10(b). Types of Opportunities and Risks That Should be Disclosed
[L]egalistic approaches to financial reporting seem to impede rather than facilitate communication of financial information. We suggested a private companies version of the Management Discussion and Analysis (MD&A) required of public companies by the SEC. Lenders need to understand their customers' businesses, a necessity best met by open and good faith explanations of the business by the customer and his or her accountant, either in writing or verbally. [Also included in 5(a) and final sentence also included in 13] [RMA92, p. 2]
__________
The APC [Accounting Policy Committee] has considered and expresses below its opinions on a number of specific issues affecting financial accounting standards and financial reports. The APC believes that the following [item] should be included in the single body of accounting concepts, standards, principles and methods: [RMA90, p. 5]
Variations in income between years ("swings") should be explained either in footnotes or in supplementary analyses, such as the "Management Discussion and Analysis" (MD&A) that the Securities and Exchange Commission requires of all publicly-owned companies. [RMA90, p. 7]
__________
[Context] Meeting of the Investor Discussion Group on January 13, 1993. Part of the meeting was devoted to the topic of disclosure about operating opportunities and risks.
Committee/Staff/Observer
The number and variety of operating opportunities and risks that companies face can be rather daunting. The Special Committee has been trying to develop a framework for identifying those opportunities and risks that should be disclosed in external reporting. The meeting materials referred to 3 frameworks that may help in identifying the appropriate opportunities and risks. We would like your reaction to those frameworks. [TI 1/13, p. 44-45]
The first framework mentioned in the materials is the list of nonfinancial business information that we discussed with you at our first meeting back in October. You may recall that the list was categorized into 3 sections: information about the economy, the company's industry, and the company itself. Our question is: to what extent would the information on the list provide the information that you need to know about the company's operating opportunities and risks? Does that list provide a workable framework for categorizing and disclosing what you need to know about operating opportunities and risks? Is the list a promising starting point or basis from which to develop an accounting standard requiring disclosure of information about operating opportunities and risks? [TI 1/13, p. 45]
Participant I-8
You tend to get from management now much more attention to opportunities and much less attention to risks. [TI 1/13, p. 45]
Committee/Staff/Observer
Do they talk to you about opportunities in one-on-one kinds of situations as opposed to telling you about opportunities in the normal course of their business reporting? [TI 1/13, p. 45]
Participant I-7
The answer is yes. Every company will tell you about their opportunities privately but, in formal presentations, discussing certain things like marketing strategies is not done and I believe it shouldn't be done. Talking about new products and pricing strategies, that type of information you don't get in dialogues and I understand that. [TI 1/13, p. 45]
Participant I-8
I think there should be more of a push on talking about risks and problems. [TI 1/13, p. 45]
Participant I-7
One way you can get some sense in terms of risk management is to talk to the company about what their outlook is. If they have a glowing outlook, and you're making a bet that it isn't, you know that they're structuring their organization for that outlook from a cost point of view, and somewhere along the way they might minimize the risk. [TI 1/13, p. 46]
Participant I-12
We get quite a bit on risks and opportunities in a lot of the SEC documents. There is a big section in the K talking about the underlying business; it almost parallels what you see in a prospectus. You get a lot of information in prospectuses as well. [Also included in 10(d)] [TI 1/13, p. 46]
Participant I-7
I found those statements being nothing more, for the most part, than disclaimers. Management knows quite well what the risks are; we should get more of that information in detailed form rather than just broad disclaimers. [Also included in 10(d)] [TI 1/13, p. 46]
Committee/Staff/Observer
You would then be in favor of us developing an accounting standard that would require disclosure, more than a disclaimer, about true analysis of the risks and opportunities? [TI 1/13, p. 46]
Participant I-7
If that's what it takes to get it, the answer is yes. [TI 1/13, p. 46]
Committee/Staff/Observer
[Participant I-12], in your focus on prospectuses, is the presentation well balanced or does it focus almost exclusively on the risk side rather than also on the opportunity side? [TI 1/13, p. 46]
Participant I-12
Prospectuses emphasize more the risk side. On the other hand, that provides balance to the annual report where more emphasis is placed on the opportunity side. Another thought is that the analyst's job is to ferret out those risks and returns because lots of times management may not be even aware of it. Analysts make their own determination of what the real value is, where the real risks and opportunities are. [TI 1/13, p. 46-47]
Committee/Staff/Observer
There are many companies that are not followed by analysts. Should there be a standard that provides shareholders with getting financial reporting from the company, without the benefit of an analyst interpreting it for them, about opportunities and risks? [TI 1/13, p. 47]
Participant I-8
There should be an attempt, absolutely. [TI 1/13, p. 47]
Participant I-14
I'm astonished that the impetus to this doesn't come from the companies themselves. If something goes wrong that they might have known about, they're sued. [TI 1/13, p. 47]
Participant I-8
That's only recent. Before recently, the prospectus was the basis of class action; now, it's just lousy results that trigger a suit. [TI 1/13, p. 47]
Committee/Staff/Observer
My fear is that it will lead you to an out of balance situation; there will be less discussion about opportunities because the cost of being wrong will be so great and companies will play things closer to their vest. [TI 1/13, p. 47]
Participant I-8
You're not going to be able to prevent that. On the other hand, maybe you can help companies in terms of formalizing some risk disclosures that help insulate them from the worst part of what the lawyers are doing. [TI 1/13, p. 47]
Participant I-12
In our work on the annual report survey, one of the things we stress is that the chairman's letter really needs to address what went right and what went wrong in the past year, where they are today, and what they are going to try to achieve in the coming year. There is an awful lot of chairman's letters that get very low scores. Maybe we need a standard, I don't know. [TI 1/13, p. 47-48]
Committee/Staff/Observer
[T]he next question we have is right on that point. The second framework that we talk about in the materials is the SEC's MD&A requirements. In MD&A, the discussion and analysis of results of operations is to focus on events and uncertainties known to management that would cause the reported information to not be a good indicator of future operating results. It is also to describe known trends or uncertainties that have had or that management expects will have a material impact on net sales or revenues or income from continuing operations. Our question is: do those MD&A requirements provide a workable framework for categorizing and disclosing what you need to know about operating opportunities and risks? Is it a promising starting point or basis from which to develop an accounting standard requiring disclosure of information about operating opportunities and risks? And there is also [committee/staff/observer]'s question; do you believe what you get? [Also included in 2(b) and 13] [TI 1/13, p. 48]
Participant I-7
Reliability is in the mind of the issuer. I think it goes beyond reliability. There are certain managements that are "ept" and others that are inept. So when you read the MD&A or have a discussion with management, for the most part, they're trying to give you as reliable information as they possibly can. But within the context of a competitive environment, some are being inept. [Also included in 2(b) and 13] [TI 1/13, p. 48]
For example, management thinks the company is going to have a 10% sales increase this year in the motor industry; 6% increase in units and 4% increase in sales price. The statement is absolutely true until you go out into the marketplace and find that 25% of the business is distributor-related; so the distributor will also increase its price by 4%, but salesmen of the 75% segment of the business will be under pressure to get the price increase down to as close as 1% as possible. So 10% is going to be wrong if you're setting up your cost structure on that basis. [Also included in 2(b) and 13] [TI 1/13, p. 49]
Participant I-11
Yes, the MD&A provides a promising starting point. But I think that in the vast majority of cases, the present MD&A is a joke. There is a vehicle there that could be used to do what it's supposed to do, but it sure isn't being used for that now. The bad news about the MD&A is that it is an SEC-required thing and it tends to be filled at the lowest possible level. [Also included in 13] [TI 1/13, p. 49]
Participant I-8
I'm not aware of one instance where the SEC has challenged even after the fact what a company wrote in an MD&A. [Also included in 13] [TI 1/13, p. 49]
Committee/Staff/Observer
They have. [Also included in 13] [TI 1/13, p. 49]
Committee/Staff/Observer
Do you think that the filling out to the lowest level would change if it were an accounting standard versus an SEC requirement? [Also included in 13] [TI 1/13, p. 49]
Participant I-11
I think there would be a better chance of it. The idea behind the MD&A was clearly a good one, the execution clearly has been a failure. It seems to me that over the years the accounting profession has had a little more leverage in getting some of these changes effected than the SEC has had. [Also included in 13] [TI 1/13, p. 49]
Participant I-7
You all know what we think of the information coming out of FASB 14. Consequently, I'm not sure that we would be getting anything better setting up an FASB pronouncement relative to an MD&A than we get with FASB 14. But anything is better than what we have now, so go for it. [Also included in 3(a) and 13] [TI 1/13, p. 50]
Participant I-12
I've had companies tell me that if they didn't write the MD&A that way, it would take months to get the annual report out of the SEC. The SEC is looking for certain types of descriptive phrases; it's boilerplate. Part of the reason the MD&A is not that useful, a good structure but not that useful, is because we're looking at accounting items that are not necessarily the relevant ones. Perhaps it would be better if the MD&A evolves into more disclosures about lines of business. [Also included in 13] [TI 1/13, p. 50]
The big problem I have with current disclosure on derivatives is that it is highly misleading, that is, to disclose notional amounts in a business where the principal is truly not at risk. For most derivatives, it's not a principal risk business; cash flows are being exchanged and it's more of an interest rate risk business (at least for swaps). The current disclosure overstates the risks in some contracts and understates the risks in other contracts. It's very difficult to understand what the huge lump sum number being disclosed mean. What are the real risks and opportunities? [Also included in 19] [TI 1/13, p. 50]
Committee/Staff/Observer
One of the reasons for the problems with the disclosure is that we don't have agreement on what the right accounting should be. Until we get that, it's a little hard to address these risks. [Also included in 19] [TI 1/13, p. 50]
Committee/Staff/Observer
Is it possible, [participant I-12], that some kind of a sensitivity analysis, or a stress test, on those instruments would be more meaningful in terms of how they move in relation to interest rate changes and how they are related to the instruments they're linked to? [Also included in 10(c) and 19] [TI 1/13, p. 51]
Participant I-12
I think that something along those lines could be very useful. There are people who are using those instruments who I suspect haven't the foggiest notion of what they've got. There is a lot of work that needs to be done. [Also included in 10(c) and 19] [TI 1/13, p. 51]
Participant I-11
[Participant I-12] isn't part of the problem on that issue the fact that even the participants don't understand the risks? We've seen a number of cases in the past few years where some risk-reducing derivative transaction proved not to work, like portfolio insurance. From my perspective, I think the understanding of the nature of the risks in that whole business is very poor. [Also included in 19] [TI 1/13, p. 51]
Participant I-12
I think there is a dealer community that really does understand what they're doing. And there are some unscrupulous people who are selling these things to companies who don't know what they're doing. Maybe by having an accounting that makes better sense, it would point out to them that they're getting into something they don't understand. [Also included in 19] [TI 1/13, p. 51]
Participant I-5
The dealer community may know the risks for derivatives that have been around for 5 years, but every year there is something new that comes out and they may not know so well what the risks are. [Also included in 19] [TI 1/13, p. 51]
Participant I-14
When you get into the big international pharmaceutical or consumer goods companies, especially in a year where there has been a huge currency change, I question whether hedging will do everything. I think that's going to be a very big issue. I don't know how many companies will be very clear about the effects of currency fluctuations on their results. [Also included in 19] [TI 1/13, p. 52]
Participant I-12
It's not only the big international companies. I was looking recently at a small thrift ($200 million in assets) that had 2 or 3 million dollars in contracts; if the yield curve changed its shape, this company could have real problems or huge gains. [Also included in 19] [TI 1/13, p. 52]
Committee/Staff/Observer
Let me get to a third framework and that's the AICPA proposal. The Institute recommends disclosure in 3 categories: (1) to describe the nature of operations, (2) to discuss current vulnerability due to concentrations, and (3) to discuss the company's financial flexibility. Our question is: do these 3 categories provide a workable framework for categorizing and disclosing what you need to know about operating opportunities and risks? Is it a promising starting point for an accounting standard? Is the focus on risks rather than opportunities reasonable? And is information about risks more relevant to investors than information about opportunities? [TI 1/13, p. 52]
Participant I-11
The focus on risks and uncertainties is appropriate. I don't think there is any shortage of information for us about opportunities. I think there are some realistic limits about what we ought to expect the accounting profession to address in that arena, and it seems to me that information about concentrations and financial flexibility is material and reasonably quantifiable and appropriate. [TI 1/13, p. 52]
Participant I-15
It's a good starting point but there should be greater elaboration on the concentration disclosures between the production base versus the sale base (in geographic terms). [TI 1/13, p. 53]
Participant I-12
The issue of concentration is important. There are a number of issues that have come out over recent years in the financial services industry (for example, bad loans that turned into a real estate concentration because of the repossession of collateral) that make it difficult to define concentration. And there is also the issue of what is material. [TI 1/13, p. 53]
Participant I-11
If you set a very low materiality threshold, let's say 1%, don't you run the risk of having so much risk to disclose that people will tend to treat it as litigation protection and ignore it, and it becomes valueless? [Also included in 18(b)] [TI 1/13, p. 53]
Committee/Staff/Observer
The definition that the AICPA is using is "make the enterprise vulnerable to risk of severe impact on near-term cash flows or results of operations". They tried to focus on things that you better pay some attention to right now. [TI 1/13, p. 53]
Participant I-11
That's the context in which I would define it. [TI 1/13, p. 53]
Participant I-7
I don't have a problem with that; it's a starting point. [TI 1/13, p. 53]
Committee/Staff/Observer
Thus far, our discussion has focused on how to identify the types of relevant operating opportunities and risks. The number and variety of risks and opportunities are endless, so let's turn our attention to the ways to narrow these opportunities and risks down to those that you most need to know about. Question 13 on pages 29 and 30 of the meeting materials identifies several screens that could be used to narrow the list of opportunities and risks[:
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.]
Our question is: which of these screens, if any, provide a good way of narrowing the list of opportunities and risks to be disclosed? Do you have any suggestions for better screens? [TI 1/13, p. 53-54]
Participant I-10
What do you mean by reasonably possible? [TI 1/13, p. 54]
Committee/Staff/Observer
I think the point that we want to address with the first bullet is: should we have a screen that screens out certain opportunities and risks based on probability, based on some measure of the likelihood of its occurrence? [TI 1/13, p. 54]
Participant I-10
The problem is that my assessment of the likelihood of an event may be very different from yours. [TI 1/13, p. 54]
Committee/Staff/Observer
Do you feel differently about risks that you think have a low likelihood of happening versus those that have a high likelihood of happening? And is that a reasonable screen or do you want to know both? [TI 1/13, p. 54]
Participant I-11
I think it's a little more complex than that. The cut-off level gets lower as the risk gets higher. [TI 1/13, p. 55]
Committee/Staff/Observer
Which is the second bullet in the meeting materials. [TI 1/13, p. 55]
Participant I-11
If it's a life threatening situation, I want to know about it a lot more and a lot earlier than if it's a situation that might knock this quarter's earnings down 20% and then be gone. It's similar to analysing distribution companies where you look at a "turn and earn" index (gross margin times inventory turnover) and you get a figure of merit. This is kind of a risk and probability index; there's some figure of demerit that the two are intertwined in. Also, I think that a combination of all the bullets included in the meeting materials is appropriate. [TI 1/13, p. 55]
Participant I-10
It's a very complicated subject. You can have 5 different risks, each of which is unlikely to happen. But if they're all present, the likelihood of two of them happening is dramatically increased. For example, you look at insurance companies that insure municipal bonds. We know that if we have a disaster in America, not just Peoria won't be able to pay its bills. Risks are related to each other even though each risk may appear to be small. [TI 1/13, p. 55]
Participant I-12
I feel very uncomfortable with the notion of screens to determine which risks are highlighted or reported and which aren't for many of the reasons [participant I-10] just outlined. I think it's a good idea of letting people know what the risks are and where they are. But there are a lot of unforeseen events and you really are leaving it wide open for lawsuits and a lot of liabilities. I'm not sure it's worth it; it's good to have a list of what could go wrong but not to screen that list for disclosure. [TI 1/13, p. 55]
Participant I-7
We're constantly looking for more information. Risk measurement is a subjective element and I hate to force accountants into providing that information. Measurement is very difficult. [TI 1/13, p. 56]
Committee/Staff/Observer
On the other hand, there are all kinds of examples that you could talk about. For example, what are the risks and uncertainties of being a U.S. defense contractor? Is that something that management should talk about? [TI 1/13, p. 56]
Participant I-5
But it's something so general and broad that it might not be useful. [TI 1/13, p. 56]
Participant I-11
In trying to grapple with what the role of the accounting profession should be in this, it strikes me that the relevant issue is that we are dealing with firms that have had financial statements audited on an ongoing basis. I think the accountants should get involved when the risks and uncertainties threatened the company's going concern basis. I'm a lot less concerned with the opportunities side because I don't have any problems hearing about those. [TI 1/13, p. 56-57]
Committee/Staff/Observer
That says we stay where we are now? [TI 1/13, p. 57]
Participant I-11
Just about. [TI 1/13, p. 57]
Committee/Staff/Observer
Just to clarify one thing, [participant I-11]. In terms of your timeframe, when you say something is going to sink the company, what timeframe are you looking at? Is it 12 months, more than 12 months? [TI 1/13, p. 57]
Participant I-11
I'm not sure. [TI 1/13, p. 57]
Committee/Staff/Observer
[Participant I-11], is your willingness to accept current practice in part a function of your good knowledge of your industry and your ability to get the information through talking to various sources? Would you be willing to accept current practice if you didn't have access to those sources? [Also included in 10(d)] [TI 1/13, p. 57]
Participant I-11
I can't answer that question; I don't know. I'm in the business of getting that kind of information, I don't know how I would react otherwise. [Also included in 10(d)] [TI 1/13, p. 58]
Participant I-12
A lot of that information is available to people outside our profession through things like Investment Dealers Digest or some of these newsletters that go out, the business press, etc. It seems to me that a lot of the things that we see as analysts and portfolio managers are increasingly available to the general public. [Also included in 10(d)] [TI 1/13, p. 58]
[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of disclosure about operating opportunities and risks.
Participant C-11
Would this be something like in a prospectus for a somewhat speculative security? Are there any legal or accounting or SEC guidelines that have been framed from that? [Also included in 10(a)] [TC 2/2, p. 28]
Committee/Staff/Observer
I think you can view it as somewhat of a Venn diagram where some of the things that you see under the risk section of a prospectus, and some of the things you see in a MD&A, may be well scooped up under this definition. There may be other things that are not in that area, that would also be scooped up, particularly things that might be outside MD&A. Now, they may not be outside risk factors. But they would be things that are not yet known trends, but could be trends. That's where MD&A slices off. Did I answer your question? [Also included in 10(a)] [TC 2/2, p. 28]
Participant C-11
Just to be contrarian, I'm not sure that I know what this means. And I'm talking about the borderline between concerns you may have or just strong beliefs about positive things at the time you're doing your statements. I don't see that this definition really gives you any guidance as to the difference between those two things. For example, thinking about the current method of loan loss reserving where companies I think very appropriately may have an element of unallocated reserves reflecting the risks and uncertainties of loans on the books that are not performing or future loans. [Also included in 10(a)] [TC 2/2, p. 28-29]
Committee/Staff/Observer
To my knowledge, reserves relate to loans on the books. [Also included in 10(a)] [TC 2/2, p. 29]
Participant C-11
I think perhaps we're having a semantic problem here. [Also included in 10(a)] [TC 2/2, p. 29]
Participant C-4
I've got an example that I think has worked very well. In Pennsylvania, workers' compensation is 3%; if a contractor has a job locked in at certain prices, you know that there's going to be a profit; under current accounting, I would say that's neither a liability or a contingent liability. But it's going to have a major impact on the cash flows of that contract and it should be disclosed. So that's the type of information that, if I'm a creditor and I'm loaning somebody doing business, I would want that information disclosed to me. Another example would be a major change in their insurance program and the risk management program. [Also included in 10(a)] [TC 2/2, p. 29]
__________
Participant C-15
Would the disclosures run parallel to the SEC? Or separate from those? [TC 2/2, p. 30]
Committee/Staff/Observer
I don't want to imply that there is some kind of a very concrete proposal underneath all of this. But, right now, we'd be talking about things that are not in the universe that was required of financial statements. So whatever the SEC requires now, inside financial statements, what we're talking about is outside that boundary. [TC 2/2, p. 30]
Participant C-15
The SEC would have general guidelines about disclosure of factors the company is aware of that might impede trends at a certain point. Financial or not financial. [TC 2/2, p. 30]
Participant C-11
I'd like to make a rather flat statement. I think that the management discussion and analysis framework which developed at the beginning of the '80's is an excellent framework for discussion of these types of items with risk uncertainties. It obviously gets into the operating circumstances of the company, but also into issues of liquidity and capital and so forth that I think is superb. [TC 2/2, p. 30-31]
Committee/Staff/Observer
I want to ask you two questions, [participant C-11]. One is whether some pieces of the MD&A really should be included as part of the financial statements subject to audit oversight, and the second one is to the extent MD&A reports are always valuable, should it be extended, other than just the 10,000 public companies? [TC 2/2, p. 31]
Participant C-11
Those are two very different questions. On the first one, I would say, if there are certain types of things in the MD&A that went into a different framework, we should get a good definition and talk about what those might mean, as opposed to just going with this. [TC 2/2, p. 31]
Participant C-17
The way I look at this is that I want help from you folks in terms of being able to identify a quantifiable risk, something that's measurable. Insurance that you dropped. But I don't want an accountant getting involved in trying to determine the future. I think that's management's responsibility, and my responsibility. [Also included in 12] [TC 2/2, p. 31]
Participant C-13
I agree with that. I approach this whole thing with a fair degree of skepticism. I agree with what [participant C-11] said, I draw the analogy with the discussions of forecasting. I don't think that forecasting has a place in financial disclosure. And I don't think that what we're talking about here has a place in financial statements. Its place is elsewhere. [Also included in 12] [TC 2/2, p. 31]
Participant C-17
For example, I'd love to know that collective bargaining was going to commence quickly. I don't want you to interpret for me. I just want to know, hey, there's a risk there. [TC 2/2, p. 32]
Participant C-5
Item C in the meeting materials seems to be something where you could get a little bit more detailed without being subjective. I think that is something that is quantifiable within management's ability to provide to you. [TC 2/2, p. 32]
Participant C-14
Wouldn't these issues be discussed in MD&A if management felt as though they were going to be relevant or significant enough as to impair future cash flows? [TC 2/2, p. 32]
Participant C-5
My problem is that they never quantify it, they talk about all of it but, I don't get the sense they quantify the potential impact. [TC 2/2, p. 32]
Participant C-14
My guess is a lot of this gets on to the competitive information areas that managements are going to be reluctant on disclosing. I think rightfully so. I'm just not clear, I think, on what the objective for this section is. [Also included in 2(d)] [TC 2/2, p. 32]
Participant C-4
We're small lenders. We don't get the MD&A information and if the accounting profession would take that upon themselves in that one area, that would be very useful information. [TC 2/2, p. 32]
Participant C-5
Just another example of the situation at [name deleted]. I have a lease expiring in 1994. It's nice they show you that, but they don't tell you that it's above market. It's above market by $26 and, therefore, I'd like you to have a reduction in my occupancy expense by this dollar amount. You know, the impact on future years' revenues, the future periods beyond that. There is a need for that. It just helps to build the historical financial statements; you're looking at the past to predict the future. And right now, we don't get that sort of flow from the historical forward as much as we should. [Also included in 10(c)] [TC 2/2, p. 32-33]
Participant C-11
I think we can repeat the words that we've been saying all the way through here. And that is, relatively near term, relative certain, relatively quantifiable are thing that could be disclosed. [Also included in 10(c)] [TC 2/2, p. 33]
__________
Participant C-11
Talking about the specific examples in the meeting materials, some of them very good, where there could well be a near term quantifiable change occurring because of certain items. I think, ultimately, the preparer has a responsibility to understand and determine what those elements might be. An interesting subject here, is to what extent does the auditors also have responsibility to ascertain and know whether the management has properly identified quantifiable near-term things that could happen, that would have an impact on the various financial statements? [Also included in 17(b)] [TC 2/2, p. 35]
Committee/Staff/Observer
If we try and address the cost issue by saying that disclosure should be made of things that management does not have to incur special work to look for; is that an appropriate approach for disclosures? Does that make any sense? [TC 2/2, p. 35]
Participant C-13
How far did you look? [TC 2/2, p. 35]
[Context] Responses to the postmeeting questionnaire to the February 2, 1993 Creditor Discussion Group meeting.
QUESTION 13-Definition of Operating Opportunities and Risks and Relative Importance of Each
The Special Committee has defined operating opportunities and risks as follows:
Operating opportunities and risks are beneficial or detrimental circumstances in which a company is involved at the reporting date that are not its assets or liabilities but that may cause the reporting entity to have increases or decreases in cash flows in the future.
With respect to the foregoing proposed definition of operating opportunities and risks, please indicate your agreement or disagreement with the following:
SA Strongly Agree
A Agree
N Neutral
D Disagree
SD Strongly Disagree
For public companies, Management's Discussion and Analysis is a better location for disclosures of opportunities and risks than the financial statement footnotes. SA A N D SD 7 5 2 Any required disclosure of operating opportunities and risks should be balanced with considerations of the costs of providing and auditing such disclosures. SA A N D SD 7 6 1 Disclosure of operating opportunities and risks should focus on specific, clear identifications of near-term events and circumstances rather than discuss unspecified possibilities. SA A N D SD 11 3 Disclosure of operating opportunities and risks should be specific to the company rather than address risks generally knows to be associated with the industry. SA A N D SD 3 4 4 3 Identification, rather than interpretation, should be the primarydisclosure goal for operating opportunities and risks. SA A N D SD 4 8 1 1 Participant C-18: Identification, rather than interpretation, or measurement or estimates should be the primary disclosure goal for operating opportunities and risks. A requirement to disclose operating opportunities and risks should be worded in a way that the list of potential matters to be considered for disclosure by the preparer and auditor is also known to the users of the financial report. SA A N D SD 1 5 4 3 1 Participant C-18: Disclose what you didn't disclose? Reason needs to prevail here. [PMQC 2/2, p. 23-24] __________
QUESTION 14-Kinds of Operating Opportunities and Risks About Which Information May Be Disclosed
The following are examples of operating opportunities and risks about which information might be disclosed in external reporting.
Please mark each to indicate whether you would I-Include or E-Exclude it in a disclosure requirement:
Operating opportunities and risks related to sensitivity to
I-12,E-1 Interest rates
I-13,E-1 Exchange rates
I-8,E-6 Inflation
Participant C-11: Depending on circumstances. For example, inflation would not be relevant for a large number of U.S. domestic companies.
Operating opportunities and risks resulting from
I-6,E-7 Possibilities of new competitors
I-8,E-6 Possibilities of substitute products
Participant C-13: Include only if probability is very high or certain.
I-7,E-7 Changes in bargaining power of employees
I-4,E-10 Changes in bargaining power of customers
I-12,E-2 Changes in costs of producing products or services
I-6,E-8 Changes in bargaining power of suppliers
Participant C-11: But a high-probability threshold should be used.
Participant C-12: First, third and fourth: No one is going to tell the truth in print about these three!
I-14,E-0 Large increases or decreases in proportion of products or services sold to one or two large customers
I-12,E-2 Large increases or decreases in proportion of materials purchased from one or two large suppliers
I-13,E-1 A growing inability to pay suppliers and lenders on time
I-7,E-6 Possibilities of changes in the company's relative competitive position
I-5 Other. Please describe
Participant C-17: Back logs and trend.
Participant C-3: Changes in government regulations.
Participant C-5: Product initiatives/Status/RTD
Participant C-4: Changes in risk management of insurance issues with compensation and probability/liability. Disclose increasing in self insurance.
Participant C-17: Unfunded construction projects and cost.
Participant C-3: Changes in consumer demands.
Participant C-5: Changes in product mix, new releases.
Participant C-4: Possible environmental liabilities from purchase of property, etc.
Participant C-17: Capital exp. budget (annual).
Participant C-5: Changes in employee/union contracts.
Participant C-17: Pending acquisition or sale of assets.
Participant C-11: Judgement is critical to decisions on risk and uncertainty and this cannot be standardized. There is risk in all business activities. If disclosures are made, they must be specific to the company, and represent material and identifiable circumstances. For many of these the MD&A is by far the most appropriate plea for disclosure.
[PMQC 2/2, p. 24-25]
[Context] Meeting of the Creditor Discussion Group on March 11, 1993. Part of the meeting was devoted to the topic of priority of improvements needed in external reporting. During the discussion, a comment was made on disclosure about operating opportunities and risks.
Participant C-15
I'll go with number 11 (core earnings) as my first choice. And 13 (financial instruments) is my second choice. [W]e always ask the questions and we meet with financial institutions and increasingly with industrial companies and so on about their off-balance-sheet financing, in particular swaps and other types of instruments. And I think that we find at the senior management level, CFO level, that we deal with that they broadly understand the issues. But when it comes down to getting into specifics, they say that they have somebody locked away in a corner room someplace who is really doing all this work. Something going forward which I think is going to be increasingly important are these environmental liabilities (number 14). They're kind of difficult to get your hands around but these are the types of things, if you look at a company like [name deleted] for example, that just came out of the clear blue. You looked at their balance sheet and income statement, you didn't have a hint anything was wrong with the company. Well, you knew something was wrong by reading the footnotes that they had these asbestos related liabilities but the next thing they're on their way over to bankruptcy court. I think that disclosure of those types of liabilities going forward is going to be increasingly important. [Also included in 15 and 19] [TC 3/11, p. 70-71]
[Context] Responses to the postmeeting questionnaire of the December 9, 1992 and January 13, 1993 Investor Discussion Group meetings.
QUESTION 19 - Definition of Operating Opportunities and Risks and Relative Importance of Each
b. Is information about risk more important to you than information about opportunities? Please answer by indicating your ranking of the following with 1 meaning most preferred, 2 meaning next preferred, and 3 meaning least preferred (use a number only once)
Most preferred Next preferred Leastpreferred Investors' and analysts' needs for information about opportunities and information about risk are roughly equal 1 5 Investors and analysts need more information about opportunities than about risks because (please describe) 6 Investors and analysts need more information about risks than about opportunities because (please check as many as are appropriate) 5 1 Warnings of probable unfavorable changes in assets and liabilities and profits are more necessary than messages of probable favorable changes 4 Companies already have a propensity to talk a lot about opportunities but to withhold information about risks 5 Other. Please explain Participant I-12: Fiduciaries are interested in preserving capital and must assess the risk of loss in their investment decisions. Lenders (both loans and debt) are concerned about getting repaid interest and principal. Participant I-9: I do not think that this section is a fruitful area for accountants to get into. It is the job of the analyst to ask the right questions of management on risks and opportunities based on the knowledge of the company, the industry, and trends in competition, etc. Accountants should stay away from this area, it is not their area of expertise. 1
QUESTION 21 - Kinds of Operating Opportunities and Risks About Which Useful Information May Be Disclosed
The following are examples of operating opportunities and risks about which information might be disclosed in external reporting. Please mark each to indicate whether you would I-Include or E-Exclude it in a requirement to disclose information about operating opportunities and risks facing a company:
Include Exclude Operating opportunities and risks related to volatility of: Interest rates 6 1 Exchange rates 7 Inflation Participant I-12: unless a company has a very specific, direct exposure to inclation/deflation alone 2 4 Operating opportunities and risks resulting from: Possibilities of new competitors 4 2 Possibilities of substitute products 5 2 Changes in bargaining power of employees Participant I-11: Exclude or include depending on facts and circumstances 4 2 Changes in bargaining power of customers Participant I-11: Exclude or include depending on facts and circumstances 4 2 Changes in costs of producing products or services 7 Changes in bargaining power of suppliers Participant I-11: Exclude or include depending on facts and circumstances 3 3 Include Exclude Large increases or decreases in proportion of products or services sold to one or two large customers 7 Large increases or decreases in proportion of materials purchased from one or two large suppliers 7 A growing inability to pay suppliers and lenders on time Participant I-12: When would this be insider information? 7 Possibilities of changes in the company's relative competitive position 4 2 Other. Please describe
For an institution that has the intent and ability to hold assets for the foreseeable future (defined as 12 to 18 months), indicate whether you believe fair value accounting is appropriate.
30% Yes
60 No
8 No opinion
2 No response
[Also included in 2(b), 2(c), 4, and 15] [KPMG BANK STUDY, p. A-13]
[One user commented] no. The crux of bank valuation is the ability to manage risk over an intermidiate time frame so day to day market values may be irrelevant. [Also included in 4 and 15] [KPMG BANK STUDY, p. A-13]
__________
As part of the industry analysis, key rating factors are identified--keys to success and areas of vulnerability. A specific company's rating is affected crucially by its ability to achieve success and avoid pitfalls in its business. [Also included in 1(b), 1(c), 10(d), and 13] [S&P, p. 16]
The basis for competition determines which factors are analyzed for a given company. [Also included in 1(b), 1(c), 10(d), and 13] [S&P, p 16]
For any particular company, one or more factors can hold special significance, even if that factor is not common to the industry. For example, the fact that a company has only one major production facility should certainly be regarded as an area of vulnerability. Similarly, reliance on one product creates risk, no matter how successful that product. For example, one major pharmaceutical company has reaped a financial bonanza from a single drug. The firm's debt is highly rated, given its exceptional profits and cash flow--but it would be viewed still more favorably if it were not dependent on a single medication, which is subject to competition and patent expiry. [Also included in 1(b), 1(c), 10(d), and 13] [S&P, p.16]
When a company participates in more than one business, each segment is analyzed separately. A composite is formed from these building blocks, weighting each element according to its importance to the overall organization. Then the potential benefits of diversification, which may not be apparent from the additive approach, are considered. [Also included in 1(b), 1(c), 10(d), and 13] [S&P, p. 16]
Limited credit will be given if the various lines of business react similarly to economic cycles. For example, diversification from nickel into copper cannot be expected to stabilize performance; similar risk factors are associated with both metals. [S&P, p. 16]
Market share analysis is often an important rating consideration. However, large shares are not always synonymous with competitive advantage or industry dominance. For instance, if an industry has a number of large but comparably sized participants, none may have a particular advantage or disadvantage. conversely, if an industry is highly fragmented, even the large firms may lack pricing leadership potential. [Also included in 1(b), 1(c), 10(d), and 13] [S&P, p. 16]