[Federal Register Volume 67, Number 97 (Monday, May 20, 2002)]
[Proposed Rules]
[Pages 35620-35652]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-12259]



[[Page 35619]]

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Part II





Securities and Exchange Commission





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17 CFR Parts 228, 229 and 249



Disclosure in Management's Discussion and Analysis About the 
Application of Critical Accounting Policies; Proposed Rule

  Federal Register / Vol. 67, No. 97 / Monday, May 20, 2002 / Proposed 
Rules  

[[Page 35620]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 228, 229 and 249

[Release Nos. 33-8098; 34-45907; International Series Release No. 1258; 
File No. S7-16-02]
RIN 3235-AI44


Disclosure in Management's Discussion and Analysis About the 
Application of Critical Accounting Policies

AGENCY: Securities and Exchange Commission (``Commission'').

ACTION: Notice of proposed rulemaking.

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SUMMARY: As an initial step in improving the transparency of companies' 
financial disclosure, the Commission is proposing disclosure 
requirements that would enhance investors' understanding of the 
application of companies' critical accounting policies. The proposals 
would encompass disclosure in two areas: accounting estimates a company 
makes in applying its accounting policies and the initial adoption by a 
company of an accounting policy that has a material impact on its 
financial presentation. Under the first part of the proposals, a 
company would have to identify the accounting estimates reflected in 
its financial statements that required it to make assumptions about 
matters that were highly uncertain at the time of estimation. 
Disclosure about those estimates would then be required if different 
estimates that the company reasonably could have used in the current 
period, or changes in the accounting estimate that are reasonably 
likely to occur from period to period, would have a material impact on 
the presentation of the company's financial condition, changes in 
financial condition or results of operations. A company's disclosure 
about these critical accounting estimates would include a discussion 
of: the methodology and assumptions underlying them; the effect the 
accounting estimates have on the company's financial presentation; and 
the effect of changes in the estimates. Under the second part of the 
proposals, a company that has initially adopted an accounting policy 
with a material impact would have to disclose information that 
includes: what gave rise to the initial adoption; the impact of the 
adoption; the accounting principle adopted and method of applying it; 
and the choices it had among accounting principles. Companies would 
place all of the new disclosure in the ``Management's Discussion and 
Analysis of Financial Condition and Results of Operations' section 
(commonly referred to as ``MD&A'') of their annual reports, 
registration statements and proxy and information statements. In 
addition, in the MD&A section of their quarterly reports, U.S. 
companies would have to update the information regarding their critical 
accounting estimates to disclose material changes.

DATES: Comments should be received by July 19, 2002.

ADDRESSES: You should send three copies of your comments to Jonathan G. 
Katz, Secretary, U.S. Securities and Exchange Commission, 450 Fifth 
Street, NW, Washington, DC, 20549-0609. You also may submit your 
comments electronically to the following address: [email protected]. All comment letters should refer to File No. S7-16-
02; this file number should be included in the subject line if you use 
electronic mail. Comment letters will be available for public 
inspection and copying at the Commission's Public Reference Room, 450 
Fifth Street, NW, Washington, DC 20549-0102. We will post 
electronically-submitted comment letters on the Commission's Internet 
Web site (http://www.sec.gov). We do not edit personal identifying 
information, such as names or electronic mail addresses, from 
electronic submissions. Submit only information you wish to make 
publicly available.

FOR FURTHER INFORMATION CONTACT: Questions about this release should be 
referred to Anita Klein or Andrew Thorpe, Division of Corporation 
Finance (202-942-2980) or Jackson Day or Jenifer Minke-Girard, Office 
of the Chief Accountant (202-942-4400), Securities and Exchange 
Commission, 450 Fifth Street, NW, Washington, DC 20549.

SUPPLEMENTARY INFORMATION:
    We are proposing amendments to Item 303 \1\ of Regulation S-K, \2\ 
Item 303 \3\ of Regulation S-B \4\ and Item 5 of Form 20-F \5\ under 
the Securities Exchange Act of 1934 \6\ (``Exchange Act'').
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    \1\ 17 CFR 229.303.
    \2\ 17 CFR 229.10 et seq.
    \3\ 17 CFR 228.303.
    \4\ 17 CFR 228.10 et seq.
    \5\ 17 CFR 249.308b.
    \6\ 15 U.S.C. Sec. 78a et seq.
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Table of Contents

I. Executive Summary
II. Background
    A. Current MD&A Disclosure
    B. Current Disclosure in Financial Statements about Accounting 
Estimates
    C. Current Disclosure in Financial Statements about Initial 
Adoption of Accounting Policies
III. Proposed Rules
    A. Objectives of the Current Proposals
    B. Scope of the Proposals
    C. Proposed Disclosure about Critical Accounting Estimates
    1. Accounting estimates covered under the proposals
    2. Identification and description of the accounting estimate, 
the methodology used, certain assumptions and reasonably likely 
changes
    3. Impact of the estimate on financial condition, changes in 
financial condition and results of operations
    4. Quantitative disclosures
    a. Quantitative disclosures to demonstrate sensitivity
    b. Quantitative and qualitative disclosures concerning past 
changes in the estimate
    5. Senior management's discussions with the audit committee
    6. Disclosure relating to segments
    D. Examples of Proposed Disclosure about Critical Accounting 
Estimates
    Example 1
    Example 2
    Example 3
    E. Auditor Examination of MD&A Disclosure Relating to Critical 
Accounting Estimates
    F. Quarterly Updates
    G. Proposed Disclosure about Initial Adoption of Accounting 
Policies
    H. Disclosure Presentation
    I. Application to Foreign Private Issuers
    J. Application to Small Business Issuers
    K. Application of Safe Harbors for Forward-looking Information
IV. General Request for Comment
V. Paperwork Reduction Act
VI. Cost-Benefit Analysis
VII. Effects on Efficiency, Competition and Capital Formation
VIII.Initial Regulatory Flexibility Analysis
IX. Small Business Regulatory Enforcement Fairness Act
X. Codification Update
Statutory Bases and Text of Proposed Amendments

I. Executive Summary

    One important challenge facing our capital markets today is the 
need to improve the quality and transparency of corporate disclosure. 
Our capital markets could reach a higher level of efficiency and 
investor confidence if companies were to provide higher-quality, more 
insightful financial information. To serve that purpose, we issued 
cautionary advice in December 2001 regarding MD&A disclosure. \7\ In 
that release, we recognized the need for

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disclosure that allows investors to understand more completely the 
manner in which, and degree to which, a company's reported operating 
results, financial condition and changes in financial condition depend 
on estimates involved in applying accounting policies that entail 
uncertainties and subjectivity. We also asked companies to begin better 
addressing investors' need for this disclosure.
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    \7\ See Securities Act Release No. 8040, FR-60 (Dec. 12, 2001) 
[66 FR 65013]. See also Securities Act Release No. 8056, FR-61 (Jan. 
22, 2002)[67 FR 3746]. In addition, we recently announced our 
intention to propose other changes in disclosure rules to improve 
the financial reporting and disclosure system. See SEC Press Release 
No. 2002-22 (Feb. 13, 2002).
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    As contemplated in that release, we are now proposing to amend the 
MD&A requirements \8\ to mandate improved disclosure in a new 
``Application of Critical Accounting Policies'' section in companies' 
filed annual reports, annual reports to shareholders, registration 
statements and proxy and information statements. \9\ The new section 
would encompass disclosure both about accounting estimates resulting 
from the application of critical accounting policies and the initial 
adoption of accounting policies that have a material impact on a 
company's financial presentation. The proposed disclosure requirements 
would apply to all companies except small business issuers that have 
not had revenues from operations during the last two fiscal years. The 
proposed MD&A disclosure requirements would cover the most recent 
fiscal year and any subsequent interim period for which financial 
statements are required to be presented.
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    \8\ We propose to amend Item 303 of Regulation
S-K, and the parallel provisions in Regulation S-B (which applies to 
small business issuers) and Form 20-F (which applies to foreign 
private issuers).
    \9\ The proposals would not alter which documents require 
presentation of an MD&A. MD&A disclosure is only required in proxy 
and information statements themselves if action is to be taken with 
respect to: (1) the modification of any class of securities of the 
registrant; (2) the issuance or authorization for issuance of 
securities of the registrant; or (3) mergers, consolidations, 
acquisitions and similar matters. See Items 11, 12 and 14 of 
Schedule 14A, 17 CFR 240.14a-101. Investors otherwise receive the 
MD&A disclosure in the annual report to shareholders that must 
accompany or precede any proxy or information statement relating to 
an annual meeting at which directors are to be elected. See 17 CFR 
240.14a-3.
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    To determine whether an accounting estimate \10\ involved in 
applying the company's accounting policies would entail disclosure 
under the proposals, a company would have to answer two questions:
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    \10\ An accounting estimate is an approximation made by 
management of a financial statement element, item or account in the 
financial statements. Accounting estimates in historical financial 
statements measure the effects of past business transactions or 
events, or the present status of an asset or liability. See 
Codification of Statements on Auditing Standards (including related 
Auditing Interpretations) (``AU'') Sec. 342, Auditing Accounting 
Estimates (``AU Sec. 342''), paragraphs 1-3. For purposes of the 
proposals, an accounting estimate would include one for which a 
change in the estimate is inseparable from the effect of a change in 
accounting principle. See Accounting Principles Board (``APB'') 
Opinion No. 20, Accounting Changes (July 1971) (``APB No. 20''), 
paragraph 11. See also proposed Item 303(b)(3)(ii)(A) of Regulation 
S-B, 17 CFR 228.303(b) (3)(ii)(A); proposed Item 303(c)(2)(i) of 
Regulation S-K, 17 CFR 229.303(c)(2)(i); and proposed Item 5.E.2.(a) 
of Form 20-F, 17 CFR 249.220f.
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    1. Did the accounting estimate require us to make assumptions about 
matters that were highly uncertain at the time the accounting estimate 
was made?
    2. Would different estimates that we reasonably could have used in 
the current period, or changes in the accounting estimate that are 
reasonably likely to occur from period to period, have a material 
impact on the presentation of our financial condition, changes in 
financial condition or results of operations?

If the answers to both questions are ``yes,'' the accounting estimate 
would be a ``critical accounting estimate,'' and disclosure would be 
required in the new ``Application of Critical Accounting Policies'' 
section.
    The proposed disclosure about these accounting estimates would 
involve three basic elements.\11\ The first element would be the basic 
disclosures needed to understand the accounting estimates. A company 
would have to describe them, identify where and how they affect the 
company's reported financial results, financial condition and changes 
in financial condition, and, where material, identify the affected line 
items. It would have to describe the methodology underlying each 
critical accounting estimate, the assumptions that are about highly 
uncertain matters and other assumptions that are material. If 
applicable, a company would have to discuss why it could have chosen in 
the current period estimates that would have had a materially different 
impact on the company's financial presentation. Similarly, a company 
would have to discuss, if applicable, why the accounting estimate is 
reasonably likely to change in future periods with a material impact on 
the company's financial presentation.\12\
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    \11\ In the MD&A section of quarterly reports, U.S. companies 
would have to update their critical accounting estimates disclosure 
to reflect material changes.
    \12\ The statutory and Commission rule safe harbors for forward-
looking statements would be available to companies satisfying their 
terms and conditions in making forward-looking statements in 
connection with the proposed critical accounting estimates 
discussion. See Securities Act Section 27A, 15 U.S.C. 77z-2, 
Securities Act Rule 175, 17 CFR 230.175, Exchange Act Section 21E, 
15 U.S.C. 78u-5, and Exchange Act Rule 3b-6, 17 CFR 240.3b-6.
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    A company would have to identify the segments \13\ of its business 
that a critical accounting estimate affects. A company also would have 
to provide appropriate parts of the proposed disclosure for affected 
segments where a failure to present that information would result in an 
omission that renders the disclosure materially misleading.
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    \13\ A segment for financial reporting purposes is defined by 
Financial Accounting Standards Board (``FASB'') Statement of 
Financial Accounting Standards (``SFAS'') No. 131, Disclosures about 
Segments of an Enterprise and Related Information (June 1997) 
(``SFAS No. 131'').
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    The second element of the proposed disclosure about critical 
accounting estimates would give investors a better understanding of the 
sensitivity of the reported operating results and financial condition 
to changes in those estimates or their underlying assumption(s). For 
each critical accounting estimate, a company would discuss changes that 
would result either from: (i) Making reasonably possible, near-term 
changes in the most material assumption(s) underlying the estimate; or 
(ii) using in place of the recorded estimate the ends of the range of 
reasonably possible amounts which the company likely determined when 
formulating its recorded estimate. The company would describe the 
impact of those changes on the company's overall financial performance 
and, to the extent material, on the line items in the company's 
financial statements. In addition, the proposals would require a 
quantitative and qualitative discussion of management's history of 
changing its critical accounting estimates in recent years.
    The third element of the proposed disclosure about critical 
accounting estimates would require a company to state whether or not 
senior management discussed the development, selection and disclosure 
of those estimates with the company's audit committee. This part of the 
proposals is designed to inform investors about whether there is 
oversight of critical accounting estimates by audit committee members 
and may incidentally encourage such oversight and increase reliability 
of the proposed MD&A disclosure about critical accounting estimates.
    Our proposals also address MD&A disclosure regarding initial 
adoption of an accounting policy. If an accounting policy initially 
adopted by a company had a material impact on the company's financial 
presentation, the company would provide certain disclosures about that 
initial adoption unless it resulted solely from new accounting 
literature issued by a recognized accounting standard setter. The 
initial adoption of

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an accounting policy may occur in situations such as when events or 
transactions affecting the company occur for the first time, or were 
previously immaterial in their effect but become material, or events or 
transactions occur that are clearly different in substance from 
previous ones.
    The proposed MD&A disclosure about the initial adoption of 
accounting policies seeks more qualitative information from companies 
about those types of situations. The disclosures we are proposing would 
include a description of:
     The events or transactions that gave rise to the initial 
adoption;
     The accounting principle adopted and the method of 
applying that principle; and
     The impact, discussed qualitatively, on the company's 
financial presentation.
    In addition, if upon initial adoption the company had a choice 
between acceptable accounting principles under generally accepted 
accounting principles (GAAP), the company would disclose that it made a 
choice, explain the alternatives and state why it made the choice that 
it did. Further, if no accounting literature governed the accounting 
upon initial adoption, the company would have to explain which 
accounting principle and method of application it decided to use and 
how it made its decision.
    All of the proposed MD&A disclosure regarding the application of 
critical accounting policies would have to be presented in language and 
a format that is clear, concise and understandable to the average 
investor. Boilerplate disclosures, or disclosures written in overly 
technical accounting terminology, would not satisfy the proposed 
requirements.
    Our proposals do not attempt to address all circumstances where a 
company may exercise discretion in its accounting under GAAP. We focus 
our proposals on two areas involving the application of critical 
accounting policies in which there is a clear need for improved 
disclosure--critical accounting estimates and the initial adoption of 
accounting policies that have a material impact. As discussed below, 
disclosure in many other areas of accounting judgment is provided by 
existing MD&A requirements, materiality standards and financial 
statement disclosure requirements.

II. Background

A. Current MD&A Disclosure

    For decades, the regulations governing disclosure in registration 
statements under the Securities Act of 1933 (``Securities Act'') and 
the Exchange Act, as well as annual and quarterly reports and proxy and 
information statements by public companies under the Exchange Act, have 
mandated MD&A disclosure.\14\ MD&A disclosure should satisfy three 
related objectives:
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    \14\ See Item 303 of Regulation S-K, 17 CFR 229.303, Item 303 of 
Regulation S-B, 17 CFR 228.303 and Item 5 of Form 20-F, referenced 
in 17 CFR 249.220f. Although the current MD&A disclosure 
requirements were adopted starting in 1980, earlier versions date 
back to 1968. See Securities Act Release Nos. 6231 (Sept. 2, 1980) 
[45 FR 63630] and 4936 (Dec. 9, 1968) [33 FR 18617]. See also 
Securities Act Release No. 5520 (Aug. 14, 1974) [39 FR 31894].
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    1. To provide a narrative explanation of companies' financial 
statements that enables investors to see the company through the eyes 
of management;
    2. To improve overall financial disclosure and provide the context 
within which financial statements should be analyzed; and
    3. To provide information about the quality of, 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.\15\
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    \15\ See Securities Act Release No. 6711 (Apr. 23, 1987) [52 FR 
13715], Section II.
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    In MD&A, a company must discuss its results of operations, 
liquidity and capital resources and other information necessary to an 
understanding of the company's financial condition or changes in 
financial condition. A well-prepared MD&A discussion focuses on 
explaining a company's financial results and condition by identifying 
key elements of the business model and the drivers and dynamics of the 
business, and also addressing key variables. A company currently must 
disclose known trends, demands, commitments, events and uncertainties 
that are reasonably likely to occur and have material effects.\16\
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    \16\ In assessing whether disclosure of a trend, event, etc. is 
required, management must consider both whether it is reasonably 
likely to occur and whether a material effect is reasonably likely 
to occur. As the Commission noted when it adopted the requirement, 
the ``reasonably likely to occur'' test is to be used rather than 
the Basic v. Levinson probability and magnitude test for materiality 
of contingent events. See Securities Act Release No. 6835 (May 18, 
1989) [54 FR 22427] at fns. 27-28 and accompanying text.
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    In addition to these general subjects, a company must include in 
MD&A historical and prospective analysis of its financial statements, 
and identify the cause of material changes from prior periods in the 
line items of the financial statements where those changes are 
reflected. A company must analyze significant components of revenues or 
expenses needed to understand the results of operations. It also must 
discuss significant or unusual economic events or transactions that 
materially affected results of operations. Finally, a company also must 
discuss its ability to generate adequate amounts of cash to meet its 
short-term and long-term needs for capital and identify the anticipated 
sources of funds necessary to fulfill its commitments.
    These requirements do not call for, and indeed we have discouraged 
and continue to discourage companies from providing, rote calculations 
of percentage changes in figures in the financial statements combined 
with boilerplate recitations of a surfeit of inadequately 
differentiated material and immaterial factors related to such changes. 
Rather, companies should emphasize material factors and their 
underlying reasons and preferably omit, or at least differentiate, 
immaterial information.
    Recognizing the paramount importance of MD&A information to 
investors, in addition to today's proposal, we intend to continue to 
focus on improving disclosure in this area. In particular, we are 
considering MD&A proposals that will focus discussion on the three key 
objectives of MD&A noted above. We are considering a more explicit 
requirement for a summary of the MD&A section that would, in relatively 
short form, identify what management considers the most important 
factors in determining its financial results and condition, including 
the principal factors driving them, the principal trends on which 
management focuses and the principal risks to the business. We also are 
considering how to adjust the relative attention devoted in MD&A 
towards a more general discussion of material matters and away from a 
detailed description of business results that too often recites 
information that is otherwise available or is not material to 
investors.
    In addition, we are continuing our consideration of subjects as to 
which we believe MD&A disclosure is particularly important, including 
the topics discussed in our January 22, 2002 release regarding 
MD&A.\17\ For example, investors have become increasingly concerned 
about the sufficiency of disclosure regarding structured finance 
transactions, including those consummated using special purpose 
entities. A company's relationships with those types of entities may 
facilitate its transfer of, or access to, assets. Investors

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need to know more about the liquidity risk, market price risks and 
effects of ``off-balance sheet'' transaction structures and 
obligations. Another item of concern is a lack of transparent 
disclosure about transactions where that information appeared necessary 
to understand how significant aspects of the business were conducted. 
Investors would better understand financial statements in many 
circumstances if MD&A included descriptions of all material 
transactions involving related persons or entities, with a clear 
discussion of terms that differ from those which would likely be 
negotiated with clearly independent parties. Investors should 
understand these transactions' business purpose and economic substance, 
their effects on the financial statements, and any special risks or 
contingencies arising from them.
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    \17\ Securities Act Release No. 8056; FR-61 (Jan. 22, 2002) [67 
FR 3746].
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    Finally, we are considering improvements to MD&A disclosures 
relating to trend information. We believe that investors may be better 
able to see the company through management's eyes if MD&A includes 
information about the trends that a company's management follows and 
evaluates in making decisions about how to guide the company's 
business. As with today's proposal, that disclosure would naturally 
entail a certain degree of forward-looking information.

B. Current Disclosure in Financial Statements about Accounting 
Estimates

    Currently, GAAP and generally accepted auditing standards 
acknowledge that there are numerous circumstances in which companies, 
in applying accounting policies, exercise judgment and make estimates 
for purposes of the financial statements. For example, they call for 
companies to communicate in a number of circumstances about the use of 
estimates in the preparation of financial information. The use of 
estimates results in the presentation of many amounts that are in fact 
approximate rather than exact.\18\ For example, APB No. 20 notes that 
``changes in estimates used in accounting are necessary consequences of 
periodic presentation of financial statements'' because preparing 
financial statements requires estimating the effects of future events, 
and future events and their effects cannot be perceived with 
certainty.\19\ Estimating the impact of those events therefore requires 
the exercise of judgment. Because the preparation of financial 
statements requires estimates that are likely to change over time, APB 
No. 20 requires disclosure about changes in estimates that are expected 
to affect several future reporting periods and that are not made each 
period in the ordinary course of accounting. It recommends disclosure 
if the effects of other changes in the estimate are material.\20\
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    \18\ See American Institute of Certified Public Accountants 
(``AICPA'') Statement of Position (``SOP'') No. 94-6, Disclosure of 
Certain Significant Risks and Uncertainties (Dec. 1994), (``SOP 94-
6''), paragraph B-20; See also AU Sec. 380, Communication with Audit 
Committees (``AU Sec. 380'') and AU Sec. 508, Reports on Audited 
Financial Statements (Apr. 1998).
    \19\ See APB No. 20, paragraph 10.
    \20\ See APB No. 20, paragraph 33.
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    In addition, AICPA Statement of Position No. 94-6 \21\ requires 
general disclosure in notes to financial statements that the 
preparation of financial statements requires the use of estimates in 
the determination of the carrying amounts of assets or liabilities, 
including gain or loss contingencies.\22\ That Statement also requires 
note disclosure regarding those specific estimates when known 
information indicates that it is at least reasonably possible \23\ that 
the estimate will change in the near term and the effect would be 
material to the financial statements.\24\ A company must disclose the 
nature of the uncertainty, in addition to stating that a change in the 
estimate in the near term is at least reasonably possible. SOP 94-6, 
encourages, but does not require, disclosure of the factors that cause 
an estimate to be susceptible to change from period to period.\25\
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    \21\ See SOP 94-6, particularly paragraphs 11-19.
    \22\ See FASB SFAS No. 5, Accounting for Contingencies (Mar. 
1975) (``SFAS No. 5''), paragraph 1, which defines a contingency as 
``an existing condition, situation, or set of circumstances 
involving uncertainty as to possible gain * * * or loss * * * to an 
enterprise that will ultimately be resolved when one or more future 
events occur or fail to occur. Resolution of the uncertainty may 
confirm the acquisition of an asset or the reduction of a liability 
or the loss or impairment of an asset or the incurrence of a 
liability.''
    \23\ The term ``reasonably possible'' as used in SOP 94-6 is 
consistent with its use in SFAS No. 5. See SOP 94-6, fn. 7. SFAS No. 
5 states that ``reasonably possible'' means the chance of a future 
transaction or event occurring is more than remote but less than 
likely. Reasonably possible events are less likely to occur than 
probable events.
    \24\ SOP 94-6, paragraph 17, notes: ``Whether the estimate meets 
the criteria for disclosure under this SOP does not depend on the 
amount that has been reported in the financial statements, but 
rather on the materiality of the effect that using a different 
estimate would have had on the financial statements. Simply because 
an estimate resulted in the recognition of a small financial 
statement amount, or no amount, does not mean that disclosure is not 
required under this SOP.''
    \25\ See SOP 94-6, paragraph 14.
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    SOP 94-6 references SFAS No. 5, which itself requires certain 
disclosures about accounting estimates--specifically, estimated losses 
that arise from loss contingencies. A company is required to accrue (by 
a charge to income) an estimated loss from a loss contingency if 
certain criteria are met.\26\ If an estimated loss does not meet the 
criteria for accrual, but there is at least a reasonable possibility 
that a loss may have been incurred, the company is required to disclose 
the nature of the contingency and an estimate of the possible loss or 
range of loss, or state that an estimate of the loss cannot be made. 
Although SFAS No. 5 elicits useful disclosure about certain accounting 
estimates, not all uncertainties inherent in the accounting process 
give rise to loss contingencies as that term is used in SFAS No. 5, and 
therefore that Statement does not apply to all estimates in the 
financial statements.\27\
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    \26\ See SFAS No. 5, paragraph 8. An estimated loss should be 
accrued when both it is probable that an asset has been impaired or 
a liability has been incurred and the amount of the loss can be 
reasonably estimated. Also, when it is probable that an asset has 
been impaired or a liability has been incurred and the reasonable 
estimate of the loss is a range, the company is required to accrue 
an amount for the loss. See FASB Interpretation No. 14, Reasonable 
Estimation of the Amount of a Loss (Sept. 1976), paragraph 3.
    \27\ See SFAS No.5, paragraph 2.
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    Further, while not specifically requiring disclosure about 
estimates, APB Opinion No. 22 requires disclosure about the application 
of accounting policies which may entail generalized disclosure about 
estimation techniques.\28\ APB No. 22 notes that a company's accounting 
principles, and their method of application, can affect significantly 
the presentation of its financial position, results of operations and 
cash flows,\29\ and accordingly, requires disclosure that describes 
those accounting principles and the company's methods of applying 
them.\30\ In particular, APB No. 22 indicates that a company should 
provide disclosure when:
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    \28\ See APB Opinion No. 22, Disclosure of Accounting Policies 
(Apr. 1972) (``APB No. 22'').
    \29\ See APB No. 22, paragraphs 6-7. APB No. 22 defines 
accounting policies of a reporting entity as ``the specific 
accounting principles and the methods of applying those principles 
that are judged by the management of the entity to be the most 
appropriate in the circumstances to present fairly financial 
position, results of operations, and cash flows in accordance with 
generally accepted accounting principles * * *.'' APB No. 22, 
paragraph 6, as amended.
    \30\ See APB No. 22, paragraph 12.
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     Unusual or innovative applications of accounting 
principles materially affect the determination of financial position, 
results of operations or cash flows (such as the recognition of 
revenue);

[[Page 35624]]

     A selection is made among alternative permissible 
policies; or
     Policies are unique to the industry of the reporting 
company.\31\
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    \31\ Id.

Under APB No. 22, a company's disclosure also should encompass 
important judgments as to appropriateness of principles relating to 
revenue recognition and allocation of asset costs to current and future 
periods. Although the particular format or location of these APB No. 22 
disclosures in financial statements is not prescribed by GAAP, a 
summary of these significant accounting policies is customarily the 
first note to the financial statements.
    Finally, some accounting standards currently prescribe specific 
disclosures about accounting estimates or the underlying methodologies 
and assumptions.\32\ For example, Statement of Financial Accounting 
Standards No. 132 requires specific disclosures of the assumptions used 
in accounting for pensions and other post-retirement benefits.\33\ 
Statement of Financial Accounting Standards No. 140 requires disclosure 
regarding the measurement of retained interests in securitized 
financial assets, including the methodology, assumptions and 
sensitivity of the assumptions used in determining their fair 
value.\34\
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    \32\ In addition to the examples cited in the paragraph, see the 
disclosure requirements in FASB SFAS No. 107, Disclosures about Fair 
Value of Financial Instruments (Dec. 1991); FASB SFAS No. 123, 
Accounting for Stock-Based Compensation (Oct. 1995) (``SFAS No. 
123''); and FASB SFAS No. 144, Accounting for the Impairment or 
Disposal of Long-Lived Assets (Aug. 2001) (``SFAS No. 144'').
    \33\ See FASB SFAS No. 132, Employers' Disclosures about 
Pensions and Other Postretirement Benefits (Feb. 1998).
    \34\ See FASB SFAS No. 140, Accounting for Transfers and 
Servicing of Financial Assets and Extinguishments of Liabilities (a 
replacement of FASB Statement No. 125) (Sept. 2000).
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C. Current Disclosure in Financial Statements About Initial Adoption of 
Accounting Policies

    Certain general requirements under GAAP may elicit information 
about the initial adoption of an accounting policy by a company. When 
companies present comparative financial statements, any exceptions to 
comparability between the most recent period and prior periods must be 
clearly presented.\35\ In addition, if a company initially adopts an 
accounting policy and considers that policy to be a significant 
accounting policy, the company would provide certain disclosures about 
that policy as required by APB No. 22.\36\
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    \35\ See Accounting Research Bulletin (ARB) No. 43, Restatement 
and Revision of Accounting Research Bulletins (June 1953), Chapter 
2, ``Form of Statements,'' Section A, ``Comparative Financial 
Statements,'' paragraph 3, and paragraph 2 (``the well recognized 
principle that any change in practice which affects comparability 
should be disclosed'').
    \36\ See APB No. 22, paragraph 12.
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    APB No. 20 provides financial statement disclosure requirements for 
accounting changes, which include changes in an accounting principle, 
an accounting estimate and the reporting entity.\37\ Neither ``(a) the 
initial adoption of an accounting principle in recognition of events or 
transactions occurring for the first time or that previously were 
immaterial in their effect nor (b) adoption or modification of an 
accounting principle necessitated by transactions or events that are 
clearly different in substance from those previously occurring'' are 
considered, however, to be ``accounting changes'' under GAAP.\38\ As 
discussed below, our proposals about initial adoption of accounting 
policies address these circumstances that are not accounting changes 
under GAAP if they have a material impact on a company's financial 
presentation.
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    \37\ See APB No. 20, paragraph 6.
    \38\ See APB No. 20, paragraph 8.
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III. Proposed Rules

A. Objectives of the Current Proposals

    Our proposals would promote greater investor understanding of a 
company's important accounting estimates that reflect significant 
management judgment and uncertainty, and of a company's initial 
adoption of accounting policies that may reflect such judgment and 
uncertainty. Our primary objectives are:
     To enhance investors' understanding of the existence of, 
and necessity for, estimation in a company's financial statements;
     To focus investors on the important estimates that are 
particularly difficult for management to determine and where management 
therefore exercises significant judgment;
     To give investors an understanding of the impact those 
estimates have on the presentation of a company's financial condition, 
changes in financial condition or results of operations;
     To give investors an appreciation for how sensitive those 
estimates are; and
     To give investors an understanding of new material 
accounting policies as they arise and affect a company's financial 
results.
    Our aim is to increase the transparency of the application of those 
accounting policies where management is the most prone to use judgment, 
generally because objective data and methodologies do not exist for the 
estimates or management is given initial policy choices under GAAP. We 
believe that it is these accounting policies that are least understood 
by investors and that mandated disclosure regarding areas of the 
application of them would provide meaningful insight into the 
importance of estimates and adoption of policies to a company's 
financial presentation. With a greater understanding of the application 
of critical accounting policies, we believe that investors would be in 
a better position to assess the quality of, and potential variability 
of, a company's earnings.
    We propose to mandate enhanced disclosure of critical accounting 
estimates and initial adoption of material policies by specifically 
linking them to the objectives of MD&A, and the type of disclosure 
presented in MD&A. A focused discussion of these areas is well-suited 
to MD&A because it would further explain to investors the company's 
financial condition ``through management's eyes.'' Moreover, MD&A's 
emphasis on disclosure of significant uncertainties and favorable or 
unfavorable trends naturally dovetails with disclosure of the more 
subjective aspects used in arriving at critical accounting estimates or 
selecting which accounting policies to adopt initially. Finally, as we 
have noted previously, the less technical language customarily used 
outside the financial statements may be conducive to a clearer 
explanation to investors of the effects of estimates, assumptions, 
methodologies and initial accounting policy adoption on a company's 
financial reporting.\39\
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    \39\ See Securities Act Release No. 7793 (Jan. 21, 2000) [65 FR 
4585] (suggesting that additions to financial disclosure outside the 
financial statements could help address concerns relating to lack of 
transparency in some aspects of financial reporting within the 
financial statements).
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B. Scope of the Proposals

    Our proposals address estimates that a company makes in preparing 
financial statements using accounting policies under GAAP and the 
initial adoption by a company of an accounting policy under GAAP that 
has a material impact on its financial presentation.\40\ We believe the 
proposals address directly and clearly two areas where there is a need 
for improved disclosure. While certain elements of our proposed 
critical accounting estimates disclosure are subsumed in existing 
general MD&A requirements, we believe more direct

[[Page 35625]]

and complete requirements in our rules would lead to improved 
disclosure. In addition, while there are financial statement disclosure 
requirements that would elicit certain information about initially 
adopted accounting policies in some cases, our proposals are designed 
to provide additional MD&A disclosure that would assist investors to 
understand better a company's new accounting policies.
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    \40\ These could include estimates made on a one-time basis, on 
a few occasions, or on a recurring basis.
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    We are leaving disclosure about other circumstances where a company 
may exercise discretion over its accounting under GAAP to existing MD&A 
disclosure requirements, materiality standards and existing financial 
statement disclosure requirements. Our proposals do not, for example, 
alter disclosure requirements regarding a company's change from an 
accounting policy it has been using to another policy acceptable under 
GAAP.\41\ The proposals also do not require disclosure of a company's 
adoption of a new accounting pronouncement where the company must make 
its best judgment as to how to apply the new accounting pronouncement 
in the absence of interpretive guidance.
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    \41\ When a company has selected an accounting policy from 
acceptable alternatives, it is required under GAAP to make certain 
disclosures about that accounting policy. See APB No. 22, paragraph 
12. See supra fns. 28-31 and accompanying text.
    U.S. GAAP provides only a limited number of situations in which 
more than one method of accounting would be considered acceptable. 
Over the years, the combined efforts of accounting standard setters, 
the accounting profession, public and non-public companies, and 
regulatory agencies have significantly reduced the number of 
acceptable alternatives in U.S. GAAP. See APB No. 22, paragraph 5. 
Areas remaining in U.S. GAAP in which there are acceptable 
alternatives include inventory pricing and depreciation methods. See 
APB No. 20, paragraph 9. See also SFAS No. 123 (providing a choice 
of accounting methods for an employee stock option or similar equity 
instrument).
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    Discipline surrounding a company's changes in accounting policies 
is provided under GAAP and the federal securities laws. When a company 
changes an accounting policy, the company must determine that the 
alternative principle is preferable under the circumstances.\42\ We 
require that the company file a letter from its independent public 
accountant confirming its opinion to that effect.\43\ In addition, a 
company is required to make certain disclosures in the financial 
statements about the accounting change, including the nature and 
justification for the change and its effect on income when the change 
is made.\44\ In its justification for the change, the company is 
required to explain clearly why the newly adopted accounting principle 
is preferable.\45\
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    \42\ See APB No. 20, paragraph 16.
    \43\ See Accounting Series Release No. 177 (Sept. 10, 1975) [40 
FR 46107], as codified in the Codification of Financial Reporting 
Policies Sec. 304.02, Preferability Letters, Fed. Sec. L. Rep. (CCH) 
para. 73,096. See also Item 601(b)(18) of Regulations S-K and S-B, 
17 CFR 229.601(b)(18) and 17 CFR 228.601(b)(18). A preferability 
letter generally is not required when a company adopts a new 
accounting policy as a result of implementing a new accounting 
pronouncement or rule issued by the FASB, AICPA or SEC.
    \44\ See APB No. 20, paragraphs 17-30.
    \45\ Id.
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    In addition to the existing disclosure requirements in the 
financial statements, scrutiny over management's discretion and 
judgment in applying accounting policies occurs on a number of 
different levels. Auditors are required to inform audit committees 
about management's ``initial selection of and changes in significant 
accounting policies or their application'' and about management's 
judgments and estimates.\46\ We have encouraged companies, management, 
audit committees and auditors to consult with our accounting staff if 
they are uncertain about the application of GAAP.\47\ We also have 
committed to provide assistance to companies in a timely fashion to 
address problems before they happen.
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    \46\ See AU Sec. 380, paragraphs 7 and 8.
    \47\ See, e.g., Securities Act Release No. 8040, FR-60 (Dec. 12, 
2001) [66 FR 65013].
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    We recognize that the circumstances where a company may exercise 
discretion over its accounting policies under GAAP could yield 
significantly different financial results. Given the existing 
disclosure regime, we are not currently proposing additional MD&A 
disclosure to address all of these cases. Companies should provide 
complete, transparent disclosure under the applicable requirements. 
While we believe the proposed disclosure may be sufficient to achieve 
our currently stated objective, we may revisit the other circumstances 
where a company may exercise discretion over its accounting policies 
under GAAP at a later date.
    We solicit comment with regard to broadening the scope of our 
proposals to achieve a more expansive objective.
     Should we require additional MD&A disclosure specifically 
regarding the effects of a change by a company from one accounting 
policy to another acceptable (and preferable) accounting policy under 
GAAP?
     Should we require in MD&A a discussion of the impact that 
alternative accounting policies acceptable under GAAP would have had on 
a company's financial statements even when a company did not choose to 
apply the alternatives?
     What costs would companies incur if they had to prepare 
disclosure about the effects of alternative accounting policies that 
could have been chosen but were not?
     Beyond a company's initial adoption of those policies, 
should we require disclosure in MD&A regarding a company's reasons for 
choosing, and the effects of applying, accounting policies used for 
unusual or innovative transactions or in emerging areas? Similarly, 
should we require companies to disclose in MD&A the effects of 
accounting policies that a company could have adopted, but did not 
adopt, for unusual or innovative transactions or in emerging areas?
     Should we require more disclosure by companies about their 
process of making estimates, or in other areas of discretion relating 
to recognition and measurement in financial statements? If so, please 
describe in detail.
     Should we require in MD&A a discussion of the impact of a 
company's choice among accounting methods under GAAP that are used in 
the company's industry (for example, the completed contract and the 
percentage of completion methods of accounting for construction-type 
contracts \48\) Should we require that type of disclosure only where a 
company uses a method under GAAP that is not generally used by other 
companies in the industry?
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    \48\ See SOP No. 81-1, Accounting for Performance of 
Construction-Type and Certain Production-Type Contracts (July 1981).
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C. Proposed Disclosure About Critical Accounting Estimates

    To inform investors of each critical accounting estimate and to 
place it in the context of the company's financial presentation, we 
would require the following information in the MD&A section:\49\
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    \49\ In addition to the information specifically required, a 
company would be required to provide any other information necessary 
to keep its disclosure from being materially misleading. See 
Securities Act Rule 408, 17 CFR 230.408, and Exchange Act Rule 12b-
20, 17 CFR 240.12b-20.
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     A discussion that identifies and describes:
     The critical accounting estimate;
     The methodology used in determining the critical 
accounting estimate;
     Any underlying assumption that is about highly uncertain 
matters and any other underlying assumption that is material;
     Any known trends, demands, commitments, events or 
uncertainties that are reasonably likely to occur and materially affect 
the methodology or the assumptions described;

[[Page 35626]]

     If applicable, why different estimates that would have had 
a material impact on the company's financial presentation could have 
been used in the current period; and
     If applicable, why the accounting estimate is reasonably 
likely to change from period to period with a material impact on the 
financial presentation;
     An explanation of the significance of the accounting 
estimate to the company's financial condition, changes in financial 
condition and results of operations and, where material, an 
identification of the line items in the company's financial statements 
affected by the accounting estimate;
     A quantitative discussion of changes in overall financial 
performance and, to the extent material, line items in the financial 
statements if the company were to assume that the accounting estimate 
were changed, either by using reasonably possible near-term changes in 
the most material assumption(s) underlying the accounting estimate or 
by using the reasonably possible range of the accounting estimate; \50\
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    \50\ If those changes could have a material effect on the 
company's liquidity or capital resources, then the company also 
would have to explain that effect.
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     A quantitative and qualitative discussion of any material 
changes made to the accounting estimate in the past three years, the 
reasons for the changes, and the effect on line items in the financial 
statements and overall financial performance;\51\
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    \51\ As described below, we would phase in the three-year period 
and use two years for small business issuers.
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     A statement of whether or not the company's senior 
management has discussed the development and selection of the 
accounting estimate, and the MD&A disclosure regarding it, with the 
audit committee of the company's board of directors;
     If the company operates in more than one segment, an 
identification of the segments of the company's business the accounting 
estimate affects; and
     A discussion of the accounting estimate on a segment 
basis, to the extent that a failure to present that information would 
result in an omission that renders the disclosure materially 
misleading.
Unless otherwise stated, the discussion would cover the financial 
statements for the most recent fiscal year and any subsequent period 
for which interim period financial statements are required to be 
included.\52\
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    \52\ The proposed rules would apply equally to business 
development companies. Business development companies are defined in 
Section 2(a)(48) of the Investment Company Act of 1940. See 15 USC 
Sec. 80a-2(a)(48). Business development companies are a category of 
closed-end investment companies that are not required to register 
under the Investment Company Act, but file Forms 10-K and 10-Q, and 
also include MD&A in their annual reports to shareholders.
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1. Accounting estimates covered under the proposals
    A number of circumstances can require a company to make accounting 
estimates. For example, a company typically will estimate the net 
realizable value of its accounts receivable and of its inventory.\53\ 
Not all accounting estimates in a company's financial statements, 
however, will necessarily be critical accounting estimates to which the 
proposed disclosure relates. An accounting estimate would be a critical 
accounting estimate for purposes of the proposed disclosure only if it 
meets two criteria. First, the accounting estimate must require a 
company to make assumptions about matters that are highly uncertain at 
the time the accounting estimate is made. Second, it must be the case 
that different estimates that the company reasonably could have used 
for the accounting estimate in the current period, or changes in the 
accounting estimate that are reasonably likely to occur from period to 
period, would have a material impact on the presentation of the 
company's financial condition, changes in financial condition or 
results of operations.\54\
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    \53\ Other examples of accounting estimates include: property 
and casualty insurance loss reserves, current obligations that will 
be fulfilled over several years, future returns of products sold, 
the amount of cash flows expected to be generated by a specific 
group of assets, revenues from contracts accounted for by the 
percentage of completion method and pension and warranty expenses. 
See AU Sec. 342, paragraph 2. For a more detailed list, see the 
Appendix to AU Sec. 342.
    \54\ ``Critical accounting estimate'' is defined in proposed 
Item 303(b)(3)(ii)(B) of Regulation S-B, 17 CFR 
228.303(b)(3)(ii)(B); proposed Item 303(c)(2)(ii) of Regulation S-K, 
17 CFR 229.303(c)(2)(ii); and proposed Item 5.E.2.(b) of Form 20-F, 
17 CFR 249.220f.
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    For purposes of the first criterion, a matter involves a high 
degree of uncertainty if it is dependent on events remote in time that 
may or may not occur, or it is not capable of being readily calculated 
from generally accepted methodologies or derived with some degree of 
precision from available data. Accordingly, a matter that is highly 
uncertain requires management to use significant judgment in making 
assumptions about that matter. The application of management's judgment 
in those circumstances typically results in management developing a 
range within which it believes the accounting estimate should fall.
    The second criterion focuses the proposals further on two types of 
accounting estimates involved in the application of accounting 
policies. First, it includes accounting estimates for which a company 
in the current period could reasonably have recorded in the financial 
statements an amount sufficiently different such that it would have had 
a material impact on the company's financial presentation. Second, it 
includes any accounting estimate that is reasonably likely to change 
from period to period to the extent that the change would have a 
material impact on the company's financial presentation. Thus, whether 
management's judgment has an impact primarily in the current period or 
on an ongoing basis (or both), the estimate would qualify.
    Under the proposals, a company would discuss any accounting 
estimate that it determines to be critical. We believe that few of a 
company's accounting estimates generally would meet those thresholds. 
We do not currently propose an outside limit to the number of 
accounting estimates that a company must discuss under the proposals. 
As the term ``critical accounting estimate'' implies, however, the 
disclosure should not encompass a long list of accounting estimates 
resulting from the application of accounting policies which cover a 
substantial number of line items in the company's financial 
statements.\55\ While the number of critical accounting estimates will 
vary by company, we would expect a very few companies to have none at 
all and the vast majority of companies to have somewhere in the range 
of three to five critical accounting estimates. The number could be at 
the high end of the range, or be slightly higher, for companies that 
conclude that one or more critical accounting estimates must be 
identified and discussed primarily because of particular segments. 
Investors, however, will not benefit from a lengthy discussion of a 
multitude of accounting estimates in which the truly critical ones are 
obscured. If we adopt the proposals without a maximum number, we may 
monitor disclosure to determine whether disclosure would be improved if 
a maximum number were set.
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    \55\ See proposed Instruction 3 to paragraph (b)(3) of Item 303 
of Regulation S-B, 17 CFR 228.303(b)(3); proposed Instruction 4 to 
paragraph (c) of Item 303 of Regulation S-K, 17 CFR 229.303(c); and 
proposed Instruction 3 to Item 5.E of Form 20-F, 17 CFR 249.220f.
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    We seek comment on the proposed definition of critical accounting 
estimates.
     Is the definition appropriately tailored?

[[Page 35627]]

     Does the definition capture the appropriate type and scope 
of accounting estimates?
     Is the definition appropriately designed to identify the 
accounting estimates that require management to use significant 
judgment or that are the most uncertain? If not, what other aspects 
descriptive of that type of estimate should be included?
     Is the definition appropriately designed to identify the 
accounting estimates involving a high potential to result in a material 
impact on the company's financial presentation?
     Would it be difficult for a company to discern which of 
its accounting estimates require assumptions about highly uncertain 
matters? If so, how could the proposal better target them?
     Should we consider setting a minimum percentage impact on 
results of operations in the second criterion of the definition, or 
would that be unnecessary because the proposed definition would not 
capture changes that have an insignificant impact?
     How many accounting estimates would a company typically 
identify as critical accounting estimates under the proposed 
definition?
     Would a company with multiple segments have a greater 
number of critical accounting estimates than a company without multiple 
segments? If so, please provide an explanation.
     Should we establish a maximum number of accounting 
estimates that may be discussed as critical accounting estimates (e.g., 
seven)? If so, what should the maximum number be and what criteria 
should be applied to set the number so as to strike the appropriate 
balance between information truly useful to investors and overly 
extensive disclosure of marginal use? If a maximum were set, should the 
number of segments a company has be considered?
     Should we expand the definition to include MD&A disclosure 
of volatile accounting estimates that use complex methodologies but do 
not involve significant management judgment? Should we do so only when 
the underlying assumptions or methodologies of those estimates are not 
commonly used and therefore not understood by investors?
2. Identification and Description of the Accounting Estimate, the 
Methodology Used, Certain Assumptions and Reasonably Likely Changes
    A company first would have to identify and describe each critical 
accounting estimate in such a way that it gives the appropriate context 
for investors reading that section and reflects management's view of 
the importance of the critical accounting estimate.\56\ A company would 
have to disclose the methodology it used in determining the estimate. 
It also would have to disclose the assumptions underlying the 
accounting estimate that reflect matters highly uncertain at the time 
the estimate was made as well as other assumptions underlying the 
estimate that are material. We recognize that a critical accounting 
estimate may involve multiple assumptions. The proposed disclosure 
would focus in the first instance on those that are about highly 
uncertain matters because they have the greatest potential to make the 
accounting estimate highly susceptible to change.
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    \56\ See proposed Item 303(b)(3)(iii)(A) of Regulation S-B, 17 
CFR 228.303(b)(3)(iii)(A); proposed Item 303(c)(3)(i) of Regulation 
S-K, 17 CFR 229.303(c)(3)(i); and proposed Item 5.E.3.(a) of Form 
20-F, 17 CFR 249.220f.
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    If applicable, the company would have to describe why different 
estimates could have been used in the current period and why the 
accounting estimate is reasonably likely to change from period to 
period in the financial statements. For example, a critical accounting 
estimate related to a significant portfolio of over-the-counter 
derivative contracts may require that a company estimate the fair value 
of such contracts using a model or other valuation method. In that 
case, the company would disclose the methods it employs to estimate 
fair value, e.g., the types of valuation models used such as the 
present value of estimated future cash flows, and assumptions such as 
an estimated price in the absence of a quoted market price.\57\
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    \57\ See also Securities Act Release No. 8056, FR-61 (Jan. 22, 
2002) [67 FR 3746], Section II.B. (providing an example of a 
critical accounting estimate related to non-exchange traded 
contracts accounted for at fair value).
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    A company also would have to explain known trends, demands, 
commitments, events or uncertainties that are reasonably likely to 
occur and materially affect the assumptions made or the methodology 
used. Like the requirements elsewhere in MD&A, disclosure would be 
required if the trend, demand, commitment, event or uncertainty is 
currently known, it is reasonably likely to occur and it is reasonably 
likely to have a material impact. Disclosure would not be required if 
management could affirmatively conclude that the trend, demand, 
commitment, event or uncertainty is not reasonably likely to come to 
fruition or that a material effect is not reasonably likely to 
occur.\58\
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    \58\ See supra fn. 16.
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3. Impact of the Estimate on Financial Condition, Changes in Financial 
Condition and Results of Operations
    For each critical accounting estimate, a company would have to 
explain its significance to the company's financial condition, changes 
in financial condition and results of operations and, where material, 
identify its effect on the line items in the company's financial 
statements.\59\ Because not all estimates themselves are line items in 
the financial statements,\60\ their existence and their effect may not 
be readily apparent. Thus, this disclosure would provide additional 
information and clarity for investors.
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    \59\ See proposed Item 303(b)(3)(iii)(B) of Regulation S-B, 17 
CFR 228.303(b)(3)(iii)(B); proposed Item 303(c)(3)(ii) of Regulation 
S-K, 17 CFR 229.303(c)(3)(ii); and proposed Item 5.E.3.(b) of Form 
20-F, 17 CFR 249.220f.
    \60\ For example, an estimate of fair value used to measure an 
impairment loss on a long-lived asset may not itself appear as a 
line item in the financial statements.
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4. Quantitative Disclosures
    There are two areas of the proposed MD&A disclosure relating to 
critical accounting estimates in which we explicitly would require a 
presentation of quantitative information.\61\ First, the proposals 
would require disclosure that demonstrates the sensitivity of financial 
results to changes made in connection with each critical accounting 
estimate. Second, the proposals would require quantitative disclosure 
relating to historical changes in a company's critical accounting 
estimates in the past three years.
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    \61\ See proposed Item 303(b)(3)(iii)(C) of Regulation S-B, 17 
CFR 228.303(b)(3)(iii)(C); proposed Item 303(c)(3)(iii) of 
Regulation S-K, 17 CFR 229.303(c)(3)(iii); and proposed Item 
5.E.3.(c) of Form 20-F, 17 CFR 249.220f.
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a. Quantitative Disclosures To Demonstrate Sensitivity

    We propose to require that a company present quantitative 
information about changes in its overall financial performance and, to 
the extent material, line items in the financial statements that would 
result if certain changes relating to a critical accounting estimate 
were assumed to occur. The company would identify the change being 
assumed and discuss quantitatively its impact on the company. Because 
the point of the disclosure is to demonstrate the degree of 
sensitivity, the impact on overall financial performance would be 
discussed regardless of how large that is.
    As proposed, a company would have two possible choices of changes 
it would assume for purposes of the sensitivity analysis. First, the 
company

[[Page 35628]]

could choose to assume that it changed the most material assumption or 
assumptions underlying the critical accounting estimate and discuss the 
results of those changes. Second, the company could choose to assume 
that the critical accounting estimate itself changes. In addition to 
providing two choices of methods to demonstrate sensitivity, we allow a 
company to determine the amount of the change that it assumes for this 
analysis rather than attempting to standardize those amounts. Under the 
first choice, a company could select the alternative material 
assumption or assumptions to use as long as the alternative represents 
a change that is reasonably possible in the near term. ``Reasonably 
possible'' means the chance of a future transaction or event occurring 
is more than remote but less than likely.\62\ ``Near-term'' means a 
period of time going forward up to one year from the date of the 
financial statements.\63\ Under the second choice, the company would 
use the upper and the lower ends of the range of reasonably possible 
estimates which it likely determined in formulating its recorded 
critical accounting estimate. It would substitute the upper end of the 
range for the recorded estimate and discuss the results. It would do 
the same for the lower end of the range.
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    \62\ ``Reasonably possible'' would have the same meaning as 
defined in SFAS No. 5. See supra fn. 23. See also proposed Item 
303(b)(3)(ii)(D) of Regulation S-B, 17 CFR 228.303(b)(3)(ii)(D); 
proposed Item 303(c)(2)(iv) of Regulation S-K, 17 CFR 
229.303(c)(2)(iv); and proposed Item 5.E.2.(d) of Form 20-F, 17 CFR 
249.220f.
    \63\ ``Near-term'' would have the same meaning as defined in SOP 
94-6 at paragraph 7. See proposed Item 303(b)(3)(ii)(C) of 
Regulation S-B, 17 CFR 228.303(b)(3)(ii)(C); proposed Item 
303(c)(2)(iii) of Regulation S-K, 17 CFR 229.303(c)(2)(iii); and 
proposed Item 5.E.2.(c) of Form 20-F, 17 CFR 249.220f.
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    We believe the most informative disclosure about sensitivity would 
result if we allow companies significant flexibility to customize these 
analyses. Our approach would accommodate different types of companies, 
different critical accounting estimates and different types of 
underlying assumptions. The parameters selected for the sensitivity 
analysis must, however, be realistic and meaningful measures of 
change.\64\ For purposes of the sensitivity analysis, a company should 
disclose, if known or available, the likelihood of occurrence of the 
changes it selects, such as estimated probabilities of occurrence or 
standard deviations where applicable.
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    \64\ For example, companies would be required to select 
meaningful changes in material assumptions and not ones so minute as 
to avoid, or materially understate, any demonstration for investors 
of sensitivity. See proposed Instruction 1 to paragraph (b)(3) of 
Item 303 of Regulation S-B, 17 CFR 228.303(b)(3); proposed 
Instruction 1 to paragraph (c) of Item 303 of Regulation S-K, 17 CFR 
229.303(c); and proposed Instruction 1 to Item 5.E of Form 20-F, 17 
CFR 249.220f.
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    Under the first choice for demonstrating sensitivity, we would 
provide that a company choose its most material assumption underlying 
the critical accounting estimate and alter it at least twice \65\ to 
reflect reasonably possible, near-term changes.\66\ A company would 
have to complete the analysis assuming a positive change in the 
assumption. It would also have to complete the analysis assuming a 
negative change. In some cases, a company may not be able to select a 
single most material assumption to use for purposes of these analyses, 
or it may believe that using a single assumption would not provide 
meaningful sensitivity information for investors. If that were to 
occur, a company either could select the second choice for analyzing 
sensitivity (i.e., using the ends of the range) or it could demonstrate 
the effects of near-term reasonably possible changes in more than one 
material assumption underlying the critical accounting estimate. If the 
company chooses the latter course of action, it also would have to 
disclose clearly the separate effect of each changed assumption.
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    \65\ Where use of only one positive change, or use of only one 
negative change, would render the analysis materially misleading, 
companies would have to include more than one assumed positive 
change, or more than one assumed negative change, to avoid that 
result.
    \66\ In completing the analysis, companies would have to 
consider whether assumed events that alter the most material 
assumption also could have some impact on other assumptions made in 
formulating the critical accounting estimate. For example, if a 
company were to assume a reasonably possible near-term change in 
fuel prices occurred, that change may impact multiple assumptions 
underlying a critical accounting estimate that each take fuel prices 
into account. Companies would have to determine whether and how 
their other assumptions would change and disclose the aggregate 
effect of all of those changes.
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    In general, we believe the impact of a positive change and the 
impact of a negative change would both have to be disclosed where a 
company is assuming changes in its most material assumption (or 
assumptions). There may be cases, however, where both types of changes 
would not be applicable. In some instances, an increase in an 
assumption, but not a decrease in an assumption, or vice versa, would 
have no effect on the line items or the overall financial performance 
and therefore would not have to be discussed other than noting that 
fact.\67\ It is conceivable that in other cases either a decrease or an 
increase would not be reasonably possible and therefore would not have 
to be discussed other than noting that fact.
---------------------------------------------------------------------------

    \67\ For an example of when this could take place, see infra 
Example 3 in Section III.D.
---------------------------------------------------------------------------

    With the proposed analysis, a company would demonstrate sensitivity 
of reported results to changes that affect its critical accounting 
estimates. Investors would have a better understanding of the extent to 
which there is a correlation between management's key assumptions and 
the company's overall financial performance. Investors also would 
understand better which particular line items in reported results would 
be materially affected and how much. In addition, a company would be 
required to state whether those assumed changes could have a material 
effect on the company's liquidity or capital resources. If they could 
have such an effect, the company would have to explain how, as a 
company currently is required to explain in MD&A when factors affecting 
liquidity or capital resources are present.\68\
---------------------------------------------------------------------------

    \68\ See, e.g., Item 303(a)(1)-(2) of Regulation S-K, 17 CFR 
229.303(a)(1)-(2).
---------------------------------------------------------------------------

    From the proposed disclosure, the average investor should be able 
to ascertain the general degree to which the company's results of 
operations, liquidity and capital resources are susceptible to changes 
in management's views relating to critical accounting estimates. Along 
with the other provisions in the proposal, this quantitative and 
qualitative disclosure conveys information about the impact of 
management's subjective assumptions on current and future financial 
results.
    We request comment on the proposed identification and analysis of 
changes.
     Are there some types of critical accounting estimates or 
some circumstances where the proposed disclosure relating to 
sensitivity would not be meaningful or otherwise helpful to investors? 
If so, which estimates or what circumstances?
     In addition to the two choices we propose for assuming 
changes relating to the critical accounting estimates to analyze 
sensitivity, are there others that we should permit? Should we require 
instead that all companies use the same method? If so, which one?
     Should we require a company to use whichever of the two 
proposed choices demonstrates the greatest impact on the company's 
financial presentation?
     Are there circumstances under which a company should be 
required to demonstrate sensitivity using both of the proposed choices?
     Are there any critical accounting estimates for which 
neither of the two

[[Page 35629]]

choices for selecting the assumed changes would be appropriate?
     Will companies be able to select appropriate changes in 
their most material assumption or assumptions, or should we provide 
further guidance?
     To enhance an investors' ability to compare the 
sensitivity of various companies' financial statements to changes 
relating to a particular type of accounting estimate, should we 
standardize the changes that companies must assume for various types of 
estimates? If so, what should they be and why? For example, should we 
set a specified percentage increase and decrease to assume (e.g., a 10% 
increase and decrease), or a presumptive increase and decrease, 
provided that degree of change is reasonably possible in the near term?
     Conversely, would any changes we standardize not be 
equally meaningful to measure sensitivity, or equally probable, for 
various accounting estimates, industries and companies, and thus reduce 
the value of any disclosure about sensitivity?

b. Quantitative and Qualitative Disclosures Concerning Past Changes in 
the Estimate

    We recognize that a company will change its accounting estimates 
over time as new events occur or as management acquires more experience 
or additional information. Existing MD&A disclosure rules would call 
for discussion of the effects of changes in accounting estimates where 
those changes are material to an investor's understanding of financial 
position or results of operations. For example, MD&A currently requires 
companies to disclose:
     Information necessary for an understanding of financial 
condition, changes in financial condition and results of 
operations;\69\
---------------------------------------------------------------------------

    \69\ See, e.g., Item 303(a) of Regulation S-K, 17 CFR 
229.303(a).
---------------------------------------------------------------------------

     Significant components of revenues or expenses that 
should, in the company's judgment, be described in order to understand 
results of operations;\70\
---------------------------------------------------------------------------

    \70\ See, e.g., Item 303(a)(3)(i) of Regulation S-K, 17 CFR 
229.303(a)(3)(i).
---------------------------------------------------------------------------

     A material change in the relationship between costs and 
revenues resulting from a known event;\71\
---------------------------------------------------------------------------

    \71\ See, e.g., Item 303(a)(3)(ii) of Regulation S-K, 17 CFR 
229.303(a)(3)(ii).
---------------------------------------------------------------------------

     Matters that will have an impact on future operations and 
have not had an impact in the past;\72\ and
---------------------------------------------------------------------------

    \72\ See, e.g., Instruction 3(A) to Item 303(a) of Regulation S-
K, 17 CFR 229.303(a).
---------------------------------------------------------------------------

     Matters that have had an impact on reported operations and 
are not expected to have an impact upon future operations.\73\
---------------------------------------------------------------------------

    \73\ See, e.g., Instruction 3(B) to Item 303(a) of Regulation S-
K, 17 CFR 229.303(a).
---------------------------------------------------------------------------

    Notwithstanding the existing MD&A disclosure requirements, we 
believe it would be appropriate to require specific disclosure 
regarding past changes in critical accounting estimates. This type of 
information required under the proposal would give investors a clear 
understanding of a company's recent history of those changes. A company 
other than a small business issuer would have to include the proposed 
quantitative and qualitative discussion of any material changes in 
those accounting estimates under the proposals during the past three 
fiscal years.\74\ A small business issuer would discuss material 
changes in its critical accounting estimates during the past two 
years.\75\ Companies would have to identify how the material changes 
affected measurements in the financial statements and their overall 
financial performance.\76\ This would enable investors to evaluate 
management's formulation of critical accounting estimates over time.
---------------------------------------------------------------------------

    \74\ See proposed Item 303(c)(3)(iv) of Regulation S-K, 17 CFR 
229.303(c)(3)(iv), and proposed Item 5.E.3.(d) of Form 20-F, 17 CFR 
249.220f. As part of its disclosure, a company would have to include 
discussion of assumptions that changed materially from a prior 
period but did not cause the estimate itself to change by a material 
amount. For example, a company could change two or more material 
assumptions underlying an accounting estimate, but the changes in 
the assumptions could have an offsetting impact, resulting in no 
material change to the amount of the accounting estimate recorded in 
the financial statements.
    \75\ See proposed Item 303(b)(3)(iii)(D) of Regulation S-B, 17 
CFR 228.303(b)(3)(iii)(D). These periods correspond to the time 
frame currently encompassed by the MD&A requirements applicable to 
each of those types of companies.
    \76\ Compare APB No. 20, paragraph 33, which requires financial 
statement disclosure of the effect on income before extraordinary 
items, net income, and related per share amounts of the current 
period for a change in an estimate not made in the ordinary course 
of accounting that materially affects several future periods.
---------------------------------------------------------------------------

    Companies also would be required to describe the reasons for those 
changes. If no material changes in the critical accounting estimates 
were made in the prescribed time period, or if a company did not make 
that estimate during any part of that period, a company would only be 
required to disclose that fact.
    Although the period covered for the proposed disclosure of past 
changes in critical accounting estimates would be two years for small 
business issuers and three years for other companies, our proposed 
requirement relating to past changes would be put into effect in 
stages. Thus, when a small business issuer or other company files its 
first covered report, registration statement or proxy or information 
statement following adoption of the proposed rules, the rules would 
require it to provide the proposed specific past changes disclosure 
only for the past one or two years respectively. For example, if the 
first report were an annual report on Form 10-K for the fiscal year 
ended December 31, 2002, the company would include that information in 
the ``Application of Critical Accounting Policies'' section of MD&A 
about changes in 2001 and 2002 (and a small business issuer would 
include it only for 2002). In the first annual report, registration 
statement or proxy or information statement filed by a company more 
than one year following the effective date of the rules, it would have 
to provide that information for the past three years (two years for a 
small business issuer).\77\
---------------------------------------------------------------------------

    \77\ Of course, the phase-in of the specific MD&A disclosure 
about changes in estimates would not delay the effect of the rest of 
the proposed changes or affect the requirements for disclosure under 
current MD&A rules.
---------------------------------------------------------------------------

    We solicit comment on the proposed disclosure of past material 
changes in critical accounting estimates.
     Is sufficient disclosure of these changes already required 
under current MD&A requirements?
     Is a three-year period the most appropriate period of time 
over which investors should consider changes? If not, why would a 
shorter or longer period be more appropriate?
     Would requiring disclosure over a longer period, such as 
five years, make it easier for investors to identify trends? If so, 
over how many years should we phase in a longer period requirement?
     Should we mandate a standardized format for quantitative 
disclosure about past changes in critical accounting estimates (e.g., a 
chart illustrating the dollar value of the change from the prior year 
for each year showing the impacted line items and other effects in each 
year)?
5. Senior Management's Discussions with the Audit Committee
    Independent auditors discuss accounting estimates with management 
in order to conduct an audit, and the auditors may discuss them with 
the audit committee. In 1999, following the recommendations in the 
Report of the Blue Ribbon Committee on Improving the Effectiveness of 
Corporate Audit Committees, we adopted a rule that would require an 
audit committee report in proxy or information statements connected to 
board of

[[Page 35630]]

director elections.\78\ Among other items, the audit committee report 
must state whether the audit committee has discussed with the 
independent auditors the matters required to be discussed by Statement 
on Auditing Standards (``SAS'') No. 61 (codified in AU Sec. 380), as 
may be modified or supplemented. \79\ SAS 61 requires independent 
auditors to communicate certain matters related to the conduct of an 
audit to those who have responsibility for oversight of the financial 
reporting process, specifically the audit committee. With respect to 
accounting estimates, SAS 61 states, ``[t]he auditor should determine 
that the audit committee is informed about the process used by 
management in formulating particularly sensitive accounting estimates 
and about the basis for the auditor's conclusions regarding the 
reasonableness of those estimates.'' \80\ In addition, in connection 
with each SEC engagement, the auditor should discuss with the audit 
committee the auditor's judgments about the quality of the entity's 
accounting principles as applied in its financial reporting. The 
discussion should include items that have a significant impact on the 
financial statements (for example, estimates, judgments and 
uncertainties, among other items). \81\
---------------------------------------------------------------------------

    \78\ See Exchange Act Release No. 42266 (Dec. 22, 1999) [64 FR 
73389] and Item 306 of Regulation S-K, 17 CFR 229.306.
    \79\ See Item 306(a)(2) of Regulation S-K, 17 CFR 229.306(a)(2), 
SAS No. 61, Communication with Audit Committees (Apr. 1988) (``SAS 
61'') and SAS No. 90, Audit Committee Communications (Dec. 1999) 
(``SAS 90'') (amending SAS 61 and AU Sec. 380).
    \80\ SAS 61, paragraph 8.
    \81\ See AU Sec. 380, paragraph 11 (added by SAS 90).
---------------------------------------------------------------------------

    In addition to the disclosure relating to SAS 61 (as amended), the 
audit committee report must state whether the audit committee has 
reviewed and discussed the audited financial statements with 
management. \82\ Because that item relates to the financial statements 
generally, a focused discussion on critical accounting estimates may or 
may not result from it. Moreover, the newly required disclosure in MD&A 
would not be a part of the financial statements, and therefore would 
not necessarily be covered by that proxy statement disclosure 
requirement.
---------------------------------------------------------------------------

    \82\ See Item 306(a)(1) of Regulation S-K, 17 CFR 229.306(a)(1).
---------------------------------------------------------------------------

    The existing audit committee report also requires audit committees 
to state whether, based on discussions with management and the 
auditors, the committee recommended to the board of directors that the 
audited financial statements be included in the company's Form 10-K or 
10-KSB for the last fiscal year. \83\ This disclosure requirement 
conveys whether the audit committee review of the financial statements 
and discussions with management and the auditors have provided a basis 
for recommending to the board that the audited financial statements be 
filed with the Commission. This item too does not require any specific 
discourse between management and the audit committee about critical 
accounting estimates.
---------------------------------------------------------------------------

    \83\ See Item 306(a)(4) of Regulation S-K, 17 CFR 229.306(a)(4).
---------------------------------------------------------------------------

    We believe that senior management should discuss the company's 
critical accounting estimates with the audit committee of its board of 
directors. \84\ If specific discussions between senior management and 
audit committees regarding the development, selection and disclosure of 
the critical accounting estimates were to take place, the audit 
committee may seek to understand the company's critical accounting 
estimates, the underlying assumptions and methodologies, the 
appropriateness of management's procedures and conclusions, and the 
disclosure about those accounting estimates. This type of oversight 
would have the potential to improve the quality and the transparency of 
disclosure.
---------------------------------------------------------------------------

    \84\ See Securities Act Release No. 8040, FR-60 (Dec. 12, 2001) 
[66 FR 65013].
---------------------------------------------------------------------------

    Requiring a company to disclose in MD&A whether or not senior 
management has engaged in discussions with the audit committee about 
the critical accounting estimates would give investors a better 
understanding of whether such oversight by those responsible for the 
general oversight of the financial reporting process was applied to 
those accounting estimates and the disclosure about those accounting 
estimates. We therefore are proposing to require such disclosure. \85\ 
When senior management and the audit committee have not had those 
discussions, we would require disclosure that they have not, and an 
explanation of the reasons why they have not. \86\ If the company does 
not have an audit committee, then the proposed disclosure would address 
discussions with the board committee that performs equivalent functions 
to those of an audit committee or, if no such committee exists, the 
entire board of directors. \87\ Unlike the audit committee report, our 
proposed disclosure of discussions between the audit committee and 
senior management would not be limited to proxy and information 
statements that involve the election of directors. \88\
---------------------------------------------------------------------------

    \85\ See proposed Item 303(b)(3)(iii)(E) of Regulation S-B, 17 
CFR 228.303(b)(3)(iii)(E); proposed Item 303(c)(3)(v) of Regulation 
S-K, 17 CFR 229.303(c)(3)(v); and proposed Item 5.E.3.(e) of Form 
20-F, 17 CFR 249.220f.
    \86\ The proposed MD&A disclosure is distinguishable from the 
audit committee report in annual proxy or information statements. 
Under the proxy requirements, the audit committee must prepare a 
report and state whether it recommended, based on its review and 
discussions with management and the auditors, that the financial 
statements be included in the Form 10-K. In our proposals, we would 
not require an audit committee report or recommendation, but only 
that the company state whether or not discussions between the audit 
committee and senior management occurred and, if they did not, why 
not. We therefore are not convinced that a liability exemption like 
that applicable to the audit committee report is necessary for 
disclosure in MD&A of whether or not a company's senior management 
has discussed the development and selection of critical accounting 
estimates, and the disclosure in MD&A regarding them.
    \87\ If the registrant is not a corporation, the disclosure 
would address senior management's discussions with the equivalent 
group responsible for the oversight of the financial reporting 
process.
    \88\ This disclosure would be required in annual reports filed 
with the Commission, annual reports to shareholders, registration 
statements and proxy and information statements. When a new critical 
accounting estimate is identified in a quarterly report, there also 
would be disclosure in the Form 10-Q or Form 10-QSB regarding 
whether the development, selection and disclosure regarding the 
estimate was discussed by management with the audit committee of the 
board of directors.
---------------------------------------------------------------------------

    We do not propose to require disclosure of the substance of the 
discussions between senior management and the audit committee. We 
believe that such a requirement could deter the type of open discourse 
that we expect to take place in those discussions.
    We request comment on the proposed disclosure about discussions 
between senior management and the audit committee regarding the 
development, selection and disclosure of critical accounting estimates.
     To what extent does senior management currently discuss 
critical accounting estimates with the audit committee of the board of 
directors and the company's auditors?
     Would the proposed requirement provide useful information 
to investors?
     Would the proposed disclosure be a catalyst for discussion 
between audit committees and senior management? Could it chill 
discussions?
     Is there other related disclosure that should be required 
for the benefit of investors?
     Should we require that companies disclose any unresolved 
concerns of the audit committee about the critical accounting estimates 
or the related MD&A disclosure?
     Should we require disclosure of any specific procedures 
employed by the audit committee to ensure that the company's response 
to the proposed

[[Page 35631]]

disclosure requirements is complete and fair?
     Should we consider requiring disclosure of whether the 
audit committee recommends the disclosure be included in the MD&A, 
which is akin to the disclosure required in the Item 306 audit 
committee report?
     Instead of the proposed disclosure, should we amend Item 
306 of Regulation S-K and Regulation S-B to require that the audit 
committee report disclose whether the audit committee has reviewed and 
discussed with senior management the development, selection and 
disclosure regarding critical accounting estimates?
     If we were to amend Items 306 in this manner, should we 
also expand them to include the discussions about critical accounting 
estimates between senior management and the audit committee as one of 
the bases for the audit committee's recommendation to include the 
financial statements in the annual report?
     Should we expand Items 306 to require disclosure of 
whether, based on an audit committee's review of and discussions about 
the MD&A, the audit committee recommended to the board of directors 
that the MD&A be included in the company's annual report?
     Should we expand Items 306 to require disclosure of 
whether the audit committee has reviewed and discussed the entire MD&A 
disclosure (current and proposed) with management and/or the auditors?
     If any of a company's accounting policies diverge, to its 
knowledge, from the policies predominately applied by other companies 
in the same industry, should we require that the company disclose, 
possibly in connection with the audit committee report, whether the 
audit committee has had discussions with senior management about the 
appropriateness of the accounting policies being used? When such 
discussions have taken place, should we require that the company 
disclose the audit committee's unresolved concerns about the divergent 
accounting policies being applied? Prior to the adoption of our 
proposals, to what extent would a company know that its accounting 
policies diverge from those of other companies in its industry?
6. Disclosure Relating to Segments
    Current MD&A disclosure requirements provide companies with the 
discretion to include a discussion of segment information where, in the 
company's judgment, such a discussion would be appropriate to an 
understanding of the company.\89\ In 1989, we stated in an interpretive 
release, ``[t]o the extent any segment contributes in a materially 
disproportionate way to [revenues, profitability, and cash needs], or 
where discussion on a consolidated basis would present an incomplete 
and misleading picture of the enterprise, segment disclosure should be 
included.'' \90\ In accordance with this interpretation, we are 
proposing disclosure regarding the impact of critical accounting 
estimates on segments of a company's business.\91\ Where applicable, we 
believe that this disclosure would be important for investors because 
it would enable them to determine which reported segments' results are 
dependent on management's subjective estimates, and material 
information would be provided on a segment basis.
---------------------------------------------------------------------------

    \89\ See Item 303(a) of Regulation S-K, 17 CFR 229.303(a).
    \90\ See Securities Act Release No. 6835 (May 18, 1989) [54 FR 
22427].
    \91\ See proposed Item 303(b)(3)(iii)(F) of Regulation S-B, 17 
CFR 228.303(b)(3)(iii)(F); proposed Item 303(c)(3)(vi) of Regulation 
S-K, 17 CFR 229.303(c)(3)(vi); and proposed Item 5.E.3.(f) of Form 
20-F, 17 CFR 249.220f.
---------------------------------------------------------------------------

    Under the proposals, if a company operates in more than one segment 
\92\ and a critical accounting estimate affects fewer than all of the 
segments, the company would have to identify the segments it affects. A 
company also would have to determine whether it must include, in 
addition to the disclosure on a company-wide basis, a separate 
discussion of the critical accounting estimates for each identified 
segment about which disclosure is otherwise required.\93\ That 
determination would follow an analysis similar to that in the 1989 
guidance. A company would have to provide a discussion on a segment 
basis to the extent that discussion only on a company-wide basis would 
result in an omission that renders the disclosure materially 
misleading.\94\ We would not mandate repetition on a segment basis of 
all matters discussed on a company-wide basis. Rather, a company would 
have to disclose only that information necessary to avoid an incomplete 
or misleading picture.
---------------------------------------------------------------------------

    \92\ See SFAS No. 131 for requirements as to presentation of 
segment disclosure in the financial statements.
    \93\ Certain foreign private issuers providing disclosure under 
Item 17 of Form 20-F are not required to provide segment disclosure 
in their filed financial statements and therefore would not be 
required to provide a quantitative discussion of the identified 
segments.
    \94\ Any discussion on a segment basis would appear in the 
section of MD&A devoted to critical accounting estimates, and not in 
the separate discussion of segment results in MD&A.
---------------------------------------------------------------------------

    We request comment regarding identification of the segments 
affected and the proposed additional disclosure of the critical 
accounting estimates on a segment basis.
     Should we provide more guidance for determining the 
circumstances that warrant segment disclosure?
     Should we require the additional segment discussion only 
when more than one segment is affected?

D. Examples of Proposed Disclosure About Critical Accounting Estimates

    To assist in understanding the scope of the MD&A disclosure that is 
proposed, we have developed three examples. Each example examines how a 
fictional public company that has identified a critical accounting 
estimate could draft MD&A disclosure to satisfy the proposal. The 
examples are illustrative only. In addition, our January 22, 2002 
release provides an example of disclosure that companies should 
consider when discussing in MD&A trading activities involving contracts 
that are accounted for at fair value where a lack of market price 
quotations necessitates the use of fair value estimation 
techniques.\95\
---------------------------------------------------------------------------

    \95\ See Securities Act Release No. 8056, FR-61 (Jan. 22, 
2002)[67 FR 3746], Section II.B.
---------------------------------------------------------------------------

Example 1
Background
    Alphabetical Company manufactures and distributes electrical 
equipment used in large-scale commercial pumping and water treatment 
facilities. The company operates in four business segments. The 
company's equipment carries standard product warranties extending over 
a period of 6 to 10 years. If equipment covered under the standard 
warranty requires repair, the company provides labor and replacement 
parts to the customer at no cost. Historically, the costs of fulfilling 
warranty obligations have principally related to providing replacement 
parts, with labor costs representing the remainder. Over the past 3 
years, the cost of copper included in replacement parts constituted 
approximately 35% to 40% of the total cost of warranty obligations.
    A liability for the expected cost of warranty-related claims is 
established when equipment is sold. The amount of the warranty 
liability accrued reflects the company's estimate of the expected 
future costs of honoring its obligations under the warranty plan. 
Because of the long-term nature of the company's equipment warranties, 
estimating the

[[Page 35632]]

expected cost of such warranties requires significant judgment. Based 
on management's evaluation of analysts' forecasts for copper prices, 
management believes a 30% decrease in copper prices or a 50% increase 
in copper prices is reasonably possible in the near term. In each of 
the last three years, warranty expense represented approximately 19% to 
22% of cost of sales.

Possible MD&A Disclosure Under the Proposal

Application of Critical Accounting Policies

    Alphabetical's products are covered by standard product warranty 
plans that extend 6 to 10 years. A liability for the expected cost 
of warranty-related claims is established when equipment is sold. 
The amount of the warranty liability accrued reflects our estimate 
of the expected future costs of honoring our obligations under the 
warranty plan. We believe the accounting estimate related to 
warranty costs is a ``critical accounting estimate'' because: 
changes in it can materially affect net income, it requires us to 
forecast copper prices in the distant future which are highly 
uncertain and require a large degree of judgment, and copper is a 
significant raw material in the replacement parts used in warranty 
repairs. The estimate for warranty obligations is a critical 
accounting estimate for all of our four segments.
    Historically, the costs of fulfilling our warranty obligations 
have principally related to replacement parts, with labor costs 
representing the remainder. Over the past 3 years, the cost of 
copper included in our parts constituted approximately 35% to 40% of 
the total cost of warranty repairs. Over that same period, warranty 
expense represented approximately 19% to 22% of cost of sales.
    Over the past 10 years, the price of copper has exhibited 
significant volatility. For example, during 1994, the price of 
copper rose by approximately 72%, while in 2001 the price decreased 
by approximately 19%. Our hedging programs provide adequate 
protection against short-term volatility in copper prices, as 
described in ``Risk Management,'' but our hedging does not extend 
beyond 5 years. Accordingly, our management must make assumptions 
about the cost of that raw material in periods 6 to 10 years in the 
future. Management forecasts the price of copper for the portion of 
our estimated copper requirements not covered by hedging. Our 
forecasts are based principally on long-range price forecasts for 
copper which are published by private research companies 
specializing in the copper markets.
    Each quarter, we reevaluate our estimate of warranty 
obligations, including our assumptions about the cost of copper. 
During 2001, we decreased our estimated cost of unhedged copper 
purchases over the next 10 years by 15%, reflecting a growing excess 
of supply over forecasted demand, which reduced our accrued warranty 
costs and our cost of sales (and, accordingly, increased operating 
income) by $15 million. In contrast, during 2000, long-term price 
forecasts were essentially unchanged, so we made no adjustments to 
our estimated cost of unhedged copper purchases over the next 10 
years. During 1999, copper prices increased by approximately 28% 
over the prior year. Long-term prices also reflected increases in 
prices over those projected in 1998. Thus, in 1999, we increased our 
estimated cost of unhedged copper purchases over the next 10 years 
(through 2009) by 15%. That increase in our estimate resulted in an 
$18 million addition to our accrued warranty cost and our cost of 
sales, and an equal reduction in our operating income.
    If, for the unhedged portion of our estimated copper 
requirements, we were to decrease our estimate of copper prices as 
of December 31, 2001 by 30%, our accrued warranty costs and cost of 
sales would have been reduced by approximately $27 million or 6% and 
4%, respectively, while operating income would have increased by 9%. 
If we were to increase our estimate as of December 31, 2001 by 50%, 
our accrued warranty costs and cost of sales would have been 
increased by approximately $45 million or 10% and 7%, respectively, 
while our operating income would have been reduced by 23%.
    A very significant increase in our estimated warranty 
obligation, such as one reflecting the increase in copper prices 
that occurred in 1994, could lower our earnings and increase our 
leverage ratio (leverage refers to the degree to which a company 
utilizes borrowed funds). That, in turn, could limit our ability to 
borrow money through our revolving credit facilities described in 
``Liquidity and Capital Resources.''
    Our management has discussed the development and selection of 
this critical accounting estimate with the audit committee of our 
board of directors and the audit committee has reviewed the 
company's disclosure relating to it in this MD&A.
Example 2
Background
    MQB Corp. is a developer and publisher of desktop publishing 
software that operates in two segments. MQB distributes its products 
primarily through third-party distributors, resellers, and retailers 
(customers). Like many companies in the software industry, MQB has a 
product return policy and has historically accepted significant product 
returns. MQB permits its customers to return software titles published 
and distributed by the company within 120 days of purchase.
    MQB recognizes revenues under SOP 97-2, ``Software Revenue 
Recognition.'' The company ships its products FOB (Free on Board) 
shipping point. Therefore, legal title to the products passes to the 
customers upon shipment, and the company has no legal obligation for 
product damage in transit. Accordingly, MQB recognizes revenue upon 
shipment of its software products, provided that collection of payment 
is determined to be probable and no significant obligations on MQB's 
part remain. Payment is due from customers 30 days after shipment. At 
the time revenue is recorded, MQB accounts for estimated future returns 
by reducing sales by its estimate of future returns and by reducing 
accounts receivable by the same amount. For example, MQB reduced its 
gross sales and accounts receivable by 12% for its fiscal year ended 
December 31, 2001 to reflect estimated product returns. In the last 
three years, the range in which the company has reduced its gross sales 
and accounts receivable to reflect product returns has been between 11% 
and 13%.
    MQB receives weekly reports from distributors and retailers 
regarding the amount of MQB products in their inventory. A historical 
correlation exists between levels of inventory held by distributors and 
retailers (together, the distribution channel) and the amount of 
returns that actually occur. The weekly reports from distributors and 
retailers provide the company with visibility into the distribution 
channel such that MQB has the ability to estimate future returns. In 
each of the past few years, actual returns have varied from period to 
period, although they have not exceeded the estimated amounts by more 
than 5%. The company's products are, however, subject to intense 
marketplace competition, including several recently introduced 
competing products. If actual returns significantly exceed the 
previously estimated amounts, it would result in materially lower sales 
and net income before taxes in one or more future periods.

Possible MD&A Disclosure Under the Proposal

Application of Critical Accounting Policies

    Our recognition of revenue from sales to distributors and 
retailers (the ``distribution channel'') is impacted by agreements 
we have giving them rights to return our software titles within 120 
days after purchase. At the time we recognize revenue, upon shipment 
of our software products, we reduce our measurements of those sales 
by our estimate of future returns and we also reduce our 
measurements of accounts receivable by the same amount.
    For our products, a historical correlation exists between the 
amount of distribution channel inventory and the amount of returns 
that actually occur. The greater the distribution channel inventory, 
the more product returns we expect. For each of our products, we 
monitor levels of product sales and inventory at our distributors' 
warehouses and at retailers as part of our effort to reach an 
appropriate accounting estimate for returns. In estimating returns, 
we analyze historical returns, current inventory in the distribution 
channel, current economic trends, changes in consumer demand,

[[Page 35633]]

introduction of new competing software and acceptance of our 
products.
    In recent years, as a result of a combination of the factors 
described above, we have materially reduced our gross sales to 
reflect our estimated amount of returns. It is also possible that 
returns could increase rapidly and significantly in the future. 
Accordingly, estimating product returns requires significant 
management judgment. In addition, different return estimates that we 
reasonably could have used would have had a material impact on our 
reported sales and thus have had a material impact on the 
presentation of the results of operations. For those reasons, we 
believe that the accounting estimate related to product returns is a 
``critical accounting estimate.'' Our estimate of product returns is 
a critical accounting estimate for both of our segments. Management 
of the company has discussed the development and selection of this 
critical accounting estimate with the audit committee of our board 
of directors and the audit committee has reviewed the company's 
disclosure relating to it in this MD&A.
    We are aware of several recently introduced products that 
compete with several of our significant products. These new 
competitive factors have not, to date, materially impacted returns; 
therefore, we have made no adjustment as a result of these factors 
in our estimated returns for 2001. In our highly competitive 
marketplace, these factors have some potential to increase our 
estimates of returns in the future. The introduction of new 
competing products has impacted our estimate of returns in the past. 
In 1999, we increased our estimate of returns over the previous year 
by 1%, as a percentage of gross sales, because of increased 
inventory in the distribution channel due to new products introduced 
by two of our competitors.
    In preparing our financial statements for the year ended 
December 31, 2001, we estimated future product returns for all of 
our products to be $145 million, and we reduced our gross sales by 
that amount. Our 2001 estimate for returns was $20 million greater 
than our estimate in 2000 and $15 million greater than our estimate 
in 1999. From 1999 to 2000, products introduced by two of our 
competitors in 1998 lost market share to our products and our sales 
increased. Due to our increased sales in 2000, the distribution 
channel inventory declined over levels in 1999, which also resulted 
in a 2% decline in the estimated amount of returns, as a percentage 
of gross sales. In 2001, with the slow down in consumer spending 
over the prior period, distribution channel inventory grew faster 
than sales, necessitating an increase in the estimated returns equal 
to 1% of gross sales. The estimates for returns represented 
approximately 12%, 11% and 13% of our gross sales for 2001, 2000 and 
1999, respectively.
    If we were to assume that our estimate of future product returns 
for all of our products was changed to the upper end or lower end of 
the range we developed in the course of formulating our estimate, 
the estimate for future returns as of December 31, 2001 would range 
from $130 million to $160 million. Accordingly, the amounts by which 
we would reduce gross sales and operating income also would range 
from $130 million to $160 million as compared to the recorded amount 
of $145 million. In each of the years in the three-year period ended 
2001, our actual returns have not deviated from our estimates by 
more than 5%. Our actual returns for 2000 and 1999 were $129 million 
and $134 million, respectively. If we were to change our estimate of 
future product returns to the high end of the range, there would be 
no material impact on our liquidity or capital resources.
Example 3
Background
    Betascott Company manufactures and sells data storage devices 
including computer hard drives. The hard drive industry is subject to 
intense competition and significant shifts in market share amongst the 
competitors. In the last three years, Betascott has reported falling 
sales and market share, which has contributed to a fiscal year 2001 
loss from operations in the hard drive segment. (This trend is 
separately discussed in MD&A.)
    As of December 31, 2001, the company had $200 million in property, 
plant and equipment (``PP&E'') used in producing hard drives. The 
company's accounting policies require that it test long-lived assets 
for impairment whenever indicators of impairment exist. The 2001 fiscal 
year loss from operations in that segment, coupled with the company's 
falling sales and market share, are indicators of a potential 
impairment of the hard drive-related PP&E.
    The company follows the provisions of FASB SFAS No. 121, Accounting 
for the Impairment of Long-Lived Assets and for Long-Lived Assets To Be 
Disposed Of.\96\ That accounting standard requires that if the sum of 
the future cash flows expected to result from the assets, undiscounted 
and without interest charges, is less than a company's reported value 
of the assets, then the asset is not recoverable and the company must 
recognize an impairment. The amount of impairment to be recognized is 
the excess of the reported value of the assets over the fair value of 
those assets.
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    \96\ SFAS No. 144 superseded SFAS No. 121 and is effective for 
financial statements issued for fiscal years beginning after 
December 15, 2001.
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    The hard drive-related PP&E accounts for approximately 67% of 
Betascott's PP&E. The sum of Betascott's current estimate of expected 
future cash flows from its hard drive-related PP&E, undiscounted and 
without interest charges, is near the reported value of that PP&E. In 
the year ended December 31, 2001, Betascott would have been required to 
recognize an impairment loss of approximately $30 million if its 
estimate of those future cash flows had been 10% lower.

Possible MD&A Disclosure Under the Proposal

Application of Critical Accounting Policies

    We evaluate our property, plant and equipment (``PP&E'') for 
impairment whenever indicators of impairment exist. Accounting 
standards require that if the sum of the future cash flows expected 
to result from a company's asset, undiscounted and without interest 
charges, is less than the reported value of the asset, an asset 
impairment must be recognized in the financial statements. The 
amount of impairment to recognize is calculated by subtracting the 
fair value of the asset from the reported value of the asset.
    As we discuss in the notes to the financial statements, we 
operate in four segments, one of which is the hard drive segment. In 
our hard drive segment, we reviewed our hard drive-related PP&E for 
impairment as of December 31, 2001, due to a trend of declining 
sales and market share. We determined that the undiscounted sum of 
the expected future cash flows from the assets related to the hard 
drive segment exceeded the recorded value of those assets, so we did 
not recognize an impairment in accordance with GAAP. The PP&E in our 
hard-drive segment represents approximately two-thirds of our total 
PP&E.
    We believe that the accounting estimate related to asset 
impairment is a ``critical accounting estimate'' because: (1) It is 
highly susceptible to change from period to period because it 
requires company management to make assumptions about future sales 
and cost of sales over the life of the hard drive-related PP&E 
(generally seven years); and (2) the impact that recognizing an 
impairment would have on the assets reported on our balance sheet as 
well as our net loss would be material. Management's assumptions 
about future sales prices and future sales volumes require 
significant judgment because actual sales prices and volumes have 
fluctuated in the past and are expected to continue to do so. 
Management has discussed the development and selection of this 
critical accounting estimate with the audit committee of our board 
of directors and the audit committee has reviewed the company's 
disclosure relating to it in this MD&A.
    In estimating future sales, we use our internal budgets. We 
develop our budgets based on recent sales data for existing 
products, planned timing of new product launches, customer 
commitments related to existing and newly developed products, and 
current unsold inventory held by distributors.
    Our estimates of future cash flows assume that our sales of hard 
drive inventory will remain consistent with current year sales. 
While actual sales have declined by an average of approximately 2% 
per year during the last three years, our introduction of the Stored 
line of hard drives in August 2001 has resulted in a 0.5% increase 
in market share over the last five months of 2001, and a

[[Page 35634]]

corresponding increase in sales of 5% over the comparable 5-month 
period last year. We therefore have assumed that sales will not 
continue to decline in the future. We have also assumed that our 
costs will have annual growth of approximately 2%. This level of 
costs is comparable to actual costs incurred over the last two 
years, following the 1999 restructuring of the hard drive division 
(which is described in the note 2 to the financial statements).
    In each of the last two years, we have tested the hard drive-
related PP&E for impairment and in each year we determined that, 
based on our assumptions, the sum of the expected future cash flows, 
undiscounted and without interest charges, exceeded the reported 
value and therefore we did not recognize an impairment. Because 2001 
sales were lower than those in 2000 and 1999, despite the 
improvement in the latter part of the year, and because our 
estimates of future cash flows are assumed to be consistent with 
current year sales, the current year impairment analysis includes 
estimated sales that are 2% and 5% less than those assumed in the 
2000 and 1999 impairment tests, respectively.
    As of December 31, 2001, we estimate that our future cash flows, 
on an undiscounted basis, are greater than our $200 million 
investment in hard drive-related PP&E. Any increases in estimated 
future cash flows would have no impact on the reported value of the 
hard drive-related PP&E. In contrast, if our current estimate of 
future cash flows from hard drive sales had been 10% lower, those 
cash flows would have been less than the reported amount of the hard 
drive-related PP&E. In that case, we would have been required to 
recognize an impairment loss of approximately $30 million, equal to 
the difference between the fair value of the equipment (which we 
would have determined by calculating the discounted value of the 
estimated future cash flows) and the reported amount of the hard 
drive-related PP&E. A $30 million impairment loss would have reduced 
PP&E and Total Assets as of December 31, 2001 by 10% and 3%, 
respectively. That impairment loss also would have increased Net 
Loss Before Taxes, for the year ended December 31, 2001, by 100%.
    If we had been required to recognize an impairment loss on our 
hard-drive related PP&E, it would likely not have affected our 
liquidity and capital resources because, even with the impairment 
loss, we would have been within the terms of the tangible net-worth 
covenant in our long-term debt agreement discussed in note 5 to the 
financial statements.

E. Auditor Examination of MD&A Disclosure Relating to Critical 
Accounting Estimates

    A company's management bears primary responsibility for its 
accounting estimates. Auditors also have important responsibilities 
regarding a company's accounting estimates. A company's auditor 
currently is responsible for evaluating the reasonableness of the 
accounting estimates made by management in the context of the financial 
statements taken as a whole.\97\ When a company's audited financial 
statements are included in an annual report filed with the Commission, 
the independent auditor is required to read the information in the 
entire filed document, including the MD&A, and consider whether such 
information, or the manner of its presentation, is materially 
inconsistent with information, or the manner of its presentation, 
appearing in the financial statements.\98\
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    \97\ See AU Sec. 342, paragraph 4. In evaluating the 
reasonableness, the auditor's objective is ``to obtain sufficient 
competent evidential matter to provide a reasonable assurance that--
    a. All accounting estimates that could be material to the 
financial statements have been developed.
    b. Those accounting estimates are reasonable in the 
circumstances.
    c. The accounting estimates are presented in conformity with 
applicable accounting principles and are properly disclosed.''
    AU Sec. 342, paragraph 7. The auditor normally focuses on key 
factors and assumptions that are significant to the accounting 
estimate, that are sensitive to variations, that are deviations from 
historical patterns or that are subjective and susceptible to 
misstatement and bias. See AU Sec. 342, paragraph 9.
    \98\ See AU Sec. 550, Other Information in Documents Containing 
Audited Financial Statements (``AU Sec. 550'').
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    Despite the current auditing standards, and the auditor's 
consideration of the proposed MD&A disclosure that may take place by 
virtue of them, we are considering whether to take additional steps 
with a view to ensuring the accuracy and reliability of the proposed 
disclosure. Subjecting the MD&A disclosure to the auditing process 
itself would require the imposition of auditing standards, including 
examination of the disclosure itself, application of auditing processes 
regarding internal controls, coverage in management representations of 
material relevant to the disclosure and other procedures. One possible 
approach would be to adopt a requirement that an independent auditor 
must examine, in accordance with Attestation Standards,\99\ the new 
MD&A disclosure relating to critical accounting estimates.
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    \99\ See Codification of Statements on Standards for Attestation 
Engagements (``AT'') Sec. 101, Attest Engagements and AT Sec. 701, 
Management's Discussion and Analysis.
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    The American Institute of Certified Public Accountants has 
established standards and procedures when an auditor is engaged by a 
company to examine and render an opinion that the disclosure in a 
company's MD&A satisfies applicable Commission requirements.\100\ An 
auditor's objective in an examination is to express an opinion on:
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    \100\ AT Sec. 701 contemplates two levels of service by an 
auditor with respect to MD&A: an ``examination'' of an MD&A 
presentation and a more limited ``review'' of an MD&A presentation. 
Unlike an examination, a review culminates with the auditor giving 
negative assurance. The auditor's review report states whether any 
information came to the auditor's attention to cause him or her to 
believe that: the MD&A presentation taken as a whole does not 
include in all material respects the required elements of the 
disclosure; the historical financial amounts have not been 
accurately derived, in all material respects, from the company's 
financial statements; or the underlying information, determinations, 
estimates and assumptions of the company do not provide a reasonable 
basis for the disclosures contained in the MD&A. In undertaking a 
review, an auditor is expected to apply analytical procedures and 
make inquiries of people at the company who are responsible for 
financial, accounting and operational matters, but is not expected 
to test accounting records through inspection or observation, obtain 
corroborating evidence in response to inquiries, or take other steps 
required during an MD&A examination. An auditor's review report is 
not intended to be filed with the Commission. See AT Sec. 701, 
paragraph 2.
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     Whether the MD&A presentation includes in all material 
respects the required elements of the disclosure mandated by the 
Commission;
     Whether the historical financial amounts have been 
accurately derived, in all material respects, from the company's 
financial statements; and
     Whether the underlying information, determinations, 
estimates and assumptions of the company provide a reasonable basis for 
the disclosures contained in the MD&A.\101\
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    \101\ See AT Sec. 701, paragraph 5.
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    To complete an examination, an auditor must examine documents and 
records and accumulate sufficient evidence in support of the 
disclosures and assumptions and take other steps to get reasonable 
assurance of detecting both intentional and unintentional misstatements 
that are material to the MD&A presentation.\102\ To accept an 
examination engagement, an auditor must have sufficient knowledge about 
the company and its operations. AT Sec. 701 therefore requires that an 
auditor must have at least audited the company's financial statements 
for the most recent period covered by the MD&A, and the other periods 
covered by the MD&A must have been audited by it or another 
auditor.\103\
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    \102\ See AT Sec. 701, paragraphs 28-29.
    \103\ See AT Sec. 701, paragraph 6.
---------------------------------------------------------------------------

    Auditor examinations of MD&A disclosure are, we believe, undertaken 
on few occasions. Some companies have engaged independent auditors to 
conduct an examination of their MD&A disclosures either in connection 
with their initial public offering or after a major restructuring or 
acquisition when the company disclosure is being presented on a pro 
forma basis.\104\ In

[[Page 35635]]

one case, an auditor examination of MD&A was undertaken pursuant to a 
settlement with the Commission of an enforcement action alleging 
material deficiencies in the company's past MD&A disclosure.\105\
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    \104\ Goldman Sachs engaged an auditor to review its MD&A 
disclosure in connection with its initial public offering. See Form 
S-1, Commission File No. 333-74449. In addition, in the course of 
reading agreements between issuers and their underwriters created in 
connection with registered offerings, the staff has noted that 
approximately 50 companies have agreed to engage an auditor to 
conduct an examination of the company's MD&A disclosure as a 
condition to closing.
    \105\ In 1998, we issued a cease-and-desist order in a 
settlement with Sony Corporation that required Sony to engage an 
independent auditor to examine its MD&A disclosure for the fiscal 
year ending March 31, 1999. See SEC v. Sony Corporation, Litigation 
Release No. 15832 (Aug. 5, 1998).
---------------------------------------------------------------------------

    We solicit comment with respect to independent auditor examinations 
of the proposed MD&A disclosure regarding critical accounting 
estimates.
     Should we require that the critical accounting estimates 
disclosure in the MD&A undergo an auditor examination comparable to 
that enumerated in AT Sec. 701?
     Would these engagements significantly improve the 
disclosure provided in MD&A?
     In practice, when companies engage auditors to examine the 
MD&A pursuant to AT Sec. 701, does it elicit a higher quality of 
disclosure than when auditors consider only, as currently required, 
whether an MD&A is materially inconsistent with the financial 
statements?
     If we were to require examinations by auditors of part or 
all of MD&A disclosures, should we also require that a company file, or 
disclose the results of, the auditor's reports?
     If we do not require auditors' examinations of MD&A 
disclosure but an auditor nonetheless examines MD&A disclosure on 
critical accounting estimates, should we require that the auditor's 
report be filed or the results be disclosed?
     What would be the relative benefits and costs of a 
requirement for an auditor examination with respect to the critical 
accounting estimates portion of the MD&A?
     Should we require an auditor ``review'' under standards 
comparable to AT Sec. 701,\106\ as opposed to an auditor 
``examination'' of the critical accounting estimates MD&A disclosure?
---------------------------------------------------------------------------

    \106\ See supra fn. 100.
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     Do current requirements relating to what an auditor must 
consider make an examination or review of the proposed MD&A disclosure 
under standards comparable to AT Sec. 701 unnecessary?
     If we do not require auditor examination or review, are 
there other steps we should take to help ensure the quality of 
disclosure in this proposed section of MD&A?

F. Quarterly Updates

    Material changes relating to critical accounting estimates may 
occur from fiscal period to fiscal period. For example, management 
could materially change an accounting estimate previously disclosed as 
a critical accounting estimate because it changes the methodology for 
computing it. A company could determine that an additional accounting 
estimate met the standards and is a critical accounting estimate for 
the period subsequent to its most recent annual or quarterly report. A 
company also could materially change one of the important assumptions 
underlying an existing critical accounting estimate (which may or may 
not result in a change to the critical accounting estimate depending on 
what changes in other assumptions underlying the estimate are made). 
Any of those changes could have a material effect on the company's 
financial condition, changes in financial condition or results of 
operations. We expect that U.S. companies would be evaluating 
accounting estimates and the underlying assumptions and methodologies 
on at least a quarterly basis \107\ and therefore we believe that 
quarterly updates to reflect material developments would be 
appropriate. Disclosure of material developments made only at the end 
of each fiscal year also may not identify changes quickly enough to 
inform investors adequately.
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    \107\ The procedures performed by an independent accountant to 
issue a review report on the financial statements filed in a Form 
10-Q generally would include reading information such as that found 
in the MD&A section of the Form 10-Q. Further, the independent 
accountant's association with those financial statements would 
require the independent accountant to read the MD&A. See AU 
Sec. 722, Interim Financial Information, paragraph 35 and AU 
Sec. 550, paragraph 4.
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    In quarterly reports on Form 10-Q or Form 10-QSB, companies would 
be required to provide an update to the MD&A information related to 
critical accounting estimates discussed in the company's last filed 
annual or quarterly report under the Exchange Act.\108\ Newly 
identified critical accounting estimates would be disclosed in the same 
manner as in an annual report. If other material changes have occurred 
that would render the critical accounting estimates disclosure in the 
company's latest report materially out of date or otherwise materially 
misleading, we propose that those changes and their effect be described 
in the quarterly report. The proposed rules would not, however, require 
quarterly updates with regard to the proposed quantitative and 
qualitative discussion concerning past material changes in critical 
accounting estimates in annual reports, registration statements and 
proxy and information statements.
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    \108\ See proposed Item 303(b)(3)(v) of Regulation S-B, 17 CFR 
228.303(b)(3)(v), and proposed Item 303(c)(5) of Regulation S-K, 17 
CFR 229.303(c)(5). To assist companies in preparing quarterly 
updates, we would allow them to presume that investors have read, or 
have access to, the discussion of critical accounting estimates in 
their previously filed Exchange Act annual reports and any quarterly 
reports filed subsequent to the most recent annual report.
---------------------------------------------------------------------------

    We solicit comment on the quarterly updating requirement for U.S. 
companies.
     Are there some accounting estimates or material 
assumptions or methodologies that would normally be considered by 
companies only on a less frequent basis than quarterly? If so, which 
ones? Should they be omitted from the quarterly updating requirement on 
that basis?
     Is the scope of the disclosure required in a quarterly 
update appropriate? If not, what should be added or omitted?

G. Proposed Disclosure About Initial Adoption of Accounting Policies

    A company initially adopts an accounting policy when events or 
transactions that affect the company occur for the first time, when 
events or transactions that were previously immaterial in their effect 
become material, or when events or transactions occur that are clearly 
different in substance from previous events or transactions. For 
example, a company may for the first time enter into transactions 
involving derivative instruments, such as interest rate swaps, or may 
begin selling a new type of product that has delivery terms and 
conditions that are different from those associated with the products 
the company has previously been selling.
    If an initially adopted accounting policy has a material impact on 
the company's financial condition, changes in financial condition or 
results of operations, that impact will likely be of interest to 
investors, to financial analysts and others. If a company considers an 
accounting policy that it has initially adopted to be a significant 
accounting policy, the company would provide certain disclosures about 
that accounting policy as required by APB No. 22. Those disclosures are 
typically in the first note to the financial statements.\109\ The 
disclosure provided in the notes to the financial statements, however, 
may not adequately describe,

[[Page 35636]]

in a qualitative manner, the impact of the initially adopted accounting 
policy or policies on the company's financial presentation. We are 
therefore proposing additional MD&A disclosure to further describe, 
where a material impact exists, the initial adoption of accounting 
policies.\110\ The proposed MD&A disclosure would be provided in 
companies' filed annual reports, annual reports to shareholders, 
registration statements and proxy and information statements and would 
include description of:
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    \109\ See APB No. 22, paragraphs 12 and 15.
    \110\ See proposed Item 303(b)(3)(iv) of Regulation S-B, 17 CFR 
228.303(b)(3)(iv); proposed Item 303(c)(4) of Regulation S-K, 17 CFR 
229.303(c)(4); and proposed Item 5.E.4. of Form 20-F, 17 CFR 
249.220f. These proposed disclosures would not be required if the 
initial adoption of an accounting policy solely results from 
adoption of new accounting literature issued by a recognized 
accounting standard setter (including, in the U.S., new accounting 
pronouncements or rules issued by the FASB, AICPA or SEC or a new 
consensus of the Emerging Issues Task Force (EITF)).
---------------------------------------------------------------------------

     The events or transactions that gave rise to the initial 
adoption of an accounting policy;
     The accounting principle that has been adopted and the 
method of applying that principle; and
     The impact (discussed qualitatively) resulting from the 
initial adoption of the accounting policy on the company's financial 
condition, changes in financial condition and results of operations.
    If, upon initial adoption of one of those accounting policies, a 
company is permitted a choice among acceptable accounting 
principles,\111\ the company also would be required to explain in MD&A 
that it had made a choice among acceptable alternatives, identify the 
alternatives, and describe why it made the choice that it did. In 
addition, where material, the company would have to provide a 
qualitative discussion of the impact on the company's financial 
condition, changes in financial condition and results of operations 
that the alternatives would have had. Finally, if no accounting 
literature exists that governs the accounting for the events or 
transactions giving rise to the initial adoption of a material 
accounting policy (e.g., the events or transactions are unusual or 
novel or otherwise have not been contemplated in past standard-setting 
projects), the company would be required to explain its decision 
regarding which accounting principle to use and which method of 
applying that principle to use.
---------------------------------------------------------------------------

    \111\ See supra fn. 31 and accompanying text.
---------------------------------------------------------------------------

    We seek comment on the proposed disclosures related to initial 
adoption of accounting policies.
     Would the proposed disclosures about initial adoption of 
accounting policies provide useful information to investors and other 
readers of financial reports?
     Are there particular situations involving the initial 
adoption of a material accounting policy for which we should require 
additional disclosure? If so, what are those situations and what 
additional disclosure should we require?
     Should we require companies to disclose, in MD&A or in the 
financial statements, the estimated effect of adopting accounting 
policies that they could have adopted, but did not adopt, upon initial 
accounting for unusual or novel transactions?
     What would be the costs for companies to prepare 
disclosure about the effects of alternative accounting policies that 
could have been chosen but were not?
     Would investors be confused if companies presented 
disclosure of the effects of acceptable alternative policies that were 
not chosen?
     Should we require in MD&A a discussion of whether the 
accounting policies followed by a company upon initial adoption differ 
from the accounting policies applied, in similar circumstances, by 
other companies in its industry, and the reasons for those differences? 
Please explain. If such a discussion should be required, please 
identify the specific disclosures companies should make.
     Would a company know the policies applied in similar 
circumstances by other companies in its industry? If not, would 
auditing firms or other financial advisors be able to assist companies 
in determining whether their accounting policies generally diverge from 
industry practices?

H. Disclosure Presentation

    The proposals would require that a company present the required 
information in a separate section of MD&A. While the proposed 
disclosure may relate to other aspects of the discussion in MD&A, such 
as the results of operations or liquidity and capital resources, we 
have chosen to separate it both to highlight the discussion and because 
we believe the proposed discussion would present information that is 
better communicated separately to promote understanding.
    The proposed MD&A discussion must be presented in language, and a 
format, that is clear, concise and understandable to the average 
investor.\112\ The disclosure should not be presented in such a way 
that only an investor who is also an accountant or an expert on a 
particular industry would be able to understand it fully. To reinforce 
the importance of the disclosure being presented in a manner that 
investors will understand, we also would specify that the proposed 
disclosure must not be presented, for example, solely as a single 
discussion of the aggregate consequences of multiple critical 
accounting estimates or the aggregate consequences of the initial 
application of multiple new accounting policies.\113\ Because a company 
may identify and discuss more than one critical accounting estimate or 
more than one newly adopted accounting policy, and those estimates or 
those policies could materially affect a company's financial 
presentation in differing ways, a separate discussion of the 
application of each estimate and each new accounting policy will 
facilitate investors' understanding of the implications of each one.
---------------------------------------------------------------------------

    \112\ See proposed Instruction 3 to paragraph (b)(3) of Item 303 
of Regulation S-B, 17 CFR 228.303(b)(3); proposed Instruction 4 to 
paragraph (c) of Item 303 of Regulation S-K, 17 CFR 229.303(c); and 
proposed Instruction 3 to Item 5.E. of Form 20-F, 17 CFR 249.220f.
    \113\ Id.
---------------------------------------------------------------------------

    Boilerplate disclosures that do not specifically address the 
company's particular circumstances and operations also would not 
satisfy the proposed requirements.\114\ Disclosure that could easily be 
transferred from year to year, or from company to company, with no 
change would neither inform investors adequately nor reflect the 
independent thinking that must accompany the periodic assessment by 
management that is intended under the proposal. Finally, the purpose of 
the proposed disclosure would be hindered if a company were to include 
disclosures that consisted principally of blanket disclaimers of legal 
responsibility for its application of a new accounting policy or its 
development of its critical accounting estimates in light of the 
uncertainties associated with them. While the Commission fully expects 
companies to craft the proposed disclosure responsibly to take 
advantage of any available safe harbors, simple disclaimers of legal 
liability would be contrary to the disclosure goals underlying the 
proposal and would not be permitted.\115\
---------------------------------------------------------------------------

    \114\ Id.
    \115\ Id.
---------------------------------------------------------------------------

    We solicit comment on the disclosure presentation aspects of the 
proposals.
     Should the proposed disclosure be presented in a separate 
section of MD&A

[[Page 35637]]

or should we require that it be integrated into the other discussions 
of financial condition, changes in financial condition, results of 
operations and liquidity and capital resources when the proposed 
disclosure is closely related to an aspect discussed in those separate 
sections of MD&A?
     Should other requirements relating to the language and 
format be added to the requirement for clear, concise and 
understandable disclosure? If so, what requirements?

I. Application to Foreign Private Issuers

    In annual reports and registration statements filed with the 
Commission by foreign private issuers,\116\ we propose to apply the 
same MD&A disclosure requirements regarding the application of 
accounting policies that would apply to U.S. companies.\117\ Foreign 
private issuers, however, may present their financial statements either 
in accordance with U.S. GAAP, in accordance with GAAP of a foreign 
country, or in accordance with International Accounting Standards and 
International Financial Reporting Standards issued by the International 
Accounting Standards Committee and the International Accounting 
Standards Board. If financial statements are presented in accordance 
with non-U.S. GAAP, a reconciliation to U.S. GAAP accompanies them. The 
MD&A disclosure that foreign private issuers currently make in 
documents filed with the Commission \118\ must focus on the primary 
financial statements, whether those are prepared in accordance with 
non-U.S. GAAP or U.S. GAAP, although the reconciliation also must be 
taken into account.\119\
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    \116\ Foreign private issuers are non-governmental foreign 
issuers that primarily are owned by non-U.S. investors or are 
primarily located, doing business and managed outside the U.S. See 
17 CFR 240.3b-4. Foreign governments, and Canadian issuers filing 
reports and registration statements with the Commission pursuant to 
Canadian disclosure requirements under the Multijurisdictional 
Disclosure System with Canada, would be unaffected by the proposals.
    \117\ Under the proposals, the MD&A disclosure would apply to 
foreign private issuers regardless of whether they reconcile in 
accordance with Item 17 or Item 18 of Form 20-F.
    \118\ Item 5 in Form 20-F, the provision parallel to disclosure 
entitled ``MD&A'' for domestic issuers, is entitled ``Operating and 
Financial Review and Prospects.''
    \119\ Instruction 2 to Item 5 states that the ``discussion 
should focus on the primary financial statements presented in the 
document. You should refer to the reconciliation to U.S. GAAP, if 
any, and discuss any aspects of the differences between foreign and 
U.S. GAAP, not otherwise discussed in the reconciliation, that you 
believe are necessary for an understanding of the financial 
statements as a whole.''
---------------------------------------------------------------------------

    The proposed MD&A disclosure regarding critical accounting 
estimates would do the same. If the primary financial statements were 
in non-U.S. GAAP, the company would have to consider critical 
accounting estimates in connection with both its primary financial 
statements and its reconciliation to U.S. GAAP. The reasons are 
essentially two. First, a company could make an accounting estimate 
under non-U.S. GAAP that would not constitute a critical accounting 
estimate or could use a method under non-U.S. GAAP that would not 
involve an estimate, but in applying U.S. GAAP in the reconciliation 
could be required to make different assumptions that involve highly 
uncertain matters therefore causing it to be highly susceptible to 
change where change would have a material impact. For example, non-U.S. 
GAAP may permit or require derivative instruments held as investments 
to be reported at cost (or not recognized), while U.S. GAAP would 
require the same instruments to be reported at fair value. If the 
instruments are not traded and therefore no quoted market prices are 
available, assumptions about highly uncertain matters would be required 
to estimate fair value for purposes of the reconciliation.
    Second, a foreign private issuer could apply different accounting 
methods under U.S. GAAP than under non-U.S. GAAP, and while both may 
involve critical accounting estimates, they may do so for different 
reasons that investors would need to understand. For example, both non-
U.S. GAAP and U.S. GAAP may require recognition of liabilities for 
environmental or mass tort claims. However, the methodologies, 
assumptions and judgments necessary to estimate the amount to recognize 
may be significantly different under the two different GAAPs. Thus, a 
foreign private issuer would be required also to include the proposed 
disclosure for any critical accounting estimate that is related to the 
application of U.S. GAAP.\120\
---------------------------------------------------------------------------

    \120\ See proposed Instruction 2 to Item 5 of Form 20-F, 17 CFR 
249.220f.
---------------------------------------------------------------------------

    Similarly, the proposed MD&A disclosures about the initial adoption 
of accounting policies would focus on the primary financial statements 
but also take into account the reconciliation to U.S. GAAP. When a 
foreign private issuer initially adopts an accounting policy under non-
U.S. GAAP, it may have different acceptable alternative principles 
available to it than it would if it were initially adopting an 
accounting policy under U.S. GAAP. Those alternatives may be unfamiliar 
to investors. Accordingly, we would require that the foreign private 
issuer provide the proposed disclosure about initial adoption in 
relation to its primary financial statements. Foreign private issuers 
also would be required to consider the reconciliation to U.S. GAAP. The 
reconciliation would not necessarily present an initial adoption of an 
accounting policy simply because the company is initially adopting a 
policy under non-U.S. GAAP. In the event that it does, however, and it 
has the requisite material impact on the foreign private issuer's 
financial presentation, we believe disclosure would be appropriate.
    The Commission has fundamentally conformed the non-financial 
statement disclosure requirements for foreign private issuers to the 
non-financial statement disclosure requirements adopted by the 
International Organization of Securities Commissions (IOSCO).\121\ The 
MD&A-equivalent provision is intended to mirror in substance the MD&A 
requirements for U.S. companies in Regulation S-K.\122\ Our application 
of the proposed critical accounting estimates disclosure and the 
disclosure regarding initial adoption of an accounting policy to 
foreign private issuers is consistent with the current approach to 
MD&A. MD&A disclosure is narrative financial disclosure and the 
proposed MD&A disclosure can be viewed particularly as an important new 
aspect of financial disclosure.
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    \121\ See Securities Act Release No. 7745 (Sept. 28, 1999) [64 
FR 53900].
    \122\ Although the wording of the MD&A requirement in Form 20-F 
was revised in 1999, the Commission's adopting release noted that we 
interpret that Item as calling for the same disclosure as Item 303 
of Regulation S-K. See Securities Act Release No. 7745 (Sept. 28, 
1999) [64 FR 53900 at 59304]. In addition, Instruction 1 to Item 5 
in Form 20-F provides that issuers should refer to the Commission's 
1989 interpretive release on MD&A disclosure under Item 303 of 
Regulation S-K (Securities Act Release No. 6835 (May 18, 1989) [54 
FR 22427]) for guidance in preparing the discussion and analysis by 
management of the company's financial condition and results of 
operations required in Form 20-F.
---------------------------------------------------------------------------

    Foreign private issuers are not required to submit quarterly 
reports on Form 10-Q or Form 10-QSB to the Commission. Instead, foreign 
private issuers submit information on Form 6-K, which encompasses only 
information that the issuer makes public under its home country 
requirements.\123\ In addition, foreign private issuers are exempt from 
U.S. proxy and information statement disclosure

[[Page 35638]]

requirements. \124\ Thus, unless a foreign private issuer files a 
registration statement that must include interim period financial 
statements and related MD&A disclosure, it would not be required to 
update the proposed MD&A disclosure more frequently than annually. 
Foreign private issuers could, however, voluntarily disclose newly 
identified critical accounting estimates and any other material changes 
to the most recent MD&A disclosure on Form 6-K, and we encourage them 
to do so.
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    \123\ Many foreign country disclosure systems do not require 
quarterly reporting. Nonetheless, some registered foreign private 
issuers do report financial information on a quarterly basis. If a 
foreign regulatory authority were to adopt the proposed MD&A 
requirements, foreign private issuers subject to it would provide 
the information on Form 6-K.
    \124\ See 17 CFR 240.3a12-3(b).
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    We request comment regarding the proposed MD&A disclosure of the 
application of critical accounting policies as it relates to foreign 
private issuers.
     Should we apply different standards for foreign private 
issuers with respect to the proposed MD&A disclosure?
     Are there specific items of the proposed disclosure that 
would be less appropriate for foreign private issuers? If so, what 
should substitute for that disclosure?
     Should we consider applying an updating requirement to the 
proposed critical accounting estimates disclosure for foreign private 
issuers that do not file quarterly reports? If so, what should trigger 
that updating requirement?
     Are there reasons to distinguish this aspect of MD&A 
disclosure when foreign private issuers otherwise may not prepare MD&A-
equivalent disclosure on a quarterly basis?

J. Application to Small Business Issuers

    Small business issuers \125\ are permitted to register and report 
under somewhat different disclosure requirements than those applicable 
to larger companies. With respect to MD&A disclosure, the requirements 
for small business issuers and larger companies are substantially 
similar.\126\ One exception, however, is that small business issuers 
that have not had revenues from operations in each of the last two 
fiscal years (or the last fiscal year and any interim period presented 
in the furnished financial statements) must provide business plan 
disclosure rather than MD&A disclosure.\127\ Those small business 
issuers must discuss in the business plan disclosure matters such as: 
how they will satisfy their requirements for cash and raise additional 
funds in the next 12 months; planned product research and development 
in that period; expected acquisitions or dispositions of plant and 
significant equipment; and anticipated significant changes in the 
number of employees.
---------------------------------------------------------------------------

    \125\ ``Small business issuer'' is defined to mean any entity 
that (1) has revenues of less than $25,000,000, (2) is a United 
States or Canadian issuer, (3) is not an investment company, and (4) 
if a majority-owned subsidiary, has a parent corporation that also 
is a small business issuer. An entity is not a small business 
issuer, however, if it has a public float (the aggregate market 
value of the outstanding equity securities held by non-affiliates) 
of $25,000,000 or more. See 17 CFR 228.10.
    \126\ Compare Item 303 of Regulation S-B, 17 CFR 228.303, to 
Item 303 of Regulation S-K, 17 CFR 229.303.
    \127\ See Item 303(a) of Regulation S-B, 17 CFR 228.303(a).
---------------------------------------------------------------------------

    Under our proposals, we would not apply the new requirements for 
MD&A disclosure to the small business issuers disclosing their business 
plans instead of providing MD&A disclosure. We believe a modified 
approach is consistent with the objectives underlying the small 
business issuer disclosure system's alteration of the MD&A disclosure 
requirements for these companies. Thus, we would not add to the 
compliance burdens for these small companies. Small business issuers 
with a recent history of revenues would be required to provide the 
proposed MD&A disclosure.
    We request comment regarding the application to small business 
issuers of the proposed MD&A disclosure.
     Should we require the proposed MD&A disclosure for small 
business issuers with no recent revenues even though MD&A disclosure by 
them is otherwise not required? If so, why?
     Are there modifications or simplifications to the proposed 
disclosure requirements that we could make, consistent with our ongoing 
simplification and reduction of burden for small business issuers, that 
still would achieve the goal of providing investors with an adequate 
understanding of the implications of management's critical accounting 
estimates and its initial adoption of accounting policies with a 
material impact?
     Should we create an exemption from the quarterly updating, 
or simplify it, for small business issuers?

K. Application of Safe Harbors for Forward-Looking Information

    As we note in the proposed MD&A requirements, companies preparing 
disclosure under the proposal that would constitute a forward-looking 
statement should consider the conditions under which several existing 
safe harbors apply.\128\ As defined in the relevant statutory 
provisions, a ``forward-looking statement'' generally is
     A statement containing a projection of revenues, income 
(or loss), earnings (or loss) per share, capital expenditures, 
dividends, capital structure, or other financial items;
---------------------------------------------------------------------------

    \128\ See proposed Instruction 2 to Item 303 of Regulation S-B, 
17 CFR 228.303; proposed Instruction 2 to Item 303(c) of Regulation 
S-K, 17 CFR 229.303(c); and proposed Instruction 2 to Item 5.E of 
Form 20-F, 17 CFR 249.220f.
---------------------------------------------------------------------------

     A statement of the plans and objectives of management for 
future operations, including plans or objectives relating to the 
products or services of the issuer;
     A statement of future economic performance, including any 
such statement contained in MD&A
     Any statement of assumptions underlying or relating to any 
statement described in the three bullet points above; or
     Any report issued by an outside reviewer retained by an 
issuer, to the extent that the report assesses a forward-looking 
statement made by the issuer.\129\
---------------------------------------------------------------------------

    \129\ See 15 U.S.C. 77z-2 and 78u-5.
---------------------------------------------------------------------------

    The Exchange Act and the Securities Act contain parallel safe 
harbor protection for forward-looking statements against private legal 
actions that are based on allegations of a material misstatement or 
omission.\130\ In addition, two Commission rules under those Acts that 
pre-date the adoption of the statutory safe harbors also provide 
protection for forward-looking statements.
---------------------------------------------------------------------------

    \130\ While the statutory safe harbors by their terms do not 
apply to forward-looking statements included in financial statements 
prepared in accordance with U.S. GAAP, they do cover MD&A 
disclosures. The statutory safe harbors would not apply, however, if 
the MD&A forward-looking statement were made in connection with: an 
initial public offering, a tender offer, an offering by a 
partnership or a limited liability company, a roll-up transaction, a 
going private transaction, an offering by a blank check company or a 
penny stock issuer, or an offering by an issuer convicted of 
specified securities violations or subject to certain injunctive or 
cease and desist actions. See 15 U.S.C. 77z-2(b) and 78u-5(b).
---------------------------------------------------------------------------

    The statutory safe harbors provide three separate bases for a 
company to claim the protection against liability for forward-looking 
statements made in the company's MD&A. First, a forward-looking 
statement would fall within that safe harbor if it is identified as 
forward-looking and it is accompanied by meaningful cautionary 
statements that identify important factors that could cause actual 
results to differ materially from those in the forward-looking 
statement. Second, the safe harbor protects from private liability any 
forward-looking statement that is not material. Finally, the safe 
harbor precludes private liability if a plaintiff fails to prove that 
the forward-looking statement was made by or with the approval of an 
executive officer of the

[[Page 35639]]

company who had actual knowledge that it was false or misleading. The 
statutory safe harbors cover statements by reporting companies, persons 
acting on their behalf, outside reviewers retained by them, and their 
underwriters (when using information from, or derived from, the 
companies).
    The Commission safe harbor rules that apply to forward-looking 
statements are Rule 175 under the Securities Act and Rule 3b-6 under 
the Exchange Act.\131\ Under those rules, a forward-looking statement 
made by or on behalf of a company is deemed not to be a fraudulent 
statement if it is made in good faith and made or reaffirmed with a 
reasonable basis. The rule-based safe harbors apply to a company if it 
is a reporting company at the time it makes the forward-looking 
statement or if it is not a reporting company but it is making the 
statement in a Securities Act registration statement\132\ or an 
Exchange Act registration statement. The safe harbors cover forward-
looking statements in filed documents, in annual reports to 
shareholders and in Part 1 of Forms 10-Q and 10-QSB.\133\
---------------------------------------------------------------------------

    \131\ See 17 CFR 230.175 and 17 CFR 240.3b-6. Forward-looking 
statements covered by the safe harbors under Rules 175 and 3b-6 are:
     Projection of revenues, income (loss), earnings (loss) 
per share, capital expenditures, dividends, capital structure, other 
financial items;
     Management's plans and objectives for future 
operations;
     Statements of future economic performance in MD&A and
     Statements of assumptions underlying or relating to any 
of the above.
    \132\ Thus, unlike the statutory safe harbors, the Rule 175 safe 
harbor would protect MD&A forward-looking statements made in a 
registration statement or prospectus for an initial public offering.
    \133\ The rule safe harbors also cover statements that reaffirm 
forward-looking statements made in those documents and forward-
looking statements made prior to filing or submission of those 
documents that are reaffirmed in those documents.
    In addition to the statutory and rule safe harbors directed at 
forward-looking statements, companies preparing the proposed MD&A 
disclosure also could be protected by the ``bespeaks caution'' legal 
doctrine that has developed through case law and is recognized by 
most circuit courts of appeal. See, e.g., Lilley v. Charren, 2001 
U.S. App. LEXIS 19430 (9th Cir. 2001); EP Medsystems, Inc. v. 
Echocath Inc., 235 F.3d 865; (3d Cir. 2000); Parnes v. Gateway 2000, 
122 F.3d 539 (8th Cir. 1997). The bespeaks caution doctrine 
recognizes that forecasts, projections and expectations must be read 
in context and that accompanying cautionary language can render a 
misstatement or omission immaterial or render a plaintiff's reliance 
on it unreasonable. For a forward-looking statement to be covered by 
the bespeaks caution doctrine, there must be adequate cautionary 
language that warns investors of the potential risks related to the 
forward-looking statement.
---------------------------------------------------------------------------

    Some of the proposed MD&A disclosure, but not all of it, would 
require a company to make forward-looking statements. For example, a 
company's disclosure of the reasonably possible, near-term changes in 
its most material assumption(s) underlying accounting estimates would 
qualify as forward-looking statements, but its quantitative disclosure 
of the changes it made to its accounting estimates during the past 
three years would not. Other examples of forward-looking statements 
that could be made in response to the proposed mandates are: A 
discussion of the assumptions underlying an estimate that involve, for 
example, projections of future sales; and a discussion of the expected 
effect if a known uncertainty were to come to fruition and result in a 
change in management's assumptions.
    In light of the forward-looking statements that would be required, 
we propose to delete the statements in the existing MD&A rules that 
indicate that companies are not required to make forward-looking 
statements under those rules.\134\ New Instructions would note that 
forward-looking statements are required, provide some examples of 
required forward-looking statements and alert companies preparing the 
proposed MD&A disclosure to consider the terms, conditions and scope of 
the safe harbors in drafting their disclosure.
---------------------------------------------------------------------------

    \134\ See Instruction 2 to Item 303 of Regulation S-B, 17 CFR 
228.303; Instruction 7 to Item 303(a) of Regulation S-K, 17 CFR 
229.303(a); Instruction 6 to Item 303(b) of Regulation S-K, 17 CFR 
229.303(b); and Instruction 3 to Item 5 of Form 20-F, 17 CFR 
249.220f.
---------------------------------------------------------------------------

    We request comment regarding the application of safe harbors for 
forward-looking information to the proposed MD&A disclosure.
     Is there any need for further guidance from the Commission 
with respect to the application of either the statutory or rule safe 
harbors?

IV. General Request for Comment

    The Commission is proposing these amendments to the MD&A 
requirements to improve the quality and relevance of explanatory 
disclosure about a company's financial condition, changes in financial 
condition, results of operations and reasonably likely trends, demands, 
commitments, events and uncertainties affecting a company. We welcome 
your comments. We solicit comment, both specific and general, upon each 
component of the proposals. If you would like to submit written 
comments on the proposals, to suggest additional changes or to submit 
comments on other matters that might affect the proposals, we encourage 
you to do so.
    We also solicit comment on the following general aspects of the 
proposals:
     Is the additional information elicited by the proposals 
useful to investors, other users of company disclosure and readers of a 
company's financial statements? If not, how can it be improved to 
achieve that goal?
     In addition to the requirements we propose, are there 
particular aspects of critical accounting estimates or their 
development or impact that the proposals should specifically require 
companies to address? If so, what are they?
     In addition to the requirements we propose, are there 
particular aspects concerning a company's initial adoption of an 
accounting policy that the proposals should specifically require 
companies to address? If so, what are they?
     Is disclosure necessary concerning the procedures that 
management follows in selecting its critical accounting estimates? If 
so, what additional disclosure should be provided?
     Is additional disclosure or regulation necessary or 
appropriate concerning the role of the audit committee in discussing 
the critical accounting estimates and the disclosure about them that 
management drafts?
     In addition to the proposed disclosure, should we adopt a 
specific requirement that a company must provide any other information 
that is needed to make the proposed disclosure reflective of 
management's view of the critical accounting estimates and the 
initially adopted policies being discussed?
     For critical accounting estimates of fair value, should we 
mandate the example in FR-61 \135\ as part of these rules? If yes, do 
other areas exist for which that type of detailed disclosure would be 
appropriate?
---------------------------------------------------------------------------

    \135\ See Securities Act Release No. 8056, FR-61 (Jan. 22, 
2002)[67 FR 3746], Section II.B. (providing an example of a critical 
accounting estimate related to non-exchange-traded contracts 
accounted for at fair value).
---------------------------------------------------------------------------

     If the proposed disclosure would involve competitive or 
other sensitive information, are there any mechanisms that would ensure 
full and accurate disclosure while reducing a company's risk of 
competitive harm?
     Are there some aspects of the proposed disclosure that 
should be retained while eliminating other parts of the proposed 
disclosure? We solicit comment on the desirability of adopting some 
sections of the proposed rules, but not all sections.
    Any interested person wishing to submit written comments on any 
aspect of the proposals, as well as on other matters that might have an 
impact on the proposals, is requested to do so. In addition, we request 
comment on whether any further changes to our rules

[[Page 35640]]

and forms are necessary or appropriate to implement the objectives of 
the proposals. Please submit three copies of your comment letter to 
Jonathan G. Katz, Secretary, U.S. Securities and Exchange Commission, 
450 Fifth Street, NW, Washington, DC 20549-0609. You may also submit 
comments electronically to the following e-mail address: [email protected]. \136\ All comments should refer to file number S7-16-
02. If you are commenting by e-mail, include this file number in the 
subject line. We will make comments available for public inspection and 
copying in the Commission's public reference room at 450 Fifth Street, 
NW, Washington, DC 20549-0102. In addition, we will post electronically 
submitted comments on our Internet website (www.sec.gov).
---------------------------------------------------------------------------

    \136\ For more information on how to submit comments 
electronically, see www.sec.gov/rules/submitcomments.htm.
---------------------------------------------------------------------------

V. Paperwork Reduction Act

A. Background

    The proposed amendments to Regulations S-B, S-K \137\ and Form 20-F 
contain ``collection of information'' requirements within the meaning 
of the Paperwork Reduction Act of 1995 (``PRA'').\138\ We are 
submitting the proposal to the Office of Management and Budget 
(``OMB'') for review in accordance with the PRA.\139\ The titles for 
the collections of information are:
---------------------------------------------------------------------------

    \137\ While we are proposing amendments to Regulations S-B and 
S-K, the burden is imposed through the forms that refer to the 
disclosure regulations. To avoid a Paperwork Reduction Act inventory 
with duplicative burdens, we estimate the burdens imposed by 
Regulations S-B and S-K to be one hour.
    \138\ 44 U.S.C. 3501 et seq.
    \139\ 44 U.S.C. 3507(d) and 5 CFR 1320.11.
---------------------------------------------------------------------------

    (1) ``Form S-1'' (OMB Control No. 3235-0065);
    (2) ``Form F-1'' (OMB Control No. 3235-0258);
    (3) ``Form SB-2'' (OMB Control No. 3235-0418);
    (4) ``Form S-4'' (OMB Control No. 3235-0324);
    (5) ``Form F-4'' (OMB Control No. 3235-0325);
    (6) ``Form 10'' (OMB Control No. 3235-0064);
    (7) ``Form 10-SB'' (OMB Control No. 3235-0419);
    (8) ``Form 20-F'' (OMB Control No. 3235-0288);
    (9) ``Form 10-K'' (OMB Control No. 3235-0063);
    (10) ``Form 10-KSB'' (OMB Control No. 3235-0420);
    (11) ``Proxy Statements--Regulation 14A (Commission Rules 14a-1 
through 14a-15) and Schedule 14A'' (OMB Control No. 3235-0059);
    (12) ``Information Statements--Regulation 14C (Commission Rules 
14c-1 through 14c-7 and Schedule 14C)'' (OMB Control No. 3235-0057);
    (13) ``Form 10-Q'' (OMB Control No. 3235-0070);
    (14) ``Form 10-QSB'' (OMB Control No. 3235-0416);
    (15) ``Regulation S-K'' (OMB Control No. 3235-0071); and
    (16) ``Regulation S-B'' (OMB Control No. 3235-0417).
    These regulations and forms were adopted pursuant to the Securities 
Act and the Exchange Act and set forth the disclosure requirements for 
annual and quarterly reports, registration statements and proxy and 
information statements filed by companies to ensure that investors are 
informed. The hours and costs associated with preparing, filing, and 
sending these forms constitute reporting and cost burdens imposed by 
each collection of information. An agency may not conduct or sponsor, 
and a person is not required to respond to, a collection of information 
unless it displays a currently valid control number.
    Under the proposals, we would require companies to include a 
discussion of the application of critical accounting policies in the 
MD&A section of annual reports, registration statements and proxy and 
information statements and make updates to some of that disclosure 
quarterly. We believe that the proposed MD&A disclosure would provide 
investors with a better understanding of management's application of 
accounting policies and how those accounting policies affect the 
financial statements. We believe this disclosure would increase 
transparency regarding financial disclosure. Compliance with the 
revised disclosure requirements would be mandatory. There would be no 
mandatory retention period for the information disclosed, and responses 
to the disclosure requirements would not be kept confidential.
    We estimate the annual incremental paperwork burden for all 
companies to prepare the disclosure that would be required under our 
proposals to be approximately 781,911 hours and a cost of approximately 
$98,467,000.\140\ We estimated the average number of hours each entity 
spends completing the form and the average hourly rate for outside 
professionals from discussions with persons regularly involved in 
completing the forms.\141\
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    \140\ For convenience, the estimated PRA hour burdens have been 
rounded to the nearest whole number, and the estimated PRA cost 
burdens have been rounded to the nearest $1,000.
    \141\ In connection with this rulemaking, we have contacted a 
few companies to obtain cost estimates for preparing the proposed 
disclosure. Also, in connection with other recent rulemakings, we 
have had discussions with several private law firms to estimate an 
hourly rate of $300 as the cost of outside professionals that assist 
companies in preparing these disclosures.
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B. Registration Statements

    Table 1 below illustrates the total annual compliance burden of the 
proposed collection of information in hours and in cost for 
registration statements under the Securities Act and the Exchange Act. 
The burden was calculated by multiplying the estimated number of 
responses by the estimated average number of hours each entity spends 
completing the form. We have based our estimated number of annual 
responses on the actual number of filers during the 2001 fiscal year. 
We have estimated that, based on a three-year sample period, the 
average amount of time it would take to prepare the application of 
critical accounting policies disclosure for registration statements 
would be approximately 34 hours.
    To determine the average total number of hours each entity spends 
completing each form, we added the estimated hour increment discussed 
below to the current burden hour estimate for each form reported to 
OMB. For registration statements, we estimate that 25% of the burden of 
preparation is carried by the company internally and that 75% of the 
burden of preparation is carried by outside professionals retained by 
the company at an average cost of $300 per hour. The portion of the 
burden carried by outside professionals is reflected as a cost, while 
the portion of the burden carried by the company internally is 
reflected in hours. The incremental cost of outside professionals for 
registration statements would be approximately $22,811,000 per year and 
the incremental company burden would be approximately 25,345 hours per 
year. For purposes of our submission to OMB under the PRA, the total 
cost of outside professionals for registration statements would be 
approximately $3,740,773,000 per year and the company burden would be 
approximately 4,156,415 hours per year.
    To determine a new PRA burden per form that would accurately 
reflect the amount of respondents required to prepare the new 
disclosure, we adjusted the 34-hour incremental burden for some of the 
forms of registration statements. For the other registration statements 
in Table 1, we used the 34-

[[Page 35641]]

hour burden estimate. We adjusted the incremental burden to account for 
the fact that some registration statements allow incorporation by 
reference, and other forms would not require the company to 
substantially change a previously prepared MD&A.\142\ We have adjusted 
the incremental burden for Forms S-1, F-1, S-4 and F-4 in recognition 
of the fact that many repeat issuers complete these forms.\143\ A 
repeat issuer (who is already a reporting company) would not have to 
prepare an entirely new MD&A for each new registration statement 
because it would have already prepared MD&A for its periodic reports.
---------------------------------------------------------------------------

    \142\ We have not included registration statements where a 
registrant fulfills its MD&A disclosure obligation entirely through 
incorporation by reference (such as Forms S-3 and S-2).
    \143\ In addition, Forms S-4 and F-4 allow for incorporation by 
reference when the issuer would be eligible.
---------------------------------------------------------------------------

    To account for this, we estimate that 40% of the Forms S-1, 65% of 
Forms F-1, 38% of Forms S-4 and 34% of Forms F-4 would be required to 
carry the full burden of preparing entirely new MD&A disclosure about 
the application of critical accounting policies.\144\ To reflect the 
fact that the proposed disclosure would only be prepared anew for a 
subset of the total forms filed, yet the collection burden is 
calculated and submitted to OMB for 100% of the forms filed, we reduced 
the incremental burden hours for the above forms by the percentage of 
respondents who would not be required to carry the full burden of 
preparing new disclosure about the application of critical accounting 
policies. Therefore, we estimate that the average annual incremental 
burden for all Forms S-1 would be 14 hours per form, which is 
approximately 40% of the 34-hour burden estimate for preparing the 
disclosure. We estimate that the average annual incremental burden for 
all Forms F-1 would be 22 hours per form, which is approximately 65% of 
the 34-hour burden estimate for preparing the disclosure. We estimate 
that the average annual incremental burden for all Forms S-4 would be 
13 hours per form, which is approximately 38% of the 34-hour burden 
estimate for preparing the disclosure. Finally, we estimate that the 
average annual incremental burden for all Forms F-4 would be 12 hours 
per form, which is 34% of the 34-hour burden estimate for preparing the 
disclosure.
---------------------------------------------------------------------------

    \144\ We derived these percentages from the proportion of new 
issuers to total issuers derived from our internal database.

                                                            Table 1.--Registration Statements
                                                 [Columns in bold are the PRA burdens submitted to OMB]
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                         Annual responses   Total hours/form     Total burden       25% Company      75% Professional   $300 Prof. cost
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                      (A)                (B)        (C)=(A)*(B)       (D)=(C)*0.25       (E)=(C)*0.75       (F)=(E)*$300
--------------------------------------------------------------------------------------------------------------------------------------------------------
S-1...................................                452              1,742            787,384            196,846            590,538       $177,161,000
F-1...................................                 48              1,905             91,440             22,860             68,580         20,574,000
SB-2..................................                698                582            406,236            101,559            304,677         91,403,000
S-4...................................              3,774              3,973         14,994,102          3,748,526         11,245,577      3,373,673,000
F-4...................................                211              1,323            279,153             69,788            209,365         62,810,000
Form 10...............................                 91                126             11,466              2,867              8,600          2,580,000
10-SB.................................                458                122             55,876             13,969             41,907         12,572,000
                                       -----------------------------------------------------------------------------------------------------------------
    Total.............................  .................  .................         16,625,657          4,156,415  .................      3,740,773,000
--------------------------------------------------------------------------------------------------------------------------------------------------------

C. Annual Reports and Proxy/Information Statements

    Table 2 below illustrates the total annual compliance burden of the 
collection of information in hours and in cost for annual reports and 
proxy and information statements under the Exchange Act. The burden was 
calculated by multiplying the estimated number of responses by the 
estimated average number of hours each entity spends completing the 
form. We have based our estimated number of annual responses on the 
actual number of filers during the 2001 fiscal year. We have estimated 
that, based on a three-year sample period, the average amount of time 
it would take to prepare disclosure about the application of critical 
accounting policies for annual reports and proxy and information 
statements would be approximately 29 hours.
    To determine the average total number of hours each entity spends 
completing each form, we added the 29-hour increment to the current 
burden hours estimated for each form. For Exchange Act reports and 
proxy and information statements, we estimate that 75% of the burden of 
preparation is carried by the company internally and that 25% of the 
burden of preparation is carried by outside professionals retained by 
the company at an average cost of $300 per hour.\145\ The portion of 
the burden carried by outside professionals is reflected as a cost, 
while the portion of the burden carried by the company internally is 
reflected in hours. The incremental cost of outside professionals for 
annual reports and proxy/information statements would be approximately 
$32,508,000 per year and the incremental company burden would be 
approximately 325,083 hours per year. For purposes of our submission to 
OMB under the PRA the total cost of outside professionals for annual 
reports and proxy/information statements would be approximately 
$1,738,387,000 per year and the company burden would be approximately 
17,383,796 hours per year.
---------------------------------------------------------------------------

    \145\ This allocation of the burden is a departure from our past 
PRA submissions for Exchange Act periodic reports and proxy and 
information statements, for which we estimated that the company 
carried 25% of the burden internally and 75% of the burden of 
preparation was carried by outside professionals retained by the 
company. We believe that this new allocation more accurately 
reflects current practice for annual and quarterly reports and proxy 
and information statements.
---------------------------------------------------------------------------

    To determine the average total number of hours each entity spends 
completing each form, we added the estimated hour increment discussed 
above to the current burden hour estimate for each form reported to 
OMB. We made one exception, however, with respect to Schedules 14A and 
14C. Those schedules only require MD&A in three situations: (1) The 
modification of any class of securities of the company; (2) the 
issuance or authorization for issuance of securities of the company; or 
(3) mergers, consolidations, acquisitions and similar matters.\146\ In 
addition, many of these Schedules are filed by reporting companies. 
Because in many

[[Page 35642]]

instances reporting companies would have previously prepared MD&A for 
their periodic reports, we estimate that 5% of Schedules 14A and 14C 
would require a company to prepare an entirely new MD&A.\147\ To 
reflect the fact that only the above percentage would require new 
disclosure, yet the collection burden is calculated and submitted to 
OMB for 100% of the Schedules filed, we reduced the incremental burden 
hours for Schedules 14A and 14C by the percentage of respondents who 
would not be required to carry the full burden of preparing new 
disclosure about the application of critical accounting policies. 
Therefore, we estimate that the average annual incremental burden for 
these forms would be approximately 2 hours, which is approximately 5% 
of the 34-hour burden estimate for registration statements.
---------------------------------------------------------------------------

    \146\ See Items 11, 12 and 14 of Schedule 14A, 17 CFR 240.14a-
101.
    \147\ That percentage is our best estimate based on our belief 
that the percentage of companies that file Schedules 14A and 14C 
that would actually be required to carry the full burden of 
preparing the proposed disclosure would be minimal. 7

                            Table 2.--Annual Reports and Proxy/Information Statements
                             [Columns in bold are the PRA burdens submitted to OMB]
----------------------------------------------------------------------------------------------------------------
                      Annual       Total hours/    Total burden     75% Company         25%         $300 Prof.
-----------------    responses         form      --------------------------------  Professional        Cost
                 --------------------------------                                -------------------------------
                        (A)             (B)         (C)=(A)*(B)    (D)=(C)*0.75    (E)=(C)*0.25    (F)=(E)*$300
----------------------------------------------------------------------------------------------------------------
20-F............           1,177           1,752       2,062,104       1,546,578         515,526    $154,658,000
10-K............           9,384           1,749      16,412,616      12,309,462       4,103,154   1,230,946,000
10-KSB..........           3,789           1,205       4,565,745       3,424,309       1,141,436     342,431,000
SCH 14A.........           8,239              16         131,824          98,868          32,956       9,887,000
SCH 14C.........             407              15           6,105           4,579           1,526         458,000
                 -----------------------------------------------------------------------------------------------
    Total.......  ..............  ..............      23,178,394      17,383,796  ..............   1,738,380,000
----------------------------------------------------------------------------------------------------------------

D. Quarterly Reports

    Table 3 below illustrates the total annual compliance burden of the 
collection of information in hours and in cost for quarterly reports 
under the Exchange Act. The burden was calculated by multiplying the 
estimated number of responses by the estimated average number of hours 
each entity spends completing the form. We have based our estimated 
number of annual responses on the actual number of filers during the 
2001 fiscal year. We have estimated that, based on a three-year sample 
period, the average amount of time it would take each year to add the 
new disclosures would be 15 hours per form for each company.\148\
---------------------------------------------------------------------------

    \148\ That estimate assumes that all U.S. reporting companies 
would have material updates to disclosure about critical accounting 
estimates in each quarter.
---------------------------------------------------------------------------

    To determine the average total number of hours each entity spends 
completing each form, we added the 15-hour increment to the current 
burden hours for each form. For quarterly reports, we estimate that 75% 
of the burden of preparation is carried by the company internally and 
that 25% of the burden of preparation is carried by outside 
professionals retained by the company at an average cost of $300 per 
hour. The portion of the burden carried by outside professionals is 
reflected as a cost, while the portion of the burden carried by the 
company internally is reflected in hours. Additionally, there would be 
no change to the estimated burden of the collection of information 
entitled ``Regulation S-B'' and ``Regulation S-K'' because the burdens 
are already reflected in our estimates for the forms. The incremental 
cost of outside professionals for quarterly reports would be 
approximately $43,148,000 per year and the incremental company burden 
would be approximately 431,483 hours per year. For purposes of our 
submission to OMB under the PRA, the total cost of outside 
professionals for quarterly reports and Regulation S-K and S-B would be 
approximately $427,395,000 per year and the company burden would be 
4,273,945 hours per year.

                                                 Table 3.--Quarterly Reports and Regulations S-K and S-B
                                                 [Columns in bold are the PRA burdens submitted to OMB]
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                              Annual       Total hours/    Total burden     75% Company         25%         $300 Prof.
---------------------------------------------------------    responses         form      --------------------------------  Professional        Cost
                                                         --------------------------------                                -------------------------------
                                                                (A)             (B)         (C)=(A)*(B)    (D)=(C)*0.75    (E)=(C)*0.25    (F)=(E)*$300
--------------------------------------------------------------------------------------------------------------------------------------------------------
10-Q....................................................          26,746             151       4,038,646       3,028,985       1,009,662    $302,899,000
10-QSB..................................................          11,608             143       1,659,944       1,244,958         414,986     124,496,000
Regulation S-K..........................................               0               1               1               1               0               0
Regulation S-B..........................................               0               1               1               1               0               0
                                                         -----------------------------------------------------------------------------------------------
    Total...............................................  ..............  ..............  ..............       4,273,945  ..............     427,395,000
--------------------------------------------------------------------------------------------------------------------------------------------------------

E. Solicitation of Comment

    Pursuant to 44 U.S.C. 3506(c)(2)(B), we solicit comments to: (i) 
Evaluate whether the proposed collection of information is necessary 
for the proper performance of the functions of the agency, including 
whether the information will have practical utility; (ii) evaluate the 
accuracy of our estimate of the burden of the proposed collection of 
information; (iii) determine whether there are ways to enhance the 
quality, utility and clarity of the information to be collected; and 
(iv) evaluate whether there are ways to minimize the burden of the 
collection of information on those who are to respond, including 
through the use of automated collection

[[Page 35643]]

techniques or other forms of information technology.
    Persons submitting comments on the collection of information 
requirements should direct the comments to the Office of Management and 
Budget, Attention: Desk Officer for the Securities and Exchange 
Commission, Office of Information and Regulatory Affairs, Washington, 
DC 20503, and should send a copy to Jonathan G. Katz, Secretary, 
Securities and Exchange Commission, 450 Fifth Street, NW., Washington, 
DC 20549-0609, with reference to File No. S7-16-02. Requests for 
materials submitted to OMB by the Commission with regard to these 
collections of information should be in writing, refer to File No. S7-
16-02, and be submitted to the Securities and Exchange Commission, 
Records Management, Office of Filings and Information Services. OMB is 
required to make a decision concerning the collection of information 
between 30 and 60 days after publication of this release. Consequently, 
a comment to OMB is assured of having its full effect if OMB receives 
it within 30 days of publication.

VI. Cost-Benefit Analysis

A. Background

    The Commission is proposing disclosure rules to address investors' 
increasing demand for greater transparency with respect to the 
application of companies' accounting policies and their effects. The 
proposed disclosure about the application of critical accounting 
policies encompasses a company's critical accounting estimates and its 
initial adoption of accounting policies that have a material impact. 
While the existing disclosure requirements in GAAP result in some basic 
disclosure of a company's material changes in accounting estimates, 
initial adoption of accounting policies and risks and uncertainties 
that may materially affect the financial statements, the proposals 
would require companies to provide more comprehensive information and 
analysis about a company's application of critical accounting policies. 
Because of the potential impact of a company's critical accounting 
policies and the subjectivity and complexity involved, they are 
important for investors' understanding of a company's overall financial 
condition, changes in financial condition and results of operations. 
The proposals would require companies that are reporting, raising 
capital in the registered public markets or asking shareholders for 
their votes to identify their critical accounting estimates and their 
initial adoption of material accounting policies. For those 
applications, a company would provide a meaningful analysis of their 
impact in the ``Management's Discussion and Analysis'' section of the 
disclosure documents.

B. Objectives of Proposed Disclosure of Critical Accounting Estimates

    Beyond the disclosure of the application of accounting policies 
provided for in the accounting literature, our proposals would provide 
additional key information in MD&A that enhances understanding of a 
company's financial statements, and provides information about the 
quality of, and potential variability of, a company's earnings. Our 
proposals would give management the impetus to discuss candidly, and 
provide insight into, the company's critical accounting estimates and 
its initial adoption of accounting policies that have a material 
impact. Our proposals are expected to increase investor understanding, 
to enhance the ability of investors to make informed investment 
decisions and to allocate capital on a more efficient basis.

C. Alternative Regulatory Approaches

    We considered alternative regulatory actions for achieving the 
proposed disclosure and greater transparency of a company's application 
of critical accounting policies. We considered encouraging companies to 
provide disclosure regarding the application of critical accounting 
policies.\149\ Although some public companies are voluntarily providing 
more detailed information in their financial statements, it has been 
noted that some companies generally have not been providing investors 
with the desired level of detail in their disclosure. To stimulate 
higher quality disclosures regarding the application of critical 
accounting policies, we are proposing mandated disclosures.
---------------------------------------------------------------------------

    \149\ See Securities Act Release No. 8040, FR-60 (Dec. 12, 2001) 
[66 FR 65013]. See also Securities Act Release No. 8056, FR-61 (Jan. 
22, 2002) [67 FR 3746].
---------------------------------------------------------------------------

    The proposed mandated disclosures are likely to result in a more 
focused and descriptive discussion of the company's critical accounting 
estimates and initial adoption of accounting policies that have a 
material impact. In addition, mandated disclosures regarding the 
application of critical accounting policies should benefit investors 
because the enumerated disclosure under the proposed rule would likely 
be more comparable across all firms and consistent over time.\150\
---------------------------------------------------------------------------

    \150\ See generally, Kothari, S., Capital Markets Research In 
Accounting, 31 Journal of Accounting and Economics 105 (2001). This 
author suggests that mandated disclosures provide useful information 
to markets reducing information processing costs for investors by 
providing for consistent, comparable disclosures.
---------------------------------------------------------------------------

    In addition to voluntary disclosure, we considered various methods 
of mandating this disclosure to the public. We are proposing what we 
believe to be the least onerous method that retains the primary benefit 
of increased transparency. One alternative approach we considered was 
to change accounting rules regarding the presentation of financial 
statements to require more disclosure in the financial statements with 
respect to the application of critical accounting policies. Another 
approach we considered was to require companies to file schedules of 
all accounting estimates as exhibits to their quarterly and annual 
filings. These schedules would contain a demonstration of how a company 
calculated each estimate.
    Unlike these alternative approaches, we believe that the placement 
of the proposed disclosure in the MD&A would encourage management to 
provide more insightful disclosure in a manner more understandable to 
the average investor than these other disclosure alternatives.
    We solicit comment with respect to alternative regulatory 
approaches.
     Is there evidence that market forces would elicit the 
disclosures we are proposing?\151\
---------------------------------------------------------------------------

    \151\ See generally, Healy, P. and K. Palepu, Information 
Asymmetry, Corporate Disclosure And Capital Markets: A Review Of The 
Empirical Disclosure Literature, 31 Journal of Accounting and 
Economics 405 (2001). The authors argue that one reason why firms 
are reluctant to disclose voluntarily is that they face significant 
proprietary and litigation costs.
---------------------------------------------------------------------------

     What are the relative costs and benefits of pursuing these 
or other alternative regulatory solutions to elicit disclosure of the 
application of critical accounting policies?

D. Potential Benefits of the Proposed Rules

    The primary anticipated benefit of the proposed rules is to 
increase transparency of the financial condition, changes in financial 
condition and operating results of companies and to reduce the 
information asymmetry between management and investors. Current market 
events have evidenced a need to provide investors with a clearer 
understanding of where a company's accounting policies, estimates, 
assumptions and methodologies materially affect the financial 
statements

[[Page 35644]]

when they are prepared.\152\ The proposed disclosure is intended to 
enhance the quality of the disclosure in the MD&A section by providing 
more information about management's insight into the company. By making 
information about the application of critical accounting policies and 
their implications on the presentation of the company's financial 
position available and more understandable, the proposals would benefit 
investors both directly and indirectly through the financial analysts 
and the credit rating agencies whose analyses investors consider. 
Greater transparency would thus enable investors to make more informed 
investment decisions and to allocate capital on a more efficient basis.
---------------------------------------------------------------------------

    \152\ See generally, Marcia Vickers, Mike McNamee et. al, The 
Betrayed Investor, BusinessWeek, Feb. 25, 2002 at 105.
---------------------------------------------------------------------------

    As a secondary benefit to investors, a possible by-product of the 
proposed MD&A disclosure may be to deter improper accounting practices 
by some companies. For example, the proposed disclosure of critical 
accounting estimates could make inappropriate earnings management more 
difficult because it could be easier to detect. The proposed disclosure 
could also assist investors in evaluating management's performance. 
With the proposed disclosure, an investor may be better able to judge 
whether management applies the company's accounting policies either 
aggressively or conservatively.
    Another possible beneficial by-product of the proposed MD&A 
disclosure could be to increase the discipline and oversight of 
management in their application of a company's critical accounting 
policies. In order to prepare the disclosure, management would be 
required to review and explain the company's application of accounting 
policies, and the reasonably likely impact. The proposed disclosure 
could increase management's motivation to exercise greater discipline 
in applying the company's accounting policies because the material 
assumptions and methodologies would be more transparent and subject to 
greater investor scrutiny. In light of this possibility, both auditors 
and audit committees may also improve their oversight of the 
application of critical accounting policies.
    We solicit comment with respect to the potential benefits of the 
proposed MD&A disclosure.
     We solicit quantitative data to assist our assessment of 
the benefits of identifying critical accounting estimates and analyzing 
their effects on the financial statements and explaining the initial 
adoption of material accounting policies and their impacts in the 
manner proposed.
     Would the proposed disclosure serve as a deterrent for 
improper accounting practices?

E. Potential Costs of Proposed Rules

1. Costs of Preparing Disclosure
    We estimate that proposed rules would impose a new disclosure 
requirement on approximately 14,000 public companies.\153\ We 
anticipate that the average company's application of critical 
accounting policies disclosure would consist of about six pages of 
additional text when the company is required to prepare the proposed 
disclosure in its entirety. We estimate that the disclosure would 
involve multiple parties, including in-house preparers, senior 
management, in-house counsel, outside counsel, outside auditors, and 
audit committee members. For purposes of the Paperwork Reduction 
Act,\154\ we estimated that company personnel would spend approximately 
780,000 hours per year (56 hours per company) to prepare, review and 
file the proposed disclosure. Based on our estimated cost of in-house 
staff time, we estimated the PRA hour-burden would translate into an 
approximate cost of $98,000,000 ($7,000 per company).\155\ We also 
estimated that companies would spend approximately $98,000,000 ($7000 
per company) on outside professionals to comply with the 
disclosure.\156\ We also estimate that companies will incur some 
additional printing and dissemination costs.\157\ We are unable to 
estimate the potential printing and dissemination costs because there 
is a wide possible range of paper and ink available and different 
companies will print a different number of reports depending on their 
shareholder base.
---------------------------------------------------------------------------

    \153\ We derived this estimate by assessing the number of 
registrants who filed annual reports last year, and subtracting an 
estimated number of small business issuers who we expect would not 
be required to provide the disclosure.
    \154\ 44 U.S.C. Sec. 3501 et seq.
    \155\ This cost estimate is based on data obtained from The SIA 
Report on Management and Professional Earnings in the Securities 
Industry (Oct. 2001).
    \156\ To derive our estimates for the Paperwork Reduction Act, 
we multiplied the number of filers for each form by the incremental 
hours per form. The portion of the product carried by the company is 
reflected in hours and the portion carried by outside professionals 
is reflected as a cost.
    \157\ See generally, Del Jones, Companies Beef up their Annual 
Reports, USA Today, Mar. 12, 2002 at 1B.
---------------------------------------------------------------------------

    While companies may face increased costs associated with the 
preparation, review, filing, printing and dissemination of these 
disclosures, we believe our proposals would not substantially increase 
the costs to collect the information necessary to prepare the proposed 
disclosure. This information should largely be readily available from 
each company's books and records. Since management must calculate 
accounting estimates and apply initially adopted accounting policies to 
prepare the required financial statements, the proposed disclosure may 
not impose significant incremental costs for the collection and 
calculation of data. In addition, management is likely to already 
conduct analysis of the application of the company's accounting 
policies in the course of managing the business activities of the 
company. We recognize that management does not currently describe its 
analysis and is likely to confer with legal counsel in drafting the 
disclosure. Because of the wide variance among public companies, it is 
difficult to estimate the average cost. We did contact a few companies 
that voluntarily had provided information about critical accounting 
policies in their 2001 Form 10-Ks. They indicated that preparation of 
the proposed disclosure would cost from approximately $5,000 to 
$500,000 per year.
    We solicit comment regarding the potential cost of compliance with 
the proposals.
     What types of expenses would companies incur in order to 
comply with the proposed disclosure requirements?
     What would the average printing and dissemination costs be 
for each firm?
     We solicit quantitative data to assist our assessment of 
the compliance costs of identifying critical accounting estimates and 
the initial adoption of accounting policies that have a material impact 
and analyzing their effects on the financial statements in the manner 
proposed.
2. Competitive Harm
    There is some possibility that a company's competitors could be 
able to infer proprietary or sensitive information from disclosure 
about management's application of critical accounting policies under 
our proposals. To the extent that all companies make the proposed 
disclosure, that impact may diminish.
    We solicit comment regarding possible competitive harm.
     To what degree would our proposed disclosure requirements 
create competitively harmful effects upon public companies?

[[Page 35645]]

     How could we minimize those effects?
3. Perception of Increased Liability
    With any new disclosure mandate, there may be an increased chance 
that a company could include a materially misleading statement or a 
material omission in its disclosure document. A company may be 
concerned that it could be subjected to increased liability due to the 
disclosure required by the proposed rules. For example, one aspect of 
our proposed rules would require a quantitative and qualitative 
analysis to depict the effects of changing a critical accounting 
estimate. Companies may believe that this disclosure would subject them 
to potential liability if actual changes to the critical accounting 
estimates affect line items and overall financial performance to a 
greater or lesser degree than disclosed. Companies may particularly be 
concerned with the potential liability when required disclosure is 
forward-looking in nature.
    In part to help alleviate this perception, we are proposing the new 
disclosure be included in the MD&A section--a section not excluded from 
the coverage of the safe harbor for forward-looking statements provided 
by the Private Securities Litigation Reform Act of 1995.\158\ Those 
safe harbors were designed to help companies reduce the costs of 
litigation relating to those types of statements. The PSLRA safe 
harbors, as well as those provided by existing Commission Rules 175 and 
3b-6 and the ``bespeaks caution'' legal doctrine created by the courts, 
should reduce potential litigation costs of companies that craft the 
disclosure under the proposed rules to meet the conditions of those 
safe harbors and that doctrine.
---------------------------------------------------------------------------

    \158\ Pub. L. No. 104-67, 109 Stat. 737 (1995).
---------------------------------------------------------------------------

    We are soliciting comment with regard to the perception of 
increased liability.
     What are the potential litigation and liability costs that 
would be associated with the proposed disclosure requirements?

F. Small Business Issuers

    We have proposed to require that those small business issuers that 
must currently make MD&A disclosure also must provide disclosure about 
the application of critical accounting policies. Small business issuers 
that are not currently required to prepare MD&A would not be subject to 
the proposed MD&A disclosure. Thus, only small business issuers that 
have generated revenues in the past two years would be required to 
disclose the proposed information about their application of critical 
accounting policies. The proposals would not impose additional costs 
for start-up and early stage businesses at a time when they need their 
resources for growth. We believe the burden on small firms may be less 
significant overall because these firms would be likely to have fewer 
critical accounting estimates. We do not have specific data, however, 
with respect to that assumption.
    We ask commenters to provide us with data to estimate the costs of 
the proposed regulations for small business issuers.
     Would small business issuers on average have fewer 
critical accounting estimates to discuss?
     Who would prepare the disclosure for small business 
issuers?
     What types of expenses would be incurred to prepare this 
disclosure?

G. Foreign Private Issuers

    We propose to apply to foreign private issuers the same MD&A 
disclosure requirements regarding the application of critical 
accounting policies that would apply to U.S. companies. Foreign private 
issuers, however, may present their financial statements either in 
accordance with U.S. GAAP, in accordance with GAAP of a foreign 
country, or in accordance with International Accounting Standards and 
International Financial Reporting Standards issued by the International 
Accounting Standards Committee and the International Accounting 
Standards Board. If financial statements are presented in accordance 
with non-U.S. GAAP, a reconciliation to U.S. GAAP accompanies them. If 
the primary financial statements were in non-U.S. GAAP, the company 
would have to consider the application of critical accounting policies 
in connection with both its primary financial statements and its 
reconciliation to U.S. GAAP. Therefore, foreign private issuers may 
incur additional costs with regard to the proposed disclosure because 
of possible additional disclosure regarding the reconciliation to U.S. 
GAAP.
    Offsetting this additional cost, however, is the fact that foreign 
private issuers would not be required to submit quarterly reports on 
Form 10-Q or Form 10-QSB to the Commission. In addition, foreign 
private issuers are exempt from U.S. proxy and information statement 
disclosure requirements.\159\ Thus, unless a foreign private issuer 
files a registration statement that must include interim period 
financial statements and related MD&A disclosure, it generally would 
not be required to update the proposed MD&A disclosure more frequently 
than annually. Therefore, the overall cost of compliance could be lower 
for foreign private issuers than for U.S. companies.
---------------------------------------------------------------------------

    \159\ See 17 CFR 240.3a12-3(b).
---------------------------------------------------------------------------

    We ask commenters to provide us with data to estimate the costs of 
the proposed regulations for foreign private issuers.
     On average, would the U.S. GAAP reconciliation cause 
foreign private issuers to have more critical accounting estimates and 
more initial adoptions of accounting policies to discuss than a U.S. 
company? If so, how many more?

H. Request for Comments

    To assist the Commission in its evaluation of the costs and 
benefits of the proposed disclosure discussed in this release, we 
request that commenters provide views and data relating to any costs 
and benefits associated with the proposed rules.

VII. Effects on Efficiency, Competition and Capital Formation

    Section 23(a)(2) of the Exchange Act \160\ requires us, when 
adopting rules under the Exchange Act, to consider the anti-competitive 
effects. The proposed rules are intended to make information about the 
application of critical accounting policies and their implications for 
the presentation of a company's financial condition, changes in 
financial condition and operating results more understandable to 
investors. We have identified one possible area where the proposed 
rules could potentially place a burden on competition. In our cost-
benefit analysis above, we note that there is some possibility that a 
company's competitors could be able to infer proprietary or sensitive 
information from disclosure about management's application of critical 
accounting policies under our proposals. To the extent that all 
companies make the proposed disclosure, that impact may diminish. In 
our cost-benefit analysis above, we request comment regarding the 
degree to which our proposed disclosure requirements would create 
competitively harmful effects upon public companies, and how to 
minimize those effects. We request comment on any disproportionate 
cross-sectional burdens among the firms affected by our proposals that 
could have anti-competitive effects.
---------------------------------------------------------------------------

    \160\ 15 U.S.C. Sec. 78w(a)(2).
---------------------------------------------------------------------------

    Section 2(b) of the Securities Act \161\ and Section 3(f) of the 
Exchange Act \162\

[[Page 35646]]

require us, when engaging in rulemaking that requires us to consider or 
determine whether an action is necessary or appropriate in the public 
interest, to consider, in addition to the protection of investors, 
whether the action will promote efficiency, competition and capital 
formation. We believe the proposed disclosure may promote market 
efficiency by making information about the application of critical 
accounting policies, and their impact on the presentation of the 
company's financial position, more understandable. As a result, we 
believe that investors may be able to make more informed investment 
decisions and capital may be allocated on a more efficient basis. In 
addition, we believe this disclosure would assist investors in 
evaluating management. The possibility of these effects, their 
magnitude if they were to occur and the extent to which they would be 
offset by the costs of the proposals are difficult to quantify. We 
request comment on these matters and how the proposed amendments, if 
adopted, would affect efficiency and capital formation. Commenters are 
requested to provide empirical data and other factual support to the 
extent possible.
---------------------------------------------------------------------------

    \161\ 15 U.S.C. 77b(b).
    \162\ 15 U.S.C. 78c(f).
---------------------------------------------------------------------------

VIII. Initial Regulatory Flexibility Analysis

    This Initial Regulatory Flexibility Analysis has been prepared in 
accordance with 5 U.S.C. 603. It relates to proposed revisions to Item 
303 of Regulation S-K,\163\ Item 303 of Regulation S-B \164\ and Item 5 
of Form 20-F.\165\ The proposals require a company to discuss the 
application of critical accounting policies. The new disclosure would 
be included in the MD&A section of a company's annual reports, 
registration statements and proxy and information statements. Companies 
would be required to update the portion of the proposed MD&A 
information about critical accounting estimates by disclosing material 
changes quarterly on Form 10-Q or Form 10-QSB.
---------------------------------------------------------------------------

    \163\ 17 CFR 229.303.
    \164\ 17 CFR 228.303.
    \165\ 17 CFR 249.220f.
---------------------------------------------------------------------------

A. Reasons for the Proposed Action

    The requirements of GAAP for disclosure in financial statements and 
the current requirements in MD&A have not resulted in the type of 
discussion of the application of critical accounting policies that our 
proposals would require. The potential consequences of not taking this 
action to require disclosure regarding the application of critical 
accounting policies are: (a) Less transparency in the presentation of 
companies' financial statements and, correspondingly, a lesser 
understanding of companies' financial condition, changes in financial 
condition and results of operations when making investment decisions; 
and (b) a potential decrease in investor confidence in the full and 
fair disclosure system that is the hallmark of the U.S. capital 
markets.

B. Objectives

    Beyond the disclosure of the application of accounting policies 
provided for in the accounting literature, our proposals would provide 
additional key information in MD&A that enhances understanding of a 
company's financial statements, and provides information about the 
quality of, and potential variability of, a company's earnings. Our 
proposals would give management the impetus to discuss candidly, and 
provide insight into, the company's application of critical accounting 
policies. We believe that our proposals may increase investor 
understanding, enhance the ability of investors to make informed 
investment decisions and allocate capital on a more efficient basis.

C. Legal Basis

    We are proposing the amendments under the authority set forth in 
Sections 7, 10 and 19 of Securities Act of 1933 and Sections 12, 13, 14 
and 23 of the Securities Exchange Act of 1934.

D. Small Entities Subject to the Proposed Regulation and Rules

    The proposals would affect companies that are small entities. 
Exchange Act Rule 0-10(a) \166\ and Securities Act Rule 157 \167\ 
define a company, other than an investment company, to be a ``small 
business'' or ``small organization'' if it had total assets of $5 
million or less on the last day of its most recent fiscal year. As of 
February 20, 2002, we estimated that there were approximately 2,500 
companies, other than investment companies, that may be considered 
small entities. The proposed disclosure requirements would apply to any 
small entity that fulfills its disclosure obligations by either 
complying with our standard disclosure requirements \168\ or providing 
the ``Management's Discussion and Analysis'' disclosure item contained 
in our optional disclosure system available only to small 
businesses.\169\ If a small entity elects to fulfill its disclosure 
obligations pursuant to our optional disclosure system for small 
businesses, it would be required to comply with our proposed rule only 
if it had revenues during the past two fiscal years. While we believe 
that there are a number of small entities that therefore would not be 
required to comply with our proposals, we are unable to quantify that 
number. We request comment on the number of small entities that would 
not be required to comply with our proposals.
---------------------------------------------------------------------------

    \166\ 17 CFR 270.0-10(a).
    \167\ 17 CFR 230.157.
    \168\ Regulation S-K, 17 CFR 229.10-229.1016.
    \169\ Regulation S-B, 17 CFR 228.10-228.701.
---------------------------------------------------------------------------

E. Reporting, Recordkeeping and Other Compliance Requirements

    Small entities would either utilize existing personnel or hire an 
outside professional to provide the proposed disclosure. This would 
impose incremental costs on small entities in connection with drafting, 
reviewing, filing, printing and disseminating additional disclosure in 
annual reports, registration statements, proxy and information 
statements and quarterly reports. The data underlying the proposed 
disclosure should be readily available from a company's books and 
records. Thus, the proposed rules involve relatively low incremental 
costs for the collection and calculation of data. This belief is based 
on the fact that management already must calculate the critical 
accounting estimates and apply initially adopted accounting policies to 
prepare the required financial statements. In addition, the burden on 
small entities of disclosing the effects of those estimates and changes 
in them may be less because it is possible that these firms may have 
fewer critical accounting estimates that would be covered by the 
proposals.
    The proposed rule was designed to reduce costs for small entities 
by requiring the proposed disclosure only in the event that a small 
business issuer has generated revenue in the past two years. Our 
proposals thus would avoid applying the new requirements for MD&A 
disclosure relating to the application of critical accounting policies 
to start-up or developing companies that need not provide MD&A 
disclosure otherwise. Those companies describe a business plan rather 
than the traditional MD&A. In addition, small business issuers that 
provide the critical accounting estimates disclosure would only be 
required to provide a quantitative discussion of past material changes 
in estimates for the last two fiscal years. This corresponds to the 
income statements required to be included in our small business forms.

[[Page 35647]]

Other companies would be required to discuss this information for the 
past three years.

F. Duplicative, Overlapping or Conflicting Federal Rules

    We believe that there are no rules that conflict with or completely 
duplicate the proposed rules. There is a possible partial overlap with 
financial statement requirements requiring disclosure about material 
changes in critical accounting estimates and risks and uncertainties 
that could materially affect the financial statements and with MD&A 
requirements that may require some discussion of the application of 
critical accounting policies if that is essential to an understanding 
of a company's financial condition, changes in financial condition or 
results of operations. However, those requirements do not include much 
of the information specifically targeted for inclusion in the proposed 
rules.

G. Significant Alternatives

    The Regulatory Flexibility Act directs the Commission to consider 
significant alternatives that would accomplish the stated objective, 
while minimizing any significant adverse impact on small entities. In 
connection with the proposals, we considered the following 
alternatives:
    (a) The establishment of differing compliance or reporting 
requirements or timetables that take into account the resources 
available to small entities;
    (b) The clarification, consolidation, or simplification of 
disclosure related to critical accounting estimates for small entities;
    (c) The use of performance rather than design standards; and
    (d) An exemption for small entities from coverage under the 
proposals.
    We have drafted the proposed disclosure rules to require clear and 
straightforward disclosure in MD&A. Separate disclosure requirements 
for small entities would not yield the disclosure that we believe to be 
necessary to achieve our objectives. In addition, the informational 
needs of investors in small entities are typically as great as the 
needs of investors in larger companies. Therefore, it does not seem 
appropriate to develop separate requirements for small entities 
involving clarification, consolidation or simplification of the 
proposed disclosure.
    We have used design rather than performance standards in connection 
with the proposals for three reasons. First, we believe the proposed 
disclosure would be more useful to investors if there were enumerated 
informational requirements. The proposed mandated disclosures may be 
likely to result in a more focused and comprehensive discussion of the 
company's application of its critical accounting policies. Second, 
mandated disclosures regarding the application of critical accounting 
policies may benefit investors in small entities because the enumerated 
disclosure under the proposed rule would likely be more comparable 
across all firms and consistent over time. Third, a mandated discussion 
of a company's application of critical accounting policies is uniquely 
suited to the MD&A disclosure in light of MD&A's emphasis on the 
identification of significant uncertainties and events and favorable or 
unfavorable trends. Therefore, adding a disclosure requirement to the 
existing MD&A appears to be the most effective method of eliciting the 
disclosure.
    As noted above, we have proposed not to cover small business 
issuers that have not generated revenue during the last two years. We 
have made this accommodation in recognition of the fact that a limited 
modified approach is consistent with the objectives underlying the 
small business issuer disclosure system's alteration of the MD&A 
requirements for these companies and reduction of compliance burdens 
for these small companies. We believe that exempting small entities 
further from coverage of the proposals would not be appropriate. 
Investors in smaller companies may want and benefit from the 
disclosures about the application of critical accounting policies just 
as much as investors in larger companies. We note that a study 
commissioned by the Committee of Sponsoring Organizations of the 
Treadway Commission found that the incidence of financial fraud was 
greater at small companies.\170\ Accordingly, a possible secondary 
benefit to investors in small entities may be to deter improper 
accounting practices. For example, the proposed disclosure could make 
inappropriate earnings management more difficult because it could be 
easier to detect.
---------------------------------------------------------------------------

    \170\ See Beasley, Carcello and Hermanson, Fraudulent Financial 
Reporting: 1987-1997, and Analysis of U.S. Public Companies (Mar. 
1999).
---------------------------------------------------------------------------

H. Solicitation of Comments

    We encourage the submission of comments with respect to any aspect 
of this Initial Regulatory Flexibility Analysis. In particular, we 
request comments regarding: (i) The number of small entities that may 
be affected by the proposals; (ii) the existence or nature of the 
potential impact of the proposals on small entities discussed in the 
analysis; and (iii) how to quantify the impact of the proposed 
revisions. Commenters are asked to describe the nature of any impact 
and provide empirical data supporting the extent of the impact. Such 
comments will be considered in the preparation of the Final Regulatory 
Flexibility Analysis, if the proposals are adopted, and will be placed 
in the same public file as comments on the proposed amendments 
themselves.

IX. Small Business Regulatory Enforcement Fairness Act

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996 (``SBREFA''), \171\ a rule is ``major'' if it has resulted, 
or is likely to result in:
---------------------------------------------------------------------------

    \171\ Pub. L. No. 104-121, Title II, 110 Stat. 857 (1996).
---------------------------------------------------------------------------

     An annual effect on the economy of $100 million or more;
     A major increase in costs or prices for consumers or 
individual industries; or
     Significant adverse effects on competition, investment or 
innovation.
    We preliminarily believe that our proposals could constitute a 
``major rule'' under SBREFA. We request comment on whether our 
proposals would be a ``major rule'' for purposes of SBREFA. We solicit 
comment and empirical data on: (a) The potential effect on the U.S. 
economy on an annual basis; (b) any potential increase in costs or 
prices for consumers or individual industries; and (c) any potential 
effect on competition, investment or innovation.

X. Codification Update

    The Commission proposes to amend the ``Codification of Financial 
Reporting Policies'' announced in Financial Reporting Release No. 1 
(April 15, 1982):
    By adding Section 501.12, captioned ``The Application of Critical 
Accounting Policies,'' to include the text in the adopting release that 
discusses the final rules, which, if the proposed rules are adopted, 
would be substantially similar to Section III of this release. The 
Codification is a separate publication of the Commission. It will not 
be published in the Code of Federal Regulations.

Statutory Bases and Text of Proposed Amendments

    We are proposing amendments to Commission's existing rules under 
the authority set forth in Sections 7, 10 and 19 of the Securities Act 
and Sections 12, 13, 14 and 23 of the Exchange Act.

[[Page 35648]]

List of Subjects 17 CFR Parts 228, 229 and 249

    Reporting and recordkeeping requirements, Securities.

Text of Proposed Amendments

    In accordance with the foregoing, the Securities and Exchange 
Commission proposes to amend Title 17, chapter II of the Code of 
Federal Regulations as follows:

PART 228--INTEGRATED DISCLOSURE SYSTEM FOR SMALL BUSINESS ISSUERS

    1. The authority citation for Part 228 continues to read as 
follows:

    Authority: 15 U.S.C. 77e, 77f, 77g, 77h, 77j, 77k, 77s, 77z-2, 
77z-3, 77aa(25), 77aa(26), 77ddd, 77eee, 77ggg, 77hhh, 77jjj, 77nnn, 
77sss, 78l, 78m, 78n, 78o, 78u-5, 78w, 78ll, 78mm, 80a-8, 80a-29, 
80a-30, 80a-37 and 80b-11.

    2. Section 228.303 is amended by adding paragraph (b)(3) and 
Instructions to paragraph (b)(3) and revising Instruction 2 of 
Instructions to Item 303 to read as follows:


Sec. 228.303  (Item 303) Management's Discussion and Analysis or Plan 
of Operation.

* * * * *
    (b) * * *
    (3) The application of critical accounting policies.
    (i) Annual reports, registration statements and proxy and 
information statements. In an annual report filed under the Exchange 
Act, an annual report to shareholders prepared under Sec. 240.14a-3 or 
Sec. 240.14c-3 of this chapter, a registration statement filed under 
the Securities Act or the Exchange Act, or a proxy or information 
statement filed under the Exchange Act, include a separately-captioned 
section in ``Management's Discussion and Analysis'' setting forth the 
disclosure regarding the small business issuer's application of 
critical accounting policies required by paragraphs (b)(3)(iii) and 
(b)(3)(iv) of this section. Except as otherwise stated, the discussion 
must cover the financial statements for the most recent fiscal year and 
any subsequent period for which interim period financial statements are 
required to be included.
    (ii) Definitions.
    (A) Accounting estimate. As used in paragraph (b)(3) of this 
section, the term accounting estimate means an approximation made by 
management of a financial statement element, item or account in the 
financial statements.
    (B) Critical accounting estimate. An accounting estimate recognized 
in the financial statements presented is a critical accounting estimate 
for purposes of this section if:
    (1) The accounting estimate requires the small business issuer to 
make assumptions about matters that are highly uncertain at the time 
the accounting estimate is made; and
    (2) Different estimates that the small business issuer reasonably 
could have used in the current period, or changes in the accounting 
estimate that are reasonably likely to occur from period to period, 
would have a material impact on the presentation of the small business 
issuer's financial condition, changes in financial condition or results 
of operations.
    (C) Near-term. As used in paragraph (b)(3) of this section, the 
term near-term means a period of time going forward up to one year from 
the date of the financial statements.
    (D) Reasonably possible. As used in paragraph (b)(3) of this 
section, the term reasonably possible means the chance of a future 
transaction or event occurring is more than remote but less than 
likely.
    (iii) Disclosure regarding critical accounting estimates. For each 
critical accounting estimate:
    (A) Identify and describe the accounting estimate. Describe the 
methodology underlying the accounting estimate. Describe the 
assumptions underlying the accounting estimate that relate to matters 
highly uncertain at the time the estimate was made. Describe any other 
underlying assumptions that are material. Discuss any known trends, 
demands, commitments, events or uncertainties that are reasonably 
likely to occur and materially affect the methodology or assumptions 
described. Disclose, if applicable, why different estimates that would 
have had a material impact on the small business issuer's financial 
presentation could have been used in the current period. Describe, if 
applicable, why the accounting estimate is reasonably likely to change 
from period to period with a material impact on the financial 
presentation;
    (B) Explain the significance of the accounting estimate to the 
small business issuer's financial condition, changes in financial 
condition and results of operations and, where material, identify the 
line items in the financial statements affected by the accounting 
estimate;
    (C)(1) Present either:
    (i) A quantitative discussion of changes in overall financial 
performance, and to the extent material the line items in the financial 
statements, assuming that reasonably possible near-term changes occur, 
both negative and positive (where applicable), in the most material 
assumption or assumptions underlying the accounting estimate; or
    (ii) A quantitative discussion of changes in overall financial 
performance, and to the extent material the line items in the financial 
statements, assuming that the accounting estimate was changed to the 
upper end and the lower end of the range of reasonable possibilities 
determined by the small business issuer in the course of formulating 
its recorded estimate; and
    (2) Discuss the impact, if material, on the small business issuer's 
liquidity or capital resources if any of the changes being assumed for 
purposes of satisfying paragraph (b)(3)(iii)(C)(1)(i) or paragraph 
(b)(3)(iii)(C)(1)(ii) of this section were in effect;
    (D) Present a quantitative and qualitative discussion of any 
material changes made to the accounting estimate in the past two years 
(or in the past year for any filing made before [one year after the 
effective date of the final rule]), describe the reasons for the 
changes and discuss the effect on line items in the financial 
statements and overall financial performance;
    (E) Disclose whether or not the small business issuer's senior 
management has discussed the development and selection of the critical 
accounting estimates, and the MD&A disclosure regarding them, with the 
audit committee of the small business issuer's board of directors (or 
the equivalent oversight group). If the senior management has not had 
these discussions, disclose the reasons why not; and
    (F) If the small business issuer operates in more than one segment, 
identify the segments that the accounting estimate affects. To the 
extent that the disclosure under the requirements of paragraph (b)(3) 
of this section only on a company-wide basis would result in an 
omission that renders the disclosure materially misleading, include a 
separate discussion on a segment basis for the identified segments of 
the small business issuer's business about which disclosure is 
otherwise required.
    (iv) Disclosure regarding initial adoption of an accounting policy. 
If an accounting policy initially adopted by the small business issuer 
(other than those solely resulting from the adoption of new accounting 
literature issued by a recognized accounting standard setter) had a 
material impact on its financial condition, changes in financial 
condition or results of operations, disclose:

[[Page 35649]]

    (A) The events or transactions that gave rise to the initial 
adoption;
    (B) The accounting principle that has been adopted and the method 
of applying that principle;
    (C) The impact, qualitatively, of the initial adoption on the 
financial condition, changes in financial condition and results of 
operations of the small business issuer;
    (D) If the small business issuer is permitted a choice between 
acceptable accounting principles, an explanation it made such a choice, 
what the alternatives were, and why it made the choice that it did 
(including, where material, qualitative disclosure of the impact on 
financial condition, changes in financial condition and results of 
operations that alternatives would have had); and
    (E) If no accounting literature exists that governs the accounting 
for the events or transactions giving rise to the initial adoption, an 
explanation of the small business issuer's decision regarding which 
accounting principle to use and which method of applying that principle 
to use.
    (v) Quarterly reports. In a quarterly report on Form 10-QSB 
(Sec. 249.308b of this chapter), in a separately-captioned section of 
``Management's Discussion and Analysis,'' disclose:
    (A) For any critical accounting estimate that was not previously 
discussed as a critical accounting estimate in the MD&A section of the 
small business issuer's last Form 10-KSB (Sec. 249.310b of this 
chapter) or any of its subsequent Forms 10-QSB, the information 
required by paragraph (b)(3)(iii) of this section; and
    (B) For any critical accounting estimate previously discussed as a 
critical accounting estimate in the MD&A section of the small business 
issuer's last Form 10-KSB or any of its subsequent Forms 10-QSB, any 
material change to that prior disclosure (other than disclosure under 
paragraph (b)(3)(iii)(D) of this section) necessary to make that 
disclosure not materially misleading as of the time the small business 
issuer files its Form 10-QSB for the current fiscal quarter.
    Instructions to paragraph (b)(3):
    1. The changes being assumed in connection with paragraph 
(b)(3)(iii)(C)(1) of this section must be meaningful and therefore may 
not be so minute as to avoid, or materially understate, any 
demonstration of sensitivity.
    2. For purposes of paragraph (b)(3)(v) of this section, the small 
business issuer preparing the disclosure required by this paragraph may 
presume that investors have read or have access to the discussion of 
critical accounting estimates in its most recently filed Form 10-KSB 
and any of its subsequent Forms 10-QSB.
    3. All information provided under paragraph (b)(3) of this section 
must be presented in clear, concise format and language that is 
understandable to the average investor. The information provided in 
this section must not be presented, for example: only as a general 
discussion of multiple critical accounting estimates in the aggregate 
or of multiple new accounting policies in the aggregate; as boilerplate 
disclosures that do not specifically address the small business 
issuer's particular circumstances and operations; as lists of 
accounting estimates relating to each material line item in the small 
business issuer's financial statements; or as disclosures that consist 
principally of disclaimers of legal liability for the small business 
issuer's preparation of critical accounting estimates or initial 
application of an accounting policy.
    4. Refer to the Commission's release number 33-______ dated______, 
200__ (adopting paragraph (b)(3) of this section) for guidance in 
preparing the disclosure relating to critical accounting estimates in 
this MD&A.

Instructions to Item 303

* * * * *
    2. Your response to this Item requires you to make certain forward-
looking statements. Examples include, but are not limited to: a small 
business issuer's disclosure of the reasonably possible, near-term 
changes in assumptions underlying accounting estimates; a discussion of 
the assumptions underlying an estimate that involve, for example, 
projections of future sales; and a discussion of the expected effect if 
a known uncertainty were to come to fruition and result in a change in 
management's assumptions. If the terms and conditions of Section 27A of 
the Securities Act (15 U.S.C. 77z-2), Section 21E of the Exchange Act 
(15 U.S.C. 78u-5), Sec. 230.175 of this chapter or Sec. 249.3b-6 of 
this chapter are satisfied, forward-looking statements would be 
entitled to the safe harbor protection. Small business issuers are 
encouraged to consider the terms, conditions and scope of those safe 
harbors when drafting disclosure, particularly when preparing 
disclosure under the provisions of paragraph (b)(3) of this section.

PART 229--STANDARD INSTRUCTIONS FOR FILING FORMS UNDER SECURITIES 
ACT OF 1933, SECURITIES EXCHANGE ACT OF 1934 AND ENERGY POLICY AND 
CONSERVATION ACT OF 1975--REGULATION S-K

    3. The general authority citation for Part 229 is revised to read 
as follows:

    Authority: 15 U.S.C. 77e, 77f, 77g, 77h, 77j, 77k, 77s, 77z-2, 
77z-3, 77aa(25), 77aa(26), 77ddd, 77eee, 77ggg, 77hhh, 77iii, 77jjj, 
77nnn, 77sss, 78c, 78i, 78j, 78l, 78m, 78n, 78o, 78u-5, 78w, 
78ll(d), 78mm, 79e, 79j, 79n, 79t, 80a-8, 80a-9, 80a-20, 80a-29, 
80a-30, 80a-31(c), 80a-37, 80a-38(a), 80a-39 and 80b-11, unless 
otherwise noted.
* * * * *
    4. Section 229.303 is amended by:
    a. Removing the authority citation following Sec. 229.303;
    b. Removing Instruction 7 of ``Instructions to Paragraph 303(a)'' 
and Instruction 6 of ``Instructions to Paragraph (b) of Item 303;''
    c. Redesignating Instructions 8 through 12 of ``Instructions to 
Paragraph 303(a)'' as Instructions 7 through 11; and
    d. Adding paragraph (c).
    The addition reads as follows:


Sec. 229.303    (Item 303) Management's discussion and analysis of 
financial condition and results of operations.

* * * * *
    (c) The application of critical accounting policies.
    (1) Annual reports, registration statements and proxy and 
information statements. In an annual report filed under the Exchange 
Act, an annual report to shareholders prepared under Sec. 240.14a-3 or 
Sec. 240.14c-3 of this chapter, a registration statement filed under 
the Securities Act or the Exchange Act, or a proxy or information 
statement filed under the Exchange Act, include a separately-captioned 
section in ``Management's Discussion and Analysis of Financial 
Condition and Results of Operations'' setting forth the disclosure 
regarding the registrant's application of critical accounting policies 
required by paragraphs (c)(3) and (c)(4) of this section. Except as 
otherwise stated, the discussion must cover the financial statements 
for the most recent fiscal year and any subsequent period for which 
interim period financial statements are required to be included.
    (2) Definitions.
    (i) Accounting estimate. As used in paragraph (c) of this section, 
the term accounting estimate means an approximation made by management 
of a financial statement element, item or account in the financial 
statements.

[[Page 35650]]

    (ii) Critical accounting estimate. An accounting estimate 
recognized in the financial statements presented is a critical 
accounting estimate for purposes of this section if:
    (A) The accounting estimate requires the registrant to make 
assumptions about matters that are highly uncertain at the time the 
accounting estimate is made; and
    (B) Different estimates that the registrant reasonably could have 
used in the current period, or changes in the accounting estimate that 
are reasonably likely to occur from period to period, would have a 
material impact on the presentation of the registrant's financial 
condition, changes in financial condition or results of operations.
    (iii) Near-term. As used in paragraph (c) of this section, the term 
near-term means a period of time going forward up to one year from the 
date of the financial statements.
    (iv) Reasonably possible. As used in paragraph (c) of this section, 
the term reasonably possible means the chance of a future transaction 
or event occurring is more than remote but less than likely.
    (3) Disclosure regarding critical accounting estimates. For each 
critical accounting estimate:
    (i) Identify and describe the accounting estimate. Describe the 
methodology underlying the accounting estimate. Describe the 
assumptions underlying the accounting estimate that relate to matters 
highly uncertain at the time the estimate was made. Describe any other 
underlying assumptions that are material. Discuss any known trends, 
demands, commitments, events or uncertainties that are reasonably 
likely to occur and materially affect the methodology or assumptions 
described. Disclose, if applicable, why different estimates that would 
have had a material impact on the registrant's financial presentation 
could have been used in the current period. Describe, if applicable, 
why the accounting estimate is reasonably likely to change from period 
to period with a material impact on the financial presentation;
    (ii) Explain the significance of the accounting estimate to the 
registrant's financial condition, changes in financial condition and 
results of operations and, where material, identify the line items in 
the financial statements affected by the accounting estimate;
    (iii)(A) Present either:
    (1) A quantitative discussion of changes in overall financial 
performance, and to the extent material the line items in the financial 
statements, assuming that reasonably possible near-term changes occur, 
both negative and positive (where applicable), in the most material 
assumption or assumptions underlying the accounting estimate; or
    (2) A quantitative discussion of changes in overall financial 
performance, and to the extent material the line items in the financial 
statements, assuming that the accounting estimate was changed to the 
upper end and the lower end of the range of reasonable possibilities 
determined by the registrant in the course of formulating its recorded 
estimate; and
    (B) Discuss the impact, if material, on the registrant's liquidity 
or capital resources if any of the changes being assumed for purposes 
of satisfying paragraph (c)(3)(iii)(A)(1) or paragraph 
(c)(3)(iii)(A)(2) of this section were in effect;
    (iv) Present a quantitative and qualitative discussion of any 
material changes made to the accounting estimate in the past three 
years (or in the past two years for any filing made before [one year 
after the effective date of the final rule]), describe the reasons for 
the changes and discuss the effect on line items in the financial 
statements and overall financial performance;
    (v) Disclose whether or not the registrant's senior management has 
discussed the development and selection of the critical accounting 
estimates, and the MD&A disclosure regarding them, with the audit 
committee of the registrant's board of directors (or the equivalent 
oversight group). If the senior management has not had these 
discussions, disclose the reasons why not; and
    (vi) If the registrant operates in more than one segment, identify 
the disclosed segments that the accounting estimate affects. To the 
extent that the disclosure under the requirements of paragraph (c) of 
this section only on a company-wide basis would result in an omission 
that renders the disclosure materially misleading, include a separate 
discussion on a segment basis for the identified segments of the 
registrant's business about which disclosure is otherwise required.
    (4) Disclosure regarding initial adoption of an accounting policy. 
If an accounting policy initially adopted by the registrant (other than 
those solely resulting from the adoption of new accounting literature 
issued by a recognized accounting standard setter) had a material 
impact on its financial condition, changes in financial condition or 
results of operations, disclose:
    (i) The events or transactions that gave rise to the initial 
adoption;
    (ii) The accounting principle that has been adopted and the method 
of applying that principle;
    (iii) The impact, qualitatively, on the financial condition, 
changes in financial condition and results of operations of the 
registrant;
    (iv) If the registrant is permitted a choice between acceptable 
accounting principles, an explanation it made such a choice, what the 
alternatives were, and why it made the choice that it did (including, 
where material, qualitative disclosure of the impact on financial 
condition, changes in financial condition and results of operations 
that alternatives would have had); and
    (v) If no accounting literature exists that governs the accounting 
for the events or transactions giving rise to the initial adoption, an 
explanation of the registrant's decision regarding which accounting 
principle to use and which method of applying that principle to use.
    (5) Quarterly reports. In a quarterly report on Form 10-Q 
(Sec. 249.308a of this chapter), in a separately-captioned section of 
``Management's Discussion and Analysis of Financial Condition and 
Results of Operations,'' disclose:
    (i) For any critical accounting estimate that was not previously 
discussed as a critical accounting estimate in the MD&A section of the 
registrant's last Form 10-K (Sec. 249.310 of this chapter) or any of 
its subsequent Forms 10-Q, the information required by paragraph (c)(3) 
of this section; and
    (ii) For any critical accounting estimate previously discussed as a 
critical accounting estimate in the MD&A section of the registrant's 
last Form 10-K or any of its subsequent Forms 10-Q, any material change 
to that prior disclosure (other than disclosure under paragraph 
(c)(3)(iv) of this section) necessary to make that disclosure not 
materially misleading as of the time the registrant files its Form 10-Q 
for the current fiscal quarter.
    Instructions to paragraph (c) of Sec. 229.303:
    1. The changes being assumed in connection with paragraph 
(c)(3)(iii)(A) of this section must be meaningful and therefore may not 
be so minute as to avoid, or materially understate, any demonstration 
of sensitivity.
    2. Your response to this section requires you to make certain 
forward-looking statements. Examples include, but are not limited to: a 
registrant's disclosure of the reasonably possible, near-term changes 
in its assumptions underlying accounting estimates; a discussion of the 
assumptions underlying an estimate that involve, for example, 
projections of future sales; and

[[Page 35651]]

a discussion of the expected effect if a known uncertainty were to come 
to fruition and result in a change in management's assumptions. If the 
terms and conditions of Section 27A of the Securities Act (15 U.S.C. 
77z-2), Section 21E of the Exchange Act (15 U.S.C. 78u-5), Sec. 230.175 
of this chapter or Sec. 249.3b-6 of this chapter are satisfied, 
forward-looking statements would be entitled to the safe harbor 
protection. Registrants are encouraged to consider the terms, 
conditions and scope of those safe harbors when drafting disclosure, 
particularly when preparing disclosure under the provisions of 
paragraph (c) of this section.
    3. For purposes of paragraph (c)(5) of this section, the registrant 
preparing the disclosure required by this paragraph may presume that 
investors have read or have access to the discussion of critical 
accounting estimates in its most recently filed Form 10-K and any of 
its subsequent Forms 10-Q.
    4. All information provided under paragraph (c) of this section 
must be presented in clear, concise format and language that is 
understandable to the average investor. The information provided in 
this section must not be presented, for example: only as a general 
discussion of multiple critical accounting estimates in the aggregate 
or of multiple new accounting policies in the aggregate; as boilerplate 
disclosures that do not specifically address the registrant's 
particular circumstances and operations; as lists of accounting 
estimates relating to each material line item in the registrant's 
financial statements; or as disclosures that consist principally of 
disclaimers of legal liability for the preparation of the registrant's 
critical accounting estimates or initial application of an accounting 
policy.
    5. Refer to the Commission's release number 33-______ dated______, 
200__ (adopting paragraph (c) of this section) for guidance in 
preparing the disclosure relating to critical accounting estimates in 
this MD&A.

PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934

    5. The authority citation for Part 249 continues to read, in part, 
as follows:

    Authority: 15 U.S.C. 78a et seq., unless otherwise noted.
* * * * *
    6. Form 20-F (referenced in Sec. 249.220f), Item 5 is amended by:
    a. Adding paragraph E.,
    b. Adding a sentence to the end of Instruction 2 of Instructions to 
Item 5,
    c. Removing Instruction 3 of Instructions to Item 5, and
    d. Adding Instructions to Item 5.E. to read as follows:

    Note: Form 20-F does not, and this amendment will not, appear in 
the Code of Federal Regulations.

Form 20-F

* * * * *

Item 5. Operating and Financial Review and Prospects

* * * * *

E. The application of critical accounting policies.

    1. Disclosure requirement in annual reports and registration 
statements. In an annual report filed under the Exchange Act or a 
registration statement filed under the Securities Act or the Exchange 
Act, include a separately-captioned section in ``Operating and 
Financial Review and Prospects'' setting forth the disclosure regarding 
the company's application of critical accounting policies required by 
Item 5.E.3. and Item 5.E.4. of this Form. Except as otherwise stated, 
the discussion must cover the financial statements for the most recent 
fiscal year and any subsequent period for which interim period 
financial statements are required to be included.
    2. Definitions.
    (a) Accounting estimate. As used in Item 5.E., the term accounting 
estimate means an approximation made by management of a financial 
statement element, item or account in the financial statements.
    (b) Critical accounting estimate. An accounting estimate recognized 
in the financial statements presented is a critical accounting estimate 
for purposes of this Item if:
    (i) the accounting estimate requires the company to make 
assumptions about matters that are highly uncertain at the time the 
accounting estimate is made; and
    (ii) different estimates that the company reasonably could have 
used in the current period, or changes in the accounting estimate that 
are reasonably likely to occur from period to period, would have a 
material impact on the presentation of the company's financial 
condition, changes in financial condition or results of operations.
    (c) Near-term. As used in Item 5.E.3., the term near-term means a 
period of time going forward up to one year from the date of the 
financial statements.
    (d) Reasonably possible. As used in Item 5.E.3., the term 
reasonably possible means the chance of a future transaction or event 
occurring is more than remote but less than likely.
    3. Disclosure regarding critical accounting estimates. For each 
critical accounting estimate:
    (a) Identify and describe the accounting estimate. Describe the 
methodology underlying the accounting estimate. Describe the 
assumptions underlying the accounting estimate that relate to matters 
highly uncertain at the time the estimate was made. Describe any other 
underlying assumptions that are material. Discuss any known trends, 
demands, commitments, events or uncertainties that are reasonably 
likely to occur and materially affect the methodology or assumptions 
described. Disclose, if applicable, why different estimates that would 
have had a material impact on the company's financial presentation 
could have been used in the current period. Describe, if applicable, 
why the accounting estimate is reasonably likely to change from period 
to period with a material impact on the financial presentation.
    (b) Explain the significance of the accounting estimate to the 
company's financial condition, changes in financial condition and 
results of operations and, where material, identify the line items in 
the financial statements affected by the accounting estimate.
    (c)(1) Present either:
    (i) A quantitative discussion of changes in overall financial 
performance, and to the extent material the line items in the financial 
statements, assuming that reasonably possible near-term changes occur, 
both negative and positive (where applicable), in the most material 
assumption or assumptions underlying the accounting estimate; or
    (ii) A quantitative discussion of changes in overall financial 
performance, and to the extent material the line items in the financial 
statements, assuming that the accounting estimate was changed to the 
upper end and the lower end of the range of reasonable possibilities 
determined by the company in the course of formulating its recorded 
estimate; and
    (2) Discuss the impact, if material, on the company's liquidity or 
capital resources if any of the changes being assumed for purposes of 
satisfying paragraph 5.E.3.(c)(1)(i) or paragraph 5.E.3.(c)(1)(ii) of 
this Item were in effect.
    (d) Present a quantitative and qualitative discussion of any 
material changes made to the accounting estimate in the past three 
years (or in the past two years for any filing made before [one year 
after the effective date of the final rule]), describe the reasons for 
the changes and discuss the effect on

[[Page 35652]]

line items in the financial statements and overall financial 
performance.
    (e) Disclose whether or not your senior management has discussed 
the development and selection of the critical accounting estimates, and 
the MD&A disclosure regarding them, with the audit committee of your 
board of directors (or the equivalent oversight group). If your senior 
management has not had these discussions, disclose the reasons why not.
    (f) If the company operates in more than one segment, identify the 
disclosed segments that the accounting estimate affects. To the extent 
that the disclosure under the requirements of this Item 5.E. made only 
on a company-wide basis would result in an omission that renders the 
disclosure materially misleading, include a separate discussion on a 
segment basis for the identified segments of your business about which 
disclosure is otherwise required.
    4. Disclosure regarding initial adoption of an accounting policy. 
If an accounting policy initially adopted by the company (other than 
those solely resulting from the adoption of new accounting literature 
issued by a recognized accounting standard setter) had a material 
impact on its financial condition, changes in financial condition or 
results of operations, disclose:
    (a) The events or transactions that gave rise to the initial 
adoption;
    (b) The accounting principle that has been adopted and the method 
of applying that principle;
    (c) The impact, qualitatively, on the financial condition, changes 
in financial condition and results of operations of the company;
    (d) If the company is permitted a choice between acceptable 
accounting principles, an explanation it made such a choice, what the 
alternatives were, and why it made the choice that it did (including, 
where material, qualitative disclosure of the impact on financial 
condition, changes in financial condition and results of operations 
that alternatives would have had); and
    (e) If no accounting literature exists that governs the accounting 
for the events or transactions giving rise to the initial adoption, an 
explanation of the company's decision regarding which accounting 
principle to use and which method of applying that principle to use.
    Instructions to Item 5: * * *
    2. * * * With respect to the disclosure under Item 5.E., although 
the discussion would focus on the primary financial statements, you 
also must consider any reconciliation to U.S. GAAP and include 
disclosure required under Item 5.E. for any critical accounting 
estimate that is related to the application of U.S. GAAP and for any 
initial adoption of an accounting policy that is related to the 
application of U.S. GAAP.
    Instruction to Item 5.A:
* * * * *
    Instructions to Item 5.E:
    1. The changes being assumed in connection with Item 5.E.3.(c)(1) 
must be meaningful and therefore may not be so minute as to avoid, or 
materially understate, any demonstration of sensitivity.
    2. Item 5 requires you to make certain forward-looking statements. 
Examples of forward-looking statements include, but are not limited to: 
a company's disclosure of the reasonably possible, near-term changes in 
its assumptions underlying accounting estimates; a discussion of the 
assumptions underlying an estimate that involve, for example, 
projections of future sales; and a discussion of the expected effect if 
a known uncertainty were to come to fruition and result in a change in 
management's assumptions. If the terms and conditions of Section 27A of 
the Securities Act (15 U.S.C. 77z-2), Section 21E of the Exchange Act 
(15 U.S.C. 78u-5), Sec. 230.175 of this chapter or Sec. 249.3b-6 of 
this chapter are satisfied, forward-looking statements would be 
entitled to the safe harbor protection. Companies are encouraged to 
consider the terms, conditions and scope of those safe harbors when 
drafting disclosure, particularly when preparing disclosure under the 
provisions of Item 5.E.
    3. All information provided under Item 5.E. must be presented in 
clear, concise format and language that is understandable to the 
average investor. The information provided in Item 5.E. must not be 
presented, for example: only as a general discussion of multiple 
critical accounting estimates in the aggregate or of multiple new 
accounting policies in the aggregate; as boilerplate disclosures that 
do not specifically address the company's particular circumstances and 
operations; as lists of accounting estimates relating to each material 
line item in the company's financial statements; or as disclosures that 
consist principally of disclaimers of legal liability for the company's 
preparation of critical accounting estimates or initial application of 
an accounting policy.
    4. Refer to the Commission's release number 33-______ dated______, 
200__ (adopting Item 5.E.) for guidance in preparing the disclosure 
relating to critical accounting estimates in this discussion and 
analysis by management of the company's financial condition, changes in 
financial condition and results of operations.
* * * * *

    Dated: May 10, 2002.

    By the Commission.
 Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-12259 Filed 5-17-02; 8:45 am]
BILLING CODE 8010-01-P