July 26, 2002

Mr. Jonathan G. Katz
Secretary
Securities and Exchange Commission
450 Fifth Street, NW
Washington, D.C. 20549-0609

Disclosure in Management's Discussion and Analysis about the
Application of Critical Accounting Policies
(Release Nos. 33-8098; 34-45907)
Commission File No. S7-16-02

Dear Mr. Katz:

We are pleased to comment on the proposed rule to require disclosure in Management's Discussion and Analysis (MD&A) of critical accounting estimates and the initial adoption of material accounting policies.

Ernst & Young shares the Commission's objective that financial and performance reporting should be transparent and understandable. We too believe that the quality, relevance and presentation of disclosures in the financial statements and MD&A should be challenged and improved. Accordingly, we supported implementation of the SEC's cautionary guidance on MD&A issued in December 2001 and January 2002. In our view, FR-60 and FR-61 were appropriate responses to investor concerns about corporate accounting and disclosure practices following Enron. Many public companies responded to the SEC's cautionary guidance by providing additional disclosures in MD&A, including additional disclosures about their critical accounting policies in response to FR-60.

The preparation of financial statements requires the extensive use of estimates by management, and notes to the financial statements contain disclosure to that effect. However, current accounting standards do not require extensive disclosure about the sensitivity of the financial statements to these estimates and the underlying assumptions. Given that accounting estimates are by their nature forward-looking, we share the SEC's view that MD&A provides an appropriate forum for management to discuss the basis for its forward-looking assumptions and the risks and uncertainties that are reasonably likely to affect those estimates in a material way. Ideally, the financial statements could provide these types of insight into accounting estimates, but unfortunately, current safe harbors would not apply to these disclosures if they were made in the financial statements.

While we support the basic thrust of the SEC's proposal, we are providing a number of suggestions to make the proposed MD&A disclosures about critical accounting estimates more focused and operational and to achieve the SEC's objective that the new MD&A disclosures be clear, concise and understandable. In addition, we have suggested the SEC reconsider the need for the proposed MD&A disclosures about communications with the audit committee and the initial adoption of accounting policies. Our comments and suggestions are discussed below.

Definition of Critical Accounting Estimate

The proposed definition of "critical accounting estimate" in S-K Item 303(c)(2)(ii) and S-B Item 303(b)(3)(ii)(B) includes accounting estimates that meet each of the following conditions:

"(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."

We recommend that condition (A) in the proposed definition be deleted. We do not believe that the term "highly uncertain" will be susceptible to consistent interpretation and application. Moreover, we believe that an accounting estimate could be a critical accounting estimate without meeting condition (A). For example, an accounting estimate (such as anticipated sales returns) may be subject to a reasonably narrow range of expected variability, but future experience different that than estimated still could have a material effect on the financial statements. In that case, we believe the accounting estimate should still be evaluated as to whether it is "critical," even though the related matters (i.e., future sales returns) are not considered "highly uncertain."

We also recommend that condition (B) be amended, as follows:

(B) Changes in the accounting estimate that are reasonably likely to occur, considering known trends and uncertainties, would have a material impact on the presentation of the registrant's financial condition, changes in financial condition or results of operations.

In this manner, critical accounting estimates would be defined in a way that is consistent with the well-established standard for MD&A disclosure about other currently known trends, events, demands and uncertainties that could affect the company's results of operations and liquidity. We do not believe that it is essential to define a critical accounting estimate as one where the registrant reasonably could have used a different estimate in the current period. If a range of reasonable estimates existed at the reporting date, it also would be reasonably likely that a material change in estimate could occur in the future.

Numerous accounting estimates still could fall within the definition of a critical accounting estimate, notwithstanding the SEC's commentary in the proposing release that the vast majority of companies would have only three to five critical accounting estimates. As a practical matter, we believe that the number of critical accounting estimates required to be discussed in MD&A should be subject to a guideline limit (e.g., maximum of five critical estimates). In that way, MD&A disclosures would be limited to the most critical accounting estimates.

Definition Should Exclude Certain Loss Contingencies

Critical accounting estimates, by any reasonable definition, may include those with respect to specific loss contingencies, such as pending or threatened litigation and asserted or unasserted claims and assessments, which currently are accounted for under FASB Statement 5 (FAS 5), Accounting for Contingencies. FAS 5 contingencies are highly uncertain by their nature and frequently there are several reasonably possible outcomes that would be materially different than the amount provided, if any. Related estimates are usually dependent on the ultimate decision of a third party (e.g., a court, a government agency, an arbitration panel, the counter-party in a dispute).

We do not believe it is necessary or appropriate to require additional disclosures in MD&A about the accounting estimates involving specific loss contingencies, particularly those arising from certain litigation, tax and environmental matters. Providing MD&A disclosures of the type proposed with respect to litigation, claims and assessments would place the registrant (and thus its shareholders) at a disadvantage when attempting to resolve these contingencies. Accordingly, we suggest that the scope of any required MD&A disclosure about critical accounting estimates exclude specific loss contingencies of the types identified in paragraphs 4.e and 4.f of FAS 5 (i.e., pending or threatened litigation, and actual or possible claims and assessments). We believe that the existing MD&A and GAAP requirements are sufficient to inform investors about the effects, and potential effects, on earnings and liquidity of these types of loss contingencies, while balancing the interests of current shareholders and creditors.

Sensitivity Analysis

The proposed disclosures about the sensitivity of the financial statements to critical accounting estimates in S-K Item 303(c)(3)(iii)(A) and S-B Item 303(b)(3)(iii)(C)(1) would require the presentation of 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."

We recommend that disclosure alternative (2) be eliminated. We suggest that the MD&A disclosure about critical accounting estimates focus solely on the implications to future financial performance should future experience differ from that assumed. In this manner, the MD&A disclosure about critical accounting estimates would be consistent with the required MD&A disclosures about the prospective implications of other known risks and uncertainties. Otherwise, the quantitative disclosures could take the form of "pro forma earnings" had different assumptions been used.

While we support the objective of the proposed sensitivity analysis, we are uncertain whether the proposed quantitative disclosures could be provided in all cases for each critical accounting estimate. We believe that many companies might have great difficulty generating the type of disclosures that would be required by the proposed rule, in a practical, cost-beneficial way that would be useful and understandable. For example, a company with numerous long-term contracts accounted for using the percentage of completion method relies heavily on estimates about future contract costs in reporting its financial results. It would be very difficult for such a company to provide quantitative disclosures about the effects of reasonably possible near term changes in such estimates, in the aggregate, assuming each contract were similarly affected, either positively or negatively. As another example, the estimation of the fair value of reporting units may be a critical accounting estimate for many companies with a material amount of goodwill. However, it would be very difficult for an issuer to quantify the potential amount of any impairment of its goodwill without also estimating the fair value of all of the assets and liabilities of the reporting unit. Accordingly, we recommend that the proposed quantitative disclosures be subject to a practicability exception. When quantification is not practicable, MD&A should include a qualitative discussion of the sensitivity of the financial statements to the critical accounting estimate.

Other Disclosures About Critical Accounting Estimates

The SEC has proposed a number of specific MD&A disclosures about each critical accounting estimate, including:

• The methodology underlying the accounting estimate,

• A description of the assumptions underlying the accounting estimate involving particular uncertainties,

• A description of other underlying assumptions that are material,

• Known trends, demands, commitments, events or uncertainties that are reasonably likely to occur and materially affect the estimate's methodology or assumptions,

• Why the accounting estimate is reasonably likely to change in the future with a material impact on the financial presentation,

• The significance of the accounting estimate to the registrant's financial statements and, where material, the affected line items in the financial statements,

• A quantitative and qualitative discussion of any material changes made to the accounting estimate in the past three years, including the reasons for the changes and the effect on line items in the financial statements and overall financial performance, and

• The segments affected by the accounting estimate (as well as each of above disclosures as it relates to the affected segment, to the extent that disclosure only on a company-wide basis would result in an omission that renders the disclosure materially misleading).

We are concerned that lengthy narrative disclosures about all aspects of each critical accounting estimate may detract from the more meaningful disclosure about the potential effects of future changes in the estimate. Accordingly, we believe that these specific items should be listed as disclosure considerations (to be provided if necessary to an understanding of the critical accounting estimate and its potential effects on the financial statements of the issuer), but they should not be required disclosures. For example, in our view, disclosures regarding the estimation methodology, the individual financial statement line items affected by the estimate, and the history of past changes in the estimate would not always be necessary to explain the sensitivity of the financial statements to future changes in the estimate.

Disclosures About Alternatives

The SEC solicited comment on whether MD&A should discuss:

• Whether a newly adopted accounting policy differs from that applied by others in the issuer's industry,

• The impact of the use of accounting methods not generally used by others in the issuer's industry,

• Upon the initial adoption of a material accounting policy, qualitative disclosure about the financial statement impacts that alternative accounting treatments would have had, and

• The impact of alternatives to the issuer's critical accounting policies.

As a practical matter, we believe that it would be very difficult for an issuer to discuss, in a meaningful way, differences in its accounting policies and practices from those of others in its industry or other alternatives that are also generally accepted. Such discussion also could detract from the more meaningful disclosure about the potential effects of future changes in the accounting estimate. Accordingly, we believe that disclosures of the type enumerated above should be listed as possible disclosure considerations, to the extent that the registrant believes that they could enhance the investor's understanding of the company's financial reporting, but they should not be required.

Audit Committee Involvement

The SEC has proposed that MD&A disclose whether or not management has discussed the development and selection of critical accounting estimates, and the related MD&A disclosures, with the issuer's audit committee. Statement on Auditing Standards No. 61, Communications with Audit Committees, as amended, already requires, among other things, that the auditor determine that the audit committee is informed about:

• the initial selection of and changes in significant accounting policies or their application,

• the methods used to account for significant unusual transactions and the effect of significant accounting policies in controversial or emerging areas for which there is a lack of authoritative guidance or consensus, and

• the process used by management in formulating particularly sensitive accounting estimates and the basis for the auditor's conclusions regarding the reasonableness of those estimates.

In addition, S-K Item 306(a)(2) requires the audit committee report, as part of the annual proxy statement, to disclose whether the audit committee has discussed with the independent auditors the matters required under SAS 61. As a result, we believe that existing auditing standards and SEC disclosures assure that audit committees are sufficiently engaged in communications about critical accounting policies and estimates. Accordingly, we do not see a benefit from MD&A containing essentially boilerplate disclosures about management and audit committee communications regarding critical accounting estimates. To the extent that the SEC determines that explicit disclosure is warranted regarding management's discussion with the audit committee about the development and selection of critical accounting estimates, and any related MD&A disclosures, we believe that such disclosures would be more appropriate within the audit committee report included in the proxy statement. To the extent that the SEC believes that existing S-K Item 306(a)(2) disclosures are not sufficiently informative, we recommend the SEC amend that Item to identify the nature of the communications required by SAS 61 (e.g., the selection of and changes in significant accounting principles, the basis for critical accounting estimates).

Initial Adoption of Accounting Policies

The SEC has proposed that MD&A include disclosures about the initial adoption of an accounting policy for new or different events and transactions. We believe that the financial statement footnotes are the more appropriate location for disclosures related to newly adopted accounting policies. We concur that a company should be able to justify its selection of a new accounting policy from the acceptable alternatives. To the extent that current GAAP does not require disclosures for new accounting policies similar to the disclosures required upon a change in accounting principle, we suggest that the FASB, as part of a short term "repairs and maintenance" project, require clear disclosure of the basis for a company's initial selection of a significant accounting policy. In that project, the FASB also could address the need for more insightful disclosures about accounting policies and estimates in the financial statement footnotes. In the meantime, we would support the issuance of an SEC staff accounting bulletin (SAB) to improve the quality of financial statement disclosures about newly adopted accounting policies.

Auditor Attestation to MD&A

The SEC solicited comment on the independent auditor's examination of the proposed MD&A disclosure about critical accounting policies. Although AICPA attestation standards have provided for the examination (or review) of MD&A by an independent accountant since March 1998, in practice attestation reports on MD&A have been rarely issued. Indeed, we recall only one instance in which our firm has issued such an attestation report on MD&A. In our view, market demand for such MD&A reports has not developed because the costs to registrants for obtaining such assurance outweigh the perceived benefits derived from such assurance.

However, we believe that auditor attestation beyond the financial statements deserves further consideration. We believe that issuers, investors and auditors should have the opportunity to comment separately on additional auditor attestation before the SEC proceeds with any related rulemaking. Accordingly, we would support issuance of a proposed rule, or preferably a concepts release, regarding auditor attestation subsequent to the SEC's adoption of its contemplated MD&A amendments and after an opportunity for practice to consider and adapt to the new MD&A disclosure requirements.

Conclusion

We share the SEC's concerns about the need to improve the quality and transparency of public company disclosure, both in the financial statements and MD&A. We encourage the SEC to adopt a balanced approach to improving the quality of MD&A, and we hope that our comments and recommendations will assist that effort.

* * * * *

We would be pleased to discuss our comments with the Commission or its staff at your convenience.

Very truly yours,

/s/ Ernst & Young LLP