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New disclosure requirements for risks and uncertainties.

If you or one of your clients prepares financial statements in accordance with generally accepted accounting principles (GAAP), then you need to become familiar with a new reporting requirement established by the American Institute of Certified Public Accountants (AICPA). In December 1994, the Accounting Standards Executive Committee (AcSEC) of the AICPA issued Statement of Position 94-6 (SOP) entitled "Disclosure of Certain Significant Risks and Uncertainties." This new SOP requires new disclosures of certain risks and uncertainties that face entities and is effective for fiscal years ending after December 15, 1995. It is important that all accounting practitioners understand the new disclosure requirements, as they apply to all business and not-for-profit entities of all sizes that prepare financial statements in conformity with GAAP The statement does not apply to state and local governmental units, however.

The current volatile economic environment has increased the risks and uncertainties faced by all enterprises and has incited recent interest in expanding disclosure requirements. In 1985, the AICPA established a task force, and in 1987, the Report of the Task Force on Risks and Uncertainties was issued, with the intention of helping standard setting bodies and others identify ways of improving disclosures to users of financial statements regarding the risks and uncertainties involved in preparing and analyzing financial statements. SOP 94-6 is based upon this report and focuses on certain risks and uncertainties that could significantly affect the amounts reported in the financial statements in the near term.

Since there are multitudes of risks and uncertainties that all entities face, the SOP focuses on only four specific areas: 1) the nature of operations, 2) the use of estimates in the preparation of financial statements, 3) certain significant estimates, and 4) current vulnerability due to certain concentrations. The four areas of focus are discussed in turn.

Disclosure 1: Nature of Operations

Under the new SOP, notes to the financial statements should include a description of the entity's major products and/or services, along with the location of its principle markets. The entity must make these disclosures for all industries in which it operates, including the relative importance of each industry using assets, revenues, earnings or some such basis. In addition to these disclosures, not-for-profit entities must provide a description of the principal services and the revenue sources for these services. These disclosures need not be quantified.

Figure 1 includes two examples from the SOP that are used to illustrate the disclosure requirements of the nature of operations. Note that the SOP allows nonquantitative language such as principal, primarily and about equal. These disclosures are fairly straightforward descriptions about the location and type of principal markets and products/services of the entity. The purpose is to provide information to users of the financial statements about the broad risks and uncertainties associated with the businesses and markets in which the company operates and competes.

Figure 1: Nature of Operations

The following illustrates the application of the first disclosure requirement of the new Statement of Position regarding the nature of the entity's operations. Under this section of the SOP, an entity is required to provide a description of its major products and/or services, as well as the location of its principal markets.

Example 1: Conglomerate, Inc. is a multinational manufacturer and engineering concern. The company's principal lines of business are automotive products, aerospace products and technologies, textiles and nonprescription health-care products, all of which are about equal in size based on sales. The principal markets for the automotive and aerospace products and technologies are European- and Far East-based industrial concerns. Textiles are sold primarily to domestic clothing manufacturers, while non-prescription health-care products are sold primarily to wholesale and retail distributors worldwide [emphasis added].

Example 2: Smith Corporation is engaged principally in the design, engineering and manufacturing of military aircraft and related peripheral equipment for sale primarily to the U.S. Government.

Disclosure 2: Use of Estimates in

the Preparation of Financial


This section of the SOP requires that notes include an explanation that the preparation of financial statements in conformity with GAAP requires the use of management's estimates.

Figure 2 includes an illustration of the disclosure required under this section of the SOP The purpose of this requirement is to inform financial statement users about the inherent uncertainties, measuring financial statement items.

Figure 2: Use of Estimates

The following paragraph is an example of the required disclosure of an entity's use of estimates in the preparation of the financial statements: The preparation of financial statement 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 revenues and expenses during the reporting period. Actual results could differ from those estimates.

Disclosure 3: Certain

Significant Estimates

Under the new SOP, entities are required to make significant disclosures about financial statement items that are based on estimates that are sensitive to change in the near term (i.e., change within one year of the balance sheet date), such as inventory and specialized equipment subject to rapid technological obsolescence. The potential near-term effects on the financial statements associated with such estimates should be discussed in the notes if it is at least reasonably possible that the estimate will change in the near term and the effect of the change would be material to the financial statements. This new disclosure does not require the near-term effects to be quantified beyond the requirements of Statement of Financial Accounting Standards (SFAS) No. 5, Accounting for Contingencies, issued by the Financial Accounting Standards Board FASB).

Figure 3 illustrates the application of the requirement for a company that has made estimates regarding a discontinued operation (example 1) and inventory valuation (example 2).

The requirements under this section of the SOP are intended to supplement the existing disclosure requirements under SFAS No. 5; however, the new disclosures expand SFAS No. 5 by incorporating all significant estimates made by management, not just estimates made for contingent gains and losses. However, routine estimates, such as the allowance for doubtful accounts, probably will not require disclosure because such estimates are not usually subject to fluctuations that could materially affect the financial statements.

Figure 3: Certain Significant Estimates

The following two examples are intended to illustrate the application of the third disclosure requirement of the new Statement of Position. Under the new SOP, entities must disclose information regarding certain estimates used in preparing financial statements. The first example is for a company with a discontinued operation, while the second example is for estimates of inventory valuation. Example 1: Discontinued operations includes management's estimates of the amounts expected to be realized on the disposition of certain facilities. The amounts the company will ultimately realize could differ materially in the near term from the amounts assumed in arriving at the loss in connection with the discontinued operation. Example 2: At December 31, 19x7, some portion of $6 million of inventory of one of the company's products is in excess of XYZ's current requirements based on the recent level of sales. Management has developed a program to reduce this inventory to desired levels over the near term and believes no loss will be incurred on its disposition. No estimate can be make of a range of amounts of loss that are reasonably possible should the program not be successful.

Disclosure 4: Current Vulnerability

Due to Certain Concentrations

Vulnerability from concentrations arise when an entity is exposed to risk of loss by not diversifying a particular area of its operations. For example, if an entity has only one supplier of raw materials, it may be exposed to loss if the supplier goes out of business. Under the new SOP, an entity may have to disclose certain concentrations existing at the date of the financial statements. A concentration must be disclosed when it is at least reasonably possible that an event will occur that could cause a severe impact on the financial statements. A severe impact is defined as a near-term event that has a significant financially disruptive effect on the normal functioning of the entity.

Only certain concentrations that exist at the date of the financial statements need be considered. Concentrations that are considered under the new SOP follow:

* Concentrations in the volume of business transacted with a particular customer, supplier, lender, grantor or contributor.

* 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.

* Concentrations in the market or geographic area in which an entity conducts its operations.

Illustrations of the required disclosure are included in Figure 4 for supplier concentrations (Example 1) and geographic concentrations (Example 2).

The requirements under the new SOP are far-reaching, as all business and not-for-profit entities, regardless of size, must comply. Some of the disclosure requirements of this new SOP are similar to those required by currently existing requirements of the FASB, such as the FASB's SFAS No. 5, Accounting for Contingencies. The disclosure requirements of this SOP are meant to supplement the existing standards; thus, the new disclosure requirements may be added to existing notes or placed in a separate note to the financial statements.

If you or your client prepares financial statements in conformity with generally accepted accounting principles, make sure you incorporate the AICPA's new disclosure requirements concerning certain risks and uncertainties. Copies of the new Statement of Position 94-6 can be obtained by calling the AICPA's order department at 800-862-4272.

Figure 4: Vulnerability Due to Certain Concentrations

The new disclosure requirements of current vulnerability due to certain concentrations are illustrated in the following examples. The first example depicts a supplier concentration and the second, a geographic concentration. Example 1: The company currently buys all of its integrated circuits, an important component of its products, from one supplier. Although there are a limited number of manufacturers of the particular integrated circuits, management believes that other suppliers could provide similar integrated circuits on comparable terms. A change in suppliers, however, could cause a delay in manufacturing and affect results adversely. Example 2: Included in the company's consolidated balance sheet at December 31, 19x4, are the net assets of the company's manufacturing operations, all of which are located in a single facility in Switzerland and which total approximately $20 million.
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Title Annotation:Statement of Position 94-6
Author:Trussel, John M.
Publication:The National Public Accountant
Date:Apr 1, 1996
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