An Analysis of Critical Accounting Policies Carolyn Levine Tepper School of Business Carnegie Mellon University Michael Smith Boston University

Financials require estimates and forecasts To improve the transparency of financial disclosure, Commission proposes [Critical Accounting Policy] disclosure requirements . The disclosure of critical accounting policies will “wean the investment community off the notion there's a single, magic number.” SEC Chairman Pitt, April 30, 2000 SOX CEO and CFO certification. Lowers the bar for legal liability. “They make you sign documents that basically say every transaction made by everybody in your company is 100% honest. If it isn't, you go to jail for the rest of your life” [Donald Trump]

What was proposed? Amended MD&A requirements If accounting estimate requires assumptions about matters that are highly uncertain and different (reasonable) estimates or changes will have a material impact then policy is CRITICAL Where/how CAPs affect results. Methodology, assumptions and sensitivity. Whether senior management has discussed the development, selection and disclosure of those estimates with the company's audit committee.

Questions we answer Do firms comply with proposal? Which policies are classified as critical? Consistent with financial statement information? Do they provide sensitivity and discussion? Does critical = lower accounting quality? Are disclosures informative? Consistent with voluntary disclosure models? Incrementally informative?

Data Extract Critical Accounting Policy section from 10-K text filing. Lose firms without readable electronic filings. Firms without a critical section (i) exclude and/or (ii) include and set all to zero. Code for different policies. Read to find patterns and keywords. Code keywords and assign 1 if text match, 0 otherwise Check accuracy for subset of firms.

A typical disclosure There are numerous critical assumptions that may influence accounting estimates... We base our critical assumptions on historical experience, third-party data and various other estimates we believe to be reasonable. Asset Impairment Determinations Intended use of assets and expected future cash flows Industry specific trends and economic conditions Customer preferences and behavior patterns Impact of regulatory initiatives Judgments and estimates of uncertainties are required in applying the Company's accounting policies in certain areas. Following are some of the areas requiring significant judgments and estimates: determination of an asset's useful life, estimates of allowances for bad debts, cash flow and valuation assumptions in performing asset impairment tests of long-lived assets…

Numbers, Size, and Frequencies Number of Critical Accounting Policies 1-2 3-4 5-6 7-8 9-10 11+ r % Firms 0.08 0.18 0.25 0.16 -- ln(Assets) 5.11 5.13 5.46 5.68 6.07 6.45 0.20 Price/Earnings 5.18 4.34 9.15 10.76 12.15 12.96 0.07 Business Segments 1.64 1.85 2.03 2.18 2.36 2.61 Geographic Segments 1.38 1.78 2.17 2.51 2.86 3.25 0.26 Analyst Following 1.81 1.95 2.75 3.44 4.16 5.01 0.17 Institutional Holding 0.47 0.53 0.63 0.67 0.72 0.76 0.23 Accounts Receivable 50.80% Intangible Assets 53.85% Taxes 55.13% Revenue Recognition 55.23% Asset Impairment 58.07% Contingencies 65.91% Marketable Securities 67.10%

Other Aspects of CAP regulation Disclosure about sensitivity 14% discuss sensitivity. Sensitivity discussions are still fairly broad. “All such valuation methodologies… involve significant judgments and estimates. Different assumptions and subsequent actual events could yield materially different results.” Discussion with audit committee Less than 10% of firms mention whether CAPs have been discussed with the audit committee. If they disclose, use the same language as examples provided in the proposed rule.

Consistent with existing information Consistent with existing information? Means and variances higher for disclosers

Percentiles of 3 year means EXCERPTED FROM TABLE 4, PANEL B

Unexpected disclosures CURRENT MEAN and VARIANCE HIGH LOW IF EVERYTHING WERE TO STAY THE SAME CRITICAL DISCLOSURE NO CRITICAL DISCLOSURE IF DISCLOSURES REVEAL INFO ABOUT FUTURE NOT DISCLOSED  FUTURE MEAN or VARIANCE LOWER THAN IF DISCLOSED IF DISCLOSED  FUTURE MEAN or VARIANCE HIGHER THAN IF NOT DISCLOSED

CAPs and future balances

Other firm characteristics Reasons for voluntary disclosure Litigation costs and external financing

Total surprises matter CURRENT MEAN and VARIANCE OF BOTH HIGH LOW EXPECT 2 CRITICAL DISCLOSURES NO CRITICAL DISCLOSURES IF COVARIANCE IS FEWER CRITICAL DISCLOSURES MORE CRITICAL DISCLOSURES In logistic regression (1=either disclosed, 0=neither disclosed), coefficient on covariance is negative and significant. Control variables are historical and future means and variances as well as other voluntary disclosure drivers.

Two tests of incremental informativeness Valuation Multiples: Pre vs. Post Regulation Coefficient on earnings should go up (down) after the period if fewer than expected (more than expected) CAPs allow investors to differentiate between firms where they couldn't before. Event study On the 10-K filing date, is there a “reversal” of the reaction to the initial earnings announcement for higher than expected CAP firms (lower reliability)?

Summarizing CAPs confirm existing (historical) financial statement information. When unexpected, relates to future financial statement balances. Firms seem to make overall disclosure choices; not solely account by account. Lower (higher) weight on earnings for firms with many (few) critical policies is post disclosure period than in pre-disclosure period. Reversal (exacerbation) of the earnings announcement reaction on the 10K filing date for more than (fewer than) expected disclosures.