Reporting Critical Accounting Policies

CPA Journal, The, Dec 2007 by Holtzman, Mark P

Accountants inevitably make many accounting estimates and policy decisions when preparing financial statements. They must select depreciable lives for long-lived assets, choose an inventory costing method, make assumptions about pensions, and make many more judgments. These accounting estimates are driven by an entity's accounting policy as it applies to the issues at hand. These decisions could significantly affect a company's financial statements and how users understand a company's results and financial position.

For this reason, the SEC requires companies to report "critical accounting policies" (CAP) as part of Management's Discussion and Analysis (MD&A). The SEC has issued many comment letters about companies' CAPs, indicating their importance. What follows is an overview of the SEC's requirements and proposed rule on CAPs, as well as a survey of current practices by large companies.

The SECs Interpretation

In December 2003, the SEC released FR72, "Interpretation: Commission Guidance Regarding Management's Discussion and Analysis of Financial Condition and Results of Operations" (www.sec.gov/rules /33-8350.htm). This covered many different areas of MD&A, including critical accounting estimates. The interpretation defines critical accounting estimates as those "estimates or assumptions where [1] the nature of the estimates or assumptions is material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change; and [2] the impact of the estimates and assumptions on financial condition or operating performance is material."

The rule states that critical accounting estimate disclosures in the MD&A should supplement the description of significant accounting policies provided at the beginning of the notes to the financial statements [required under Accounting Principles Board (APB) Opinion 22 and AICPA Statement of Position (SOP) 94-6]. The MD&A disclosure should provide more insight into the quality and variability of information on the balance sheet and income statement. Furthermore, the disclosure should analyze the uncertainties involved in applying an accounting principle, or the variability likely to result from its application over time.

Accountants should explain why critical accounting estimates bear the risk of change. Furthermore, they should explain how they arrived at the estimate, how accurate the estimate or assumption has been in the past, how much the estimate or assumption has changed in the past, and whether the estimate or assumption is reasonably likely to change in the future. When quantitative, material information is available, accountants should quantify the sensitivity to change based on reasonably likely outcomes.

The SECs Proposed Rule

In May 2002, prior to the issuance of the above interpretation, the SEC released a proposed rule, "Disclosure in Management's Discussion and Analysis about the Application of Critical Accounting Policies" (www.sec.gov/rules /proposed/330 -8098.htm). This proposed rale provides more complete and direct guidance than the interpretation. The SEC has yet to act upon this proposal; it has not issued any amended proposals or final rules on the matter. Furthermore, the SECs Division of Corporation Finance's most recent Current Accounting and Disclosure Issues (November 30, 2006) did not mention CAPs.

The proposed rule would redefine the criteria for CAPs to focus on the following: 1) critical accounting estimates that require a company to draw assumptions about highly uncertain matters; and 2) alternate estimates in the current period, or changes in the estimate that are reasonably likely in future periods that would materially impact the presentation of the company' s financial condition, changes in financial condition, or results of operations.

The proposed rule sets a number of additional disclosures for each estimate. Companies would be required to explain the significance of each critical accounting estimate to the financial statements and, where material, to individual financial statement line items. Furthermore, the proposed rule would require quantifying financial statements' sensitivity to changes made in each critical accounting estimate, and disclosing historical changes in a company's critical accounting estimates over the past three years (two years for small business issuers). Companies would be required to explain the reasons for those changes.

For initial adoptions of accounting policies, companies would be required to describe the following: 1) the events or transactions that gave rise to the initial adoption; 2) the accounting principle adopted, and the method of applying it; and 3) the qualitative impact of the adoption on the company's financial statements. If there is a choice among acceptable accounting principles, the company would have to identify the alternatives and describe why it made the choice that it did. In the absence of existing accounting literature for unusual or novel transactions, a company would be required to explain its decision regarding the initial adoption.