July 19, 2002
Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: Comments to Proposed Rule on Disclosure in Management's Discussion and Analysis about the Application of Critical Accounting Policies (File No. S7-16-02)
Dear Mr. Katz:
I am a Senior Vice President and the Chief Financial Officer of Constellation Energy Group, Inc. Constellation Energy's common stock is traded on the NYSE (Symbol: CEG) and its market capitalization as of July 15, 2002 was $4.3 billion. Constellation Energy is a North American energy company that conducts its business through various subsidiaries including a merchant energy business that generates and markets wholesale electricity and Baltimore Gas and Electric Company (BGE), a regulated electric and gas public transmission and distribution utility company which is subject to the jurisdiction of Maryland Public Service Commission. Our merchant energy business operates in the wholesale markets across North America and applies both accrual and mark-to-market accounting to various portions of its business.
Constellation Energy is submitting these comments in response to the proposed rulemaking noted above, which proposes disclosure requirements for 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. The following discussion represents our views on these proposed requirements and the request for comments.
Critical accounting estimates
We do not object to the proposed definition of critical accounting estimates and believe the definition captures the appropriate type and scope of accounting estimates and appropriately identifies the accounting estimates that require management to use significant judgment. We believe many accounting estimates use complex methodologies but do not involve significant management judgment. These are subjective but are generally standard procedures within a company and across companies and hence should not be considered a critical accounting estimate. This would include items such as depreciation, pension and other post-employment benefits, and unbilled revenues. Accordingly, the costs of including this type of information to investors would not necessarily be beneficial and could result in excess information that works to make disclosures taken as a whole less useful to investors. We also do not believe the SEC Staff should establish "bright line" percentages or the number of accounting estimates that a company can provide in its filings given the diversity of companies and the businesses within which they operate. Instead, the Staff should allow the nature of the company's business to dictate the critical accounting estimates disclosed in its filings. Ultimately, we recommend that the Staff provide examples and not create redundancies of existing GAAP related to the disclosure of material accounting policies and significant risks and uncertainties (SOP 94-6).
Quantitative disclosure to demonstrate sensitivity
We understand that investors are seeking information that provides sensitivity analysis for significant assumptions used in critical accounting estimates. However, for energy companies, we believe there must be a common approach used by each company to provide meaningful disclosures. This is because in the energy business, numerous factors and assumptions affect the estimation process, of which many interact with each other (i.e., weather, prices, regional differences, supply and demand of the energy, etc.) and can change rapidly. In order to provide more meaningful information to investors and analysts, our industry's Committee of Chief Risk Officers is working to develop a common framework for standard disclosures for the energy industry, including standard sensitivity analyses that would be provided by similarly situated entities. Therefore, we encourage the Staff to allow industry groups, such as ours, to interpret these proposed rules and provide guidance to industry participants. Finally, significant additional investments in systems and staff costs will be required to implement this type of disclosure. The impact of these investments and costs need to be taken into consideration in determining the implementation date of this proposal. Meaningful sensitivity and stress test disclosures would be impossible for many companies to implement by year-end.
Quantitative disclosure concerning past changes
We also do not believe that specifically identifying and quantifying past changes in estimates is necessary. The current requirements of MD&A are sufficient with respect to past changes whereby, if the changes during the past three years were significant, they would need to be discussed in understanding the financial results of operations. If this were not the case, than the information would not be useful to investors. Finally, providing a discussion of the management's history of changes in accounting estimates does not necessarily provide insight as to the future prospects of the company.
Discussions between senior management and audit committee
Our senior management and the audit committee currently review and discuss the MD&A and financial statements with the company's auditors. The current requirement under Item 306 of Regulation S-K requires that "the audit committee state whether it has reviewed and discussed the audited financial statements with management and the company's auditors." While we would not object to the proposed rules requiring the disclosure of whether or not senior management has engaged in discussions with the audit committee about the critical accounting estimates, we do not necessarily believe that providing this statement to investors would give them a better understanding of whether appropriate oversight was applied to those accounting estimates. We recommend that if the decision is made to provide some positive report regarding the audit committee's involvement with critical accounting estimates, we would prefer that Item 306 be expanded only to disclose in the audit committee report that the audit committee has reviewed and discussed MD&A with management. We do not believe that this information is best disclosed in the MD&A discussion.
Initial adoption of accounting policies
APB No. 22 currently requires that a company should "identify and describe the accounting principles and the methods of applying those principles that materially affect the determination of financial position or results of operations. In general, the disclosure should encompass important judgments as to appropriateness of principles relating to recognition of revenue and allocation of asset costs to current and future periods." While typically these disclosures are made in the notes to the financial statements, existing MD&A requirements would require a discussion of the impact of any new accounting policies to the extent that an accounting policy materially affects the financial results. While we do not necessarily object to the concept that the impact of new accounting policies should be included in the discussion of MD&A, we believe that the existing accounting and disclosure requirements provide the appropriate guidance for the initial adoption of significant accounting policies.
We do not agree with the proposed rule to disclose alternative, acceptable policies. We believe the purpose of these disclosures is to provide investors the accounting policies used for transactions and events that occur in a company's business. In our discussions with investors, they are seeking for clearer and more concise information and providing alternative policies would only lead to further complexity and less concise disclosures and potential misleading information, all of which may confuse investors by focusing their attention on extraneous information that did not affect a company's results. We also disagree with the notion that a company should include the accounting treatment used by other companies and in the industry in general in its filings. The facts and circumstances for specific transactions and events are critical in making prudent decisions with respect to the selection of the most appropriate accounting policy. In addition, monitoring and evaluating other alternate policies and the accounting practices of the industry and other companies, as well as transactions of other companies (discussed below), is burdensome and costly.
Similarly, we do not believe there should be a requirement to address the accounting treatment of other companies as the facts and circumstances surrounding their decision may only need to be slightly different to result in the selection of an alternative accounting policy. We strongly believe that providing this type of disclosure may be misleading and require company management to make assumptions about another company's transactions and again, provide extraneous information that is not useful to investors.
Summary and recommendation
We agree with the definition of a critical accounting estimate and believe that the disclosure of that estimate should be included in MD&A. However, we believe that existing reporting and disclosure requirements provide adequate guidance supporting this disclosure and recommend that the Staff not create redundancies of this existing GAAP and ultimately provide examples of the required disclosures.
We also understand that investors are seeking information that provides sensitivity analysis for significant assumptions used in critical accounting estimates. However, for energy companies, we believe there must be a common approach used by all companies to provide meaningful disclosures and encourage the Staff to consider the efforts of industry groups, such as our industry's Committee of Chief Risk Officers to develop the appropriate disclosures. The Staff also must consider system constraints and additional staff costs in determining the implementation date of this proposal.
We do not believe that proposed rules requiring past changes in estimates is necessary and recommend the elimination of this portion of the rules as any discussion relating to material past changes is required under existing guidance. While we support initiatives for audit committee involvement in the oversight of management, we believe that mandating additional disclosure requirements from the audit committee would not increase the reliability of the information disclosed for investors. However, if the decision is made to provide some positive report regarding the audit committee's involvement with critical accounting estimates, we would prefer that Item 306 be expanded only to disclose in the audit committee report that the audit committee has reviewed and discussed MD&A with management.
Finally, we disagree with the proposed rule to disclose alternative acceptable policies and the concept of providing other company practices. Providing this type of disclosure would result in further complexity and less concise disclosures that investors want and potentially misleading information, all of which could confuse investors by focusing their attention on extraneous information. Providing this type of disclosure also would be burdensome and costly to a company.
Our 2001 Annual Report on Form 10-K (excluding exhibits) was 94 pages. Providing alternate accounting policies that the company did not use, and including other company or industry policies would only lengthen this document and not necessarily prove useful to investors. One of many criteria that investors consider is the reliance on management and auditors. This proposal undermines that basic principle and does not allow for management's discretion to make the right decisions with the concurrence of the auditors and disclose only those decisions made by management.
I would be happy to discuss my comments further with you. If you have any questions, please call me.
Very truly yours,
E. Follin Smith