SEC Reacts to Enron: New Disclosure of Critical Accounting Policies and Transactions

By James M. Boak, CPA

Harvey L. Pitt, Chairman of the Securities and Exchange Commission, recently wrote an article entitled "How to Prevent Future Enrons" in which he suggested that inadequate and non-timely financial disclosures have created the potential of a financial "perfect storm." In apparent reaction to the Enron "perfect storm", the Securities and Exchange Commission has recently published two Financial Reporting Releases ("FRR"), No.60, Cautionary Advice Regarding Disclosure About Critical Accounting Policies and No.61, Commission Statement about Management's Discussion and Analysis of Financial Condition and Results of Operations.

FRR 60, released in December 2001, suggests that public companies employ a "disclosure regimen" along the following lines: (1) management and auditors must increase their focus on the critical accounting policies used by the company to do its accounting; (2) the company must increase disclosure of critical accounting policies in the Management's Discussion and Analysis of the company's operations; (3) the company's audit committee must review the application and disclosure of critical accounting policies; and (4) management and auditors should consult openly with the Commission if uncertain about the application of critical accounting policies.

What are critical accounting policies? Robert K. Herdman, Chief Accountant of the SEC, has defined a critical accounting policy as "one that is both very important to the portrayal of the company's financial condition and results, and requires management's most difficult, subjective or complex judgments." Typically, a critical accounting policy involves a new, emerging and complex accounting standard (often based on a new business practice) that is particularly sensitive to estimates and interpretation, and which can have very material impact on the financial position and results in the company's financial statements.

The Commission's primary thrust of FRR 60 is disclosure to the public in MD&A (Management, Discussion and Analysis) of the four or five critical accounting policies that have the greatest current or future impact on the company's financial statements. The disclosure should be proactive and include sufficient detail so an investor can understand how management ".forms its judgments about [current and] future events, including the variables and assumptions underlying estimates, and the sensitivity of those judgments to different circumstances." As the complexity and subjectivity of judgments increase, so must the level of disclosure.

Before the financial statements are filed, the company should review its analysis and proposed disclosures with the audit committee. The company should make sure the audit committee members understand the policies and how they have been applied. Whenever the auditors, management or the audit committee are uncertain about the application or adequacy of disclosure about critical accounting policies, the Commission wants the parties to consult with the Commission in advance of financial statement filings to prevent the misapplications of accounting standards. This is part of the recent focus by the Commission to prevent accounting errors in advance, rather than relying on punitive enforcement actions after the errors have been committed.

In January 2002, the Commission issued FRR 61 in which it continued its efforts to improve disclosure of critical accounting policies by discussing three areas in which the quality of disclosure should be improved.

This first area concerns liquidity and capital resources, including "off-balance sheet" arrangements. In discussing liquidity and capital resources, companies should avoid general and relatively uninformative disclosures that the company is liquid and has sufficient resources to continue its operations for the next year. Instead, the company should elaborate on the sources of liquidity and capital resources as well as the inherent risks of maintaining that liquidity or the availability of the capital resources. The disclosure should also discuss known trends, events and uncertainties (favorable or unfavorable) that can affect liquidity or capital resources on a "reasonably likely to occur" basis. FRR 61 discusses, in some detail, disclosures needed to adequately describe off-balance sheet transactions and commitments, with so-called structured finance or special purpose entities; and the effect on liquidity and resources of relationships with those entities. FRR 61 also provides examples of how this information can be presented in part by use of data tables.

The second area concerns disclosures about the fair value of trading activities involving derivatives, commodities, and other similarly complex transactions, especially where there is a lack of public information about prices and contractual details.

The third area concerns disclosures about the effects of related party transactions. By their nature, transactions with related parties create uncertainty as to the terms of the arrangements. When those transactions are material, the Commission re-emphasizes that both GAAP and SEC regulations require disclosure in sufficient detail. This is so that the investor can understand the business purpose and economic substance, the effects on the financial statements, and any special risks or contingencies that can arise from the related party transactions.

As companies prepare their annual reports and write their related MD&A, they must consider and incorporate the additional disclosures described in these two significant financial releases.