July 19, 2002
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549-6009
Dear Mr. Katz:
The AICPA SEC Regulations Committee (Committee) is pleased to respond to the Commission's request for comments on its proposed changes to disclosure requirements as presented in Release Nos. 33-8098/34-45907, Disclosure in Management's Discussion and Analysis About the Application of Critical Accounting Policies (the Release). We support the Commission's goal to improve the quality and transparency of corporate financial disclosures.
General Overview of Comments
The following is a general overview of our comments on the two areas of the Release:
Disclosure of Critical Accounting Policies
The scope of any required additional disclosures about critical accounting estimates should exclude certain loss contingencies, such as pending or threatened litigation, and actual or possible claims and assessments.
We believe that forward-looking sensitivity analyses of the effects of future changes in estimates may be more useful and relevant to users than a historical quantitative review of the accuracy of previous critical accounting estimates. We would also support further elaboration in MD&A of why management chose a particular estimate or why management chose certain key assumptions relative to the estimate.
To the extent that the SEC determines that explicit disclosure is warranted regarding management's discussion with the audit committee about the development and selection of critical accounting estimates, and any related MD&A disclosures, we believe that such disclosures would be more appropriate within the audit committee report included in the proxy statement.
Initial Adoption of Accounting Policies
Detailed Comments and Discussion
DISCLOSURE OF CRITICAL ACCOUNTING POLICIES
Align Disclosures with Current GAAP Objectives to Minimize Redundancies and Achieve More Robust Financial Statement Disclosures
We believe the goal of providing useful and understandable information could more effectively be achieved by promulgating an additional interpretation of existing GAAP disclosure requirements to provide more robust disclosures in the footnotes to the financial statements. This would enable investors to go to one place - the financial statements - for a full and complete understanding of the company's accounting policies.
As the Release observes, GAAP currently requires certain disclosures about a company's accounting policies in the footnotes to the financial statement. Accounting Principles Board (APB) Opinion No. 22, Disclosure of Accounting Policies, requires that "...the disclosure should encompass important judgments as to appropriateness of principles relating to recognition of revenue and allocation of asset costs to current and future periods; in particular, it should encompass those accounting principles and methods that involve a selection from existing acceptable alternatives; principles and methods peculiar to the industry in which the reporting entity operates, even if such principles and methods are predominantly followed in that industry; and unusual or innovative applications of generally accepted accounting principles (and, as applicable, of principles and methods peculiar to the industry in which the reporting entity operates)." Also, Statement of Position 94-6, Disclosure of Certain Significant Risks and Uncertainties, requires the disclosure of risks and uncertainties that could significantly affect the amounts reported in the financial statements in the near term or the near-term functioning of the reporting entity. Further, changes in accounting policies that occur during interim periods are required to be disclosed in interim reports by APB Opinion No. 28, Interim Financial Reporting.
We encourage the SEC staff to work with the private sector standards setters (FASB and AICPA Accounting Standards Executive Committee) to develop additional guidance or interpretation of GAAP to achieve more robust disclosures in the footnotes to the financial statements about critical accounting policies and estimates. We encourage the Commission to evaluate respondents' views on the meaningfulness and usefulness of the proposed disclosures in the Release, and, as an interim step, provide appropriate principles-based guidance through the issuance of a Staff Accounting Bulletin (SAB) on the considerations in making disclosures about critical accounting policies in the footnotes to the financial statements.
Definitions and Approach to Achieve Disclosures
We believe that a "principles-based" approach to MD&A disclosures about accounting estimates, rather than a "rules-based" approach, would be more consistent with the well-established purpose and expectations of MD&A. We are concerned that the detailed, "rules-based" approach of the SEC's proposal could over time lead to less meaningful boilerplate disclosures. Moreover, the length of the proposed rule addressing the application of critical accounting policies exceeds the total length of the SEC's existing MD&A rules for disclosures about a registrant's liquidity, capital resources and results of operations. We are concerned that extensive MD&A disclosures about accounting policies may eclipse more important disclosures in MD&A about business developments, risks and trends, as possibly implied by the relative length of the proposed rule.
Consistent with a "principles-based" approach, we suggest that the proposed definition of "critical accounting estimate" in S-K Item 303(c)(2)(ii) and S-B Item 303(b)(3)(ii)(B) be reconsidered. We are concerned that the definition as currently proposed would not be susceptible to consistent interpretation and application. Instead, we believe that the concept of a "critical accounting estimate" can be articulated without a prescriptive rule definition. We suggest that a "critical accounting estimate" be described rather than defined, as, for example, one where the financial statements, principally the results of operations, would have been materially different had the issuer used a different estimate. This description would be more easily understood and more consistently applied than the SEC's proposed definition.
Similarly, we suggest that the evaluation whether critical accounting estimates merit MD&A disclosure should be based on well-established standards. MD&A should discuss the implications to the financial statements of critical accounting estimates that, in the eyes of management, are reasonably expected to have a material effect should reasonably likely future experience differ from that assumed. In this manner, the disclosure principle underlying critical accounting estimates would be consistent with that for other currently known trends, events, demands and uncertainties that could affect the company's results of operations and liquidity.
Further, we suggest that the MD&A disclosure about critical accounting estimates focus on the uncertainties surrounding the estimate and the implications to the financial statements should future experience differ from that assumed. Accordingly, we question the Release's proposal to require the disclosure in MD&A of the methodology used by management to develop the estimate, the various assumptions underlying the estimate, or why materially different estimates might have been used in the current period. These types of disclosures might be helpful in some circumstances to convey the nature and extent of the uncertainties surrounding the estimate. However, we question the need to provide these disclosures in every case.
As an overarching principle, in determining the number of critical accounting estimates, and the extent of disclosures about any individual estimate, we also believe that companies should convey their view to investors about the relative importance of those estimates to the financial statements. Generally, we would expect that a company would highlight no more than four or five critical accounting estimates, and in many cases, it may be appropriate for a company to discuss only one or two, if those are the more likely to result in a highly material change in estimate.
Critical accounting estimates for specific loss contingencies pertaining to litigation, tax and environmental matters
Critical accounting estimates, by any reasonable definition, may include those with respect to specific loss contingencies, such as pending or threatened litigation and asserted or unasserted claims and assessments, which currently are accounted for under Statement of Financial Accounting Standards No. 5 (FAS 5), Accounting for Contingencies. These FAS 5 contingencies, including certain litigation, tax and environmental matters, are uncertain by their nature, and frequently there are reasonably possible outcomes that would be materially different than the amount provided, if any. Related estimates are usually dependent on the ultimate decision of a third party (e.g., a court, a government agency, an arbitration panel, the counter-party in a dispute). Providing disclosures in MD&A or the basic financial statements of the type proposed with respect to litigation, claims and assessments may place the registrant (and thus its shareholders) at a serious disadvantage when attempting to resolve these contingencies. Accordingly, we suggest that the scope of any required MD&A disclosure about critical accounting estimates exclude specific loss contingencies of the types identified in paragraphs 4.e and 4.f of FAS 5 (i.e., pending or threatened litigation, and actual or possible claims and assessments).
FAS 5 currently requires disclosure of the nature of an accrued loss and, when necessary, the amount accrued. Even when no accrual is appropriate, FAS 5 requires disclosure when there is an exposure that is reasonably possible and significant. Item 303 of Regulation S-K (and the corresponding rules for S-B and foreign filers) requires registrants to discuss known trends, demands, events or uncertainties that are reasonably likely to affect liquidity or future operations in a material way, as well as those that have significantly affected the current year's results.
We believe that forward-looking sensitivity analyses of the effects of future changes in estimates may be more useful and relevant to users than a historical quantitative review of the accuracy of previous critical accounting estimates. The "what-if" analysis that would be required to make the proposed sensitivity disclosures could create a form and level of disclosure that is both difficult for both management to prepare and less relevant to users than more prospective disclosures. Also, many accounting estimates are not hinged on one single most-important assumption; rather the evaluation of a number of variables is often inherent in determining a single accounting estimate (or a range of estimates). Additionally, those variables or assumptions are not necessarily independent of one another or of other variables and assumptions that are used to prepare other estimates or to prepare other areas of the financial statements.
Disclosure of the impact of a single assumption change could be confusing (and perhaps misleading). An attempt to quantify and explain all of the possible combinations and permutations associated with a change (or multiple changes) would be complex and increasingly speculative. This type of disclosure is essentially projection information as to which the SEC has historically insisted, and rightly so, upon a rigorous analysis prior to public disclosure. Even in its simplest form, assuming 5 critical accounting estimates, a financial statement reader would be presented with a total of 15 different estimates (the 5 that were actually recorded in the financial statements and up to 10 others representing the ranges' endpoints) to digest and evaluate and could ultimately lead to multiple "pro forma like" earnings calculations. Furthermore, focusing on the impact of a specific variable or range with respect to a recorded estimate may divert attention from the impact that such a change could have on the registrant's overall business environment or future prospects.
It is axiomatic that changes in estimates are a direct consequence of the fact that the future cannot be predicted with certainty. Generally accepted accounting principles already provide a mechanism for the evaluation of and disclosure of changes in estimates. Similarly, GAAP provides disclosure requirements in respect of risks and uncertainties.
The type of quantitative disclosure called for in the proposed rules could imply that changes in estimates have resulted from previously incorrect estimates (or, conversely, that the absence of change means the previous estimate is "correct"). Estimates are a necessary part of a timely financial reporting model; so too are the changes in those estimates that follow from the reality that actual results may (and oftentimes do) vary from expectations. Additionally, changes in critical accounting estimates arise for many different reasons and those reasons may include events having transpired that may or may not have been reasonably possible at the time that the original estimate was made. Therefore, to promote improved transparency, we would support further elaboration in MD&A of why management chose a particular estimate or why management chose certain key assumptions relative to an estimate.
We do not believe that providing a "report card" (beyond those disclosures already required by GAAP) on the good faith, reasonable estimates previously made by management would benefit many readers of the financial statements. Additionally, we do not believe that the limited resources available to registrants to generate, evaluate and disseminate meaningful information to the investing public should be focused on a backward-looking evaluation. If, however, the Commission does adopt this element of the disclosure proposal, we would strongly urge that it be applied on a prospective basis only, in recognition of the fact that the information necessary to provide this data may not have been prepared or retained.
The Committee believes the proposed segment disclosure requirements included in the Release does not coincide with the purpose of MD&A as expressed in the existing regulations. Under the existing regulations, segment information must be included "to the extent any segment contributes in a materially disproportionate way to revenues, profitability or cash needs." Under the Release, the requirement for segment disclosure is not as limited as expressed in the existing regulations. A registrant that operates in more than one segment, where a critical accounting estimate impacts more than one segment, may be required to disclose information about a segment that does not contribute in a materially disproportionate way to revenues, profitability or cash needs.
As a result, we believe that unless the segment contributes in a materially disproportionate way to revenues, profitability or cash needs, the additional segment disclosures as contained in the Release should not be required. If segment disclosure is to be required, the final rule must make it clear that the overall entity still would be thought to have a limited number of critical accounting estimates so as not to have registrants interpret the instructions as requiring a number of critical accounting estimates per reportable segment.
Audit Committee Involvement
The SEC has proposed that MD&A disclose whether or not management has discussed the development and selection of critical accounting estimates, and the related MD&A disclosures, with the issuer's audit committee. Statement on Auditing Standards No. 61, Communications with Audit Committees, as amended, already requires, among other things, that the auditor determine that the audit committee is informed about:
In addition, S-K Item 306(a)(2) requires the audit committee report, as part of the annual proxy statement, to disclose whether the audit committee has discussed with the independent auditors the matters required under SAS 61. As a result, we believe that existing auditing standards and SEC disclosures assure that audit committees are already sufficiently engaged in communications about critical accounting policies and estimates. Accordingly, we question whether MD&A should contain essentially boilerplate disclosures about audit committee communications regarding critical accounting estimates. To the extent that the SEC determines that explicit disclosure is warranted regarding management's discussion with the audit committee about the development and selection of critical accounting estimates, and any related MD&A disclosures, we believe that such disclosures would be more appropriate within the audit committee report included in the proxy statement. To the extent that the SEC believes that existing S-K Item 306(a)(2) disclosures are not sufficiently informative, we recommend that Item be amended to identify the nature of communications required by SAS 61 related to critical accounting policies and estimates.
AUDITOR EXAMINATION OF DISCLOSURE RELATING TO CRITICAL ACCOUNTING ESTIMATES
The Release requests comments on whether the proposed critical accounting policies to be included in the MD&A section should be subject to independent auditor examination. We would not support examining and reporting on only a portion of MD&A. By attempting to carve out a separate section of MD&A and subjecting this separate section to examination, but not MD&A in its entirety, would imply that this separate section is more important than another section. We believe a "piecemeal" approach to providing assurance on only limited portions of the MD&A section would also inappropriately elevate one component of MD&A over other equally or more important components. It also would be confusing for readers of the MD&A section to understand different levels of auditor involvement with the MD&A information when some information is subjected to the auditor's procedures under SAS No. 8, Other Information in Documents Containing Audited Financial Statements, and if other selected information, such as critical accounting policies, is subjected to examination-level assurance. This may actually mislead a reader into thinking that an auditor had examined a certain section when, in fact, they had not. We also wish to point out that the AICPA Attestation Standards (AT Section 701) do not address examining only a portion of MD&A. Should the SEC propose auditor attestation on a portion of MD&A, the AICPA would likely need to amend AT 701 to provide such form of report.
As noted above, by including certain critical accounting policy disclosures in the footnotes, appropriate independent assurance on such disclosures could also be achieved in the context of the overall financial statements because the disclosures would be within the scope of the financial statement audit.
We believe that it would be advisable and preferable to defer, for at least the current reporting year, any consideration of an auditor's examination of the proposed critical accounting policy disclosures in the MD&A section. This is based on the current efforts to assimilate former Andersen clients by other audit firms, the potential for shorter filing periods for the 2002 reporting year and the need for one year of registrant experience with any new MD&A disclosures.
Therefore, should the Commission decide to amend MD&A to include critical accounting policies and wish to require auditor examination of this part of the MD&A section, we believe that the Commission should expose a specific rule on auditor examination of MD&A. This would allow the SEC, the audit profession and registrants to address both the suitability of the criteria on which to evaluate compliance, and the need to amend Section AT 701 to provide additional implementation guidance regarding the procedures that should be performed with respect to the disclosures about critical accounting estimates.
INITIAL ADOPTION OF ACCOUNTING POLICIES
We believe that robust disclosure of initial accounting policy selection is useful to users of financial statements. While APB No. 22, Disclosure of Accounting Policies, requires the disclosure of a newly adopted accounting policy if it is considered to be a "significant accounting policy", the current requirements of APB No. 22 do not entail the additional disclosures regarding existing alternatives considered in the Release.
We believe that certain of the disclosures required by the Release relative to the adoption of accounting policies are more integral to the basic financial statements and should be included in the footnotes to the financial statements. We suggest that the Commission staff adopt certain of the disclosures in the Release through the issuance of a Staff Accounting Bulletin, as an interim step. The SEC should request the Financial Accounting Standards Board to add an agenda item to enhance or interpret existing generally accepted accounting principles to consider the disclosures included in the Staff Accounting Bulletin.
We also note that as currently drafted, the Release does not seem to require discussion of initial adoption of a new policy until a Form 10-K, registration statement or proxy statement is filed. As a result, the disclosure on initial adoption appears to contemplate an annual requirement only, with no disclosure for a policy initially adopted during an interim period. We believe that to maximize effectiveness and utility to the user, the disclosure requirements should also apply to quarterly filings.
While we support the overall objective of disclosure relative to initial adoption of accounting policies, we do not support certain features of the proposing release and have concerns regarding its implementation.
Impact of Alternative Accounting Treatments. We believe that detailed and quantified disclosure of the impact of alternative accounting treatments that a company could have adopted for a transaction could result in confusion. Discussion of the impact on the financial statements of the multiple alternative policies and methods of application available, (i.e., in methods of inventory valuation or depreciation of fixed assets), could potentially obfuscate the alternative that management believes to be the most appropriate under the circumstances. For example, a number of methods of inventory valuation and depreciation exist. Disclosure of every possible alternative, or even several alternatives, would result in a lengthy narrative, with a limited informational or predictive value to the reader. It should be sufficient to note that other alternatives exist and to indicate, if applicable, that results could be materially different under the alternative(s) not selected.
Comparative Analysis of Policies Selected in Same Industry. While comparative analysis of policies selected against those applied by companies in the same industry could theoretically be useful and illuminating to the reader, practical application of the requirement could be exceedingly difficult. Many companies are aware of the policy choices made by their competitors, but they may not have sufficient detail regarding competitor transactions to determine that transactions are similar enough to warrant the same accounting policy and/or methods of application, thereby making any comparison speculative. Similarly, while aware of policy choices made by their competitors, there may be other situations in which a registrant is not aware of the method of application of that policy, making comparison again difficult, speculative and potentially ineffective.
Auditor Assistance in Determining Divergence from Industry Practice. The Release seeks comment regarding the ability of auditing firms to assist companies in determining whether their accounting policies generally diverge from industry practices. While auditors must be familiar with general industry practices used under GAAP, seeking nonpublic data on competitor accounting choices and methods from auditors is inconsistent with the role of an auditor. Auditors are precluded by standards of confidentiality from conveying confidential information to clients about the application of policies to help with this determination.
Resources. Most companies devote significant accounting and reporting function resources to preparing their financial statements using the policies management believes most appropriate. The Commission's proposal to accelerate reporting deadlines will add to the accounting and reporting resource needs of these companies. Adding an additional requirement to calculate the effect of accounting policies and methods not considered preferable could, in many cases, strain resources further and add significant costs. We recommend the Commission consider the costs of these additional resources in their cost/benefit analysis.
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The AICPA appreciates the opportunity to comment on the Release. We would be pleased to discuss these comments with you at your convenience.
Jay P. Hartig
AICPA SEC Regulations Committee