The Securities and Exchange Commission (SEC) has adopted final rules requiring public companies to include in Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A):

• a comprehensive explanation of off-balance sheet arrangements in a separately captioned subsection of MD&A; and

• an overview of aggregate contractual obligations in a table.

The off-balance sheet disclosure will be required starting with a company's first SEC filing that contains full-year financial statements for fiscal years ending on or after June 15, 2003. The new contractual obligations disclosure will be required in SEC filings that contain full-year financial statements for fiscal years ending on or after December 15, 2003.

Background and Context of the Amendment

In July 2002, Congress provided the SEC with a statutory basis for the new MD&A rules by passing Section 401(a) of the Sarbanes-Oxley Act of 2002. Section 401(a) requires disclosure of "all material off-balance sheet transactions…that may have a material current or future effect on financial condition, results of operations, liquidity, capital expenditures [or] capital resources."

The new rules, which amend Item 303 of Regulation S-K, not only carry out the mandate of Congress but also continue the SEC's long-term effort to enhance MD&A disclosure. In January 2002, the SEC called upon companies to improve MD&A disclosure, including off-balance sheet arrangements. In May 2002 the SEC issued a proposed rule to require more in-depth disclosure of critical accounting policies and estimates. With this amendment to Item 303, the SEC furthers its goal of enhancing transparency and completeness in MD&A.

Disclosing Off-Balance Sheet Arrangements in MD&A

Off-Balance Sheet Arrangements: What Are They?

"Off-balance sheet" arrangements, such as securitization of financial assets, can provide financing, liquidity, market or credit risk support, or can be used to engage in leasing, hedging, or research and development services. Off-balance sheet arrangements often involve somewhat complex structures, including special-purpose entities, to facilitate a company's transfer of, or access to, assets. The company transferring assets may continue to be involved with the transferred assets under servicing arrangements, financial guarantees, retained interests or other contingent arrangements designed to reduce the risks to the special-purpose entities or other third parties. These arrangements may significantly affect a company's liquidity and capital resources and possibly future operating results.

New Item 303(a)(4)(ii) now defines an "off-balance sheet arrangement" as any transaction, agreement or other contractual arrangement to which an unconsolidated entity is a party, under which a company has:

• any obligation under certain guarantee arrangements (as identified in FASB Interpretation No. 45);

• a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to the entity;
• any obligation (including contingent obligations) under a derivative instrument that is both indexed to the company's own stock and classified as stockholders' equity in the balance sheet; or
• any obligation (including contingent obligations) arising out of a material variable interest held by the company in an unconsolidated entity that provides financing, liquidity, market or credit risk support to, or engages in leasing, hedging or research and development services with, the company.

What Does Item 303(a)(4) Cover?

Although Item 303 of Regulation S-K has long required general disclosure of off-balance sheet arrangements and other contingencies, new paragraph (a)(4) of Item 303 calls for a separately captioned subsection of MD&A that discusses any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on a company's financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.

Which Off-Balance Sheet Arrangements Must Companies Disclose?

Disclosure is required of those off-balance sheet arrangements that are "material to investors." In the adopting release, the SEC included a helpful decision tree to assist in determining whether a particular arrangement requires disclosure:

• first, management should identify and critically analyze off-balance sheet arrangements;

• second, management should objectively assess the likelihood of the occurrence of any known trend, demand, commitment, event or uncertainty, such as performance under a guarantee or recognition of an impairment, that could affect an off-balance sheet arrangement:
  • if management concludes that the known trend, demand, commitment, event or uncertainty is not reasonably likely to occur, then no disclosure relating to the off-balance sheet arrangement is required in MD&A; but
  • if management cannot determine that the known trend, demand, commitment, event or uncertainty is not reasonably likely to occur, then it must assume it will come to fruition and provide disclosure relating to the off-balance arrangement unless it determines that a material effect on the company's financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources is not reasonably likely to occur.

In adopting the "reasonably likely" standard, the SEC backed away from its original proposal to require disclosure of an off-balance sheet arrangement unless the likelihood of a material effect was "remote."

Disclosure of off-balance sheet arrangements is not required until a definitive agreement exists that is unconditionally binding or subject only to customary closing conditions (or, if there is no such agreement, when the transaction is settled).

What Must Be Disclosed?

The separately captioned subsection of MD&A calls for descriptions of the following, to the extent necessary for an understanding of the off-balance sheet arrangement and its effects:

• the nature and purpose of the arrangement;

• the importance to the company of the liquidity, capital resources, market risk support, credit risk support or other benefits provided by the arrangement;
• the revenues, expenses and cash flows of the company arising from the arrangement, the obligations or liabilities of the company arising from the arrangement that are or are reasonably likely to become material, and the triggering events that could cause them to arise;
• the nature and amount of any interests retained, securities issued and other indebtedness incurred by the company in connection with the arrangement; and
• any known event, demand, commitment, trend or uncertainty that will or is reasonably likely to result in the termination or material reduction in the benefits of the arrangement, and the course of action that the company has taken or proposes to take in response.

Which Filings Must Include Off-Balance Sheet Disclosure?

The new off-balance sheet arrangements disclosure required under Item 303(a)(4) will be required in registration statements, proxy statements and periodic reports for which MD&A is required. Unlike the new tabular contractual obligations disclosure discussed below, the off-balance sheet arrangements disclosure will apply to filings containing financial statements for interim periods, such as quarterly reports on Form 10-Q.

New Table of Contractual Obligations

New paragraph (a)(5) of Item 303 requires companies to include in MD&A a table that discloses known contractual obligations, both on- and off-balance sheet, as of the latest fiscal-year-end balance sheet date. In the final rules, the SEC backed away from a proposed requirement relating to disclosure of contingent liabilities and commitments. Additionally, the SEC decided not to require contractual obligations disclosure of "small business issuers" (those companies that are SB filers).

Required Table

This amendment to Item 303 requires disclosure of the amounts of payments that the company owes under contract, aggregated by specified type, for the time periods set forth in the table below. The company may disaggregate the specified categories of contractual obligations using other categories, but the presentation must include all the obligations of the company that fall within the five categories specified in the following table:

	Payments Due by Period
Contractual Obligations	Total			Less than 1 year		1-3 years		3-5 years	More than 5 years
[Long-Term Debt]
[Capital Lease Obligations]
[Operating Leases]
[Purchase Obligations]
[Other Long-Term Liabilities Reflected on the Company's Balance Sheet under GAAP]
Total

 

Which Filings Must Include the Table?

Disclosure of contractual obligations is required to appear in proxy statements and in periodic reports and registration statements covering full fiscal-year periods. A company is not required to include the table in quarterly reports; instead, the company may disclose material changes outside the ordinary course of its business by including in its Form 10-Q a discussion of any relevant changes.

Do the New Disclosure Requirements Apply to Foreign Private Issuers?

These amendments to Item 303 of Regulation S-K apply equally to foreign private issuers and U.S. public companies. However, because foreign private issuers are not required to file quarterly reports, foreign private issuers generally will not be required to update their MD&A disclosure more frequently than annually, unless they file a registration statement that must include interim period financial statements and related MD&A disclosure. While the disclosure provided by Canadian issuers that file Form 40-F is generally that required under Canadian law, the SEC has supplemented these disclosure requirements with specific additional required items of information under Form 40-F as a result of the Sarbanes-Oxley Act.

Foreign private issuers must focus the disclosure about off-balance sheet arrangements and the table of contractual obligations on the primary financial statements presented in the document, while taking any reconciliation to U.S. GAAP into account. To identify the types of arrangements that are subject to disclosure under amended Item 303 of Regulation S-K, a foreign private issuer must assess its guarantee contracts and variable interests pursuant to U.S. GAAP. Foreign private issuers must already make these assessments when reconciling or preparing financial statements in accordance with U.S. GAAP. A foreign private issuer's MD&A disclosure should continue to focus on its primary financial statements despite the fact that its various "off-balance sheet arrangements" have been defined by reference to U.S. GAAP.

When Must Companies Comply With the New Disclosure Requirements?

Companies must comply with the disclosure requirements regarding off-balance sheet arrangements in SEC filings that are required to include financial statements for fiscal years ending on or after June 15, 2003. Companies must include the table of contractual obligations in SEC filings that are required to include financial statements for fiscal years ending on or after December 15, 2003. Although the final rules are silent on the issue, a staff member at the SEC has clarified that disclosure under the new requirements need not appear in a Form 10-Q until disclosure is first made in an annual report on Form 10-K, even if a Form 10-Q includes interim periods ending after the compliance dates for the new requirements. The SEC also stated that it welcomes voluntary compliance before these dates.

Statutory Safe Harbors

The amendment to Item 303 includes a safe harbor that applies the existing statutory safe harbors for forward-looking statements to the disclosure required by the amendment.

Text of the Final Rule

You can find the full text of the SEC final rules at http://www.sec.gov/rules/final/33-8182.htm. You can find further discussion of the Sarbanes-Oxley Act and of other recent laws, regulations, and rule proposals of interest to public companies on our website.

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