By James Hamilton, J.D., LL.M.
Although the SEC staff believes that MD&A disclosure has improved both qualitatively and quantitatively since the last interpretative release in 2003, there is still room for improvement in discussions of critical accounting estimates and liquidity. According to Corp Fin Associate Chief Accountant Sondra Stokes, all too often the discussion of critical accounting estimates merely repeats the accounting policy disclosure found in the footnotes to the financial statements. An accounting policy footnote is not a synonym for a critical accounting estimate disclosure, cautioned the senior official, since the objectives are simply not the same.
In her view, the ideal critical accounting estimates discussion would provide insights into the quality and variability of information regarding financial condition and operating performance. Rather than describing the method used to apply an accounting principle, the discussion would present an 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. Since the accounting policy disclosure is in the financial statements, she urged that MD&A be used to explain what the application of those policies means.
The first step, she advised, is to clearly explain why the accounting estimates or assumptions bear a risk of change. In order to communicate this point, companies should discuss how the estimate was arrived at and how accurate estimates have been in the past. In addition, there should be a discussion of how much the estimate has changed in the past and whether the estimate or assumption is reasonably likely to change in the future.
Because critical accounting estimates and assumptions are based on matters that are highly judgmental, the assistant chief accountant reasoned, companies should discuss the sensitivity of such estimates or assumptions to change, providing a quantified sensitivity analysis when possible. The SEC staff sees far too little quantification, she said, and the staff issues comments when quantification would provide an investor with meaningful information.
That said, she continued, the discussion of critical accounting estimates should be limited to only the most critical so these do not get lost in the disclosure. Truly critical accounting estimates are the valuation of long-lived assets, goodwill and other intangibles, post employment benefits, liabilities and reserves, derivatives, revenue recognition, income taxes, and environmental conservation costs. The SEC official cautioned that this list is neither comprehensive nor all-inclusive since the discussion of critical accounting estimates is specific to each company.
More broadly, she noted that the disclosure of critical accounting estimates may be appropriate where the impact of the estimates and assumptions on financial condition or operating performance is material. Disclosure becomes particularly important when the nature of the estimates or assumptions is potentially volatile, either due to the level of judgment necessary to account for highly uncertain estimates and assumptions, or when the estimates and assumptions are readily susceptible to change.
More importantly, the disclosure of critical accounting estimates has the potential to be some of the most relevant and crucial disclosure in the MD&A. This is because the average lay person often neither understands nor appreciates the extent to which the use of estimates and assumptions is inherent in the preparation of financial statements. There is the ever present risk that users of financial statements may assume when they see audited financial statements that the numbers are the numbers and there is little, if any, gray. This is not true, she emphasized, particularly as accounting moves towards the use of fair value. As these trends inexorably accelerate, it becomes increasingly important to make sure that the use of estimates and assumptions in the preparation of financial statements is adequately communicated to the users of those statements.
With respect to liquidity and sources and uses of cash, the official said that the MD&A must go beyond the information that is available on the face of the cash flow statement. The focus should be on the drivers of the company's cash flows, and other information necessary to help someone understand what the future requirements for cash are, and where management intends to obtain those funds.
If funds are going to be generated internally, there should be a clear explanation of cash flows from operations to help readers understand the key drivers behind that number. For example, rather than merely citing what the change in working capital was, which is evident from the face of the financials, the MD&A should discuss what is causing the changes in the underlying working capital components. Rather than saying cash increased because the company collected more of their accounts receivable, the MD&A should focus on explaining why that change occurred.
A second component of the liquidity discussion pertains to a company's borrowings. If financing arrangements have been material to the historical cash flows, additional information should be provided in the liquidity discussion, including the impact of known or reasonably likely changes in credit ratings, the company’s ability to access financing sources, and future plans to borrow material amounts.
When reviewing the liquidity discussion, management should ask what the company’s obligations are and how they can they be satisfied; and whether more cash can be readily accessed. If these questions are not clearly answered, said the assistant chief accountant, the disclosure probably needs to be enhanced.