While some controversial disclosures contained in the exposure draft have been removed, the new SOP requires financial statements to include additional information about an entity's operations and the risks and uncertainties that may affect its operating results. The authors explain the new requirements and provide some guidance on its application.

In December 1994, the AICPA's Accounting Standards Executive Committee (AcSEC) issued Statement of Position 94-6 (SOP), Disclosure of Certain Significant Risks and Uncertainties, in response to increased demand for improved disclosures by reporting entities. The final pronouncement comes after months of deliberation and consideration of more than 300 letters of comment on AcSEC's exposure draft, Disclosure of Certain Significant Risks and Uncertainties and Financial Flexibility. Although the final requirements are less onerous than those in the proposal - disclosure of financial flexibility is no longer required - the SOP nevertheless requires entities to disclose information about certain risks and uncertainties beyond what is now required or generally included in financial statements. The requirements are effective for financial statements issued for fiscal years ending after December 15, 1995, and for financial statements for interim periods in fiscal years following the year for which the SOP is first applied. Although early application is encouraged, it is not required.

The SOP does not change current requirements for recognition, measurement, or classification of assets and liabilities in the financial statements. AcSEC believes, however, that the SOP's expanded disclosure requirements will give financial statement users an early warning that an entity may be in danger of failing or suffering severe financial setbacks.

Scope

The SOP applies to all public and private business entities and not-for- profit organizations that issue financial statements prepared in accordance with GAAP. Although some commentators asked AcSEC to clarify whether the SOP's requirements apply to financial statements prepared using an other comprehensive basis of accounting (OCBOA), AcSEC decided the issue of the applicability of GAAP disclosures to OCBOA financial statements is beyond the scope of the SOP.

SOP 94-6 does not apply to state and local governments. It applies to complete interim financial statements, but not to summarized financial information presented in conformity with the guidance in APB Opinion No. 28, Interim Financial Reporting. If comparative financial statements are presented; the required disclosures need only be presented for the most recent fiscal period.

Required Disclosures

In many ways, the SOP's disclosure requirements are similar to, or overlap, the disclosure requirements of certain statements of financial accounting standards (e.g., SFAS No. 5, Accounting for Contingencies, and SFAS No. 14, Financial Reporting for Segments of a Business Enterprise). They may also overlap the disclosure requirements of certain SEC rules. The SOP does not, however, change the requirements of FASB or SEC pronouncements.

Disclosure of four types of information is required: the nature of operations, use of estimates in the preparation of financial statements, certain significant estimates, and current vulnerability due to concentrations. The first two disclosures. are always required. The other two are only required if certain conditions arise. Because the disclosures are not mutually exclusive and may overlap, entities are permitted to choose their own methods of presentation. Also, to allow for additional flexibility, the disclosures may be combined in various ways, presented in different parts of the notes to the financial statements, or incorporated with disclosures required by other pronouncements.

The central theme of the new rule is "selectivity." The SOP concentrates on risks and uncertainties that could significantly affect amounts reported in the financial statements in the near term or affect a reporting entity's near-term operating capability. It specifies criteria that limit the required disclosures to matters significant to the entity issuing the financial statements, rather than requiring disclosure of the multitude of risks and uncertainties that may affect every entity.

The requirements do not apply to 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. Nor do they include acts of God, war, or sudden catastrophes.

Defined Terms

Certain terms are defined specifically for use in the SOP; others are used as defined elsewhere in the accounting literature. For example, "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 SOP:

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

Severe impact (used in reference to current vulnerability due to certain concentrations). A significant financially disruptive effect on the normal functioning of the entity. Matters 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 includes matters that are less than catastrophic.

The Nature of Operations

SFAS No. 14, Financial Reporting for Segments of a Business Enterprise, which requires disclosure about an entity's major types of products and services that produce revenues, applies only to publicly held business entities. Therefore, users of a closely held entity's financial statements sometimes cannot determine the nature of its operations from information presented in financial statements. Under SOP 94-6, however, all entities are required to describe their major products or services and principal markets along with the locations of those principal markets. Entities operating in more than one business are required to describe the relative importance of their operations in each business and how that was determined (e.g., based on assets, revenues, or earnings). A not-for-profit organization should briefly describe the principal services it provides and the sources of its revenues. Although the disclosures need not be quantified, relative importance can be conveyed by such terms as "predominately," "about equally," or "major and other." AcSEC believes such disclosures about the nature of operations will provide users unfamiliar with an entity's operations with information they need to identify the broad risks and uncertainties faced by all entities operating in a specific industry or market.

Illustrations of such disclosure follow:

* The Company has one factory in North Carolina and another in New York that produce textiles sold throughout the United States, primarily to clothing manufacturers.

* XYZ Company is a diversified, global corporation. It operates in three principal business arenas, consumer products, defense electronics, and financial services, all of which are about equal in size based on revenues. Industrial concerns in the Far East are the principal market for the Company's consumer products. Defense electronics are sold primarily to U.S. government agencies and to U.S. allies. XYZ's financial services consist of lending and leasing activities throughout the Eastern United States.

* South County Home Health Services is a not-for-profit organization that provides free home nursing care to disabled individuals with an income of less than $10,000 per year. The organization's revenues are derived from an endowment, contributions made by individuals, and state and Federal grants.

The Use of Estimates in Preparing Financial Statements

The notes to financial statements should explain that management uses estimates to prepare financial statements. The purpose of this disclosure is to put users on notice that reported amounts may not be precise and sometimes may be based on future events. For example, to establish an allowance for doubtful accounts, management must estimate the amount of receivables that eventually will not be collected. The following illustrates such a disclosure:

In preparing financial statements in conformity with GAAP, management is required 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

Under the requirements of SOP 94-6, entities must discuss the potential near-term effects of using change-sensitive estimates to measure assets or liabilities and the amounts of gain or loss contingencies. Disclosure is required when information known to management before issuing the financial statements meets the following criteria: 1) it is at least reasonably possible that management's estimate of the effect of a condition, situation, or circumstances existing at the date of the financial statements will change in the near term as a result of one or more future confirming events and 2) the effect of the change would be material to the financial statements. The decision whether the information meets the criteria for disclosure depends on how significantly the financial statements will be affected by using a different estimate, rather than on the magnitude of the amount reported or disclosed in the financial statements.

The disclosure should state the nature of the uncertainty and that it is at least reasonably possible that a change in the estimate will occur in the near term. Disclosures of loss contingencies covered by SFAS No. 5 should also include an estimate of the possible loss, a range of loss, or a statement that an amount cannot be estimated. In addition, AcSEC encourages, but does not require entities to disclose the factors that cause such estimates to be change-sensitive.

Some risks and uncertainties may not meet the criteria for disclosure because the entity has reduced its risk of loss or the uncertainty that may result from future events by using techniques such as hedging. AcSEC encourages those entities to disclose information about their risk reduction techniques and information about the related risks that would otherwise be required under the SOP.

Although the SOP's requirements supplement the disclosure requirements of SFAS No. 5, they do not change them. Specifically, SFAS No. 5 does not distinguish between near-term and long-term contingencies and excludes estimates that do not involve contingencies. This SOP, however, specifically calls for disclosure of information about changes in estimates of near-term contingencies that meet the SOP's criteria for disclosure. That disclosure is also required for changes in estimates not involving contingencies, such as the carrying amounts of long-term operating assets or amounts reported under profitable long-term contracts, if they meet the two criteria.

The SOP includes the following 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,

* Valuation allowances for deferred tax assets based on future taxable income,

* Capitalized motion picture film production costs,

* Capitalized computer software costs,

* Deferred policy acquisition costs of insurance enterprises,

* Valuation allowances for commercial or real estate loans,

* Environmental remediation-related obligations,

* Litigation-related liabilities,

* Contingent liabilities for obligations of other entities,

* Amounts reported for long-term obligations, such as amounts reported for pensions and postemployment benefits,

* Estimated net proceeds recoverable, the provisions for expected loss incurred, or both, on disposition of a business or assets, and

* Amounts reported for long-term contracts.

The SOP also provides the following list of events or changes in circumstances that indicate the estimated carrying amount of a long- lived asset may be especially sensitive to changes in the near term. It is based on a list in the FASB's exposure draft, Accounting for the Impairment of Long-Lived Assets:

* A significant decrease in the market value of an asset,

* A significant change in the extent or manner in which an asset is used,

* A significant adverse change in legal factors or in the business climate that affects the value of an asset,

* An accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset, and

* A history of losses associated with an asset, a projection, or forecast, if available, demonstrating continuing losses associated with an asset, or both.

The following illustrate disclosure on the use of estimates:

* The Company operates in an industry characterized by the continuous introduction of new products, rapid technological advances, and product obsolescence. Inventory of models X and Y with a book value of $4,000,000 are particularly sensitive to technological obsolescence in the near term. The Company has developed a program to reduce quantities of models X and Y, but its ability to recover the cost of the inventories depends on the success of the program. No estimate can be made of the range of losses that are reasonably possible.

* South County Home Health Services received $300,000 under a grant from the Federal government. During 19X5, the grantor questioned $50,000 of the costs charged against the grant. It is reasonably possible that the agency may be required to refund, in the near term, up to $300,000 to the grantor if it is determined that the agency has violated the requirements of the grant. However, the agency believes it will prevail and has therefore made no provision for a refund.

Vulnerability Due to Concentrations

Concentrations known to management before issuing the financial statements must be disclosed if 1) they exist at the balance sheet date, 2) they make the entity vulnerable to the risk of a near-term severe impact, and 3) it is at least reasonably possible the events that could cause the severe impact will occur in the near future. Such concentrations may be associated with assets or liabilities, or with commitments and contingencies not requiring recognition under GAAP. They may also be associated with the nature of an entity's operations or operating needs. The SOP applies only to concentrations associated with current operations and does not require disclosure of future concentrations.

Although AcSEC did not define the term "concentrations," which includes group concentrations consisting of several counterparties or items with similar economic characteristics, the SOP describes the following areas in which a current concentration might make an entity vulnerable to a risk that would need to be disclosed:

* Concentrations in the volume of business transacted with a particular customer, supplier, lender, grantor, or contributor (Under this SOP, it is always considered at least reasonably possible that a customer, grantor, or contributor will be lost in the near term.);

* Concentrations in revenue from particular products, services, or fund-raising events;

* Concentrations in the available sources of supply of materials, labor, or services, or of licenses or other rights used in the entity's operations; and

* Concentrations in the market or geographic area in which an entity conducts its operations. (Under this SOP, it is always considered at least reasonably possible that operations located outside the entity's home country will be disrupted in the near term.)

The SOP provides specific guidance related to concentrations of labor subject to collective bargaining agreements and concentrations of operations located outside the enterprise's home country. Entities must disclose 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 carrying amounts of net assets and the geographic locations of operations outside of an entity's home country must also be disclosed.

A disclosure about a risk as a result of a concentration from a source of supply might state the following:

* The Company has generally been able to obtain component parts from multiple sources without difficulty. Nevertheless, because of price and quality considerations, the Company buys substantially all of its integrated circuits from one manufacturer. The Company's manufacturing and operating results could be adversely affected if the supply of integrated circuits were delayed or curtailed. The Company attempts to mitigate this risk by entering into a guarantee supply arrangement with the manufacturer at a slightly higher cost per unit.

The following illustrates a not-for-profit organization's disclosure of a concentration due to a single contributor:

* The Organization receives approximately 50% of its combined support and revenues under a grant from the Generosity Foundation of Anytown.

Applying the Disclosure Criteria

AcSEC notes that despite the SOP's requirements, there may be situations when the users of financial statements will not become fully aware of all the risks and uncertainties facing a business or not-for-profit entity. Or, users may be provided with information about potential events that ultimately do not occur. For example, the occurrence of a severe impact related to a concentration not reported in a prior period does not suggest the SOP's ruleswere violated if management made an appropriate judgment that it was not at least reasonably possible at the prior reporting date that a severe impact would occur. Likewise, AcSEC concluded management should not be held responsible for failing to disclose a severe impact resulting from a concentration of which management was unaware at the time the financial statements were issued. Conversely, management may have disclosed a potential change in a significant estimate that ultimately did not occur. In any of these situations, the decision whether a required disclosure should or should not have been made must not be questioned simply as a result of the occurrence of future events.

Study and Work Needed

AcSEC's original proposal was quite controversial. Although the most contentious requirements, such as disclosure about the entity's financial flexibility, have been eliminated, preparers of financial statements will be providing users with more information about their operations. Many believe the SOP goes far in answering the call for increased discloses and early warning signals. In fact, the final SOP responds to several of the concerns put forth by the AICPA's Special Committee on Financial Reporting, also known as the Jenkins Committee, in its recent report, Improving Business Reporting - A Customer Focus: Meeting the Information Needs of Investors and Creditors. Preparers and practitioners now need to study the SOP's requirements and work together to present the required information in a manner that is cost effective for the reporting entity and at the same time useful to users.

RELATED ARTICLE: KNOWN VERSUS SHOULD HAVE KNOWN

The exposure draft on the risks and uncertainties SOP provided that the evaluation of the likelihood and materiality of a change in estimate and thus, the need for disclosure, should be based on "information available prior to the issuance of the financial statements and of which management is reasonably expected to have knowledge." In the final SOP, the basis for disclosure is changed to "known information available prior to the issuance of the financial statements." In other words, there has been a switch from "should have known" to "known."

During the exposure period, some of those who commented expressed concern about the criterion of knowledge that management would reasonably be expected to have. Some believed this would promote second guessing of what management knew and what an auditor would be expected to detect. The disclosure duty is now limited to known information. However, the change in wording does not mean that a disclosure duty can be avoided by the failure to exercise due care to be informed about relevant trends, events, and uncertainties that would be expected to affect significant estimates.

There is a relatively similar duty of disclosure for the management discussion and analysis (MD+A) required of SEC registrants by Item 303 of Regulation S-K. The instructions to Item 303 indicate that the MD+A "shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or future financial position." Although required disclosure is limited to currently known rather than merely trends, events, and uncertainties that are reasonably expected to have material effects, an implicit standard of reasonableness applies.

The instructions to Item 303 apply the criterion of information that "is available to the registrant without undue effort or expense." In other words, the information should be reasonably available at a reasonable cost. This seems to be a useful guideline for interpreting the meaning of known information in the SOP on risks and uncertainties.

Reva B. Steinberg, CPA, is director of Accounting Research for Ten Eyck Associates, Inc., a consulting and litigation support firm. Ms. Steinberg is a former member of AcSEC. Judith Fellner Weiss, CPA, is a former senior manager in Grant Thornton's national accounting and auditing department and now a freelance writer covering matters relating to accounting and auditing.