Reporting Critical Accounting Policies

By Mark P. Holtzman

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 SEC’s Interpretation

In December 2003, the SEC released FR-72, “Interpretation: Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations” (www.sec.gov/rules/interp/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 SEC’s 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/33-8098.htm). This proposed rule 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 SEC’s 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.

The proposed rule implicitly differentiates CAPs from estimates. Policies are plans of action to guide future decisions, whereas estimates are individual decisions made when preparing financial statements.

Companies must disclose information about initial adoptions of new policies. New estimates, however, may need to be reconsidered with every new set of financial statements.

Under the proposal, filers would be required to disclose whether they discussed a company’s critical accounting estimates with the audit committee. They would not be required to disclose the nature of those discussions.

Companies operating with more than one segment would have to identify specific segments affected by a CAP. In addition to company-wide critical accounting disclosures, companies would have to discuss CAPs for each identified segment.

The proposed rule also put forward the idea of requiring an independent audit of MD&A. It would require companies to provide quarterly updates of critical accounting estimates in their quarterly filings, including newly identified critical accounting estimates, and other material changes that would render previous disclosures out of date or misleading. The proposed rule would not require companies to update sensitivity analyses each quarter. Foreign private issuers would be required to meet these same CAP disclosure requirements. Small business issuers would have substantially lower disclosure requirements. Existing safe harbors would apply to forward-looking information.

When preparing CAP disclosures, accountants will find the SEC’s interpretation (FR-72) lacking useful specifics. Even though the SEC has not acted upon it as of yet, accountants should read and consider using the proposed rule as a source of more specific guidance.

Current Practice

The author reviewed annual reports of the largest 100 publicly traded companies from the Fortune 500. The author analyzed 10-K filings with fiscal year-ends between December 31, 2005, and December 30, 2006.

Three accounting issues dominate companies’ CAP disclosures: impairments, pensions, and income taxes. As indicated in Exhibit 1, 39 out of 100 companies reported CAPs for impairments of intangibles, 25 reported CAPs for impairments in general, and 14 reported impairments of tangible assets. Another six reported CAPs for the valuation of residual costs of leased assets. With respect to postemployment benefits, 64 companies reported CAPs, and two of those companies reported additional CAPs just for other postemployment benefits. With respect to accounting for income taxes, 56 companies reported CAPs.

The 100 companies reported many additional types of CAPs, as shown in Exhibit 1. Forty-four companies reported CAPs for contingencies, 32 for revenue recognition, and 32 for bad-debt reserves. Valuation of investments and financial instruments was addressed by CAPs for 30 companies, and inventory for 24.

Several CAP disclosures were industry-specific. Insurance companies reported claims liabilities as a CAP. Most retailers and retail suppliers addressed purchase and sales allowances (21 CAPs). Oil and gas companies reported oil and gas accounting (four CAPs), and entertainment companies reported capitalization of entertainment assets (three CAPs).

The average company reported 5.6 CAPs in its MD&A. By contrast, a previous study by the Financial Executives Research Foundation reported an average of 6.1 CAPs per company (this author, A Review of 2002 MD&A Disclosures: Critical Accounting Policies). The fewest CAPs reported were two, by an investment bank, but this company’s disclosures were very long and detailed. The highest number of CAPs reported was 11, by a grocery chain.

Many companies provided very detailed disclosures. For example, Exhibit 2 shows the Ford Motor Company’s disclosure about other postemployment benefits (10-K/A, fiscal year-end December 31, 2005). This disclosure indicates that management believes that other postemployment benefits are a delicate area of accounting for the company, and that Ford’s income and financial position are very sensitive to specific assumptions. Ford explains, in detail, the need for estimates and the assumptions used. Furthermore, the sensitivity analysis indicates, for example, that a one-point decrease in the discount rate would have increased the company’s liabilities by $6,330 million and its expenses by $530 million.

Exhibit 2 also illustrates many important concepts about reporting such policies. First of all, accountants should write disclosures in plain English, using simple declarative sentences. Use the active voice rather than the passive voice. Avoid complex words when simple ones will suffice. Use formatting tools, such as bullet points, to clarify the structure of ideas.

Ideally, CAP disclosures should explain why estimates are necessary, emphasizing the necessary judgments and the inherent uncertainty in each area. For example, according to Best Buy: “Our impairment loss calculations contain uncertainties because they require management to make assumptions and to apply judgment to estimate future cash flows and asset fair values, including forecasting useful lives of the assets and selecting the discount rate that reflects the risk inherent in future cash flows” (Form 10-K, 2/25/2006).

According to United Technologies:

In assessing the need for a valuation allowance, we estimate future taxable income, considering the feasibility of ongoing tax planning strategies and the realizability of tax loss carryforwards. Valuation allowances related to deferred tax assets can be affected by changes to tax laws, changes to statutory tax rates and future taxable income levels. In the event we were to determine that we would not be able to realize all or a portion of our deferred tax assets in the future, we would reduce such amounts through a charge to income in the period in which that determination is made. Conversely, if we were to determine that we would be able to realize our deferred tax assets in the future in excess of the net carrying amounts, we would decrease the recorded valuation allowance through an increase to income in the period in which that determination is made. Subsequently recognized tax benefits associated with valuation allowances recorded in a business combination will be recorded as an adjustment to goodwill (www.sec.gov).

The disclosures should describe the company’s accounting. For example, Delphi Corporation explains how it estimates future cash flows when testing long-lived assets for impairment: “We estimate cash flows using internal budgets based on recent sales data, independent automotive production volume estimates and customer commitments and consultation with and input from external valuation experts” (Form 10-K, 12/31/2005).

Companies should provide sensitivity analysis for each critical accounting area, quantifying how different estimates could affect the financial statements. For example, Lockheed Martin issued the following disclosure about “Accounting for Design, Development and Production Contracts”:

Products and services provided under long-term design, development and production contracts make up the majority of our business. Therefore, the amounts we record in our financial statements using contract accounting methods and cost accounting standards are material. Because of the significance of the judgments and estimation processes, it is likely that materially different amounts could be recorded if we used different assumptions or if the underlying circumstances were to change. For example, if underlying assumptions were to change such that our estimated profit at completion for all design, development and production contracts was higher or lower by 1%, our net earnings would increase or decrease by approximately $190 million. When adjustments in estimated contract revenues or costs are required, any changes from prior estimates are included in earnings in the current period (Form 10-K, 12/31/2005).

For another example, see Ford Motor’s disclosure in Exhibit 2. Merck disclosed possible but unaccrued losses in connection with environmental remediation:

Although it is not possible to predict with certainty the outcome of these matters, or the ultimate costs of remediation, management does not believe that any reasonably possible expenditures that may be incurred in excess of the liabilities accrued should exceed $88.0 million in the aggregate. Management also does not believe that these expenditures should result in a material adverse effect on the Company’s financial position, results of operations, liquidity or capital resources for any year (Form 10-K, 12/31/2005).

Based on the SEC’s proposed rule, companies should consider providing historical information about previous material changes in critical accounting estimates. For example, WellPoint disclosed the following in accounting for its income taxes:

During 2004 and 2003, the valuation allowance decreased by $33.8 million and $81.9 million, respectively. The 2004 and 2003 reductions resulted from utilizing alternative minimum tax, or AMT, credits and net operating losses on our federal income tax return for which we had a deferred tax asset with a corresponding valuation allowance. As deferred tax assets related to those deductions are available for use in the tax return, a valuation was no longer required and was reduced. The decrease in the valuation allowance in 2004 was partially offset by an additional $5.6 million related to Indiana state taxes, as discussed below (Form 10-K, 12/31/2005).

Companies should mention the process whereby senior management discussed CAPs with the audit committee. For example, Sears Holdings disclosed that “Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of its Board of Directors and the Audit Committee has reviewed the disclosure presented below relating to the selection of these estimates” (Form 10-K, 1/28/2006).

SEC Comment Letters

The SEC takes CAP disclosures seriously, according to a recent report issued by the Financial Executives Research Foundation, Current Financial Reporting Trends: A Qualitative Review of SEC Comment Letters (by Cheryl de Mesa Graziano and Mark P. Holtzman). For example, the SEC sent this comment letter to Global Payments Inc.:

Your critical accounting estimate disclosure should supplement, not duplicate, the description of accounting policies already disclosed in the notes to the financial statements. The disclosure should provide greater insight into the quality of the information regarding financial condition and operating performance as well as the variability that is reasonably likely to result from applying the accounting policy over time. Please expand your disclosure in future filings to disclose your known historical losses and processing volume used in developing an estimate of your operating losses and qualitatively and quantitatively discuss how a change in these assumptions could impact your financial statements. Please show us how you will revise your disclosure in response to this comment. Refer to SEC Release 33-8350 (January 19, 2006; www.sec.gov/Archives/edgar/data/1123360
/000119312506018316/filename1.htm).

On January 24, 2006, the SEC sent a follow-up letter to another filer, Ligand Pharmaceuticals, Inc.:

Please expand your critical accounting estimate disclosure for each of the captions listed above on pages 118 and 119 to address the following:

• Augment your assertion that amounts “may be materially different than our estimates” by quantifying the reasonably likely effect of changes in these estimates on your results of operations and financial position. If you are unable to quantify the reasonably likely effect, please disclose this fact. In addition, clarify on pages 103 and 104 whether the impact of a 20% variance on your estimated Medicaid and managed care contract rebate accruals for AVINZA and a 20% variance to your Medicaid rebate and estimated chargeback accruals for ONTAK is reasonably likely. We believe that a meaningful sensitivity analysis should be based on reasonably likely changes and not on hypothetical changes. Please revise your analysis accordingly.
• We note your schedule on page 187 for the allowances for loss on returns, rebates, chargebacks and other discounts, ONTAK end-customer and Panretin returns. Please reference this schedule in your critical accounting estimate section of the MD&A. In addition, please provide separate line items in your schedule for the provision for sales made in the current period and the provision for sales made in prior periods. In your Results of Operations MD&A discussion, please quantify and discuss the effects that changes in estimates for these accruals had for each period presented. If you are unable to determine changes in estimates for each period, disclose this fact and explain in the disclosure why management believes the financial statements are fairly stated (January 24, 2006;
  www.sec.gov/Archives/edgar/data/886163/000000000006003956
  /filename1.pdf).

The SEC wrote to another filer, Landry’s Restaurants, Inc., about the following:

Given that your inventory balance is approximately 41% of your total current assets and that your valuation of inventory requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes, as disclosed in the last paragraph of your critical accounting policies in MD&A, we believe you should consider expanding the critical accounting policies section of your MD&A and your significant account policies to include the amount of and a discussion of the material implications associated with methods and assumptions underlying how you arrived at the estimated inventory allowance. Additionally, you should address the questions that arise once the critical accounting estimate or assumption has been identified, by analyzing, to the extent material, factors such as how accurate the estimate/assumption has been in the past, how much the estimate/assumption has changed in the past, and whether the estimate/assumption is reasonably likely to change in the future (April 10, 2006; www.sec.gov/Archives/edgar/data/908652/
000000000006016828/filename1.txt).

The Importance of Disclosure

CAP disclosures provide more information about how the uncertainties inherent in estimates may affect a company’s financial statements. Policy decisions about depreciable lives, inventory costing methods, pension assumptions, and other areas can have a significant impact. The SEC now requires detailed disclosures in MD&A about these CAPs, and has issued a number of comment letters about companies’ disclosures, underscoring their importance. Accountants should look carefully at their critical accounting policy disclosures to ensure that they are complete. Even though it is not mandatory to do so, registrants should consider following the guidance in the SEC’s proposed rule on CAP disclosures.

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