[Federal Register Volume 66, Number 242 (Monday, December 17, 2001)]
[Notices]
[Pages 65013-65014]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-30978]


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SECURITIES AND EXCHANGE COMMISSION

[Release Nos. 33-8040; 34-45149; FR-60]


Accounting Policies; Cautionary Advice Regarding Disclosure

AGENCY: Securities and Exchange Commission.

ACTION: Cautionary advice regarding disclosure about critical 
accounting policies.

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SUMMARY: The Securities and Exchange Commission is issuing a statement 
regarding the selection and disclosure by public companies of critical 
accounting policies and practices.

FOR FURTHER INFORMATION CONTACT: Robert A. Bayless, Special Assistant 
to the Chief Accountant, 202-942-4400.

SUPPLEMENTARY INFORMATION: As public companies undertake to prepare and 
file required annual reports with us, we wish to remind management, 
auditors, audit committees, and their advisors that the selection and 
application of the company's accounting policies must be appropriately 
reasoned. They should be aware also that investors increasingly demand 
full transparency of accounting policies and their effects.
    Reported financial position and results often imply a degree of 
precision, continuity and certainty that can be belied by rapid changes 
in the financial and operating environment that produced those 
measures. As a result, even a technically accurate application of 
generally accepted accounting principles (``GAAP'') 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.
    Of course, public companies should be mindful of existing 
disclosure requirements in GAAP and our rules. Accounting standards 
require information in financial statements about the accounting 
principles and methods used and the risks and uncertainties inherent in 
significant estimates.\1\ Our rules governing Management's Discussion 
and Analysis (``MD&A'') currently require disclosure about trends, 
events or uncertainties known to management that would have a material 
impact on reported financial information.\2\
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    \1\ See, e.g., Accounting Principles Board Opinion No. 22, 
``Disclosure of Accounting Policies'' (Apr. 1972); AICPA Statement 
of Position No. 94-6, ``Disclosure of Certain Significant Risks and 
Uncertainties'' (Dec. 1994).
    \2\ The underlying purpose of MD&A is to provide investors with 
``information that the registrant believes to be necessary to an 
understanding of its financial condition, changes in financial 
condition and results of operations.'' Item 303(a) of Regulation S-K 
[17 CFR 229.303(a)]. As we have previously stated, `` `[i]t is the 
responsibility of management [in MD&A] to identify and address those 
key variables and other qualitative and quantitative factors which 
are peculiar to and necessary for an understanding and evaluation of 
the company.' '' Securities Act Rel. No. 6835 (May 18, 1989) [54 FR 
22427] (quoting Securities Act Rel. No. 6349 (Sept. 28, 1981) [not 
published in the Federal Register]).
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    We have observed that disclosure responsive to these requirements 
could be enhanced. For example, environmental and operational trends, 
events and uncertainties typically are identified in MD&A, but the 
implications of those uncertainties for the methods, assumptions and 
estimates used for recurring and pervasive accounting measurements are 
not always addressed. Communication between investors and public 
companies could be improved if management explained in MD&A the 
interplay of specific uncertainties with accounting measurements in the 
financial statements. We intend to consider new rules during the coming 
year to elicit more precise disclosures about the accounting policies 
that management believes are most ``critical''--that is, they are both 
most important to the portrayal of the company's financial condition 
and results, and they require management's most difficult, subjective 
or complex judgments, often as a result of the need to make estimates 
about the effect of matters that are inherently uncertain.
    Even before new rules are considered, however, 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 preparation. 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 those 
policies, and the likelihood that materially different amounts would be 
reported under different conditions or using different assumptions. The 
objective of this disclosure is consistent with the objective of MD&A.
    Investors may lose confidence in a company's management and 
financial statements if sudden changes in its financial condition and 
results occur, but were not preceded by disclosures about the 
susceptibility of reported amounts to change, including rapid change. 
To minimize such a loss of confidence, we are alerting public companies 
to the importance of employing a disclosure regimen along the following 
lines:

1. Each Company's Management and Auditor Should Bring Particular 
Focus to the Evaluation of the Critical Accounting Policies Used in 
the Financial Statements

    As part of the normal audit process, auditors must obtain an 
understanding of management's judgments in selecting and applying 
accounting principles and methods. Special attention to the most 
critical accounting policies will enhance the effectiveness of this 
process. Management should be able to defend the quality and 
reasonableness of the most critical policies, and auditors should 
satisfy themselves thoroughly regarding their selection, application 
and disclosure.

2. Management Should Ensure That Disclosure in MD&A Is Balanced and 
Fully Responsive

    To enhance investor understanding of the financial statements, 
companies are encouraged to explain in MD&A the effects of the critical 
accounting policies applied, the judgments made in their application, 
and the likelihood of materially different reported results if 
different assumptions or conditions were to prevail.

3. Prior To Finalizing and Filing Annual Reports, Audit Committees 
Should Review the Selection, Application and Disclosure of Critical 
Accounting Policies

    Consistent with auditing standards, audit committees should be 
apprised of the evaluative criteria used by management in their 
selection of the accounting principles and methods.\3\

[[Page 65014]]

Proactive discussions between the audit committee and the company's 
senior management and auditor about critical accounting policies are 
appropriate.
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    \3\ See Codification of Statements on Auditing Standards, AU 
Sec. 380, Communication with Audit Committees or Others with 
Equivalent Authority and Responsibility (``SAS 61''). SAS 61 
requires independent auditors to communicate certain matters related 
to the conduct of an audit to those who have responsibility for 
oversight of the financial reporting process, specifically the audit 
committee. Among the matters to be communicated to the audit 
committee are: (1) Methods used to account for significant unusual 
transactions; (2) the effect of significant accounting policies in 
controversial or emerging areas for which there is a lack of 
authoritative guidance or consensus; (3) the process used by 
management in formulating particularly sensitive accounting 
estimates and the basis for the auditor's conclusions regarding the 
reasonableness of those estimates; and (4) disagreements with 
management over the application of accounting principles, the basis 
for management's accounting estimates, and the disclosures in the 
financial statements. Id.
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4. If Companies, Management, Audit Committees or Auditors Are 
Uncertain About the Application of Specific GAAP Principles, They 
Should Consult With our Accounting Staff

    We encourage all those whose responsibility it is to report fairly 
and accurately on a company's financial condition and results to seek 
out our staff's assistance. We are committed to providing that 
assistance in a timely fashion; our goal is to address problems before 
they happen.

    Dated: December 12, 2001.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-30978 Filed 12-14-01; 8:45 am]
BILLING CODE 8010-01-P