15 ASC 275 RISKS AND UNCERTAINTIES
Use of Estimates in the Preparation of Financial Statements
Current Vulnerability Due to Concentrations
Examples of concentrations that need disclosure
Example Disclosure – Geographic Concentration
PERSPECTIVE AND ISSUES
Subtopic
ASU 275, Risks and Uncertainties, contains one subtopic:
- ASU 275-10, Overall, that provides guidance on disclosures of risks and uncertainties inherent in entity's operations.
This topic recognizes that all businesses face risk and uncertainty. The objective of ASC 275 is to provide guidelines that will enable the preparer to screen the many risks and uncertainties faced by entities and focus on those most useful to the readers of the particular entity's report, those that will enable the readers to assess the future cash flows and result of operations. Thus, the topic focuses on screening criteria for risks and uncertainties and the resulting required disclosures.
Scope and Scope Exceptions
The guidance applies to all GAAP financial statements, interim and annual, but not to condensed or summarized financial statements. The guidance does not apply to risks and uncertainties associated with:
- “Management or key personnel
- Proposed changes in accounting principles
- Deficiencies in the internal control structure
- The possible effects of acts of God, war, or sudden catastrophes”.
ASC 275-10-15-4
The Codification points out that there is overlap between this topic and the requirements of the SEC and other Codification topics. The guidance in ASC 275 does not alter any of those requirements.
DEFINITIONS OF TERMS
Source: ASC 275, Risks and Uncertainties
Fair Value. The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
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 an entity. Severe impact is a higher threshold than material. Matters that are 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 entity itself. The concept of severe impact, however, includes matters that are less than catastrophic. Matters that are catastrophic include, for example, those that would result in bankruptcy.
CONCEPTS, RULES, AND EXAMPLES
ASC 275-10-50, Risks and Uncertainties, requires disclosure in financial statements about risks and uncertainties existing as of the date of those statements that could significantly affect the amounts reported in the near term. The four areas of disclosure required by ASC 275-10-50 are risks and uncertainties relating to
- The nature of the entity's operations,
- Use of estimates in the preparation of financial statements,
- Certain significant estimates, and
- Vulnerability due to certain concentrations.
These areas are not mutually exclusive and may overlap with other requirements. The disclosures may be grouped together or placed in other parts of the financial statements or made as part of the disclosures required by other topics.
Nature of Operations
ASC 275-10-50 requires that entities disclose the major products or services that they sell or provide, the principal markets that they serve, and the location of those markets.
If an entity operates in more than one industry, it must disclose all industries it is operating within as well as the relative importance of each industry. The basis for determining the relative importance of each industry (assets, revenue, or earnings) is also to be disclosed. Not-for-profit entities should disclose the nature of their principal services and the revenue sources for those services. Quantification is not required in disclosures about the nature of operations. Comparisons of relative importance for entity's operating in more than one business can be conveyed by the use of words such as predominantly, equally, or major. (ASC 275-10-50-2)
Use of Estimates in the Preparation of Financial Statements
Financial statements must include an explanation that the preparation of financial statements in accordance with GAAP requires the use of estimates by management. The purpose of this disclosure is to clearly alert users to the pervasiveness of estimates. (ASC 275-10-50-4)
Certain Significant Estimates
ASC 275-10-50 requires disclosures regarding estimates used in valuing assets, liabilities, or gain or loss contingencies if both of the following conditions are met:
- It is at least reasonably possible that the estimate of the effect on the financial statements of a condition, situation, or set of circumstances that existed at the date of the financial statements will change in the near term due to one or more future confirming events.
- The effect of the change would be material to the financial statements.
For the purposes of determining materiality, it is not the amount of an estimate that determines whether an item is material and must be disclosed, but rather the effect of using a different estimate that determines materiality.
The disclosure is to indicate the nature of the uncertainty and that it is reasonably possible that the estimate will change in the near term. ASC 275-10-50 is separate from and does not change ASC 450, Contingencies. If an estimate is covered under ASC 450 as a loss contingency, the disclosure also is to include an estimate of the possible range of loss, or state that an estimate cannot be made. Disclosure of any factors that would make an estimate sensitive to change is encouraged but not required.
Examples of items that may be based on estimates that are particularly sensitive to change in the near term (ASC 275-10-50-15)
- Inventory subject to rapid technological obsolescence
- Specialized equipment subject to technological obsolescence
- Valuation allowances for deferred income tax assets based on future taxable income
- Capitalized motion picture film production costs
- Capitalized computer software costs
- Deferred policy acquisition costs of insurance entities
- Valuation allowances for commercial and real estate loans
- Environmental remediation-related obligations
- Litigation-related obligations
- Contingent liabilities for guarantees of other entities' obligations
- Amounts reported for long-term obligations, such as amounts reported for pensions and postemployment benefits
- Net proceeds recoverable, the provisions for expected loss to be incurred, or both, on disposition of a business or assets
- Amounts reported for long-term contracts.
Current Vulnerability Due to Concentrations
Vulnerability from concentrations occurs when entities fail to diversify in order to mitigate risk. Financial statements must disclose such concentrations if management knows prior to issuance of the financial statements that all of the following conditions exist (ASC 275-10-50-16):
- The concentration exists at the date of the financial statements.
- The concentration makes the entity vulnerable to the risk of a near-term severe impact.
- It is at least reasonably possible that the events that could cause the severe impact will occur in the near term.
- Concentrations in the volume of business transacted with a particular customer, supplier, lender, grantor, or contributor
- Concentrations in revenue from particular products, services, or fundraising events
- Concentrations in the available sources of supply of materials, labor, 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.
The potential for severe impact can occur as the result of the total or partial loss of a business relationship, price or demand changes, loss of patent protection, changes in the availability of a resource or right, or the disruption of operations in a market or geographic area. For purposes of ASC 275-10-50, it is always considered reasonably possible in the near term that any customer, grantor, or contributor will be lost and that operations located outside an entity's home country will be disrupted.
For concentrations of labor subject to collective bargaining agreements and concentrations of operations outside an entity's home country, the following additional disclosures are required (ASC 275-10-50-20):
- For labor subject to collective bargaining agreements, disclosure is to include both the percentage of the labor force covered by collective bargaining agreements and the percentage of the labor force covered by collective bargaining agreements that will expire within one year.
- For operations located outside the entity's home country, disclosure is to include the carrying amounts of net assets and the geographic areas in which they are located.
Example Disclosure – Geographic Concentration
The Group's operations are conducted in Hong Kong and the PRC. Accordingly, the Group's business, financial condition and results of operations may be influenced by the political, economic and legal environment in the PRC, and by the general state of the PRC economy.
The Group's operations in the PRC are subject to special considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environment and foreign currency exchange. The Group's results may be adversely affected by changes in the political and social conditions in the PRC, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, and rates and methods of taxation, among other things.