SEC Amends MD&A to Require Certain Disclosures for Critical Accounting Estimates; Other changes include eliminating 5-yr selected financial data, more

(Nov. 19, 2020) Earlier today, the U.S. Securities and Exchange Commission (SEC) published a final rule containing wide-ranging amendments to the requirements under Regulation S-K for Management's Discussion and Analysis (MD&A). Among the significant changes: issuers will be required to include certain quantitative and qualitative disclosures relating to Critical Accounting Estimates as part of MD&A. This new requirement is effected through new Item 303 (b) (3), Critical accounting estimates, in Reg S-K.

New Item 303 (b) (3): Critical Accounting Estimates

How different are the new MD&A requirements for critical accounting estimates vs. previous SEC guidance issued in 2003? The SEC states in the final rule published today (full title: Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information (Rel. No. 33-10890) ) that the new rule on Critical Accounting Estimates "largely clarifies and codifies Commission guidance in this area" [emphasis added].

?My two cents: the definition of "largely" can vary, depending on one's perspective, and I would suggest that issuers (i.e., preparers of public company financial reporting) review the final rule in detail to determine what new disclosures (or changes to existing disclosures) their company may have to provide under the new rule. Similarly, auditors, audit committee members, and investors more generally will find the new rule of interest in connection with their role in the financial reporting supply chain.

Of particular note was a lengthy discussion in the final rule regarding the Commission's consideration of comments received on the proposed rule published earlier this year (the predecessor to this final rule) regarding the potential cost and practicability of providing - and the potential usefulness to investors of receiving/reading - the proposed sensitivity disclosures relating to critical accounting estimates.

The following excerpts from the final rule illustrate how the Commission handled those comments on sensitivity disclosures and certain other key areas of the final rule pertaining to critical accounting estimates. [NOTE: excerpts from the SEC rule have been reformatted in the form of bullets, with emphasis added in bold, below] :

• "We are adopting new Item 303(b)(3)272 substantially as proposed for the reasons described in the Proposing Release and above, but with certain modifications in response to commenters’ concerns to make clear that: (i) the application of the material and reasonably available qualifier applies to all parts of the disclosure, not just to quantitative information; (ii) the discussion on how much each estimate has changed may also be met through a discussion of changes in the assumptions during the period; and (iii) the disclosure of changes in the estimate/assumption will cover a “relevant period,” rather than a “reporting period.”[fn 273] "
• "We agree with commenters who raised concerns that, as proposed, the requirements to disclose the sensitivity of reported amounts to the methods, assumptions, and estimates underlying a calculation and how much each estimate has changed during the reporting period for each critical accounting estimate could have been read to require disclosure that is not material, or that was costly or otherwise challenging to prepare. Specifically, these commenters stated that the proposed requirement could suggest that registrants are required to provide quantification for “every” critical accounting estimate, [fn 274] have limited flexibility in presenting such disclosures,[fn 275] or are subject to a different standard than the rest of MD&A. [fn 276]"
• "In order to clarify that this was not our intent, new Item 303(b)(3) more clearly states that the reasonably available and material qualifier applies to all information about a critical accounting estimate that has had or is reasonably likely to have a material impact on financial condition or results of operations, whether qualitative or quantitative, including whether the information relates to sensitivity of the reported amount or how much the estimate has changed." [fn 277]"
• "While some commenters asked the Commission to adopt different thresholds, such as when “practicable” or “in the ordinary course of business and not solely for purposes of disclosure,” we believe that “reasonably available” is the appropriate standard as it is familiar to registrants and consistent with current Commission rules. [fn 278] We believe that, in practice, if the disclosure is “impracticable” to provide, it would not be “reasonably available.” In addition, limiting the discussion to material information is intended to avoid disclosure that is not useful to investors and is consistent with the principles-based nature of MD&A."
• "New Item 303(b)(3) will require registrants to disclose how much an estimate and/or assumption has changed over a relevant period. This is intended to allow an investor to better evaluate the uncertainty associated with the critical accounting estimate by observing changes in estimates or assumptions over time. The revised item also specifically references “assumptions” in addition to estimates because, as suggested by one commenter, this would make clear that registrants have flexibility to provide appropriate context in the discussion of changes underlying a critical accounting estimate. This disclosure requirement, along with the required sensitivity disclosure, is not intended to yield discussions of quantitative changes to reported amounts, which would be disclosed in response to other requirements in Item 303, such as the discussion of results of operations under new Item 303(b)(2). Instead, our intent is for registrants to provide investors with a greater understanding of the variability that is reasonably likely to affect the financial condition or results of operations so investors can adequately evaluate the estimation uncertainty of a critical accounting estimate."

In related news, on November 12, the Public Company Accounting Oversight Board (PCAOB) published a document entitled, "Audit Committee Resource: New PCAOB Requirements Regarding Auditing Estimates and Use of Specialists." Although the PCAOB's publication relates to their own rules on auditing estimates rather than directly relating to the SEC's rules pertaining to issuers' disclosures regarding critical accounting estimates, various participants in the financial reporting supply chain will find this publication of interest as well.

Other MD&A Requirements Removed - or Added - by Final Rule

A summary of all areas of the final rule published by the SEC on November 19 can be found below. This list is excerpted from the table which appears on page 8 of the final rule.

Item 301, Selected financial data:

• "Registrants will no longer be required to provide 5 years of selected financial data."

Item 302(a), Supplementary financial information

• "Registrants will no longer be required to provide 2 years of tabular selected quarterly financial data. The item will be replaced with a principles-based requirement for material retrospective changes."

Item 303(a), MD&A

• "Clarify the objective of MD&A and streamline the fourteen instructions." 

Item 303(a)(2), Capital resources

• "Registrants will need to provide material cash requirements, including commitments for capital expenditures, as of the latest fiscal period, the anticipated source of funds needed to satisfy such cash requirements, and the general purpose of such requirements."

Item 303(a)(3)(ii), Results of operations

• "Registrants will need to disclose known events that are reasonably likely to cause a material change in the relationship between costs and revenues, such as known or reasonably likely future increases in costs of labor or materials or price increases or inventory adjustments."

Item 303(a)(3)(iii), Results of operations

• "Clarify that a discussion of material changes in net sales or revenue is required (rather than only material increases)." 

Item 303(a)(3)(iv), Results of operations Instructions 8 and 9 (Inflation and price changes)

• "The item and instructions will be eliminated. Registrants will still be required to discuss these matters if they are part of a known trend or uncertainty that has had, or the registrant reasonably expects to have, a material favorable or unfavorable impact on net sales, or revenue, or income from continuing operations."

Item 303(a)(4), Off-balance sheet arrangements

• "The item will be replaced by a new instruction to Item 303. Under the new instruction, registrants will be required to discuss commitments or obligations, including contingent obligations, arising from arrangements with unconsolidated entities or persons that have, or are reasonably likely to have, a material current or future effect on such registrant’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, cash requirements, or capital resources even when the arrangement results in no obligation being reported in the registrant’s consolidated balance sheets."

Item 303(a)(5), Contractual obligations

• "Registrants will no longer be required to provide a contractual obligations table. A discussion of material contractual obligations will remain required through an enhanced principles-based liquidity and capital resources requirement focused on material short- and long-term cash requirements from known contractual and other obligations."

Instruction 4 to Item 303(a) (Material changes in line items)

• "Incorporate a portion of the instruction into amended Item 303(b). Clarify in amended Item 303(b) that where there are material changes in a line item, including where material changes within a line item offset one another, disclosure of the underlying reasons for these material changes in quantitative and qualitative terms is required." 

Item 303(b), Interim periods

• "Registrants will be permitted to compare their most recently completed quarter to either the corresponding quarter of the prior year or to the immediately preceding quarter. Registrants subject to Rule 3- 03(b) of Regulation S-X will be afforded the same flexibility."

Item 303(b)(3) Critical Accounting Estimates

• "Registrants will be explicitly required to disclose critical accounting estimates."

Additional changes were made to the MD&A rules to streamline and restructure them; the amended structure of Item 303, MD&A vs. current structure is shown in a table on pg. 26 of the final rule.

Effective date and "compliance date"

The SEC's final rule amending the MD&A requirements in Reg. S-K states that it has an "effective date" of 30 days after publication in the Federal Register. To assist companies in transitioning to the new rules, the final rule also provides a "compliance date" as follows: "registrants will be required to apply the amended rules for their first fiscal year ending on or after [INSERT DATE 210 DAYS AFTER PUBLICATION IN THE FEDERAL REGISTER] (the “mandatory compliance date”)" The final rule also states "Registrants will be required to apply the amended rules in a registration statement and prospectus that on its initial filing date is required to contain financial statements for a period on or after the mandatory compliance date."

A type of early adoption provision (although not described in those terms) is provided, although it includes highly specific requirements as follows: "Although registrants will not be required to apply the amended rules until their mandatory compliance date, they may provide disclosure consistent with the final amendments any time after the effective date, so long as they provide disclosure responsive to an amended item in its entirety." [emphasis added]. An example is provided on pages 104-105 of the final rule.