MD&A Disclosure about Critical Accounting Estimates vs Critical Accounting Policies: More than a Name Change

In November 2020, the U.S. Securities and Exchange Commission (SEC) issued a Rule (Securities Act Release No 10890) on Management’s Discussion and Analysis (MD&A) – (the 2020 Rule). The 2020 Rule codified the disclosure requirements regarding critical accounting estimates. The rule requires a separate category of disclosure titled “Critical Accounting Estimates” within MD&A when presented in any filing for annual periods. The guidance below is intended to help ensure compliance and reduce the risk of the SEC staff issuing a comment on your disclosure.

The 2020 Rule is the SEC’s latest attempt to improve the usefulness of information provided in the financial statements and MD&A. While the SEC has issued proposals and interpretive guidance for almost a quarter of a century, the previous guidance did not achieve the desired objective. The 2020 Rule has been in effect for over three years. While there has been improvement in disclosures by some companies, based on the volume of SEC comments, many companies have not made the necessary changes in their presentation.

A look back at History

In December 2001, in response to issues surrounding the Enron scandal, the SEC issued interpretive guidance in Financial Reporting Release 60—Cautionary Advice Regarding Disclosures About Critical Accounting Policies. The objective of this guidance was to assist a reader’s understanding of the policies the company selected—not just a factual recital but to explain how the policies affect the understanding of the financial statements.

In May 2002, the SEC proposed a rule requiring disclosure in a separate section of MD&A about accounting estimates a company makes when applying its accounting policies. Disclosure about those estimates would then be necessary if different estimates that the company reasonably could have used in the current period or changes in the accounting estimate that are reasonably likely to occur from period to period would have a material impact on the financial statements. This proposed rule was much more prescriptive than the 2020 Rule.

A year later, the SEC again issued interpretive guidance on MD&A disclosures in Financial Reporting Release 72 (FRR 72), including a Critical Accounting Estimates section. This guidance indicated companies should provide disclosures about critical 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 of the susceptibility of such matters to changes; and
• The impact of the estimates and assumptions on financial condition or operating performance is material.

The objective of the disclosure was to provide greater insight into the quality and variability of information regarding financial condition and operating performance. MD&A should present a company’s analysis of the uncertainties involved in applying a principle to a given item or the variability that is reasonably likely to result from its application over time.

The 2020 Rule

The 2020 Rule requires disclosure about critical accounting estimates, which are defined as 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 registrant’s financial condition or results of operations.

The 2020 Rule is intended to follow the guidance and objectives articulated in FRR 72. For companies following the guidance in FRR 72, the codification into Regulation S-K had minimal impact on the information disclosed. However, for many companies that were not following FRR 72 and were repeating information about their accounting policies, there was a significant change in the disclosure that was provided.

Disclosure Requirements

The 2020 Rule requires the following be provided in a separate section in MD&A for the identified critical accounting estimates:

• Qualitative and quantitative information necessary to understand the estimation uncertainty and the impact the estimate has had or is reasonably likely to have on financial condition or results of operations.*
• An explanation as to:
  • why each critical accounting estimate is subject to uncertainty;
  • how much each estimate and/or assumption has changed over a relevant period*; and
  • the sensitivity of the reported amounts to the methods, assumptions and estimates underlying its calculation.*

*The disclosure requirements only apply to the extent the information is material and reasonably available.

The disclosure should provide management insights into estimation uncertainties that have had or are reasonably likely to have a material impact on reported financial statements.

Accounting Estimates vs Accounting Policies

The SEC emphasized that this disclosure should NOT repeat the disclosure about accounting policies in the notes to the financial statements. Based on comment letters the SEC staff has issued and observations at various conferences, many companies are not complying with the 2020 Rule, continuing to repeat disclosure about accounting policies, and not providing insightful information about estimates.

An accounting policy may be critically important and require significant judgment in its application, but it would not be a critical accounting estimate discussed in MD&A. To illustrate, a company describes its accounting policy on consolidation in the notes to the financial statements. Further assume there is significant judgment in applying that policy, but no estimation is involved. If there is no estimation involved, the company would not disclose consolidation as a critical accounting estimate in MD&A. On the other hand, a warranty reserve is based on estimates. The company would disclose its accounting policy on warranties in the financial statements. It would also provide the applicable information about estimates relating to warranties required by the 2020 Rule in the Critical Accounting Estimate section of MD&A. This information should not repeat the information in the accounting policy note in the financial statements; rather, it should supplement the information by providing insight into the estimation uncertainty and its historical impact and reasonably likely future impact on the financial statements.

SEC Comment Letters

The SEC staff has noted that the disclosures about critical accounting estimates often are too general and should provide a more robust analysis and have focused on the following areas:

• Explain why the disclosed critical accounting estimate is subject to uncertainty. One of the more frequent comments the SEC staff will ask is to explain why the selected items are critical accounting estimates. This comment is issued when the disclosure repeats the accounting policy note in the financial statements. This question focuses on the objective of the disclosure – information about estimates in the financial statements that can change. An accounting policy can be critically important, but if there is not an element of estimation that could change, it is not a critical accounting estimate.
• Provide additional information about the judgments used to determine the estimated amount. For example, a company that identified impairment of goodwill as a critical accounting estimate was requested to provide information about how the company determined the fair value of the reporting unit. Another example was a company that identified credit loss as a critical accounting estimate and was requested to provide quantified information about the inputs in the analysis.
• Provide both qualitative and quantitative information about changes in the estimate and the assumptions. Companies should disclose how much estimates have changed and the changes in the underlying assumptions that are used to determine the estimate. Companies should consider disclosing the various attributes used to determine an estimate. One of the objectives of disclosing qualitative and quantitative information about changes in estimates and assumptions in the past is to provide a reader with information to evaluate how these estimates and assumptions can change in the future. The disclosure should explain how much the assumptions changed and why they changed. The “why” is essential to allow a reader to understand those factors that could impact the estimate in the future.
• Expand the disclosure to provide information about sensitivity. For example, a company that discloses that impairment of goodwill is a critical accounting estimate should consider disclosing the percentage by which fair value exceeded the carrying value of the reporting unit. Additionally, in determining the estimate of the reporting unit’s fair value, the company should consider providing information about changes in assumed growth rates, how discount rates are determined, and how changes in these assumptions could impact the determination of fair value.

  Recommendations

  Perform these three steps before preparing the Critical Accounting Estimates section of the MD&A this year.

  1. Read the MD&A in last year’s annual report.
  2. Read the section about Critical Accounting Estimates in the 2020 Rule.
  3. Evaluate your compliance with the rules and objectives of this release.

  In evaluating compliance, consider the following:

  • Carefully determine those estimates that should be disclosed. The disclosure needs to explain why the item is a critical accounting estimate.
  • Ensure that the disclosure requirements articulated above are provided for each critical accounting estimate as appropriate. The more significant the estimate and the greater a potential change that could have a material impact on the financial statements, the more robust the disclosure should be.
  • Make sure the disclosure includes quantitative information—including dollar amounts—as appropriate. It should not be limited to a qualitative discussion.
  • Last and most obvious, use the proper title for the section – Critical Accounting Estimates.

  Make the necessary modifications to the disclosure to ensure compliance with the 2020 Rule.

  Have questions about critical accounting estimates and the 2020 Rule? Contact Marcum for advice and guidance today.