December 9, 2002

Mr. Jonathan G. Katz, Secretary
U. S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549-0609

File No. S7-42-02
Proposed Rule: Disclosure in Management's Discussion and Analysis
About Off-Balance Sheet Arrangements, Contractual Obligations and
Contingent Liabilities and Commitments
Release Nos. 33-8144; 34-46767

Dear Mr. Katz:

KPMG LLP (KPMG) appreciates the opportunity to submit this letter in response to the Securities and Exchange Commission's (the Commission) request for comments on its proposed rule to require disclosure in management's discussion and analysis of off-balance sheet arrangements, contractual obligations and contingent liabilities and commitments (the Proposed Rule or proposing release).

KPMG acknowledges and appreciates the significant efforts of the Commission and the Commission staff to restore investor confidence in our capital markets through improved financial reporting and disclosure by public companies and regulation of market participants.

We believe that it is critical for investors to have accurate and complete information for a clear understanding of a registrant's financial condition, results of operations, cash flows and sources of capital and liquidity. In particular, investors must have information about transactions and arrangements that are not discernable from the financial statements but that are integral and material to the manner in which the registrant operates and finances its business. Therefore, we support the Commission's efforts to improve the utility of non-financial reporting by requiring disclosure in a manner that facilitates locating and identifying critical information and enhances analysis and comparability of information among registrants.

As the text of the proposing release acknowledges, the existing requirements of Regulation S-K, Item 303, Management's Discussion and Analysis (MD&A):

...already require disclosure regarding off-balance sheet arrangements and other contingencies. The MD&A rules are designed to cover a wide range of corporate events, including events, variables and uncertainties not otherwise required to be disclosed under U.S. generally accepted accounting principles ("GAAP").

In addition, the proposing release notes:

The MD&A rules are intentionally flexible to elicit more meaningful disclosure and to avoid boilerplate discussions. Therefore, while only one item in our current MD&A rules specifically identifies off-balance sheet arrangements, the other requirements clearly require disclosure of off-balance sheet arrangements if necessary to an understanding of a registrant's financial condition, changes in financial condition and results of operations.

In 1989, the Commission issued an interpretive release on MD&A in response to a request from the accounting profession to adopt rulemaking to mandate improved risk disclosure in MD&A. After studying MD&As of hundreds of companies, the Commission concluded that rulemaking was not necessary but that an interpretive release was needed to direct registrants' attention to the appropriate interpretation and application of the MD&A requirements.

We concur with the Commission's position in its 1989 interpretive release that if a registrant appropriately applies the requirements of MD&A, the resulting disclosures should be adequate to meet the objectives of providing reasonable information to investors. Furthermore, we observe that the vast majority of registrants make reasonable efforts to comply with the requirements of MD&A, however, refinements and improvements can always be made. As a result, we recognize the perceived need to identify specific disclosures that should be provided, although we continue to believe that flexibility and relevance should be overarching considerations in any guidance or rules the Commission may adopt.

We offer the following specific comments on various aspects of the Proposed Rule.

Off-Balance Sheet Arrangements

The petition submitted on December 31, 2001 by the "Big 5" accounting firms and the AICPA to the Commission recognized that existing MD&A requirements should elicit disclosures needed to understand the reasonably likely material effects on financial condition and results of operations that may flow from off-balance sheet transactions and arrangements. The petition, as well as the Commission's statement on MD&A (FRR 61), approached suggested improvements in these disclosures as appropriate interpretive guidance under existing rules at the same time recognizing that additional rulemaking may be needed. In view of the limited number of public companies that may have failed to provide disclosures of off-balance sheet transactions and arrangements needed for transparency, and recognizing that such failures may be violations of existing rules, we have significant reservations about whether the additional cost of regulation cited in the proposing release is a justified imposition on the many thousands of companies who have provided appropriate disclosures.

We also note that the Financial Accounting Standards Board recently issued FASB Interpretation 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (FIN 45), which requires extensive disclosure about the effects, nature and terms of guarantees issued by a registrant, even if the likelihood of the guarantor having to make any payments under the guarantee is remote. The disclosures required by FIN 45 are effective for annual and interim reporting periods ending after December 15, 2002. Further, the FASB is expected to issue a final interpretation on the consolidation of special-purpose entities that will require disclosure of the possible effects of consolidating special-purpose entities and the registrant's involvement with special-purpose entities. The Commission should consider these initiatives by the private sector. While, we recognize that the Commission is required to adopt rules in this area, the rules that are adopted could be as straightforward as complying with the requirements of the FASB regarding off-balance sheet arrangements such as guarantees and special-purpose entities.

Consistent with the potential for rulemaking identified in these earlier initiatives, Section 401(a) of the Sarbanes-Oxley Act of 2002 (SOA) mandates that -

Not later than 180 days after the date of enactment of the Sarbanes-Oxley Act of 2002, the Commission shall issue final rules providing that each annual and quarterly financial report required to be filed with the Commission shall disclose all material off-balance sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of the issuer with unconsolidated entities or other persons, that may have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital resources, or significant components of revenues and expenses.

The proposed amendment to Regulation S-K, Item 303 defines an off-balance sheet arrangement as follows:

...any transaction, agreement or other contractual arrangement to which an entity unconsolidated with the registrant is a party, under which the registrant, whether or not a party to the arrangement, has, or in the future may have:

    (A) Any obligation under a direct or indirect guarantee or similar arrangement;

    (B) A retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement;

    (C) Derivatives to the extent that the fair value thereof is not fully reflected as a liability or asset in the financial statements; or

    (D) Any obligation or liability, including a contingent obligation or liability, to the extent that it is not fully reflected in the financial statements (excluding the footnotes thereto). Obligations and liabilities that are not fully reflected in the financial statements (excluding the footnotes thereto) include, without limitation: obligations that are not classified as a liability according to generally accepted accounting principles; contingent liabilities as to which, as of the date of the financial statements, it is not probable that a loss has been incurred or, if probable, it is not reasonably estimable; or liabilities as to which the amount recognized in the financial statements is less than the reasonably possible maximum exposure to loss under the obligation as of the date of the financial statements. Contingent liabilities arising out of litigation, arbitration or regulatory actions (not otherwise related to off-balance sheet arrangements) are not off-balance sheet arrangements.

We have several concerns that we believe should be addressed in the final rulemaking. First, we believe that the definition of an off-balance sheet arrangement needs to be clarified to more precisely identify the arrangements that are and are not within the definition. The current definition is expansive, open-ended and appears to capture arrangements that are not typically viewed as off-balance sheet arrangements. As drafted, the following arrangements appear to be encompassed by the definition:

  • Unrecognized pension and other obligations under post-employment benefit plans and any other employee benefit plans such as accrued vacation or termination obligations that are based on estimated benefits rather than maximum possible benefits;

  • Unfulfilled executory contracts such as unfilled purchase orders and take-or-pay contracts;

  • Fully cancelable operating leases;

  • Contingent consideration payable pursuant to earn-out or similar provisions in asset and business acquisitions;

  • The discounted portion of certain liabilities such as original issue discount liabilities and asset retirement obligations;

  • Unrecognized obligations under promissory estoppal interpretations;

  • Unrecognized obligations that may be asserted under implied warranties or common law interpretations of commercial arrangements; and

  • Insurance and similar contracts issued by an insurer or reinsurer.

We believe that the definition should be more specific about the types of entities and arrangements to which the disclosures should be applied. For example, if the objective is to capture off-balance sheet entities that are used by the company to facilitate financing, liquidity, cash flows, research and development, and similar activities and the registrant has an unrecognized risk of loss or obligation to fund, finance, guarantee or acquire assets from the entity, then that definition should be specified. In addition, many such arrangements already are required to be disclosed by generally accepted accounting principles.

A second but equally significant concern is establishing "more than remote" as the threshold for disclosure as rather than the existing MD&A threshold of "reasonably likely" which applies to all other disclosures within MD&A. We believe that introduction of a different threshold for disclosures about off-balance sheet arrangements would:

  • confuse investors and other financial statement users who are unlikely to understand that different probability thresholds attach to different disclosures within the same item;

  • imply that off-balance sheet arrangements are inherently more significant and vulnerable than on-balance sheet items (an inference that we believe may be misleading since risk of loss applies equally to on- and off- balance sheet items); and

  • create inconsistency with the historical purpose of MD&A to discuss the business through the eyes of management, which may consider remote outcomes, but which is more likely to manage based on reasonably likely outcomes.

The inconsistent probability standards for determining required disclosure of on- and off- balance sheet risk of loss should be reconciled in the final rulemaking.

It also appears that the proposed amendment to MD&A would apply to off-balance sheet arrangement, requirements that exceed the disclosure principles of FASB Statement No. 5, Accounting for Contingencies (FAS 5) regardless of whether those arrangements involve contingent losses as contemplated by FAS 5. Specifically, proposed Item 303(a)(4)(iii)(D) requires disclosure of a contingent obligation or liability for which it is not probable that a loss has been incurred, or the loss is not reasonably estimable, or for which the reasonably possible maximum amount in a range has not been recognized in the financial statements. It is unclear how disclosure of the existence or amount of a loss for which it is not probable that a loss has been incurred, or the amount cannot be estimated, or for which the upper end of the range of loss is not the best estimate of the loss, would be useful to investors. The proposal is reminiscent of the Commission's proposals with respect to critical accounting estimates. Therefore, the proposed disclosure:

  • is inconsistent with GAAP required disclosures;

  • is similar to, but distinguishable from, the proposals for critical accounting estimates (which apparently may result in different cuts on the same disclosure concept which may be redundant, confusing or both); and

  • encompasses a mixed model of probability in determining what must be disclosed.

If the Commission adopts this disclosure requirement as proposed, a contingent liability or obligation that falls within the scope of FAS 5 and is also within the scope of a critical accounting estimate would be reported within the same periodic report three times and based on a different measurement model for each of the three disclosures. As an example, a registrant that self-insurers workers' compensation or other loss events will disclose the contingent liability in the footnotes based on FAS 5 principles, in the critical accounting estimates based on a second but different set of disclosure principles, and in the off-balance sheet obligations section of MD&A based on a third set of principles. This redundancy may be confusing rather than helpful to investors. It is difficult to contemplate what an investor's reaction will be to having one set of disclosures about contingencies in the financial statements, a different set of disclosures in MD&A, and a third set of disclosures in critical accounting estimates. Further, we believe that the proposed disclosures may be more appropriately summarized in a separate risk factors section rather than included in MD&A that purports to be the business through the eyes of management.

Additionally, the adoption of a threshold for disclosure that captures all obligations and contingent liabilities down to, but not including, the remote category is likely to encompass detail disclosures of voluminous information at a level that may be more costly and less useful to investors than appropriate. Although the aggregation provisions may mitigate the detail, it is unlikely that it will sufficiently reduce the myriad of detail that will be captured by reporting everything that exceeds the remote threshold. Further, the population of events that can be characterized as truly remote has dwindled as events have occurred that previously were considered remote. For example, five years ago the possibility of a drop in the prime rate of interest to below 5% and a drop in the Fed funds rate to below 2% may have been considered remote. In addition, the wholesale overcapacity in the telecommunications industry might have been considered a remote possibility, outside of the realm of reasonably possible, when AT&T was broken up in 1984.

The proposed disclosure requirements could encompass penalty provisions or the right to assert claims based on events for which there may be significant disagreement about whether the probability is more than remote. The task of identifying all events that are considered higher than remote at any given point in time and quantifying the material obligations and liabilities that would attach to those events is both daunting and highly subjective. We believe that the reasonably likely standard as the threshold for disclosure has worked well for the vast majority of public companies and should be continued as the one consistently applied standard for all disclosure requirements in MD&A. We believe that disclosure failures generally have not been the fault of the rule or standard for disclosure but have been at fault in the manner of application. A more stringent standard will not cure failures to follow the rule.

There are several other sections of the proposed rulemaking that need clarification.

Proposed Item 303(a)(4) (D) states:

An analysis of the degree to which the registrant relies on off-balance sheet arrangements for its liquidity and capital resources or market risk or credit risk support or other benefits must be disclosed.

"Degree" is not defined in the proposal nor does an objective measurement criterion for "degree" exist. It is unclear whether "degree" is to be based on the impact such arrangements have on the financial position as of a particular date, the statement of operations for a defined period, or a subjective management measurement. Definitive measurement of "degree" should be provided and should include the measurement criteria.

Proposed Item 303(a)(4)(D)(ii) states:

If under a contractual provision or as a result of a known event, demand, commitment, trend, or uncertainty, an off-balance sheet arrangement that materially benefits the registrant will be terminated or the benefits thereof to the registrant will be materially reduced, or it is reasonably likely that such a termination or reduction will occur, describe the circumstances under which such termination or reduction may occur and discuss any material effects thereof. (Emphasis added.)

Section I.B.3. Proposed Disclosure Threshold states that the word "may" indicates a probability of occurrence that is other than remote. That is, an event may occur unless it is outside the realm of reasonable possibility, or remote. The above sentence in the proposed rule uses a "reasonably likely" standard and a "may occur" standard as a threshold for disclosure. It is unclear whether the proposed disclosure is required when an event is reasonably likely or when it is merely above remote.

Proposed item 303(a)(4)(iii) defines off-balance sheet transactions and arrangements to include those to which the registrant is not a party to the arrangement. It is unclear how a registrant becomes obligated without being a party to an arrangement. If the language is intended to encompass a specific arrangement, clarification of the intended scope should be provided in the final rulemaking.

Proposed Item 303(a)(4)(B) would require a registrant to disclose the nature and amount of assets, obligations and liabilities of the off-balance sheet entity with which the registrant has a transaction or arrangement. We have several concerns about this proposal. First, the registrant may not have access to that information. Second, not all arrangements expose the registrant to sufficient risk to warrant disclosure of all arrangements. We believe an appropriate alternative would be to require disclosure of exposures that individually or, for related exposures in the aggregate, exceed a defined significance level. The disclosures should then be limited to that information that management obtains or has access to monitor its exposure. If no information is available, management should disclose that it has an exposure for which no risk exposure monitoring or evaluation information is available. For example, information about the entire off-balance sheet entity may not be available from a multi-party conduit, leasing company, or similar unconsolidated entity. Finally, any such disclosure should be required in terms of information that is useful to the evaluation of the risk of loss and not merely a pre-ordained set of metrics that may not be relevant to the risk of loss. For example, it is presumed that companies take reasonable actions to protect themselves by requiring delivery of identified information. The disclosure should require no more information than that the company has contractually arranged to obtain for purposes of monitoring its own risk exposure.

Contractual Obligations and Contingent Liabilities

We believe that summarized aggregate disclosures about contractual obligations may not be useful to investors when presented outside the context of the financial statements. The table may become boilerplate and may not provide meaningful information to the investing public because the disclosure does not present information about how obligations will be satisfied based on either the current financial position of the registrant or its on-going projected business activities. While we concur that there is utility to providing a summarized table of all contractual obligations, we believe that objective is best accomplished in the presentation of the statement of financial position and the financial statements taken as a whole so that operating and cash flow information is emphasized as part of a balanced package of information. We have significant concerns that presenting some financial statement information in isolation from other financial statement information detracts from the importance of the financial statements taken as a whole and implies that the isolated information can be or should be used outside of the context of financial statements taken as a whole.

In addition, we believe the Commission should clarify the requirement to include the summarized aggregate disclosures about contractual obligations and contingent liabilities in registration statements filed pursuant to the Securities Act of 1933 (the Securities Act). The proposed instruction to Paragraph (b) of Item 303 would not require the table in a quarterly report on Form 10-Q. However, if an interim period balance sheet is presented in a Securities Act filing, would Item 303(5) require the tabular presentation as of the latest interim period balance sheet date because the instructions do not provide a similar exception? Would this presentation be in addition to or in lieu of providing the summary as of the fiscal year end balance sheet date?

Summary and Recommendation

Consistent with other observations in this letter, we believe that the purposes of MD&A can be appropriately satisfied by careful application of the existing Regulation S-K Item 303. In recognition of the Congressional mandate to adopt rulemaking to address off-balance sheet transactions and arrangements, we support final adoption of the proposed rules with the following modifications:

  • Maintain a "reasonably likely" standard for required disclosure throughout MD&A;

  • Limit required information about off-balance sheet arrangements so that information about the off-balance sheet entity is required only to the extent available and relevant;

  • Refine the definition of off-balance sheet arrangements to ensure that it does not inadvertently scope in arrangements that are part of the ordinary course of a registrant's business;

  • Consider the disclosure initiatives developed in the private sector for off-balance sheet arrangements and not duplicate such disclosure through this rulemaking; and

  • Ensure that MD&A disclosures of contractual obligations are not presented in an isolated manner that detracts from the significance of the resources available to satisfy the obligations or from the importance of the totality of the financial statements of which the obligations are only one part.

Other Matters

We note the proposing release does not propose an effective date for the disclosures that would be required by the final rule. We also note the Commission is required to adopt final rules by January 26, 2003. We believe that transition guidance to at least interim periods ended after March 15, 2003 should be included in the final rule to allow registrants an appropriate amount of time to read, understand, develop processes and accumulate to information for disclosure. The Commission also should recognize that the ability of a registrant to gather the appropriate information to present the data in its December 31, 2002 financial statements may put an increased burden on all the participants in the financial reporting system. During this transition period, the Commission should continue to encourage registrants to follow the guidance in FRR 61.

In the proposing release, the Commission poses a number of questions to elicit comment on specific proposed disclosure requirements. Our comments above are intended to be responsive to many of those questions. Specific responses to those questions are not separately provided.

If you have any questions about our comments please contact Teresa Iannaconi at (212) 909-5426 or Michael Pierce at (212) 909-5663.

Very truly yours,