By James Hamilton, J.D., LL.M.
With the coming of judgment-driven principles-based standards, the SEC staff urges companies to engage in continuing upward dialogue regarding their accounting judgments made while preparing financial statements. Reasonable judgment is the foundation of the US financial reporting system, declared Associate Chief Accountant Todd Hardiman at a recent AICPA seminar. Reasonable accounting judgments are necessary for both rules-based standards and the more subjective principles-based standards, he said, as well as for transactions for which the accounting literature does not specifically apply. In his remarks, Mr. Hardiman also lays out the chain of command for a company to use if it disagrees with an SEC staff comment on professional accounting judgment. The chain goes right up though the Division of Corporation Finance accounting command all the way up to the SEC’s Office of the Chief Accountant.
The associate chief accountant advised issuers not to silently accept a staff conclusion that they do not agree with. Doing so stops the dialogue, he reasoned, and the staff may view the silence as validation of their comments. In that situation, the official urged issuers to seek a review of the staff’s decision by more senior SEC accounting staff.
Laying out a roadmap for going up the chain of command, the official noted that the issuer-SEC dialogue starts with the staff accountant and review accountant identified in the staff comment letter. An issuer that thinks their conclusion is not appropriate should continue the dialogue by asking for a review by more senior accounting staff of the Division of Corporation Finance.
The first layer of additional review will come from the senior assistant chief accountant; of which there is one for each of the division's eleven industry groups. If the issuer still does not agree with the staff decision, it should request a review by the division’s Office of Chief Accountant.
At that level, the decision will be reviewed by one of seven associate chief accountants. Depending on the course of the dialogue with division, either the Deputy Chief Accountant or Chief Accountant may be pulled into the dialogue. Finally, after working up the division’s chain of command, there is the opportunity to have the division's decision reviewed by the Office of Chief Accountant of the Commission.
Generally, companies and their management do a good job of making judgments, said the SEC official, and that is appropriate. Management is closest to the action and thus best-suited to make the delicate inferences and judgments unique to their facts and circumstances. But at times, he continued, their disclosure documents do not explain those important judgments and sometimes actually seem inconsistent with the exercise of appropriate judgment. When that happens, he noted, the SEC staff enters the mix.
The official explained that the staff will question accounting judgments when the basis for an important judgment is counterintuitive or unclear from the disclosure. The staff will also raise a question when the judgments appear to be inconsistent with other judgments or assumptions made by management. The staff will also query when the analogy to accounting literature cited by management to support a judgment has been superseded by more recent thinking in other more closely analogous accounting literature that existed at the filing date. Broadly, then, the SEC staff will question an important judgment when they cannot understand it or when on it seems inappropriate on its face.
But the SEC official assured that the staff’s questioning of an accounting judgment does not mean that they have concluded that the judgment is wrong. In virtually every comment that asks questions about judgment, he explained, the comment should be viewed as an invitation to a dialogue. While it is an invitation that may be difficult to decline, he acknowledged, companies must understand that the comment is intended to elicit a dialogue.
Indeed, the SEC needs issuers to fully participate in a dialogue since there is not always one right answer, especially when the judgment relates to principles-based standards or transactions where the accounting literature is not directly on point. In those circumstances, the SEC staff is trying to determine if the company's accounting is unreasonable. In order to answer that question, the staff needs help in understanding why the company made the judgment. Sometimes the reason why is self evident from the disclosure document, he observed, but if the staff is raising a question it probably is not.