Briefing Paper for the Financial Reporting Series Roundtable Discussion

Measurement Uncertainty in Financial Reporting: How Much to Recognize and How Best to Communicate It

In general, “uncertainty” means a state of limited knowledge where it is impossible or impracticable to describe exactly an existing state or a future outcome.¹ Uncertainty exists in financial statements where measurements “to a large extent…are based on estimates, judgments, and models rather than exact depictions.”² As the level of uncertainty increases, challenges may exist for:

• financial statement preparers to estimate the future outcome of the uncertainties inherent in many business transactions,
   
• auditors to verify the subjective judgments about those uncertainties, and
   
• investors to understand those uncertainties and assess their potential impact on future earnings or cash flows.

For example, seemingly small changes from a management-selected input used to determine fair value could have a material impact on the reported result at any specific date. For example, when a fair value measure is determined primarily based on a discounted cash flow analysis, use of a discount rate that is 100 basis points different could mean the difference between a material goodwill impairment charge, or none at all.

This roundtable will bring together investors, preparers, and auditors to provide input about those measurements (and associated disclosures) where the outcome depends on future events that by definition are presently unknown. As the initial step in gathering input on this topic, the roundtable discussion will focus on:

• Measurement and recognition — whether measurements that involve uncertainty provide investors with useful information.
   
• Disclosure — the information that investors find important to understand and assess measurement uncertainties and the challenges or impediments that preparers face in providing that information.
   
• Auditability — the auditor's role and responsibility for reporting on financial statements with measurement uncertainties.

Certain recent accounting standards have increased the extent of measurement uncertainty in financial statements³ and some standards have attempted to increase the transparency into the measurement uncertainty that underlies financial statement items.⁴ Nonetheless, there continue to be questions about the recognition and measurement of uncertainty; the disclosures necessary to understand the measurement uncertainty; and how uncertainty impacts auditability.

The FASB's Conceptual Framework for Financial Reporting states, “if the level of uncertainty … is sufficiently large, that estimate will not be particularly useful.”⁵ The nature and extent of measurement uncertainty depend on the economic phenomena that the underlying financial statement item is intended to represent. Some question what is the right balance and whether sufficient information is provided to understand the nature and extent of measurement uncertainty.

To explore this topic, it may be useful to illustrate some of the various accounting treatments that currently incorporate uncertainty. For example,

• Certain illiquid financial assets reflected at estimated fair value are adjusted up or down for changes in the estimated fair value; however, non-financial assets (e.g., goodwill) are only adjusted down when the recorded amount is greater than the fair value at a point in time.
   
• Contingent liabilities are recognized when it is probable that a loss has been incurred and can be reasonably estimated and are measured as a single point estimate. If the single point estimate is within a range, the additional maximum exposure to loss is required to be disclosed.
   
• Certain guarantees are measured based on probability-weighted expected future outcomes.
   
• The financial statement effects of uncertain tax positions are recognized when it is more likely than not, based on the technical merits, that the positions will be sustained upon examination and are measured as the largest amount that has more than a 50% chance of being realized.
   
• Certain illiquid financial assets are measured at present value based on discounted future cash flows regardless of the certainty of those cash flows.
   
• Acquired identifiable intangibles are recognized without regard to measurement uncertainty. However, most internally developed intangibles (e.g., research and development and goodwill) are never recognized in the financial statements because the future benefits are deemed to be too uncertain.
   
• When there is substantial doubt about an entity's ability to continue as a going concern, the financial statements are generally not adjusted to reflect the uncertainty. Instead, disclosures are provided and include, among other things, information about the uncertainty, the recoverability and classification of recorded asset amounts, and the amounts or classification of liabilities.

Panel Discussions

The panel discussions will focus on the following questions. Panelists will be encouraged to specify, where applicable, the topic — financial instruments, goodwill, loss contingencies, etc — that their comments address.

1. Please provide feedback on any topics where the extent of uncertainty is less useful to investors and why a more certain measurement would be preferable. Likewise, provide comments on those topics where a measurement with uncertainty gives investors more useful information and why it is preferable to a more certain measurement.
    
2. For those topics where uncertain measurements are useful to investors, how should the uncertainties be incorporated into the measure? Please explain the reasons for the measurement method(s) you selected.
    
3. What information do investors utilize to understand uncertainty? Please describe why such information is useful and, if it is not disclosed in the financial statements, indicate its source.
    
4. What are the challenges for investors in understanding the nature and extent of measurement uncertainty?
    
5. As measurement uncertainty increases, please explain whether (and how, if applicable) it changes the investor’s expectation of preparers and auditors.
    
6. For preparers, what are the challenges in or impediments to providing investors with information to understand the nature and extent of measurement uncertainties?
    
7. What are the challenges for auditors in evaluating management’s judgments related to measurement uncertainties?
    
8. Please provide comments on whether (and how) a change in the auditor’s responsibility or role would enhance the investor’s understanding of the nature and extent of measurement uncertainties.
    
9. Please provide any additional comments or suggestions pertinent to how much uncertainty to recognize and how best to communicate it.

A separate request for comment has been issued for the public to submit feedback on the above questions. Public responses can be provided through the SEC website at www.sec.gov.

Additional Resources

The Commission staff believes that the following resources may contain additional background information related to the topic of measurement uncertainty.

1. http://americanassembly.org/publication/future-accounting-profession

2. http://www.aicpa.org/interestareas/frc/accountingfinancialreporting/
   enhancedbusinessreporting/pages/jenkinscommittee.aspx - See Recommendation 5 - Improve disclosures about the uncertainty of measurements of certain assets and liabilities.

3. Christensen, Glover et al. “Extreme Estimation Uncertainty in Fair Value Estimates: Implications for Audit Assurance.” Auditing: A Journal of Practice & Theory. Forthcoming http://ssrn.com/abstract=1916336

4. “The future of accounts: True and fair is not hard and fast — For accounts to reflect reality, they need to be more volatile and less precise.” The Economist. April 24, 2003. http://www.economist.com/node/1730918

5. Schuetze, Walter P. “Auditing: Objective Evidence vs. Subjective Judgments.” Foundation for Accounting Education, New York State Society of CPAs. New York. 9 Sept. 2003.

6. International Accounting Standards Board’s discussion paper: “Measurement Bases for Financial Accounting— Measurement on Initial Recognition.” Paragraphs 205-215. November 2005.

   http://www.iasb.org/NR/rdonlyres/E1A542DB-3A19-47AC-B995-EFCFA044F3EC/0/MeasurementBasesforFinancialAccountingDPfullversion.pdf

7. Jerry L. Arnold and William W. Holder. “At War — Disclosure of Measurement Uncertainties.” Journal of Accountancy. December 1998. http://www.journalofaccountancy.com/Issues/1998/Dec/arnold.htm

8. Securities and Exchange Commission Release FR-60, “Cautionary Advice Regarding Disclosure About Critical Accounting Policies,” December 12, 2001.

   http://www.sec.gov/rules/other/33-8040.htm

9. Securities and Exchange Commission Release FR-72, “Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations,” December 19, 2003.

   http://www.sec.gov/rules/interp/33-8350.htm

10. Financial Accounting Standards Board’s (FASB) project: “Disclosure Framework.” http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FProjectUpdatePage&cid=1176156344894

11. FASB’s joint project with the IASB: “Conceptual Framework.” http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FProjectUpdatePage&cid=900000011090

12. Public Company Accounting Oversight Board’s (PCAOB) Concept Release on Possible Revisions to PCAOB Standards Related to Reports on Audited Financial Statements and Related Amendments to PCAOB Standards. http://pcaobus.org/Rules/Rulemaking/Pages/Docket034.aspx

¹ See Douglas Hubbard. “How to Measure Anything: Finding the Value of Intangibles in Business,” John Wiley & Sons, 2007.

² Statement of Financial Accounting Concepts No. 8, paragraph OB 11.

³ For example, ASC Topic 825-10, Fair Value Option. This standard increased the use of fair value measures that may be determined using unobservable inputs.

⁴ For example, ASC 820-10, Fair Value Measurement. This standard defined fair value, established a framework for measuring fair value, and expanded disclosures about fair value measurements.

⁵ Statement of Financial Accounting Concepts No. 8, paragraph QC 16.

http://www.sec.gov/about/offices/oca/ocafrseries-briefing-measurement.htm