SEC Proposals Address Financial Disclosure Sarbanes-Oxley Rules - Off-Balance Sheet Arrangements, Use of Non-GAAP Financial Measures and Filing of Earnings Releases

In November, 2002, the SEC proposed new rules to implement Sections 401(a) and 401(b) of the Sarbanes-Oxley Act of 2002. These proposed rules would require disclosure in the Management's Discussion and Analysis of Financial Condition and Results of Operations section of a company's periodic reports of off-balance sheet transactions and other relationships, as well as contractual obligations and contingent liabilites and commitments. The proposed rules would also define the conditions under which public companies may disclose or release financial information that is derived on the basis of methodologies other than in accordance with the GAAP and would require public companies to file their earnings releases on Form 8-K.

On November 4 and 5, 2002, the SEC proposed new rules to implement Sections 401(a) and 401(b) of the Sarbanes-Oxley Act of 2002 (the Act). The proposed rules would require disclosure in the Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) section of a company’s periodic reports of off-balance sheet transactions and other relationships, as well as contractual obligations and contingent liabilities and commitments. The proposed rules would also define the conditions under which public companies may disclose or release financial information that is derived on the basis of methodologies other than in accordance with generally accepted accounting principles (GAAP) and would require public companies to file their earnings releases on Form 8-K.

The SEC has solicited comments with respect to numerous issues raised by the proposed rules. Comments were due December 4, 2002 with respect to the proposed rules regarding off-balance sheet arrangements, contractual obligations and contingent liabilities and commitments. Comments were due December 5, 2002 with respect to the proposed rules regarding non-GAAP financial measures and filing earnings releases on Form 8-K. Given the scope of comments requested by the SEC, the rules as finally enacted are likely to contain significant differences from the proposed rules.

Section 401(a) of the Act added Section 13(j) to the Securities Exchange Act of 1934 (the "Exchange Act"), which requires the Commission to adopt final rules by January 26, 2003 to require each annual and quarterly financial report required to be filed with the Commission by domestic or foreign companies to disclose "all material off-balance sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of the issuer with unconsolidated entities or other persons, that may have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenues or expenses."

In implementing the legislative mandate in Section 13(j) of the Exchange Act, the SEC has stated that its objectives are: (i) to provide investors with the information and analysis necessary to gain a more comprehensive understanding of the implications of a company’s obligations and contingencies from off-balance sheet arrangements that are not readily apparent or understood from a reading of the financial statements alone; and (ii) to better inform investors of the aggregate impact of short- and long-term contractual obligations and contingent liabilities and commitments of a company from both on- and off-balance sheet activities.

The proposed rules define the term "off-balance sheet arrangement" as any transaction, agreement or other contractual arrangement that is not required by GAAP to be reflected on a balance sheet and to which an entity that is not consolidated with the reporting company is a party, under which the reporting company, 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 the fair value thereof is not fully reflected as a liability or asset in the financial statements; or
• any obligation or liability, including a contingent obligation or liability, to the extent that it is not fully reflected in the financial statements (excluding the footnotes thereto).

Such obligations or liabilities include:

• obligations that are not classified as liabilities according to GAAP;
• contingent liabilities that, as of the date of the financial statements, are not probable or, if probable, are not reasonably estimable; and
• liabilities as to which the amount recognized in the financial statements is less than the reasonably possible maximum exposure to loss under the obligation as of the date of the financial statements.

The Commission’s proposal makes clear that no obligation to make disclosure of an off-balance sheet arrangement shall arise until an unconditionally binding definitive agreement, subject only to customary closing conditions, exists or, if there is no such agreement, when settlement of the transaction occurs.

The threshold for disclosure of off-balance sheet arrangements falling within the proposed definition is whether they "may have a current or future material effect on the company’s financial condition, changes in financial condition, results of operations, revenues or expenses, liquidity, capital expenditures or capital resources." Disclosure would not be required for off-balance sheet arrangements where the likelihood of either the occurrence of an event, or the materiality of its effect, is remote.

The Commission states in its release that to apply the proposed disclosure threshold, management must make assessments similar to those required for current MD&A disclosure of known trends, demands, commitments, events or uncertainties. Under the proposed disclosure threshold, management first must identify and carefully review the company’s direct or indirect guarantees, retained interests, equity-linked or -indexed derivatives and obligations (including contingent obligations) that are not fully reflected on the face of the financial statements. Second, management must assess the likelihood of the occurrence of any known trend, demand, commitment, event or uncertainty that could either require performance of a guarantee or other obligation, or require the company to recognize an impairment. If management concludes that the likelihood of occurrence is remote, then no disclosure would be required under the proposed rules. If management cannot make that determination, it would have to evaluate the consequences of the known trend, demand, commitment, event or uncertainty on the assumption that it will occur, and disclosure then would be required unless management concludes that the likelihood of the event having a material effect is remote. The assessment of remoteness must be objectively reasonable, viewed as of the time the determination is made.

Under the proposed rules, a series of disclosures regarding off-balance sheet arrangements would be required to the extent necessary for an understanding of the effect of the arrangements on a company’s financial condition, changes in financial condition, revenues and expenses, results of operations, liquidity, capital expenditures and capital resources. A reporting company would be required to disclose the nature and business purpose of disclosable off-balance sheet arrangements. In addition, companies would be required to disclose, to the extent material to an understanding of the proposed disclosure, the significant terms and conditions of the off-balance sheet arrangements. The proposal would also require a company to disclose the nature and amount of the total assets and total obligations and liabilities (including contingent obligations and liabilities) of an entity in which off-balance sheet activities are conducted. Specific disclosure would be required of:

• the amounts of revenues, expenses and cash flows arising from the arrangements;
• the nature and total amount of any interests retained, securities issued and other indebtedness incurred; and
• the nature and amount of any other obligations or liabilities (including contingent obligations or liabilities) of the company arising from the arrangements that are, or may become, material and the triggering events or circumstances that could cause them to arise.

The proposals would require a company to provide management’s analysis of the material effects of the off-balance sheet arrangements and resulting obligations and liabilities on the company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures and capital resources. A company would also have to provide an analysis of the degree to which the company relies on off-balance sheet arrangements for its liquidity and capital resources or market risk or credit risk support or other benefits and the effects of a termination or material reduction in the benefits of off-balance sheet arrangements if such termination or reduction is reasonably likely to occur.

The proposed rules would require a company to present the disclosure about off-balance sheet arrangements in a designated section of MD&A. According to the Commission’s release, the proposed MD&A discussion should also be presented in a language and a format that is clear, concise and understandable, rather than in such a manner that only an investor who is also an accountant or financial expert or an expert on a particular industry would be able to fully understand.

The SEC suggested in its November 4 proposing release that aggregated information about contractual obligations and contingent liabilities and commitments in a single location in MD&A would improve the transparency of a company’s short- and long-term liquidity and capital resource needs and demands and would also provide appropriate context for investors to assess the relative role of off-balance sheet arrangements with respect to liquidity and capital resources. The Commission’s proposed rules would require all domestic and foreign companies filing annual reports under the Exchange Act (other than small business issuers) to include tabular disclosure about contractual obligations, and either tabular or textual disclosure about contingent liabilities and commitments, in the MD&A section in their annual reports. Companies would not be required to include the table or repeat the other proposed required textual disclosure in quarterly reports, but should discuss material changes to the amounts of contractual obligations and contingent liabilities and commitments.

The proposed table requires disclosure of the amounts of contractual obligations, aggregated by type of contractual obligation, for at least the periods specified in the table below. If appropriate, a company may use other categories of obligations that are suitable for its business. The table should be accompanied by any footnotes that are necessary to describe provisions that create, increase or accelerate obligations, or other pertinent data.

Under the proposed rules, a company would also have to disclose, either in tabular format or in text, the expected amount, range of amounts or maximum amount of contingent liabilities or commitments that are expected to expire in less than one year, in from one to three years, in from three to five years, and in more than five years. If a range of amounts is not presented, the disclosure should indicate whether the amount disclosed is an expected amount or a maximum amount. The contingent liabilities or commitments must be aggregated by type in a manner that is suitable for the company’s business. In its release, the Commission gives examples of contingent liabilities or commitments that would be covered under the proposals, including lines of credit, standby letters of credit, guarantees, and standby repurchase obligations. Unlike the proposed disclosure about off-balance sheet arrangements, which is required to be set apart in a designated section of MD&A, a company may place the tabular and textual disclosure of known contractual obligations and contingent liabilities and commitments in any MD&A location that it deems appropriate.

Section 401(b) of the Act directs the Commission to adopt rules requiring that any public disclosure or release of non-GAAP financial measures by a company filing reports under Section 13(a) or 15(d) of the Exchange Act be presented in a manner that:

• does not contain an untrue statement of a material fact or omit to state a material fact necessary in order to make the non-GAAP financial measure, in light of the circumstances under which it was presented, not misleading; and
• reconciles the non-GAAP financial measure presented with the financial condition and results of operations of the company under GAAP.

In its November 5 release, the Commission proposed a new disclosure regulation, Regulation G, which would require public companies that publicly disclose or release non-GAAP financial measures to include, in that disclosure or release, a presentation of the most directly comparable GAAP financial measure and a reconciliation of the disclosed non-GAAP financial measure to the most comparable GAAP financial measure. In addition, the Commission proposed amending Item 10 of Regulations S-K and S-B and Form 20-F to provide additional guidance to companies that include non-GAAP financial measures in Commission filings. The SEC also proposed to require that public companies file on Form 8-K earnings releases or similar announcements, which would make those filings subject to the guidance in amended Item 10 of Regulations S-K and S-B.

Proposed Regulation G would apply whenever a company that is required to file reports pursuant to Sections 13(a) or 15(d) of the Exchange Act (including, under certain circumstances, a foreign private issuer, but excluding registered investment companies) discloses or releases publicly any material information that includes a non-GAAP financial measure. A "non-GAAP financial measure" is a numerical measure of a company’s historical or future financial performance, financial position or cash flows that:

• excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that are included in the comparable measure calculated and presented in accordance with GAAP in the statement of income, balance sheet or statement of cash flows (or equivalent statements) of the company; or
• includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the comparable measure so calculated and presented.

The definition of non-GAAP financial measures is intended by the Commission to capture all measures that have the effect of depicting either:

• a measure of performance that is different from that presented in the financial statements, such as income or loss before taxes, or net income or loss as calculated in accordance with GAAP; or
• a measure of liquidity that is different from cash flow or cash flow from operations computed in accordance with GAAP.

Proposed Regulation G and the Commission’s proposing release make clear, however, that non-GAAP financial measures would not include:

• operating and other statistical measures (such as unit sales, numbers of employees, number of subscribers, or number of advertisers);
• ratios or measures that are calculated using only:
• financial measures calculated in accordance with GAAP; and
• operating measures or other measures that are not non-GAAP financial measures;
• disclosures of amounts of expected indebtedness, including contracted and anticipated amounts, and amounts of repayments that have been planned or decided upon but not yet made;
• disclosures of estimated revenues or expenses of a new product line, so long as such amounts were estimated as GAAP figures; and
• measures of profit or loss and total assets for each segment required to be disclosed in accordance with GAAP.

An example of a non-GAAP financial measure would be a measure of operating income that excludes one or more expense or revenue items identified as "non-recurring." Another example would be EBITDA (earnings before interest, taxes, depreciation and amortization), which could be calculated using elements derived from GAAP financial presentations but is itself not presented in accordance with GAAP. An example of a ratio that would be a non-GAAP financial measure would be a measure of operating margin where either the revenue component or the operating income component of the calculation, or both, were not calculated in accordance with GAAP. Examples of ratios and measures that would not be non-GAAP financial measures would include sales per square foot (assuming that the sales figures were calculated in accordance with GAAP) and same store sales (again assuming the sales figures for the stores were calculated in accordance with GAAP).

Proposed Regulation G would require affected companies to provide the following information as part of the disclosure or release of the non-GAAP financial measure:

• a presentation of the most directly comparable financial measure calculated and presented in accordance with GAAP; and
• a reconciliation (by schedule or other clearly understandable method), which is required to be quantitative for historic measures and quantitative, to the extent available without unreasonable efforts, for prospective measures, of the differences between the non-GAAP financial measure presented and the most comparable financial measure or measures calculated and presented in accordance with GAAP.

With regard to the quantitative reconciliation of forward-looking non-GAAP financial measures, a schedule or other presentation detailing the differences between the forward-looking non-GAAP financial measure and the appropriate forward-looking GAAP financial measure would be required. If the GAAP financial measure is not accessible on a forward-looking basis, the company must disclose that fact, explain why it is not accessible on a forward-looking basis and provide any reconciling information that is available without an unreasonable effort. The company must also identify any information that is unavailable and disclose its probable significance.

If a non-GAAP financial measure is released orally, telephonically, by webcast or broadcast or by similar means, proposed Regulation G would permit a company to provide the required accompanying information by posting it on the company’s website so long as the company discloses the location and availability of the required accompanying information during its presentation.

Proposed Regulation G also provides that a non-GAAP financial measure, taken together with the accompanying information, may not misstate a material fact or omit to state a material fact necessary to make the presentation of the non-GAAP financial measure not misleading, in light of the circumstances under which is it presented. Regulation G expressly provides that nothing in the Regulation will affect any person’s liability, and a person’s compliance or non-compliance with Regulation G will not affect any person’s liability, under Exchange Act Section 10(b) or Rule 10b-5 thereunder.

Proposed Regulation G would apply to companies that are foreign private issuers, except that it would not apply to the public disclosure of a non-GAAP financial measure by or on behalf of a foreign private issuer if the following conditions were satisfied:

• the securities of the issuer are listed or quoted on a securities exchange or inter-dealer quotation system outside the United States;
• the non-GAAP financial measure and the most comparable GAAP financial measure are not calculated and presented in accordance with generally accepted accounting principles in the United States; and
• the disclosure is made by or on behalf of the foreign private issuer outside the United States, or is included in a written communication that is released by or on behalf of the foreign private issuer only outside the United States.

This exception would still apply notwithstanding the existence of any of the following circumstances:

• foreign or U.S. journalists or other third parties have access to the information, so long as the information is disclosed or released by or on behalf of the foreign private issuer only outside the United States;
• following its release or disclosure, the information appears on one or more web sites maintained by the foreign private issuer, so long as the web sites, taken together, are not available exclusively to, or targeted at, persons located in the United States; and/or
• following the disclosure or release of the information outside the United States, the information is included in a submission by the foreign private issuer on Form 6-K.

The Commission has also proposed amending Item 10 of Regulations S-K and S-B and Form 20-F to provide additional guidance to companies that include non-GAAP financial measures in Commission filings (as opposed to other public disclosures, which are proposed to be covered by Regulation G). The proposed amendments provide that companies using non-GAAP financial measures in filings with the Commission would be required to provide:

• a presentation, with equal or greater prominence, of the most directly comparable financial measure calculated and presented in accordance with GAAP;
• a quantitative reconciliation (by schedule or other clearly understandable method) of the differences between the non-GAAP financial measure disclosed with the most directly comparable measure or measures calculated and presented in accordance with GAAP;
• a statement disclosing the purposes for which the company’s management uses the non-GAAP financial measure presented; and
• a statement describing the reasons why the company’s management believes such non-GAAP financial measures provide useful information to investors.

In addition to these mandated disclosure requirements, the proposed rules would also prohibit the following:

• presenting a non-GAAP financial measure in a manner that would give it greater authority or prominence than the comparable GAAP financial measure or measures;
• excluding charges or liabilities that required, or will require, cash settlement, or would have required cash settlement absent an ability to settle in another manner, from non-GAAP liquidity measures;
• adjusting a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual, when the nature of the charge or gain is such that it is reasonably likely to recur;
• presenting non-GAAP financial measures on the face of the registrant’s financial statements prepared in accordance with GAAP or in the accompanying notes;
• presenting non-GAAP financial measures on the face of any pro forma financial information required to be disclosed;
• using titles or descriptions of non-GAAP financial measures that are the same as, or confusingly similar to, titles or descriptions used for GAAP financial measures; and
• presenting a non-GAAP per-share measure.

The requirements for non-GAAP financial information filed with the Commission are proposed to be more extensive and detailed than those of proposed Regulation G. The Commission’s proposing release points out that these additional requirements would be generally consistent with the staff’s historical practice in situations where it has reviewed filings containing non-GAAP financial measures. In addition, the requirements in filed documents for a GAAP presentation and for a reconciliation would be slightly more stringent than those set forth under Regulation G. In particular, in filings with the Commission, the presentation of the comparable GAAP financial measure must have equal or greater prominence, and there would not be an "unreasonable effort" exception for forward-looking information to the requirement for a quantitative reconciliation between the non-GAAP financial measure and the comparable GAAP financial measure. Additionally, any non-GAAP financial measure presented must be accompanied by statements disclosing the purposes for which the registrant’s management uses the non-GAAP financial measure and why the registrant believes the non-GAAP financial measure would be useful to investors. This requirement is designed to ensure that companies are using non-GAAP financial measures that provide information that is important in analyzing and understanding the company.

The requirements that statements regarding the purposes for which management uses the non-GAAP financial measure and the utility of the non-GAAP financial measure to investors could be satisfied by including the statements in the most recent annual report filed with the Commission (or a more recent filing) and by updating those statements, as necessary, no later than the time of the filing.

The definition of "non-GAAP financial measure" is proposed to be the same for purposes of filings with the Commission as for Regulation G. Unlike under Regulation G, however, there is no limited exception for foreign private issuers and, therefore, the proposed requirements would apply to filings on Form 20-F. However, a non-GAAP financial measure that would otherwise be prohibited would be permitted in a Form 20-F filing of a foreign private issuer if the measure was expressly permitted under the generally accepted accounting principles used in the issuer’s primary financial statements and was included in the issuer’s annual report or financial statements used in its home country jurisdiction or market.

In its November 5th release, the Commission also proposed to amend Form 8-K to add new Item 1.04 "Results of Operations and Financial Condition." New Item 1.04 would require companies to file a Form 8-K within two business days of any public announcement or release disclosing material non-public information regarding a company’s results of operations or financial condition for a completed annual or quarterly fiscal period.

Currently, these types of announcements and releases are subject to Regulation FD. Unlike disclosure made to satisfy Regulation FD, however, historical information filed under proposed Item 1.04 of Form 8-K would be considered filed with the Commission for liability purposes. Further, a Form 8-K filed pursuant to Item 1.04 would satisfy a company’s obligation under Regulation FD only if the Form 8-K were filed within the time frame required by Regulation FD. As is currently the case, Regulation FD could be satisfied by public disclosure other than through the filing of a Form 8-K meeting Regulation FD’s requirements; in that case, a Form 8-K filed pursuant to Item 1.04 would be required to be filed within the two-business day timeframe. Proposed Item 1.04 would require the company to identify briefly the announcement or release and file the announcement or release as an exhibit to the Form 8-K. Further, the requirements of Item 10 of Regulations S-K and S-B as proposed to be amended would apply to a Form 8-K filed under proposed Item 1.04 to the extent non-GAAP financial measures are included. As noted above, these requirements are somewhat more stringent than the requirements of proposed Regulation G, which would otherwise apply to earnings releases (to the extent non-GAAP financial measures are included) if they were not required to be filed on Form 8-K.

The filing requirement under proposed Item 1.04 of Form 8-K would be triggered by the disclosure of material non-public information regarding a completed fiscal year or quarter. Repetition of previously publicly disclosed information or release of the same information in a different form, for example in an interim or annual report to shareholders, would not trigger the proposed Item 1.04 requirement. This result would not change if the repeated information were accompanied by information that was not material, whether or not already public. However, release of additional or updated material non-public information regarding a company’s results would trigger an additional Item 1.04 filing requirement. Companies that make earnings announcements or other disclosures of material non-public information regarding a completed fiscal year or quarter in an interim or annual report to shareholders would be permitted to specify which portion of the report contains the information required to be filed under Item 1.04. In addition, the requirement to file under Item 1.04 of Form 8-K would not apply to companies that make these announcements and disclosures only in their quarterly or annual reports filed with the Commission.

Proposed Item 1.04 of Form 8-K would apply only to publicly disclosed or released material non-public information concerning an annual or quarterly fiscal period that has ended. Accordingly, proposed Item 1.04 would not apply to public disclosure of earnings estimates for future or ongoing fiscal periods, unless those estimates are included in the public announcement or release of material non-public information regarding an annual or quarterly fiscal period that has ended. In such a case, specifically identified forward-looking information could be furnished under Item 6.01 of Form 8-K (Regulation FD Disclosure), rather than filed under proposed Item 1.04.

If material non-public information is disclosed orally, telephonically, by webcast, broadcast, or by similar means, Item 1.04 would not require the registrant to file a Form 8-K if:

• the information is provided as part of a presentation that initially occurs within 48 hours of a related written announcement or release that is filed on Form 8-K pursuant to Item 1.04;
• the presentation is accessible to the public by dial-in conference call, webcast or similar technology;
• the financial and statistical information contained in the presentation is provided on the company’s website, together with any information that would be required under proposed Regulation G; and
• the presentation was announced by a widely disseminated press release that included instructions as to when and how to access the presentation and the location on the company’s website where the information would be available.

The Commission’s proposal would not require any company to issue an earnings release or similar announcement. However, if a company issues such a release or announcement containing material non-public information regarding its results of operations or financial condition for an annual or quarterly fiscal period that has ended, the new proposed filing requirement would be triggered.

Obtaining the Commission’s Releases

You can locate the Commission’s proposing releases, which contain greater detail about the proposed rules, regulations and amendments discussed in this article, on the Commission’s Web site at: http://www.sec.gov/rules/proposed/33-8144.htm and http://www.sec.gov/rules/proposed/33-8145.htm.