Trends in Preferability Letters

Last week we discussed FedEx’s change to their pensions accounting policy and how many companies have made similar changes. In this post, we will look at trends in accounting policies overall.

First, some background: Generally accepted accounting principles (GAAP) sometimes offer a couple options. In inventory accounting, for example, there are the options of FIFO, LIFO, and Average Cost. Once a method is settled on, however, there is a presumption that the entity will continue to use the same method going forward. Changes are only allowed if there is a compelling reason to do so.

Although not very common, such changes to accounting policy do occur. For the sake of transparency, companies have to provide certain disclosures about the change. In particular, companies that change an accounting policy must disclose why they think the new policy is preferable to the former.

The major rules governing these disclosures come from FASB and the SEC. ASC 250-10-45-3 states that a company should only change a principle if they “can justify the use of an allowable alternative accounting principle on the basis that it is preferable.” Prior periods presented in the financial statements must be restated as if the new policy had been previously in effect.

SEC Rule 10-01(b)(6) of Regulation S-X requires registrants to obtain a preferability letter from their independent auditor. In these letters, the auditor states whether, in their judgment, the new policy is preferable.

In the table below, we show the five most common accounting policies addressed in these preferability letters over the past five years.
Goodwill Impairment Measurement Date

Between 2010 and 2014, 173 Preferability Letters disclosed a change in the goodwill impairment measurement date. Nearly 44% of all letters over that period relate to this specific issue.

Interestingly, most companies who changed their goodwill impairment measurement date, changed it away from the last day of the fourth quarter. On one hand, the end of the fiscal period is an eminently reasonable time to assess the value of goodwill. That is, after all, the “as of” date on the balance sheet. On the other hand, the period end close process is already complicated and hectic enough, and moving the impairment test to another time might help alleviate some of the stress.

While this issue has been by far the most common over the past five years, we expect it to decrease significantly in 2015 and beyond. At the AICPA conference last fall, the SEC indicated that it would relax its view on obtaining a preferability letter for changes to the impairment measurement date.

Inventory Valuation

58 Preferability Letters referenced a change in inventory valuation over the past five years. The majority of these Preferability Letters disclosed companies changing away from the Last-in-first-out (LIFO) inventory accounting method. Thirteen of those companies switched to the average cost method and twenty switched the first-in-first-out (FIFO) method. 

US public companies have been steadily abandoning the LIFO valuation method. Alhough the method is still allowed under GAAP, it appears not to be a “best practice”.

Benefits Program

During the period under review, there were 53 Preferability Letters disclosing a change in benefits programs. 51 of these letters referenced a change in the method of accounting for pensions; and of these 51, all discussed a change from the amortize-the-excess of the corridor method to the mark-to-market method.

As we discussed last week, there is a clear trend in the accounting for benefits programs. Companies are switching to the mark-to-market method en masse. As AT&T noted, adopting the mark-to-market method allowed them to “improve transparency in our operating results by more quickly recognizing the effects of economic and interest rate conditions on plan obligations, investments and assumptions.”

It’s important to understand the accounting principles of public companies. Without knowing the differences between various accounting policies and methods, it would be very difficult to accurately compare financial statements between different companies and industries. Further, it is also important to know when a company is using a less common, or even a non-standard, accounting method.