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U.S. Securities and Exchange Commission

Petition to U.S. Securities and Exchange Commission for Issuance of Interpretive Release:
Appendix A - Proposed Interpretive Release


17 CFR Part xxx

[Release Nos. 33-xxxx; 34-xxxxx; FR-xx]


An Interpretation of Regulation S-K, Item 303, Management's Discussion and Analysis of Financial Condition and Results of Operations

Agency:   Securities and Exchange Commission ("Commission")

Action:   Interpretive Release.

Summary:   The Commission today announced the publication of an interpretive release regarding disclosure required by Item 303 of Regulation S-K, Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A").1 The release sets forth certain views of the Commission regarding disclosure that should be considered by registrants in preparing MD&A. Disclosure matters addressed by the release are (1) liquidity and capital resources including off-balance sheet arrangements; (2) certain trading activities that include non-exchange traded contracts accounted for at fair value; and (3) relationships and transactions on terms that would not be available from clearly independent third parties.

For Further Information Contact: General questions about this release should be referred to Jackson Day, Deputy Chief Accountant, Office of the Chief Accountant, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.

I. Background

In 1989 the Commission issued FRR-36 that addressed MD&A. That release briefly summarized the history of the MD&A requirements from their adoption in 1980. At that time, the Commission noted that:

While the MD&A requirements adopted in 1980 are far more comprehensive than earlier formulations, they are intentionally general, reflecting the Commission's view that a flexible approach elicits more meaningful disclosure and avoids boilerplate discussions, which a more specific approach could foster.

Further a 1987 Concept Release2 notes the following:

The Commission has long recognized the need for a narrative explanation of the financial statements, because a numerical presentation and brief accompanying footnotes alone may be insufficient for an investor to judge the quality of earnings and the likelihood that past performance is indicative of future performance. MD&A is intended to give the investor an opportunity to look at the company through the eyes of management by providing both a short and long-term analysis of the business of the company. The Item asks management to discuss the dynamics of the business and to analyze the financials.

The seeming suddenness and severity of recent investor losses arising from "off-balance sheet" transactions and other arrangements have led the five largest US auditing firms, with the endorsement of the American Institute of Certified Public Accountants (AICPA), to petition the Commission to issue interpretive guidance in three critical areas where greater transparency could provide investors with information important to an understanding of the business activities, financial arrangements, and financial statements as of the most recent balance sheet date and for the most recent annual and interim period(s). The three critical areas are: (1) liquidity and capital resources including off-balance sheet arrangements, (2) certain trading activities that include non-exchange traded contracts accounted for at fair value; and (3) relationships and transactions on terms that would not be available from clearly independent third parties. The firms are considering an additional petition to pursue rulemaking in this area.

The Commission has reviewed the adequacy, clarity, and transparency of disclosure necessary for investors and others to appropriately analyze and understand the business activities, financial arrangements, and financial statements of public companies. In particular, the Commission reviewed the adequacy of disclosures intended to inform investors and other users of financial statements of the extent to which public companies are exposed to adverse effects that may arise as a result of loss of liquidity, off-balance sheet arrangements, and unfavorable market price changes.

The Commission concurs with the concerns expressed by the five firms and the AICPA. We believe that the quality of information provided by public companies in these areas should be improved. Because many companies are currently preparing disclosures for fiscal 2001 annual reports, the Commission considers it appropriate to issue this interpretive guidance addressing the three areas identified by the auditing firms and the AICPA. The Commission is issuing interpretive guidance that should be considered by all public companies in preparing year-end and interim financial reports and disclosures for filings made after the issuance of this release. The Commission will also consider proposing additional rules that would set forth minimum disclosures in these areas to promote more consistency, comparability and transparency of disclosures by registrants.

II. Regulation S-K. Item 303. Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A)

Paragraph (a) of Item 303 of Regulation S-K identifies a basic and overriding requirement of MD&A: to "provide such other information that the registrant believes to be necessary to an understanding of its financial condition, changes in financial condition and results of operations." Accordingly, the development of MD&A disclosure should begin with management's identification of the information that it believes is important to an understanding of the registrant's financial position, of recent or reasonably likely changes in its financial condition, and of the trends underlying its historical and expected results of operations.

Investors, as well as the financial press, have become increasingly interested in public disclosure, or absence of disclosure, concerning liquidity risk, market price risks, and effects of the use of "off-balance sheet" structures. Also, many readers of financial statements have cited a lack of transparency in disclosure about transactions with unconsolidated entities and other parties where that information appeared necessary to understand how significant aspects of the business were conducted.

Responding to these events and concerns, the Commission is issuing interpretive guidance concerning the requirements of MD&A as they relate to (1) liquidity and capital resources including off-balance sheet arrangements, (2) certain trading activities that include non-exchange traded contracts accounted for at fair value; and (3) relationships and transactions on terms that would not be available from clearly independent third parties.

We also want to remind registrants that disclosure must be both useful and understandable. That is, management should strive to provide the most relevant information, and to provide it using language and formats that investors can be expected to understand. Registrants should be aware also that investors will often find information relating to a particular matter most meaningful if it is disclosed in a single location, rather than presented in a fragmented manner throughout the filing.

A. Disclosures Concerning Liquidity and Capital Resources Including "Off-Balance Sheet" Arrangements

Paragraphs (a) (1) and (a)(2)(ii) of Item 303 of Regulation S-K set forth certain requirements for disclosures about "Liquidity" and "Capital Resources" including "off-balance sheet" arrangements that are addressed in this interpretive release. The pertinent language is as follows:

(1) Liquidity. Identify any known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrant's liquidity increasing or decreasing in any material way.

* * * * *

(2)(ii) Capital Resources. Describe any known material trends, favorable or unfavorable, in the registrant's capital resources. Indicate any expected material changes in the mix and relative cost of such resources. The discussion shall consider changes between equity, debt and any off-balance sheet financing arrangements.

A registrant's liquidity and capital resources are closely aligned and disclosures about each are likely to be impacted by many of the same facts and circumstances. To the extent that off-balance sheet arrangements are used by a company in its financing and operations, those arrangements are likely to affect both liquidity and capital resources. Liquidity and capital resources including off-balance sheet arrangements are discussed together below and should be considered together in connection with a registrant's drafting of disclosures about liquidity and capital resources.

1. Liquidity Disclosures

In reviewing MD&A disclosure by public companies, the SEC staff has noted that disclosures in some cases are overly general and provide limited insight into the registrant's liquidity. Disclosure stating only that the registrant has sufficient short- term funding to meet its liquidity needs for the next year provides little useful information. Instead, registrants should describe the sources of short-term funding and the circumstances that could affect those sources of liquidity. For example, a registrant that identifies its principal source of liquidity as operating cash flows may need also to disclose that this source could be negatively impacted by a decrease in demand for the company's products, which in turn is vulnerable to rapid technological changes. Similarly, if commercial paper is a principal source of liquidity, the registrant should consider the need to disclose how this facility could be adversely affected by deterioration in certain of the company's financial ratios or other measures of financial performance. If the registrant's liquidity is dependent upon the use of off-balance sheet financing arrangements such as securitization of receivables or other assets through special purpose entities, the registrant may need to consider disclosure of the market factors that could impact its ability to successfully continue to utilize off-balance sheet financing arrangements such as securitizations.

Registrants are reminded that identification of circumstances that could affect liquidity is necessary if they are "reasonably likely" to occur. This disclosure threshold is considerably lower than "probable." Because market price changes, economic downturns, defaults on guarantees, and contractions of operations are all reasonably likely, the Commission believes that disclosure of the effects on liquidity as a result of the impact of changes should be considered for disclosure pursuant to this item.

Registrants preparing disclosure about liquidity should consider the need to discuss the following:

  • provisions in financial guarantees or commitments, debt or lease agreements or other arrangements that could trigger a requirement of an early payment, additional collateral support, changes in terms, or the acceleration of maturity, such as adverse changes in the registrant's credit rating, earnings, cash flows, or stock price;
  • circumstances that could impair the registrant's ability to continue to engage in certain financially or operationally critical transactions, such as the inability to maintain a specified investment grade credit rating, or specified level of earnings, earnings per share, EBIT or EBITDA, market price per share, or collateral;
  • factors specific to the registrant and its markets that the registrant understands, based on information obtained from rating agencies or other expert sources, are given significant weight in the determination of the registrant's credit rating or otherwise affect the ability to raise short-term and long-term financing;
  • material guarantees of debt or other commitments to third parties; and
  • material written options on non-financial assets (for example, real estate puts).

2. Off-Balance Sheet Arrangements

Registrants should consider the need to provide disclosures concerning transactions, arrangements and other relationships with unconsolidated entities or other persons that result in exposures to the registrant that are not reflected in the financial statements. Disclosure in MD&A is not ordinarily necessary regarding normal executory contracts undertaken in the ordinary course of business for performance of routine services. But specific disclosure may be necessary regarding relationships with unconsolidated, non-independent, limited purpose entities, often referred to as structured finance or special purpose entities. The non-independent, limited purpose entities may be in the form of corporations, partnerships and limited liability companies, trusts, structured finance entities, special purpose entities, or other types of agreements, relationships or understandings. Clear and transparent disclosure may be needed where these entities provide financing, liquidity, market risk or credit risk support; or involve leasing, hedging, research and development services, or present exposures to the registrant and for which the registrant's maximum possible liability is not reflected in the financial statements. The objective of the disclosures should be to provide investors with sufficient information and transparency about how these arrangements expose the registrant to current or future possible liability, obligations, expenses, cash flow impacts or affect the recognition of revenue or carrying value or potential impairment of assets.

Consideration should be given to the need to include information about the arrangements such as: the business purpose and activities; the key terms and conditions of any commitments; the initial and ongoing relationships with the registrant and its affiliates; and the exposures resulting from contractual or other commitments. For example, if the registrant would be economically or legally required to or would be reasonably likely to fund losses, provide additional funding, purchase the capital stock or assets of a structured finance or other entity, or would otherwise be financially impacted by the performance or non-performance of an entity or counterparty to a transaction or arrangement, information about the arrangements and exposures resulting from contractual or other commitments may be needed in order to have a clear understanding of the registrant's business activities, financial arrangements, and financial statements. Other possible disclosures that may be useful include:

1. Total amount of assets and obligations of the entity together with a description of the nature of assets and obligations and including separate identification of the class and amount of any debt or equity securities issued by the registrant;
2. The exit strategy for any special purpose entity; for example, what happens at its maturity if it has a finite life; what otherwise is the registrant's exit strategy for its relationship with the special purpose entity;
3. Amounts receivable or payable and revenues and expenses and cash flows resulting from the arrangements;
4. Extended payment terms of receivables, including loans and debt securities, resulting from the arrangements and related uncertainties as to realization or repayment that is contingent upon future performance;
5. The amounts and key terms and conditions of purchase and sale agreements between the registrant and the counterparties in any such arrangements; and
6. The amounts of any guarantees, lines of credit, standby letters of credit or commitments or take or pay contracts, throughput contracts or other similar types of arrangements including tolling, capacity, or leasing arrangements that could require the registrant to provide funding of any obligations under the arrangements including provisions to guarantee repayment of obligors of parties to the arrangements, make whole agreements or value guarantees.

If a registrant has numerous similar arrangements, the suggested disclosures could be aggregated by similar types of arrangements. The relative significance to the registrant's financial position and results of arrangements with unconsolidated, non-independent, limited purpose entities should be clear from the disclosures.

3. Disclosures About Contractual Obligations and Commercial Commitments

Various accounting standards and Commission rules require disclosure concerning a registrant's obligations and commitments to make future payments under contracts such as debt and lease agreements and under contingent commitments such a debt guarantees. The disclosures that are responsive to these requirements usually are located in various parts of a registrant's filings. We believe that users of financial statements would find it beneficial if aggregated information about contractual obligations and commercial commitments were provided in a single location so that a total picture of obligations would be readily available. One aid to presenting the total picture of a registrant's liquidity and capital resources and the integral role of on- and off-balance sheet arrangements may be schedules of contractual obligations and commercial commitments3 as of the latest balance sheet date, such as the following.

Contractual Cash Obligations Payments Due by Period
Total Less than 1 year 1-3 years 4 - 5 years After 5 years
Long Term Debt          
Capital Lease Obligations          
Operating Leases          
Unconditional Purchase Obligations          
Other Long Term Obligations          
Total Contractual Cash Obligations          

(These tables could be accompanied by footnotes to describe acceleration provisions or other pertinent data)

Other Commercial Commitments Total Amounts Committed Amount of commitment expiration per period
Less than 1 year 1 - 3 years 4 - 5 years Over 5 years
Lines of Credit          
Standby Letters of Credit          
Standby Repurchase Obligations          
Other Commercial Commitments          
Total Commercial Commitments          

The format and content of any such schedules provided by a registrant would necessarily be reflective of their specific obligations and commitments. In that regard the use of the "other" designations would depend upon a registrant's unique obligations and commitments and would include descriptive information as needed to understand the nature and content of items in the "other" category.

B. Disclosures about Certain Trading Activities That Include Non-Exchange Traded Contracts Accounted for at Fair Value

A business activity for which accounting and disclosures have come under intense scrutiny recently is energy trading. Even sophisticated financial analysts who follow and make recommendations about the energy industry now are reported to have expressed concern about the lack of transparent disclosures by and about enterprises engaged in energy trading activities. A lack of transparency and understandability appears also to extend to activities involving trading in other commodity contracts that are accounted for at fair value but for which a lack of market price quotations necessitates the use of fair value estimation techniques. These trading activities may involve contracts indexed to measures of weather, commodities prices, and quoted prices of service capacity, such as energy storage and bandwidth capacity contracts.

Companies engaged to a material extent in (a) energy trading activities as defined in Emerging Issues Task Force Issue 98-10 (EITF 98-10), Accounting for Contracts Involved in Energy Trading and Risk Management Activities, (b) weather trading activities as defined in Emerging Issues Task Force Issue No. 99-2, Accounting for Weather Derivatives, or (c) non-exchange traded commodity trading contracts that are marked to fair value through earnings and are part of analogous trading activities (for example, nonderivative trading contracts on pulp, bandwidth, newsprint, and so on) must provide the specific disclosures in financial statements indicated by applicable accounting standards. However, investor understanding and financial reporting transparency often require additional statistical and other information about these business activities and transactions, as well as any contracts that are derivatives involving the same commodities that are part of trading activities (for example, energy derivatives that are part of energy trading activities as such activities are defined in EITF 98-10) where they comprise a significant part of the registrant's business.

Information about these trading activities, contracts and modeling methodologies, assumptions, variables and inputs, along with explanation of the different outcomes possible under different circumstances or measurement methods, should be considered in management's discussion of how the activities affect reported results for the latest annual period and subsequent interim period and how financial position is affected as of the latest balance sheet date. While some of this information may be provided in response to Item 305 of Regulation S-K, important information about the uncertainties affecting reported financial position and results may be absent without information, quantified to the extent practicable, that;

  • disaggregates realized and unrealized changes in fair value;
  • identifies changes in fair value attributable to changes in valuation techniques;
  • disaggregates estimated fair values at the latest balance sheet date based on whether fair values are determined by quoted market prices or more subjective means; and
  • indicates the maturities of contracts at the latest balance sheet date (e.g., within one year, within years one through three, within years four and five, and after five years).

An example of this disclosure in the form of a schedule is provided below.

Fair value of contracts outstanding at the beginning of the period  xxxxxx
Contracts realized or otherwise settled during the period  xxxxxx
Fair value of new contracts when entered into during the period  xxxxxx
Changes in fair value values attributable to changes in valuation techniques  xxxxxx
Other changes in fair values  xxxxxx
Fair value of contracts outstanding at the end of the period  xxxxxx

Source of Fair Value Fair Value of Contracts at Period-End
Maturity less than 1 year Maturity 1-3 years Maturity 4 - 5 years Maturity in excess of 5 years Total fair value
Prices actively quoted          
Prices provided by other external sources          
Prices based on models and other valuation methods          

In addition, consideration should be given to the need to disclose the fair value of claims against counterparties that are in a net asset position at the most recent balance sheet date, based on the credit quality of the contract counterparty (e.g., investment grade, noninvestment grade; and no external ratings).

C. Disclosures About Relationships and Transactions With Persons or Entities That Are Able To Negotiate Transactions on Terms That Would Not Be Available From Clearly Independent Third Parties

Statement of Financial Accounting Standards No. 57 (FAS 57), Related Party Disclosures, sets forth the requirements under US generally accepted accounting principles concerning transactions with related parties. SEC Regulation S-X Rule 4-08(k) also requires that related party transactions be identified and specifies that the amounts must be stated on the face of the financial statements. Notwithstanding compliance with these requirements, disclosures often are insufficient to explain fully the importance of these relationships to reported financial position and results of operations. In addition, they do not include equally important information about parties, not within the definition of "related parties," with whom the registrant or its related parties has a relationship that enables the parties to negotiate terms that may not be available from other clearly independent parties and are material to an understanding of the registrant's financial condition and results of operations. For example, an entity may be established and operated by individuals that were former senior management of a registrant. The purpose of the entity may be to own assets used by the registrant or provide financing or services to the registrant. Although former management does not meet the definition of a related party pursuant to FAS 57, the former management positions may result in negotiation of terms that are more or less favorable than those available from clearly independent third parties that are significant to the financial position or result of operations of the registrant.

The Commission believes that the understandability of financial statements would be enhanced in many circumstances if MD&A included descriptions of these special relationships and transactions involving related parties, as well as those involving other parties with whom the registrant has an unusual interdependent relationship. Generally, disclosure should include a description of the elements of the transactions that are necessary for an understanding of their business purpose and economic substance, their effects on the financial statements, and the special risks or contingencies arising from the transactions. Discussion of the following may be necessary:

  • the business purpose of the arrangement;
  • a description of persons who have both significant influence relative to the registrant, such as executive officers, management, directors, promoters, principal owners and other related parties, and financial and/or operating interests in entities transacting business with the registrant;
  • the extent of the registrant's influence or control over the transactions or entities;
  • how transaction prices were determined by the parties;
  • if disclosures represent that transactions have been evaluated for fairness, a description of how the evaluation was made; and
  • any ongoing contractual or other commitments as a result of the arrangement.

The Codification is a separate publication of the Commission. It will not be published in the Federal Register/Code of Federal Regulations Systems.

List of Subjects in Parts 211, 231, 241 and 271

Reporting and Record Keeping Requirements, Securities.

Parts 211, 231, 241 and 271 of Title 17, Chapter II of the Code of Federal Regulations are amended by adding this Release No. xxxxxxxx and this release date of January xx, 2002) to the lists of interpretive releases.

By the Commission.

1 The interpretive guidance in this release should also be considered in preparing disclosures that are provided in response to Form 20-F, Item 5. Operating and Financial Review and Prospects, and Regulation S-B, Item 303, Management's Discussion and Analysis or Plan of Operations.
2 See Securities Act Release No. 6711.
3 Disclosure of commercial commitments would communicate potential cash outflows resulting from a contingent event that requires registrant performance pursuant to a funding commitment; for example, funding pursuant to a debt guarantee.



Modified: 01/03/2002