The New MD&A Rule: Part Five – Off-Balance Sheet Arrangements

In this post, we overviewed the changes to MD&A in the SEC’s Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information Final Rule. This rule was published in the Federal Register on January 11, 2021.  It is effective for filings on or after February 10, 2021.

The rule’s transition provisions include a mandatory transition date but also allow voluntary early compliance.  The mandatory transition date is each company’s first fiscal year that ends after August 9, 2021, 210 days after the effective date.  Companies may voluntarily apply the new rule, on an S-K item-by-item basis, in any filing made on or after the effective date of February 10, 2021.

This means a company that files a Form 10-K on or after February 10, 2021, has the option to early implement this new MD&A (S-K Item 303) guidance.  Even if a company does not implement the rule early, it is not too soon to start planning for any required changes.

In the second, third and fourth posts in this series, we reviewed and discussed the addition of an objective to S-K Item 303, the new critical accounting estimate disclosures, and changes to results of operations and known trend discussions.

This fifth post addresses the SEC’s proposed changes to disclosures about off-balance sheet arrangements or OBAs.

The history of OBA disclosures is deeply entwined with the history of one company, Enron.  When MD&A was created in 1980, well before Enron made news, it required discussion of OBAs via this requirement in S-K Item 303(a) for capital resources:

(2) Capital resources. (i) Describe the registrant’s material commitments for capital expenditures as of the end of the latest fiscal period, and indicate the general purpose of such commitments and the anticipated source of funds needed to fulfill such commitments.

(ii) Describe any known material trends, favorable or unfavorable, in the registrant’s capital resources. Indicate any expected material changes in the mix and relative cost of such resources. The discussion shall consider changes between equity, debt and any off-balance sheet financing arrangements.

Even with this requirement, Enron demonstrated that companies did not always robustly disclose these risks.  In the wake of Enron’s use of OBAs, Congress wrote new requirements into the Sarbanes-Oxley Act to expand OBA disclosures.  The SEC implemented this requirement via a new paragraph 4 in S-K Item 303, which starts with this language:

(4) Off-balance sheet arrangements. (i) In a separately-captioned section, discuss the registrant’s off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the registrant’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.

While the term off-balance sheet arrangements can be interpreted in several ways, S-K Item 303(a) limits this disclosure to four very technical areas:

(ii) As used in this paragraph (a)(4), the term off-balance sheet arrangement means any transaction, agreement or other contractual arrangement to which an entity unconsolidated with the registrant is a party, under which the registrant has:

(A) Any obligation under a guarantee contract that has any of the characteristics identified in FASB ASC paragraph 460-10-15-4 (Guarantees Topic), as may be modified or supplemented, and that is not excluded from the initial recognition and measurement provisions of FASB ASC paragraphs 460-10-15-7, 460-10-25-1, and 460-10-30-1.

(B) A retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to such entity for such assets;

(C) Any obligation, including a contingent obligation, under a contract that would be accounted for as a derivative instrument, except that it is both indexed to the registrant’s own stock and classified in stockholders’ equity in the registrant’s statement of financial position, and therefore excluded from the scope of FASB ASC Topic 815, Derivatives and Hedging, pursuant to FASB ASC subparagraph 815-10-15-74(a), as may be modified or supplemented; or

(D) Any obligation, including a contingent obligation, arising out of a variable interest (as defined in the FASB ASC Master Glossary), as may be modified or supplemented) in an unconsolidated entity that is held by, and material to, the registrant, where such entity provides financing, liquidity, market risk or credit risk support to, or engages in leasing, hedging or research and development services with, the registrant.

Over time the FASB began to require financial statement disclosures about many of these areas.  In the Final Rule the SEC notes:

Since the adoption of Item 303(a)(4), as described further in the Proposing Release, the FASB has issued additional requirements that have caused U.S. GAAP to further overlap with the item. In the Commission staff’s experience, this overlap often leads to registrants providing cross-references to the relevant notes to their financial statements or providing disclosure that is duplicative of information in the notes in response to Item 303(a)(4).

The SEC also includes this rationale for the change:

For the reasons discussed in the Proposing Release, we continue to believe that the updates to U.S. GAAP since the adoption of Item 303(a)(4), as well as the current amendments designed to emphasize the principles-based nature of MD&A, justify the replacement of the current, more prescriptive requirement with a principles-based instruction.

The new MD&A guidance removes the old disclosure in paragraph (a)(4) and adds this instruction to S-K Item 303:

  1. Discussion of commitments or obligations, including contingent obligations, arising from arrangements with unconsolidated entities or persons that have or are reasonably likely to have a material current or future effect on a registrant’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, cash requirements or capital resources must be provided even when the arrangement results in no obligations being reported in the registrant’s consolidated balance sheets. Such off-balance sheet arrangements may include: guarantees; retained or contingent interests in assets transferred; contractual arrangements that support the credit, liquidity or market risk for transferred assets; obligations that arise or could arise from variable interests held in an unconsolidated entity; or obligations related to derivative instruments that are both indexed to and classified in a registrant’s own equity under U.S. GAAP.

In theory, this change would eliminate disclosure that essentially duplicates information in the financial statement footnotes and would focus on the potential “future effect” such arrangements might have.  The opportunity to improve MD&A here focuses on eliminating information that is already in the financial statements and making MD&A disclosure more focused on risk and how OBAs might affect future financial position and performance.

As always, your thoughts and comments are welcome!

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