10. Operating Opportunities and Risks
10(a). Definition
Leading view
For financial reporting purposes, operating opportunities and risks are defined to be beneficial or detrimental circumstances in which the reporting entity is involved at the reporting date that are not assets or liabilities but that may cause the reporting entity to have increases or decreases in cash flows in the future.
Several users agree with the definition as representing the types of operating opportunities and risks that should be considered for disclosure [p. 1-3]
Some users, while agreeing in general with the definition, found the definition to be deficient in the following respects:
The definition does not deal with the notion of risk mitigation [p. 1]
The definition provides no guidance as to the distinction between concerns versus "strong beliefs" about positive events [p. 2]
The definition fails to clearly describe the required degree of involvement of an entity in beneficial or detrimental circumstances for the circumstances to be disclosed [p. 3].
10(b). Types of opportunities and risks that should be disclosed
Leading view
Users welcome more information about operating opportunities and risks in external financial reports. Particularly, they are interested in disclosures about operating risks.
Users want information about opportunities and risks that are relatively near-term, relatively certain and relatively quantifiable [p.12]. Assessments by accountants should not result in forecasting an event. That is the job of management and users [p. 11-12]. Most creditors strongly agree that disclosure of operating opportunities and risks should focus on specific, clear identifications of near-term events and circumstances rather than discuss unspecified possibilities, probably on a company specific rather than an industry basis. Identification of opportunities and risks, rather than interpretation, should be the goal [p. 14]
Users want information about opportunities and risks resulting from concentrations in assets, customers and suppliers. Information about concentrations may be material, is quantifiable and disclosure is appropriate [p. 6-7]. Although the reasons are not specified, users believe that the following types of information should be disclosed:
Large increases or decreases in the proportion of materials purchased from the one or two largest suppliers [p. 15]
Large increases or decreases in the proportion of products or services sold to the one or two largest customers [p. 15]
Concentration in assets resulting from unusual or special circumstances such as, for example, bad loans that eventually become real estate because of collateral repossessions [p. 7]
Information about geographic concentrations in the production base of a company (as well as the sales base) [p. 6]
Some users agree that illiquidity should be discussed if it makes a company vulnerable to risk of severe impact on near-term cash flows or results of operations [p. 7]. Most users believe that one of the factors that warn about the risk of illiquidity, a growing inability to pay suppliers and lenders on time, should be disclosed [p. 15]
Contingent loss disclosure becomes more important as the potential amount becomes larger and more quantifiable. Users want to know "immediately" about potentially "life threatening" events in a company [p. 8]. Environmental problems such as potential asbestos related liabilities is an example [p. 16]. Disclosure of material, but not "life threatening" events, is important but has a longer time frame [p. 8]. The time frame is a matter of user judgment [p. 8, 16]. It is not a subject easily reducible to an accounting standard or SEC edict [p. 2, 4-5].
The SEC MD&A requirements, which focus on events and uncertainties that would cause the reported information to be an inadequate indicator of future operating results, represents a good framework for disclosures about operating risks, although current MD&A disclosures are not satisfactory.
Most users agree the MD&A is a better location for disclosure of opportunities and risks than the financial statement footnotes [p. 13]
Users identify these weaknesses in some current MD&A disclosures:
Management tends to overstate the opportunities and understate the risks that it sees [p. 1-2; section 10(d), p. 4]
Disclosures tend to be in the nature of broad disclaimers [p.2]
Disclosures use descriptive phrases (boilerplate) and the discussion includes information about accounting items that are not necessarily the relevant business issues [p. 2, section 10(d), p. 4]
Disclosures are met at the minimum [p. 4]
Users of financial statements of private companies would welcome a MD&A type disclosure but are concerned whether the cost could be justified [section 10(d), p. 5-6].
Users are generally not in favor of allowing management to use subjective screens to determine the nature and extent of disclosures to be made about operating opportunities and risks.
The application of the following screens for limiting the number of risks that might have to be disclosed is viewed as unworkable, oversimplified and misdirected:
If it is at least reasonably possible that the future events that will convert risk to loss and perhaps liability will occur
If that future event carries the risk of severe impact on the company
If that impact will be on near-term cash flows or results of operations of the company
If the risks are other than those generally known to be associated with the industry or trade in which the entity operates
A definitional problem in providing disclosures parameters exists. "Reasonably possible" cannot be adequately defined. Every user makes his or her own assessment [p. 7-8]
The screens are not adequate. Risks are related to each other and cannot be segregated. A small risk when related to others may need to be disclosed [p. 8]
Users want to be able to review all information that they can secure. They don't want anyone screening it, particularly management [p. 8-9]
Although examples are sometimes useful in defining what is to be screened, they are frequently so general that they aren't helpful [p. 9].
Alternative view
Requirements to disclose operating opportunities and risks is unlikely to be productive in practice.
Reasons cited for low likelihood of productive disclosure include:
Too much of the potential disclosure involves information that would be competitively disadvantageous to disclose [p. 2, 12]
Creditors and by implication, investors, are split on whether the following types of information should be disclosed. Although the reason for the split are not stated, it would appear that some believe the data is viewed generally as so sensitive that any information provided would not be helpful:
The possibility of new competitors [p. 15]
The possibility of substitute products [p. 15]
Changes in the bargaining power of suppliers [p. 15]
Changes in the bargaining power of customers [p. 15]
To avoid litigation exposure, disclosures may be excessive and boilerplate [section 10(d), p. 7]
Difficulties in quantifying disclosures and inability to distinguish "reasonably possible" future risks will make useful disclosure impractical [p. 7-8, 11-13]
Identification of opportunities and risks is the job of analysts, not accountants, and analysts have significant access to management and other tools to do this
[p. 3, 9]
The needed improvement in MD&A disclosures is not likely to be achieved by a rules change [section 10(d), p. 4-5]
Any attempt to "screen" disclosures or otherwise selectively choose the disclosures to be made will result in inconsistent reporting among companies and year-to-year as judgments change [p. 8]
For small companies, the cost may drive issuers away from issuing audited statements [section 10(d), p. 6].
10(c). Content of disclosures about opportunities and risks
Leading view
Giving due consideration to cost, users want detailed specific disclosures about operating risks.
Users want information about opportunities and risks that are relatively near-term, relatively certain and relatively quantifiable [p, 12]
Users have interest in specific risks or those that are unique or different from that which someone would expect for the industry [section 10(d), p. 8]
Users are interested in sensitivity disclosures with respect to interest rates and exchange rates, but not inflation rates. Other types of sensitivity reporting or stress testing would be welcomed [p. 1-2; section 10(b), p. 5-6, 14]
Users identified environmental liability risks as a particular interest [section 10(b), p. 15-16; section 10(d), p. 1]
More disclosure should be required for risks related to derivative financial instruments [section 10(b), p. 5-6].