Earlier this week, the SEC voted unanimously to require corporate filers to explain how they apply critical accounting policies in the Management’s Discussion and Analysis (MD&A) section of their financial statements.
The new rule would require companies to include an Application of Critical Accounting Policies section in annual reports, registration statements, and proxy and information statements. In that section, a filer would have to disclose any information about the “critical” accounting estimates that are made by the company in applying its accounting policies. Corporate filers would also have to offer details about the initial adoption of a new accounting policy.
Under the SEC’s proposal, an accounting estimate would be deemed critical if it requires a company to make assumptions about matters that are highly uncertain at the time of the estimation. The estimate would also be deemed critical if the filer could have reasonably made different estimates—or if periodic changes to the estimate the company did make would have a material impact on the filer’s financial condition or operating results.
The bugaboo here? Corporate filers are still pretty much left to their own devices to determine what constitutes a “material impact.” In fact, as CFO.com reported in January, regulators at the SEC are still struggling to come up with a more-precise definition of material impact.
The SEC’s proposal is clearly a response to the recent high-profile bankruptcies of Enron, Global Crossing, and Kmart, as well as the recent raft of corporate revenue restatements. The commission’s proposal would require the following information in the MD&A section:
- A discussion that identifies and describes an estimate, the methodology used, certain assumptions, and reasonably likely changes.
- An explanation of the significance of an accounting estimate to a company’s financial condition, changes in financial condition, and results of operations, and, where material, an identification of line items in a company’s financial statements affected by an accounting estimate.
- A quantitative discussion of changes in line items in financial statements and overall financial performance if a company were to assume that the accounting estimate was changed. This can be done either by using reasonably possible near-term changes in certain assumptions underlying an accounting estimate or by using a reasonably possible range of the accounting estimate.
- A quantitative and qualitative discussion of any material changes made to an accounting estimate in the past three years, the reasons for the changes, and the effect on line items in financial statements and overall financial performance.
- A statement of whether a company’s senior management has discussed the development and selection of an accounting estimate—and the MD&A disclosure regarding that estimate—with the audit committee of the company’s board of directors.
- An identification of the segments of a company’s business the accounting estimate affects.
- A discussion of an estimate on a segment basis, mirroring the one required on a companywide basis, to the extent that a failure to present that information would result in an omission that renders the disclosure materially misleading.
Companies would also be required to disclose:
- The events or transactions that gave rise to the initial adoption.
- The accounting principle that has been adopted and the method of applying that principle.
- The impact on a company’s financial condition, changes in financial condition, and results of operations (discussed on a qualitative basis).
- An explanation as to why an estimate was chosen, particularly if a company could have used an estimate based on acceptable principles. A company must also list alternative methods for calculating the figure, and must disclose why it made the choice it did (including, where material, qualitative disclosure of the impact the alternatives would have had on its financial presentation).
- If no accounting literature exists that governs the accounting for the events or transactions giving rise to the initial adoption, an explanation of the decision regarding which accounting principle to use and which method of applying that principle to use.
The commission is seeking comments on the proposals for the next 60 days.