Securities and Exchange Commission (SEC) registrants following SEC rules and regulations must disclose their significant and critical accounting policies in their filings with the SEC. For those well versed in the financial reporting profession, the disclosure requirements may, on the surface, seem the same. However, I can’t tell you how many people, even some heavily experienced in the industry, that do not understand the difference between these two disclosure requirements.
The SEC has released guidance and insight on the distinguishing factors registrants should consider between these two disclosure requirements. Today’s post will generally cover the disclosure requirements for both policy definitions. I’ll also address the reason why understanding the differences between these disclosure requirements is critical for forensic accountants assisting their clients in determining whether or not a registrant complied with SEC regulations.
Regulation S-X and disclosure of significant accounting policies
SEC Regulation S-X governs the form and content of annual financial statements not only for SEC filings but also for shareholder reports of SEC registrants. This regulation is comprised of 12 articles, with Article 3 discussing the general instructions for financial statements.
Accounting Principles Board (APB) Opinion No. 22, Disclosure of Accounting Policies, adopted in 1972 states in paragraph 12:
Disclosure of accounting policies should identify and describe the accounting principles followed by the reporting entity and the methods of applying those principles that materially affect the determination of financial position, cash flows, or results of operations. In general, 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. (emphasis added)
The next paragraph states,
Examples of disclosures by a business entity commonly required with respect to accounting policies would include, among others, those relating to basis of consolidation, depreciation methods, amortization of intangibles, inventory pricing, accounting for recognition of profit on long-term construction-type contracts, and recognition of revenue from franchising and leasing operations. This list of examples is not all-inclusive.
Another relevant accounting standard is Statement of Position (SOP) 94-6, Disclosure of Certain Significant Risks and Uncertainties, issued in 1994. Paragraphs 1 and 2 state:
The central feature of this SOP’s disclosure requirements is selectivity: specified criteria serve to screen the host of risks and uncertainties that affect every entity so that required disclosures are limited to matters significant to a particular entity. The disclosures focus primarily on 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. The risks and uncertainties this SOP deals with can stem from the nature of the entity’s operations, from the necessary use of estimates in the preparation of the entity’s financial statements, and from significant concentrations in certain aspects of the entity’s operations. (emphasis added)
Significant accounting policies are to be disclosed in the notes to the financial statements in accordance with Regulation S-X. Notice the emphasis on materiality (in APB 22), inferred in SOP 94-6 by the use of the word “significantly.” However, there is no mention of an integral component to classify a policy as “critical”, which I will discuss next.
Regulation S-K and disclosure of critical accounting policies
SEC Regulation S-K governs qualitative information about the registrant, such as the nature of its business, its properties, legal proceedings, its executives and officers (including executive compensation), and management’s discussion and analysis of the results of operations (MD&A). In May 2002, the SEC issued a proposed rule called Disclosure in Management’s Discussion and Analysis about the Application of Critical Accounting Policies. As far as I can tell, the proposed rule has not been adopted by the Commission.
In summary, if adopted, the scope of disclosures related to critical accounting estimates within a registrant’s MD&A section would broaden beyond those contemporaneously required. The SEC summarized the proposed rules, in part, stating:
The proposals would encompass disclosure in two areas: accounting estimates a company makes in applying its accounting policies and the initial adoption by a company of an accounting policy that has a material impact on its financial presentation. Under the first part of the proposals, a company would have to identify the accounting estimates reflected in its financial statements that required it to make assumptions about matters that were highly uncertain at the time of estimation. (emphasis added)
Notice the words “highly uncertain” describing accounting estimates. The SEC proposed that a company would have to answer two questions, with a “yes” to both questions, in order to conclude that an estimate meets the disclosure criteria of a “critical accounting estimate.”
- Did the accounting estimate require us to make assumptions about matters that were highly uncertain at the time the accounting estimate was made?
- Would different estimates that we 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 our financial condition, changes in financial condition or results of operations?
In essence, the above proposal encapsulates what the SEC believed back in 2003 must be established to qualify an accounting estimate as “critical.”
The following year in December 2003, the SEC released an Interpretation titled Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations as a means of improving the disclosures by registrants with respect to critical accounting estimates, among other things.
Specifically, the SEC’s guidance on preparation of disclosure of critical accounting estimates is that companies consider:
whether they have made accounting estimates or assumptions where 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 the impact of the estimates and assumptions on financial condition or operating performance is material. (emphasis added)
If these criteria are met, companies should disclose the details within their MD&A.
The SEC made it clear that, “[s]uch disclosure should supplement, not duplicate, the description of accounting policies that are already disclosed in the notes to the financial statements. The disclosure should provide greater insight into the quality and variability of information regarding financial condition and operating performance. While accounting policy notes in the financial statements generally describe the method used to apply an accounting principle, the discussion in MD&A should present a company’s analysis of the uncertainties involved in applying a principle at a given time or the variability that is reasonably likely to result from its application over time.”
Understand what standard or guidance was applicable at the time
This should go without saying, but forensic accountants must always keep in mind the “date stamps” associated with (1) accounting standards, (2) SEC rules and regulations, (3) SEC proposed rules, and (4) SEC interpretations. Understanding the timing of authoritative (or even non-authoritative, as in the case of a proposed rule) guidance relative to the facts and circumstances in a dispute is critical to assessing whether or not a client adequately complied with the rules at that point in time.
Applicability
Disclosure of accounting estimates deemed significant means the estimates have a pervasive or material impact on the financial statements (e.g., revenues, fixed asset depreciation, inventory pricing). Critical accounting estimates, however, reflect subjective, judgmental, highly uncertain, susceptible to change accounting estimates. Therefore, the threshold to disclose critical accounting estimate policies is different than the threshold to disclose significant accounting estimate policies.
I recently assisted a defendant in a litigation matter that dealt with, among other allegations, allegations that the defendant did not adequately disclose sufficient details with respect to certain accounting estimates stemming back a few years prior to the financial crisis of 2008. The plaintiff’s counsel argued that the accounting estimate was both “critical” and material and should have been treated as such from a disclosure standpoint. I assisted the client defendant in putting together a case that it was not possible at the time to know that the accounting estimate would be material. If you recall, one of the requirements of a critical accounting estimate has to do with materiality. Although the accounting estimate was potentially subjective and susceptible to high estimation uncertainty, I assisted the client in formulating a position that the accounting estimate did not meet the materiality requirement for disclosure as a critical accounting policy.