Disclosures of risks, uncertainties and financial flexibility - solid ground or quicksand?by Weiss, Judith Fellner
For many years, regulators and standard setters have called for more and improved disclosures to help users of financial reporting make better informed investment and credit decisions. In response, the AICPA's Accounting Standards Executive Committee (AcSEC) recently exposed a proposed Statement of Position (SOP), Disclosure of Certain Significant Risks and Uncertainties and Financial Flexibility. This proposal would require all public and private business enterprises as well as not-for-profit organizations and state and local governments to disclose in their financial statements information about certain risks and uncertainties beyond what is now required or generally included. It would be effective for financial statements issued for fiscal years ending after December 15, 1994, and for financial statements for interim periods in fiscal years subsequent to the year for which the SOP is first applied. Early application would be encouraged but not required.
The SOP would not change any requirements for recognition, measurement, or classification of assets and liabilities in the financial statements. Proponents of the proposed disclosures believe they will provide an early warning system to alert financial statement users to the possibility that an enterprise is in danger of failing or suffering severe financial setbacks. On the other hand, opponents believe the proposed requirements are onerous for preparers and those that attest to financial statements and are not cost justified. Because several of the conclusions are highly controversial, four of AcSEC's fifteen members opposed exposing the SOP. This discussion of the proposed requirements and some of the surrounding controversy is intended to help interested parties understand the issues and determine whether there is a need for such information.
An early step towards requiring disclosure of information about risks and uncertainties was taken by the SEC in 1974. This led to the current requirement for public companies to include certain information related to liquidity, capital resources, and results of operations, as well as management's analysis of trends and other factors, in Management's Discussion and Analysis (MD&A). However, such information is reported outside the basic financial statements in annual reports filed with the SEC and is not covered by the auditor's report.
The AICPA established the Task Force on Risks and Uncertainties in 1985 to consider ways to meet the need for improved disclosure. In 1987, the task force issued a report intended to help standard setters and others identify practical methods of improving the information communicated to users of financial statements and assess risks and uncertainties.
Today's volatile business and economic environment has increased the risks and uncertainties faced by enterprises and has spurred new interest in expanding disclosure requirements. In 1991, AcSEC added a project to its agenda to issue an SOP based on the task force's recommendations. While the proposed SOP expands the applicability of the task force's recommendations to governmental entities and not-for-profit organizations and requires additional disclosures such as information about financial flexibility, its conclusions and central theme resemble those of the 1987 task force report. Both documents focus on selectivity; they specify criteria to limit disclosures of risks and uncertainties to those that would significantly affect the particular entity.
The proposed SOP separates the required disclosures into five types of information: the nature of operations, use of estimates in the preparation of financial statements, certain significant estimates, current vulnerability due to concentrations, and financial flexibility. Because they are not mutually exclusive, the disclosures may be combined in various ways, presented in diverse parts of the notes to the financial statements, or incorporated with disclosures required by other pronouncements.
The proposed disclosures would not encompass risks and uncertainties associated with management or key personnel, proposed changes in government regulations and accounting principles, or deficiencies in the internal control structure over financial reporting. Also excluded are acts of God, war, sudden catastrophes, and losses from uninsured risks caused by damages occurring after the date of the financial statements.
Certain terms are defined specifically for use in the proposed SOP; others are used as defined elsewhere in the accounting literature. For instance, reasonably possible is used the same as in SFAS No. 5, Accounting for Contingencies, to mean the chance an event will occur is more than remote but less than likely. The following terms are defined in the proposed SOP:
* Concentration. Includes group concentrations related to a number of counterparties or items that have similar economic characteristics, and, collectively, expose the reporting entity to a particular kind of risk.
* Financial flexibility. The ability to take action that will eliminate an excess of required and expected cash payments over expected resources.
* Near term. A period of time not to exceed one year from the date of the financial statements.
* Severe impact. A significant financially disruptive effect on the normal functioning of the entity. 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 (disrupt) the enterprise itself. The concept of severe impact, however, includes matters that are less than catastrophic.
The Nature of Operations
The proposed SOP would require entities to describe their major products or services and principal markets along with the locations of those principal markets. Enterprises operating in more than one industry would be required to describe the relative importance of their operations in each industry and the basis for the determination (e.g., assets, revenues, or earnings). The disclosures would not need to be quantified; relative importance could be conveyed by using terms such as "predominately," "about equally," or "major and other." It is anticipated that such disclosures about the nature of operations would provide users unfamiliar with an enterprise's operations with information they need to identify the broad risks and uncertainties faced by all enterprises operating in a specific industry or market. The following illustrates such a disclosure:
The Company has one factory in North Carolina and another in New York manufacturing textiles sold throughout the United States, primarily to clothing manufacturers.
The Use of Estimates in Preparing
The notes to the financial statements would be required to include an explanation that management uses estimates to prepare financial statements in conformity with GAAP. The purpose of this disclosure would be to emphasize the inherent limitations on the precision of amounts reported in the financial statements. The following illustrates such a disclosure:
Financial statements prepared in conformity with generally accepted accounting principles require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Actual results could differ from those estimates.
Certain Significant Estimates
This disclosure would require a discussion of the potential near-term effects of using change-sensitive estimates to measure assets or liabilities and gain or loss contingencies. Disclosure would be required when it is reasonably possible that 1) the estimate will change in the near term and 2) the effect of the change would be material to the financial statements. The disclosure would be based on information available before the financial statements are issued and "of which management is reasonably expected to have knowledge." Materiality in this disclosure does not depend on the amount reported or disclosed in the financial statements, but rather on the significance of the effect that using a different estimate would have on the financial statements.
Although entities would be required to describe the potential near- term effects on the financial statements, they would not be required to disclose quantitative information about significant estimates beyond the requirements of SFAS No. 5. The proposed SOP encourages, but does not require, disclosure of the factors that cause the estimate to be change sensitive.
The following are examples of assets, liabilities, related revenues and expenses, and gain or loss contingencies that may be based on change-sensitive estimates:
* Inventory subject to rapid technological obsolescence,
* Specialized equipment subject to technological obsolescence,
* Goodwill and other intangible assets,
* Deferred tax assets based on significant future income,
* Long-term investments,
* Capitalized motion picture film, production costs,
* Environmental-related liabilities,
* Litigation-related liabilities,
* Contingent liabilities related to loan guaranties,
* Provisions for discontinued operations and restructurings, and
* Amounts reported for long-term contracts.
The following illustrates this disclosure:
At December 31, 1992, the Company has inventories of $6 million in excess of its current operating requirements. Management has developed a program to reduce the quantities to desired levels over the near term and believes no loss will be incurred on its disposition. The Company's ability to recover the cost of the inventories depends, however, on the success of the program. No estimate can be made of the range of losses that are reasonably possible.
Current Vulnerability Due to
Disclosure would be required of concentrations existing at the balance sheet date that make the enterprise vulnerable to the risk of a near- term severe impact when it is at least reasonably possible that the events that could cause the impact will occur. Such concentrations may relate to assets or liabilities, or to commitments and contingencies not requiring recognition under GAAP. They may also relate to the nature of an entity's operations or operating needs. The proposal applies only to concentrations relating to current operations and would not require disclosure of future concentrations.
The following, although not all inclusive, is a list of areas in which a current concentration might make an entity vulnerable to a risk that would need to be disclosed:
* Concentrations of products, suppliers, or customers;
* Exposure to interest rate or foreign exchange rate fluctuations;
* Dependence on patent protection; and
* Assets subject to expropriation.
An illustration of the required disclosure follows:
The Company is a pharmaceutical manufacturer with sales throughout the United States. The patent on Drug X, one of its major products, expires next year. Drug X accounts for 35% of the Company's revenues and a higher percentage of its gross profit. Competition from generic Drug X is likely to lower selling prices over time. However, management believes that consumer trends and brand-name recognition are good indicators of future sales growth and profit.
Management would be required to discuss its expected course of action when it is determined it is at least reasonably possible the entity will not have the ability in the near term to pay its expected cash outflows without taking certain actions such as entering into credit agreements, modifying or renewing existing credit agreements, or liquidating assets. The disclosure would be required regardless of any disclosure made if there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time.
An illustrative disclosure follows:
During 1991 and 1992, substantially all of the Company's cash flows from operations were used to service the company's debt. Management expects this situation to continue in 1993. However, if cash flows from operations were to fall below debt service requirements, the Company would have to take actions such as postponing purchases of inventories, attempting to restructure its debt, and if necessary, selling certain segments of its business to raise cash.
Basis for Support
FASB Statement of Financial Accounting Concepts No. 1, Objectives of Financial Reporting by Business Enterprises, states that financial reporting should provide useful information to present and potential investors and creditors and other users. Such information would enable users to make rational investment, credit, and similar decisions, and to assess the amounts, timing, and uncertainty of prospective net cash inflows. In addition, financial reporting should provide information about the economic resources of an enterprise, the claims to its resources and the effects of transactions, events, and circumstances that change those resources or claims. Those who support the general thrust of the SOP argue the expanded disclosures about significant risks and uncertainties are needed to more fully meet those objectives in the current volatile business environment.
The first two requirements are the least controversial. Proponents of the first disclosure, which deals with the nature of operations, believe users who are unfamiliar with an entity's operations need the information to generally identify risks associated with a company's industry and markets and to compare information about entities in the same industry. They note that SFAS No. 14, Financial Reporting for Segments of a Business Enterprise, already requires publicly-held entities to disclose certain information about the nature of their operations. They further argue that it would not be financially burdensome for entities, particularly those that are publicly held, to gather that information, because it is readily available and need not be quantified.
The second disclosure is the least controversial of all the requirements. It puts users on notice that management uses estimates to prepare financial statements. Although the auditor's report already states that financial statements are based on estimates, supporters of the proposed SOP believe it is necessary to reinforce the notion that the financial statements of all entities may include some uncertainties.
The third and fourth requirements are likely to create much debate, because AcSEC is clearly breaking new ground in financial reporting. In the third requirement, which relates to certain significant estimates, disclosure is triggered based on an estimate's sensitivity to change rather than on its dollar amount. Supporters believe that financial statement users will benefit from being put on notice that certain amounts are sensitive to change and that change in those amounts could materially affect future financial results, rather than just the relative size of the amounts.
The fourth requirement deals with vulnerability due to concentrations using severe impact as a new measurement concept. This concept involves a higher threshold than materiality as generally understood, but lower than what the proposed SOP refers to as "catastrophic." Proponents think this additional benchmark or guideline for disclosure will provide financial statement users with more information about significant liquidity risks at a level that will not clutter up the statements and can be developed at a reasonable cost.
While the fifth requirement is also controversial, some believe users of financial statements need to know whether an entity has financial flexibility when it is reasonably possible that such flexibility will be required in the near term. In recent years, a lack of financial flexibility has caused some entities to take drastic actions not in the normal course of business. In many cases, it was not apparent to financial statement users the entity might take such actions.
AcSEC's Minority View
The proposed SOP has created much controversy even before exposure. Four AcSEC members dissented from the issuance of the proposed SOP for the following reasons.
Expanded Responsibilities Are Too Burdensome. The dissenters believe the SOP's requirement for financial statement preparers to disclose "information of which management is reasonably expected to have knowledge" would expand the responsibilities of financial statement preparers and would be too burdensome for all entities. They are particularly concerned about small and mid-sized entities that are privately-owned and not subject to the SEC's MD&A requirements. They argue the proposed SOP goes beyond those requirements, which are based on known trends, commitments, or events and information "available to the registrant without undue effort or expense...," while the scope of the requirements in the proposed SOP is unlimited. Moreover, because the proposed disclosures, unlike the MD&A requirements, would be included in the basic financial statements, independent accountants' responsibility for the information would also be increased.
Reasonably Possible Goes Beyond Substantial Doubt. The proposed SOP requires disclosure of reasonably possible events that might affect the financial statements even if there are no concerns about an entity's ability to continue as a going concern. SAS No. 59, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern, however, limits the auditor's responsibility to determining "whether there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time," and to considering mitigating factors.
Expansion of SFAS No 105 Requirements Are Premature. The proposed requirements would exceed those in SFAS No. 105, Disclosure of Information about Financial Instruments with Off-Balance Sheet Risk and Financial Instruments with Concentrations of Credit Risk. The minority believes expanding SFAS No. 105's requirements before its effectiveness can be measured is unwarranted.
No Objective Basis For Developing Reliable Information. The dissenters are concerned that the scope of the requirement to disclose all risks and uncertainties of which "management is reasonably expected to have knowledge" is so broad and subjective it will result in subsequent challenges based on hindsight. Consequently, preparers and their independent accountants could encounter additional risks and increased costs. The dissenters also believe the requirements will encourage users to have unrealistic expectations about the completeness of the disclosures although preparers and their independent accountants will actually be unable to ascertain whether all risks and uncertainties are known and have been disclosed.
Particularly Burdensome to Non-public Entities. Proponents of the minority view believe nonpublic entities and their independent accountants would be most burdened by the required disclosures about an entity's financial flexibility, significant estimates, and vulnerability to concentrations. They also argue the disclosures are unnecessary because users of the financial statements of such entities have always been able to receive such information on request.
In their opinion, a significant number of entities, such as privately- owned entities and not-for-profit organizations, which generally have limited resources, would have to perform additional procedures and incur costs that exceed the benefits of the information disclosed. Because of the low threshold of the reasonably possible criterion, such entities might have to prepare cash-flow projections specifically for the purpose of disclosing information about financial flexibility.
Other Opposing Views
Others have raised additional concerns about the proposed disclosures. Some believe the five disclosure requirements will result in increased risks for reporting entities and their accountants without providing users with equivalent benefits. In addition, some argue that the need for the information has not been demonstrated, and they are unaware of users' requests to include such information in the financial statements. After all, they argue, public companies are already providing most of that information in MD&A, and, as noted earlier, users of the financial statements of non-public companies, such as investors and creditors, have always had access to such information on request. They note the requirement to disclose information about the nature of operations extends the disclosures about an entity's major products or services, principal markets and locations to entities exempted by SFAS No. 21, Suspension of the Reporting of Earnings per Share and Segment Information by Nonpublic Enterprises, as well as to not-for-profit organizations and governmental entities. Although the proposed SOP does not require quantitative information, they believe gathering data based on the criterion of "relative importance" would not simplify the task.
Some are concerned that all the disclosures, except for the second requirement, would reveal competitive information about an entity. For example, the first disclosure would discuss an entity's plans for market expansion and product diversification, and information about its market share in foreign countries. They argue that the third disclosure concerning certain significant estimates would provide competitors with critical information about an entity's weaknesses that would be more useful to them than to users who could obtain the information in other ways. They believe the fourth disclosure dealing with an entity's current vulnerability due to concentrations can only have similar adverse effects.
Opponents of requiring disclosures about certain significant estimates argue that SFAS No. 5 already requires disclosure of information about an entity's risks and uncertainties. They question the need for expanding those requirements, because they believe there is no need for additional information and the requirements of the proposed SOP focus on projected information rather than historical information.
Others observe that financial statements that include the proposed disclosures would make them look like a "red herring," which is intended to warn potential investors about all possible risks and uncertainties associated with an entity. They suggest creditors and investors in nonpublic entities should do their own due diligence and should not depend solely on the information provided in financial statements.
Another view is that AcSEC should not have undertaken this project in the first place. The proposed disclosure requirements are broad based and would apply to financial statements of virtually all entities. Proponents of this view believe that FASB and GASB, as independent bodies with extensive due process, were established to set broad-based accounting principles, while AcSEC deals with more narrow, industry specific issues.
Time to Respond
Because of the controversial aspects of the proposed SOP, we encourage the AICPA to publicize the exposure draft in a manner that will reach as many preparers, practitioners and other interested parties as possible. We also encourage the AICPA to hold public hearings and field test the requirements.
Practitioners and preparers should obtain copies of the exposure draft from the AICPA and review its implications. Important considerations include the costs of implementation, the implications of required disclosures on preparers' and independent accountants' exposure to litigation, and the ability to ascertain the completeness of the information. AcSEC specifically asks respondents to comment on, among other things, 1) whether some reporting entities should be excluded from the scope of the SOP or from certain of its disclosure requirements and 2) what criteria might be used for exclusion. In addition, AcSEC asks respondents who believe the proposed disclosures are not relevant to the users of some entities' financial statements to provide the reasons for their views.
We share the concerns the minority of AcSEC and others have expressed about the proposed SOP. Although we believe conceptually that the proposed disclosures would be useful to those making investment and credit decisions, we are particularly troubled about the added costs and risks to which preparers and accountants would be exposed in our current litigious environment. Therefore, it is imperative for preparers, practitioners, and other interested parties to express their positive or negative views on the proposal during the exposure process.
Reva B. Steinberg, CPA, is Director of Accounting Research for Ten Eyck Associates, Inc., a consulting and litigation support firm. Ms. Steinberg recently completed a thee year term as a member of AcSEC and currently serves on the AICPA Technical Standards Subcommittee.
Judith Fellner Weiss, CPA, is a senior manager in Grant Thornton's national office in New York. Ms Weiss is a member of the AICPA'S Task Force on Common Interest Realty Associations and the NYSSCPA'S Real Estate Accounting Committee.
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