MD & A revealing the soft numbers: a new executive report from the Financial Executives Research Foundation (FERF) reviews MD&A reporting of critical accounting policies. (Corporate Reporting).Recent high-profile accounting is and growing distrust in corporate financial reports have raised concerns about distortions of reported earnings. While a few cases of earnings distortions arise from manipulation of transactions, most arise from manipulating "soft-number" accruals Accruals Accounts on a balance sheet that represent liabilities and non-cash-based assets used in accrual-based accounting. These accounts include, among many others, accounts payable, accounts receivable, goodwill, future tax liability and future interest expense. , such as restructuring charges restructuring charge The expense of reorganizing a company's operations. A restructuring charge is an infrequent expense that generally results from asset writedowns or facility closings. and reserves for bad debts and inventory obsolescence ob·so·les·cent adj. 1. Being in the process of passing out of use or usefulness; becoming obsolete. 2. Biology Gradually disappearing; imperfectly or only slightly developed. . To address these distortions, the Securities and Exchange Commission (SEC) issued Cautionary Advice Regarding Disclosure About Critical Accounting Policies (FR-60), in December 2001. Cautionary Advice encouraged companies to disclose information about critical accounting policies and estimates in the Management's Discussion & Analysis (MD&A) section of corporate annual reports. Soon after issuing Cautionary Advice, the SEC released proposed rule 33-8098, Disclosure in Management's Discussion and Analysis Management's discussion and analysis (MD&A) A report from management to shareholders that accompanies the firm's financial statements in the annual report. It explains the period's financial results and enables management to discuss topics that may not be apparent in the financial about the Application of Critical Accounting Policies, beginning the process of codifying disclosure requirements for critical accounting policies. Finally, in February, the SEC released its Summary by the Division of Corporation Finance of Significant Issues Addressed in the Review of the Periodic Reports of the Fortune 500 Companies. which was sent to select Fortune 500 companies. Expressing its dissatisfaction with current disclosures, it stated: In our review of the Fortune 500 companies, we noted a substantial number of companies did not provide any critical accounting policy disclosure in circumstances where FR-60 could fairly be read as calling for this disclosure. We also found that the critical accounting policy disclosure of many companies did not adequately respond to the guidance provided in FR-60. We also found that many companies failed to provide the sensitivity analysis the Commission encouraged in FR-60. The language in this report provides clear evidence that the SEC is not waiting for approval of a final rule before requiring the disclosure of critical accounting policies. Although there is little practical guidance available, the SEC is sending a message that these disclosures are key to transparent financial reporting. Just What Are "Critical Accounting Policies?" Critical accounting policies are those policies that management considers to be most important to portraying the company's financial condition, and that require management's most difficult, subjective or complex judgments. Some common examples include: bad debt reserves, depreciation, revenue recognition policies, expected rate of return expected rate of return The rate of return expected on an asset or a portfolio. The expected rate of return on a single asset is equal to the sum of each possible rate of return multiplied by the respective probability of earning on each return. on pension assets, employee stock options, contingent liabilities Contingent Liability 1. The possibility of an obligation to pay certain sums dependent on future events. 2. Defined obligations by a company that must be met, but the probability of payment is minimal. Notes: 1. , goodwill, impairments, deferred taxes and derivative contracts. Often these disclosures include estimates that might represent materially large amounts on a company's income statement or balance sheet. Also, certain critical accounting policies might be particular to specific industries. Banks, for instance, will probably report bad debt reserves as critical accounting policies. Computer software companies, on the other hand, might be expected to focus on the valuation of intangible assets Intangible Asset An asset that is not physical in nature. Notes: Examples are things like copyrights, patents, intellectual property, and goodwill. These are the opposite of tangible assets. and revenue recognition. Firms commonly refer to such policies and estimates as "soft numbers." The largest soft numbers (in relation to other elements of the financial statements) should be deemed critical. Accrual accounting Accrual Accounting An accounting method that measures the performance and position of a company by recognizing economic events regardless of when cash transactions happen. Notes: often necessitates that management predict the amounts and timing of future cash flows, a process that involves estimation and judgment. Critical accounting policies, therefore, should also include accounting for complex accrual transactions, such as trading derivatives, funding pension plans, recording deferred taxes and maintaining off-balance-sheet financing Off-Balance-Sheet Financing A way of raising money that does not appear on the balance sheet. Notes: This is unlike loans, debt and equity, which do appear on the balance sheet. entities. Highlighting such policies warns investors that these policies are important and complicated, giving management a new opportunity to educate investors about how different outcomes may impact the company and its financial statements. Says Norman Strauss, Ernst and Young Executive Professor in Residence at Baruch College Baruch College: see New York, City University of. , and a former National Director of Accounting at Ernst and Young: "New disclosure requirements for critical accounting policies now serve to focus practitioners' attention to critical and other significant accounting policies. Business and accounting are complicated. Placing these disclosures at the beginning of the MD&A gives the user the most important keys to understanding the financial reporting process." However, just because a policy is disclosed does not guarantee that it will be easy to understand, argues Marsha Hunt Two notable women are called Marsha Hunt:
"Still, it remains unclear that these disclosures can help an investor without a detailed appreciation of GAAP GAAP See: Generally Accepted Accounting Principles GAAP See generally accepted accounting principles (GAAP). [generally accepted accounting principles The standard accounting rules, regulations, and procedures used by companies in maintaining their financial records. Generally accepted accounting principles (GAAP) provide companies and accountants with a consistent set of guidelines that cover both broad accounting ]. The disclosures are usually about complex accounting issues, and even those explained in plain English Plain English (sometimes known, more broadly, as plain language) is a communication style that focuses on considering the audience's needs when writing. It recommends avoiding unnecessary words and avoiding jargon, technical terms, and long and ambiguous sentences. can be difficult to understand without some foundation in GAAP. Satisfying the needs of all investors with this disclosure requires a balance between detail about the business and an explanation of GAAP." Operationalizing the SEC's New Requirements How can financial executives satisfy the SEC's enhanced MD&A requirements while keeping the MD&A clear, concise and useful? Here are some suggestions: * Report only those critical accounting policies that are most significant to your company. The SEC has recommended three to five as a rough guideline. * Assure users that estimates and judgments are an integral part of financial reporting and that you are confident in the estimates and judgments you use. * Present sensitivity analysis in the context that there is always a range of possible outcomes, however remote their likelihood. Enumerate To count or list one by one. For example, an enumerated data type defines a list of all possible values for a variable, and no other value can then be placed into it. See device enumeration and ENUM. the specific conditions and circumstances that could lead to one of these alternative outcomes (war with x-country, oil supply shortage, changes in the discount rate, changes in congressional representation, etc.). * Limit the boilerplate-type statements that could really apply to any company in your industry. Rather, be specific about the particular opportunities and uncertainties affecting your company, and how they would affect your financial statements. The chart here shows a summary of new trends that have been identified in critical accounting policy disclosures. Bear in mind that the SEC's goal is to improve transparency by providing more information to help users understand how the financial statements were prepared. Corning Inc.'s Goodwill Impairments For example, consider Corning's treatment of goodwill impairments, as shown in the sidebar on the previous page. Corning identifies goodwill impairment as the first of six different critical accounting policies. The disclosure is written in plain English. It describes in detail outside trends relevant to the accounting judgments made. Furthermore, the disclosure explains how alternative assumptions would affect net income. Hunt says the accounting staff expended ex·pend tr.v. ex·pend·ed, ex·pend·ing, ex·pends 1. To lay out; spend: expending tax revenues on government operations. See Synonyms at spend. 2. great effort to provide detailed relevant information, some of which was not disclosed elsewhere by the company, without reporting competitor-friendly information about such areas as future pricing. Judging from the current regulatory-climate, it appears that new critical accounting policy disclosures will take a permanent place in the MD&A. Going forward with experience and dissemination of different corporate disclosures, the expectation of improved reporting of critical accounting policies can help to enhance the overall transparency--and usefulness--of financial reports.
Trends in MD&A Disclosures of Critical Accounting Policies
OUT IN
Keeping the audit committee "in Reporting audit committee and
the dark." top management involvement in
application of critical accounting
policies.
Quietly introducing new critical Providing more details about new
accounting policies. critical accounting policies.
Brief, concise descriptions of Detailed, almost textbook-like
critical accounting policies. descriptions of complex accounting
treatments.
No information about how Providing sensitivity analysis,
alternative accounting treatments explaining how different accounting
would have affected income. estimates would affect the
financial statements.
No discussion about prior changes Providing detailed historical
in critical accounting estimates. information about previous changes
in critical accounting estimates.
Using complex technical jargon. Using plain English.
Aggregation of segments. Explaining how critical accounting
policies affect individual
segments' reporting.
Boilerplate statements. Providing substantive information
not found elsewhere in the Annual
Report or 10-K.
RELATED ARTICLE: Corning Inc. Excerpt ex·cerpt n. A passage or segment taken from a longer work, such as a literary or musical composition, a document, or a film. tr.v. ex·cerpt·ed, ex·cerpt·ing, ex·cerpts 1. from Annual report, 2002 Impairment of goodwill in the telecommunications reporting unit. SFAS SFAS Statement of Financial Accounting Standards SFAS Special Forces Assessment and Selection SFAS Student Financial Aid Services SFAS Sport Fishing Association of Singapore SFAS Safety Features Actuation System SFAS Statewide Fixed Assets System No. 142, "Goodwill and Other Intangible Assets," requires management to make judgments about the fair value of its reporting unit. Corning measures fair value on the basis of discounted expected future cash flows Expected future cash flows Projected future cash flows associated with an asset. . The determination of expected future cash flows involves judgment. Corning's judgment was based upon our historical experience in the telecommunications business, our current knowledge from our commercial relationships, and available external information about future trends. With this input, it is management's expectation that there will be minimal volume growth in the short term; volume growth is assumed to accelerate beginning in 2005 commensurate with overall market recovery. Terminal value of the business assumes a growth in perpetuity Of endless duration; not subject to termination. The phrase in perpetuity is often used in the grant of an Easement to a utility company. in perpetuity adj. forever, as in one's right to keep the profits from the land in perpetuity. of 3 percent. These cash flows are also used to value intangible and tangible assets Tangible Asset An asset that has a physical form such as machinery, buildings and land. Notes: This is the opposite of an intangible asset such as a patent or trademark. Whether an asset is tangible or intangible isn't inherently good or bad. which determine the implied value of reporting unit goodwill. The discount rate applied to these cash flows represents a telecommunications weighted average cost of capital Weighted average cost of capital (WACC) Expected return on a portfolio of all a firm's securities. Used as a hurdle rate for capital investment. Often the weighted average of the cost of equity and the cost of debt The weights are determined by the relative proportions of equity based upon current debt and equity activity of 11 public companies representing a cross-section of worldwide competitors of the reporting unit. Coming used a discount rate of 12 percent in its calculation of fair value of the expected future cash flows and recorded an impairment charge of $400 million. Had Coming used a discount rate of 11.5 percent, the fair value of the reporting unit would have exceeded its carrying value Carrying Value Also know as "book value," it is a company's total assets minus intangible assets and liabilities, such as debt. Notes: This is different than market value, as it can be higher or lower depending on the circumstances. and there would not have been an impairment. Had Coming used a discount rate of 12.5 percent, the pre-tax impairment charge would have been approximately $225 million higher. Dr. Mark P. Holtzman is Assistant Professor of Accounting at Seton Hall University Seton Hall University is a private Roman Catholic university located 14 miles from Manhattan in historic South Orange, New Jersey. Founded in 1856 by Archbishop James Roosevelt Bayley, Seton Hall is the oldest diocesan university in the United States. (holtzmma@shu.edu). Dr. Elizabeth K. Venuti is Assistant Professor of Accounting at the Frank G. Zarb School of Business, Hofstra University Hofstra University (hŏf`strə, hôf`–), at Hempstead, N.Y.; coeducational. Founded as a division of New York Univ. in 1935, it became independent in 1940, and its name was changed to Hofstra College. (Elizabeth, Venuti@Hofstra.edu). The full report, "A Review of 2002 MD&A Disclosures," can be purchased from FERF FERF Financial Executives Research Foundation FERF Far End Reporting Failure FERF Far End Receive Failure at www.fei.org/rfbook store/ or telephone 973.765.1012. |
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