The Securities and Exchange Commission's proposal to require publicly traded companies to reveal their so-called critical accounting policies is a step in the right direction, according to leading fund companies.
"It will enable portfolio managers to make better decisions," said Greg Smith, director of fund accounting at the Investment Company Institute.
However, others warn that it could be a prescription for disaster.
Holding that view: A group of Silicon Valley-based lawyers headed by Stanford University securities law Professor Joseph A. Grundfest. The group strongly opposes the rule's adoption unless the SEC provides for a "substantially broader safe harbor from private-party litigation."
In comment letters to the SEC, the attorneys argued that the proposed SEC rule would require every corporate issuer, for the first time, to make extensive forward-looking statements. Therefore, the lawyers reason, the new rules would "impose mandatory litigation risk for forward-looking statements on every publicly traded issuer."
The controversial rule, proposed by the SEC in May, would require that companies add a new section to "Management's Discussion and Analysis of Financial Condition and Results of Operations." The new section, "Application of Critical Accounting Policies," would be included in public companies' 10-Q quarterly and 10-K annual reports, registrations, proxy and information statements.
Under the SEC proposal, public companies - including the handful of mutual fund management companies which are public -would need to disclose information in two areas. First, what critical accounting estimates the company makes in preparing its financial statements. Second, the adoption of standard accounting policies.
"Our aim is to increase the transparency of the application of those accounting policies where management is the most prone to usejudgment," the SEC says.
Not an Echo in the Valley
The Silicon Valley attorneys, who claimed to work for private law firms that represent technology companies as well as corporations, stressed that their comments were their own opinions.
An SEC spokesman said that at press time, no recommendation for further action had yet been scheduled on the proposed rule.
The SEC considers an accounting estimate "critical" if a company can answer yes to any of these questions:
* Did the accounting estimate require the company to make assumptions about matters that were highly uncertain?
* Would different estimates that the company could have reasonably used alter the company's financial condition?
If a company could answer yes, then it would have to disclose how it came upon its accounting estimates.
Further, the company would have to include a "sensitivity analysis" describing how changes in critical accounting estimates or their underlying assumptions might impact operating results and/or financial condition.
The mutual company or other investment firm would also have to indicate whether senior management discussed these estimates with the audit committee.
As far as adopting and disclosing an accounting policy is concerned, the company would have to reveal what events or transactions gave rise to the adoption of those policies. The company would also have to reveal what accounting principle has been adopted and how it will be applied.
Lastly, the firm would have to reveal how it expects the new accounting rules to impact its financial presentation.
Should a company have a choice between accounting principles, it would need to explain why it selected one accounting principle over another alternative.
But the Silicon Valley group doesn't like these ideas. Besides calling for a private-litigation safe harbor, the Silicon Valley lawyers want the SEC to reduce quantitative and probabilistic analysis that the new rule would require. They also don't think that detailed disclosure on audit committee deliberations is necessary.
The attorneys suggested that the SEC reach out to members of the academic community who've studied probabilistic reporting to ask them what could go wrong.
"Issuers going public for the first time are often young companies operating in risky environments that have low visibility as to future developments," the attorneys wrote in their comment letter. "The class of issuers who may most legitimately require the greatest protection against private litigation will receive the least. Other categories of issuers excluded from the safe harbor, such as participants in tender offers or going private transactions, face a similar Hobson's choice."
The ICI, while largely favoring the rule, opposes a provision that would require a discussion on the impact alternative accounting policies would have on the issuer's results of operations and financial position.
"Our concern is that some financial statements may [already] be 50 pages right now," Smith explained, noting that this particular requirement could "double or triple" that amount.
"That would be overkill," Smith said.
The ICI also believes that further details on accounting policies should only be required if they are markedly "different than those typically used by competitors in its industry."
780,000 Man Hours
The SEC said it expected the vast majority of companies to have "somewhere in the range of three to five critical accounting estimates." The agency projected that company personnel cumulatively would spend 780,000 hours per year to prepare, review and file the added disclosures. The added disclosures, the SEC estimated, will cost $98 million, or $7,000 per company.
However Charles Schwab & Co. of San Francisco said that the new rules would create tension in view of the SEC's thrust to accelerate disclosure.
"This year, Schwab's outside auditors [took] more than 50 days to complete their annual audit after we closed our financial books for 2001," reported W. Hardy Callcott, Schwab's senior vice president and general counsel. "Under the new proposal, our auditors would have only 30 to 35 days to complete the same work."
Letters that arrived during the comment period, which closed July 19, were largely critical, particularly of the hypothetical information the disclosures would require.
"The amount of detailed hypothetical data created will be so voluminous that it will be meaningless," complained Joseph L. Sclafani, executive vice president and controller of J. P. Morgan Chase & Co. of New York.
Other commenters complained that such extensive disclosure could lead to the release of competitive information.