SEC Proposes Disclosure Rules for Critical Accounting Policies

NUMBER 202 FROM THE LATHAM & WATKINS CORPORATE DEPARTMENT BULLETIN NO. 202 JULY 3, 2002 SEC Proposes Disclosure Rules for Critical Accounting Policies This new rule would add several pages or more of textual discussion of accounting policies to an average reporting company s MD&A. On May 10, the Securities and Exchange Commission published for comment a proposed rule that, if adopted, will impose major additional reporting obligations for public companies. This client alert summarizes the proposed rule, which would amend Management s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) to require companies to identify and discuss their critical accounting policies in filings with the Commission. Introduction MD&A is intended to allow investors to see the issuer s financial profile through management s eyes by providing a narrative explanation of the issuer s financial statements. 1 MD&A is required disclosure in companies annual and quarterly reports and in all registration statements. The new proposal would amend MD&A to require a new section under the heading Application of Critical Accounting Policies that would contain a narrative discussion identifying and describing the issuer s critical accounting policies. 2 This new rule would add several pages or more of textual discussion of accounting policies to an average reporting company s MD&A. A critical accounting policy is one that is both very important to a company s financial presentation and also requires management s most difficult, subjective or complex judgments. The proposed rule defines a critical accounting policy as: a critical accounting estimate; or the initial adoption of an accounting policy. Critical Accounting Estimates Under the proposed rule, a company would be required to discuss any accounting estimate that it determines to be critical. According to the Commission, the vast majority of companies would have somewhere in the range of three to five critical accounting estimates. 3 Definition and Examples A company s accounting estimate would, under the proposed rule, be considered a critical accounting estimate only if: the accounting estimate requires the issuer to make highly uncertain assumptions; and the issuer could have reasonably used different estimates, or the issuer s estimate is reasonably likely to change, and the different or changed estimates would materially affect the issuer s presentation of its financial condition, changes in financial condition or results of operations. 4

Depending on a company s circumstances, examples of critical accounting estimates could include: revenue recognition; the net realizable value of accounts receivable; the net realizable value of inventory; property and casualty insurance loss reserves; current obligations that will be fulfilled over several years; future returns of products sold; the amount of cash flows expected to be generated by a specific group of assets; revenues from contracts accounted for by the percentage of completion method; contingency reserves; pension expenses; and warranty expenses. 5 Highly Uncertain Assumptions For purposes of the first requirement in determining a critical accounting estimate, an assumption would be highly uncertain if it: depends on temporally remote events that may or may not occur; is not capable of being readily calculated from generally accepted methodologies; or cannot be derived with some degree of precision from available data. Thus, a highly uncertain matter requires management to use significant judgment in making its assumptions, typically resulting in a range within which management believes the estimate should fall. 6 Different or Changeable Amounts The second requirement for determining a critical accounting estimate focuses on two types of accounting estimates that would have a material impact on the company s financial presentation: those that are reasonably likely to change from period to period. Thus, an estimate would qualify as critical if management s judgment would have an impact in the current period or on an ongoing basis, or both. 7 Required Disclosure for Critical Accounting Estimates The MD&A, under the proposed rule, would inform investors of each critical accounting estimate and place it in the context of the company s financial presentation by including specified information regarding each critical accounting estimate. The nature of this information is so detailed that this disclosure, if adopted, could constitute a separate MD&A within the MD&A: identification and description of the critical accounting estimate, as well as: the methodology used to determine the estimate; underlying assumptions about highly uncertain or otherwise material matters; known trends, demands, commitments, events or uncertainties that would materially affect the methodology or assumptions; if applicable, why different estimates that would have materially affected the company s financial presentation could have been used; and if applicable, why the accounting estimate is reasonably likely to change from period to period and materially affect the company s financial presentation; 8 the significance of the accounting estimate to the company s financial condition and identification of material line items in the financials affected by the estimate; 9 quantitative disclosure about changes in overall financial performance and line items in the financials that would materially change if certain changes relating to the critical accounting estimate were assumed to occur; 10 those for which the company could have reasonably recorded a different amount in its financial statements; and BULLETIN NO. 202 2 JULY 3, 2002

quantitative and qualitative disclosure of material changes to the accounting estimate within the past three years, the reasons for the changes and the effect on specific financial line items and overall financial performance; 11 whether or not the company s senior management and audit committee have discussed the critical accounting estimates (which may incidentally encourage audit committee oversight of critical accounting estimates); 12 and discussion of the accounting estimate on a segment basis (where appropriate to an understanding of the company) and identification of the segments of the company s business (where the company operates in more than one segment). 13 Sample Disclosures For illustrative purposes, the Commission s release included samples of the types of disclosure required under the proposed rule for critical accounting estimates relating to each of the following: estimated warranty costs for a manufacturer and distributor of electrical equipment; 14 future returns of software products sold by a software developer; 15 and impairment of assets relating to a business segment of a manufacturer of data storage devices. 16 Initial Adoption of an Accounting Policy According to the proposed rule, a company would initially adopt an accounting policy when events or transactions: occur in a way that affects the company for the first time; become material after previously being immaterial to the company; or are clearly different in substance from previous events or transactions. For example, a company may for the first time enter into transactions involving derivative instruments, such as interest rate swaps, or may begin selling a new product with substantially different delivery terms and conditions. 17 A company that initially adopts an accounting policy that has a material impact on the company s financial statements should, under the proposed rule, include in its MD&A a description of: the events or transactions giving rise to the accounting policy s initial adoption; the accounting principle adopted and the method of applying it; and a qualitative discussion of the adopted policy s effects on the company s financials. 18 In addition, if the company had a choice of more than one acceptable accounting principle, the proposed rule would require the company to: explain that it had chosen among acceptable alternatives; identify the alternatives; describe why it adopted the policy actually chosen; where material, provide a qualitative discussion of the alternative choices effects on the company s financials; and if the events or transactions are so unusual or novel that no existing accounting literature governs the accounting for those events or transactions, then the company would have to explain its decision regarding the applicable accounting principle and method of applying that principle. 19 The release does not specifically address whether the nature and disclosure of the polices would be reviewed by the Staff on a quarterly basis or only in connection with the filing of registration statements. Application to Foreign Private Issuers The proposed rule would also impose these new MD&A requirements on foreign private issuers. If the foreign private issuer s primary financials were in non-u.s. GAAP, the company would have to consider application of the new disclosure rules both to its primary financial statements and to its reconciliation to U.S. GAAP. 20 BULLETIN NO. 202 3 JULY 3, 2002

General Requirements If the release is adopted, the new MD&A section, Application of Critical Accounting Policies, would be subject to a plain English requirement. The new section would have to be presented in language and a format that is clear, concise and understandable to the average investor, meaning that the disclosure would have to be fully comprehensible to someone who is not an accountant or an expert on a particular industry. identification of affected segments and proposed disclosure on a segment basis; independent auditor examinations of the newly proposed disclosures; quarterly updating requirement for U.S. companies; proposed disclosures related to initial adoption of accounting policies; disclosure presentation aspects of the proposals; The proposed rule would also require a separate discussion of each critical accounting estimate and each new accounting policy, rather than a single discussion of the aggregate consequences of multiple critical accounting estimates or multiple new accounting policies. 21 The proposed rule would not allow boilerplate disclosures that either do not specifically address the company s particular circumstances or could easily be transferred from year to year, or from company to company, with no change. Finally, the proposed rule would not permit companies to rely on blanket disclaimers of legal responsibility or simple disclaimers beyond any available safe harbors such as those available for forward-looking statements. 22 In addition, the proposed rule would require disclosure on a segment basis of the impact of critical accounting estimates. The Commission noted, however, that segment-based disclosure would be required only to the extent necessary to avoid an incomplete or misleading picture. 23 Solicitation of Comments The Commission sought comment on: broadening the scope of the proposals; the definition of critical accounting estimates; the identification and analysis of changes; the disclosure of past material changes in critical accounting estimates; the disclosure about discussions between management and the audit committee regarding identification and disclosure of critical accounting estimates; BULLETIN NO. 202 4 JULY 3, 2002 application of the newly proposed disclosure as it relates to foreign private issuers; application to small business issuers; application of safe harbors for forward-looking information; and a long list of general aspects of the proposals. 24 Issues to Consider In submitting their comments to the Commission, companies and other parties may wish to consider, in addition to the many requests for comment contained in the release, the following observations and related issues: The proposed requirement for senior management to disclose specifically whether it has discussed with the audit committee the company s critical accounting estimates and their presentation in the MD&A exposes the audit committee to additional liability, particularly with respect to the company s quarterly reports on Form 10-Q, and could portend a trend toward further increases in matters for which the audit committee is responsible and increased exposure for audit committees. 25 The proposed rule creates some tension between, on the one hand, the proposed rule s highly uncertain standard for assumptions that a company must make regarding critical accounting estimates and, on the other hand, the unable to make a reasonable estimate standard that requires an audit opinion to include an explanatory paragraph. The proposed rule requires management to use significant judgment in making its assumptions, whereas existing accounting rules require special disclosure in the case of matters that are highly uncertain.

Companies should note, with regard to the proposed requirement regarding disclosure of different estimates that would have materially affected the company s financial presentation, that a disclosure regarding the effect of a more negative estimate might be misconstrued as an assurance that an even more negative outcome could not occur. In light of that risk, these types of disclosures will require special care in drafting. 26 In making materiality assessments, under the proposed rule, companies would need to bear in mind SAB 99, in which the staff expressed the view that misstatements are not immaterial simply because they fall beneath a numerical threshold. 27 Compliance costs will be significant: the Commission estimates that compliance with the proposed rule would entail, on average, the inclusion of about six pages of additional text when the company is required to prepare the proposed disclosure in its entirety and that preparation of the proposed disclosure would cost from approximately $5,000 to $500,000 per year. 28 Comments to the proposed rule are due on or before July 19, 2002. 29 Endnotes 1 Disclosure in Management s Discussion and Analysis about the Application of Critical Accounting Policies (Proposed Rule), Securities Act Release No. 33-8098, Exchange Act Release No. 34-45907 (May 10, 2002) http://www.sec.gov/rules/proposed/33-8098.htm [hereinafter Proposed Rule ]. 2 In addition to Item 303 of Regulation S-K, the proposed rule would amend the parallel provisions in Form 20-F (which applies to foreign private issuers) and Regulation S-B (which applies to small business issuers). Proposed Rule, supra note 1, at 4 n.8. 3 Id. at 15. Moreover, the Commission would expect very few companies to have none at all, and, though it declined to propose an outside limit to the number of accounting estimates that a company must discuss, a company s disclosure should not encompass a long list of accounting estimates... which cover a substantial number of line items in the company s financial statements because investors will not benefit from a lengthy discussion of a multitude of accounting estimates in which the truly critical ones are obscured. Id. (indicating that the Commission will monitor disclosure to determine whether to fix a maximum number of critical accounting policies). 4 Id. at 14. 5 Id. at 14 & 14 n.53. 6 Id. at 14. 7 Id. 8 Id. at 16. 9 Id. at 16-17. 10 Id. at 17-18. 11 Id. at 19-20. 12 Id. at 5, 21-22. 13 Id. at 23-24. 14 Id. at 24-26. 15 Id. at 26-28. 16 Id. at 28-31. 17 Id. at 34. 18 Id. 19 Id. 20 Id. at 36-37. 21 Id. at 35. 22 Id. at 36, 39-40. The Commission intends to delete existing rules indicating that forward-looking statements are not required in MD&A (such as Instruction 7 to Item 303(a) and Instruction 6 to Item 303(b)) because the proposed rule would require companies to make forwardlooking statements in their MD&A (such as disclosure of near-term future changes in assumptions underlying accounting estimates or of the expected effect of an uncertainty s future occurrence). See id. at 40 & 40 n.134. BULLETIN NO. 202 5 JULY 3, 2002

23 Id. at 23-24. 24 Id. at 12, 15, 18-24, 32-36, 38-41. 25 See id. at 5, 21-22. 26 See id. at 16. 27 Staff Accounting Bulletin No. 99 (Materiality), Release No. SAB 99 (Aug. 12, 1999) http://www.sec.gov/interps/account/sab99.htm (explaining that quantitatively small misstatements in a company s financial presentation can be material where, for example, the misstatement changes a loss into income or vice versa, masks a change in earnings or other trends, hides a failure to meet analysts expectations, concerns a business segment identified as significant to the company, affects regulatory or contractual compliance, triggers a bonus or other incentive compensation or involves concealment of unlawful activity). 28 Proposed Rule, supra note 1, at 50-51. Within this wide range, the Commission fixed the per-company estimated preparation costs at $14,000 (divided equally between in-house staff time and outside professionals) plus some additional printing and dissemination costs. See id. 29 See SEC Proposed Rules http://www.sec.gov/rules/proposed.shtml. Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the attorneys listed to the right or the attorney whom you normally consult. 2002 Latham & Watkins. All Rights Reserved. If you have any questions about this Client Alert, please contact John J. Huber or Joel H. Trotter in our Washington, D.C. office, Kirk A. Davenport II in our New York office or any of the attorneys listed here. CHICAGO Mark D. Gerstein Christopher D. Lueking (312) 876-7700 FRANKFURT John D. Watson, Jr. +49-69-60 62 60 00 HAMBURG Joachim von Falkenhausen +49-40-41 40 30 LOS ANGELES Brian G. Cartwright Gary Olson (213) 485-1234 MOSCOW Anya Goldin +7-095-785-1234 NEW YORK Kirk A. Davenport II Peter M. Labonski (212) 906-1200 ORANGE COUNTY Patrick T. Seaver (714) 540-1235 PARIS Pierre Descheemaeker +33 1 40 62 20 00 SAN DIEGO Scott N. Wolfe (619) 236-1234 SAN FRANCISCO Scott R. Haber (415) 391-0600 SILICON VALLEY Robert A. Koenig (650) 328-4600 SINGAPORE Michael W. Sturrock +65-6536-1161 BOSTON BRUSSELS CHICAGO FRANKFURT HAMBURG HONG KONG LONDON LOS ANGELES MILAN MOSCOW NEW JERSEY NEW YORK NORTHERN VIRGINIA ORANGE COUNTY PARIS SAN DIEGO SAN FRANCISCO SILICON VALLEY SINGAPORE TOKYO WASHINGTON, D.C. HONG KONG Andrew D. Hutton +852-2522-7886 LONDON Olof Clausson Bryant B. Edwards +44-20-7710-1000 BULLETIN NO. 202 6 JULY 3, 2002 TOKYO Michael J. Yoshi +81-3-5524-1900 WASHINGTON, D.C. John J. Huber Joel H. Trotter (202) 637-2200