Critical Accounting Policies
Accounting Policies, Estimates and Measurement Uncertainties
Accounting Policies
The accounting policies selected by the corporation should be proposed by management, agreed to by the external auditor, and approved by the audit committee.
In order to approve them, audit committees first need to establish the corporation's philosophy with respect to compliance with generally accepted accounting principles. Some suggest that minimal compliance with GAAP is all that is necessary. We do not advocate this approach. The preferred view is that the accounting policies adopted by the corporation should be the most appropriate in the circumstances.
The CICA Handbook provides this discussion regarding changes in accounting policies:
Accounting policies encompass the specific principles and the methods used in their application that are selected by an enterprise in preparing financial statements. There is a general presumption that the accounting policies followed by an enterprise are consistent within each accounting period and from one period to the next. A change in an accounting policy may be made, however, to conform to new Handbook Recommendations, Accounting Guidelines, Abstracts of Issues Discussed by the CICA Emerging Issues Committee or legislative requirements or if it is considered that the change would result in a more appropriate presentation of events or transactions in the financial statements of the enterprise.
Audit committees should only countenance changes in accounting policy if those changes result in a more appropriate presentation or if the changes are necessary as a result of the implementation of new accounting standards.
In assessing the overall reasonableness of accounting policies, audit committees should understand whether the policies are too conservative, too aggressive or appropriate. Each audit committee should set out its expectations in this regard in its charter.
The evaluation of these policies involves a high degree of judgment. Management and the external auditor should provide the audit committee with information to enable it to assess whether the policies used in the preparation of the financial statements are consistent with those used by companies in the industry or similar businesses, or whether they are more conservative or more aggressive. The audit committee should ascertain the degree of conservatism in the accounting policies, both individually and in the aggregate, and should review the impact on the financial statements.
A change in accounting policy would be made only when it is required by a primary source of GAAP or results in a reliable and more relevant presentation in the financial statements. Unless the primary source of GAAP contains specific transitional provisions, a change in accounting policy would be applied retroactively.
The AcSB expects to issue its proposals by the second quarter of 2004 with an effective date for fiscal years beginning on or after January 1, 2005.
Management's Estimates
Management is responsible for making the estimates required in the preparation of the financial statements. It is the audit committee's role to understand and evaluate the most significant accounting estimates. To do so, the audit committee must understand the methodology used in making the estimates, the major assumptions used, the sensitivity of the outcome (e.g., how would the accounting estimate change if changes were made in the assumptions), and the overall reasonableness of the result.
By their very nature, all accounting estimates involve some degree of measurement uncertainty. GAAP requires that the nature of a measurement uncertainty that is material should be disclosed when it is reasonably possible that the recognized amount could change by a material amount in the near term, except when disclosing the amount would have a significant adverse effect on the entity. When this amount is not disclosed, the financial statements should indicate the reasons for non-disclosure. It is important for audit committees to understand the above principle when assessing the presentation of accounting estimates and measurement uncertainties in the financial statements.
Audit committees should understand that securities regulators have been particularly concerned about companies that have "smoothed earnings" through the use of accounting estimates. The popular phrase "cookie-jar reserves" is used to describe situations where management has established reserves in good times and drawn down those reserves in bad times. This practice does not produce an accurate or reliable presentation of the corporation's actual earnings, but rather artificially smoothes earnings to present a picture of stable growth, when the reality is something different.
Audit committees should insist that management prepare a report for each quarterly audit committee meeting describing all significant estimates/reserves indicating any changes made since the last report and the reasons for those changes. Audit committees should also require the external auditor to provide his or her opinion on the reasonableness of the estimates/reserves, including any changes to them.
Finally, audit committees should step back and assess the overall impact of the estimates and judgments, and determine whether they, individually and in the aggregate, fairly present the economic reality of the corporation and its performance in the accounting period.
In May 2002, the SEC proposed disclosure requirements that would enhance investors' understanding of the impact of accounting estimates a company makes in preparing the financial statements.
- Under the first part of the proposal, a company would have to identify the accounting estimates reflected in its financial statements that required it to make assumptions about matters that were highly uncertain at the time of estimation. Disclosures about these estimates would include:
- the methodology and assumptions underlying them;
- the effect the estimates have on the financial presentation; and
- the effect of changes in the estimates.
- Under the second part of the proposal, a company that has initially adopted an accounting policy with a material impact would have to disclose information that includes:
- what gave rise to the initial adoption;
- the impact of the adoption;
- the accounting principle adopted and method of applying it;
- and the choices it had among accounting principles.
The final rule has not been released.