SEC Issues Financial Disclosure Cautionary Advice

On December 12, 2001, the Securities and Exchange Commission issued a statement regarding the disclosure by public companies of their critical accounting policies and the effects these policies may have on the operating results of a company. Prompted by recent, highly publicized instances of large market losses, this statement makes clear that the SEC expects companies to provide enhanced disclosure in Management's Discussion and Analysis regarding the methods, assumptions and judgments underlying the preparation of GAAP financial statements and the likelihood that different GAAP results would be reported if these assumptions changed or proved incorrect. The Commission states that it will consider promulgating new rules on the topic in the near future, but the release encourages companies to implement these concepts immediately.

 In the statement, the SEC says that "…even a technically accurate application of generally accepted accounting principles may nonetheless fail to communicate important information if it is not accompanied by appropriate and clear analytic disclosures to facilitate an investor's understanding of the company's financial status, and the possibility, likelihood and implication of changes in the financial and operating status." The SEC goes on to state "…we believe it is appropriate to alert companies to the need for greater investor awareness of the sensitivity of financial statements to the methods, assumptions and estimates underlying their presentation. We encourage public companies to include in their MD&A this year full explanations, in plain English, of their 'critical accounting policies,' the judgments and uncertainties affecting the application of these policies and the likelihood that materially different amounts would be reported under different conditions or using different assumptions." 

The SEC identifies four steps that companies can undertake to implement the disclosure regimen advocated by the SEC.

1. The company's management and independent auditor should work together to obtain an understanding of management's judgments in selecting and applying key accounting policies and methods. 

2. Management should ensure that disclosure in MD&A explains the effects of critical accounting policies, the judgments made in applying those policies and the likelihood that reported results might change if different assumptions or conditions prevailed. 

3. Prior to finalizing and filing annual reports, the audit committee should discuss with the company's senior management and independent auditors the selection and application of critical accounting policies. 

4. Participants in the reporting process should contact the SEC staff with any questions about application of these concepts or any aspect of GAAP. 

If implemented fully, these steps will produce significant substantive changes to most companies' financial statements and MD&A disclosures and significant changes in the procedures companies follow to prepare those sections of their filings. We believe that notes to financial statements and MD&A disclosures will need to provide greater detail regarding the underlying assumptions and judgments in those areas identified as "critical accounting policies." In addition, with respect to critical accounting policies that involve significant amounts of management judgment and estimation- such as reserves, valuation allowances or fair valued assets or liabilities - companies will need to quantify the effects that changes in the underlying assumptions would have. 

It is also important to note that the SEC expects substantive participation by the audit committee in this process. This release follows other recent pronouncements by the SEC and by various stock exchanges which require more active participation by audit committees and which stress that, in addition to compliance with GAAP, company disclosures must now address the more subjective aspects of financial reporting. Taken as a whole, these pronouncements require audit committees to develop a deeper understanding of the processes underlying the company's financial reporting, to inquire into aspects of the financial statements that involve significant amounts of judgment and estimation, and to take steps to ensure that the judgments and assumptions utilized by management in formulating the financial statements are both reasonable and fully disclosed. We recommend that, at a minimum, the audit committee meet with management and the independent auditors preferably before annual financial results are announced, to review both the financial statements and a nearly final draft of MD&A and to discuss in depth the critical accounting policies and the judgments and assumptions underlying the company's reported results. 

Our corporate securities practitioners are well-versed in these topics and would be glad to consult with you about compliance with the new SEC release, or about any other disclosure issues. In addition, for over 25 years, our securities litigators have represented companies, Big Five accounting firms, and other defendants in some of the largest and most highly publicized accounting-related cases and SEC proceedings ever filed. As a result of this experience and our close relationships with the Big Five firms, we bring insight into best practices being employed by both issuers and accountants. 

You can find a copy of the release at http://www.sec.gov/rules/other/33-8040.htm