The New MD&A Rule:  Part Three - Critical Accounting Estimate Disclosure

By George Wilson

In this post, we overviewed the changes to MD&A in the SEC’s Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information Final Rule. This rule was published in the Federal Register on January 11, 2021, and is effective for filings on or after February 10, 2021.

The rule’s transition provisions provide a mandatory transition date but also allow voluntary early compliance.  The mandatory transition date is each company’s first fiscal year that ends after August 9, 2021, which is 210 days after the effective date.  Companies may voluntarily apply the new rule, on an S-K item-by-item basis, in any filing made on or after the effective date of February 10, 2021.

If a company did not implement the rule early, it is not too soon to start planning for these required changes.

In the second post in this series, we reviewed the first of the changes to the MD&A requirements, the addition of an objective to S-K Item 303.

This third post in the series addresses disclosure of critical accounting estimates.  The history of this disclosure has created more than a bit of confusion about its goal.  As a result, disclosure about critical accounting estimates is too often vague and uninformative.  

The first mention of anything “critical” about accounting principles or estimates was a “Cautionary Advice” issued on December 2, 2001, in the wake of Enron’s downward spiral.  It is very short.  It builds on the belief that:

“Investors may lose confidence in a company's management and financial statements if sudden changes in its financial condition and results occur, but were not preceded by disclosures about the susceptibility of reported amounts to change, including rapid changes.”

Without defining “critical accounting policy,” the Release suggested several disclosure steps, including: 

“Each company's management and auditor should bring particular focus to the evaluation of the critical accounting policies used in the financial statements.”; and

“Prior to finalizing and filing annual reports, audit committees should review the selection, application and disclosure of critical accounting policies.”

This was the first step in addressing accounting policies involving subjective and challenging estimates which could potentially create material financial statement volatility.  The SEC issued a proposed rule in 2002 that would have required “critical accounting estimate” disclosure.  (Note the change in terminology from “policy” to “estimate.”)

This rule was never finalized.

One of the reasons the SEC never finalized this rule was their conclusion that existing MD&A guidance provides for “critical accounting estimate” disclosure.  The 2003 MD&A release, FR 72,  formally changed the terminology to “critical accounting estimates” and provided disclosure guidance:

V. Critical Accounting Estimates

Many estimates and assumptions involved in the application of GAAP have a material impact on reported financial condition and operating performance and on the comparability of such reported information over different reporting periods. Our December 2001 Release reminded companies that, under the existing MD&A disclosure requirements, a company should address material implications of uncertainties associated with the methods, assumptions and estimates underlying the company's critical accounting measurements. In May 2002 we proposed rules, which remain under consideration, that would broaden the scope of disclosures beyond those currently required.

When preparing disclosure under the current requirements, companies should 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.

FR 72, the 2003 MD&A release, goes on to say:

Such 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.

This disclosure guidance is consistent with the overall objective of MD&A to help investors understand how well historical financial performance is predictive of future financial performance.  (We discussed this objective in the previous post in this series.)  If a company makes an estimate which could materially change in future periods, investors should be aware of this risk.

With all of this as preamble, it is still clear that many companies do not disclose information consistent with this guidance.  All too frequently this disclosure is simply a repetition of information in the financial statement’s summary of significant accounting policies.  

This leads us to the Final Rule which adds a critical accounting estimate disclosure requirement to S-K Item 303.  This clarifies and codifies existing Commission guidance.  S-K Item 303 now includes this paragraph:

(3) Critical accounting estimates. Critical accounting estimates are those estimates made in accordance with generally accepted accounting principles that involve a significant level of estimation uncertainty and have had or are reasonably likely to have a material impact on the financial condition or results of operations of the registrant. Provide qualitative and quantitative information necessary to understand the estimation uncertainty and the impact the critical accounting estimate has had or is reasonably likely to have on financial condition or results of operations to the extent the information is material and reasonably available. This information should include why each critical accounting estimate is subject to uncertainty and, to the extent the information is material and reasonably available, how much each estimate and/or assumption has changed over a relevant period, and the sensitivity of the reported amount to the methods, assumptions and estimates underlying its calculation. 

The rule also adds this language in new Instruction 3, using the same wording as the 2003 MD&A release:

For critical accounting estimates, this disclosure must supplement, but not duplicate, the description of accounting policies or other disclosures in the notes to the financial statements. 

The SEC explained their rationale for adding this requirement to S-K Item 303 in this comment from the Final Rule:

The Commission proposed amending Item 303 to add new Item 303(b)(4), which would explicitly require disclosure of critical accounting estimates in order to clarify the required disclosures of critical accounting estimates, facilitate compliance, and improve the resulting disclosure. Because registrants often repeat the information in the financial statement footnotes about significant accounting policies, the proposals were also intended to eliminate disclosure that duplicates the financial statement discussion of significant accounting policies and, instead, promote enhanced analysis of measurement uncertainties. 

The Final Rule also articulates the overall goal of critical accounting estimate disclosure and its forward-looking focus:

Further, unlike existing requirements in U.S. GAAP, our amendments emphasize forward-looking information as they are intended to provide investors with greater insight into estimation uncertainty that is reasonably likely to have a material impact on financial condition and operating performance. We remind registrants that the principle that MD&A should not be a recitation of financial statements in narrative form extends to disclosure of critical accounting estimates.

This new requirement will create an opportunity for many companies to review their current disclosure and eliminate information that does not help assess potential variability or that simply duplicates information in the financial statements.  There is also an opportunity to consider whether critical accounting estimate disclosure should be similar to the auditor’s discussion of critical audit matters.

As always, your thoughts and comments are welcome!

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