MD&A Issues, Off Balance Sheet Financing And New Audit Committee Responsibilities
Richard Langan, Business Group Leader at Nixon Peabody LLP, presented a discussion on two current management's discussion and analysis ("MD&A") issues, off balance sheet financing, and new audit committee responsibilities. He began by noting that "MD&A is the linchpin of disclosure and is being closely scrutinized by the SEC's Corporation Finance and Enforcement Divisions." Other than the financial statements, MD&A is the area of disclosure that receives the most SEC comments.
Several of the SEC's new disclosure requirements reflect a direct response to particular problems that were encountered over the past year. For example, new requirements relating to off balance sheet arrangements relate to the Enron debacle and the Dynegy case. With regard to disclosure of contractual obligations, new rules were prompted by the failures of Winstar, Global Crossing and other companies with liquidity crises that weren't disclosed in their MD&A.
The disclosure with regard to off balance sheet arrangements is covered by Item 303(a)(4) of Regulation S-K, which is effective for companies filing reports or registration statements with the SEC for fiscal periods that ended on or after June 15, 2003. The requirement with respect to contractual obligations applies to SEC filings containing reports for fiscal years ending on or after December 15, 2003; however, this requirement is not applicable to small business issuers.
Mr. Langan reports that many companies are uncertain when they should include disclosure of off balance sheet arrangements, or a table of contractual obligations. The requirement is: disclose the arrangements when they have or are reasonable likely to have a current or future material effect on the company's financial condition, results of operation, liquidity, capital resources, revenue or expenses. The SEC has taken the position that an arrangement could have one of these effects even if it is not more likely than not. So, an arrangement can have less than a 50% chance of occurring, but would still need to be disclosed.
Due to the difficulty of ascertaining which arrangements require disclosure, resulting in part from the recent adoption of the FASB's Interpretation No. 46 (FIN 46), companies should begin now to determine which off-balance sheet arrangements will need to be discussed in their year-end Form 10-Ks. The audit firms also are beginning to grapple with FIN 46 and it would be better to determine now whether there are any new or extensive disclosures to be made.
Companies should also begin to determine which of their contractual obligations will require tabular disclosure in their year-end MD&A as a result of the new requirement for tabular disclosure of contractual obligations. The SEC rule calls for disclosure in a table of a variety types of contractual relationships first by type and then by the date they become due. Essentially, the SEC is looking for disclosure by category of long term debt obligations, capital lease arrangements, operating lease arrangements, and other types of contractual obligations.
New Audit Committee Responsibilities - An Update
Mr. Langan next spoke about new audit committee responsibilities, particularly the role of the "audit committee financial expert" ("ACFE"). "The audit committee," Mr. Langan remarked, "is at the center of the Sarbanes-Oxley reforms."
The ACFE rule is a disclosure rule, not a substantive requirement that every company have an ACFE. This disclosure requirement is applicable to annual reports for fiscal years that ended on or after July 15, 2003, except for small business issuers, in which case the applicable date is December 15, 2003.
In order to determine that a company has an ACFE, its board of directors needs to conclude that the individual who constitutes the financial expert has any one of five attributes, which can be gained through any of four prescribed means of education or experience.
If the board relies on "other relevant experience" as part of its designation of the ACFE, the company will be required to list the other relevant experience in its proxy statement. Some companies have amended their audit committee charters to identify other experience that may fall within this category in advance preparation for their reliance on it. Companies are also using expanded D&O questionnaires as a basis for determining the status of an audit committee financial expert.
The need for boards of directors to have an ACFE provides an opportunity for them to consider board succession planning and rotation issues, to upgrade the expertise and experience of their audit committee members, and to recruit of additional members with financial expertise, so that more than one member qualify as an ACFE. However, Langan notes that the demands placed upon an ACFE are rigorous, and it can take a lot of time to find audit committee members who can step up to this level of commitment.
Although the SEC rule provides a safe harbor, stating that the ACFE will not be subject to a higher standard of care than other audit committee members, companies should be aware that state courts may not give credence to the safe harbor and may seek to impose a higher standard on the financial expert. One way to reduce this risk is to provide a disclaimer that addresses this point in the company's audit committee charter. Citigroup and Motorola have amended their charters to include such a disclaimer.
The audit committee charter should be reviewed and updated regularly. The board's annual self-assessment provides a good opportunity to review the audit committee charter. Companies should take a principles-based approach in their audit committee charters, and the charter should be viewed as setting forth the minimum level of duties and activities of the committee.
Langan concluded by noting that the audit committee chair needs assistance. The chair can be close to a full-time job in some companies, and assistance can come from a variety of sources, including the general counsel, chief governance officer, and corporate secretary.