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vided to audit committees. Examples of additional written communications that we
expect will be considered material to an issuer include:
• Management representation letter;
• Reports on observations and recommendations on internal controls;
• Schedule of unadjusted audit differences, and a listing of adjustments and re-
classifications not recorded, if any;
Accounting Policy Disclosures 307

• Engagement letter, and
• Independence letter.
These examples are not exhaustive, and accountants are encouraged to critically
consider what additional written communications should be provided to audit
The Securities and Exchange Commission amended Regulation S-X in this way:

[E]ach public accounting firm registered with the Board that audits an issuer™s fi-
nancial statements must report to the issuer™s audit committee (1) all critical ac-
counting policies and practices used by the issuer, (2) all material alternative
accounting treatments within GAAP that have been discussed with management, in-
cluding the ramifications of the use of the alternative treatments and the treatment
preferred by the accounting firm, (3) other material written communications be-
tween the accounting firm and management of the issuer such as any management
letter or schedule of “unadjusted differences,” and (4) in the case of registered in-
vestment companies, all non-audit services provided to entities in the investment
company complex that were not pre-approved by the investment company™s audit
committee. The required reports need not be in writing, but must be provided to the
audit committee before the auditor™s report on the financial statements is filed with
the Commission.14

Exhibit 10.3 presents Wal-Mart™s summary of critical accounting policies.

Accounting Changes
Of particular importance to the audit committee are the changes in accounting dur-
ing the fiscal period. According to the Accounting Principles Board:

A change in accounting by a reporting entity may significantly affect the presenta-
tion of both financial position and results of operations for an accounting period and
the trends shown in comparative financial statements and historical summaries. The
change should therefore be reported in a manner which will facilitate analysis and
understanding of the financial statements.15

In order to familiarize the committee with the accounting changes, the types of
changes are briefly set forth at this point.

A change in accounting principle results
Change in Accounting Principle
from the adoption of a generally accepted accounting principle different from the
one used previously for reporting purposes. For example, a change in the method
of inventory pricing is a common change in accounting principles. Although there

Securities and Exchange Commission, Release No. 33-8183, “Strengthening the Commission™s Re-
quirements Regarding Auditor Independence,” January 28, 2003, www.sec.gov/rules/final/33-
8183.htm, pp. 33“38.
Ibid., p. 45.
Opinions of the Accounting Principles Board No. 20, “Accounting Changes” (New York: AICPA,
1971), para. 1.
308 Reviewing Accounting Policy Disclosures

Exhibit 10.3 Critical Accounting Policies at Wal-Mart Stores, Inc.

Summary of Critical Accounting Policies
Management strives to report the financial results of the Company in a clear and under-
standable manner, even though in some cases accounting and disclosure rules are complex
and require us to use technical terminology. We follow generally accepted accounting
principles in the U.S. in preparing our consolidated financial statements. These principles
require us to make certain estimates and apply judgments that affect our financial position
and results of operations. Management continually reviews its accounting policies, how
they are applied and how they are reported and disclosed in our financial statements. Fol-
lowing is a summary of our more significant accounting policies and how they are applied
in preparation of the financial statements.

We use the retail last-in, first-out (LIFO) inventory accounting method for the Wal-Mart
Stores segment, cost LIFO for the SAM™S CLUB segment and other cost methods, in-
cluding the retail first-in, first-out (FIFO) and average cost methods, for the International
segment. Inventories are not recorded in excess of market value. Historically, we have
rarely experienced significant occurrences of obsolescence or slow moving inventory.
However, future changes in circumstances, such as changes in customer merchandise pref-
erence or unseasonable weather patterns, could cause the Company™s inventory to be ex-
posed to obsolescence or be slow moving.

Financial Instruments
We use derivative financial instruments for purposes other than trading to reduce our ex-
posure to fluctuations in foreign currencies and to minimize the risk and cost associated
with financial and global operating activities. Generally, the contract terms of hedge in-
struments closely mirror those of the item being hedged, providing a high degree of risk
reduction and correlation. Contracts that are highly effective at meeting the risk reduction
and correlation criteria are recorded using hedge accounting. On February 1, 2001, we
adopted Financial Accounting Standards Board (FASB) Statements No. 133, 137 and 138
(collectively “FAS 133”) pertaining to the accounting for derivatives and hedging activi-
ties. FAS 133 requires all derivatives, which are financial instruments used by the Com-
pany to protect (hedge) itself from certain risks, to be recorded on the balance sheet at fair
value and establishes accounting treatment for hedges. If a derivative instrument is a
hedge, depending on the nature of the hedge, changes in the fair value of the instrument
will either be offset against the change in fair value of the hedged assets, liabilities, or firm
commitment through earnings or recognized in other comprehensive income until the
hedged item is recognized in earnings. The ineffective portion of an instrument™s change
in fair value will be immediately recognized in earnings. Most of the Company™s interest
rate hedges qualify for the use of the “short-cut” method of accounting to assess hedge ef-
fectiveness. The Company uses the hypothetical derivative method to assess the effective-
ness of certain of its net investment and cash flow hedges. Instruments that do not meet the
criteria for hedge accounting or contracts for which we have not elected hedge accounting
are marked to fair value with unrealized gains or losses reported currently in earnings. Fair
values are based upon management™s expectation of future interest rate curves and may
change based upon changes in those expectations.
Impairment of Assets
We periodically evaluate long-lived assets other than goodwill for indicators of impairment
and test goodwill for impairment annually. Management™s judgments regarding the exis-
Accounting Policy Disclosures 309

tence of impairment indicators are based on market conditions and operational perfor-
mance. Future events could cause management to conclude that impairment indicators
exist and that the value of long-lived assets and goodwill associated with acquired busi-
nesses is impaired. Goodwill is evaluated for impairment annually under the provisions of
FAS 142 which requires us to make judgments relating to future cash flows and growth
rates as well as economic and market conditions.
Revenue Recognition
We recognize sales revenue at the time a sale is made to the customer, except for the fol-
lowing types of transactions. Layaway transactions are recognized when the customer sat-
isfies all payment obligations and takes possession of the merchandise. We recognize
SAM™S CLUB membership fee revenue over the 12-month term of the membership. Cus-
tomer purchases of Wal-Mart/SAM™S CLUB shopping cards are not recognized until the
card is redeemed and the customer purchases merchandise using the shopping card. De-
fective merchandise returned by customers is either returned to the supplier or is destroyed
and reimbursement is sought from the supplier.
We use a combination of insurance, self-insured retention, and/or self-insurance for a
number of risks including workers™ compensation, general liability, vehicle liability and
employee-related health care benefits, a portion of which is paid by the Associates. Lia-
bilities associated with the risks that we retain are estimated in part by considering histor-
ical claims experience, demographic factors, severity factors and other actuarial
assumptions. The estimated accruals for these liabilities could be significantly affected if
future occurrences and claims differ from these assumptions and historical trends.
For a complete listing of our accounting policies, please see Note 1 to our consolidated fi-
nancial statements that appear after this discussion.

Source: Wal-Mart Stores, Inc., 2003 Annual Report, pp. 22“23.

is a presumption that an accounting principle, once adopted, should not be
changed, management may overcome this presumption if it justifies the use of an
alternative acceptable accounting principle. For example, management may justify
the change in accounting principle on the basis of the issuance of a new FASB ac-
counting standard. Moreover, management may justify the change on the basis
that such a change in accounting method enhances the fairness in the presentation
of the financial statements.
With respect to the disclosure of a change in accounting principle, the Board

The nature of and justification for a change in accounting principle and its effect on
income should be disclosed in the financial statements of the period in which the
change is made. The justification for the change should explain clearly why the
newly adopted accounting principle is preferable.16

Ibid., par. 17. Additional reporting matters should be discussed with the chief financial officer and/or
the external auditor.
310 Reviewing Accounting Policy Disclosures

Exhibit 10.4 Illustrative Accounting Changes

Accounting Changes
Statement of Financial Accounting Standards No. 106, “Employers™ Accounting for
Postretirement Benefits Other Than Pensions,” and No. 109, “Accounting for Income
Taxes,” were implemented in the fourth quarter of 1992, effective as of January 1, 1992.
The cumulative effect of these accounting changes on years prior to 1992, as shown
below, has been reflected in the first quarter of 1992.
(millions of dollars)
SFAS No. 106 (net of $408 million income tax effect) $(800)
SFAS No. 109 760
Net charge $(40)
The cumulative effect per share was $(0.64) and $0.61 for SFAS No. 106 and No. 109,
respectively, resulting in a net change of $(0.03).
Neither standard had a material effect on 1992 income before the cumulative effect of
the accounting changes.

Source: Exxon Corporation, 1992 Annual Report, p. F12.

An example of a change in accounting principle is disclosed in the 1992 annual
report of Exxon Corporation, presented in Exhibit 10.4.

Certain accounting actions are based on
Change in Accounting Estimate
management™s judgment regarding the use of estimates. Accounting estimates are
required because of the matching principle of accounting that revenues and their
related costs must be properly matched in the same accounting period to determine
a fair measurement of the net income or loss of the entity. Thus as management ac-
quires additional information and more experience concerning such matters as the
economic life of plant and equipment assets and probable uncollectible receiv-
ables, a change in accounting estimate may occur.
Concerning the disclosure of changes in accounting estimates, Ford Motor
Company reported:

Depreciation and Amortization”Automotive. Depreciation is computed using an
accelerated method that results in accumulated depreciation of approximately two-
thirds of asset cost during the first half of the asset™s estimated useful life. On aver-
age, buildings and land improvements are depreciated based on a 30-year life;
automotive machinery and equipment are depreciated based on a 141„2-year life.
It is the company™s policy to review periodically fixed asset lives. A study completed
during 1990 indicated that actual lives for certain asset categories generally were
longer than the useful lives used for depreciation purposes in the company™s finan-
cial statements. Therefore, during the third quarter of 1990, the company revised the
Accounting Policy Disclosures 311

estimated useful lives of certain categories of property, retroactive to January 1,
1990. The effect of this change in estimate was to reduce 1990 depreciation expense
by $211 million and increase 1990 net income, principally in the U.S., by $135 mil-
lion or $0.29 per share.
When plant and equipment are retired, the general policy is to charge the cost of such
assets, reduced by net salvage proceeds, to accumulated depreciation. All mainte-
nance, repairs and rearrangement expenses are expensed as incurred. Expenditures
that increase the value or productive capacity of assets are capitalized. The cost of
special tools is amortized over periods of time representing the productive use of
such tools. Preproduction costs incurred in connection with new facilities are ex-
pensed as incurred.17

Change in the Reporting Entity This particular change occurs when the reporting
entity changes its reporting as a result of a change in its composition, such as a merger. As
the Board points out:

One special type of change in accounting principle results in financial statements
which, in effect, are those of a different reporting entity. This type is limited mainly
to (a) presenting consolidated or combined statements in place of statements of indi-
vidual companies, (b) changing specific subsidiaries comprising the group of compa-
nies for which consolidated financial statements are presented, and (c) changing the
companies included in combined financial statements. A different group of companies
comprise the reporting entity after each change. A business combination accounted
for by the pooling of interests method also results in a different reporting entity.18

For example, Bristol-Myers Squibb reported:

Business Combination
On October 4, 1989, Squibb Corporation merged with a subsidiary of Bristol-Myers
Company, and Bristol-Myers Company changed its name to Bristol-Myers Squibb
Company. As a result, 97.4 million shares of Squibb common stock became entitled
to be exchanged at a ratio of one share of Squibb for 2.4 Bristol-Myers Squibb
shares, and 9.8 million shares of Squibb common stock owned by Squibb as treasury
stock were retired. The merger has been accounted for as a pooling-of-interests.
In connection with the merger, a charge of $740 million was recorded in the fourth
quarter of 1989 to integrate the operations of Bristol-Myers and Squibb and to orga-
nize its businesses on a global basis. The fourth quarter of 1989 also included an ad-
ditional $115 million charge for the costs of professional fees and other expenses
related to the merger. The after-tax effect of both charges was $693 million, or $1.32
per share.19

Thus it is apparent that management has “choices among accounting principles
or procedures” and that such choices affect “the major areas in the financial state-


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