April 17, 2000
Jonathan G. Katz
U.S. Securities and Exchange Commission
Mail Stop 6-9
450 Fifth Street, N.W.
Washington, DC 20549
Re: File No. S7-03-00 (Release Nos. 33-7793; 34-42354)
Supplementary Financial Information
Dear Mr. Katz:
This letter is the response of Arthur Andersen LLP to the Securities and Exchange Commission's request for comments on Release Nos. 33-7793/34-42354 (the "Proposal") regarding (1) the expansion of supplemental disclosure requirements for valuation and loss accrual accounts, and (2) the institution of supplemental disclosure requirements for tangible and intangible long-lived assets and related accumulated depreciation, depletion, and amortization.
We commend the Commission for its continued efforts to address abusive earnings management issues. We also fully support efforts to enhance the quality and transparency of financial reporting. However, we are concerned whether expanding the level of disclosure of detail financial information, as would be required by the Proposal, is a cost effective solution. Considering the existing requirements of both Generally Accepted Accounting Principles (GAAP) and Management's Discussion and Analysis (MD&A), as well as ongoing efforts to improve the quality and relevance of financial reporting, we question whether a significant expansion in the quantity of financial information to be reported to investors is an appropriate next step by the Commission.
It is our view that the Financial Accounting Standards Board's (FASB) conceptual framework identifies objectives of financial reporting and qualitative characteristics of accounting information that are wholly consistent with the Commission's stated objectives. Although the Commission has the authority to require financial information that goes beyond the requirements of GAAP, we would encourage the Commission to take any concerns relative to the level of disclosure in financial statements to the FASB rather than promulgate additional, separate financial information requirements. Alternatively (or additionally), the Commission may have evidence suggesting that the requirements of MD&A are not fully understood or consistently applied. Therefore, actions to enhance the information presented in MD&A may be appropriate.
The Proposal's requirement to provide detailed supplementary financial information clearly will add to the volume of data available to investors. To our thinking, however, the relevant issue is whether such information is sufficiently meaningful and incremental to merit the cost of its preparation. As the Commission is aware, the accounting profession and business community have explored, and continue to address, the broad issue of improvements in financial reporting with the clear objective of meeting investor needs. One of those efforts involves the development of recommendations for ways to coordinate GAAP and Securities and Exchange Commission disclosure requirements and to reduce redundancies. We strongly encourage the Commission to await the outcome of these efforts before mandating a further expansion in the volume of financial information presented in SEC filings. In the interim, we recommend that the Commission limit its changes to providing incremental guidance regarding the requirements of MD&A and Schedule II. Further discussion of the our recommendation is contained in the following section of this letter (MD&A and Schedule II - - Considerations for Improved Disclosures).
Putting aside our recommendation, we acknowledge that the Commission may decide to move forward with the Proposal in its current form. If that is the case, we are concerned about the operationality of the proposed requirements. For that reason, in the final section of this letter (Specific Comments on Proposed Requirements) we identify our concerns and offer suggestions that we believe would improve preparers' ability to understand and consistently apply the proposed rules.
MD&A and Schedule II - - Considerations for Improved Disclosures
We acknowledge the Commission's oversight responsibility to protect investors and to help ensure that appropriate disclosures are made by registrants in financial statements, and in other financial information filed with the Commission, to meet the needs of investors and other users of this information. We also fully support the objectives of transparency in financial reporting and the curbing of earnings management abuses. However, we believe that the tabular presentation of supplementary information about specific balance sheet accounts may not be the most informative or cost effective vehicle. Rather, we believe that (a) incremental guidance regarding the requirements of MD&A, (b) the referral of concerns regarding the adequacy of financial statement disclosures to the FASB, (c) the implementation of new segment disclosures (SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information), and (d) guidance with respect to the existing requirements of Schedule II are an appropriate starting point for achieving the Commission's objectives.
Incremental Guidance for MD&A:
In certain respects the Commission's proposal appears to duplicate the information required in MD&A. It is our view that a narrative discussion regarding significant matters and the events underlying current year operating results and changes in management's judgements about significant uncertainties (consistent with the requirements of Item 303 of Regulation S-K) is a more appropriate, and likely cost effective, means of achieving the Commission's stated objectives than is a detail listing of changes in account balances.
As you know, Item 303 of Regulation S-K requires registrants to "[d]escribe any unusual or infrequent events or transactions or any significant economic changes that materially affected the amount of reported income from continuing operations and, in each case, indicate the extent to which income was so affected. In addition, describe any other significant components of revenues or expenses that, in the registrant's judgment, should be described in order to understand the registrant's results of operations." We believe this requirement is entirely consistent with the objective of informing investors about significant uncertainties in loss accruals, provisions made to address those uncertainties, and changes in management's judgement about those risks. We believe that disclosures in MD&A by registrants concerning historical results have improved over time. However, we acknowledge the existence of opportunities for further enhancing the discussion of known matters, trends or uncertainties that management expects to impact materially future results of operations or cause reported operating results to not be indicative of future operating results.
Accordingly, we suggest that the Commission provide registrants with additional guidance in applying the existing MD&A rules to achieve a greater level of transparency in the discussion of historical results and known material trends. The Commission could provide this incremental guidance through a Financial Reporting Release (similar to FRR No. 36, Management's Discussion and Analysis). Alternatively, the Commission could issue a specific release as was done to communicate the Commission's views on Year 2000 disclosures (i.e. Release No. 33-7558, Disclosure of Year 2000 Issues and Consequences by Public Companies, Investment Advisers, Investment Companies, and Municipal Securities Issuers).
Referral of Disclosure Concerns to the FASB:
We believe that assessing the appropriate level of disclosures of detailed financial information is consistent with the objectives of the private sector standard setting process, which primarily involves the FASB. In its Statements of Financial Accounting Concepts No. 1, Objectives of Financial Reporting by Business Enterprises and No. 2, Qualitative Characteristics of Accounting Information, the FASB discusses the objectives of financial reporting and the criteria or qualities that are needed for high quality, transparent financial statements. Specifically, the objective of financial reporting is to provide information that is useful to present and potential investors in making rational investment, credit and similar decisions, in assessing cash flow prospects and in understanding the enterprise's resources and obligations. Further, the characteristics of accounting information include relevance, reliability, representational faithfulness, verifiability, neutrality, comparability and consistency, and operationality. These objectives and criteria appear to us to be consistent with objectives expressed by the Commission.
We observe that the FASB and other private standard setters consider the level of disclosures required in setting financial reporting standards. For example, with respect to disclosure requirements for valuation and loss accrual accounts and long-lived assets, the private standard setters have addressed specific areas (e.g., SFAS No. 5, Accounting for Contingencies, and SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of) and concluded that the financial reporting objectives were met without requiring detail account analysis. In other areas, (e.g., SFAS No. 109, Accounting for Income Taxes, and EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)), more detailed information has been required. Further, as evidenced by the discussion of segment disclosures below, the FASB has acted, and we believe will continue to act, on financial reporting disclosures that analysts and investors believe are necessary.
We believe the Commission should have confidence in the private sector's ability and willingness to address the need for transparency and quality in financial reporting. Accordingly, we encourage the Commission to refer questions regarding the adequacy of financial statement disclosures to the FASB.
Implementation of New Segment Disclosures (SFAS No. 131):
We appreciate the desire expressed by analysts for the disclosure of more detailed information to allow them to estimate future cash flows. However, we note that the letter from the Association for Investment Management and Research (dated October 19, 1998) referenced in footnote 14 of the Proposal precedes the effective date of SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (i.e., application required beginning with calendar year 1998). SFAS No. 131 requires disclosure, by segment, of (1) depreciation, depletion and amortization expense, and (2) total expenditures for additions to long-lived assets other than financial instruments, long-term customer relationships of a financial institution, mortgage and other servicing rights, deferred policy acquisition costs, and deferred tax assets.
As discussed in the Basis for Conclusions, SFAS No. 131 was issued to address the investor community's concern that disaggregation was needed in order "to predict to the overall amounts, timing or risks of a complete enterprise's future cash flows". The FASB noted that analysts "consistently requested that financial statement data be disaggregated to a much greater degree". In reaching its conclusions, the FASB addressed the need for disaggregated information about operating results, cash flows, assets and liabilities. The FASB specifically considered costs and benefits of disaggregated disclosures, noting that too much detail "may not be useful to readers of external financial statements and it also may be cumbersome for an enterprise to present."
We also note that:
We believe that recent changes in segment disclosures, combined with the existing requirements in GAAP and MD&A, may be sufficient to address to investors need for more information. We also note that the accounting profession continues to address investor needs for quality information and that further enhancements are likely to be forthcoming. We encourage the Commission to assess whether these efforts are sufficient before instituting additional detail disclosures.
Incremental Guidance for Schedule II:
We acknowledge the Commission's observations, as stated in the Proposal, with respect to the Schedule II and agree that the use of the term "reserve" may have confused registrants and contributed to diverse reporting. We also note that the instructions to Rule 12-09 of Regulation S-X are quite brief and that little supplemental guidance has been provided relative to that rule's requirement. Regulation S-X generally uses financial reporting terminology that is well understood by preparers, auditors and investors. It also often states specific materiality thresholds that provide for a consistent understanding of when an item is of sufficient importance to be disclosed. Further, the schedule requirements in Regulation S-X typically relate to captions on the financial statements, thereby allowing both the investor and the preparer understand the context of the reported information. The requirements for Schedule II do not offer that type of clarity. Greater clarity regarding the existing requirement could provide the improvement in reporting that the Commission, preparers and investors seek.
Accordingly, we believe that the Commission could offer incremental guidance with respect to its view on the existing requirements of Schedule II and that a wholesale change in the focus of that supplemental schedule is perhaps premature. Specifically, we suggest that the schedule be linked to line items that are reported on the balance sheet and that quantitative materiality thresholds be used to determine which line items require analysis.
Specific Comments on Proposed Requirements
As indicated above, we believe that the tabular presentation of supplementary information about specific balance sheet accounts may not be the most informative or cost effective vehicle and we have offered comments on the steps we encourage the Commission to take relative to the objectives stated in the Proposal. However, if the Commission moves forward with the Proposal in its current form, we have a number of concerns about the operationality of the proposed requirements. Accordingly, in this last section of the letter we offer suggestions that we believe would improve preparers ability to understand and consistently apply the new rules.
We have organized our comments to respond to the various questions posed in the Proposal. We also offer some incremental observations.
Specific Questions Posed in Proposal:
Questions 1 and 2: Are there other specific loss accrual or valuation accounts that should be added to the list of accounts identified? Should specific percentage tests be used to trigger specific account disclosures within the proposed rules? For example, should disclosure of loss accrual account activity be required only when the balance sheet item and change during the period exceeds a certain pre-established numerical threshold (for example, 5% of total assets or 3% of pretax income)? If so, what is an appropriate threshold?
Definition of terms - We believe the Proposal lacks a clear model with regard to the specific items that the Commission intends for registrants to present, especially for the "valuation and loss accrual accounts." For example, the use of a "laundry list" and the broad phrase, "all loss contingencies recorded pursuant to the requirements of FASB Statement 5," do not provide a practical, operational model for registrants to follow. One of the reasons we find this confusing is that several of the items detailed in the "laundry list" in the forepart of the Proposal do not appear to be valuation accounts or contingent liabilities but rather are merely accruals that are based on estimates. We believe that the establishment of "bright lines" in assessing what disclosures should be made is crucial in developing a functional model that would result in consistent presentation by registrants. In the Proposal the Commission noted that disclosures currently being made in Schedule II are inconsistent between registrants. We believe that the Proposal, as currently worded, would only add to the diversity and inconsistencies in practice.
Several key terms are used in the Proposal that are not adequately defined. For example, the phrase, "major class of valuation or loss accrual account (estimated liabilities)," used in the first sentences of the proposed Item 302(c) and Item 8C(a) should be explicitly defined, as should the phrase, "major long-lived asset accounts," used in the proposed Item 302(d). For a disclosure standard to provide consistent, comparable information between registrants, key terms must be defined clearly in order to avoid confusion on the part of those applying the standard.
We also believe that parameters must be established to avoid the requirement for disclosure of information with little relevance due to immateriality. As currently worded, it appears that the Proposal would require disclosure of all valuation and loss accounts without regard to materiality, thereby establishing a materiality level that is considerably lower than that currently required by Regulation S-X. Similarly, the Proposal would require the discussion of items at a much lower level of materiality than that currently required by Item 303 of Regulation S-K. This lack of consistency in materiality standards for disclosures could create confusion or cause misunderstandings for users of the data and should be reconciled.
Specific Suggestions for Operational Models - - We offer the following specific suggestions relative to a model addressing both the nature of accounts to be disclosed as well as the materiality of those accounts.
1. Valuation and loss accrual accounts - If the Commission proceeds with requiring additional disclosures, we believe the focus of the disclosure should be on accruals and valuation accounts that have materially affected income during the year or are material to a registrant's balance sheet at the end of the year. We believe quantitative tests are an appropriate way of gaining uniformity of disclosure and ensuring that the extent of information reported is not excessive. The following is an option for a model that we believe would be operational:
For purposes of this disclosure requirement, we suggest defining accrued liabilities as any liability other than (a) debt (long term and current), (b) mandatorily redeemable securities, (c) minority interest, (d) net deferred tax liabilities, (e) liabilities for pensions and postretirement benefits other than pensions, and (f) accounts payable, including overdrafts. This definition would link back to line item captions on a balance sheet (e.g. under Article 5 of Regulation S-X) and provide a consistent, understandable framework for determining whether a liability requires disclosure.
Disclosure of the components of the changes in an accrued liability, as defined above, should be required when certain materiality tests are met. Those tests could be designed similar to other materiality tests in Regulation S-X, e.g., Rule 1-02(w). For example, a change in an accrued liability (as defined above) would be disclosed when either of the following conditions is met:
Income statement test: This test focuses on the materiality of the impact of the changes in an accrued liability account on the current year's pretax income. Specifically, disclosure would be required if the absolute value of the amount of the change in the accrued liability account that was reflected in earnings exceeded 10% of the absolute value of (1) pretax income (loss) from continuing operations for the year or (2) the average of the pretax income (loss) from continuing operations for the last 5 years, if the absolute value of the current year income (loss) is at least 10% lower than the absolute value of the 5-year average. This use of averaging is intended to address anomalous situations in which the current year's results are not indicative of a registrant's more typical operations. For example, it reduces the likelihood of a break-even year creating a significant increase in disclosure requirements.
Balance sheet test: This test focuses on the materiality of the accrued liabilities to total accrued liabilities. Specifically, disclosure would be required if the accrued liability's end-of-year balance exceeded 10% of total accrued liabilities. Total accrued liabilities, for this purpose, would be computed as:
Total liabilities less debt (both current and noncurrent portions) less SFAS No. 109 net deferred tax liabilities less accounts payable less liabilities for pensions and postretirement benefits other than pensions = Total accrued liabilities. Mandatorily redeemable securities and minority interest should also be excluded from total accrued liabilities.
Consideration could be given for the development of specific formulas for the balance sheet test for specific industries. For example, in computing the denominator for the proposed balance sheet test for a financial institution, total accrued liabilities could exclude deposits in addition to the items detailed above.
For this purpose, we suggest defining a valuation account as (a) a contra-asset account other than accumulated depreciation, amortization or depletion, or (b) a contra-liability account. Disclosure of the change in a valuation account should be required when either of the following conditions is met:
Income statement test: This test focuses on the materiality of the valuation account's impact on the current year's pretax income. Specifically, disclosure should be required if the absolute value of the amount of the change in the valuation allowance account that was reflected in earnings exceeds the absolute value of 10% of (1) pretax income (loss) from continuing operations for the year or (2) of the average of the pretax income (loss) from continuing operations for the last 5 years, if the absolute value of the current year income (loss) is at least 10% lower than the absolute value of the 5-year average. As stated above, this use of averaging is intended to address anomalous situations in which the current year's results are not indicative of a registrant's more typical operations. For example, it reduces the likelihood of a break-even year creating a significant increase in disclosure requirements.
Balance sheet test: This test focuses on the materiality of the valuation account to the related asset or liability, and that asset's or liability's significance to the total balance sheet. Specifically, disclosure would be required if the valuation allowance's year-end balance exceeds 10% of the related asset or liability account when the related asset or liability itself exceeds 5% of total assets/liabilities.
For the accrued liabilities and valuation accounts exceeding the thresholds of these tests, registrants should be required to present a schedule of changes in the account balance (i.e., a rollforward) for each fiscal year in which a threshold was exceeded. No rollforward should be required for fiscal years in which the thresholds were not exceeded. Thus, for example, a rollforward for accrued warranties would be presented for the current year but not for either of the prior two years if that accrued liability did not meet the materiality thresholds in the prior two years.
1. Long-lived assets and corresponding accumulated depreciation, depletion and amortization accounts - If the Commission proceeds with requiring additional disclosures, we believe the focus of the disclosure should be on long-lived assets that are material to a registrant's balance sheet at the end of the year. We believe quantitative tests are an appropriate way of gaining uniformity of disclosure and also insuring that the reported information is not excessive. The following is a model that we believe would be operational:
Balance sheet test: Our suggested test focuses on the materiality of long-lived assets to total assets at year end. We suggest having three categories for long-lived assets: (1) total property, plant and equipment, (2) total intangible assets (i.e. identified intangibles and goodwill) and (3) any other category of long-lived assets. Each of these three categories should be evaluated separately for significance based on year-end balances. If the year end balance of any of these asset groups exceeds 10% of total assets, disclosure should be required for the group or groups of assets that exceeds the threshold.
Disclosure should be in the form of a rollforward schedule, and should be required only for those categories for which the materiality threshold was exceeded, and only for those years in which the materiality threshold was exceeded. The rollforward schedule should include the major components of property, plant and equipment, consistent with the registrant's GAAP disclosures, while amounts disclosed for intangible assets should be separated into (1) goodwill and (2) identified intangibles.
Questions 3, 4, 5, 7, and 8: Should the placement of the proposed data be moved within MD&A or to some other section of the filing to enhance the prominence of the disclosures? Should presentation of the proposed data be limited to the Form 10-K? Should the disclosure requirements be restricted to those registrants that exceed a certain size or meet some other threshold? If so, what would be the appropriate threshold? Should the disclosures concerning valuation and loss accrual account activity be required when interim financial statements are presented? Should the disclosures concerning changes in property, plant, equipment, and intangible assets and related accumulated depreciation, depletion, and amortization be required when interim financial statements are presented?
The Proposal would require the presentation of the supplemental disclosure information in a manner similar to the current presentation of the Selected Quarterly Financial Data required by Item 302(a) of Regulation S-K. If the Commission concludes that disclosure of the information is required, we believe the information should continue to be presented in schedules to the financial statements in the same manner as the current Schedule II. We do not believe the information warrants the prominence suggested by the Proposal, and we believe that its inclusion in annual reports would be excessive.
We believe that the disclosure of this information should apply only to the primary annual financial statements of a registrant (e.g., the disclosures of the additional supplementary information should not apply to any financial statements presented in response to the requirements of Rules 3-05, 3-09, 3-10 or 3-14 of Regulation S-X). We also do not believe that registrants should be required to report the supplemental disclosure information on an interim basis.
If disclosures of the detail supplementary financial information are required, they should apply to all registrants, including small business issuers and foreign private issuers. We are not aware of any indicators that earnings management or lack of transparency is a problem that is limited to companies of a particular size or a particular geographic location.
Question 6. Are there circumstances where registrants may appropriately exclude disclosure about loss accruals related to litigation because of concerns about confidentiality while still conforming with GAAP? If so, please describe such circumstances in detail.
The Proposal specifically mentions disclosures of contingent income tax liabilities and probable losses from pending litigation. We believe that existing disclosure requirements are adequate given the combination of materiality and the sensitive nature of these items, as discussed below.
Contingent income tax liabilities -
Litigation accruals -
Both contingent income tax liabilities and litigation accruals -
As indicated in the Proposal, Section 23(a) of the Securities Exchange Act of 1934 (the "Act") requires the Commission, when adopting rules under the Act, to consider the anti-competitive effect of such rules, and to balance them against the regulatory benefits that further the purpose of the Act. We believe that instituting additional disclosure requirements for contingent income tax liabilities and litigation accruals could result in competitive harm to a registrant, or could put a registrant at a significant disadvantage with regard to its defense to a litigation matter or a claim asserted against it (e.g., if a registrant was denying and aggressively defending a litigation matter, but had recorded a liability as required by SFAS No. 5, and then was required to disclose the amount accrued, for the other party to readily see). Competitive and/or financial harm to a registrant resulting from such disclosure requirements would also translate into harm to the registrant's investors. This potential for harm, combined with our belief that the existing disclosure requirements for contingent income tax liabilities and litigation accruals are adequate, results in our view that contingent income tax liabilities and litigation accruals should be excluded from any new disclosure requirements for loss accrual accounts.
Examples of the Commission's previous acknowledgements that disclosure of certain information could be detrimental or cause competitive harm to a registrant include:
"Information required by any item or other requirement of this Form with respect to any foreign subsidiary may be omitted to the extent that the required disclosure would be detrimental to the registrant. However, financial statements and financial statement schedules, otherwise required, shall not be omitted pursuant to this instruction. Where information is omitted pursuant to this instruction, a statement shall be made that such information has been omitted and the names of the subsidiaries involved shall be separately furnished to the Commission. The Commission may, in its discretion, call for justification that the required disclosure would be detrimental."
We have several other observations regarding the Proposal, should the Commission move forward with it in its present form:
If the Proposal is implemented, we recommend that prospective adoption be allowed (i.e., prior periods should not be required to be presented upon initial adoption), and that sufficient time be incorporated into the final release to allow registrants adequate time to implement any necessary data accumulation procedures and make any computer systems or other modifications necessary to capture the required information. Specifically, implementation should not be required until the year after any final rules are made, so that registrants are aware of the requirements prior to the beginning of the initial fiscal year for which disclosures will be required. While we have not surveyed our clients, we doubt that many registrants, especially large, multinational registrants, currently accumulate data on a consolidated basis in the manner that would be necessary to meet the presentation requirements.
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We appreciate the opportunity to comment on the rules the Commission has proposed.
If you would like to discuss our comments, please do not hesitate to contact us. Please contact Ms. Amy A. Ripepi at 312-507-7258 or via electronic mail at firstname.lastname@example.org.
Very truly yours,
Arthur Andersen LLP