Have you heard the one about the man who woke up from a coma and asked, âWhat's an auditor?â He got the traditional reply: âSomeone who arrives after the battle and bayonets all the wounded.â If Robert Herdman gets his way, that joke won't be so funny any more. Mr. Herdman is the chief accountant of the Securities and Exchange Commission (SEC), and he has a new solution that will help companies avoid the battles altogether.
The Perils of Too Much Precision
Mr. Herdman wants companies to make their financial reports clearer by revealing more information about critical accounting policies and what might be called âwhat-ifâ numbers. In a recent speech to financial executives, Mr. Herdman cut through the complexities of financial reporting and offered a simple reason why investors lose confidence in the process. In a nutshell, the problem is that accounting uses very precise-looking numbers, and the precision of the numbers belies the level of subjectivity involved in their calculations.
It has gotten to the point, Mr. Herdman said, where some may even think that bottom line numbers, such as net income and earnings per share, represent âconclusive, perhaps even infallible, measures of a company's performance.â Not so, he explained. The irony of accounting is that the precision of the numbers contributes to what many see as the impenetrability of financial reports.
How To Explain Critical Accounting Policies
To help investors penetrate the veil of precision, the SEC issued Financial Reporting Release No. 60, âCautionary Advice Regarding Disclosure About Critical Accounting Policies.â Among other things, FRR 60 asks management to explain the following in their financial reports:
- The effects of the critical accounting policies applied.
- The judgments made in the applications of critical accounting policies.
- The likelihood of materially different reported results, if different assumptions or conditions were to prevail.
As a real life example of how and when such âwhat-ifâ information might be useful, Mr. Herdman described the accounting for product warranty reserves. A company may have voluminous historical statistical information available to support its assumptions about the average reserve needed, and that's important. But what would be even more useful would be to look beyond the averages and probe the factors that have caused the highs and lows for past products. These factors might include the introduction of a new material or a sudden change in temperature. The key to complete reporting is to identify these causal factors and then answer the unspoken question, âWhat if?â these factors were to recur in the future.
While each company has different critical accounting policies, Mr. Herdman said, the key objectives for all companies are to identify the following for investors:
- The types of assumptions that underlie the most significant and subjective estimates.
- The sensitivity of these estimates to deviations of actual results from management's assumptions.
- The circumstances that have resulted in revised assumptions in the past.
The SEC is allowing companies a great deal of flexibility in providing this information, Mr. Herdman explained, and some may choose to disclose ranges of possible outcomes. For companies that choose that route, the solution will mean more numbers, not less numbers. Who was it who said, âthere is safety in numbersâ?