Disclosures About Off-Balance Sheet Arrangements and Contractual Obligations

Release 33-8182 outlines new rules the SEC adopted to implement Section 401(a) of the Act. The new rules expand the information a company must provide in its MD&A. The rules require a company to provide:

• A comprehensive explanation of its off-balance sheet arrangements in a separately captioned section of MD&A; and
• An overview of its aggregate contractual obligations in a tabular format.

With the following exceptions, these new disclosure requirements apply to all issuers, including small business issuers and foreign private issuers. Small business issuers are not required to provide the tabular disclosure of contractual obligations but are encouraged to provide this information. Foreign private issuers are subject to all of the requirements, but are required to provide interim updates only if they file registration statements that require interim financial statements. The rules do not apply to registered investment companies. The rules affecting domestic issuers have been added to Item 303 of Regulations S-K and S-B. Companion rules affecting foreign private issuers have been added to Forms 20-F and 40-F.

Off-Balance Sheet Arrangements

The new rules require companies to disclose information about their off-balance sheet arrangements in a separate section of MD&A in quarterly and annual reports and in Securities Act registration statements. The rules follow current MD&A guidelines, requiring a company to disclose an off-balance sheet arrangement only if it is reasonably likely that the arrangement will have an effect on the company that is material to investors.

Definition – The rules use concepts in existing U.S. accounting literature to define “off-balance sheet arrangements.” Foreign private issuers who do not prepare their primary financial statements in accordance with U.S. GAAP must nevertheless look to the U.S. GAAP references in the definitions to identify the types of arrangements they need to discuss. However, a foreign private issuer’s MD&A should continue to focus on its primary financial statements.

The definition includes the following categories of contractual arrangements:

• Obligations under certain guarantee contracts, whether or not they are recorded as liabilities;
• Retained or contingent interests in assets transferred to an unconsolidated entity;
• Obligations under derivative instruments that are classified as equity; and
• Obligations under material variable interests in unconsolidated entities that conduct certain activities.

Retained or contingent interests include interests in assets transferred to an unconsolidated entity or similar arrangement that serve as credit, liquidity, or market risk support to such entity for such assets.

Obligations under derivatives referred to above relate to derivatives that are excluded from the scope of FASB Statement 133 (pursuant to paragraph 11a). Under U.S. GAAP they are accounted for as equity, and subsequent changes in fair value may not be periodically recognized in the financial statements. Under other GAAP they might be excluded entirely from the balance sheet. The FASB has been evaluating the accounting for such instruments and expects to issue a new standard covering this accounting.

Variable interests in unconsolidated entities include those with the characteristics addressed in FASB Interpretation 46, Consolidation of Variable Interest Entities. This includes entities that provide financing, liquidity, market risk or credit risk support to the registrant, or engage in leasing, hedging or research and development services with the registrant.

Disclosure requirements – Generally, the disclosures should cover the most recent fiscal year. However, the discussion should address changes from the previous year where necessary to an understanding of the disclosure.

Observation – The rules do not specifically cover the interim period MD&A requirements related to off-balance sheet arrangements. The general approach to interim period MD&As in Item 303(b) of Regulations S-K and S-B is to require registrants to describe material changes. The Commission took this approach to updating the new contractual obligations disclosure (discussed below). Therefore, it appears that in interim MD&As registrants need not repeat the disclosure about off-balance sheet arrangements, but should update it to communicate material changes.

A registrant must disclose the following, to the extent necessary to an understanding of its off-balance sheet arrangements:

• The nature and business purpose of the arrangements;
• The importance of the arrangements to the registrant for its liquidity and capital resources, market risk or credit risk support, or other benefits;
• The amounts of revenues, expenses, and cash flows arising from off-balance sheet arrangements;
• The nature and amounts of any interests retained, securities issued, and other indebtedness incurred in connection with such arrangements;
• The nature and amounts of any other material obligations or liabilities (including contingent obligations or liabilities) arising from such arrangements and the triggering events that could cause them to arise; and
• Any known event, demand, commitment, trend, or uncertainty that will result in, or is reasonably likely to result in the termination, or material reduction in, the availability of off-balance sheet arrangements that provide material benefits to the registrant, and the course of action that will be taken or is planned in response to any such circumstances.

Disclosure about an off-balance sheet arrangement is not required until an unconditionally binding agreement exists or, if there is no such agreement, when settlement of the transaction occurs. In analyzing and disclosing off-balance sheet arrangements, those with common or similar effects should be aggregated to the extent aggregation increases understanding.

Contractual Obligations

The new rules require registrants (other than small business issuers) to provide tabular disclosure of their aggregate contractual obligations. Registrants may provide the disclosure in any location within MD&A that they deem appropriate. The table should present information as of the end of the most recent fiscal year. In interim period MD&As, registrants should update the information by disclosing material changes outside the ordinary course of business that have taken place since the most recent fiscal year-end.

The tabular disclosure must cover both on- and off-balance sheet items. It must present aggregate amounts due, by type, for the following types of obligations:

• Long-term debt;
• Capital leases obligations;
• Operating leases;
• Purchase obligations; and
• Other long-term obligations reflected on the balance sheet.

Except for purchase obligations, which are defined in the new rules, companies that prepare their financial statements in accordance with U.S. GAAP should identify items to be included in the above categories based on U.S. GAAP. Other companies should identify these items based on the classifications used in the GAAP they use to prepare their primary financial statements.

A “purchase obligation” is defined as an agreement to purchase goods or services that is enforceable and legally binding and specifies all significant terms. If the purchase obligations are subject to variable pricing provisions, estimates of payments due must be provided in a footnote to the table. The footnotes to the table should also discuss any material termination or renewal provisions.

Observations – The rules are not specific regarding the items to be included in the purchase obligations or the other long-term obligations lines in the table. We understand that the SEC staff expects each management to use judgment and prepare a table that best informs readers about the company’s aggregate future cash payment requirements and believes that a key element of the table will be the footnotes explaining how the table was constructed.

Companies should begin to consider the items they should present in the table and the processes they will need to develop to gather the information. For example:

• For the purchase obligations line, companies may need to develop processes to accumulate obligations related to uncompleted contracts, where no liability has been reflected on the balance sheet.
• For the purchase obligations line, companies will also need to consider how they should communicate cash payment requirements related to completed contracts, where liabilities (i.e., accounts payable, accruals, etc.) are reflected on the balance sheet. Alternatives might range from (1) presenting none of these items in the table and discussing them in a footnote to (2) including in the table all current liabilities with the attributes reflected in the definition. In that regard, it should be noted that some liabilities (e.g., deferred revenue, contingent liabilities) may not meet the definition of a purchase obligation.
• Regarding the other long-term obligations line, companies should consider the extent to which they have items that they should present on this line and whether they need to enhance their processes to be able to schedule the payment requirements with sufficient precision. Examples of such items might include pensions, other postretirement benefits, and income taxes.

The rules contain a safe harbor which specifies that, except for historical facts, the disclosures will be deemed to be “forward looking statements” as that term is defined in the statutory safe harbors. In addition, the “meaningful cautionary statements” element of the statutory safe harbors will be satisfied if all of the disclosure requirements with respect to off-balance sheet arrangements are met.

Effective Dates

Registrants must comply with the off-balance sheet arrangement disclosure requirements in registration statements, annual reports, and proxy or information statements that are required to include financial statements for their fiscal years ending on or after June 15, 2003. Registrants (other than small business issuers) must include the table of contractual obligations in registration statements, annual reports, and proxy or information statements that are required to include financial statements for their fiscal years ending on or after December 15, 2003.

Until the new disclosures are provided, registrants should follow the guidance in FRR 61, Commission Statement about Management’s Discussion and Analysis of Financial Condition and Results of Operations.³

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³This release may be found at http://www.sec.gov/rules/other/33-8056.htm.