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September 29, 2003 Mr. Alan Beller, Director Ms. Carol Stacey, Chief Accountant Division of Corporation Finance Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549-0609 Subject: FR-67, Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations The Committee on Corporate Reporting of Financial Executives International and the Financial Reporting Committee of the Institute of Management Accountants (the Committees) are writing to make the Commission aware of significant issues that have arisen regarding certain requirements of FR-67, Disclosure in Management's Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations. As our members are working on implementing the new rule, significant concerns have arisen regarding FR-67’s requirements to provide tabular disclosure of contractual purchase obligations. Those concerns include whether the requirement is consistent with the true objective of the Sarbanes-Oxley Act which prompted issuance of the rule, the costs of compliance and the relevance of the resulting disclosure. We believe that clarification of the scope of the requirement and inclusion of a materiality threshold for purchase obligations is not only appropriate, but is crucial to an orderly and consistent implementation of the disclosure. We therefore ask that the SEC Staff examine the language in FR-67 in light of the information presented herein and provide interpretive guidance that is responsive to these concerns. When the SEC issued the proposed rule (File No. S7-42-02) in late 2002, the objective was to put in place disclosures that complied with Section 401(a) of the Sarbanes-Oxley Act, which required the Commission to adopt final rules that require registrants to disclose: “…all material off-balance sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of the issuer with unconsolidated entities or other persons, that may have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenues or expenses.” Securities and Exchange Commission Page 2 September 29, 2003 Included in that rule proposal was a requirement to provide tabular disclosure of contractual obligations including “Unconditional Purchase Obligations” – a term that was left undefined in the proposal. The Commission requested comment on whether it should provide a definition and, if so, what that definition should include. The proposal provided no specific guidance on materiality related to items included in the table. Other parts of the proposal provided comforting language that led most respondents to assume that customary notions of materiality would apply to the tabular disclosure. Those included statements like “…[off balance sheet obligations are required to be disclosed when] they may have a current or future material effect on the company’s financial condition, results of operations, revenues or expenses, liquidity, capital expenditures or capital resources,” and the Staff’s concerns that “an overly broad definition [of off-balance sheet arrangements] could elicit unnecessarily voluminous and repetitive disclosure.” The Commission’s analysis of the costs of compliance also provided comfort that the disclosure obligations were not intended to be onerous: the Staff concluded that the cost would average approximately $5,000 per company. Accordingly, the proposed tabular disclosure did not attract significant attention from companies and organizations that were in a position to respond to the rule. In contrast to the proposal, the final rule provides an expansive and complex definition of purchase obligations that, for most large companies, has the potential to capture hundreds of thousands of executory contracts. Because FR-67 provides no materiality threshold for the aggregation of purchase obligations, and provides no scope exception for executory contracts entered into in the ordinary course of business, our members have struggled with how to implement the requirement and many of them have raised significant concerns about this provision. In addition, this provision is difficult to reconcile with other parts of the rule. For example, Section II B 4 states that "…the definition of purchase obligations is designed to capture the registrant's capital expenditures for purchases of goods or services over a five-year period.” In Section II B 1, the Staff notes “We agree that certain modifications to the proposed definition [of off-balance sheet arrangements] are necessary to eliminate disclosure of routine arrangements that could obscure more meaningful information.” The rule assumes that information about these contracts is readily available because “management should be fully apprised of off-balance-sheet arrangements and contractual obligations in the ordinary course of managing the company, maintaining adequate internal controls and preparing financial statements.” While this may be true for purchase obligations that truly are material to the registrant, it is an inaccurate characterization for the vast majority of the population of contracts covered by this rule. These include ordinary course of business contracts for services (e.g., custodial, food, maintenance, legal), non-inventoried goods (e.g., supplies, stationary), and utilities (e.g., electricity, telecom) that occur in large volumes but immaterial amounts. Such contracts are typically managed in the aggregate and are very rarely included in any system that could provide for systematic retrieval necessary to comply cost effectively with the requirements of FR-67. Rather, much of this required analysis can only be conducted by opening file drawers, reading the contracts, analyzing the obligations, developing estimates of required cash flows, and reporting that information along with relevant details (e.g., significant terms, termination and renewal provisions, etc.) to be aggregated across the consolidated entity. One of our members provided a sample of the range of contracts covered by this disclosure, which is attached at the conclusion of this letter. While that list is representative of the potential scope of the rule for one registrant, it is by no means comprehensive. Securities and Exchange Commission Page 3 September 29, 2003 As issues began to surface regarding this requirement, FEI and IMA asked their members for additional information about the difficulties they were having with this disclosure. The comments we received from companies confirmed that the population of executory contracts covered by the rule is indeed large and diverse. Moreover, the effort required to identify, analyze, review and disclose will require a large-scale resource commitment to comply. Based on our review, we are certain that the estimates that justified FR-67 as cost-effective are materially understated. The following comments from two large public companies that responded are illustrative of these concerns. Registrant A: “We have over 1,000 reporting units and while we have a centralized procurement function, certain commitments are made outside of this function. In addition, there are numerous systems that are used. Many of our commitments are made on spot purchases that can have thousands of items outstanding at any point in time. Commitments can include a wide variety of purchases e.g., raw materials, insurance, legal retainers, leases, etc. These all have different handling and since the disclosure requires some separation, analysis would be required to ensure there is no double counting. Long-term commitments will have to be aged. Many of them have variable prices, which will have to be estimated. There is no centralized system that accumulates this information on a real-time basis. We believe that the best way to accumulate the information will be through each reporting unit. We don't think it is unreasonable to estimate one FTE working on this for a week at each reporting unit. For some units this may understate the level of effort required. This would amount to about 50,000 hours for the whole corporation. However, if it turns out that this estimate is grossly over-stated and we use the estimate of 5.5 hours assumed in the rule and apply that to each reporting unit, the total time would still be in excess of 5,000 hours. The assumption underlying the rule appears to be that companies maintain an aged ledger of open purchase commitments from which a total amount can be obtained and simply dropped into the disclosure table. Since there is no balancing amount from which to reconcile, it is impossible to determine whether all items have been included. In order to comply, we will need to begin developing procedures for capturing the information now. However, because the population of commitments is always different at any given point in time, the actual data gathering will need to take place after the end of the year at a time when resources are stretched the thinnest.” Registrant B: “As a global organization, we undertook a study to estimate the potential impact of this requirement. Our findings were as follows: Purchase Orders. There were approximately 250,000-300,000 open purchase orders at the end of the most recent quarter. Not all purchase orders are firm commitments. As such, each would need to be examined manually to determine whether it qualifies. We estimate this annual effort, assuming no systemic solution, would require approximately 100,000 person-hours of effort (approximately 20 min per purchase order) with a cost of $5,000,000 ($50/hour). Purchase orders are in multiple systems (capital, expense, supply chain, etc.), platforms, and geographies covering over 350 legal entities. Documentation, Training and Process Design (excluding time to gather data on a quarterly basis): 200 person-hours to understand and document requirements (initial process for Securities and Exchange Commission Page 4 September 29, 2003 accumulating data), 800 person hours of effort for training. This includes multi-functional training (e.g., purchasing), which creates additional challenges since the base familiarity with accounting requirements is lower. Over a one-month period, we received 15-20 questions per day on off-balance sheet related issues. Total estimated cost for training is approximately $100,000 and will need to be continued in subsequent years.” Beyond data collection and analysis issues, there also is the difficulty of taking the aggregate data and translating it into a meaningful disclosure. We cannot conceive of a way to provide insightful, relevant disclosure about changes in cash flows associated with thousands of individually immaterial transactions. We are similarly challenged as to how to describe, in a transparent and helpful way, the key attributes (e.g., payments subject to market risk, material termination or renewal provisions) of this population in accordance with the rule’s requirements. This basket of contracts will move up and down with the acquisition of new businesses, divestitures of others, changes in the terms of arrangements, and the discovery of deficiencies in the collection mechanisms established solely to comply with this disclosure. The Committees note that the final disclosure requirements for purchase obligations are inconsistent with other MD&A rules and, as previously noted, the approach to materiality taken in other parts of the final rule. We are certain that the costs of tracking and reporting purchase obligations under this broad definition will far exceed the benefits of providing this information to investors. We therefore believe that it is important that the Commission undertake immediate steps to remedy this problem in a timely manner so that investor information needs are met in 2003 financial reports. We encourage the Staff to consult with knowledgeable representatives of registrants to refine its approach in a manner that is both cost-effective and consistent with the broader mandate of the Sarbanes-Oxley Act. In that regard, we would support disclosures of FAS 47 unconditional purchase obligations and other unconditional “take-or-pay” type obligations that are outside the ordinary course of business. Because capital expenditures often follow an irregular pattern and usually are unconditional, we believe such contracts should also be included. Although the approach we propose will require the development of new systems and processes, we strongly believe that restricting the scope to these areas will significantly moderate compliance costs while meeting the need for disclosure about obligations that have significant liquidity implications. The Committees understand the difficulties the Commission may have in implementing a change in a timely manner if it were necessary to undertake a change through rulemaking. We therefore recommend that the Staff consider the development of a Question and Answer document that could address this and other issues that have arisen with respect to FR-67. For example, a number of questions have been raised about the scope of the Long Term Liabilities line in the tabular disclosure. Some of our members believe that pension and OPEB liabilities are intended to be included, while others do not believe so; and if they are required to be included, it is not clear whether the disclosure for the former relates to plan contributions or benefit payments from the pension trust. A Q&A document would greatly assist implementation and improve the comparability of the resulting disclosures. Securities and Exchange Commission Page 5 September 29, 2003 ***** The Committees welcome the opportunity to continue an open dialogue on these issues and would be pleased to respond to any questions the Staff may have regarding this joint response. We note that FEI’s Committee on Corporate Reporting has a liaison meeting with Staff scheduled for October 17th and we would be pleased to discuss this matter further at that time. Sincerely, Frank Brod Mitchell A. Danaher Chair, Committee on Corporate Reporting Chair, Financial Reporting Committee Financial Executives International Institute of Management Accountants (989) 636-1541 (203) 373-3563 cc: Mr. Donald Nicolaisen, SEC Chief Accountant Securities and Exchange Commission Page 6 September 29, 2003 Contractual Obligations - Purchase Obligations General & Administrative Professional & consulting fees Audit services Valuation services System security assessment services Legal fee retainers Janitorial and maintenance services for property & facilities Catering services for employee cafeterias Health care / benefit administrative fees and management costs Office supplies contracts Telephone and cell phone vendor contracts Dues and memberships Contracts with senior management Costs to fulfill obligations from transactions resulting in deferred/unearned revenue Cost of Products & Services Network access contracts Advertising and sponsorships Affinity agreements Product royalties Union contracts with employees Capital Expenditures Information technology hardware and software infrastructure upgrades Warehousing equipment Warranty agreements Licenses for technology use Software licenses Maintenance commitments for hardware and software licenses Product Wholesale product for resale Financing Services Banking services - lockbox, line of credit etc. Credit scoring services for receivables Outsourcing Contracts IT services Administrative functions Security services Equipment maintenance and support Copier and duplicating equipment support The final regulation requires that a registrant disclose the significant terms and conditions of its obligating arrangements. This is difficult to do in any summarized manner. Contracts in each of the above categories could have multiple factors that govern the amount of payment obligations, the years in which such obligations arise, and the manner of calculating payment. By way of example, contracts can have both minimum purchase requirements and maximum guaranteed quantities to be provided, as well as either of these terms separately. Contracts can have minimum prices, maximum prices, variable pricing based on quantity purchased or inflation factors or market pricing with discounts or premiums included. Contracts can extend for several years with the obligations not defined to a specific year of the contract. Even within each type of contract above, there may be multiple vendors with whom a registrant holds obligations, and each contract could have different terms.
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