It has been a while since we posted about critical accounting estimates. While this is now a normal part of MD&A it is surprising how many folks in our workshops don’t know where the “official” guidance for this disclosure is found.

There is a bit of confusion in the history of this disclosure. It all started in the post-Enron period with concerns about the quality of accounting principle selection discussed in FR 60 (the FRs are Financial Reporting Releases, interpretations that are approved by the SEC Commissioners). This release addressed the aggressive use of accounting principles and required disclosure in plain English of “Critical Accounting Policies”. FR 60 did not describe in great detail exactly what a critical accounting policy was or what disclosures should be made. You can find this brief FR, for perhaps historical purposes, here.

FR 60 was issued as a “quick fix” and the SEC planned to follow it with a formal rule for this disclosure. The rule was proposed, but it was never actually finalized. Instead the SEC dealt with this disclosure in FR72. If you scroll to Section V towards the end of FR 72 you will find the requirements for disclosure of critical accounting estimates.

www.sec.gov/rules/interp/33-8350.htm

(As you read this FR, note the evolution in terminology from Critical Accounting Policies to Critical Accounting Estimates.)

Don’t forget to look at the most recent Staff guidance in this area in FRM Section 9500, which gives guidance on disclosure of critical accounting estimates in the area of goodwill impairment.

Here are a few key issues about disclosure of Critical Accounting Estimates:

1. Critical accounting estimates are not the same as significant accounting policies, and this part of MD&A should not simply duplicate this information from the financial statements. The focus should be on estimates and assumptions used in GAAP that have a material impact on financial condition and operating performance and on comparability over time.
2. This disclosure should focus on why the estimate is “critical” and what is challenging about the estimate. Why is it difficult to make this estimate and what creates uncertainty about the precision of the estimate?
3. Most companies won’t have that many of these “critical” estimates. Most companies start with a few and build from there. Often, lessons from past changes in estimates can help your identification process.
4. The staff sometimes will ask about the quantified sensitivity analysis discussed in the last part of FR 72, so if information is available and will help investors understand the significance of the estimate and its uncertainty, consider disclosing it.

To help understand this disclosure, here is a recent comment from the SEC:

Critical Accounting Policies and Estimates

2. In future filings please provide a more robust discussion of your critical accounting policies and estimates to focus on the assumptions and uncertainties that underlie your critical accounting estimates rather than duplicating the accounting policy disclosures in the financial statement footnotes. Please quantify, where material, and provide an analysis of the impact of critical accounting estimates on your financial position and results of operations for the periods presented. In addition, please include a qualitative and quantitative analysis of the sensitivity of reported results to changes in your assumptions, judgments, and estimates, including the likelihood of obtaining materially different results if different assumptions are applied. If reasonably likely changes in inputs to estimates would have a material effect on your financial condition or results of operations, the impact that could result given the range of reasonable outcomes should be disclosed and quantified. Please refer to SEC Release No. 33-8350. In your response, please show us what your disclosure would have looked like if these changes were made in your most recently filed Form 10-K.

As always, your thoughts and comments are appreciated!