Although each of the recent large business bankruptcies of public companies has unique circumstances accounting for its failure, most of the companies also have a common thread: the presence of off-balance sheet and contractual arrangements.

A review of news stories quickly draws attention to the fact that most have had one or more off-balance sheet arrangements or obligations. With the exception of those with alleged "accounting scandals," most companies did, in one way or another, disclose the off-balance sheet activity. However, questions persist that the content of those disclosures were not adequate enough for "average" investors or even institutional investors to make informed business decisions.

The authors of the Sarbanes-Oxley Act of 2002 (SOXA), and now more recently the Securities and Exchange Commission (SEC), have taken action to rectify the matter. By now, investors and professionals dealing with financial reporting should be familiar with SOXA. Enacted into law on July 30, 2002, SOXA represents the reaction of Congress to the recent corporate scandals and business failures.

Interestingly, more than a year after SOXA was signed into law, there is still confusion over the specific implementation and reporting of enforcement parameters of each of its many sections, as well as varying compliance effective dates. For example, §401(a) of SOXA (to be discussed further) required compliance for fiscal year-end reporting on or after June 15, 2003 (an exception for contractual obligations was extended to Dec. 15, 2003). However, the compliance period for §404 of SOXA, relating specifically to Internal Control Over Financial Reporting and Certification of Disclosures, was recently extended after the SEC released its final form "Rules" on June 6, 2003.

Would the existence of SOXA-type rules have prevented some of the larger financial and accounting scandals—e.g., Enron, Tyco and WorldCom—or could it have reduced the number of bankruptcies in recent years? Additionally, is the process of improving financial disclosures moving forward quickly enough to achieve SOXA's objectives of "transparency" and "accountability?" And most importantly, will the enactment of SOXA, including §401(a) and the SEC's new disclosure requirements related to off-balance sheet arrangements and aggregate contractual obligations, reduce the potential for scandal and more readily alert readers of financial statements, registration statements or proxy information to difficult financial transactions?

These are very difficult questions to address. The SEC has weighed in as required by SOXA in its recent release, "Disclosure in Management's Discussion and Analysis about Off-balance Sheet Arrangements and Aggregate Contractual Obligations."³ Before we dive into the SEC's requirements, let us begin with an overview of §401(a), Off-balance Sheet Arrangements and Aggregate Contractual Obligations.

Sarbanes-Oxley §401(a): Background Overview

SOXA is comprised of a number of sections and subsections covering matters ranging from establishing and defining the duties of the Public Company Accounting Oversight Board (§101, et al.) to regulating the actions of auditors (§201, et al.) to defining corporate responsibility for financial reporting (§301, et al.). Other parts of SOXA address SEC resources and authority and white-collar crime penalties. The §400 series specifically addresses disclosure and reporting issues.

Section 401(a) of SOXA added §13(j) to the Securities Exchange Act of 1934, which required the SEC to adopt final rules by Jan. 26, 2003, 180 days after the enactment. Section 401(a) relates specifically to "Disclosures in Periodic Reports; Disclosure Required: Each annual and quarterly financial report...shall disclose all material 'off-balance sheet transactions' and 'other relationships' with unconsolidated entities that may have a material current or future effect on the financial condition of the issuer."⁴ Another section of SOXA that is a direct result of Enron is §401(c): Study and Report on Special Purpose Entities. Section 401(c), however, is not addressed in the SEC's recent ruling.

The objective of §401(a) has been primarily achieved with the SEC's issuance of its final ruling on the additional required disclosures. These additional disclosures are directed at previously undisclosed off-balance sheet arrangements that expose a company to continuing risks or contingent liabilities. "The amendments require disclosure to improve investor's understanding of a company's overall financial condition, changes in financial condition and results of operations."⁵ In order to comply with the amendments, a registrant must provide an explanation of its off-balance sheet arrangements in a separately captioned subsection of the Management's Discussion and Analysis (MD&A) section of a registrants disclosure documents. Registrants (other than small business users) must also provide an overview of certain known contractual obligations in a tabular format.⁶

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

Required Disclosures

The adopted disclosure requirements were implemented to adhere to the principles found in the current reporting rules. The rules require that the registrant should disclose information that will provide investors with a clear understanding of the registrant's material off-balance sheet arrangements. The following items are now required:

• the business purpose of the off-balance sheet arrangements and the importance to a company's liquidity, capital resources, market or credit risk supports
• the overall magnitude of off-balance sheet activities
• the events that trigger contingent obligations or liabilities and the resulting financial impact
• termination or reduction events for arrangements that provide material benefits.⁷

What Is an Off-balance Sheet Arrangement?

An off-balance sheet arrangement is defined as an undisclosed transaction that may expose a company to risks or loss that are not fully transparent to investors. The following transactions are included under the definition of off-balance sheet arrangement:

• any obligation under certain guarantee contracts
• retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangements that serve as credit, liquidity or market risk support to that entity for such assets
• any obligation under certain derivative instruments
• any obligations arising out of a material variable interest held in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to the registrant, or engages in leasing, hedging or research and development services with the registrant.

Guarantees include any contract with one or more of the following characteristics:

• contracts that require payment based on changes in an "underlying" that is related to an asset, a liability or an equity security of the guaranteed party, a specified rate and security or commodity price
• performance guarantee
• indemnification agreements that require payments based on the changes to an "underlying"
• indirect guarantees that arise under an agreement that obligates the transfer of funds to another entity upon the occurrence of specified events (e.g., keepwell agreements)
• retained or contingent interests that are off-balance sheet arrangements where assets are transferred to an unconsolidated entity where the retained interests serve as credit, liquidity or market risk support for that entity
• derivative instruments that are used in structuring an off-balance sheet arrangement when registrant may issue or hold derivative instruments that are indexed to its stock and classified as stockholders' equity
• variable interest, defined as "contractual, ownership or other pecuniary interests in an entity that change with changes in the entity's net asset value." They are investments that will absorb a portion of an entity's expected losses if they occur or receive a portion of the entity's expected return if they occur.

Contractual Obligations

The SEC also now requires companies to aggregate information about obligations and commitments to make future payments under contracts, such as debt and lease agreements. The registrant must provide the information as of the latest fiscal year-end balance sheet date. In addition to the recommended table proposed by the SEC, footnotes should accompany the disclosure to describe material information necessary for an understanding of the timing and amount of the contractual obligations in the table.

Conclusion

Would the additional required disclosures have prevented some of the larger financial and accounting scandals and business failures? This question will continue to be a topic of debate, since in most cases, the dynamics of the circumstances exceed the scope of SOXA, §401(a) and the SEC's recent ruling.

Do the new rules move SOXA's objectives of "transparency" and "accountability" forward?

Along with the other issues raised earlier, this question is difficult to address in that the SEC's additional disclosure requirements are for the fiscal years ending June 15, 2003. It is too early to determine what impact, if any, the additional disclosures will have on how investors evaluate companies. However, it would seem that the additional disclosures and placement of those disclosures in the MD&A, if actually read by investors, should aid in achieving SOXA's objectives and what the authors will call "heightened awareness."

For further information and the comprehensive SEC ruling related to new disclosure rules, please refer to: https://www.sec.gov/rules/proposed/33-8114.htm and www.sec.gov/rules/final/33-8182.htm.

Footnotes

¹ Dan Wikel is a director in Huron Consulting Group LLC's Corporate Advisory Services practice. His experience has spanned a wide variety of debtor and creditor assignments in industry and as a consultant. Return to article

² Gavin Toepke is an analyst in Huron Consulting Group LLC's Corporate Advisory Services practice. Return to article

³ 17 CFR Parts 228, 229 and 249 (Release Nos. 33-8182; 34-47264; FR-67 International Series Release No. 1266 File No. S7-42-02). Return to article

⁴ Summary of Sarbanes-Oxley Act of 2002, Pub. L. 107-204-§401[15] U.S.C. SS78m (j). Return to article

⁵ Final Rule: Disclosure in (MD&A) about Off-balance Sheet Arrangements and Aggregate Contractual Obligations (www.sec.gov/rules/final/33-8182.htm). Return to article

⁶ Summary of Sarbanes-Oxley Act of 2002, Pub. L. 107-204-§401[15] U.S.C. SS78m (j). Return to article

⁷ Final Rule: Disclosure in (MD&A) about Off-balance Sheet Arrangements and Aggregate Contractual Obligations (www.sec.gov/rules/final/33-8182.htm). Return to article