Speech by SEC Staff:
Remarks Before the 2006 AICPA National Conference on Current SEC and PCAOB Developments

by

Sondra L. Stokes

Associate Chief Accountant, Division of Corporation Finance
U.S. Securities and Exchange Commission

Washington, D.C.
December 13, 2006

As I'm sure you are aware, the requirements governing the content of MD&A are found in Item 303 of Regulation S-K, which covers the requirements to discuss liquidity and capital resources, the results of operations, off balance sheet arrangements, as well as provide a table of contractual obligations. It also sets forth disclosures to be made in interim filings, as well as the safe harbor provisions that Brian talked about earlier. Item 303 dates back to 1968, but has been around in its current form since 1980. Since these requirements have not changed significantly over the past two and a half decades, you might think we wouldn't need to continually talk about MD&A disclosures year after year. Why then have we issued six separate pieces of guidance in the form of releases, cautionary advice and Commission statements and one new rule, often with similar themes, in that period?

One of the first questions that came up when we were preparing for this panel was - what is the overall state of MD&A disclosure? So let's take a quick look at how things stand today - a check-up if you will. The last interpretive release on MD&A was issued in December 2003, so registrants have had a few years now to absorb the guidance, apply and even improve upon the initial application.

How have they done? To echo the remarks made in March 2006 by former Commissioner Cynthia A. Glassman, MD&A has improved since the 2003 Release. Quantitatively, we have seen more executive summaries. Qualitatively, the summaries tend to be more informative, particularly when they provide context to the discussion that follows. We have also seen changes in formatting such as the use of headers and tables to help break up MD&A and make it more reader friendly. With respect to results of operations, more companies are explaining why the results of operations are what they are, instead of merely repeating what GAAP requires. So, these are positive changes.

While I am encouraged there has been progress there is plenty of room for improvement. Today I would like to focus my remarks on the following areas where I believe still more improvement is most critically needed: (1) disclosure that explains the why, (2) critical accounting estimates and (3) liquidity.

Explaining the Why
The first thing that will probably strike you if you were to sit down and re-read Item 303 is how broadly it is written. It is meant to give management flexibility in discussing the overall performance of a company, not limiting what is required to be discussed. Through the various interpretive releases, three key objectives of MD&A have been identified. The first objective, and the one that you are probably the most familiar with, is to provide sufficient information to allow an investor to see through the eyes of management. The second objective is "to enhance the overall financial disclosure and provide the context within which financial information should be analyzed" - in other words, to clearly explain the GAAP financial statements and give context to the numbers. The third objective is to provide information about the quality and potential variability of a company's earnings and cash flow so that investors can ascertain the likelihood that past performance is indicative of future performance. It is the combination of the first two objectives that I would like to spend some time on now.

MD&A is an ideal place to disclose information about the most difficult and judgmental areas found in the preparation of financial statements. If you were able to attend OCA's discussion on complex accounting matters and the use of judgment on Monday, this thought should resonant with you. While I am going to talk about critical accounting estimates a bit later, my remarks here are intended to be broader in scope.

MD&A is management's opportunity to tell a story - a non-fiction story of course, but a story nonetheless. Ideally it should be a story that is compelling and understandable, and one that allows the reader to see the company the way management does - both its opportunities as well as the potential risks. It is also management's opportunity to provide some background color to the financial statements, as it gives them an opportunity to talk about the substance of transactions.

It is important to remember that simply complying with GAAP may leaves gaps in disclosure and give investors an incomplete picture of a company's operations. Consistent with the Commission's actions in Edison Schools and Coca-Cola , technical compliance with GAAP does not give you a free pass if GAAP doesn't provide a clear picture of a company's operations and transactions. For those of you not familiar with either of those actions, both are similar in that the Commission alleged a failure to disclose the true nature of certain transactions. MD&A provides an avenue to address some of the imperfections in GAAP with improved disclosure outside of the financial statements - namely, by allowing management to communicate the story behind the numbers as part of the MD&A discussion. Where accounting issues are more subjective and the standards are less detailed, the disclosures in MD&A should comply with both the spirit, as well as the letter, of the law. This helps make the story being told complete, meaning more specific, transparent, and ultimately, more informative.

In 2004, the PCAOB clarified that the reference in AS 2, An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements, to "financial statements and related disclosures" was not intended to cover MD&A. However, MD&A is covered under the definition of disclosure controls and procedures (DCP), as DCP includes information required to be disclosed by the company in the reports that it files or submits under the Exchange Act. Accordingly, in order to conclude whether or not their disclosure controls and procedures are effective, management will need to consider whether the company has appropriate systems in place to generate the necessary information to prepare a complete MD&A.

Critical Accounting Estimates
MD&A is also a good place to disclose information about the areas that are the most sensitive to material change from external factors. Disclosure of critical accounting estimates may be appropriate where the impact of the estimates and assumptions on financial condition or operating performance is material. Disclosure becomes particularly important when the nature of the estimates or assumptions is potentially volatile, either due to the level of judgment necessary to account for highly uncertain estimates and assumptions, or when the estimates and assumptions are readily susceptible to change.

I believe that the disclosure surrounding critical accounting estimates has the potential to be some of the most relevant and important disclosure found in the document. After all, the average lay person often doesn't understand, or at least appreciate the extent to which the use of estimates and assumptions is inherent in the preparation of financial statements. Once you move outside of this conference, there is a risk that users of financial statements may assume when they see audited financial statements that the numbers are the numbers - it is black and white, and there is little, if any, gray. As you well know, that simply isn't true, particularly as accounting moves towards the use of fair value. So it becomes increasingly important to make sure that the use of estimates and assumptions in the preparation of financial statements is adequately communicated to the users of the financial statements.

Unfortunately, all too often I see a discussion of critical accounting estimates that merely repeats the accounting policy disclosure found in the footnotes to the financial statements. Let's be clear here; an accounting policy footnote is not a synonym for a critical accounting estimate disclosure - the objectives are not the same. Ideally, the critical accounting estimates discussion would provide insights into the quality and variability of information regarding financial condition and operating performance. Rather than describing the method used to apply an accounting principle, the discussion of critical accounting estimates presents an analysis of the uncertainties involved in applying a principle at a given time or the variability that is reasonably likely to result from its application over time. This is a perfect example of avoiding duplicative information in MD&A. You've already got the accounting policy disclosure in the financial statements - MD&A can be the avenue to explain what the application of those policies means.

The first step is to make sure it is clear why the accounting estimates or assumptions bear a risk of change. In order to communicate this point, you may wish to consider a discussion of items such as:

• How the estimate was arrived at; how accurate the estimates or assumptions have been in the past; how much the estimate or assumption has changed in the past; and what are some of the drivers in past and expected variability; and
• Whether the estimate or assumption is reasonably likely to change in the future.

Because critical accounting estimates and assumptions are based on matters that are highly judgmental, you should consider discussing the sensitivity of such estimates or assumptions to change, providing a quantified sensitivity analysis when possible. As a general rule, we see far too little quantification, and you should be aware that the staff does issue comments where we believe quantification would provide meaningful information to an investor.

That being said, too much of anything, even a good thing, can still be, well, too much. Limit your discussion of critical accounting estimates to only the most critical so as not to obscure the truly critical ones. These might include the valuation of long-lived assets (including the calculation of impairment charges), goodwill and other intangibles, pensions and other post employment benefits, liabilities and reserves, derivatives and financial instruments, revenue recognition, income taxes, and environmental conservation costs. But please don't use that as a comprehensive list or an all-inclusive one, or think just because I mentioned it that every registrant should be talking about it. The discussion of critical accounting estimates is specific to each company.

Liquidity
Let's move on to a discussion of the third area where I believe improvement is needed - liquidity.

Improved discussion surrounding liquidity certainly isn't a new area of focus. Liquidity was a key item in the 1989 interpretative release, and has continued to be discussed in almost every release since then. When crafting the disclosure, as discussed in the 2003 Interpretive Release, focus should be placed on known trends, events, demands, commitments and uncertainties that are reasonably likely to have a material effect on liquidity. In making disclosure decisions regarding known trends, as discussed in the 2003 Interpretive Release, management should consider ALL relevant information, even if that information itself isn't required to be disclosed.

The fact that this guidance is just as relevant now as it was in 1989 can be seen in the Commission's recent action against the former CEO and CFO of Kmart. The Commission alleged that management failed to disclose the reasons for a massive inventory overbuy and the impact it had on the company's liquidity. What lessons can you take away from this case? When a liquidity issue is identified, as discussed in the 1989 Interpretive Release, disclose how the company intends to remedy the situation, and identify the internal and external sources of liquidity that are available. And if you don't have a plan to remedy the situation, no matter how bad the state of affairs is, the investors should know that as well.

I'd like to go back to the third objective of MD&A I mentioned earlier, and put it in the context of liquidity. That third objective is to provide sufficient information so that investors can determine the likelihood that historical sources of cash are indicative of the company's future ability to meet its cash requirements. With respect to the sources and uses of cash, robust disclosure in this area involves expanding MD&A beyond the information that is available on the face of the cash flow statement, particularly if the indirect method of presenting cash flows is being used. As discussed in greater detail in the 2003 Interpretive Release, the focus should be on the drivers of the company's cash flows, and other information necessary to help someone understand what the future requirements for cash are, and where management intends to obtain those funds. If management anticipates that the funds are going to be generated internally, then a clear explanation of cash flows from operations is critical to help a reader understand the key drivers behind that number. For example, rather than merely citing what the change in working capital was, which is evident from the face of the financial statements, discuss what is causing the changes in the underlying working capital components. Rather than saying cash increased because the company collected more of their accounts receivable, focus on explaining why that change occurred. Was there a new focus on collection of accounts more than 60 days old, a decrease in normal credit terms, a change in collection procedures for a material customer? Has there been a new or increased use of securitizations related to receivables? Are new products and services adding a lift relative to previous product lines? By explaining the underlying causes, a reader will be better able to assess the company's ability to generate similar cash flows in the future.

A second component of the liquidity discussion pertains to a company's borrowings. For many, financing is a key component of a company's liquidity. If financing arrangements have been material to the historical cash flows, you may need to provide additional information in your liquidity discussion. For example, the impact of known or reasonably likely changes in credit ratings, your ability (or inability) to access financing sources including the use of the registrant's own shares as well as any off-balance sheet arrangements you have used historically, or future plans to borrow material amounts are all types of items that you should consider disclosing.

I would encourage management to ask the following questions when reviewing the liquidity discussion. If these questions aren't clearly answered, the disclosure is likely to need to be enhanced.

• What are your obligations? When are they due? What will it take to satisfy them? What is available to satisfy them?
• Can you readily access more cash? How will you access that cash?

I'd like to mention off-balance sheet arrangements here briefly, as the report that was issued on this in 2005 noted that disclosure in this area could use improvement, and I believe that the observations made in 2005 are still true as we near 2007. If you have off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on your financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material, you have a disclosure obligation. As required by Item 303(a)(4) of Regulation S-K, the disclosure should address why you engaged in the off-balance sheet arrangement, the magnitude and importance of the arrangement and the circumstances that would cause you to recognize material liabilities or losses related to the arrangement. Where off balance sheet financing has been used in lieu of more traditional debt or capital raising transactions, discuss why the borrowing was structured the way it was, giving insight into the pros and cons management considered in making their determination that the particular method of financing was the most appropriate one for the company.

Summary
There is a common theme that unites each of the three items I've talked about this afternoon - and it circles back to remembering what the A in MD&A stands for - Analysis. MD&A should go beyond parroting what is apparent from the face of the financial statements, or already provided in the footnotes. Comprehensive MD&As will drill down and analyze the financial statements; explain the whys, highlight the key areas where judgment has been used and discuss the material estimates that were inherent in the preparation of the financials. The liquidity discussion should be a candid picture of demands on a company's cash, and sources available to meet those demands. Ensuring that MD&A is heavy on the "A" will dramatically improve the quality of the disclosures.

http://www.sec.gov/news/speech/2006/spch121306sls.htm