SEC Emphasizes MD&A Disclosures, Proposes Rule for MD&A Disclosure of Critical Accounting Policies

05/20/2002

To Our Public Company Clients:

Partly in response to the recent Enron crisis and related media publicity, the Securities and Exchange Commission has announced its views regarding disclosure that should be considered by companies in the Management’s Discussion and Analysis (“MD&A”) section of Form 10-K, Form 10-Q, and registration statements filed with the SEC.  The Commission issued a statement on January 22, 2002 (the “Statement”) emphasizing the need for companies to improve the “quality of information” in MD&A concerning liquidity and capital resources, including off-balance sheet arrangements, trading activities involving non-exchange traded contracts, and the effects of transactions with affiliates.

More recently, the Commission on May 10, 2002 announced a proposed MD&A disclosure rule requiring qualitative and quantitative disclosures about a company’s critical accounting policies and accounting estimates.  The SEC is proposing required MD&A disclosure by companies of their critical accounting policies, accounting estimates made by the company in applying these policies, and the likelihood of a material change in the company’s financial statements under different conditions or using different assumptions to arrive at these accounting estimates.

The Commission has clearly increased its scrutiny of MD&A disclosure.  The SEC’s recent pronouncements and proposed rule concerning MD&A disclosure indicate that the Commission is focused on altering the way in which public companies prepare their MD&A discussions.  The January 2002 Statement purports to simply reiterate existing legal requirements.  However, the Statement appears to expand the scope of MD&A disclosure to cover areas that many public companies may not have previously addressed.  The proposed rule would significantly expand the disclosure requirements of accounting policies and accounting estimates.

We believe that our public company clients should carefully consider how these recent SEC pronouncements and proposed rule concerning MD&A disclosure may affect their SEC disclosure practices.

SEC Reminds Companies of MD&A Disclosure Requirements:

An MD&A discussion is included or incorporated by reference in most company reports and registration statements filed with the SEC.  The MD&A must discuss all known trends, demands, commitments, events and uncertainties that are reasonably likely to have a material effect on the company’s financial condition, results of operations, liquidity and capital resources.  The January 2002 Statement was issued in response to a request by the “Big Five” accounting firms for more definitive guidance on MD&A disclosures.  The Statement does not create any new legal requirements, nor does it modify any existing requirements.  In the Statement, the SEC suggests steps that companies should consider in meeting their disclosure obligations to “provide such other information that the registrant believes to be necessary to a understanding of its financial condition, changes in financial condition and results of operations.”

The SEC called for companies to improve disclosure in three specific areas:

  • liquidity and capital resources, including off-balance sheet arrangements;
  • certain trading activities involving non-exchange traded contracts accounted for at fair value; and
  • relationships and transactions with persons or entities who derive benefits from their non-independent relationship with the registrant or the registrant’s related parties.

Liquidity, Capital Resources and Off-Balance Sheet Transactions.  Liquidity and capital resources are closely aligned.  Most liquidity factors have a direct impact on a company’s capital resources.  The Statement encourages companies to tailor their MD&A disclosures in this area to particular facts and circumstances and to avoid boilerplate language.  Instead of disclosing that they have sufficient funding to meet liquidity needs over the next year, companies should describe their sources of short-term funding and the risks and circumstances that are reasonably likely to affect those funding sources.  The Statement lists some specific items noted by the Commission that companies should examine when disclosing the contingencies affecting their liquidity.

The Statement also specifically identifies off-balance sheet transactions as an area that companies should discuss in the liquidity section of MD&A.  Companies should disclose any transactions, arrangements and other relationships with unconsolidated entities or other persons (including “special purpose entities”) that are reasonably likely to have a material effect on the company’s liquidity.  The discussion should highlight the extent of the company’s use of off-balance sheet transactions to facilitate financing, liquidity, market or credit risk management, hedging, leasing, and research and development activities.  Companies should also indicate whether their off-balance sheet arrangements expose the company to liabilities that are not reported on  its balance sheet.

If the contingencies inherent in a company’s off-balance sheet arrangements are reasonably likely to affect the availability of a material source of liquidity or finance which the company has utilized in the past, the company must identify those contingencies and their potential effects in the MD&A discussion.  Companies should consider including specific factual information concerning each off-balance sheet arrangement so that investors can fully understand the nature of the transaction and the associated risk.

The Commission suggests that a schedule listing a company’s contractual obligations and commercial commitments and the timing of the required payments be included in MD&A.  The schedule should include both on and off-balance sheet arrangements as of the date of the company’s most recent balance sheet.  The idea behind the schedule is to present a comprehensive picture of on and off-balance sheet obligations and commitments in one central location.

Certain Trading Activities.  The SEC expressed its concern that there may be a lack of transparency and clarity regarding trading activities involving commodities contracts that are accounted for at fair value, but which are valued based on estimated fair values due to the lack of market quotations.  Although a company’s financial statements should contain some disclosure regarding the valuation process and related contingencies of the valuation, the Commission believes that the MD&A section should also contain a discussion of the material trends or uncertainties arising from the trading of these contracts and the methodologies used to determine their value.  An assessment of how these transactions and valuations would be altered under different methodologies or circumstances that are reasonably likely to occur should be included in MD&A, along with a discussion of how these activities affect reported results for the latest relevant financial periods and the company’s overall financial position.  Again, the Statement suggests that companies include a schedule of this information in MD&A to quantify the effects of the trends and uncertainties that are disclosed.

Transactions with Related Parties and Certain Other Parties.  The Commission is encouraging companies to consider including disclosure of material related party arrangements in MD&A to help investors better understand the Company’s current and prospective financial position and operating results.  This disclosure would be in addition to the related-party disclosures required by Item 404 of Regulation S-K that public companies are accustomed to placing in their annual reports or proxy materials.  When appropriate, the disclosure should set forth the information necessary for an understanding of the business purpose and economic substance of the transaction, the effects of the transaction on the financial statements and the risks and contingencies arising from the transaction.  Companies are also encouraged to provide similar disclosure in their MD&A for material transactions with persons or entities that are not related parties, but with whom the company or its affiliates have a relationship that facilitates transaction terms that would not be available from a more clearly independent party on an arms-length basis.

Proposed SEC Rule Requiring MD&A Disclosure of Critical Accounting Policies:

In December 2001 and February 2002, the Commission announced that investors need to more fully understand the trends, events and uncertainties involved in the preparation of financial statements in order to have a clear understanding of a company’s financial and operating status.  In other words, preparing financial statements in accordance with GAAP is not enough.  Companies should include in MD&A “full explanations, in clear and understandable format and language, of their critical accounting policies, the judgments and uncertainties affecting the application of these policies, and the likelihood that materially different amounts would be reported under different conditions or using different assumptions.”  The Commission defines a critical accounting policy as a policy that is most important to the portrayal of the company’s financial conditions or results.  Critical accounting policies require management’s most difficult, subjective or complex judgments and often involve estimates of matters that are uncertain.

On May 10, 2002, the SEC proposed disclosure requirements for MD&A concerning critical accounting policies (the “Proposed Critical Accounting Policies Rule”).  See SEC Release No. 33-8098.  The proposed rule “would encompass disclosure in two areas:  accounting estimates a company makes in applying its accounting policies and the initial adoption by a company of an accounting policy that has a material impact on its financial presentation.”  Under the terms of the proposal, a separately captioned section discussing critical accounting estimates and policies would be required in the MD&A section of annual reports, registration statements and proxy and information statements.  In addition, in the MD&A section of their quarterly reports on Form 10-Q, companies would be required to update information regarding critical accounting estimates to disclose material changes.

Disclosure Regarding Critical Accounting Estimates.  The Commission defines a critical accounting estimate as an estimate where (1) the company must make assumptions about matters that are highly uncertain at the time the accounting estimate is made and (2) the use of other permissible estimates for the current period, or reasonably likely changes in the estimate actually used, would have a material impact on the presentation of the company’s financial condition, changes in financial condition or results of operations.  Under the proposal, companies would be required to include the following information in MD&A for each critical accounting estimate:

  • A discussion that identifies and describes the estimate, the methodology used, certain assumptions and reasonably likely changes;
  • An explanation of the significance of the accounting estimate to the company's financial condition, changes in financial condition and results of operations and, where material, an identification of the line items in the company's financial statements affected by the accounting estimate;
  • A quantitative discussion of changes in line items in the financial statements and overall financial performance if the company were to assume that the accounting estimate were changed, either by using reasonably possible near-term changes in certain assumption(s) underlying the accounting estimate or by using the reasonably possible range of the accounting estimate; and any material impact on the company’s liquidity or capital resources if any of the changes being assumed were in effect;
  • A quantitative and qualitative discussion of any material changes made to the accounting estimate in the past three years, the reasons for the changes, and the effect on line items in the financial statements and overall financial performance;
  • A statement of whether or not the company's senior management has discussed the development and selection of the accounting estimate, and the MD&A disclosure regarding it, with the audit committee of the company's board of directors;
  • If the company operates in more than one segment, an identification of the segments of the company's business the accounting estimate affects; and
  • A discussion of the estimate on a segment basis, mirroring the one required on a company-wide basis, to the extent that a failure to present that information would result in an omission that renders the disclosure materially misleading.

Disclosure Regarding Initial Adoption of a Critical Accounting Policy.  The Commission also proposed additional disclosure items pertaining to the initial adoption of new accounting policies.  The terms of the proposal require companies to address the items listed below in their MD&A disclosures in annual reports, registration statements and proxy and information statements if the company adopted a new accounting policy within the past year and the policy had a material impact on the company’s financial condition, changes in financial condition or results of operations:

  • The events or transactions that gave rise to the initial adoption;
  • The accounting principle that has been adopted and the method of applying that principle;
  • The impact on the company's financial condition, changes in financial condition and results of operations (discussed on a qualitative basis);
  • If the company is permitted a choice between acceptable principles, an explanation that it had made such a choice, what the alternatives were, and why it made the choice it did (including, where material, qualitative disclosure of the impact on the company's financial presentation that the alternatives would have had); and
  • If no accounting literature exists that governs the accounting for the events or transactions giving rise to the initial adoption, an explanation of its decision regarding which accounting principle to use and which method of applying that principle to use.

The Commission encourages the public to submit comments on the proposed critical accounting policy reporting requirements.  Comments should be received by the SEC on or before July 19, 2002.

Further Information

This Alert summarizes and highlights information contained in the Statement and the Proposed Critical Accounting Policies Rule.  If you would like to comment on the Proposed Critical Accounting Policies Rule, or if you have any questions concerning this Alert, please feel free to call your regular Haynes and Boone attorney, or Darrel A. Rice at (214) 651-5969, or Jan Sharry at (214) 651-5562.

This Alert is a publication of Haynes and Boone LLP and should not be construed as legal advice on any particular facts or circumstances.  This Alert is for general informational purposes only, and may not be quoted or referred to in any other documents or legal proceeding without our prior written consent.  The publication of this Alert is not intended to create an attorney-client relationship.

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