Following the Enron scandal, the accounting professionals underwent radical transformations. A variety of legislation was either proposed or made public. On the 10th of May 2002, the Securities and Exchange Commission (which is SEC) released a proposal document that reads “Disclosure in Management’s Discussion and Analysis about the Application of Critical Accounting Policies”. The following year, SEC released final rule No.72, “Interpretation: Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations”. The first one provides guidelines for accounting critical policies; the second discusses how to interpret critical accounting practices in the section of Management’s Discussion and Analysis (MD&A). But, until the present, many people are confused about the distinctions between these accounting practices and policies: critical accounting or estimates, and significant accounting policies. This article provides a way to clearly and accurately disclose the two.
To make it easier I will review the definitions of the two principles first. Then, I’ll describe the purpose of these two policies, and the reasons we should use them. Last and not least I will make use of an example of a 10-K form provided by Apple Inc. to make an example of the way we present their contents and how we format them.
In the codification of accounting standards, Financial Accounting Standards Board (which is FASB) includes a definition of significant accounting principles that reads “Accounting principles and methods are judged by the appropriate circumstances to present fairly financial position, according to GAAP make a financial statement.” (Codification 235-25-03-5) This is general in the presentation of financial statements.
In contrast to the most important accounting practices critical accounting practices or estimates can be defined in the SEC and include “Critical accounting built on an assumption about uncertain matters, including period and affect Company’s financial condition” (SEC 2002).
It is obvious it is based on the definition of the latter Critical Accounting Policies and estimates only describe uncertainties of changes to come that could have significant effects.
The Differences of Disclosure Intent
The information provided by accounting policies is crucial and vital for accounting users. The accounting policies that are significant or estimates that form an essential to the entity’s financial statements reveal an accurate financial situation, etc. (Codification, 235-10-50-1). In addition, they form an important part of the financial statements too. They determine what accounting practices are currently being followed by the company. FASB adds that “the significant accounting policies can affect entity’s financial position, and can be used for making economic decisions” (Codification 235-210-05-4).
In light of the Enron scandal Securities and Exchange Commission plans to provide more details about the company to investors. The quality of disclosures made by companies must be enhanced. I believe that the purpose of crucial accounting guidelines is to reveal the accounting practices that require in management judgments and estimates, amidst the potential for uncertainty. Critical accounting policies are crucial parts of the management’s discussions and analysis. The SEC’s FR-60 interpretation is as follows:
Financial statements can indicate specificities, continuity, and certainty that are susceptible to rapid changes in both the financial state and operating conditions. Therefore, even the most widely accepted accounting standards (“GAAP”) could in some way fail to provide crucial information if they are not properly accompanied or clearly analytical information is provided to help investors’ understanding of the business’s financial position, and any possible changes in the operating situation (SEC 2001).
Based on the above information it is important to be aware that not only are the definitions distinct, but the intentions behind the use of the two accounting practices are significantly different from one the other. The objective of FASB’s accounting practices cannot be fulfilled with SEC’s accounting guidelines and the reverse is true.
The important accounting guidelines formulated by FASB to apply accounting principles and techniques have an extensive range of general descriptions. Contrary to that critical accounting policies and estimates made by SEC provide only a small portion of the highly insecure and important accounting policies.
FASB requires that the disclosure of important accounting policies should include the accounting principles as well as the methods that have a significant impact on the financial condition and lead to various operations or cash flow. They also include judgments, regardless of the, they are in accordance with the principle of the asset and revenue cost in the present or the next period (Codification 235-210-50-3).
In this article, I’ve used the Apple Annual Report as an illustration. In the Form 10-K/A for Apple Inc. (filed on January 25 in 2010) includes preparation and presentation of fair value measurement inventory, financial instruments machinery and property and assets, asset retirement obligations goodwill foreign currency translation and the remeasurement of revenue shipping costs allowance for doubtful accounts cost for warranty, the development of software costs tax, income taxes, compensation based on stock, advertising expenses earnings per common share complete income, segment data. For instance, Apple disclosed inventories item at (LCM) less than cost or market value measured using the FIFO (first-in-first-out) method. In the item of recognition, the Company is able to recognize revenue only when delivery has occurred or there is evidence that an agreement is in place. Additionally, in the revenue recognition items, for multi-element arrangements that may comprise tangible items that include software crucial to the tangible item’s functionality, and undeliverable software elements that connect to the tangible product’s core software, the Company assigns the revenue to all deliverables in accordance with their selling prices (Form 10K/A 2009).
Prior to the application of the critical accounting estimates, there are certain requirements the critical accounting estimates must be able to meet at the estimations of accounting and the uncertainty assumption. an additional requirement is that there must be a variety of estimates utilized during the current time and any changes to the estimate must affect the financial situation in a significant way. Three elements are essential to the estimation of accounting that is: the first is to be able to comprehend the estimates in the accounting process and the second one is to provide a better understanding of the financial situation for ordinary investors. The third is to make public the management’s discussed developments (SEC 2002). Additionally, the accounting policies and estimates must be presented as supplements to financial statements’ notes, however, they should not duplicate any other related information already provided. The critical accounting policy disclosure should be able to provide relevant information thoroughly (SEC 2003).).
According to the intent of the sec that accountants take full accountability for the risks of estimates and adjustments. Furthermore, accountants must be able to explain how they arrived at the numbers and figures. If last year, a bank had a large number of new loans, then the report could look nice. If however, many of those loanees later did not pay the loan, the report for this year could be very disappointing. Therefore, for the following year, the bank’s management is expected to calculate the number of borrowers who would be unable to pay, possibly some percentage, and then put it into the note of MD&A.
In the most recent Form 10-K/A issued by Apple Inc., the critical accounting policies and estimates pertaining to the valuation of inventory and purchases, commitments to purchase taxes on income appraisal of the marketable securities, warranty expenses allowance for unreliable accounts as well as the other legal contingencies. In the section for valuation of inventory, Apple Inc. emphasizes the accounting estimates that are critical as follows: following: 1/4 1/4
The Company has to purchase components to make its products, and also build inventory prior to shipment. The Company keeps a record of the inventories of products and components which include third-party products that are kept to be resold, that have been deemed obsolete or over the anticipated demand, or have a net achievable value.
The Company tracks accruals for estimated cancellation charges for components orders which have been canceled or are scheduled to become canceled. As is the norm in the industry the Company buys its components by an assortment from supplier agreements, purchase orders, and open orders, based on forecasted demand information. These commitments usually will cover the requirements of the Company for periods of between thirty to one hundred days. (Form 10K/A, 2009i 1/4 %0
The inventory item listed in the accounting policies that are significant is simple and straightforward similar to market or lower cost. But, in this case, the business calculates its future inventory through forecasting, and then in the event that consumers demand markets or consumers change, which isn’t predicted the business will write down the inventory records when is required.
In addition, in the revenue recognition section, we analyze the possibility of reducing revenue 1/4 s
Management made estimations based on past data. If a higher percentage of customers take advantage of the incentive not as anticipated that the company would have to record a credit to revenues, which could result in a reduction in revenue.I 1/4 Form 10K/A 2009i 1/4 %0
While the revenue reduction is calculated based on records from the past, the market conditions could change by way of example, such as the price protection obligations that increase are incurred. This additional revenue reduction will result in. In addition, the company provided an estimate of the not specified software upgrade revenues in the event that the ESP for the upgrade rights that are associated with iPhone was fluctuating between lower or higher and the net sales in 2009 could have decreased or increased by up to $50 million in comparison to the same period last year (Form 10K/A 2009).
In addition, compared to just one sentence in accounting regulations the allowance for uncertain accounts section of crucial accounting estimates provides the most detailed information. In addition to past experience, it also takes into account the economic future and the financial situation. If there is a decline in financial health and the company is required to modify the allowance accounts. This means the adjustments have to be implemented.
The accounting formats of the two policies are significantly different since one is governed developed by FASB while the other is drafted by SEC.
The important accounting policies are listed in the notes to the financial statement in item 8 of the Form 10-K. According to FASB codification, the format of disclosure for the significant accounting policy can be found “in a summary of significant accounting policies at the very beginning of the notes of the financial statements” (Codification 235-210-50-6). Typically it is mandatory to include a boilerplate that is included in the disclosure required for significant accounting policies.
In contrast to boilerplate-formatted important accounting policies, crucial accounting policies and estimates are usually laid out in plain English. The format of disclosure should be simple so that investors can easily comprehend it (SEC 2002). In a different place for disclosure and the most important accounting rules and estimates are made public in MD&A.
After reviewing both accounting policies, I discover that the most significant accounting policies, as well as the crucial estimate and policies in accounting, are produced by different individuals who have different purposes for disclosure. Additionally, as the additional policies of accounting that are significantly important accounting guidelines and forecasts usually provide adjustments that are needed in the event that the economic outlook and market or customer changes. After the Enron period, the SEC took a clear position, in the event of further accounting scandals by providing additional information on how the uncertainty, assumptions estimates, approximation, and uncertainties could influence the financial statements of the company in accounting policies that are critical to the company.