SEC Proposes Critical Accounting Policy Disclosure

In its latest effort to improve transparency of financial reporting in the wake of Enron, the Securities and Exchange Commission has proposed requiring public companies to include a new, separately captioned section discussing application of critical accounting policies as part of the Management's Discussion and Analysis contained in periodic reports, registration statements and proxy or information statements. The proposed new section would contain disclosure and analysis relating to critical accounting estimates made by management in preparing the company's financial statements as well as initial adoption by the company of any critical accounting policy. See SEC Release No. 33-8098 (May 10, 2002).

The proposed new MD&A requirement would apply to both U.S. and foreign issuers (other than small business issuers that have not had revenues during the last two fiscal years). The comment period on the proposal will expire on July 19.

According to the SEC proposal, an accounting estimate is "critical" if both (1) it requires management to make assumptions about matters that are highly uncertain at the time of the estimate, and (2) different estimates that the company reasonably could have used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the presentation of the company's financial condition, changes in financial condition or results of operations.

As hypothetical examples of critical accounting estimates, the proposing release discusses:

• estimated liability for expected cost of warranty-related claims at a company manufacturing electrical equipment used in large-scale commercial pumping and water treatment.

• estimated reduction of gross revenues to reflect a 120-day product return policy at a company selling desktop publishing software.

• estimated asset impairment of property, plant and equipment at a company manufacturing data storage devices where reported value of the assets exceeds expected future cash flows derived from them.

The SEC indicates in the proposing release that "very few" public companies would have no critical accounting estimates at all in their financial statements and that the "vast majority" would have "somewhere in the range of three to five."

Required disclosure. The proposed disclosure would be under the caption "Application of Critical Accounting Policies" in the MD&A. The company would be required to identify and describe each critical accounting estimate, giving appropriate context, explaining methodology and assumptions and outlining reasonably likely changes. For each estimate, the company would have to explain its significance to financial condition, changes in financial condition and results of operations and, where material, identify its effect on line items in the company's financial statements. In addition, the company would be required to include:

• Sensitivity analysis. Quantitative discussion of changes (both positive and negative) in line items and overall financial performance if the company were to assume that the estimate were changed, either by using reasonably possible near-term (within one year) changes in key assumptions underlying the estimate or by using the reasonably possible range (both high and low) of the estimate.

• Past changes. Quantitative and qualitative discussion of any material changes made to the estimate in the past three years (two years for small business issuers), the reasons for the changes and the effect on line items in the financial statements and overall financial performance.

• Discussion with audit committee. A statement of whether the company's senior management has discussed with the audit committee the development and selection of the accounting estimate and the MD&A disclosure relating to it. If this discussion has not occurred, an explanation of the reasons for the lack of discussion would also need to be included.

• Segments. If the company operates in more than one segment, identification of the segments that the estimate affects and discussion of the estimate on a segment basis paralleling the one required on a company-wide basis (to the extent that failure to do so would result in materially misleading disclosure).

The SEC warns that the disclosures must be clear, concise and understandable to the average investor, not just to accountants or industry experts. Boilerplate disclosures not tailored to the company's particular circumstances and operations will not suffice.

The SEC has included hypothetical examples of the disclosures contemplated by the proposal for the three critical accounting estimates noted above.

Quarterly updating. The proposal would require full "Application of Critical Accounting Policies" disclosure in the MD&As of annual reports on Form 10-K and of registration statements and proxy or information statements. If material changes have occurred that would render the last full disclosure materially out of date or otherwise materially misleading, the proposal would require an update in the MD&A of the next quarterly report on Form 10-Q. Newly identified critical accounting estimates would be disclosed in the Form 10-Q in the same manner as in annual reports. Material changes in previously disclosed estimates or assumptions could be updated in the 10-Q in more abbreviated form.

Since foreign private issuers do not file quarterly reports on Form 10-Q, the mandatory updating requirement would not apply to them.

Auditor examination. The SEC is contemplating the possibility of requiring some level of outside auditor review of the proposed critical accounting estimates disclosure. While not suggesting that the proposed disclosures be subject to full audit, the proposing release specifically requests comment regarding the possible requirement of an auditor "examination" or "review" as contemplated by relevant Attestation Engagement standards of the American Institute of Certified Public Accountants.

The proposal would also require MD&A disclosure under the "Application of Critical Accounting Policies" caption of any accounting policy initially adopted by the company (other than those solely resulting from new accounting literature issued by a recognized standard setter) that has a material impact on the company's financial condition, changes in financial condition or results of operations. Required disclosure would include:

• events or transactions giving rise to the initial adoption.

• the accounting principle adopted and method of applying the principle.

• qualitative discussion of the impact on the company's financial condition, changes in financial condition and results of operations.

• explanation of any acceptable alternative principles, why the adopted principle was chosen over alternatives and qualitative discussion of the impact on financial presentation that alternatives would have had.

• if no accounting literature exists that governs the accounting for the event or transaction giving rise to the initial adoption, an explanation of the company's decision regarding which accounting principle to use and which method of applying the principle to use.

If adopted, this new MD&A disclosure will add significantly to the length and complexity of periodic reports, registration statements and proxy or information statements. It will also add significantly to the time and costs involved in preparing the MD&A. In addition, it will bring a new level of predictive information into SEC filings at a time when the Enron debacle has incited some to call for repeal of the Private Securities Litigation Reform Act of 1995 and its safe harbor from liability for forward-looking statements.

Commentary on the proposal should help the SEC refine this expansion of disclosure requirements. In light of the attention being brought to bear on the subject of transparency of financial reporting both inside and outside of Congress, however, issuers would be well advised to become familiar with the outlines of critical accounting estimate disclosure.

May 14, 2002