July 19, 2002
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549
Proposed Rule: Disclosure in Management's Discussion and Analysis About the Application of Critical Accounting Policies - File No. S7-16-02
Dear Mr. Katz:
Thank you for the opportunity to comment on the subject proposal. ChevronTexaco fully supports the Commission's ongoing efforts to improve the quality and integrity of financial reporting and disclosures, especially during this very difficult period in our nation's financial markets.
However, for the reasons explained below, we believe that certain aspects of the proposal may have the opposite effect of the Commission's concern (expressed in Section VIII.A. of the proposal) that if this rule is not enacted, "...potential consequences...are: (a) less transparency in...companies' financial statements,...a lesser understanding of companies' financial condition; and (b) a potential decrease in investor confidence in the full and fair disclosure system...of the U.S. capital markets."
That is, we believe that some of the disclosure requirements will not result in enhanced financial reporting that is clear, concise and understandable to the average investor. We also believe that certain of the proposed disclosures could result in less comparability among the financial reports by companies in the same industry.
Our responses to, and comments on, some of the specific questions the Commission has raised in this rule proposal are as follows:
Proposed definition of critical accounting estimates
Response: Not necessarily.
The rule proposal defines a "critical accounting estimate" as one that has two characteristics: (1) The estimate requires the company "...to make assumptions about matters that are highly uncertain at the time the accounting estimate is made"; and (2) Different estimates the company reasonably could have used, or changes in the estimate that are reasonably likely to occur from period to period, "...would have a material impact on the company's financial condition, changes in financial condition or results of operations."
For companies like ChevronTexaco, which have interests in hundreds of producing oil and gas fields, depreciation and depletion expense and the realizability of the carrying value of many assets on the balance sheet are dependent upon the accuracy of the underlying estimates of proved oil and gas reserve quantities. These matters are not "highly uncertain at the time the accounting estimate is made" - as required by the SEC Regulation S-X definition of proved reserves: "Proved oil and gas reserves are the estimated quantities of crude oil, natural gas, and natural gas liquids which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions, i.e., prices and costs as of the date the estimate is made" (emphasis added). As a result, we would not consider this aspect of the "successful efforts" method of oil and gas accounting to involve a critical accounting estimate.
However, in the MD&A accompanying our 2001 audited financial statements, we disclosed the successful efforts method of accounting and the estimate of proved reserves as one of our "critical accounting policies" required to be disclosed in accordance with the Commission's December 2001 guidance. The reason we made this disclosure in our 2001 financial statements was that, in the past, a select few of these reasonably certain estimates of proved oil and gas reserve quantities for specific fields were lowered to such an extent that the properties became impaired under the accounting rules, and material charges were recorded against earnings.
Response: We do not believe the Commission should establish a maximum number of critical accounting estimates to be discussed. To do so would seem arbitrary and too prescriptive as to what each company must decide is most useful to investors according to each company's set of facts and circumstances.
Response: The existing MD&A rules require disclosure about trends, events or uncertainties known to management that would have a material impact on reported financial information. The uncertainties to be discussed under the existing MD&A rules would include volatile accounting estimates that use complex methodologies but do not involve significant management judgment.
We believe that a qualitative, non-boilerplate discussion of all accounting estimates that would have a material impact on reported financial information would be useful disclosure for the average investor. Identification of those estimates that require significant management judgment would be apparent through an effective discussion of the methodologies used in determining the accounting estimates.
Proposed identification and analysis of changes
Response: We believe the quantitative disclosures relating to critical accounting estimate sensitivities could be confusing for the average investor and distract the investor from other, more meaningful information.
The proposed rule would require that companies present either: (a) "A quantitative discussion of changes in overall financial performance, and to the extent material, the line items in the financial statements, assuming that reasonably possible near-term changes occur, both negative and positive (where applicable), in the most material assumption or assumptions underlying the accounting estimate; or (b) A quantitative discussion of changes in overall financial performance, and to the extent material, the line items in the financial statements, assuming that the accounting estimate was changed to the upper end and the lower end of the range of reasonable possibilities determined by the registrant in the course of formulating its recorded estimate."
An example of a possibly confusing or misleading sensitivity analysis of a critical accounting estimate would be a company's practice in estimating contingent losses associated with being a defendant in a number of lawsuits or asserted claims. For companies involved heavily in litigation, many liabilities are not recorded because the contingent losses do not meet the criteria for recognition under SFAS No. 5, Accounting for Contingencies. Even though a company's best judgment might be that it will not incur a liability for a particular case, the proposed rule would require some sort of quantitative disclosure if a loss were "reasonably possible" - defined in the proposal as "more than remote but less than likely." Disclosures about ranges of possible, yet highly uncertain outcomes could potentially be both unnecessarily alarming to the investor and compromising to the company's negotiations with plaintiffs and claimants. Comparability among companies may also be diminished if co-defendants in a major lawsuit disclose significantly different sensitivities for the same facts and circumstances. Such a situation would seem possible under the Commission's stated objective of enabling companies to individually "customize" their disclosures.
We also question the value to an investor of a company demonstrating sensitivities that require analyzing and disclosing the near-term reasonably possible changes in each material assumption underlying a critical accounting estimate. The alternative methods of sensitivity quantification are not always practicable. For example, some accounting estimates have multiple underlying assumptions that may offset each other in choosing reasonably possible near-term changes. We believe existing disclosure rules - properly adhered to - permit investors to assess the quality and potential variability of earnings from accounting estimates. Quantifying ranges of possible and highly uncertain outcomes could also increase exposure to lawsuits if the actual results turn out to be materially different from the sensitivities presented, safe-harbor provisions notwithstanding.
There are many uncertainties underlying a company's business environment and financial results, in addition to critical accounting estimates (e.g., technology changes affecting the company's competitiveness, political risk in the areas in which the company operates, supply-demand balance for the company's products in the global or regional marketplace, etc.). A detailed quantification of the potential impact of various outcomes is handled appropriately in a qualitative discussion of a company's risk factors. The proposed disclosure of quantitative sensitivity analysis to accounting estimates places disproportionate emphasis on this selected area of uncertainty.
Proposed disclosure of past material changes in critical accounting estimates
Response: In our view, existing MD&A rules require discussion and analysis of material changes in all estimates (whether defined as critical or not) that impact financial results. Requiring a discussion of changes in critical accounting estimates in this new section of MD&A and disclosure of changes in other "non-critical", but possibly material, accounting estimates in another section of MD&A would seem confusing.
Response: Generally, we believe a three-year historic period for considering changes in critical accounting estimates is appropriate and consistent with other information that is generally discussed in MD&A. However, in a discussion of trend information, reference to the five-year data presented pursuant to Item 301 of Regulation S-K may be required, including reference to changes in critical estimates occurring in the first two years of the five-year period. We believe that this would be required by the existing MD&A rules for material changes in critical and non-critical accounting estimates.
Auditor examination of MD&A disclosure relating to critical accounting estimates
Response: As explained in the proposal, a company's auditor is currently responsible for evaluating the reasonableness of the accounting estimates made by management in the context of the financial statements taken as a whole. For an annual Form 10-K filing, the auditor is required to read the information in the entire filed document, including the MD&A, and consider whether such information, or the manner of presentation, is materially inconsistent with information, or the manner of its presentation, appearing in the financial statements.
Absent overwhelming evidence to the contrary (such evidence not mentioned in the proposed rule), we believe this current approach is most appropriate. Companies, of course, may wish to engage their auditors to conduct MD&A examinations. However, an across-the-board increase in the work of auditors related to MD&A does not appear justified.
Senior management's discussions with the audit committee
Response: For ChevronTexaco, matters of judgment and uncertainty are summarized in a formal report and discussed in detail with the board audit committee before the filing of the company's Form 10-K. The company's outside auditor also participates in that meeting. These discussions are updated quarterly as necessary with the audit committee.
Response: Significant concerns of the audit committee must be addressed before the committee approves the financial statements for the Form 10-K. Not all audit committee concerns should be treated the same when consideration is given for disclosure. If the committee has concerns that are so significant that it is unable to recommend inclusion of the financial statements in the Form 10-K, then a company would have to disclose in a Form 8-K filing that it is unable to issue financial statements and why.
Question: Should we expand Item 306 to require disclosure of whether the audit committee has reviewed and discussed the entire MD&A disclosure (current and proposed) with management and/or the auditors?
Response: We feel that consideration should be given to placing into the Form 10-K the existing audit committee report found in the proxy and information statements. At the same time, we caution the Commission on being overly prescriptive on the individual items that should be referred to specifically in such report. Rulemaking can be specific about the roles and responsibilities of audit committees, without requiring that the audit committee report recite each role and responsibility individually that it has discharged. Any requirement to disclose specific details on how a committee has discharged its various responsibilities seems to venture closely to publishing minutes of audit committee meetings. Audit committee review of the MD&A is only one of the critical activities undertaken by the audit committee at its regular meetings. We recommend against requiring detailed disclosure of audit committee discussions, which could be an impediment to open and frank communication.
Response: We believe that the concerns raised in this aspect of the proposal should be addressed in the current discussion and review of financial statements with the audit committee. Management, with assistance from the company's auditors, must determine the accounting policies most appropriate for its business circumstances. To understand why others in the industry have chosen other policies would require full knowledge of their respective businesses, which is not realistic. Moreover, some companies' competitors may not be U.S. registrants.
Nevertheless, if it is clear that a company's policies diverge from the policies applied by other companies in the same industry, this should be addressed in the discussion currently required between the audit committee and management and/or the independent auditor about the process used by management in formulating sensitive accounting estimates. Again, disclosure of such discussions borders on the publication of meeting minutes and would appear gratuitous and possibly confusing to the average investor.
Proposed disclosures related to initial adoption of accounting policies
Response: We support the Commission's proposals regarding disclosure of the impact of initial adoption of accounting policies, viz.: "the events or transactions that gave rise to the initial adoption of an accounting policy; the accounting principle that has been adopted and the method of applying that principle; and the impact (discussed quantitatively) resulting from the initial adoption of the accounting policy on the company's financial condition, changes in financial condition and results of operations". We also support the proposed discussion of why the particular policy was chosen over other alternatives that may have been available.
Response: We believe such proposed disclosures would be superfluous and possibly misleading. As stated above, such disclosures resemble management's meeting minutes.
Response: This aspect of the rule proposal presumes that a company is able to determine the policies applied by other companies in its industry in similar circumstances. ChevronTexaco does not attempt to monitor all policies applied by its competitors, and we are uncertain of the value of such a discussion to the average investor. In the oil and gas industry, the Accounting Committee of the American Petroleum Institute (API) provides a forum for the evaluation and discussion of accounting practices among its members. Nevertheless, the API has no authority to prescribe industry accounting practices, which vary.
General aspects of the proposals
Response: We strongly believe that, on balance, the detailed requirements of the proposed rule could overwhelm the financial statement user with difficult-to-understand quantitative data. Further, for some topics, discussion will not only be included in this special section of MD&A, but also elsewhere in MD&A and in the financial statement footnotes. As an alternative, we suggest that the Commission look for registrants to correctly apply the critical accounting policy guidance provided by the Commission in December 2001, ensuring meaningful, qualitative, non-boilerplate disclosure.
Response: The Commission notes in the proposal that the proposed disclosures should be presented in language, and a format, that is clear, concise and understandable to the average investor. We strongly believe that the aspects of this rule proposal requiring quantitative, pro forma analyses and discussion are inconsistent with this goal and will result in disclosure that only technical experts in accounting or the specific industry of the registrant will be able to understand fully.
Potential benefits of the proposed rules
Response: We believe the quantitative benefits to the proposed rule are unknowable. Quite possibly, the overall effect from the increased disclosures could be negative if investors misinterpret or improperly rely upon such data. We also believe among the best deterrents to improper accounting practices are a strong system of internal controls, members of company management and boards of directors who possess a high level of personal integrity, and appropriate penalties for those who violate their fiduciary responsibilities. It's questionable whether expanded disclosures related to critical accounting estimates would have helped prevent some of the recently publicized improper accounting practices if those expanded disclosures were not truthful and forthcoming.
Potential cost of proposed rules
Question: What are the potential litigation and liability costs that would be associated with the proposed disclosure requirements?
Response: With the very detailed discussions outlined in the proposal connected with sensitivities to accounting estimates, we believe that increased liability could result -- not necessarily from statements made under safe-harbor provisions but from statements and assumptions not made. With the benefit of hindsight, litigants might argue that the company should have included other factors in their analyses. The potential costs are unquantifiable, but we believe they are real.
Scope of the proposals
Response: We believe that attempting to disclose the full gamut of critical estimates and other areas of judgment and discretion a company uses in its day-to-day business would overwhelm both the companies and the investing public. For example, estimates surrounding the economic evaluation and development of ChevronTexaco's multi-billion dollar annual capital investment program are matters of judgment that are key to our company's sustained financial success. The usefulness of the volumes of disclosure surrounding just this aspect of management decision-making seems highly questionable and may involve information management believes proprietary.
Although the Commission stated as an objective in the proposed rule to have this information disclosed in "relatively short form", it does not seem clear how this can be accomplished by companies, for example, that have several critical accounting policies with several variables embedded in the estimate, and policies that apply to several business segments. In short, this proposed rule appears to require excessive and disproportionate disclosure. This proposal also seems inconsistent with the Commission's earlier proposal to accelerate the time periods allowed for filing of Forms 10-K and 10-Q. We strongly encourage the Commission's consideration of our sincere comments and those of others who may have similar perspectives on the proposed rule.
/s/ S. J. Crowe