THE UNITED States of America's Securities and Exchange Commission (SEC) proposed rule would call for disclosures about "critical accounting estimates" and about the initial adoption of accounting policies that have a material effect on a company's financial statements.
A critical accounting estimate meets two criteria:
(i) It requires assumptions about highly uncertain matters.
(ii) There would be a material effect on the financial statements:
(a) from using a different, also reasonable, amount within the range of the estimate in the current period, or
(b) from reasonably likely period-to-period changes in the estimate.
The release proposes three types of disclosures about critical accounting estimates:
Matters needed to understand the estimates (including, for example, the methodology underlying the estimate, relevant assumptions, and the effects of the estimates on the financial statements). Companies with more than one segment would have to identify the segments that the accounting estimate affects and disclose whatever information is necessary to avoid a misleading presentation.
Quantitative and qualitative discussion of the sensitivity of the reported operating results and financial condition, including liquidity and capital resources, to changes in the estimates or their underlying assumptions. In addition, the disclosures would have to cover any material changes made to the accounting estimates for the past three years, the reasons for the changes, and the effects on line items and overall financial performance.
Two approaches to the sensitivity analysis would be permissible:
(i) The company could assume that reasonably possible near-term changes occur in the most material assumptions underlying the estimate.
(ii) The company could assume the estimate was changed to the upper and lower end of the range of reasonably possible estimates determined when formulating its estimate.
Whether or not senior management discussed the development, selection, and disclosure of the estimates with the audit committee.
The disclosures would be made annually and updated quarterly.
The SEC expects the vast majority of companies to have three to five critical accounting estimates and very few companies to have none.
An accounting policy adopted for the first time that has a material effect on the company's financial presentation, except for a policy imposed by a new General Accepted Accounting Principles (GAAP) requirement, would lead to several descriptive disclosures. They include the events or transactions triggering the policy's adoption, the accounting principle adopted and method of applying it, and the effect, in qualitative terms, on the company's financial statements. In addition, if the company made a choice between GAAP accounting principles, it would have to explain the alternatives and why it made its choice (for example, a company initially adopting a principle to account for inventory would have to explain why it chose either FIFO or LIFO). If no accounting literature was governing, the company would have to explain how it decided on the accounting principle it adopted.
According to the SEC release, the need for these disclosures would arise when an accounting policy is adopted in response to events or transactions that affect a company for the first time, events or transactions previously immaterial for accounting purposes that become material, and events and transactions that are clearly different in substance from previous events or transactions.
The release requests comments on the proposed rule and where to require auditor examination or review of the proposed disclosures about critical accounting estimates.
Mr. Raphael E. Gordon is the managing partner of KPMG Peat Marwick, Past President of the Institute of Chartered Accountants of Jamaica, a member of the Public Accountancy Board, and Jamaica's representative on the Association of Chartered Certified Accountants International Assembly.
