Financial Executives Research Foundation, Inc., gratefully acknowledges AOL Time Warner Inc. and The Proctor & Gamble Company for underwriting this Executive Report. ADVISORY COMMITTEE Marla Markowitz Bace Executive Vice President Financial Executives Research Foundation, Inc. Denise Baker Director of External Reporting The Dow Chemical Company Frank H. Brod Vice President and Controller The Dow Chemical Company Marsha Hunt Assistant Controller and Director of Accounting Corning Incorporated Dean Krogman Vice President Technical Activities Financial Executives International Connie McDaniel Vice President and Controller The Coca-Cola Company Colleen Sayther President and CEO Financial Executives International William M. Sinnett Manager of Research Financial Executives Research Foundation, Inc. Norman N. Strauss Ernst & Young Executive Professor in Residence Baruch College The City University of New York Eric J. Swanson Senior Financial Analyst The Dow Chemical Company
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A Review of 2002 MD&A Disclosures Critical Accounting Policies Table of Contents Purpose and Executive Summary Rules and Regulations APB, AICPA and SEC Regulation S-K SEC Cautionary Advice Regarding Disclosure about Critical Accounting Policies (FR-60) SEC Summary by the Division of Corporation Finance of Significant Issues Addressed in the Review of the Periodic Reports of the Fortune 500 Companies SEC Proposed Rule: Disclosure in Management’s Discussion and Analysis about the Application of Critical Accounting Policies Practices to Avoid Current Trends in Reporting Introductory Comments in Disclosure, Including Identification of Individual Critical Accounting Policies Linking Critical Accounting Policies to Economic Risks Newly Adopted Critical Accounting Policies Sensitivity Analysis Historical Information about Previous Changes in Critical Accounting Estimates Plain English Segment and Geographic Activities References to Notes to the Financial Statements References in Other Parts of MD&A to Critical Accounting Policies Columnar Formats Selected 2002 Disclosures Chart: Areas of Critical Accounting Policies Reported Post-Employment Benefits Goodwill Impairment Revenue Recognition Contingencies Tangibles Impairment Bad Debt Reserves Deferred Income Taxes Investments Inventory Insurance Derivatives and Securitizations Warranty Costs Stock-Based Compensation Depreciation & Amortization Table: Summary of Disclosures in Sample Conclusion Finding Critical Accounting Policies on the World Wide Web About the Author and the Financial Executives Research Foundation FERF President’s Circle
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Executive Report
June 2003
Dr. Mark P. Holtzman, CPA A Review of 2002 MD&A Disclosures Critical Accounting Policies Purpose This Executive Report summarizes current and proposed regulations governing disclosures of critical accounting policies. It identifies recent trends in practice, based on a review of 2002 Management Discussion and Analysis (MD&A) disclosures. To illustrate how the trends listed in this report apply to specific critical accounting policy areas, examples of 2002 disclosures are provided. Executive Summary Businesses regularly face uncertainties regarding many factors that influence future performance. Despite these uncertainties, managers must often use a single estimate in their financial statements to represent a wide range of likely outcomes. The operations of a dynamic company, in an uncertain environment, are thereby reduced to a single set of financial statements. Therefore, to improve transparency, disclosure of critical accounting policies can help investors appreciate how different estimates and assumptions affect financial statements. The Securities and Exchange Commission (SEC) defines critical accounting policies as those policies that “are most important to the portrayal of the company’s financial condition and results, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.” In December 2001, the SEC encouraged firms to expand their disclosures of critical accounting policies by providing more information about how judgments and uncertainties affect such policies, and by explaining how such policies influence the reported results of operations (FR-60). Furthermore, the SEC has proposed new rules to further expand disclosures about critical accounting estimates and the adoption of new critical accounting policies (Release No. 33-8098). We reviewed the SEC’s rules as well as the proposed rules for critical accounting policies, and read 145 samples of MD&A critical accounting policy disclosures from MD&A in Form 10-Ks filed with the SEC, drawn from the Fortune 100 and 50 smaller, randomly selected companies. In this Executive Report, we summarize SEC rules, both current and proposed, describe new trends in MD&A disclosure, and offer examples of disclosures of critical accounting policies to illustrate how the trends listed in this report were applied to specific areas.
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Rules and Regulations APB, AICPA and SEC Regulation S-K. Accounting Principles Board (APB) Opinion No. 22 (April 1972) and the American Institute of Certified Public Accountants (AICPA) Statement of Position No. 94-6 (December 1994) required companies to report in their financial statements information about the accounting principles used and the risks and uncertainties inherent in significant estimates. In its Regulation S-K, the Securities and Exchange Commission (SEC) requires companies to include MD&A in their Forms 10-K and annual reports in order to provide investors with information necessary to understand the company’s financial condition, changes in financial condition and results of operations (Regulation S-K, Item 303[a]). Such information includes any uncertainties that may have a material impact on a company’s reported results. However, Regulation S-K does not explicitly require any disclosure related to critical accounting policies. SEC Cautionary Advice Regarding Disclosure About Critical Accounting Policies (FR-60, 33-8040). In December 2001, the SEC released a statement regarding the selection and disclosure by public companies of critical accounting policies and practices, which defined critical accounting policies as those policies that • •
Are most important to the portrayal of the company’s financial condition and results, and Require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.
Companies are expected to identify and describe their most important critical accounting policies. The Cautionary Advice release recommends that companies expand disclosures to include: • • •
Full explanations about their critical accounting policies, written in plain English, Discussion of judgments and uncertainties affecting the application of those policies, and Sensitivity analysis describing how materially different amounts would be reported under different conditions or using different assumptions.
The SEC also encouraged companies to bolster their governance processes so that audit committees review the selection, application and disclosure of critical accounting policies. In a May 2002 proposal regarding MD&A [Proposed Rule 33-8098], the SEC said it believes that “it is these accounting policies that are least understood by investors and that mandated disclosure regarding areas of the application of them would provide meaningful insight into the importance of estimates and adoption of policies to a company’s financial presentation. With a greater understanding of the application of critical accounting policies, we believe that investors would be in a better position to assess the quality of, and potential variability of, a company’s earnings.” Furthermore, disclosures about critical accounting policies are expected to alert financial statement users to the economic risks underlying the company’s operations. SEC Summary by the Division of Corporation Finance of Significant Issues Addressed in the Review of the Periodic Reports of the Fortune 500 Companies. In its annual review of Fortune 500 companies’ filings for 2001, the SEC expressed dissatisfaction with critical accounting policy disclosures: 4
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In our review of the Fortune 500 companies, we noted a substantial number of companies did not provide any critical accounting policy disclosure in circumstances where FR-60 [Cautionary Advice] could fairly be read as calling for this disclosure. We also found that the critical accounting policy disclosure of many companies did not adequately respond to the guidance provided in FR-60. We also found that many companies failed to provide the sensitivity analysis the Commission encouraged in FR-60. SEC Proposed Rule: Disclosure in Management’s Discussion and Analysis about the Application of Critical Accounting Policies (33-8098). Because Regulation S-K never directly refers to critical accounting policies, and the “Cautionary Advice” statement is only two pages long, practitioners looking for detailed guidance must rely on proposed rule 33-8098, which requires additional disclosures about critical accounting policies. Released in May 2002, the proposal would create more “direct and complete requirements” about the disclosure of important accounting estimates and the adoption of new critical accounting policies.* The proposed criteria for treatment as a critical accounting policy are: First, the accounting policy requires a company to draw assumptions about matters that are highly uncertain at the time the accounting estimate is made. Second, alternate estimates in the current period, or changes in the estimate that are reasonably likely in future periods would have a material impact on the presentation of the company’s financial condition, changes in financial condition or results of operations. According to the proposal, a majority of companies would most likely have three to five critical accounting policies, while some companies may have more. A few companies may even have no critical accounting estimates to disclose. Among the disclosures that we reviewed for 2002 year-end filings, the average company reported 6.1 critical accounting policies. For each estimate made as part of a critical accounting policy, the SEC proposes the following disclosures: • • • • •
Identification and description of the accounting estimate, how the estimate was developed, any assumptions used in arriving at the estimate, and any reasonably likely changes; A description of how the estimate impacts financial condition, changes in financial condition and the results of operations; Sensitivity analysis describing how changes made in connection with each critical accounting estimate would affect financial results; Historical information about previous material changes in critical accounting estimates, including identification of how the changes affected the financial statements; Senior management's discussion of critical accounting estimates with the audit committee; and
In its terminology, the SEC proposal refers to critical accounting policies as including both accounting estimates made when applying its policies and the initial adoption of an accounting policy.
*
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•
Individual segments affected by critical accounting policies.
Furthermore, the proposal would require disclosure about the initial adoption of any accounting policy, including events or transactions that gave rise to the initial adoption, the accounting policy adopted, and how the policy affects the company’s financial statements. This new requirement builds upon previous GAAP standards that require companies to report exceptions to comparability (Accounting Research Bulletin No. 43), to disclose information about initial adoption of significant accounting policies (Accounting Principles Board No. 22), and to report accounting changes (Accounting Principles Board No. 20). The new SEC proposal also requires disclosure of “(a) the initial adoption of an accounting principle in recognition of events or transactions occurring for the first time or that previously were immaterial in their effect” and “(b) adoption or modification of an accounting principle necessitated by transactions that are clearly different in substance from those previously occurring.” These exceptions to APB No. 20 (par. 8), previously required no disclosure. Practices to Avoid. The SEC proposal (33-8098) discourages the following practices: • • •
Boilerplate language – standard writings that summarize generally accepted practice but that provide little information specific to the company. Overly technical language – language should be understandable to the lay person. Companies should try to explain even complex transactions in terms that a reasonably educated business person could understand. Narration of simple percentage changes – companies should provide substantive reasons for changes in accounting estimates.
Given the lack of binding guidance and the SEC’s determination to encourage broader disclosures, companies are relying upon proposed standards when preparing their own disclosures. Current Trends in Reporting For purposes of this study, we collected and read critical accounting policy disclosures made by the Fortune 100 publicly-traded companies and by 50 randomly-selected smaller publicly-traded companies. After excluding five companies not required to file 10-K annual reports, our sample of 145 companies contained a total of 888 critical accounting policies. The typical disclosure listed 6.1 critical accounting policies (the SEC proposal suggests that companies will identify three to five different policies). The average policy description was 240 words long. During our review, we found disclosures that range from brief, general disclosures to very long and specific explanations about critical accounting policies. Such a broad range is to be expected, given that the SEC has not yet issued a final rule. Therefore, in order to make this executive report more useful to practitioners, we chose not to focus upon the disclosures that were most prevalent in current practice, but rather to focus upon trends that appear most likely to become common in future practice. In order to illustrate each trend, we judgmentally selected the following sample disclosures, which all appear to be consistent with the SEC’s proposal:
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Introductory Comments in Disclosures, Including Identification of Individual Critical Accounting Policies. Most companies provide a brief introduction to their critical accounting policy disclosures, discuss internal procedures used to establish such policies and provide a list of the company’s individual policies. Companies also explain the governance procedures overseeing critical accounting policies, mentioning the role of the audit committee. To illustrate, we selected ChevronTexaco’s disclosure because it provides a summary of the SEC’s rule-making process in this area, lists the company’s individual policies, and distinguishes between critical and significant accounting policies. CHEVRONTEXACO CORP. APPLICATION OF CRITICAL ACCOUNTING POLICIES In May 2002, the SEC issued a proposed rule: “Disclosure in Management’s Discussion and Analysis about the Application of Critical Accounting Policies.” Although the SEC had not issued a final rule by mid-March 2003, the following discussion has been prepared on the basis of the guidelines in the SEC rule proposal. If adopted as proposed, the rule would require disclosures connected with “estimates a company makes in applying its accounting policies.” However, such discussion would be limited to “critical accounting estimates,” or those that management believes meet two criteria in the proposal: “First, the accounting estimate must require a company to make assumptions about matters that are highly uncertain at the time the accounting estimate is made. Second, different estimates that the company reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, must have a material impact on the presentation of the company’s financial condition, changes in financial condition or results of operations.” Beside estimates that meet the “critical” estimate criteria, the company makes many other accounting estimates in preparing its financial statements and related disclosures. All estimates, whether or not deemed critical, affect reported amounts of assets, liabilities, revenues and expenses as well as disclosures of contingent assets and liabilities. Estimates are based on experience and other information available prior to the issuance of the financial statements. Materially different results can occur as circumstances change and additional information becomes known, including for estimates not deemed “critical” under the SEC rule proposal. For example, the recording of deferred tax assets requires an assessment under the accounting rules that the future realization of the associated tax benefits be “more likely than not.” Another example is the estimation of oil and gas reserves under SEC rules that require “... geological and engineering data (that) demonstrate with reasonable certainty (reserves) to be recoverable in future years from known reservoirs under existing economic and operating conditions, i.e., prices and costs as of the date the estimate is made.” Refer to Table V “Reserve Quantity Information” on pages FS-51 and FS-52 for the changes in these estimates for the three years ending December 31, 2002, and to Table VII “Changes Financial Executives Research Foundation, Inc.
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in the Standardized Measure of Discounted Future Net Cash Flows From Proved Reserves” on page FS-54 for estimates of proved-reserve values for each year-end 2000–2002, which were based on year-end prices at the time. Note 1 to the Consolidated Financial Statements includes a description of the “successful efforts” method of accounting for oil and gas exploration and production activities. The estimates of crude oil and natural gas reserves are important to the timing of expense recognition for costs incurred. The upcoming discussion of the critical accounting policy for “Impairment of Property, Plant and Equipment and Investments in Affiliates” includes reference to conditions under which downward revisions of proved reserve quantities could result in impairments of oil and gas properties. The commentary should be read in conjunction with disclosures elsewhere in this discussion and in the Notes to the Consolidated Financial Statements related to estimates, uncertainties, contingencies and new accounting standards. Significant accounting policies are discussed in Note 1 to the Consolidated Financial Statements beginning on page FS25. The development and selection of accounting estimates, including those deemed “critical,” and the associated disclosures in this discussion have been discussed by management with the audit committee of the Board of Directors.
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Linking Critical Accounting Policies to Economic Risks. Critical accounting policies usually develop from uncertainties inherent to a specific business. For example, estimates for a bad debt allowance are necessitated by the inherent uncertainty in collecting accounts receivable. We selected the following disclosure by CitiGroup because it describes how the company’s accounting addresses a very specific risk – losses due to the economic crisis in Argentina. (Ellipses indicate passages omitted by the Report author.) CITIGROUP, INC. The Notes to the Consolidated Financial Statements contain a summary of Citigroup's significant accounting policies, including a discussion of recently issued accounting pronouncements. Certain of these policies as well as estimates made by management are considered to be important to the portrayal of the Company's financial condition, since they require management to make difficult, complex or subjective judgments and estimates, some of which may relate to matters that are inherently uncertain. These significant policies and estimates include valuation of financial instruments, the allowance for credit losses, securitizations, and estimating our exposure to losses in Argentina. Additional information about these policies can be found in Note 1 to the Consolidated Financial Statements. Management has discussed each of these significant accounting policies and the related estimates with the Audit Committee of the Board of Directors. … ARGENTINA The carrying value of assets and exposures to loss related to the Company's operations in Argentina represents management's estimates based on current economic, legal and political conditions. While these conditions continue to be closely monitored, they remain fluid, and future actions by the Argentine government or further deterioration of its economy could result in changes to those estimates. The carrying values of certain assets, including the compensation instruments, government-guaranteed promissory notes (GPNs) and government Patriotic Bonds are based on management's estimates of default, recovery rates and any collateral features. These instruments continue to be monitored, and have been written down to represent management's estimate of their collectibility, which could change as economic conditions in Argentina either stabilize or worsen. At December 31, 2002, the carrying values of the compensation notes, GPNs, and Patriotic Bonds were $276 million, $273 million, and $59 million, respectively. These valuations include write-downs which reduced income. Management continues to monitor the potential additional economic impact that the ongoing economic crisis may have on the collectibility of loans in Argentina. In 2002, the Company recognized net additions to the allowance for credit losses of $855 million. Additional losses may be incurred in the future.
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In 2002, the Company recognized $232 million in charges and related reserves for Amparos. The Argentina Supreme Court is considering the constitutionality of the 2002 redenomination of bank deposits to pesos. A decision that the redenomination was unconstitutional could result in a potential cost to re-dollarize the deposits depending on the terms of the court's decision. Because the provisions of any such decision could take an unknown variety of forms, the additional cost cannot be estimated. Further, any voluntary actions the Company might undertake, such as the settlement of reprogrammed deposits announced in January 2003, could mitigate such cost. In addition, the Company believes it has a sound basis to bring a claim, as a result of various actions of the Argentine government. A recovery on such a claim could serve to reduce the economic loss of the Company. In the opinion of management, the ultimate resolution of the redenomination would not be likely to have a material adverse effect on the consolidated financial condition of the Company, but may be material to the Company's operating results for any particular period.
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Newly Adopted Critical Accounting Policies. Companies provide information about the initial adoption of any accounting policy, including information about events or transactions that gave rise to the initial adoption and how the policy affects the company’s financial statements. As an illustration, the following disclosure by The CocaCola Company was selected because it explains the nature of the accounting change, its theoretical justification, and how it affects the financial statements. Note that the disclosure also refers to related financial statement footnotes. THE COCA-COLA COMPANY Adoption of New Accounting Policy-Stock-Based Compensation Our Company currently sponsors stock option plans and restricted stock award plans. Prior to 2002, our Company accounted for those plans under the recognition and measurement provisions of APB Opinion No. 25, "Accounting for Stock Issued to Employees" (APB No. 25) and related interpretations. No stock-based employee compensation expense for stock options was reflected in Net Income for the years ended December 31, 2001 and 2000, as all stock options granted under those plans had an exercise price equal to the fair market value of the underlying common stock on the date of grant. Effective January 1, 2002, our Company adopted the preferable fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation." Under the modified prospective transition method selected by our Company as described in SFAS No. 148, "Accounting for Stock-Based CompensationTransition and Disclosure," compensation cost recognized in 2002 of approximately $365 million is the same as that which would have been recognized had the fair value method of SFAS No. 123 been applied from its original effective date. The 2002 expense was recorded in the caption Selling, General and Administrative Expenses. In accordance with the modified prospective method of adoption, results for prior years have not been restated. Our Company voluntarily made a choice to change to the preferable method of accounting for employee stock options in accordance with SFAS No. 123. We concluded that stock options are a form of employee compensation expense, and therefore it is appropriate that these costs be recorded in our financial results to more clearly reflect economic reality. Refer to the heading "Corporate Governance." Our Company uses the Black-Scholes option-pricing model to determine the fair value of each option grant. To ensure the best market-based assumptions were used to determine the estimated fair value of stock options granted in 2002, we obtained two independent market quotes. Our Black-Scholes value was not materially different from the independent quotes. The Black-Scholes model includes assumptions regarding dividend yields, expected volatility, expected lives and risk-free interest rates. These assumptions reflect management's best estimates, but these items involve inherent uncertainties based on market conditions generally outside of the control of our Company. As a result, if other assumptions had been used in the current period, stock-based compensation expense could have been materially impacted. Furthermore, if management uses different assumptions in future periods, Financial Executives Research Foundation, Inc.
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stock-based compensation expense could be materially impacted in future years. Refer to Notes 1 and 13.
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Sensitivity Analysis. Companies describe how materially different amounts would have been reported under different conditions or using different assumptions. As an example, we selected Dial Corporation’s pension and post-retirement benefit footnotes because of the straightforward tabular format used. THE DIAL CORPORATION Pension and Post-Retirement Benefits . . . The table below illustrates the approximate impact to 2002 expense if we were to change the following key assumptions by 10%: Key Assumptions
Rate Used
Impact of 10% Rate Change (in millions)
Rate of return on assets
9.00%
+/- $1.7
Discount rate
7.25%
+/- $1.5
Salary growth rate
4.00%
+/- $0.3
Initial medical trend rate
6.50%
+/- $2.0
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Historical Information about Previous Changes in Critical Accounting Estimates. Companies provide users with feedback about previous periods’ accounting estimates, how they materialized, and how they affected financial results. To illustrate, we selected the following disclosure by J. C. Penney, to show how the company reports a change in the expected return on pension assets from 9.5% to 8.9%, a common change among the companies in our sample. The company reports historic returns on its pension assets, discloses that there are “lower expected future returns for 2003,” and explains how the change in estimate affects income. In order to address the underlying risk that caused the change in estimate, the company describes the nature of the invested assets (in the second sentence of this disclosure). J. C. PENNEY COMPANY, INC. To develop its expected return on [retirement] plan assets, the Company considers the mix of investments in the plan, historical actual returns and future estimates of long-term investment returns. The Company's primary pension plan is well diversified with an asset allocation policy that provides for a 70%, 20% and 10% mix of equities. . . Since the inception of the Company’s primary pension plan in 1966, the average annual return has been 9.1%. However, over the past several years, the fair value of pension assets has declined as a result of the poor performance in the global equity markets. The pension surplus, defined as the excess of the fair value of plan assets over the projected benefit obligation, has declined from approximately $1.2 billion in 2000 to approximately $50 million in 2002. Over the past two years alone, the fair value of pension plan assets has declined by approximately $700 million. In 2001, related net periodic pension income contributed $76 million to pre-tax earnings. In contrast, pension expense of $24 million was incurred in 2002. Since inception, the Company's primary pension plan has contributed cumulative pre-tax income of approximately $100 million. This is the result of cumulative pension expense during the 1966-1984 period of $366 million, cumulative pension income during the 1985-2001 period of $488 million, and pension expense in 2002 of $24 million. Given unfavorable returns over the past few years and lower expected future returns for 2003, the Company lowered the expected rate of return to 8.9% from 9.5% to reflect lower expected rates of return among all asset classes. Primarily as a result of asset performance, the Company expects a significant increase in net pension costs, which will incrementally reduce earnings per share (EPS) by approximately $0.25 in 2003 compared to $0.20 in 2002. The sensitivity of the pension expense to a plus or minus one-half of one percent of expected return on assets is an increase or decrease in expense of approximately $0.03 per share.
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Plain English. Companies explain their critical accounting policies in clear language that most people can understand. In the following disclosure, Berkshire Hathaway describes an extremely complex accounting estimate – unpaid insurance claims – in simple and straightforward language. BERKSHIRE HATHAWAY Berkshire uses a variety of techniques to establish the liabilities for unpaid claims recorded at the balance sheet date. While techniques may vary, each employs significant judgments and assumptions. Techniques may involve detailed statistical analysis of past claim reporting, settlement activity, claim frequency and severity data when sufficient information exists to lend statistical credibility to the analysis. The analysis may be based upon internal loss experience, the experience of clients or industry experience. Techniques may vary depending on the type of claim being estimated. More judgmental techniques are used in lines of business when statistical data is insufficient or unavailable. Liabilities may also reflect implicit or explicit assumptions regarding the potential effects of future economic and social inflation, judicial decisions, law changes, and recent trends in such factors.
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Segment and Geographic Activities. Where appropriate, companies provide information according to operating and geographic units, so that MD&A discussions reflect management’s perspective when running the company. FleetBoston Financial’s and Jones Lang LaSalle’s disclosures are good examples because they both break goodwill down by different business lines. This breakdown serves to link goodwill to the related businesses. FLEETBOSTON FINANCIAL CORPORATION . . . Of the total goodwill included in our consolidated balance sheet, about 65% is recorded in our Personal Financial Services business line; 26% in Commercial Financial Services; 7% in Capital Markets; and 2% in International Banking. Jones Lang LaSalle breaks down by geographical region its allowance for uncollectible accounts receivables, using a tabular format, and offering maximum and minimum allowance amounts in each region. The company also provides more information about the unusually large bad debt expense recorded in its America OOS region during 2001. JONES LANG LASALLE INCORPORATED . . . The table below sets out certain information regarding our accounts receivable, allowance for uncollectible accounts receivable, range of possible allowance and the bad debt expense we incurred by segment for the last three years (in millions).
December 31, 2002 Americas OOS Europe OOS Asia Pacific OOS Investment management Consolidated December 31, 2001 Americas OOS Europe OOS Asia Pacific OOS Investment Management Consolidated
Gross Accounts Receivable
Accounts Receivable More Than 90 Days Past Due
Allowance for Uncollectible Accounts Receivable
Maximium Allowance
Minimum Allowance
Bad Debt Expense
76.9 78.4
1.6 2.9
1.4 2.1
1.5 2.5
0.8 1.3
1.1 0.4
32.8
2.6
1.5
2.4
1.2
1.3
44.4 232.5
0.5 7.6
5.0
0.5 6.9
0.2 3.5
(0.5) 2.3
74.4 91.4
1.9 3.3
1.2 2.9
1.3 2.9
0.6 1.4
5.7 1.3
36.6
3.0
1.2
2.7
1.4
1.3
26.1 228.5
0.5 8.7
0.6 5.9
0.4 7.3
0.2 3.6
8.3
[A similar table for 2000 was provided] We would note that included in the $5.7 million bad debt expense for the Americas OOS segment in 2001 is a charge of $3.9 million for unrecoverable receivables from technology related clients.
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References to Notes to the Financial Statements. Discussion of critical accounting policies may include specific references to notes to the financial statements. Companies may also choose to place critical accounting policy information directly in the notes to the financial statements, in addition to the MD&A. For example, the following discussion was typical of critical accounting policies referring to the notes to the financial statements. LOCKHEED MARTIN CORPORATION Contract Accounting / Revenue Recognition A large part of our business is derived from long-term development and production contracts which we account for consistent with the American Institute of Certified Public Accountants’ (AICPA) audit and accounting guide, “Audits of Federal Government Contractors,” and the AICPA’s Statement of Position No. 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” We consider the nature of these contracts and the types of products and services provided when we determine the proper accounting for a particular contract. Generally, we record long-term fixed-price contracts on a percentage of completion basis using units-of-delivery as the basis to measure progress toward completing the contract and recognizing revenue. For certain other long-term fixed-price contracts which, along with other factors, require us to deliver minimal quantities over a longer period of time or to perform a substantial level of development effort in comparison to the total value of the contract, revenues are recorded when we achieve performance milestones or using the cost-to-cost method of accounting. Under the cost-to-cost method of accounting, we recognize revenue based on the ratio of costs incurred to our estimate of total costs at completion. We record sales under cost-reimbursement-type contracts as we incur the costs. As a general rule, we recognize sales and profits earlier in a production cycle when we use the cost-to-cost and milestone methods of percentage of completion accounting versus when we use the units-of-delivery method. We have accounting policies in place to address these and other complex issues in accounting for longterm contracts. For other information on accounting policies we have in place for recognizing sales and profits, see our discussion under “Sales and earnings” in Note 1 to the financial statements.
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References in Other Parts of MD&A to Critical Accounting Policies. In the MD&A performance review, companies remind users that certain accounting policies are “critical,” referring to the critical accounting policies section. Such references serve to remind readers that the numbers used required complex computations or judgment by management. To illustrate, TCF Financial Corporation, in the below excerpt from its MD&A Review of Results, refers to critical accounting policies, underscoring the relationship between operational and accounting uncertainties. TCF FINANCIAL CORPORATION [From MD&A Review of Results:] Allowance for Loan and Lease Losses. Credit risk is the risk of loss from a customer default on a loan or lease . . . The determination of the allowance for loan and lease losses is a critical accounting policy which involves estimates and management’s judgment on a number of factors such as net charge-offs, delinquencies in the loan and lease portfolio, general economic conditions and management’s assessment of credit risk in the current loan and lease portfolio. The Company considers the allowance for loan and lease losses of $77 million adequate to cover losses inherent in the loan and lease portfolios as of December 31, 2002. . . See “Forward-Looking Information” and Notes 1 and 7 of Notes to Consolidated Financial Statements for additional information concerning TCF’s allowance for loan and lease losses.
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Columnar Formats. Many companies organize critical accounting policy disclosures into columns, identifying individual attributes of each policy. Cigna’s table of critical accounting policies provides information about the nature of each policy, assumptions and the approach used, and a sensitivity analysis, emphasizing how specific assumptions affect the financial statements. Furthermore, each row explains one balance sheet caption, further highlighting the financial statement effects of each policy. CIGNA CORPORATION The table that follows presents information about CIGNA’s most critical accounting estimates, as well as the effects of hypothetical changes in the material assumptions used to develop each estimate. Balance Sheet Caption/ Nature of Critical Estimate Item
Assumptions/ Approach Used
Effect if Different Assumptions Used
Reinsurance recoverables – Reinsurance recoverables for Run-off Reinsurance Operations
The amount of reinsurance recoverable, net of reserves, represents management’s best estimate of recoverability, including an assessment of the financial strength of reinsurers. The ultimate amounts received are dependent, in certain cases, on the resolution of disputes with reinsurers, including the outcome of arbitration proceedings.
A 10% reduction of net reinsurance recoverables at December 31, 2002, would reduce net income by $59 million after-tax.
Collectibility of reinsurance recoverables requires an assessment of risks that such amounts will not be collected, including risks associated with reinsurer default and disputes with reinsurers regarding applicable coverage.
Net reinsurance recoverables for the Run-off Reinsurance Operations segment for the year ended December 31, were as follows:
This charge would impact the Run-off Reinsurance Operations segment.
• 2002 - $765 million • 2001 - $938 million • 2000 - $895 million
[Additional policies omitted]
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Selected 2002 Disclosures During our survey, we discovered a wide range of practices, and were surprised by the innovative approaches that many companies developed to provide quality information about their critical accounting policies. When preparing this study, we thought that practitioners, when preparing and revising their own disclosures, would benefit from an edited list of disclosures made by other companies. However, because of the wide range of current practice and the early stage of the SEC rule-making process, it would be premature to identify any specific disclosures as examples of “best practices.” Instead, we selected each example to illustrate how the trends listed in this report were applied to specific critical accounting policy areas. Practitioners are encouraged to review these disclosures, and other disclosures referenced later in this report, in order to develop ideas for expanding their own critical accounting policy disclosures. The SEC strongly discourages a “boilerplate” approach to preparing critical accounting policy disclosures; the uniqueness of each company requires that it report its own distinctive method of identifying and reporting critical accounting policies. Therefore, practitioners should not rely on any of these disclosures as “boilerplate” examples to be replicated. As would be expected, we found that the most complete and specific disclosures were also the longest disclosures. Accordingly, the selected disclosures on the following pages were significantly longer than typical disclosures.
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Chart: Areas of Critical Accounting Policies Reported The following chart describes the percentage of companies in our survey selecting different accounting areas as critical accounting policies. A large percentage of companies selected post-employment benefits (including pensions and other postemployment benefits), goodwill impairment, revenue recognition, and contingencies as critical accounting policies. While stock-based compensation has been politically controversial for some time, only 10% of the companies in our survey identfied stockbased compensation as a critical accounting policy.
50% 45% 40% 35% 30% 25% 20% 15% 10% 5%
Financial Executives Research Foundation, Inc.
Depreciation & amortization
Stock-based compensation
Warranty costs
Derivatives & securitizations
Insurance
Inventory
Investments
Deferred income taxes
Bad debt reserves
Tangibles impairment
Contingencies
Revenue recognition
Goodwill impairment
Post-employment benefits
0%
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Post-Employment Benefits We selected the following policy disclosure by Ford Motor because of its clear, plain English style and the tabular presentation. Furthermore, note that, for each policy described, Ford provides the “nature of estimates required,” “assumptions and approach used,” and “sensitivity analysis.” Note 20 of the Financial Statement notes provides additional sensitivity analysis. FORD MOTOR COMPANY See Note 20 of the Notes to our Financial Statements for more information regarding costs and assumptions for employee retirement benefits. Nature of Estimates Required: The measurement of our pension obligations, costs and is dependent on a variety of assumptions used by our actuaries. These assumptions include estimates of the present value of projected future pension payments to all plan participants, taking into consideration the likelihood of potential future events such as salary increases and demographic experience. These assumptions may have an effect on the amount and timing of future contributions. The plan trustee conducts an independent valuation of the fair value of pension plan assets. Assumptions and Approach Used: The assumptions used in developing the required estimates include the following key factors: o Discount rates o Inflation o Salary growth o Expected return on plan assets o Retirement rates o Mortality rates We base the discount rate assumption on investment yields available at year-end on corporate long-term bonds rated AA. Our inflation assumption is based on an evaluation of external market indicators. The salary growth assumptions reflect our long-term actual experience, the near-term outlook and assumed inflation. The expected return on plan assets reflects asset allocations, investment strategy and the views of investment managers and other large pension plan sponsors. Retirement and mortality rates are based primarily on actual plan experience. The effects of actual results differing from our assumptions are accumulated and amortized over future periods and, therefore, generally affect our recognized expense in such future periods. Sensitivity Analysis: The effect of the indicated decrease in the selected assumptions is shown below, assuming no changes in benefit levels and no amortization of gains or losses for our major plans in 2003 (in millions):
Assumption Discount rate Expected return on assets
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Percentage Point Change -0.5 pts. -0.5 pts.
Effect on U. S. Plans December 31, 2002 Decline in Reduction Funded Status in Equity $1,800 $1,100
Higher 2003 Expense $10 175
Financial Executives Research Foundation, Inc.
Goodwill Impairment We selected the following example from AOL Time-Warner because of the size of the related merger, the detailed information about goodwill and write-offs recorded in different segments, and the table describing how changes in fair value would affect net income. AOL TIME-WARNER INC. Accounting for Goodwill and Other Intangible Assets During 2001, the FASB issued FAS 142, which requires that, effective January 1, 2002, goodwill, including the goodwill included in the carrying value of investments accounted for using the equity method of accounting, and certain other intangible assets deemed to have an indefinite useful life, cease amortizing. FAS 142 requires that goodwill and certain intangible assets be assessed for impairment using fair value measurement techniques. Specifically, goodwill impairment is determined using a two-step process. The first step of the goodwill impairment test is used to identify potential impairment by comparing the fair value of a reporting unit (generally, the Company’s operating segment) with its net book value (or carrying amount), including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired and the second step of the impairment test is unnecessary. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination. That is, the fair value of the reporting unit is allocated to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the purchase price paid to acquire the reporting unit. The impairment test for other intangible assets consists of a comparison of the fair value of the intangible asset with its carrying value. If the carrying value of the intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. Determining the fair value of a reporting unit under the first step of the goodwill impairment test and determining the fair value of individual assets and liabilities of a reporting unit (including unrecognized intangible assets) under the second step of the goodwill impairment test is judgmental in nature and often involves the use of significant estimates and assumptions. Similarly, estimates and assumptions are used in determining the fair value of other intangible assets. These estimates and assumptions could have a significant impact on whether or not an impairment charge is recognized and also the magnitude of any such charge. To assist in the process of determining goodwill impairment, the Company obtains appraisals from independent valuation firms. In Financial Executives Research Foundation, Inc.
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addition to the use of independent valuation firms, the Company performs internal valuation analyses and considers other market information that is publicly available. Estimates of fair value are primarily determined using discounted cash flows and market comparisons and recent transactions. These approaches use significant estimates and assumptions including projected future cash flows (including timing), discount rate reflecting the risk inherent in future cash flows, perpetual growth rate, determination of appropriate market comparables and the determination of whether a premium or discount should be applied to comparables. During the first quarter of 2002, upon adoption of FAS 142, the Company completed its initial impairment review and recorded a $54.235 billion non-cash pre-tax charge for the impairment of goodwill, substantially all of which was generated in the Merger. During the fourth quarter of 2002, the Company performed its annual impairment review and recorded an additional $45.538 billion charge to reduce the carrying value of goodwill at the AOL segment ($33.489 billion), Cable segment ($10.550 billion) and Music segment ($646 million), as well as a charge to reduce the carrying value of brands and trademarks at the Music segment ($853 million). The $54.235 billion charge is reflected as a cumulative effect of an accounting change and the $45.538 billion charge is reflected as a component of operating income in the accompanying consolidated statement of operations. As previously discussed, the Company’s $44.685 billion goodwill impairment charge recognized in the fourth quarter of 2002, reflected the fair value of the Company’s operating divisions as of December 31, 2002. As encouraged by FRR60, the following table illustrates the hypothetical goodwill impairment charge assuming both an increase and decrease in the fair value of each of the Company’s operating divisions by 10%. Assuming 10% Increase in Fair Value AOL Cable (a) Filmed Entertainment Networks Music (a) Publishing Corporate Total
$(32,708) (8047) (339) $(41,094)
Actual 4th Quarter Impairment Charge (millions) $(33,489) (10,550) (646) $(44,685)
Assuming 10% Decrease in Fair Value $(34,270) (10,550) (646) $(47,025)
(a) Assuming a decline in fair value of 10% would not impact the amount of goodwill impairment because the carrying amount of goodwill was reduced to zero as a result of the actual fourth quarter impairment charge. The analysis does not consider any potential impairments relating to indefinite lived intangibles.
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Financial Executives Research Foundation, Inc.
Revenue Recognition We selected Boeing Company’s disclosure for its clear explanation of program accounting, discussion of underlying business risks, and sensitivity analysis. THE BOEING COMPANY The Company uses program accounting for its 7-series commercial airplane programs. Program accounting is a method of accounting for the costs of certain products manufactured for delivery under production type contracts where profitability is realized over multiple contracts and years. Under program accounting, inventoriable production costs (including overhead), program tooling costs and warranty costs are accumulated and charged to revenue by program instead of by individual units or contracts. A program consists of the estimated number of units (accounting quantity) of a product to be produced in a continuing, long-term production effort for delivery under existing and anticipated contracts. To establish the relationship of revenue to cost of sales, program accounting requires estimates of (a) the number of units to be produced and sold in a program, (b) the period over which the units can reasonably be expected to be produced, and (c) their expected selling prices, production costs, program tooling, and warranty costs for the total program. The reliance on estimates in the use of program accounting requires the demonstrated ability to reliably estimate the cost-revenue relationship for the defined program accounting quantity. The factors that must be estimated include selling price, labor and employee benefit costs, material costs, procured parts and major component costs, and overhead costs. To meet this requirement the Company employs a rigorous estimating process that is reviewed and updated on a quarterly basis. Changes in estimate are recognized on a prospective basis. Underlying all estimates used for program accounting is the assumed market and the corresponding production rates. The program accounting quantity is established based upon the assumed market. The total program revenue is determined by estimating the model mix and sales price for all unsold units within the accounting quantity added together with the revenue for all undelivered units under contract. The sales prices for all undelivered units within the accounting quantity include an escalation adjustment that is based on projected escalation rates. Cost estimates are based in a large part on historical performance trends, business base and other economic projections, and information provided by suppliers. Factors that influence these estimates include production rates, internal and subcontractor performance trends, asset utilization, anticipated labor agreements, and inflationary trends. Revenues under contracts with fixed prices are generally recognized as deliveries are made. For certain fixed-price contracts that require substantial performance over an extended period before deliveries begin, revenues are recorded based on the attainment of performance milestones. Revenues under contracts with terms that reimburse for costs incurred plus an agreed upon profit are recorded as costs are incurred. Financial Executives Research Foundation, Inc.
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Contracts may contain provisions to earn incentive and award fees if targets are achieved. Incentive and award fees that can be reasonably estimated are recorded over the performance period of the contract. Incentive and award fees that cannot be reasonably estimated are recorded when awarded. The development of gross margin and cost of sales percentages involves procedures and personnel in all areas of the Company that provide financial or production information on the status of contracts. This contract management process produces the Company’s best estimate of contract cost and contract revenue. Estimates of each significant contract’s cost and revenue are reviewed and reassessed quarterly. Changes in these estimates result in recognition of cumulative adjustments to the contract profit in the period in which changes are made. The experience of the last two years, with all programs being relatively mature, has been that estimate changes due to model mix, escalation, cost performance, and accounting quantity increases have resulted in a range of plus or minus 0.5% for the combined gross margin of all commercial airplane programs. If combined gross margin for all commercial airplane programs for all of 2002 had been estimated to be higher or lower by 0.5% it would have increased or decreased income for the year by approximately $122 million.
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Financial Executives Research Foundation, Inc.
Contingencies We selected the disclosures of Altria Group in order to demonstrate how a member of the tobacco industry accounts for its contingent liabilities. The company reiterates its legal situation, as described in the financial statement notes, and then explains how it accounts for these contingencies. Such detailed disclosures emphasize the linkage between accounting and economic uncertainties. ALTRIA GROUP, INC. As discussed in Note 18 to the consolidated financial statements (“Note 18”), legal proceedings covering a wide range of matters are pending or threatened in various jurisdictions against ALG, its subsidiaries and affiliates, including PM USA and PMI, as well as their respective indemnitees. In 1998, PM USA and certain other United States tobacco product manufacturers entered into the Master Settlement Agreement (the “MSA”) with 46 states and various other governments and jurisdictions to settle asserted and unasserted health care cost recovery and other claims. PM USA and certain other United States tobacco product manufacturers had previously settled similar claims brought by four other states (together with the MSA, the “State Settlement Agreements”). As part of the MSA, PM USA and three other domestic tobacco product manufacturers agreed to establish and fund a trust to provide aid to tobacco growers and quota-holders. The State Settlement Agreements require that the domestic tobacco industry make substantial annual payments subject to adjustment for several factors, including inflation, market share and industry volume. In addition, the domestic tobacco industry is required to pay settling plaintiffs’ attorneys’ fees, subject to an annual cap. These payment obligations, which are subject to adjustment for the factors mentioned above, are the several and not joint obligations of each settling defendant. Industry payments under the State Settlement Agreements are: 2003, $10.9 billion; 2004 through 2007, $8.4 billion each year; and, thereafter, $9.4 billion each year. PM USA’s portion of ongoing adjusted payments and legal fees is based on its relative share of the settling manufacturers’ domestic cigarette shipments, including roll-yourown cigarettes, in the year preceding that in which the payment is due. PM USA records its portion of ongoing settlement payments as part of cost of sales as product is shipped. During the years ended December 31, 2002, 2001 and 2000, PM USA recorded expenses of $5.3 billion, $5.9 billion and $5.2 billion, respectively, as part of cost of sales for the payments under the State Settlement Agreements and to fund the trust for tobacco growers and quota-holders. It is not possible to predict the outcome of the litigation pending against ALG and its subsidiaries. Litigation is subject to many uncertainties. Unfavorable verdicts awarding compensatory and/or punitive damages against PM USA have been returned in the Engle smoking and health class action, several individual smoking and health cases, a flight attendant environmental tobacco smoke (“ETS”) lawsuit and a health care cost recovery case, and are being appealed. It is possible that there could be further adverse developments in these cases and that additional cases could be decided unfavorably. An unfavorable outcome or settlement of pending tobacco-related litigation could encourage the Financial Executives Research Foundation, Inc.
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commencement of additional litigation. There have also been a number of adverse legislative, regulatory, political and other developments concerning cigarette smoking and the tobacco industry that have received widespread media attention. These developments may negatively affect the perception of potential triers of fact with respect to the tobacco industry, possibly to the detriment of certain pending litigation, and may prompt the commencement of additional similar litigation. ALG and its subsidiaries record provisions in the consolidated financial statements for pending litigation when they determine that an unfavorable outcome is probable and the amount of the loss can be reasonably estimated. Except as discussed in Note 18: (i) management has not concluded that it is probable that a loss has been incurred in any of the pending tobacco-related litigation; (ii) management is unable to make a meaningful estimate of the amount or range of loss that could result from an unfavorable outcome of pending tobacco-related litigation; and (iii) accordingly, management has not provided any amounts in the consolidated financial statements for unfavorable outcomes, if any. The present legislative and litigation environment is substantially uncertain, and it is possible that the business and volume of ALG’s subsidiaries, as well as Altria Group, Inc.’s consolidated results of operations, cash flows or financial position could be materially affected by an unfavorable outcome or settlement of certain pending litigation or by the enactment of federal or state tobacco legislation. ALG and each of its subsidiaries named as a defendant believe, and each has been so advised by counsel handling the respective cases, that it has a number of valid defenses to the litigation pending against it, as well as valid bases for appeal of adverse verdicts against it. All such cases are, and will continue to be, vigorously defended. However, ALG and its subsidiaries may enter into discussions in an attempt to settle particular cases if they believe it is in the best interests of ALG’s stockholders to do so.
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Financial Executives Research Foundation, Inc.
Tangibles Impairments We selected the following example for its segment-by-segment review of specific impairments recorded. JONES LANG LASALLE INCORPORATED Although the Land Investment Group was closed in 2001, we have retained certain investments originated by this group. Included in investments in real estate ventures as of December 31, 2002 is the book value of the five remaining Land Investment Group investments (of which three have now been fully written down) of $2.1 million. This book value is net of $6.3 million of impairment charges, of which $3.5 million was recorded in 2001 as part of our non-recurring charges. We have also provided guarantees associated with this investment portfolio of $1.2 million, which we currently do not expect to be required to fund. We continue to monitor the portfolio very carefully and have taken two additional impairment charges in 2002 as part of our non-recurring charges. We recorded $1.9 million to fully provide against an investment that had previously not been impaired, but which defaulted on certain financial covenants in 2002. In addition, we took an impairment charge of $0.9 million to fully write down an investment that we had partially impaired in 2001, as our underlying projected performance expectations continued to decline. Any future impairment charges or gains or losses on disposal relating to the Land Investment Group will be included in non-recurring charges. We currently expect to liquidate the Land Investment Group investments by the end of 2006. Although the Development Group was sold in the third quarter of 2001, we have retained certain investments originated by this group. Included in investments in real estate ventures as of December 31, 2002 is the book value of the one remaining investment project of $893,000. In 2002 we have recorded a net gain of $675,000 as a result of the disposal of three of these investments, an impairment charge of $472,000 relating to two properties that were subsequently sold and equity losses of $404,000. The net gain and expenses have been recorded in non-recurring expense in 2002. Any future impairment charges or gains or losses on disposal relating to the final Development Group investment will be included in nonrecurring expenses. We continue to evaluate this investment for impairment. We currently expect to liquidate the final Development Group investment by the end of 2003. During 2001, we reviewed our e-commerce investments on an investment by investment basis, evaluating actual business performance against foriginal expectations, projected future performance and associated cash flows, and capital needs and availability. As a result of this evaluation we determined that our investments in e-commerce were impaired and fully wrote down these investments by the end of 2001 as part of our non-recurring charges. It is currently our policy to expense any additional investments, primarily contractual commitments to fund operating expenses of existing investments, that are made into these ventures in the period they are made. These charges are recorded as
Financial Executives Research Foundation, Inc.
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ordinary recurring charges. In 2002 we expensed a total of $287,000 of such investments. Also during 2001, the Asia Pacific region underwent a realignment from a traditional geographic structure to one that is managed according to business lines. As part of this realignment, we decided to restructure our operations to exit an arrangement with a third-party in Indonesia. This decision resulted in the write-down of a net $1.0 million receivable from this third-party.
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Financial Executives Research Foundation, Inc.
Bad Debt Reserves We selected the following disclosure because it provides unusually detailed information about how Wells Fargo estimates its allowance for loan losses, emphasizing the underlying risks affecting this estimate and the collectibility of the loan portfolio. WELLS FARGO & COMPANY The Company's allowance for loan losses represents management's estimate of probable losses inherent in the loan portfolio at the balance sheet date. Allocation of the allowance is made for analytical purposes only, and the entire allowance is available to absorb probable and estimable credit losses inherent in the portfolio including unfunded commitments. Additions to the allowance may result from recording provision for loan losses or loan recoveries, while charge-offs are deducted from the allowance. PROCESS TO DETERMINE THE ADEQUACY OF THE ALLOWANCE FOR LOAN LOSSES.
The Company has an established process to determine the adequacy of the allowance for loan losses that relies on a number of analytical tools and benchmarks to arrive at a range of probable outcomes. No single statistic or measurement, in itself, determines the adequacy of the allowance. For analytical purposes, the allowance consists of two components, allocated and unallocated. To arrive at the allocated component of the allowance, the Company combines estimates of the allowances needed for loans analyzed individually and loans analyzed on a pooled basis. The determination of the allocated allowance for portfolios of commercial and real estate loans involves the use of a continuous and standardized loan grading process in combination with a review of larger individual higher-risk transactions. The Company grades loans and assigns a loss factor to each pool of loans based on the grades. The loss factors used for this analysis are derived in two ways. First, migration models are used to determine loss factors by tracking actual portfolio movements between loan grades over the loss emergence period of these portfolios. Second, in the case of graded loans without identified credit weaknesses, the loss factors are estimated using a combination of long-term average loss experience of the Company's own graded portfolios and external industry data. In addition, the Company analyzes non-performing loans over $1 million individually for impairment using a cash flow or collateral based methodology. Calculated impairment is included in the allocated allowance unless impairment has been recognized as a loss.
In the case of homogeneous portfolios, such as consumer loans and leases, residential mortgage loans, and some segments of small business loans, the determination of the allocated allowance is conducted at an aggregate, or pooled, level. For such portfolios, the risk assessment process includes the use of forecasting models to measure inherent loss in these portfolios. Such analyses are updated frequently to capture the recent behavioral characteristics of the subject portfolios, as well as any changes in the Company's loss mitigation or customer solicitation
Financial Executives Research Foundation, Inc.
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strategies, in order to reduce the differences between estimated and observed losses. To mitigate imprecision and incorporate the range of probable outcomes inherent in estimates of expected credit losses, the allocated component of the allowance is supplemented by an unallocated component. The unallocated component also incorporates the Company's judgmental determination of risks inherent in portfolio composition, economic uncertainties and other subjective factors, including industry trends impacting specific portfolio segments that have not yet resulted in changes in individual loan grades. Therefore the ratio of the allocated to the unallocated components within the total allowance for loan losses may fluctuate from period to period. The allocated and unallocated components represent the total allowance for loan losses that would adequately cover losses inherent in the loan portfolio. The determination of the level of the allowance and, correspondingly, the provision for loan losses, rests upon various judgments and assumptions, including: (1) general economic conditions, (2) loan portfolio composition, (3) prior loan loss experience, (4) management's evaluation of credit risk related to both individual borrowers and pools of loans, (5) periodic use of sensitivity analysis and expected loss simulation modeling and (6) observations derived from the Company's ongoing internal audit and examination processes and those of its regulators. The assumptions below were used to estimate a range of the 2002 allowance outcomes and related changes in provision expense assuming either a reasonably possible deterioration in loan credit quality or a reasonably possible improvement in loan credit quality. Assumptions for deterioration in loan credit quality: • For the non-homogeneous wholesale components of the portfolio, a downward migration of certain loan grades to the next lower grade, resulting in a 70% increase in the balance of loans classified as special mention and substandard, as defined by the Office of the Comptroller of the Currency (OCC); and • For the homogeneous portfolio (such as consumer loans and leases, residential mortgage loans, and some segments of small business lending), a 20 basis point increase in estimated loss rates over the historical level of losses. Assumptions for improvement in loan credit quality: • For the non-homogeneous wholesale components of the portfolio, a 25% decrease in the balance of loans classified as special mention and substandard, as defined by the OCC; and • For the homogeneous portfolio (such as consumer loans and leases, residential mortgage loans, and some segments of small business lending), a 10 basis point decrease in estimated loss rates over the historical level of losses. These assumptions would result in a potential of $500 million in additional expected losses to emerge in the portfolio under the deterioration in loan credit quality scenario and a potential of a $350 million reduction to 32
Financial Executives Research Foundation, Inc.
expected losses to emerge in the portfolio under the improvement in loan credit quality scenario. Changes in the estimate related to the allowance for loan losses can materially affect net income. This is only one example of reasonably possible sensitivity scenarios. The process of determining the allowance requires us to forecast losses on loans in the future which are highly uncertain and require a high degree of judgment; and is impacted by regional, national and global economic trends, and different assumptions regarding "reasonably possible" future economic conditions could have been used and would have had a material impact on the provision for loan losses and on the consolidated results of operations.
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Deferred Income Taxes We selected the following PepsiCo disclosure because it provides a clear, textbook-like explanation of deferred tax accounting and reviews the company’s specific practices. Note how the use of plain English makes this complex subject matter easier to understand. PEPSICO, INC. Our reported effective tax rate was 31.9% for 2002. Excluding the impact of nondeductible merger-related costs, our effective tax rate was 31.2%. For 2003, our effective tax rate, excluding the impact of nondeductible merger-related costs, is expected to be 30.5%. The decrease from 2002 primarily reflects the impact of our new concentrate plant. Our effective tax rate is based on expected income, statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we operate. Significant judgment is required in determining our effective tax rate and in evaluating our tax positions. We establish reserves when, despite our belief that our tax return positions are fully supportable, we believe that certain positions are likely to be challenged and that we may not succeed. We adjust these reserves in light of changing facts and circumstances, such as the progress of a tax audit. Our effective tax rate includes the impact of reserve provisions and changes to reserves that we consider appropriate, as well as related interest. This rate is then applied to our quarterly operating results. In the event that there is a significant unusual or one-time item recognized in our operating results, the tax attributable to that item would be separately calculated and recorded at the same time as the unusual or one-time item. We consider the Quaker merger-related costs to be a significant one-time item. Tax regulations require items to be included in the tax return at different times than the items are reflected in the financial statements. As a result, our effective tax rate reflected in our financial statements is different than that reported in our tax return. Some of these differences are permanent, such as expenses which are not deductible on our tax return, and some are timing differences, such as depreciation expense. Timing differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in our tax return in future years for which we have already recorded the tax benefit in our income statement. We establish valuation allowances for our deferred tax assets when the amount of expected future taxable income is not likely to support the use of the deduction or credit. Deferred tax liabilities generally represent tax expense recognized in our financial statements for which payment has been deferred or expense for which we have already taken a deduction on our tax return, but have not yet recognized as expense in our financial statements. We have not recognized any United States tax expense on undistributed international earnings since we intend to reinvest the earnings outside the United States for the foreseeable future. These undistributed earnings are approximately $7.5 billion at December 28, 2002.
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Financial Executives Research Foundation, Inc.
A number of years may elapse before a particular matter, for which we have established a reserve, is audited and finally resolved. The number of years with open tax audits varies depending on the tax jurisdiction. In the United States, the audits for 1991 through 1993 remain open for certain items and the Internal Revenue Service is currently examining our tax returns for 1994 through 1997. While it is often difficult to predict the final outcome or the timing of resolution of any particular tax matter, we believe that our reserves reflect the probable outcome of known tax contingencies. Unfavorable settlement of any particular issue would require use of our cash. Favorable resolution would be recognized as a reduction to our effective tax rate in the year of resolution. Our tax reserves are presented in the balance sheet within other liabilities, except for amounts relating to items we expect to settle in the coming year which are classified as current.
Financial Executives Research Foundation, Inc.
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Investments We selected the following disclosure from Lockheed Martin because it provides unusually detailed information about underlying business risks and the nature of individual writedowns. Furthermore, the company provides a useful table listing how each write-down affected operating profit, net earnings, and earnings per diluted share. LOCKHEED MARTIN CORPORATION We have investments in equity securities of several companies, some of which are publicly traded entities. We review these investments each quarter to evaluate our ability to recover our investments. We record an impairment charge if the fair value of the investment has declined below our carrying value, and that decline is viewed to be other than temporary. For publicly traded companies, the fair value of the equity securities is determined by multiplying the number of shares we own by the stock price, as well as by computing estimates of the fair values based on a variety of valuation methods (e.g., discounted cash flow analyses, sum-ofthe-parts valuations and trading multiples). For those companies that are not publicly traded, we prepare discounted cash flow analyses to compute an estimate of the fair value of the investment. Since we generally do not have access to internal projections of those companies, we prepare projections based on information that is publicly available. We use judgment in computing the fair value based on our evaluation of the investee and establishing an appropriate discount rate and terminal value to apply in the calculations. In selecting these and other assumptions, we consider the investee’s ability to execute their business plan successfully, including their ability to obtain required funding, general market conditions, and industry considerations specific to their business. It is likely that we could compute a materially different fair value for an investment if different assumptions were used or if circumstances were to change. Many of our investments are concentrated in the satellite services and telecommunications industries, including Intelsat, Ltd. (Intelsat), Inmarsat Ventures plc (Inmarsat) and New Skies Satellites, N.V. (New Skies). These industries continue to be affected by the capital markets, excess satellite capacity and competition from other kinds of telecommunications services, including fiber optic cable and other wireless communication technologies. This has been evidenced by recent bankruptcy filings by some telecommunications companies. Intelsat, Inmarsat and New Skies are also subject to regulation by the Federal Communications Commission (FCC). FCC decisions and policies have had, and may continue to have, a significant impact on these companies. In 2000, Congress passed the Open-Market Reorganization for the Betterment of International Telecommunications Act (the ORBIT Act) that, among other things, established deadlines for Intelsat and Inmarsat to complete their initial public offerings. Under the ORBIT Act, Intelsat and Inmarsat were required to complete their initial public offerings by December 31, 2002. However, Inmarsat has received an extension from the FCC until June 30, 2003. In October 2002, legislation was enacted which extends the 36
Financial Executives Research Foundation, Inc.
deadline for Intelsat to complete its initial public offering to December 31, 2003, or June 30, 2004 if approved by the FCC. Unless there are changes in the current trends and market conditions in the telecommunications industry, as well as in the capital markets, Intelsat and Inmarsat may have difficulty in completing their initial public offerings by the ORBIT Act deadlines. If those deadlines are not met or extended by further amendments to the legislation, the FCC may limit access by U.S. users to the satellite capacity of the privatized entities for some services. If this were to occur, the value of our investments could be adversely affected. In the fourth quarter 2002, as part of the ongoing evaluation of our ability to recover our investments, we calculated an estimate of the current fair values of our investments in Intelsat and Inmarsat. For our investment in New Skies, we calculated the current fair value based on the publicly traded stock price and, for analysis purposes, also calculated an estimate of the fair value using discounted cash flow analyses. In each case, the fair value of our investment was less than our carrying amount. We then made an assessment as to whether the decline in the value of these investments was other than temporary. We reviewed investment analyst reports to the extent they were available. We also assessed future business prospects for the companies and reviewed information regarding market and industry trends for their businesses. Based on our evaluation, including the factors discussed above, we determined that the decline in values of these investments was other than temporary, and recorded impairment charges related to these investments in the fourth quarter of 2002. The impact of the unusual charges on operating profit (earnings from continuing operations before interest and taxes), net earnings and diluted earnings per share was as follows: Operating Net Earnings per (In millions) Profit Earnings Diluted Share Write-down of investment in: Intelsat $(572) $(371) $(0.82) Inmarsat (101) (66) (0.15) (67) (0.15) New Skies (103) Total write-down of telecommunications $(776) $(504) $(1.12) investments
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Inventory To illustrate this area, we selected Motorola because of its detailed disclosures and membership in the high tech and telecommunications industries, which are known for the high costs associated with the rapid depreciation of hardware. Note how the company describes, in depth, procedures for identifying obsolescent inventory and explains larger-than-usual write-downs recorded in 2001. MOTOROLA, INC. The Company records valuation reserves on its inventory for estimated obsolescence or unmarketability. The amount of the reserve is equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about future demand and market conditions. On a quarterly basis, management in each segment performs an analysis of the underlying inventory to identify reserves needed for excess and obsolescence and for the remaining inventory assesses the net realizable value. Management uses its best judgment to estimate appropriate reserves based on this analysis. In addition to normal excess and obsolescence provisions for inventory, in 2001 the Company recorded $583 million in inventory write-down charges for product portfolio simplifications primarily in the Personal Communications segment attributable to accelerated erosion of average selling prices for analog and first-generation digital wireless telephones. Net Inventories consisted of the following: December 31 Finished goods Work-in-process and production materials Less inventory reserves
2002 $1,131 2,742 3,873 (1,004) $2,869
2001 $1,140 2,782 3,922 (1,166) $2,756
The Company balances the need to maintain strategic inventory levels to ensure competitive delivery performance to its customers with the risk of inventory obsolescence due to rapidly changing technology and customer requirements. As indicated above, the Company's inventory reserves represented 26% and 30% of the gross inventory balance at December 31, 2002 and 2001, respectively. These reserve levels are maintained by the Company to provide for unique circumstances facing our businesses. The Company has inventory reserves for pending cancellations of product lines due to technology changes, long-life cycle products, lifetime buys at the end of supplier production runs, business exits, and a shift of production to outsourcing. The decline in the reserve balance in 2002 compared to 2001 primarily relates to scrapping of excess and obsolete inventory with the appropriate reduction in the related gross inventory balance. If actual future demand or market conditions are less favorable than those projected by management, additional inventory writedowns may be required. Likewise, as with other reserves based on management's 38
Financial Executives Research Foundation, Inc.
judgment, if the reserve is no longer needed, amounts are reversed into income. There were no significant reversals into income of this type in 2002.
Financial Executives Research Foundation, Inc.
39
Insurance We selected the following example from the filings of Prudential Financial for its plain English explanations of complex risks and accounting treatments, evaluation of prior years’ estimates, and clear linkages to specific financial statement items. PRUDENTIAL FINANCIAL, INC. Policyholder Liabilities and Deferred Policy Acquisition Costs The liability for “Future policy benefits” is the largest liability included in our statements of financial position, 33% of total liabilities as of December 31, 2002. Changes in this liability are generally reflected in the “Policyholders’ benefits” caption in our statements of operations. This liability is primarily comprised of the present value of estimated future payments to holders of life insurance and annuity products where the timing and amount of payment depends on policyholder mortality, surrender or retirement experience. For traditional participating life insurance products of our Closed Block Business, the mortality and interest rate assumptions we apply are those used to calculate the policies’ guaranteed cash surrender values. For life insurance and annuity products of our Financial Services Businesses, expected mortality is generally based on the Company’s historical experience or standard industry tables. Interest rate assumptions are based on factors such as market conditions and expected investment returns. Although mortality and interest rate assumptions are “locked-in” upon the issuance of new insurance or annuity business with fixed and guaranteed terms, significant changes in experience or assumptions may require us to provide for expected future losses on a product by establishing premium deficiency reserves. For example, in 2000 we restructured the portfolio that supports the structured settlement products within our Retirement segment to reduce the emphasis on equity investments, which in turn lowered our expected future investment returns. As a result, we recorded a charge to establish a premium deficiency reserve for these products. Our liability for “Unpaid claims and claim adjustment expenses,” which is 1% of total liabilities as of December 31, 2002, includes estimates of claims that we believe have been incurred, but have not yet been reported (“IBNR”) as of the balance sheet date, primarily attributable to our Property and Casualty Insurance segment and our Group Insurance segment. Consistent with industry accounting practice, we do not establish loss reserves until a loss, including a loss from catastrophe, has occurred. These IBNR estimates, and estimates of the amounts of loss we will ultimately incur on reported claims, which are based in part on our historical experience, are regularly adjusted to reflect actual claims experience. When actual experience differs from our previous estimate, the resulting difference will be included in our reported results for the period of the change in estimate in the “Policyholders’ benefits” caption in our statements of operations. On an ongoing basis, trends in actual experience are a significant factor in the determination of claim reserve levels. In recent years, actual claims experience with respect to our automobile insurance business within our Property and Casualty Insurance segment has been more favorable than the assumptions we used in 40
Financial Executives Research Foundation, Inc.
originally establishing the reserves for these claims, which resulted in a benefit to earnings for these years due to reserve releases. Actual claims experience can also be less favorable than that assumed in establishing reserves, which can require a charge to earnings to increase reserves. For most life insurance and annuity products that we sell, we defer costs that vary with and are related primarily to the production of new business to the extent these costs are deemed recoverable from future profits, and we record these costs as an asset known as “Deferred policy acquisition costs” or “DAC” in the statements of financial position. We amortize this DAC asset over the expected lives of the contracts, based on the level and timing of either estimated profits or premiums, depending on the type of contract. For products with amortization based on estimated profits, the amortization rate is periodically updated to reflect current period experience or changes in assumptions that affect future profitability, such as lapse rates, investment returns, mortality experience, expense margins and surrender charges. However, for products with amortization based on future premiums, the amortization rate is locked-in when the product is sold. For example, expected profitability is a significant estimate in evaluating deferred acquisition costs related to annuity products. Expected profitability considers, among other assumptions, our best estimate of future asset returns to estimate the future fees we expect to earn, the costs associated with minimum death benefit guarantees we expect to incur and other profitability factors. For the average remaining life of our variable annuity contracts in force as of December 31, 2002, our evaluation of deferred policy acquisition costs is based on a 9.25% annual blended rate of return that reflects an assumed rate of return of 11.5% for equity type assets. Continuation of current market conditions or further deterioration in market conditions may result in increases in the amortization of deferred policy acquisition costs, while a significant improvement in market conditions may result in a decrease in the amortization of deferred policy acquisition costs. These changes in DAC balances are included as a component of “General and administrative expenses” in our statements of operations. See “—Insurance Division—Individual Life and Annuities” for discussion of the impact of DAC amortization on our results of our annuities businesses, including increased amortization recorded in 2002 and 2001 reflecting lower estimates of future gross profits as well as a discussion of the proposed AICPA Statement of Position, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts.”
Financial Executives Research Foundation, Inc.
41
Derivatives and Securitizations We selected the below disclosure because of its clear narrative explaining how derivatives were accounted for, and the extensive discussion of underlying risks affecting estimates and income. EL PASO CORPORATION Price Risk Management Activities. We account for our price risk management activities in accordance with the requirements of SFAS No. 133, which requires that we determine the fair value of the derivative instruments we use and reflect them in our balance sheet at their fair values. Changes in the fair value from period to period of all derivative instruments, except cash flow hedges, are recorded in our income statement. Changes in the fair value of derivative instruments used to hedge our cash flows are generally recognized in our income statement when the hedge is settled. Over time, these methods will derive similar results. However, from period to period, income under these methods can differ significantly. Some of our derivative instruments are traded on active exchanges such as the New York Mercantile Exchange, while others are valued using exchange prices, third party pricing data and valuation techniques that incorporate specific contractual terms, statistical and simulation analysis and present value concepts. One of the primary factors that can have an impact on our results each period is the price assumptions used to value our derivative instruments. Because of our actions to limit our trading activities and exit the trading business, our accessibility to reliable forward market pricing data for purposes of estimating fair value was significantly limited in late 2002. As a result, we obtained valuation assistance from a third party valuation specialist in determining the fair value of our trading and non-trading price risk management activities as of December 31, 2002. Based upon the specialist's input, our estimates of fair value are based upon price curves derived from actual prices observed in the market, pricing information supplied by the specialist and independent pricing sources and models that rely on this forward pricing information. These estimates also reflect factors for time value and volatility underlying the contracts, the potential impact of liquidating our position in an orderly manner over a reasonable time under present market conditions, modeling risk, credit risk of our counterparties and operational risks, as needed. We have discontinued applying our ten-year liquidity valuation allowance that we had instituted during the first quarter of 2002 in circumstances where there was uncertainty related to our forward prices in less liquid markets. To the extent that the forward market data received from the third party specialist indicates value beyond ten years, we now include that value in the fair value of our trading and non-trading price risk management activities. The amounts we report in our financial statements change as these estimates are revised to reflect actual results, changes in market conditions or other factors, many of which are beyond our control.
42
Financial Executives Research Foundation, Inc.
Another factor that can impact our results each period is our ability to estimate the level of correlation between future changes in the fair value of the hedge instrument and the transaction being hedged, both at the time we enter into the transaction and on an ongoing basis. By hedging risk, the derivative instrument's value is intended to offset value changes in the item being hedged. However, this is complicated in hedging energy commodities, because energy commodity prices have qualitative and locational differences that can be difficult to hedge effectively. Our estimates of fair value and our assessment of correlation of our hedging derivatives are impacted by actual results and changes in market conditions. We evaluate the risk in our trading and non-trading price risk management activities using a Value-at-Risk model to determine the maximum expected one-day unfavorable impact on our financial performance due to normal market movement. For a discussion of our methodology in calculating Value-at-Risk, please see Item 7A, Quantitative and Qualitative Disclosures About Market Risk. We believe that using this Value-at-Risk methodology captures many of the uncertainties associated with the estimates in our trading and non-trading activities. We have reflected our trading portfolio at estimated fair value which is the amount at which the contracts in our portfolio could be bought or sold in a current transaction between willing buyers and sellers. However, the value we ultimately receive in settlement of our trading activities may be less than our fair value estimates. As disclosed previously, we are actively liquidating our trading portfolio, which include approximately 40,000 transactions as of December 31, 2002. We believe the net realizable value of our trading portfolio may be less than their currently estimated fair value. Our belief is based on recent transactions completed at values below estimated fair value and bids received on transactions that were also below their fair value. Additionally, because of the adoption of EITF Issue No. 02-3, a portion of the transactions that we plan to liquidate are accounted for under the accrual method and are not recorded on our balance sheet. Should we have to pay counterparties to assume these transactions, future losses will result. We believe that the amount we may ultimately realize from the liquidation of our total portfolio (including our accrual-based portfolio) could result in future losses up to $200 million.
Financial Executives Research Foundation, Inc.
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Warranty Costs We selected Dell Computer for its clear description of the nature of warranty terms, and how related liabilities are recorded. Note how the company describes factors mitigating economic risks associated with warranties. DELL COMPUTER Dell records warranty liabilities for the estimated costs that may be incurred under its basic limited warranty as well as under separately priced extended warranty and service contracts for which Dell is obligated to perform. These liabilities are accrued at the time product revenue is recognized. The specific warranty terms and conditions vary depending upon the product sold and country in which Dell does business, but generally includes technical support, repair parts and labor and a period ranging from 90 days to three years. Factors that affect Dell’s warranty liability include the number of installed units currently under warranty, historical and anticipated rates of warranty claims on those units and cost per claim to satisfy Dell’s warranty obligation. The anticipated rate of warranty claims is the primary factor impacting Dell’s estimated warranty obligation. The other factors are relatively insignificant because the average remaining aggregate warranty period of the covered installed base is approximately 20 months, repair parts are generally already in stock or available at pre-determined prices, and labor rates are generally arranged at pre-established amounts with service providers. Warranty claims are relatively predictable based on historical experience of failure rates. Each quarter, Dell reevaluates its estimates to assess the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary. This critical accounting policy disclosure appears to be quite short and general. However, the company provides the following additional information in its financial statement notes: Aggregate Product Warranty Liability – Changes in the Company’s aggregate product warranty liability are presented in the following table:
Aggregate liability at beginning of period Cost accrued for standard warranties and separately priced extended warranty and service contracts issued during the period Obligations honored during the period Aggregate liability at end of period Current portion Noncurrent portion Aggregate liability at end of period
44
Fiscal Year Ended January 31, 2003 (in millions) $850 1,327 (868) $1,309 674 635 $1,309
Financial Executives Research Foundation, Inc.
Stock-Based Compensation We selected the following disclosure for its description of the Black-Scholes option pricing model, list of assumptions made, and references to notes to the consolidated financial statements. Wachovia provides additional disclosures about its stock option accounting including a pro forma analysis, which is substantively similar to sensitivity analysis, in the notes to the financial statements, as referenced to at the end of this disclosure. WACHOVIA CORP. Stock Options We have stock option plans under which incentive and nonqualified stock options may be granted periodically to certain employees. The options are granted at an exercise price equal to the fair value of the underlying shares at the date of grant, they generally vest one to three years following the date of grant, and they have a term of ten years. In July 2002, we adopted the fair value method of accounting for stock options effective for grants made in 2002 and thereafter. Under the fair value method of accounting, expense is measured as the fair value of the stock options as of the grant date and is recognized evenly over the vesting period. The Black-Scholes option pricing model is used to determine the fair value of stock options. This option pricing model has certain limitations, such as not factoring in the non-transferability of employee options, and is generally used to value options with terms shorter than the contractual ten-year life of our awards. Because of these limitations, and the use of highly subjective assumptions in the model, this and other option pricing models do not necessarily provide a reliable single measure of the fair value of our stock options. The more significant assumptions used in estimating the fair value of stock options include the risk-free interest rate, the dividend yield, the weighted average expected life of the stock options and the expected price volatility of our common stock. The riskfree interest rate is based on U.S. Treasury securities with a term equal to the expected life of the stock options. The dividend yield is based on our expected dividend payout level. The expected life is based on historical experience adjusted for changes in terms and the amount of awards granted. The expected volatility, which is the assumption where the most judgment is used, is based on historical volatility, adjusted to reflect factors such as significant changes that have occurred in our company that lead to a different expectation of future volatility. Using this model, the grant date fair value of options awarded in 2002 was $10.39 per share. The assumptions used in determining the fair value of these options included a risk-free interest rate of 4.65 percent, a dividend yield of 2.53 percent, a weighted average expected life of 6.0 years and a volatility of 29 percent. Each increase or decrease of one percent in the expected volatility assumption would change the fair value of an option by approximately 28 cents, or 2.7 percent. Additional information related to stock options is presented in Note 1 and Note 12 to Notes to Consolidated Financial Statements.
Financial Executives Research Foundation, Inc.
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Depreciation and Amortization We selected Sprint Corporation because it operates in an industry – telecommunications – where the useful lives of long-lived tangible assets are subject to varied judgment. In its disclosures, the company describes an elaborate process to estimate useful lives. SPRINT CORPORATION Long-lived Asset Recovery – A significant portion of Sprint's total assets consist of long-lived assets, consisting primarily of property, plant and equipment ("PP&E") and definite life intangibles, as well as goodwill and indefinite life intangibles. Changes in technology or in Sprint's intended use of these assets, as well as changes in broad economic or industry factors, may cause the estimated period of use or the value of these assets to change. . . . Sprint performs annual internal studies to confirm the appropriateness of depreciable lives for each category of PP&E. These studies utilize models, which take into account actual usage, physical wear and tear, replacement history, and assumptions about technology evolution, and use in certain instances actuarially-determined probabilities to calculate remaining life of our asset base. Sprint believes that the accounting estimate related to the establishment of asset depreciable lives is a "critical accounting estimate" because: (1) it requires Company management to make assumptions about technology evolution and competitive uses of assets, and (2) the impact of changes in these assumptions could be material to our financial position, as well as our results of operations. Management's assumptions about technology and its future development require significant judgment because the timing and impacts of technology advances are difficult to predict, and actual experience has varied from previous assumptions and could continue to do so. If Sprint's studies had resulted in a depreciable rate that was 5% higher or lower than those used in the preparation of Sprint's consolidated financial statements, recorded depreciation expense would have been impacted by approximately $260 million. The impact to FON Group depreciation expense would be approximately $140 million and the impact to PCS Group depreciation expense would be approximately $120 million.
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Financial Executives Research Foundation, Inc.
X X
X
X X
X X X X X
X
X X
Other
Depreciation & Amortization
Stock Compensation
Warranty Costs
Derivatives & Securitizations
Insurance X
X
X X X
X
X X X
X
X
X
Inventory
X X X
X
Investments
X
X
X
X X X
X
Deferred Income Taxes
X X
Bad Debt Reserves
X X
Tangibles Impairment
X X
Contingencies
Revenue Recognition
Fortune 100* Abbott Labs. Aetna AIG Albertson’s Alcoa Allstate Altria American Express AmeriSource Berg. AOL Time Warner Archer Daniels Mid. AT&T AutoNation Bank of America Bank One
Goodwill ImpairmentT
Company Name
Postemployment
Table: Summary of Disclosures in Sample
X X X X X X
X X X
X X X X
X X
X 3
X
X X
X X
1 2
4 X X
X
The following Fortune 100 companies were not required by the SEC to report critical accounting policies. For this reason, they were excluded from the study: Freddie Mac, New York Life, Mass. Mutual Life Insurance, State Farm Mutual, TIAA-CREF. 1 Marketing and Advertising Costs, Leasing 2 Membership Rewards Costs, Deferred Acquisition Costs 3 Merger Accounting, Accounting for Advances 4 Finance and Lease Underwriting *
Financial Executives Research Foundation, Inc.
47
X X
X X X X
X
X X X
X
X X
X X
X
X
X X X
X X X
X X
X X X X
X X X
Other
Depreciation & Amortization
Stock Compensation
X X X
X
5 6 7
X X X X X X X
X X X X
X X X
X X X
X X X X
X X
X
Acquired Research and Development, Restructuring Special Charges 7 Unusual Charge Reserve 8 Argentina 9 Other Assets 10 Marketing Costs 11 Oil and Gas Accounting, Business Acquisition/Purchase Price Allocation 12 Closed Store Lease Liability 6
Financial Executives Research Foundation, Inc.
8 9 10 11
X 12 X
5
48
Warranty Costs
X X
X X X
Derivatives & Securitizations
X
Insurance
X
Inventory
X
X
Investments
Deferred Income Taxes
X
Bad Debt Reserves
X
Contingencies
Revenue Recognition
Goodwill ImpairmentT
X
Tangibles Impairment
BellSouth Berkshire Hathaway Best Buy Boeing Bristol-Myers Squibb Cardinal Health Caterpillar ChevronTexaco Cigna Cisco Systems Citigroup Coca-Cola ConAgra Foods ConocoPhillips Costco Wholesale CVS Dell Computer
Postemployment
Company Name
Delphi Dow Chemical DuPont Electronic Data Sys. Exxon Mobil Fannie Mae FedEx Ford Motor General Electric General Motors Georgia-Pacific Goldman Sachs HCA Hewlett-Packard Home Depot Honeywell Intl. IBM Ingram Micro Intel International Paper
X X X X X
X
X
X X X X
X X X
X X X
X
X X X
X
X
X X X
X X X X X
X
X 14 15
X
X X
Other
Depreciation & Amortization
Stock Compensation
13
X
X X
Warranty Costs X
X X X X X X
Derivatives & Securitizations
Insurance
Inventory
Investments
Deferred Income Taxes
Bad Debt Reserves
Tangibles Impairment
Contingencies
Revenue Recognition
Goodwill ImpairmentT
Postemployment
Company Name
X X X X
X X
X
X X
X
16
X X X X X X X
X
X X
X
X
X
X X X
X
X
X X X
X X X
X X
X 17
X
X X X
X
X X X
X
X
Merger-Related Expenses and Restructuring Foreign Currency Translation, Oil and Gas Reserves 15 Deferred Price Adjustments 16 Sales Allowances, Mortgaging Servicing Rights 17 Sales Recognition on Long-Term Contracts, Aerospace Customer Incentives 13 14
Financial Executives Research Foundation, Inc.
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X
X
X X
X X X X X
X
X
X X X X X
X X X
X X
X
X X X
X X
X
X X
X X
X
X
X X
X
Other
Depreciation & Amortization
Stock Compensation
Warranty Costs
Derivatives & Securitizations
Insurance
Inventory X
X
X X X X
Investments
Deferred Income Taxes
X
Bad Debt Reserves
X
Tangibles Impairment
Revenue Recognition
X
Contingencies
Goodwill ImpairmentT
J.C. Penney J.P. Morgan Chase Johnson & Johnson Johnson Controls Kmart Kroger Lockheed Martin Lowe’s Marathon Oil McKesson Merck Merrill Lynch MetLife Microsoft Morgan Stanley Motorola Northrop Grumman
Postemployment
Company Name
X
18 X
X X
X X
X X X
X
19 20
X X X
X X X
X X
X
X X X X X
21
X
X X
22 23
X
24
X
Mortgage Servicing Rights and Certain Other Retained Interests Restructuring Charges 20 Store Closing Costs, Purchase Commitments 21 Estimated Net Recoverable Quantities of Oil and Gas, Expected Future Cash Flows Generated by Certain Oil and Gas Producing Properties, Net Realizable Value of Receivables from United States Steel 22 Use of Estimates 23 Research and Development Costs 24 Restructuring Activities 18 19
50
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X X X X X X X X X X X
X X X X X
X X
X
Other
Depreciation & Amortization
Stock Compensation
Warranty Costs
X
25 26 27 28
X X
X X X X
X X X X
X X
X
X
X X
X
X
X X X
X X X X
X
X
X X X X
X X
X X
X X
29 30
X
X X X
X X
X
X X
Derivatives & Securitizations
X X X
X X
Insurance
Inventory
Investments
Deferred Income Taxes
X X X
Bad Debt Reserves
X
Tangibles Impairment
Revenue Recognition
X X X
Contingencies
Goodwill ImpairmentT
PepsiCo Pfizer Procter & Gamble Prudential Fin. Safeway SBC Comm. Sears Roebuck Sprint Supervalu Sysco Target Tyson Foods United Parcel Serv. United Tech. UnitedHealth Grp. Valero Energy Verizon Comm.
Postemployment
Company Name
X
31 32 33
X
Sales Incentives, Research and Development Expenses Restructuring 27 Discontinued Operations 28 Store Closures 29 Allocation Policies between Tracking Stocks 30 Reserves for Closed Properties [and Asset Impairments], Accounting for Business Combinations 31 Contracting with the U.S. Government 32 Inflation 33 Refinery Turnaround Costs 25 26
Financial Executives Research Foundation, Inc.
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Randomly Selected Affiliated Managers Albany Intl. Aquila Banknorth Grp. BKF Capital Grp.
X
X X X
X X X
X X X
X X X
X
X X
X X
X
X X X X
X
X X
X X
X X
35 X
X
36 37 38 39
X
40
X
X X
X
41
X
42
X X
Accounting for the Production and Distribution of Motion Pictures and Television Programming Liability for Closed Locations 36 Film and Television Revenues and Costs 37 Mortgage Servicing Rights, Rate Lock Commitments 38 Mortgage Servicing Rights Valuation 39 Depletion 40 Headquarters Lease, Earnings per Share 41 Regulatory Accounting Implications 42 Purchase Price Allocation 34 35
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Other
X X X
X
Depreciation & Amortization
34 X
X X X
Stock Compensation
X X X X
X
Warranty Costs
Derivatives & Securitizations
Insurance
Inventory
Investments
Deferred Income Taxes
X
Bad Debt Reserves
X X
Tangibles Impairment
Revenue Recognition
X X X
Contingencies
Goodwill ImpairmentT
Viacom Visteon Wachovia Walgreen Wal-Mart Stores Walt Disney Washington Mutual Wells Fargo Weyerhaeuser
Postemployment
Company Name
Financial Executives Research Foundation, Inc.
X X
X
X
X X
X
X
X X
X X X
X X X X X
X X X
X
X
X X
X
Other
Depreciation & Amortization
X 44 X 45 46
X X X X
47
X X
X
Stock Compensation
43
X X X X
Warranty Costs
Derivatives & Securitizations
X
X X X
Insurance
X
Inventory
X
Investments
Deferred Income Taxes
X
Tangibles Impairment
X X X
Contingencies
Revenue Recognition
X
Bad Debt Reserves
X X
Goodwill ImpairmentT
Centerpoint Energy Circor Intl. Constellatn. Energy Dial Dynegy EastGroup Prop. El Paso Energy East Federal Realty I.T. FleetBoston Fin. Gardner Denver Glenborough R.T. Grey Global Group Health Care Prop. Hollinger Intl. Intl. Flavors & Frag. Jones Lang LaSalle
Postemployment
Company Name
X 48
X X X X
X X
X X
X X
X X
X
X
X
X
49
X X
X
Accounting for Rate Regulation Sales Incentives 45 Real Estate Properties (Capitalization of Costs) 46 Accounting for Natural Gas and Oil Producing Activities 47 Interest Costs on Development and Redevelopment 48 Our Status as a Real Estate Investment Trust (REIT), Capitalization of Real Estate Costs 49 Discontinued Operations 43 44
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Kirby Landry’s Restaurants LaSalle Hotel Prop. Lone Star Tech. Lucent Technologies Manitowoc Co. Marriott Intl. Municipal Mortgage NACCO Industries NATCO Group NS Group Oakley Orthodontic Centers Owens & Minor Park Place Entert. Phelps Dodge Potlatch
X
X X
X X X X X X X X X
X X
X X X X X X X X X X
X X X
X X X X
X X X
X X
X X X
X
X
X
X X X X X X
Other 50
X X X X X X X X
Depreciation & Amortization
Stock Compensation
Warranty Costs
Derivatives & Securitizations
Insurance
Inventory
Investments
Deferred Income Taxes
Bad Debt Reserves
Tangibles Impairment
Contingencies
Revenue Recognition
Goodwill ImpairmentT
Postemployment
Company Name
X
X X X
X X
51 X X X
X
X
52 53 54
X X
X
55
X X X X
X X X
X
X
56 57
Property, Maintenance and Repairs Business Restructuring 52 Cost Reimbursements, Costs Incurred to Sell Real Estate Projects, Marriott Rewards 53 Mortgage Servicing Rights 54 Closed-Mine Obligations 55 Foreign Currency Translation 56 Estimates Ore Reserves at Active Properties and Properties Currently on Care-and-Maintenance Status, Capitalizes Applicable Costs for Copper Contained in Mill and Leach Stockpiles 57 Restructuring and Other Charges 50 51
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Financial Executives Research Foundation, Inc.
X
X X
X X X
X X
X
X
X X
X
X
X
X
Other
Depreciation & Amortization
Stock Compensation
X 58
X X X
Warranty Costs
X
Derivatives & Securitizations
X X
Insurance
Inventory
Deferred Income Taxes X X
X X
X X
Bad Debt Reserves X
Investments
X X
Tangibles Impairment
X
Contingencies
X X
Revenue Recognition
Goodwill ImpairmentT
Protective Life Quaker Chemical Range Resources RehabCare Group Royal Appliance Ryder System TCF Financial TXU Union Pacific Weis Markets Yum! Brands
Postemployment
Company Name
X X
X X
X X X
59 60
X X
X
X
X X
61
Restructuring Liabilities Mortgage Servicing Rights; Company also reports “Other Significant Accounting Policies.” 60 Regulatory Assets and Liabilities 61 Vendor Allowances 58 59
Financial Executives Research Foundation, Inc.
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Conclusion Since the SEC first issued its “Cautionary Advice” about critical accounting policies two years ago, companies have gained considerable sophistication in their disclosures, over a very short period of time. Companies now report governance procedures overseeing critical accounting policies, sensitivity analysis, historical information about previous changes in estimates, segment and geographic activities, and other useful information to investors. Many of these disclosures have come to resemble textbook explanations, in plain English, that will help financial statement users to understand sophisticated accounting treatments of often-complex transactions.
Finding Critical Accounting Policies on the World Wide Web At the website http://www.sec.gov/edgar/searchedgar/companysearch.html, type the name of the company, click “find company,” and then select the most recent Form 10-K (displayed in html). Critical accounting policies are provided either on the 10-K itself, or incorporated by reference to the corporate financial reports. In the 10-K or financial reports, perform a search for the terms “critical accounting” and “significant accounting” (in Internet Explorer, choose “Edit” and “Find” in the menu).
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About the Author Mark P. Holtzman, PhD, CPA Dr. Holtzman is Assistant Professor of Accounting at the Stillman School of Business, Seton Hall University, South Orange, NJ. After he received a Bachelor in Business Administration at Hofstra, he began his career in the New York office of Deloitte & Touche. He later earned a PhD in accounting at The University of Texas at Austin. Dr. Holtzman currently has publications forthcoming in The CPA Journal, Research in Accounting Regulation, Strategic Finance, and The Accounting Historian’s Journal. He can be reached at
[email protected] .
Financial Executives Research Foundation, Inc. Copyright © 2003 by Financial Executives Research Foundation, Inc. All rights reserved. No part of this publication may be reproduced in any form or by any means without written permission from the publisher. International Standard Book Number 1-885065-58-2 Printed in the United States of America First Printing Financial Executives Research Foundation, Inc. is the research affiliate of Financial Executives International. The purpose of the Foundation is to sponsor research and publish informative material in the field of business management, with particular emphasis on the practice of financial management and its evolving role in the management of business. The mission of the Research Foundation is to identify and develop timely, topical research to advance the financial management profession. The Foundation’s work is educational rather than editorial. The Foundation is an independent 501(c)(3) educational organization. The Foundation receives no portion of FEI Members dues; rather, it relies on voluntary tax-deductible contributions from corporations and individuals. The views set forth in this publication are those of the author and do not necessarily represent those of the Financial Executives Research Foundation Board as a whole, individual trustees, or the members of the Advisory Committee. This and more than 50 other Research Foundation publications can be ordered by logging onto www.fei.org/rf. Discounts available to FEI members and Foundation donors.
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FERF President’s Circle Abbott Laboratories Alcoa Inc. American International Group, Inc. AOL Time Warner Inc. AT&T Corp. Baxter International Inc. Bristol-Myers Squibb Company CitigroupInc. Corning Incorporated CVS Corporation Daimler Chrysler Corporation Dell Computer Corporation The Dow Chemical Company Duke Energy Corporation E. I. du Pont de Nemours and Company Exxon Mobil Corporation General Electric Company General Motors Corporation Hewlett-Packard Company Johnson & Johnson Eli Lilly and Company Lockheed Martin Corporation Marsh & McLennan Companies, Inc. Microsoft Corporation J.P. Morgan Chase & Co. Motorola, Inc. Pfizer Inc. The Procter & Gamble Company David M. Taggart Tenneco Automotive Inc. United Technologies Corporation Verizon Communications, Inc. Wyeth
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Releases from Financial Executives Research Foundation… • • • • • • • • • • • • • • • • • • •
What is COSO? Defining the Alliance that Defined Internal Control 2003 Protecting Value Study: Managing Business Risks Integrity-Based Financial Leadership and Ethical Behavior Valuing Employee Stock Options: A Comparison of Alternative Models Best Practices for Sarbanes-Oxley Implementation Benchmarking the Planning Process—World Class Companies vs. Average Companies Audit Committee Charter—For Privately-Held Companies 2002 Year-End Tax Planning Strategies Year End Issues Update for Benefit Plan Sponsors Sarbanes-Oxley Act of 2002—A Financial Executive Checklist NASDAQ Corporate Governance Proposals—A Financial Executive Checklist NYSE Corporate Governance Proposals—A Financial Executive Checklist Corporate Reporting and the Internet—Understanding-and Using-XBRL Information Security—Keeping Data Safe Commercial Insurance—Strategies for Renewal Self-Directed Brokerage Accounts in 401(k) Plans Business Performance Intelligence Software—A Market Evaluation Promoting Ethical Conduct—A Review of Corporate Practice MD&A Trends and Techniques—How Leading Companies Promote Transparency
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