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Speech by SEC Staff:
Remarks before the 2007 AICPA National Conference on Current SEC and PCAOB Developments


Stephanie L. Hunsaker

Associate Chief Accountant, Division of Corporation Finance
U.S. Securities and Exchange Commission

Washington, D.C.
December 11, 2007

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author's colleagues upon the Staff of the Commission.

Good Morning, it is an honor and a privilege to again speak at this conference. Today it is my desire to discuss three topics that have been the subject of staff comment this past year: (1) Requirement to name and obtain consents from experts, (2) Presentation of a change in accounting from the consolidation method to the equity method for an investment, and (3) MD&A disclosures in the current credit environment.

Consents & Experts

During the past year, the staff has seen an increase in the number of companies that have chosen to make reference to the use of an independent valuation firm or other expert in both periodic filings under the '34 Act and in registration statements made pursuant to the '33 Act. For example, we have seen registrants make reference to the use of an independent valuation firm in their initial public offering registration statement related to the valuation of their common and preferred stock, in filings regarding the use of an independent valuation firm to assist in the process of determining goodwill impairment, in filings regarding their use of specialist firms to assist in determining liability exposure for asbestos-related claims, and in filings regarding the use of petroleum engineers to evaluate a company's oil and gas reserves, among other areas.

In light of the increased frequency with which registrants are making reference to independent valuation firms and other experts (which is likely only going to increase given the expanded use of fair values in financial statements), we felt it would be timely to remind everyone of the staff's views regarding the requirement to name the expert in filings under the '33 and '34 Act and provide the consent of the expert in any registration statement filed under the '33 Act.

First we will start with the requirement under the '34 Act. Some registrants choose to include a reference to the use of a valuation firm or other expert in their periodic reports. There is no requirement under the '34 Act to obtain a consent from an expert. However, in cases where a registrant chooses to make reference to the use of a valuation firm or other expert in a periodic report, the staff expects the expert to be named. The rationale for naming the expert in the periodic report, even if no consent is required, is because management is referring to the use of an expert, and appears to be transferring some, or perhaps all, of the responsibility for an item in their financial statements. Investors who trade in the registrant's securities should know who that expert is. Of course, the registrant could simply choose to not make reference to the expert at all, and thus take full responsibility for the valuation.

I should note that even though consents are not required in periodic reports, registrants that have any existing Forms S-8 or Forms S-3 (or equivalent foreign private issuer forms), that automatically incorporate by reference any subsequently filed Form 10-K (or Form 20-F) should include the consent from their independent auditors on the audit of the financial statements, as well as any consent from any expert in the Form 10-K (or Form 20-F) to alleviate having to obtain a new consent for any of these existing registration statements.

Now, moving on to the requirements under the '33 Act. Rule 436 of Regulation C provides that when a registrant in a Securities Act filing quotes or summarizes a report or opinion of an expert, the registrant must file as an exhibit the expert's written consent to the inclusion of the quotation or summarization in the registration statement. Now the question that comes up most frequently is what qualifies as a quote or summarization of a report or opinion of an expert, such that a consent would have to be obtained from the expert. The staff interprets this broadly, such that any reference to the expert, whether as the single basis for the measurement determination, or whether the expert's report is just one of several things that was considered in arriving at the measurement determination, would require the expert to be named and a consent obtained.

As noted above in the discussion of the requirements in the '34 Act arena — there is absolutely no requirement to make reference to an expert just because the expert was used and their findings were considered in the registrant's analysis. Rather, instead of naming the expert and obtaining the consent, the registrant could simply delete the reference to the expert.

Let's go through a couple of quick examples to illustrate the points.

For example, assume that a registrant disclosed in its critical accounting estimates section of MD&A that, based upon a valuation prepared by management, with the assistance of an independent third party, no impairment of goodwill had occurred. Would a consent be required in a '33 Act filing, or would the firm need to be named if the reference was only in a periodic report — the answer is yes. In lieu of naming the firm, and obtaining a consent in a '33 Act filing, the registrant could simply delete the reference to the third party.

Let's take another example. Assume a registrant is testing their indefinite-lived FCC licenses for impairment under SFAS 142 and stated in the critical accounting estimates section of MD&A that in determining the value of the FCC licenses, the registrant considered the discounted cash flow analysis prepared by management, recent sales of similar FCC licenses, and a report prepared by a independent valuation firm. Would a consent be required in a '33 Act filing, or would the firm need to be named if the reference was only in a periodic report — the answer is yes. Again, in lieu of naming the firm, and obtaining a consent in a '33 Act filing, the registrant could simply delete the reference to the individual valuation firm.

Now, one other common area of staff comment relates to the wording of the consent from the expert. I should first note that even though a consent is required from the expert if they are referenced in a registration statement, the registrant is not required to name the expert in a separate "Experts" section in the registration statement, since our forms do not require that disclosure.

Second, with regard to the content of the consent, the valuation firm or other expert may state that it does not admit to being an expert, but it may not deny that it is an expert. In addition, the expert may not attempt to limit its liability under Section 7 and 11 of the Securities Act or include language which attempts to state a legal conclusion as to which party is responsible for which item of disclosure. For example, disclosure stating that the responsibility of the valuation rests solely with the registrant would not be appropriate.

Consolidation to Equity Method

My next topic is on the appropriate presentation of a change in accounting for an entity that was previously consolidated, and will now be accounted for under the equity method. For example, (a) a calendar-year registrant may sell 60% of its wholly-owned subsidiary to an unrelated third party effective April 1, 2007, or (b) perhaps the calendar-year registrant, as general partner, historically consolidated a limited partnership due to their control of the limited partnership, but then on August 31, 2007, the registrant general partner granted the limited partners substantive kick-out rights, resulting in the registrant general partner concluding they no longer had control.1 The question is how should the change in accounting be reflected in the consolidated financial statements? For example, could the entity be shown as being accounted for under the equity method (one line presentation) for the entire year (i.e., retrospective application of equity method to the beginning of the year), or is the registrant required to reflect the entity as consolidated for the portion of the year it was controlled, and under the equity method thereafter.

Well, had the question been asked prior to the effective date of SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144), you could have obtained a different answer than the answer that is appropriate today. This is because paragraph C2.b of SFAS 144 deleted paragraph 12 of ARB 51, which stated the following:

"Where the investment in a subsidiary is disposed of during the year, it may be preferable to omit the details of operations of the subsidiary from the consolidated income statement, and to show the equity of the parent in the earnings of the subsidiary prior to disposal as a separate item in the statement"

Based on the guidance that was previously included in paragraph 12 of ARB 51, the staff had a long-standing position stating that even though the change from consolidation to equity method is accounted for prospectively from the date of change, the staff would generally not object to retroactive presentation from the beginning of a fiscal year in which the change occurs. However, as a result of the deletion of the guidance in paragraph 12 of ARB 51 by SFAS 144, it is no longer appropriate to retroactively apply the equity method to the beginning of the year. Additionally, the staff's longstanding position no longer applies effective with the adoption of SFAS 144, given that it stemmed from the same paragraph in ARB 51.

I also wanted to highlight that there is no change to GAAP (or the staff's long-standing position) regarding a change in accounting from the equity method to consolidation. Specifically, paragraph 11 of ARB 51 (which has not been deleted) provides guidance in this area, and indicates that generally it is preferable to reflect the subsidiary as being consolidated from the beginning of the year in the year of the change, because it presents results which are more indicative of the current status of the group and facilitates future comparison with subsequent years. However, it also goes on to indicate that it is acceptable to just reflect the entity as being consolidated effective with the change in accounting. I should note that the staff believes it is inappropriate to restate prior fiscal years for the change from the equity method to consolidation, although pro forma information in MD&A may be useful.

If a registrant improperly reflects the deconsolidation of an entity retroactive to the beginning of the year of the change, technically the registrant has an error that has to be evaluated for materiality. The impact of any error correction would obviously have no impact to the registrant's net loss, earnings per share, or total increases or decreases in cash and cash equivalents on the statement of cash flows, but the individual line items on the income statement and statement of cash flows, could be significantly different, and thus would need to be carefully considered in any materiality analysis.

MD&A Disclosures in Current Credit Environment

Lately it has been impossible to pick up a paper and not see at least one article relating to the status of the current credit environment — large increases in allowances for loan losses, write-downs and impairments of securities, credit downgrades, dividend reductions, liquidation of some collateralized debt obligations (CDO) or structured investment vehicles (SIV), speculation about what a company's Q4 write-downs will be (or should be, based on comparison to other companies), speculation about which company is going to get downgraded, or acquired, or file for bankruptcy. Given everything going on, and what seems to be constant negative news about the current credit environment, investors are scrambling to get their hands on information — particularly related to companies' exposure to sub-prime securities or other higher risk loans, risks related to off-balance structures which have the potential to become on-balance sheet structures, and exposure to investments that are not easily valued.

The SEC staff has been reviewing disclosures of many registrants that are significantly impacted by the current credit environment, and have noted some improvements from these registrants' prior MD&A disclosures. For example, some registrants have expanded their discussion of the exposure to the sub-prime industry, some have expanded their discussion about fair values, and some have expanded their disclosures about off-balance sheet arrangements. Additionally, some registrants have added new risk factors about transactions with off-balance entities and the fact that those transactions could cause them to recognize future gains or losses, or have to consolidate the entity, or new risk factors warning that the registrant may experience additional write-downs in the securities or loan portfolio.

There are many GAAP standards, as outlined on the slide, that contain substantial disclosure requirements regarding fair value assumptions, concentrations of credit risk and exposure to losses.

In addition to these disclosures which are required by GAAP, the SEC also has various requirements for disclosures with respect to off-balance sheet arrangements and critical accounting estimates within Management's Discussion & Analysis (MD&A).

As the staff has repeatedly stated over the years in written comments to registrants, speeches, and reports, MD&A is the best place to disclose information about the most difficult and judgmental areas found in the preparation of financial statements. Oftentimes, just complying with the minimum GAAP financial statement disclosures doesn't give investors all of the information they may want and need to evaluate a company's results and performance. I'd like to highlight a few disclosure issues you may want to consider, to the extent they are material, as you prepare for your next annual report.

Let's start first with disclosures about off-balance sheet arrangements. Item 303 of Regulation S-K requires a discussion of off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the registrant's financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. If the threshold is met, Item 303 requires various disclosures, which are outlined for you on the slide. In looking at some companies that have significant off-balance sheet exposure in the form of asset backed commercial paper conduits (conduits), collateralized debt obligations (CDO), or structured investment vehicles (SIVs), many have appropriately included some discussion of the off-balance sheet exposure related to these vehicles. Registrants likely thought their historical disclosures were sufficient as they didn't anticipate the environment we are seeing today. While Item 303 specifically mentions the disclosures noted on the slide, it also states that the registrant should include other information that the registrant believes is necessary for an understanding of the effect of the off-balance sheet arrangements.

As the staff has looked at the disclosures of some registrants with significant off-balance sheet exposure, we have thought of some other disclosures that could be considered for inclusion in filings to enhance the transparency surrounding registrants' off-balance sheet entities. This is particularly true for registrants that have material exposure to these off-balance entities or are disclosing a risk factor that their results could be materially affected by the risks related to their transactions with off-balance sheet entities. So, what are these additional disclosures companies may want to consider?

Well, here is a flavor of some of them, starting off first with suggestions for disclosure in the off-balance sheet section of MD&A. Registrants that have material exposure to commercial paper conduits, structured investment vehicles, collateralized debt obligations, or other similar entities, may want to consider these types of disclosures:

  • The categories and rating of assets held in the off-balance sheet entity (OBSE);
  • The weighted-average life of assets held in the OBSE;
  • The forms of funding (commercial paper, medium-term notes, etc) and weighted-average life of the funding held in the OBSE;
  • Whether the OBSE experienced any difficulties in issuing its commercial paper or other forms of financing during the period; or whether
  • The OBSE recognized any material write-downs or downgrades of its assets.

These disclosures would provide insight into the quality of the assets held in the structures, as well as insight into the fact that there could be large differences between the term of the liabilities used to fund the OBSE, as compared to the term of the assets in the OBSE (typically referred to as liquidity risk).

Here are some more disclosure suggestions:

  • To the extent there are first loss note holders, consider disclosing the maximum limit of the losses to be borne by those note holders, particularly if the amount of the note varies;
  • Types of variable interests held in the OBSE;
  • Whether you purchased commercial paper or other securities issued by any OBSE that you manage, and whether the purchases were required under any agreement. If they were not, consider disclosing the reasons for the purchase;
  • Also, consider disclosure better describing any obligations under the existing liquidity facilities or written put options. For example:
    • What are the triggers associated with the obligation to fund?
    • Are there any terms that would limit the obligation to perform?
    • What is the nature of your obligation under the facilities — for example, are you required to purchase assets held by the variable interest entity? If so, is the price at fair value? If you are not required to purchase assets, are you required to purchase commercial paper or other securities?
    • Are there any other liquidity providers, and if so, how does your obligation rank with the other liquidity providers?

Finally, two other disclosure suggestions you may want to consider:

  • Whether you provided or assisted the OBSE in obtaining any other type of support, or have the current intentions to do so; and
  • The potential impact on debt covenants, capital ratios, credit ratings, collateral requirements or dividends, should you be required to consolidate the entity or incur significant losses associated with the entity.

Now, I am not quite done with other "helpful" staff suggestions (even if you have already had enough) — the next area is some suggestions for disclosure considerations in critical accounting estimates, particularly for those companies that have identified consolidation and variable interest entities as a critical accounting policy already:

For example, consider disclosing:

  • The types of scenarios where you would have to consolidate the off-balance sheet entity, and your expectation of the likelihood of the event;
  • Another suggestion would be disclosure regarding the frequency with which you reconsider, and the typical events which require you to reconsider, whether you are the primary beneficiary of the entity;

Any finally, one last suggestion in this area:

Given the requirement in Item 303 to disclose any known trends or uncertainties that are reasonably expected to have a material impact on income, liquidity or capital resources, we think another thing you may want to consider disclosing is the amount of loss you expect to realize related to the OBSE.

Now, you may say that is a lot of additional disclosure for a registrant that sponsors or has transactions with hundreds of different off-balance sheet entities — but certainly this information could be aggregated to the extent it was comparable among the different types of material off-balance sheet entities. Where a registrant, based upon its own facts and circumstances, has determined to provide this disclosure, it should decide how it can best present it.

Now, moving on to the area of critical accounting estimates and fair value determination.

As Sondra Stokes mentioned last year at this conference, the disclosure in critical accounting estimates has the potential to be some of the most relevant and important disclosure in the company's filings. Most companies don't include information that provides insight into how management made its determination to use certain assumptions, what those assumptions were, how and if they changed from previous periods, the specific factors which can have the biggest impact on the estimates/assumptions, and the fact that variability could result from the company's estimate. Okay, so most state this last point as fact, but they don't say specifically why.

For example, in looking at several registrants with a significant amount of financial instruments measured at fair value, we noted that every single one of them had disclosed that the determination of fair values was a critical accounting estimate. However, some of these disclosures did not provide very insightful analysis as to how the fair values were determined. For example:

Simply disclosing that the valuation of financial instruments becomes more subjective and involves a higher degree of judgment where market data is not available is not very helpful disclosure. Also, just stating the names of other types of techniques that may be used, such as closed-form analytic formulae, or simulation models, is not very helpful unless investors are familiar with these techniques, and all of the key inputs into them — I suspect in many cases investors will not be familiar with these techniques. In cases where market data is not available, and the registrant has a material amount of financial instruments measured in this fashion, we believe registrants should consider discussing the types of models used in these situations, the significant inputs into the models, disclosure of the assumptions that can have the greatest impact on the value derived, and whether and how those assumptions have changed from prior periods and, if so, why.

For example, I think most people are familiar with the Black-Scholes model, which is commonly used to determine the fair value of employee stock options. The two biggest assumptions that can have the most impact on the value determined using a Black-Scholes model are volatility and expected term. This is the type of discussion the staff thinks could be helpful, for say a company that has a significant amount of assets that are valued using models, whether they be based on proprietary models, or other models that are disclosed as being "widely accepted in the financial institutions industry." As an example, if you are valuing a complex derivative using a proprietary model, with inputs to the model of w, x, y, and z, with x and z being the inputs that have the potential to most impact the value, then you should consider disclosing that fact, along with the assumptions that you have assumed, and the impact of reasonably likely changes to the assumptions, and what the impact to the value would be if you used those reasonably likely changed assumptions.

Now, I can already guess that the reaction back to the staff about these comments would be that we have too many financial instruments that are measured at fair value and many different models being used to value them. Okay, fair enough — the staff was not suggesting that this type of disclosure should be provided for every single financial instrument — again, we are focused on the valuations that could have the biggest impact on the company's results of operations, liquidity or capital resources. We are not suggesting that every single instrument should have this level of disclosure. However, for those registrants that have securities whose valuation is based on models (proprietary or otherwise), and the impact of such valuation could be material to the financial statements (including the income statement — we wouldn't think it was appropriate to just consider the value of the securities to the balance sheet), or those that believe that valuation of securities is one of the most significant critical accounting estimates , and are disclosing that fact in risk factors and other disclosures, then you should really consider expanding your disclosures to discuss the specific assumptions you are using, how you derived them, and real insight into how your estimate could be impacted by future events. Then, in future periods, when values materially change (either positively or negatively), you should consider disclosing any significant changes in your methodologies and assumptions so investors can understand what happened.

Before I wrap up, just a few other points I want to mention:

The first relates to those registrants that may have early adopted SFAS 157, and as a result of the current credit environment, may have decided that certain assets or liabilities were no longer classified as Level 2 instruments, but instead as Level 3 instruments. To the extent there are material reclassifications between the different levels, the staff thinks registrants should consider providing disclosure not only about the types of instruments that were reclassified, but also the nature of the inputs that the registrant felt were no longer observable. For example, instead of simply stating that XX amount of U.S. sub-prime residential mortgage related assets and asset-backed security collateralized debt obligation positions (ABS CDO) were transferred to Level 3 assets due to decrease in observability of market pricing for those instruments, consider outlining which specific market inputs were no longer observable. Additionally, it may be necessary to also discuss how you determined the fair value of the instruments in light of reduced availability of market inputs, including discussing the key assumptions used.

Secondly, I just wanted to quickly comment about some registrant's disclosures related to their variable interest entities, and the related maximum exposure to losses. This is a footnote disclosure required by FIN 46R, but registrants sometimes also repeat the discussion in their off-balance sheet disclosures. The staff notes that sometimes it is difficult to tell exactly what is being captured in the maximum exposure amount. For example, a registrant discloses that their maximum exposure to loss as a result of their involvement with their unconsolidated variable interest entities was approximately X billion, with no insight into how the number is calculated and what types of agreements are considered (i.e. liquidity facilities, guarantees, derivatives, etc) in deriving this number. Further, after disclosing the maximum exposure to these entities some registrants will disclose that this maximum exposure amount does not have any relation to the anticipated losses from their exposures.

The staff suggests that registrants consider expanding their disclosure in this area to specifically indicate what the maximum loss number incorporates — for example, not only potential losses associated with assets recorded on the registrant's balance sheet, but also with other off-balance sheet exposures, such as unfunded liquidity commitments and other contractual agreements, and specifically quantify the maximum exposure for each individually. Registrants should also consider describing what would need to happen to actually realize the maximum loss. Finally, for those registrants that disclose that the maximum exposure amount does not have any relation to anticipated losses from exposures, consider disclosure regarding expectations about losses you expect to realize — for example, to the extent you don't believe they will be material, go ahead and disclose it. To the extent that you believe the impact is reasonably likely to be material, disclosure would likely be required under Item 303, as discussed previously above.

That concludes my prepared remarks. Thank you for your time.


See also: Slide presentation (PDF)


Modified: 12/26/2007