develop new accounting procedures to accumulate the information necessary to meet the disclosure requirements of SOP 94-6. Auditors and accounting advisors of nonpublic companies and not-for-profit organizations may have an opportunity to assist their clients to meet the disclosure requirements of the SOP. In evaluating the auditor's responsibilities with respect to SOP 94-6, particular attention should be paid to SAS No. 57, Auditing Accounting Estimates. *

C. Richard Baker, PhD, CPA, is an associate professor at the College of
Business and Industry, University of
Massachusetts, Dartmouth.

FIGURE 1

SPECTRUM OF PROBABILITY OF AN EVENT OCCURRING

Remote Reasonably Possible Probable Certain

FIGURE 2

RANGE FROM IMMATERIAL TO CATASTROPHIC

TABLE 1

RANGE OF SUBJECTIVE PROBABILITIES OF AN EVENT OCCURRING

TABLE 2

COMPARISON OF DISCLOSURE REQUIREMENTS:

SFAS NO. 14 (SEGMENT REPORTING) VERSUS SOP 94-6

EXHIBIT 1

GENERAL MOTORS CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(FOR THE YEAR ENDED DECEMBER 31, 1995)

NOTE 1. SIGNIFICANT ACCOUNTING POLICIES

Use of Estimates in the Preparation of the Financial Statements

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect amounts reported therein. Due to the inherent uncertainty involved in making estimates, actual results reported in future periods may be based upon amounts which differ from those estimates.

Environmental Liabilities

General Motors recognizes environmental liabilities when a loss is probable and can be reasonably estimated. Such liabilities are generally not subject to insurance coverage. General Motors' estimates for environmental obligations are dependent primarily on the nature and extent of historical information and physical data relating to a contaminated site, the complexity of the site, uncertainty as to what remedy and technology will be required, the outcome of discussions with regulatory agencies and other PRPs at multiparty sites, the number and financial viability of other PRPs, and the timing of expenditures; accordingly, such estimates could change materially as General Motors periodically evaluates and revises such estimates based on expenditures against established reserves and the availability of additional information.

Labor Force

General Motors, on a worldwide basis, has a concentration of labor supply in employees working under union collective bargaining agreements, which represent approximately 86% of its hourly workforce and 8% of its salaried workforce. Of these represented employees, 86% of hourly and 37% of salaried employees are working under agreements that will expire in 1996.

NOTE 6. UNITED STATES, FOREIGN, AND OTHER INCOME TAXES--DEFERRED AND PAYABLE

Realization of the net deferred tax assets is dependent on future reversals of existing taxable temporary differences and future taxable income exclusive of reversing temporary differences and carryforwards. Although realization is not assured, management believes that it is more likely than not that the net deferred tax assets will be realized. The amount of the net deferred tax assets considered realizable, however, could be reduced in the near term if actual future taxable income is lower than estimated, or if there are differences in the timing or amount of future reversals of existing taxable temporary differences. The valuation allowance increased by $153.8 million and $46.8 million in 1995 and 1994, respectively. Annual tax provisions include amounts considered sufficient to pay assessments that may result from examination of prior year tax returns; however, the amount ultimately paid upon resolution of issues raised may differ materially from the amount accrued.

NOTE 16. COMMITMENTS AND CONTINGENT
LIABILITIES

In 1973, Hughes Aircraft Company filed a lawsuit against the U.S. Government in the U.S. Court of Claims for infringement of a patent utilized in the design of satellites ("the Williams Patent"). In late 1983, the U.S. Court of Appeals ruled that the patent was valid and that the government had infringed the patent. In June 1994, the U.S. Court of Claims issued a decision awarding Hughes damages of $114 million. Both parties to the lawsuit have appealed the judgment, with Hughes asserting that the award did not adequately compensate it for damages suffered. In the opinion of the management of Hughes, there is a reasonable possibility that this matter could be resolved in the near term. While no amount has been recorded in Hughes' financial statements pending the outcome of the case, resolution could result in a gain that would be material to the earnings of General Motors attributable to Class H common stock.

NOTE 21. SEGMENT REPORTING

While the major portion of General Motors' operations is derived from the automotive products industry segment, General Motors also has financing and insurance and information technology industry segments, and produces products and provides services in other industry segments. The automotive products segment consists of the design, manufacture, assembly, and sale of automobiles, trucks, and related parts and accessories. The financing and insurance operations assist in the merchandising of General Motors' products as well as other products. GMAC offers financial services and certain types of insurance to dealers and customers. In addition, GMAC is engaged in mortgage banking and investment services. The information technology operations relate to the design, installation, and operation of business information systems. The other products segment consists of military vehicles, radar and weapon control systems, guided missile systems, and defense and commercial satellites; the design, installation, and operation of telecommunication systems; as well as the design, development, and manufacture of locomotives. Because of the high degree of integration, substantial interdivisional and intersegment transfers of materials and services are made. Intersegment sales and revenues are made at negotiated selling prices. Substantially all of the products in the automotive segment are marketed through retail dealers and through distributors and jobbers in the United States, Canada, and Mexico, and through distributors and dealers overseas.

EXHIBIT 2

COCA-COLA BOTTLING CO. CONSOLIDATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(FOR THE YEAR ENDED DECEMBER 31, 1995)

15. RISKS AND UNCERTAINTIES

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Approximately 90% of the Company's sales are products of The Coca-Cola Company, which is the sole supplier of the concentrate required to manufacture these products. Additionally, the Company purchases virtually all of its requirements for sweetener from The Coca-Cola Company.

The Company currently obtains all of its aluminum cans from two domestic suppliers. The Company currently obtains all of its PET bottles from two domestic cooperatives. The inability of either of these aluminum can or PET bottle suppliers to meet the Company's requirement for containers could result in short-term shortages until alternative sources of supply could be located.

Less than 10% of the Company's labor force is currently covered by collective bargaining agreements. There are no material collective bargaining contracts expiring during 1996.