05.17.2002

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Updates

On May 10, 2002, the Securities and Exchange Commission (SEC) proposed an amendment to Regulation S-K that would require companies to add a new section, "Application of Critical Accounting Policies," to Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) included in annual reports, registration statements, and proxy and information statements. This new section would contain disclosure about:

    • Critical accounting estimates made by the company in preparing its financial statements and

    • The initial adoption of accounting policies that have a material impact on the company's financial presentation.

In addition, companies would be required to update, in their quarterly reports, the information regarding critical accounting estimates to disclose any material changes.

Context of the Proposed Rule

MD&A's underlying purpose is to enable investors to see "through the eyes of management" in order to understand the financial performance and strength of each company. Consistent with this underlying purpose, the SEC has called for disclosure of issuers' critical accounting practices since issuing the 1974 Guides relating to MD&A that were the predecessor to Item 303 of Regulation S-K. But Chairman Harvey Pitt, Chief Accountant Robert Herdman and others at the SEC have been vocal proponents of the idea that companies need to better explain to investors the concept that financial statements present a set of numbers that rely on estimates and accounting policies that "entail uncertainties and subjectivity."

The SEC views the proposed rule as "an initial step" in "improving the transparency of companies' financial disclosure." Other MD&A proposals under consideration would seek to improve companies' disclosure regarding the factors that management considers most important in determining financial results, the use of special purpose entities and related parties' involvement in those entities, and the identification and evaluation of trends in making business decisions. All of these MD&A proposals are intended to focus MD&A on three related objectives the SEC has identified – enabling investors to see the company through the eyes of management, providing a context for analysis of the financial statements, and providing information about the potential variability of earnings and cash flow to enable investors to gauge future performance. The SEC believes that "higher-quality, more insightful financial information" from companies would result in more efficient capital markets and increased investor confidence.

Critical Accounting Estimates

Under the proposed rule, companies would be required to provide disclosure regarding "critical accounting estimates." An accounting estimate is an approximation made by management of an element within the financial statements, such as an estimate by a manufacturer of future product returns. The estimate is considered critical if the answer to both of the following questions is "yes":

  1. Did the accounting estimate require the company to make assumptions about matters that were highly uncertain at the time the accounting estimate was made?
  2. Would 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, have a material impact on the presentation of financial condition or results of operations?

While the number of critical accounting estimates varies by company, the SEC expects that most companies have between three to five critical accounting estimates.

The proposed disclosure about critical accounting estimates would involve the following three fundamental elements:

  1. Basic disclosure necessary to understand the critical accounting estimates,
  2. Sensitivity of reported operating results and financial condition to changes in critical accounting estimates or their underlying assumptions, and
  3. Senior management's discussion of the development, selection and disclosure of critical accounting estimates with the audit committee.

For each critical accounting estimate, a company would be required to include the following disclosure relating to these three elements:

1. Basic Disclosure

      • Identify and describe

        • the critical accounting estimate,
        • the methodology used in determining the critical accounting estimate,
        • any underlying assumption that is about highly uncertain matters or is otherwise material,
        • any known trends, commitments, events or uncertainties that are reasonably likely to occur and materially affect the methodology or assumptions described,
        • if applicable, why different estimates that would have had a material impact on financial presentation could have been used in the current period, and
        • if applicable, why the accounting estimate is reasonably likely to change from period to period with a material impact on the financial presentation
      • If the company operates in more than one segment, identify the segments the accounting estimate affects, and
      • Discuss the accounting estimate on a segment-by-segment basis, to the extent failure to do so would be materially misleading.

2. Sensitivity to Changes in the Estimate

    • Explain the significance of the accounting estimate to financial condition and results of operations and identify any line items in the financial statements materially affected by the accounting estimate,

    • Based on either the reasonably possible near-term changes in the most material
      assumption(s) underlying the accounting estimate or on the reasonably possible range of the accounting estimate, include a quantitative discussion of changes in overall financial performance and, to the extent material, line items in the financial statements if the accounting estimate were changed, and
    • Include a quantitative and qualitative discussion of any material changes to the accounting estimate in the past three years, the reasons for the changes, and the effect on line items in the financial statements and overall financial performance.

3. Discussion with the Audit Committee

Disclose whether or not senior management has discussed with the audit committee the development and selection of the accounting estimate and the related MD&A disclosure.

To assist in understanding the scope of the proposed rule, the SEC provides in the release three examples of how a fictional public company that has identified a critical accounting estimate could draft its MD&A to satisfy the proposal. For your convenience, we have provided the attached link to the SEC's sample disclosure: http://www.sec.gov/rules/proposed/33-8098.htm#IIID.

Initial Adoption of Accounting Policies

The second aspect of the "Application of Critical Accounting Policies" disclosure addresses a company's initial adoption of an accounting policy if the accounting policy has a material impact on financial condition or results of operations. Companies would be required to disclose:

      • The events or transactions that gave rise to the initial adoption of an accounting policy,

      • The accounting principle that has been adopted and the method of applying that principle,
      • The impact from the initial adoption of the accounting policy on financial condition and results of operations (discussed qualitatively),
      • If there is a choice between acceptable accounting principles,
        • an explanation that the company had made a choice,
        • identification of the alternatives, and
        • a discussion of why it made a particular choice (including qualitative disclosure of any material impact the alternatives would have had on financial presentation), and
      • If no controlling accounting authority exists, an explanation of the company's decision regarding which accounting principle and method of application to use.

The full proposed rule is available on the SEC's Web site at http://www.sec.gov/rules/proposed/33-8098.htm. You will find further developments of SEC rule initiatives on our website.

Comments on Proposed Rule

The 60-day period within which to provide written comments to the SEC on this proposal expires on July 19, 2002. Perkins Coie LLP expects to submit a comment letter to the SEC. We encourage you to contact any of the attorneys listed in this Update or your client service attorney no later than June 21, 2002 to discuss any concerns you would like raised in the letter.

 

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