August 05, 2002

Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, N.W., Stop 6-9
Washington, D.C. 20549

Re: File No. S7-16-02-Disclosure in Management's Discussion and Analysis about the Application of Critical Accounting Policies

Dear Mr. Katz:

The Financial Accounting Policy Committee (FAPC) of the Association for Investment Management and Research (AIMR)1 appreciates the opportunity to comment on proposed rule: Disclosure in Management's Discussion and Analysis about the application of Critical Accounting Policies. The FAPC is a standing committee of AIMR charged with both maintaining liaison with and responding to initiatives of standard setters who develop financial accounting standards and regulate financial statement disclosures.

General Comments

The FAPC supports the SEC's efforts in providing rules that will result in improving the quality and transparency of a company's critical accounting policies and estimates used to prepare its financial statements and supporting disclosures. Such transparency only improves the efficiency of the capital markets. However, this objective can only be achieved if (1) a company's management is able to defend the reasonableness of the critical accounting policies and estimates of choice, (2) the company's audit committee has reviewed and agreed with the choices made by management and (3) the company's external auditors opine that management's selection, application and disclosure present fairly the economic substance of the transaction or activity.

Specific Comments

Proposed Scope

Current requirements for financial statements and related management discussion and analysis (MD&A) should be enhanced to provide the detail that investors can rely on to make informed investment decisions. The FAPC supports the SEC's efforts to enhance corporate disclosure, particularly in areas that management has discretion to affect, in a material way, the financial results of the company. With regards to this proposal, the FAPC suggests that the scope of the MD&A disclosure should (1) be expanded as described in the next paragraph and (2) include additional guidance in the proposed rule of the type of disclosure that would be meaningful.

Our understanding of the SEC's proposed rule is that it applies to "the company's reported financial results" which would not include disclosures made in the Notes to the Financial Statements. We believe that the application of the rule should include the Basic Financial Statements2, which includes the notes to the financial statements and any parenthetical disclosures noted on the primary financial statements. Currently, auditors opine on the fairness of the financial information reported in the primary financial statements and the accompanying notes to those statements. Therefore, we believe that companies would incur minimal, if any, additional costs because this information is already (or should be) provided to and audited by the firms' external auditors.

Although we agree that management should have some discretion in reporting and describing the business activities of the company, we believe that the proposed rule should provide more guidance for establishing a minimum basis for disclosure. Our experiences show that companies are not always forthcoming with enhanced disclosure, but instead, often provide boilerplate disclosures with limited value. Therefore, we recommend that guidelines that are more explicit rather than examples be provided to establish a clear basis for disclosure content and format, which will, in turn, provide the SEC a clearer basis to enforce the application of the rule.

Critical Accounting Estimate


We believe that the current proposal does not provide sufficient guidance to apply the rule effectively. In particular, we are concerned that disclosures about the critical accounting estimates as well as the underlying models will not provide sufficient qualitative, as well as quantitative, information about reserve estimates, impairment calculations, technology obsolescence, foreign exchange rate fluctuations, and interest rate exposure. We believe that additional guidance would ensure and provide relevant and transparent information in the disclosures. (See our comments under Disclosure Presentation.)

The proposed criterion for application is a measure of material impact on the company's financial presentation. We believe that materiality should be based on the full range of estimates of potential exposures and not solely on the amount of the estimate reported. Because management most often chooses an estimate in the mid-range of expected exposure, basing materiality solely on the amount of the estimate reported may result in some critical estimates not getting disclosed. Therefore, we suggest the Commission require companies to apply a materiality standard based not only on potential exposure at the consolidated level, but also on potential exposure at the segment level. The committee believes that Staff Accounting Bulletin (SAB) No. 99 provides sufficient guidance on the application of materiality and should be referenced in the rule.

Disclosure of estimates that are the basis for so many line items in financial statements is currently required through proper application of accounting standards. However, because many companies do not comply with the intent of the standards, we recommend that the Commission require management to disclose all estimates used, including the key assumptions and methods used in their calculation. An example would be the estimated fair value used to measure impairment loss on a long-lived asset. This measure impacts a line item but may not be disclosed. We believe that disclosure of the estimated fair value used to measure the amount of the impairment should be disclosed along with any key assumptions as well as the methodology used that may impact on the fair-value calculation or provide insight on how it was derived.

Identification and Analysis of Changes

We support the SEC's proposal to provide quantitative disclosures to demonstrate sensitivity to changes in critical accounting estimates. Nonetheless, the FAPC prefers that companies be provided some flexibility to customize their analyses to best reflect their operations. Therefore, we do not believe that a bright-line test, such as a 10% increase or decrease, is the best measure sensitivity. Moreover, a fixed 10% rule would encourage boilerplate disclosures. Again, we recommend the approach under SAB No. 99, which states that it is inappropriate to rely exclusively on certain quantitative benchmarks in assessing materiality for preparing financial statements. In addition, when applying materiality to a company, the lowest reporting level, e.g., operating segment, and related qualitative, as well as quantitative, elements should be assessed in determining the materiality of an item.

The committee believes that in lieu of a fixed percentage change, companies should be permitted to tailor the disclosure to reflect any particular circumstance, e.g., transaction or activity of the company. For example, management may determine it is useful to provide variations in the estimate, using alternative assumptions or methods, to explain the uncertainty or risks pertaining to the estimate and the possible impact on the company's financial results.

Finally, we believe that the proposal's definition of critical accounting estimates may not capture other areas where estimates may be used. Users of financial statements often adjust a company's reported financial condition and financial results, using financial data provided in the notes to the financial statements. Such items include the fair value estimates of financial instruments which are not recognized in the financial statements but are provided in the notes to the financial statement, as required disclosures per Statements of Financial Accounting Standards No. 107 (SFAS 107), Disclosures About Fair Value of Financial Instruments, and as amended by SFAS 133.

Past Material Changes

The committee believes that not only large companies, but also small business issuers, should be required to provide the quantitative and qualitative discussion of any material changes in those accounting estimates under the proposal. Furthermore, these disclosures should be extended to cover at least five years. We believe that at least five years of historical information is necessary to understand fully the effect that estimates may have on trends and financial ratios. Additionally, companies should be encouraged to provide comparative analyses for longer periods when the information is available.

We agree that companies should provide a sensitivity analyses about the changes in the overall financial performance. However, we are concerned that the proposal may require too many variables in this type of scenario analysis. Companies should have the discretion to provide narrative information of alternative assumptions with summary quantitative analysis. This format would likely reduce the confusion between the method and assumptions used versus the potential outcomes from those methods or assumptions, which were not used in determining the estimate. Finally, we agree that companies should evaluate both positive and negative impacts of a change in assumptions.

Disclosure About Discussions Between Senior Management and the Audit Committee

The current auditing guidelines already require that the audit committee be informed of:

(1) The adoption or change of significant accounting policies;

(2) The methods used in formulating accounting estimates along with the auditor's opinion on the reasonableness of those estimates;

(3) All alternative treatments of financial information within GAAP that were discussed with management;

(4) The ramifications of the use of alternative approaches; and

(5) The treatment preferred by the independent auditor.

We support strongly the proposal that requires the disclosure of this information in the MD&A. Furthermore, the disclosure in the MD&A should be cross-referenced through hyperlinks back to the notes in the financial statements, highlighting the information being discussed.

Independent Auditor Examinations of the Proposed MD&A

The FAPC believes that the external auditor currently audits (or should audit) all critical accounting estimates used in preparation of a company's financial statement as part of the audit engagement. Therefore, the related information about these estimates should be disclosed preferably in the notes to the financial statements. If it is not disclosed in the note, but in the MD&A, then such disclosures should be cross-referenced to the notes.

Quarterly Updates

We support the proposal for quarterly update of critical accounting estimates in the MD&A. It is a long-standing position of the committee that reporting should be made on a timely basis and, if possible, with increased frequency. Therefore, we support MD&A updates in the quarterly filings where the information has a material impact on operations. We do not believe there are any situations that can justify exclusion from the quarterly filing requirements.

Initial Adoption of Accounting Policies

We support the additional qualitative disclosure on the initial adoption of critical accounting policies. The committee believes that any insight provided by this added disclosure about an accounting policy chosen by management, why they chose it and the impact of the policy on the corporation will help investors make better decisions. Investors would further benefit if the information were provided on a timely basis. Therefore, we recommend that initial adoption should be disclosed in the quarter of its first adoption. Since adoption of accounting policies is subject to the auditors' review, any related discussions should be included with the management discussion in the MD&A and be referenced to the notes in the financial statements using electronic hyperlinks.

Disclosure Presentation

It has been our observation that the current interpretations for existing rules have often resulted in the use of boilerplate disclosures in MD&A. Many disclosures are simply updates from previous years by changing the dates and respective dollar amounts and/or ratios. Therefore, we are concerned that the proposed rule will have similar results. Unless the SEC enforces meaningful disclosure, it is unlikely that filers (both domestic and foreign) will adhere to the spirit of the rule.

The committee believes that tabular presentation is more informative and transparent for investors to understand and, as a result, should be recommended for disclosure of various critical assumptions and their impact. The following table on the next page is an example of this type of disclosure for a hypothetical bank.

Balance Sheet Caption Critical Estimate Item Nature of Estimates Required Assumptions / Approach Used Effect If Different Assumptions / Approach Used
Derivative product Assets Fair market value of assets with limited marketability; value of derivative contract at maturity Estimating market value of underlying hedged asset; level of counterparty risk; likelihood of finding a party willing to purchase the assets; price at which party would purchase the assets Management uses quotes provided by the broker institution to estimate fair market value of derivative instrument Likelihood of finding a third-party buyer could reduce the carrying value of the asset if sold prior to maturity, reducing valuation by at least 50%; if contract is held to maturity, it is anticipated that gain or loss will be offset by changes in value to underlying hedged asset
Investment securities Fair market value of securities Estimating interest rates on securities with comparable maturities and credit risk Used quoted prices for securities with available comparables; used estimates for those without comparables based on calculations Creditworthiness of companies and changes in yield curve over the duration of these investments can have significant impact on the valuation of fixed-income securities


Loans Potential for loan losses Severity, frequency and timing of losses in loan portfolio Expectations based on loan guidelines set by banking regulators and by in-person inspections from regulators; including guidelines on classification of loans as non-performing or past due If economy sours, incidence and frequency of loss will rise; depending on severity of economic downturn, actual loss rates could climb from 1.50% of gross loans to as much as 4.50%
Securities under repurchase agreements Ability of counterparty to fulfill obligations Assumptions about credit quality of counterparty to repo transactions Exposure to any one counterparty is limited to XX% of the total repo. As such, we have estimated that potential losses are minimal. If one or more counterparty fail to fulfill obligations, the value of the portfolio could diminish;

Application to Foreign Private Issuers

We agree with the Commission's proposal to require foreign private filers to disclose how their reconciliation to U.S. GAAP is affected by critical accounting estimates. Furthermore, we agree with the proposal to require such foreign filers to disclose the initial adoption of accounting policies, both in relation to their use in the companies' primary financial statements and in their reconciliation with US GAAP. By requiring disclosures of such information, the Commission will enhance the ability of investors in U.S. capital markets to make informed investment decisions.

However, we are concerned about the Commission's continued willingness to permit foreign filers to only provide annual updates of the proposed MD&A disclosures. The omission of such information, we believe, will do more harm than good for the foreign filers because investors will likely avoid allocating funds to companies whose financial condition and results are not readily comparable. Therefore, the committee strongly believes that foreign issuers should be required to provide the same substantive disclosures, as do domestic companies.

Application to Small Business Issuers

We do not believe that small and medium-sized enterprises (SMEs) should receive an exemption from disclosing critical accounting estimates and initial adoption of accounting policies because they have not generated revenues in the previous two years. Our primary concern is that these companies pose some of the greatest risks in the markets if, for no other reason, because they have not generated revenues over the past two years. As such, when they start generating sales it is important that investors understand the manner in which they are recording those transactions. Therefore, we would suggest the Commission alter its proposal as it relates to these companies by requiring them to provide the MD&A disclosures proposed, in addition to the information already required about their business plans.

We do not believe requiring the additional disclosures will create an undue burden for the companies involved, regardless of their size. No doubt, management of these companies already will have educated themselves about the implications of the decisions relating to estimates and new policies. Furthermore, it is likely they either will analyze the alternatives on their own or receive analyses from hired consultants or auditors. As such, it will not create an excessive burden on SME's to inform their owners about the policies they have chosen and why.

Application of Safe Harbors for Forward-looking Information

We fully support the Commission's proposal to require forward-looking statements of reporting companies. However, we are concerned that filers will use specific examples of some required forward-looking statements to formulate boilerplate disclosures in the future. To that end, we recommend that the Commission provide guidance, instead of examples, on the kinds of key events and issues that would warrant such forward-looking statements, together with the kind of information relating to those issues that would be helpful to investors.

Concluding Remarks

The FAPC support the SEC's attempt, through this Proposal, to improve the quality and timeliness of information that is made available to market participants. We greatly appreciate the opportunity to comment on this Proposal. If we can provide additional information related to positions in this letter, please do not hesitate to contact us.


/s/ Ashwinpaul C. Sondhi
Ashwinpaul C. Sondhi, Ph.D.
Chair, Financial Accounting
          /s/ Nazir S. Rahemtulla
Nazir S. Rahemtulla, CFA
Policy Associate, Advocacy

cc: U.S. Advocacy Committee
Financial Accounting Policy Committee
Patricia D. Walters, Ph.D., CFA - Sr. Vice President, AIMR Professional Standards and Advocacy
Rebecca T. McEnally, Ph.D., CFA - Vice President, AIMR Advocacy

1 With headquarters in Charlottesville, VA, and regional offices in Hong Kong and London, the Association for Investment Management and Research® is a non-profit professional organization of 59,000 financial analysts, portfolio managers, and other investment professionals in 107 countries of which 45,200 are holders of the Chartered Financial Analyst® (CFA®) designation. AIMR's membership also includes 116 affiliated societies and chapters in 29 countries. AIMR is internationally renowned for its rigorous CFA curriculum and examination program, which has more than 100,000 candidates from 143 nations enrolled for the June 2002 exam.
2 As defined in the Statement of Financial Accounting Concepts No. 5.