Speech by SEC Staff:
Critical Accounting and Critical Disclosures

by

Robert K. Herdman

Chief Accountant
U.S. Securities and Exchange Commission

Financial Executives International — San Diego Chapter, Annual SEC Update

San Diego, California
January 24, 2002

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Herdman and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

It is my pleasure to be here to share with you my thoughts about some of the important issues facing virtually everyone in this room. The circumstances surrounding the Enron failure and the billions lost by Enron's investors have highlighted many aspects of our financial reporting process that are in need of attention.

Maintaining the public's trust in our financial reporting process is paramount to the continued success of our capital markets. FEI's membership has a critical role to play in that process. I want to commend Phil Livingston, the President and CEO of FEI, for his letter from the President in the January/February 2002 issue of Financial Executive. That letter emphasized the role of financial management in maintaining capital market efficiency through transparent financial reporting. You are "the front line for shareholders" as the title of his letter states, and following the FEI Code of Ethics as Phil requested, is good for you and for investors.

Many of you have questions about the specific circumstances surrounding the Enron failure. Because the SEC is actively and aggressively investigating the Enron failure, I will not discuss any particulars related to that matter. However, I do want to talk about several recent actions taken by the Commission, and the role that you, as senior financial executives must play in regaining and maintaining investor confidence. These actions are consistent with my objectives in joining the Commission's staff just a little over 3 months ago, specifically to increase the transparency and understandability of financial reporting. The ways in which the Commission has acted reflect a sense of urgency in improving financial reporting this year.

And while I'll focus today on matters that I believe can make an immediate and marked improvement in your financial reporting, I would also point out that there are many other critical steps underway to advance the interests of investors and maintain their confidence in the capital markets. Chairman Pitt recently announced the Commission's vision for a new private sector regulatory oversight body for the accounting profession. In addition, I am confident the FASB will issue definitive guidance on consolidation of so-called special purpose entities this year, and begin work on a revenue recognition project. These are critical initiatives that I hope you will all follow closely.

Before I go too far, let me also point out that as a matter of Commission policy, the comments that I make today are my own and do not necessarily represent the views the Commission, the commissioners or other members of the commission staff.

At the December 2001 AICPA Conference on SEC developments, I described my 3-point plan for advancing investor's interests ¹. The three points of that plan include, working together to: 1) get it right the first time, 2) improve the effectiveness of standard setting, and 3) modernize financial reporting and disclosures.

The SEC has taken three immediate steps towards getting it right the first time that I believe can help to improve the quality of your upcoming 2001 financial reporting. First, I'll talk about disclosures related to critical accounting policies and, secondly, about the Commission's statement with regard to effective disclosure in MD&A. I'll also briefly touch on the third step, the Commission release regarding pro forma earnings releases.

Critical Accounting Policies

On December 12, 2001, the Commission issued Financial Reporting Release (FRR) No. 60, Cautionary Advice Regarding Disclosure About Critical Accounting Policies. I hope that you have had the chance to review the release, and are busily working to incorporate these disclosures in your annual reports. The release encourages registrants and their auditors to pay special attention to the 3, 4 or 5 most critical accounting policies. The Commission also stressed the importance of Management's Discussion and Analysis disclosures regarding the judgments and uncertainties affecting the application of these policies.

A critical accounting policy is one that is both very important to the portrayal of the company's financial condition and results, and requires management's most difficult, subjective or complex judgments. Typically, the circumstances that make these judgments difficult, subjective and/or complex have to do with the need to make estimates about the effect of matters that are inherently uncertain. As the number of variables and assumptions affecting the possible future resolution of the uncertainties increase, those judgments become even more subjective and complex. And, as the time period increases over which the uncertainties will be resolved, as you and I both know those estimates will likely change in a greater number of periods, potentially adding volatility to published results.

At the heart of the Commission's release is the importance of providing investors with an understanding about how management forms its judgments about future events, including the variables and assumptions underlying the estimates, and the sensitivity of those judgments to different circumstances. As the complexity and subjectivity of judgments increase, the inherent level of precision in the financial statements decreases, which is a fact that investors should be told. What they think they know now, is that the numbers at the bottom of the income statement — net income and earnings per share — are the conclusive, perhaps even infallible, measures of a company's performance for a period. That's not really true, of course, and investors need a better picture.

MD&A is the ideal location for providing disclosures regarding these critical accounting policies. The types of judgments that are required by a critical accounting policy are of the variety that may underlie why past performance may not be indicative of future results. In addition, the safe harbor provisions afforded to qualifying MD&A disclosures allow management to provide investors with its views about future events, which, after all, forms the basis for making the underlying estimates.

As senior financial executives, take a fresh look at whether your MD&A clearly portrays the significance of management's assumptions about future events to the current accounting results. Ask yourself whether your disclosures provide appropriate insight into the level of precision inherent in the financial statements and the sensitivity of reported amounts to the methods, assumptions and estimates underlying their preparation.

The Commission's release encourages a proactive discussion about the most critical accounting policies with the audit committee. After management and the auditors have considered the policies and disclosures, but before the financial statements are filed, review your analysis and proposed disclosures with the audit committee. Make sure the audit committee members understand these policies and how they have been applied. Also, invite your attorneys into the discussion they undoubtedly help you with MD&A when you are raising capital, and they can be of great assistance in your annual report as well.

This type of disclosure is new for most companies and the Commission's statements sets forth concepts, rather than detailed rules. As I have described, the types of discourses contemplated by the release are dynamic, entity specific analyses of the impact of the most critical accounting policies and the sensitivity of those judgments to changing circumstances. To elaborate on this let me provide you with a few examples.

Energy Trading Example

Let's start off with an example of a company that has a material portfolio of energy trading contracts. The contracts may have terms ranging from a few months to 10, 15 or 20 years. Existing accounting rules, for the most part to be found in FASB 133 and EITF 98-10, require that these types of energy trading contracts be reported at fair value with disclosure of the amount of gain or loss included in income. But those rules do not specify specific measurement techniques or assumptions used in estimating the fair value of these types of contracts.

As I understand, for energy contracts with durations of five years or less, fair value can generally be derived from similar market transactions. For longer duration contracts, similar market transactions may not be available (at least not in great numbers), so more elaborate valuation models are used to estimate fair value. These valuation models require assumptions about forward prices and commodity or service price volatility.

Depending on the assumptions and estimates used, these valuation models can produce a wide range of estimated fair values. For example, contracts with durations of four or five years have more variability than shorter-term contracts because forward prices are not available beyond three years. Broker-dealer prices can be used to fair value these contracts, but the market for contracts of longer durations with similar terms is often very thin. Contracts with durations greater than five years are likely to have the widest range of possible fair values. Valuation models used in these instances require assumptions about the volatility implied by current transactions or the historical volatility of the commodities and/or services underlying the contract. Information about the process used to value these contracts, the fair value range implied by different broker-dealer prices, and the effect of volatility assumptions may be important to readers of the financial statements.

Information about 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 in the reported period. Because the duration of the contract is an indicator of the level of subjectivity in the contract's estimated fair value, it would be meaningful to disclose fair values of contracts aggregated by the source or method of estimating fair value and the maturity date of the contracts.

The Commission's statement issued just this week with regard to effective disclosure in MD&A has examples regarding the types of disclosures that should be considered for energy trading operations and I'll have more to say on that in a moment.

Loan Loss Allowance Example

As another example, consider banks and other entities that engage in lending activities. As part of managing their business, these entities carefully monitor the credit quality of their loan portfolios and make estimates about the amount of credit losses that have been incurred at each financial statement reporting date. This process significantly impacts the financial statements and involves complex, subjective judgments.

Take a financial institution that is evaluating its loan loss allowance for a significant portfolio of impaired, collateral-dependent loans for office buildings in a region suffering an economic downturn. Based on current information, management has determined that it is probable that that the company will be unable to collect all amounts due according to the contractual terms of the loan agreements. As such, it must evaluate the fair value of the office buildings. In order to estimate fair value, management must use assumptions consistent with those that would be used by unrelated buyers and sellers. These assumptions include occupancy rates, rental rates, and property expenses, among others.

Management should consider disclosing its assumptions underlying the estimated fair value of the collateral and, thus, the corresponding loan loss allowance. Management should also consider describing the sensitivity of the loan loss allowance to results different from those assumed. In other words, if the current market conditions were to continue beyond the point where management (and the market) expects the local economy to turn around, how would the allowance be impacted?

If an investor in a lending entity is to understand the impact of the allowance for loan losses on the company's financial statements, the investor must understand how management performs its analysis of the loan portfolio and how that translates into changes in the allowance. The key is to make clear that the allowance for loan losses is a significant estimate that can and does change based on management's process in analyzing the loan portfolio and on management's assumptions about specific borrowers and applicable economic and environmental conditions, among other factors.

Current accounting policy footnote disclosures about the allowance for loan loss are often boilerplate reproductions of the examples in the AICPA Audit and Accounting Guide for Banks and Savings Institutions. Let's make the disclosures in MD&A come alive! And let's make them in plain English, too.

Product Warranty Example

For balance, let me go through an example of a manufacturer's warranty reserve. Consider a company that manufactures and sells or leases equipment through a network of dealerships. The equipment carries a warranty against manufacturer defects for a specified period and amount of use. Provisions for estimated product warranty expenses are made at the time of sale.

Significant estimates and assumptions are required in determining the amount of warranty losses to initially accrue, and how that amount should be subsequently adjusted. The manufacturer may have a great deal of actual historical experience upon which to rely for existing products, and that experience can provide a basis to build its estimate of potential warranty claims for new models or products.

Necessarily, management must make certain assumptions to adjust the historical experience to reflect the specific uncertainties associated with the new model or product. These assumptions about the expected warranty costs can have a significant impact on current and future operating results and financial position.

In this example, investors may benefit from a clear description of such items as the nature of the costs that are included in or excluded from the liability measurement, how the estimation process differs for new models/product lines versus existing or established models and products, and the company's policies for continuously monitoring the warranty liability to determine its adequacy.

In terms of sensitivity, investors would benefit from understanding what types of historical events led to differences between estimated and actual warranty claims or that resulted in a significant revisions to the accrual. For example, an investor could benefit from understanding if a new material or technique had recently been introduced into the manufacturing of the equipment and historically such changes have resulted in deviations of actual results from those previously expected. Similarly, if warranty claims tend to exceed estimates, say, if actual temperatures are higher or lower than assumed, that fact may also be relevant to investors.

Obviously these examples don't address all of the possible scenarios. While each company will have differing critical accounting policies, the key points for everyone are to identify for investors the 1) types of assumptions that underlie the most significant and subjective estimates; 2) sensitivity of those estimates to deviations of actual results from management's assumptions; and 3) circumstances that have resulted in revised assumptions in the past. There is a great deal of flexibility in providing this information and some may choose to disclose ranges of possible outcomes.

We do intend to initiate rule making to formalize the requirement for these disclosures later this year. Yours and other's efforts this reporting season will provide us input as we move ahead.

Commission statement related to MD&A disclosures

Let me move on to the Commission's recent statement impacting financial reporting. Just a few weeks ago, the five largest national accounting firms, with support from the AICPA, petitioned the Commission to issue an interpretive release covering enhanced MD&A disclosures in three areas². Earlier this week the Commission issued FRR No. 61, Commission Statement about Management's Discussion and Analysis of Financial Condition and Results of Operations, which covers many of the items in that petition, suggesting registrant considerations in meeting their MD&A disclosure obligations in their 2001 annual reports.

The petition, which I noticed was posted on the FEI website, suggested an interpretive release providing guidance on three areas in MD&A:

• Liquidity and capital resources, including off-balance sheet arrangements
   
• Certain trading activities involving non-exchange traded contracts accounted for at fair value; and
   
• Relationships and transactions on terms that would not be available from clearly independent third parties.

You'll notice that the Commission's statement covers the areas raised in the petition, and the release was issued because the Commission believes that, generally, the quality of information provided by public companies in the three areas should be improved.

Understand that the statement is only the first step towards improving financial reporting, and was a timely reaction to the petition. While the Commission intends to consider rulemaking regarding the topics addressed in the statement and other topics covered by MD&A, the purpose of the statement is to suggest steps that issuers should consider in meeting their current disclosure obligations with respect to the topics described.

Before I get into the details of the Commission's statement, I want to reiterate that the current MD&A rules provide management with flexibility to frankly tell their investors about the company's current condition as well as assess its future prospects in a non-prescribed manner. Those rules also impose clear obligations to disclose know trends or uncertainties that are reasonably likely to have a material effect of the registrant's financial condition or results of operations.

I'd like to challenge each of you to capitalize on the flexibility in the rules and avoid discussions that are boilerplate and simply translate the financial statements from numbers into words. I also want put you on notice that investors and the SEC staff alike can be expected to challenge MD&A discussions that are unclear, boilerplate and missing or misleading. The Commission's statement can provide you with some very good insights on how you might energize your disclosures and improve your MD&A disclosures. The statement does not create new legal requirements, nor does it modify existing legal requirements.

This first section of the statement discusses disclosures concerning liquidity and capital resources, including "off-balance sheet" arrangements. In discussing liquidity and capital resources, consider avoiding general and relatively uninformative disclosures indicating that the company is liquid and has sufficient resources to continue its operations for the next year. Instead, elaborate on the sources of liquidity and capital resources as well as the inherent risks of maintaining that liquidity or the availability of the capital resources. For example, if liquidity is provided from operating cash flow, what are the factors that could change that fact? Is the company's operating cash flow subject to changing customer demand due to rapid changes in technology?

As any good legal counsel will no doubt remind you, circumstances that could have material consequences on liquidity and are "reasonably likely" to occur must be disclosed. Some of the factors that may identify trends, demands, commitments, events and uncertainties that require disclosure include provisions that could trigger accelerated maturities or payments due to adverse changes in your credit rating, a financial ratio or stock price. The statement provides many other factors that you should also consider in identifying situations that warrant or require disclosure.

In crafting MD&A, you should also consider the extent to which your company relies on off-balance sheet arrangements as a material source of liquidity and financing. For these types of entities, I would encourage you to take a hard look at the transactions and exposures that your company has with off-balance sheet arrangements, including unconsolidated, special purpose entities. In many cases, companies will need to include information about those arrangements, including any exposures that result from contractual or other commitments, to provide investors with a clear understanding of the impact of the arrangements on your business and the financial statements.

The Commission has also challenged you to consider how you disclose contractual obligations and commercial commitments. Disclosures about these matters can be dispersed throughout the financial statements. To provide investors with a total picture of all of these obligations and commitments, consider aggregating the information in a single location. The statement provides examples of how you might disclose these items in a tabular and easy to understand format.

As I mentioned previously, the Commission's statement also discusses disclosures relating to trading activities that include non-exchange traded contracts accounted for at fair value. I've already described some of the types of disclosures you may consider when, as usually would be the case, your accounting policies for these types of contracts are critical accounting policies. I would encourage you to consider the additional disclosure considerations that are provided in the statement.

The last item that I want to cover is related party transactions. By their nature, transactions with related parties create uncertainty as to the terms of the arrangements. When those transactions are material, GAAP and SEC regulations require that they be disclosed. And when they occur, there is a presumption that the terms are impacted by the relationship, and this is necessary to understand results of operations in the current period, as well as how those results might differ in future periods.

For material related party transactions, I believe that investors can better understand the financial statements when MD&A includes descriptive details of the arrangement. For example, what is the business purpose of the arrangement, and why is a related party being used? Also, how are transactions priced and what are the ongoing contractual or other commitments? Finally, if you make representations comparing the terms of these transactions with terms that would result in transaction with unrelated parties, the basis for those representations should be disclosed.

The Commission also asks management to consider the need for similar disclosures for transactions with parties that fall outside the definition of "related parties." The company may have relationships that enable the parties to negotiate terms of material transactions that may not be available from other, more clearly independent, parties. For example, arrangements with entities established and operated by former members of senior management or individuals with current or former relationships with the company.

Pro Forma Earnings Releases

I know that many companies provide investors with information in pro forma earnings releases and so I wanted to make a few closing comments in that regard.

On December 4, 2001, the Commission issued FRR No. 59, Cautionary Advice Regarding the Use of "Pro Forma" Financial Information in Earnings Releases, which I recommend that you and your company's advisors consider when releasing "pro forma" financial information. One of the key points in the cautionary advice release is that the antifraud provisions of the federal securities laws apply to a company issuing "pro forma" financial information. Last week, the Commission concluded its first pro forma financial reporting case ever, regarding the issuance of a misleading earnings release by the Trump Hotel and Casino Resorts, Inc³.

In the release, the Commission commended the earnings press release guidelines jointly developed by FEI and the National Investors Relations Institute. I would encourage each of you to not deviate from the FEI/NIRI guidance and the SEC cautionary advice release as you develop or review an earnings release containing pro forma financial information. In particular, reconcile any pro forma results to, or from, GAAP results with particularity and disclose the amount for each item.

Closing

As you prepare your 2001 annual reports and write the related MD&A, I encourage you to consider the areas that I have discussed. We at the SEC have given you a lot to think about and I'll pass along some good advice I heard yesterday. That is, this year's MD&A ought not just be a markup of last year's. Start with a clean sheet of paper! Hopefully next year, we can talk together about the changes that have been implemented and the prospects for further improvements in the future.

Now let's spend the rest of our time together discussing your questions and observations.

Endnotes

¹ Advancing Investor's Interests, December 6, 2001, at: http://www.sec.gov/news/speech/spch526.htm

² Available on the SEC website at: http://www.sec.gov/rules/petitions/petndiscl-12312001.htm

³ http://www.sec.gov/litigation/admin/34-45287.htm

http://www.sec.gov/news/speech/spch537.htm