11.19.2002

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Updates

On November 4, 2002, the Securities and Exchange Commission proposed an amendment to Item 303 of Regulation S-K that would require a registrant to include in Management's Discussion and Analysis of Financial Condition and Results of Operations:

    • 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 and contingent liabilities and commitments in a table or textual format.

Final action on this proposal is expected by January 26, 2003.

Context of the Proposal

In July 2002, Congress provided the SEC with a statutory basis for this initiative by passing Section 401(a) of the Sarbanes-Oxley Act of 2002. Section 401(a) requires Form 10-Q and 10-K 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 proposed amendment to Item 303 of Regulation S-K not only carries out the Section 401(a) mandate but also continues the SEC's yearlong effort to enhance MD&A disclosure. In January 2002, the SEC called upon registrants to focus on the need for improved MD&A disclosure in three areas, including off-balance sheet arrangements and related party transactions. Together with the SEC's May 2002 initiative to require greater disclosure of critical accounting policies and estimates, the proposed amendment to Item 303 represents the SEC's focus on enhancing transparency and completeness of MD&A disclosure.

Off-Balance Sheet Arrangements

Background

"Off-balance sheet" arrangements, such as securitization, can provide financing, liquidity, market or credit risk support, or document leasing, hedging, or research and development services. Off-balance sheet arrangements can involve somewhat complex structures, including special-purpose entities, to facilitate a company's transfer of, or access to, assets. In many cases, a company transferring assets has some continuing involvement with the transferred assets, such as servicing arrangements, financial guarantees, retained interests or other contingent arrangements designed to reduce the risks to the special-purpose entities or other third parties. A company's liquidity and capital resources – and possibly future operating results – may depend significantly on the use of off-balance sheet arrangements.

"Off-Balance Sheet Arrangements" Covered Under the Proposal

Currently, Item 303 of Regulation S-K requires companies to provide general disclosure of off-balance sheet arrangements and other contingencies in MD&A. The proposed amendment to Item 303 calls for a separately captioned subsection of MD&A that discusses any off-balance sheet arrangements that may have a current or future material effect on a company's financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources. This requirement would apply to periodic reports and registration statements that cover full fiscal-year periods or interim periods. The proposal defines an "off-balance sheet arrangement" as any transaction, agreement or other contractual arrangement to which an entity that is not consolidated with the registrant is a party, and under which the registrant, whether or not a party to the arrangement, has, or in the future may have:

    • any obligation under a direct or indirect guarantee or similar arrangement;

    • a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement;
    • derivatives, to the extent that their fair value is not fully reflected as a liability or asset in the financial statements; or
    • any obligation or liability, including a contingent obligation or liability not classified as a guarantee, to the extent that it is not fully reflected in the financial statements (excluding the footnotes).

Lower Threshold for Disclosure: Higher Than Remote

Consistent with Section 401(a) of the Sarbanes-Oxley Act, this proposal would lower the threshold for disclosure of off-balance sheet arrangements from the existing "reasonably likely" standard to a standard that requires disclosure unless "the likelihood of either the occurrence of an event, or the materiality of its effect, is remote."

Proposed Disclosure About Off-Balance Sheet Arrangements

The separately captioned subsection of MD&A calls for descriptions of:

    • the nature, purpose, and significant terms and conditions of the arrangements;

    • the nature and amount of the total assets, obligations and liabilities of the off-balance sheet entity;
    • the revenues, expenses and cash flows of the registrant arising from the arrangements, the liabilities of the registrant arising from the arrangements that are or may 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;
    • the material effects of the arrangements on the registrant's financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, and capital resources;
    • the effects of a termination or material reduction in the benefits of the arrangements; and
    • the extent to which the registrant relies on these arrangements for its liquidity and capital resources or other benefits.

Contractual Obligations and Contingent Liabilities and Commitments

The SEC has also proposed requiring registrants to include a table in MD&A that discloses contractual obligations and either a table or textual disclosure about contingent liabilities and commitments. This disclosure would include information about a registrant's known contractual obligations and contingent liabilities and commitments, both on- and off-balance sheet, as of the latest balance sheet date.

Proposed Table

The proposed amendment to Item 303 would require disclosure of the amounts of payments that the registrant owes under contract, aggregated by type, for the time periods set forth in the following table:

Contractual Obligations

 

Payments Due by Period

 

 


Total

 

Less than
1 year

 

1-3
years

 

3-5
years

 

More than
5 years

 

[Long-Term Debt]

         

[Capital Lease Obligations]

         

[Operating Leases]

         

[Unconditional Purchase Obligations]

         

[Other Long-Term Obligations]

         

[Total Contractual Obligations]

         

Proposed Disclosure of Contingent Liabilities or Commitments

Under Item 303 as proposed, a registrant would have to disclose, either in a table or text, the amount of contingent liabilities or commitments, classified by those that expire in less than one year, from one to three years, from three to five years and more than five years. The proposed Item 303 disclosure would indicate the range (or maximum amount if no range is specified) of the amount of contingent liabilities or commitments. The proposed disclosure must address any provisions that could create, increase or accelerate obligations, and other relevant information.

Which Filings Must Include the Proposed Table and Disclosure?

Disclosure of contractual obligations and contingent liabilities or commitments would appear in periodic reports or registration statements covering full fiscal-year periods. A registrant would not be required to include the table or repeat the other proposed required textual disclosure in quarterly reports; instead, the registrant may disclose material changes by including in the Form 10-Q a discussion of any relevant changes.

Statutory Safe Harbors

The proposal includes a safe harbor that applies the existing statutory safe harbors for forward-looking statements to the disclosure that would be required by the proposed Item 303 amendments.

Text of the Proposed Rule

As this Update is intended only as a summary of the SEC's proposed rule, you are encouraged to review the full text of the proposed rule at http://www.sec.gov/rules/proposed/33-8144.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.