Analyze this: MD & A table of contractual obligations; Financial Executives Research Foundation (FERF) studied companies responses to the MD & A requirement by reviewing annual reports and querying FEI members. One conclusion: companies are reporting similar transactions differently.

Has the Securities and Exchange Commission's attempt to make corporate annual reports' Management Discussion and Analysis (MD & A) section more useful to users been successful? Financial Executives Research Foundation (FERF) conducted a two-fold study to evaluate companies' responses to the requirement, based on both a review of annual reports and a survey of FEI members. While some progress has been made, additional questions remain.

The SEC expects its requirement--which took effect for fiscal years ending after Dec. 15, 2003--to help investors understand a company's current and future financial position and sources of liquidity. The requirement, Disclosure in Management's Discussion and Analysis (MD & A) About Off-Balance Sheet Arrangements and Aggregate Contractual Obligations (FR-67), mandates that companies disclose contractual obligations in a tabular format, listing expected future payments for a series of instruments, leases, purchase obligations and other long-term liabilities.

The impetus for this disclosure comes from The Sarbanes-Oxley Act of 2002, which mandated that the SEC require companies to disclose all off-balance-sheet transactions, arrangements and obligations that may have a material effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources or significant components of revenues or expenses. In November 2002, the SEC published a proposed rule that became the precursor to FR-67, which was issued on Jan. 28, 2003.

Cash Flow Table Required

The new rule requires companies to provide a "table" that reports the timing of future cash flows associated with 1) long-term debt, 2) capital leases, 3) operating leases, 4) purchase obligations and 5) other long-term liabilities reported on the balance sheet. Three of these items--long-term debt, capital leases and other long-term liabilities--appear as liabilities on the balance sheet. Operating leases are executed contracts that do not appear on the balance sheet. Purchase obligations, which have not been previously defined by generally accepted accounting principles (GAAP), are executory contracts, yet to be consummated.

FR-67 defines a purchase obligation as "an agreement to purchase goods or services that is enforceable and legally binding on the registrant, and that specifies all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction."

For purchase obligations subject to variable price provisions, the registrant should estimate the payments due and provide footnotes explaining payments subject to market risk, if material.

Companies should discuss any material termination or renewal provisions necessary for understanding the timing and amount of future payments. They should disclose purchase obligations even if they are expected to be satisfied with notes, drafts, acceptances, bills of exchange or other commercial instruments instead of cash. Items incurred in the ordinary course of business are not excluded from inclusion in the table.

The rule applies a disclosure threshold consistent with other MD & A requirements. To apply this disclosure threshold, management first identifies and analyzes its off-balance-sheet arrangements. Second, it assesses the likelihood of any known situations that could affect an off-balance-sheet arrangement.

If management concludes that the known situation is unlikely to occur, then no disclosure is required. If management cannot make that determination, it must evaluate the consequences of the known situation if it came to fruition.

Disclosure is required unless management determines that the situation is unlikely to have a material effect on the registrant's financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. See Figure 1 on this page for a more complete visual explanation.

Other Categories Allowed

While the table must include all obligations that fall within the five listed categories, companies may use other categories suitable to their businesses. Footnotes can be used to describe material contractual provisions or other information important to understanding the timing and amount of contractual obligations listed in the table.

The table need not include contingent liabilities and commitments. According to the SEC, an aggregate disclosure format, such as a table or text summary, would inevitably omit important information about the facts and circumstances surrounding contingent liabilities and commitments. Furthermore, small-business issuers are exempted from the requirement.

Companies are not required to include a full table of contractual obligations in interim reports unless there were material changes involved outside the ordinary course of business.

Trends in Applying FR-67

In order to learn more about trends in applying FR-67, a review of 90 annual reports was conducted to examine individual company disclosures. In addition, 59 FEI members were surveyed about their experiences applying the new rule.

The review, which included a wide range of companies in terms of both size and industry, revealed that slightly more than half examined reported three, four or five categories of contractual obligations. This is in line with the SEC's delineation of five categories in FR-67. A few of the largest companies reported as many as 14 or even 18 different categories.

The research also turned up interesting findings about how materiality thresholds were applied to purchase obligation items. For example, should companies include purchase orders in the table? Purchase orders that are enforceable and legally binding meet FR-67's definition of contractual obligations; however, they might not be material.

Furthermore, companies may not have systems in place to fully assess the future cash flows associated with purchase orders. Of the respondents to the FERF survey, 31 percent indicated that they included all instances of open purchase orders as of yearend; 41 percent did not include open purchase orders; and 28 percent used a materiality threshold. One respondent indicated that having reported obligations under blanket purchase orders supported by cancellation penalties to the extent of the penalty.

In assessing the materiality limits for purchasing obligations, companies used a wide variety of measures, including percentage of revenues (19 percent), percentage of net income (15 percent) and percentage of assets (11 percent).

The study provides names of common categories of contractual obligations not mentioned in the rule. The most common item encountered in both the survey and review was payments for pension and other post-employment benefits. D. Reed Wilson, senior financial advisor at ExxonMobil Corp., notes that existing MD & A tabular disclosure was modified to include asset retirement and pension obligations, in addition to take-or-pay obligations. The obligations are cross-referenced to related financial statement footnotes.

Approximately 11 percent of the respondents indicated that they had reported contingent liabilities or payments associated with litigation, settlements or environmental liabilities. As noted above, the SEC does not require inclusion of contingent liabilities in the table. Also common were:

* Commitments to fund investments and mortgage loans

* Payments under systems maintenance contracts

* Construction contracts

* Long-term supply contracts

Figure 2 lists more unusual categories found.

The review resulted in other observations about reporting trends. For example, many companies reconciled their tables to liabilities reported in the balance sheet, while others indicated whether each item was recorded in the balance sheet. Two companies did not indicate total payments due, a reasonable practice because of time-value-of-money concerns.

Many companies reported both a table of contractual commitments and a separate table of commercial commitments, per the Commission Statement about Management's Discussion and Analysis of Financial Condition and Results of Operations (FR-61). The latter table, reported mostly by financial services companies, is designed to summarize off-balance-sheet lending-related financial instruments, such as lines of credit.

Conclusions

According to the SEC, the table of contractual obligations will help investors to assess a company's short- and long-term liquidity and capital resource needs and demands. It will provide a brief summary of future obligations, including those not currently reported as liabilities on the company's balance sheet (such as purchase obligations, payments for operating leases and contracted capital expenditures). Furthermore, the SEC believes that the table will improve an investor's ability to compare registrants.

The table may help investors because it collects disparate information about future cash outflows in one place. The financial statement user can now find, in one table, a list of long-term debt, capital leases, operating leases, other long-term liabilities and even purchase obligations, all categorized by due date. Previously, the user would need to look through the footnotes to find operating lease payments. Information about purchase obligations has not been previously disclosed.

However, the study indicates wide variation in practice, making comparisons between companies, at the present time, difficult, if not impossible, for analysts. The survey indicated that companies reported specific types of transactions in different ways.

For example, some companies included purchase orders in the table; some excluded them; and still others applied a materiality threshold. Similar variation was revealed with respect to take-or-pay contracts, audit/valuation/legal services, health care/benefit fees and contracts with senior management.

There was also some disparity among the survey participants in the reporting of pensions and other post-employment benefits. Many companies also categorize their contractual obligations differently.

Because of the complexity of the underlying transactions, disclosures about contractual obligations will probably always be confusing. In substance, just as there can be a fine line between capital leases (appearing on the balance sheet) and operating leases (not appearing on the balance sheet), there can be a fine line between the binding contracts that appear in the table and the nonbinding contracts that do not. On a practical level, these disparities will inevitably lead to wide variation in reporting.

Figure 1 Materiality Thresholds

Step 1  Identify and analyze off-balance sheet arrangements, including
        guarantee contracts, retained or contingent interests,
        derivative instruments and variable interests.
Step 2  Assess the likelihood of any known trend, demand, commitment,
        event or uncertainty that could affect an off-balance sheet
        arrangement. Is the known trend, demand, commitment, event or
        uncertainty reasonably likely to occur?
            No -- Disclosure not required
            Yes -- Disclosure required
            Cannot make determination--Objectively evaluate the
            consequences of the known trend, demand, commitment, event
            or uncertainty on the assumption that it will come to
            fruition. Is a material effect on the registrant's financial
            condition, changes in financial condition, revenues or
            expenses, results of operations, liquidity, capital
            expenditures or capital resources reasonably likely to
            occur?
            If you can't determine that occurence is likely or
            unlikely, you need to disclose.

Figure 2 Unusual purchase obligations

The FERF survey and review indicated many unusual categories of purchase
obligations, including the following:

Aircraft purchase commitments
Consulting fees
Deferred income tax
Rental car repurchases
Programming and talent commitments
Obligations to certain investee companies
Asset retirement obligations
Estimated Environmental Protection Agency fine
Power purchase agreements
Nuclear fuel agreements
Network affiliation agreements
Advertising and sponsorship agreements
Talent employment contracts

Dr. Mark P. Holtzman ([e-mail]) is Assistant Professor of Accounting at Seton Hall University. Cheryl de Mesa Graziano, CPA ([e-mail]) is Director of Research at Financial Executives Research Foundation.