|JERRY L. ARNOLD, CPA, PhD, is
Accounting Associates Professor at the University of Southern
California, Los Angeles. |
WILLIAM W. HOLDER, CPA, PhD, is Ernst & Young Professor of Accounting and director of the SEC and Financial Reporting Institute at USC.
It's no secret that financial statement users have long been concerned about the disclosure of measurement uncertainties in GAAP statements in order to help investors, creditors and others evaluate the uncertainty of some financial statement entries. Recent pronouncements call for additional disclosures about a variety of uncertainties. These mandates—coupled with existing requirements—add up to a complex set of standards that often are confusing and difficult for companies to apply. Despite their complexity, the fact that those standards were approved at all acknowledges the view of standard setters that financial statements have not properly disclosed the degree of uncertainty in many accounting measurements.
Both FASB and AcSEC have called for companies to disclose accounting measurement uncertainties. However, the timing of such disclosures and their nature and extent varies widely. These variations exist despite a clearance process for new AcSEC standards that provides some degree of coordination with FASB. (If a majority of FASB members do not object to a proposed AcSEC standard, the standard is considered to have been cleared by FASB.) The upshot is that companies may be required to make extensive disclosures when there is little uncertainty and, conversely, to make relatively few disclosures in conditions of great uncertainty. In some cases, the standards require different disclosures for similar economic phenomena, which confuses financial statement users, preparers and attestors.
Steps to Improve Financial Statements
"5. Improve disclosures about the uncertainty of measurements of certain assets and liabilities.
"The amount of cash on hand at a balance sheet date may be known precisely, but an accrued liability for environmental cleanup costs may be very imprecise. Users want to understand better the uncertainties inherent in certain measurements to make better judgments about earnings, cash flow, opportunities, and risk.
"Because measurements often differ in their precision, companies should identify in financial statement notes the specific types of assets and liabilities subject to significant measurement uncertainties. For those assets and liabilities, companies should disclose how the reported amounts were derived and explain the estimates, assumptions, and judgments considered in their measurement."
Source: AICPA Special Committee on Financial Reporting, Improving Business Reporting — A Customer Focus. Copyright (c) 1994 by the AICPA.
In the accounting literature, the term measurement uncertainties describes financial statement amounts that are inherently imprecise and must be estimated. FASB clearly recognizes that many numbers in financial statements are imprecise estimates and that conveying this imprecision to users is an important feature of financial reporting. To understand the disclosure problem, CPAs should know how recent standards fit in the conceptual objectives and characteristics of financial reporting and in the current standards for recording and reporting uncertainties. FASB Concepts Statement no. 1, Objectives of Financial Reporting by Business Enterprises, says that, "despite the aura of precision that may seem to surround financial reporting in general and financial statements in particular, with few exceptions the measures (in financial statements) are approximations, which may be based on rules and conventions, rather than exact measures." Further emphasizing the importance of estimates, Concepts Statement no. 2, Qualitative Characteristics of Accounting Information, asserts that "reporting accounting numbers as certain and precise if they are not is a negation of reliable reporting."
For many years, FASB Statement no. 5, Accounting for Contingencies, has been the most comprehensive standard on reporting measurement uncertainties. It requires CPAs to assess the likelihood an uncertain condition will affect an entity adversely and the amount (or range) of any related loss. (Gain contingencies also must be disclosed but are typically referred to only in general terms.) While financial statements that conform to this standard are viewed as historical in nature, in reality they routinely include predictions of uncertain future events and conditions. For example, estimates of bad debts, obsolete inventory, sales returns and allowances, warranty obligations and even depreciation and amortization all require CPAs to predict future events.
Statement no. 5 says a company must accrue a loss by a charge to income if two conditions are met:
1. It is probable an asset has been impaired or a liability incurred at the date of the financial statements.
2. The amount of the loss can be reasonably estimated.
Statement no. 5, as interpreted, says the second condition is met if a range of loss can be estimated. A company must disclose that range. Interestingly, however, the standard says that disclosing the nature of an accrual, and in some circumstances the amount accrued, " may be necessary for the financial statements not to be misleading" (emphasis added). Thus, Statement no. 5 does not require disclosure of those relatively uncertain measurements although it clearly anticipates the accrual of amounts that only probably exist. Research suggests that most practitioners understand the term probable to mean approximately a 70% or 80% likelihood of occurrence. This means that even those amounts a CPA puts on the financial statements may be uncertain.
Given the importance of measurement uncertainties in financial reporting, the attention standard setters paid to this issue in recent pronouncements is appropriate. The emergence of the two markedly inconsistent systems described below is, however, cause for concern.
VARIATIONS IN UNCERTAINTY DISCLOSURE
The most recent FASB pronouncement requiring companies to disclose measurement uncertainties is Statement no. 132, Employers' Disclosures about Pensions and Other Postretirement Benefits . It requires companies to disclose the assumptions they use in estimating their net liability for pensions and other postemployment benefits. Exhibit 1, at right, summarizes Statement no. 132 and the other FASB pronouncements requiring uncertainty disclosures. Each standard in exhibit 1 requires routine disclosure of the information identified without regard to the measurement's relative uncertainty. It is clear FASB has begun to require companies to disclose accounting estimates to a much greater extent than in the past.
SOP 94-6, Disclosure of Certain Significant Risks and Uncertainties, takes a different approach. It says companies must disclose the existence of measurement uncertainties if it is reasonably possible that the underlying accounting estimate may change within a year of the financial statement date to an extent that would materially affect the financial statements.
The contrasting results of the two approaches and Statement no. 5 are summarized in exhibit 2, page 103. Exhibit 2 also shows the circumstances requiring disclosure and the differences that result from those standards. These differences and the inherent difficulties of applying the several standards are readily apparent in the treatment of a long-lived asset impairment. FASB Statement no. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, requires disclosures whenever a company recognizes a material impairment loss. Interestingly, Statement no. 121 employs a specific "event" trigger to decide when a company needs to recognize an impairment rather than using the probability test required by Statement no. 5 and SOP 94-6. It is difficult for companies to discern whether and under what circumstances SOP 94-6 would require them to disclose the possible impairment of a long-lived asset. Under Statement no.121, an impairment loss would not be recognized.
The following examples further illustrate the reporting distinctions between FASB standards and SOP 94-6.
|Exhibit 1: FASB-Required Uncertainty Disclosures|
|Statement no. 107||Financial instruments — disclosure only — no financial statement adjustment.||For all financial instruments: fair value and methods and significant assumptions used to make estimate.|
|Statement no. 121||Long-lived assets.||For long-lived assets written down due to an impairment: "how fair value was determined."|
|Statement no. 123||Stock-based compensation.||The method and significant assumptions used during the year to estimate the fair values of options, including specific elements.|
|Statement no. 124||Investment accounting by not-for-profit organizations.||Methods and significant assumptions used to estimate the fair values of investments other than financial instruments (such as oil and gas properties and real estate).|
|Statement no. 125||Mortgage servicing rights.||The fair value of capitalized mortgage servicing rights and the methods and significant assumptions used to estimate that fair value.|
|Statement no. 132||Amendments
to Statement no.106: Postemployment benefit obligations other
than pensions. |
Amendments to Statement no. 87: Defined benefit pension plans.
|Assumptions for discount rate, rate of compensation increase, long-term rate of return on plan assets, rate used to measure costs of benefits, and certain sensitivity-related assumption information.|
Example 1. FASB Statement no. 107, Disclosures about Fair Value of Financial Instruments, requires companies to disclose the fair value of long-term debt and the related methods and significant assumptions used in making those estimates. Estimating the fair value of debt instruments not actively traded (such as notes payable to banks and debt of nonpublic companies) is simple and straightforward. For example, if a company's creditworthiness has not changed since the debt was issued, it may be necessary only to identify the interest rate a lender would charge for a similar loan at the balance sheet date and apply that rate to the instrument's future cash flows. While the resulting estimate may not be subject to significant uncertainty, the disclosures would nevertheless be substantial and extend beyond an estimate of fair value to include the methods and significant assumptions.
|Exhibit 2: Disclosure of Accounting Uncertainties|
Statement no. 5
|SOP 94-6||Recent |
|Conditions requiring disclosure||Reasonably possible loss. |
Probable loss with only a range of loss estimable.
|Accounting estimate that has reasonable potential to change materially in the near term due to one or more future confirming events.||Mere occurrence of transaction or event.|
|Disclosure required||Nature and amount of possible loss or statement that
amount cannot be reasonably estimated. |
Range of loss.
General nature (nonspecific).
of the uncertainty. |
Indication that it is at least reasonably possible a change in estimate will occur in the near term.
|Significant assumptions. |
Example 2. On the other hand, consider the disclosure standards that apply to a liability for product warranties. Although the amount a company accrues might be subject to much greater uncertainty than the long potential to change-term debt discussed above, it is not required to make a disclosure unless the financial statement preparer believes certain conditions exist. Specifically, he or she must conclude, based on known information, that it is reasonably possible the amount the company accrues will change in the near term due to one or more "future confirming events" and that such a change will be material to the financial statements. Even if those conditions are met, the SOP 94-6 disclosures extend only to the nature of the uncertainty and an indication that it is at least reasonably possible a change in the estimate will occur soon. Statement no. 5, on the other hand, calls for a company to disclose the range of a contingent loss if a single point estimate is not possible. The statement does not, however, address the probability necessary to establish such a range. SOP 94-6 calls for companies to disclose the existence of any reasonably possible material variation in the amount accrued under Statement no. 5. The required disclosures, however, do not extend to how the estimate was made or to the assumptions used.
It seems at best illogical that in comparing the examples, example 2, which might involve a much greater level of uncertainty, results in substantially less information about the methods and assumptions that are used to estimate the uncertainty.
The SEC view. While nonpublic companies are not required to apply SEC pronouncements to their financial statements, these pronouncements do have an indirect impact on general financial reporting; hence their relevance here. The SEC staff underscored the need for additional product liability disclosures in Staff Accounting Bulletin (SAB) no. 92, Accounting and Disclosures Relating to Loss Contingencies. The staff issues bulletins only when it believes additional practice guidance is necessary. SAB no. 92 says, "The staff believes that product (and environmental) liabilities typically are of such significance that detailed disclosures regarding the judgment and assumptions underlying the recognition and measurement of the liabilities are necessary."
Some examples of specific disclosures that a company might make include
- Circumstances affecting the reliability and precision of loss estimates.
- The extent to which unasserted claims are reflected in any accrual or may affect the magnitude of the contingency.
- The time frame over which the accrued or presently unrecognized amounts may be paid out.
- Material components of the accruals and significant assumptions underlying the estimates.
Other inconsistencies. Another example of seemingly inconsistent disclosure requirements relates to a variety of assets. FASB Statement no. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (which superseded FASB Statement no. 122, Accounting for Mortgage Servicing Rights ), requires loan servicers to disclose the methods and significant assumptions they use to estimate the value of mortgage servicing rights reported as assets on their financial statements. While many of these estimates are rather precise and do not involve great uncertainty, disclosures are required in all cases in which mortgage servicing rights are reported.
In contrast, consider the need for estimates in valuing the inventory of a manufacturer, wholesaler or retailer. GAAP requires that inventory be valued at the lower of cost or market. The upper bound of market is net realizable value—estimated selling price less cost to complete the sale. Thus, the value assigned to inventory on a balance sheet is subject to an accounting estimate in all cases. That is, estimates of future events are necessary to determine market, and cost must be related to market to determine the current value of the inventory on the financial statements. SOP 94-6, however, does not require companies to disclose this fact unless, based on known information, it is reasonably possible the estimate will change in the near term due to one or more future confirming events and the effect of the change will be material. In no case does SOP 94-6 require a company to disclose the methods and significant assumptions used to estimate the value of the inventory.
We believe the disclosures resulting from these two estimates of asset values are inconsistent and possibly confusing. It makes no sense that a more common and more uncertain estimate requires less disclosure and in fewer circumstances than does a more common estimate that is less uncertain.
ACTIONS TO IMPROVE PRACTICE
The disclosure of measurement uncertainties in GAAP financial statements is governed by a series of standards that are complex, sometimes inconsistent with each other, require substantial professional judgment and can produce illogical results. We believe standard setters should adopt a comprehensive approach requiring companies to disclose measurement uncertainties. While the conceptual basis for each of the FASB and AcSEC standards can be understood individually, together they confuse financial information users and others. In extreme cases, they may even result in misleading inferences. Measurement uncertainties pervade financial statements and relate to some of the most significant information in the statements. All standard setters should adopt a single system of disclosing just how imprecise financial statement numbers are instead of the piecemeal approach now used. Regardless of the system standard setters select, it should be applied to all financial statement items.
The AICPA special committee on financial reporting studied this topic intensively. Its report, Improving Business Reporting—A Customer Focus, was based on extensive work with a large number of financial information users. It recommended
- Identifying in financial statement notes the specific types of assets and liabilities subject to significant measurement uncertainties.
- Disclosing—for assets and liabilities subject to significant measurement uncertainties—how the reported amounts were derived and explaining the estimates, assumptions and judgments about the future events considered in their measurement.
The special committee based its recommendations in part on its research into the needs of investors and creditors. Both groups said disclosure of measurement uncertainties and the assumptions and methods used to make the underlying estimates would be useful to them in predicting future earnings and cash flows and in assessing the reasonableness of the accounting numbers in financial statements. The special committee's recommendations are a blend of the two disclosure systems described earlier. Like SOP 94-6, not all measurement uncertainties require disclosure. Criteria such as those in the SOP would determine whether the degree of uncertainty and related materiality of an accounting estimate must be disclosed. Once a company determines disclosure is necessary, however, the disclosures the special committee recommends would extend to the methods and significant assumptions used in making the estimate. This type of information has been a hallmark of recent FASB standards but is noticeably absent from SOP 94-6.
Each of FASB's last four standards requires disclosure of the methods and significant assumptions for the estimates in those standards, regardless of the inherent degree of uncertainty. But many previous FASB standards contain no such disclosure requirements even though important estimates, based on forecasting future events, are frequently necessary when applying them. Examples include estimates necessary in complying with these FASB statements:
- Statement no. 13, Accounting for Leases.
- Statement no. 43, Accounting for Compensated Absences.
- Statement no. 67, Accounting for Costs and Initial Operations of Real Estate Projects.
- Statement no. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases.
In addition, the accounting standards established by predecessor standard-setting organizations (the AICPA Accounting Principles Board and committee on accounting procedure) have similar characteristics in that they require a large number of accounting estimates but not the disclosure of the existence of those estimates or the methods and significant assumptions used in their application. We believe the differences in accounting standards discussed above result in unnecessarily complex financial statement disclosures that are inconsistent and may confuse financial statement users. To solve this problem, FASB should undertake a project to unify or harmonize the disclosure of measurement uncertainties in financial statements.
While adopting the special committee's recommendations will substantially improve the disclosure of measurement uncertainties, it will not resolve all of the related issues. The special committee recommended disclosing only certain significant estimates depending on whether the measurement uncertainty is particularly sensitive to relatively small changes in an assumption, the likelihood that future events could be very different from the assumed future events or the existence of possible changes in the estimate due to changes in assumptions about the future. These criteria are similar to those in SOP 94-6 and give CPAs the variables to decide whether to disclose a particular uncertainty. Such criteria are subject to different interpretations; similarly situated professionals with the same facts might come to different conclusions about the need for disclosure in a particular practice situation. As such, the criteria may not result in similar information in similar reporting circumstances. Indeed, research indicates practitioners have difficulty making consistent judgments about whether to disclose uncertainties under Statement no. 5.
Finally, SOP 94-6 disclosures are based on information that is known to management. Most accounting standards establish the measurement or disclosure standard and implicitly require management to obtain the information necessary to apply it. SOP 94-6 is a marked exception to this practice. By not requiring management to obtain sufficient information about the imprecision of accounting measurements, the SOP differs from similar standards.
Different managements may accumulate and possess widely different levels of information. One consequence of this is that well-informed managers disclose more measurement uncertainty information than less informed managers. As a result, the financial statements of companies with better informed management appear more uncertain and imprecise when the opposite may actually be the case.
In light of FASB's ongoing project on disclosure effectiveness and the concerns of others about the possibility of standards and disclosure overload, a call for additional disclosures cannot be made lightly. Nevertheless, both the Association for Investment Management and Research position paper Financial Reporting in the 1990's and Beyond and the special committee recognize that more information about measurement uncertainties in financial statements would be well received. Therefore, subject to the outcome of the FASB disclosure effectiveness project, we believe companies should disclose material measurement uncertainties and that those disclosures include the methods and significant assumptions. Such a requirement would
- Reduce the judgments companies must make in deciding whether to disclose measurement uncertainties.
- Result in more similar disclosures in similar fact situations.
- Reduce the claims of inadequate disclosure of uncertainties by potential litigants.
- Not substantially add to the costs of preparing financial statements.
AT WHAT COST?
The expense of gathering and providing the disclosures recommended above would not be large. In almost all cases in making the original estimates companies already have developed the information needed to make the recommended disclosures. While other costs, particularly competitive issues, should be considered, it is difficult to envision that cost would make this recommendation prohibitive. A more uniform application of disclosure rules would improve decision making and the benefits would greatly exceed any implementation and compliance expenses. FASB, therefore, should move swiftly to generalize the accounting measurement disclosure standards they have already begun to issue.