July 19, 2002

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

Re:

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

Dear Mr. Katz:

            We are pleased to have this opportunity to comment on the release of the Securities and Exchange Commission, soliciting public comment on new rules addressing accounting estimates made by a company applying its accounting policies, including quantification of sensitivity to different assumptions, and the initial adoption by a company of an accounting policy that has a material impact on the company’s financial presentation¹ (the “Proposing Release”).

Summary

            We fully support the Commission’s goal of improving the quality of MD&A disclosure, including the proposal specifically to require discussion of important accounting judgments. However, for the reasons indicated below, we respectfully encourage the Commission to reduce the scope of the required disclosures, particularly to narrow the definition of the types of estimates that must be discussed and the requirements to quantify alternate estimates not selected. We believe the current proposal will result in many more disclosable estimates per issuer than the three to five suggested in the Proposing Release, and that the quantification disclosure will result in many additional pages of MD&A disclosure without a commensurate improvement in the quality of the information received by investors. We also offer a number of specific comments on the application of the proposal to foreign private issuers and on the proposed auditor examination issue.

General Comments

            The Proposals Require So Much Information That Investors Will Be More Overwhelmed Than Informed. We fully support the Commission’s commitment to improve the quality and transparency of MD&A disclosure and concur with the Commission’s articulation of the overarching objectives of MD&A. Nevertheless, we believe the proposed new disclosure regime for critical accounting policies is so extensive that it is likely to obscure rather than reveal.

            The current proposals appear to be motivated by the Commission’s concern that while financial statements convey the appearance of precision, they typically involve undisclosed judgments, estimates and choices among alternative principles that make reported results potentially “fuzzier” than suggested by earnings per share figures calculated to two decimal places. We agree with the premise that the accounting process underpinning financial statements involves the regular application of judgments, estimates and choices. Indeed, as the Commission itself notes, currently generally accepted accounting principles and generally accepted auditing standards acknowledge that there are numerous circumstances in which companies, in applying accounting policies, exercise judgment and make estimates for the purposes of the financial statements.

            For example, Accounting Principles Board Opinion No. 20 acknowledges that changes in estimates are necessary consequences of periodic presentation of financial statements because preparing financial statements requires estimating the effects of future events which cannot be perceived with certainty. APB No. 20 requires disclosure about changes in estimates that are expected to affect several future reporting periods and that are not made in the ordinary course of accounting. It recommends disclosure if the effects of such changes are material.

            We also agree with the proposition that investors need to know that financial statements are based on assumptions, estimates and judgments that are inherently uncertain to some extent or that in order to evaluate financial results and future financial performance investors need to understand “how management forms its judgments about future events, including variables and assumptions underlying the estimates, and the sensitivity of those judgments to different circumstances”.² However, we believe that the extensive nature of the required disclosures about each critical accounting estimate, combined with the number of critical estimates each issuer likely would have to disclose under the proposal, would give investors more information than most can use and would tend to obscure the principal disclosure issues. It seems to us that the most important point is for issuers to identify their most significant accounting judgments, and discuss them in qualitative terms. This should be sufficient to convey the warning that accounting results, even though disclosed in numbers, necessarily involve significant judgments.

            The Concept of A Critical Accounting Estimate is Too Broad. The Commission uses the concept of “highly uncertain” and materiality as its touchstone for the determination of what constitutes a critical accounting estimate.

            We believe this test will result in many more than the three to five critical accounting estimates for each issuer suggested in the Proposing Release. The Commission itself identifies the following examples of critical accounting estimates in the Proposing Release:³

• net realizable value of accounts receivable,
  
  
• net realizable value of inventory,
  
  
• current obligations that will be fulfilled over several years,
  
  
• future returns of products sold,
  
  
• amount of cash flows expected to be generated by a specific group of assets, such as analysis of impairment loss,
  
  
• actuarial assumptions in pension expenses,
  
  
• warranty claims,
  
  
• property and casualty insurance loss reserves, and
  
  
• revenues from contracts under the percentage of completion method.

            The Proposing Release also refers to Statement on Auditing Standards No. 57, “Auditing Accounting Estimates”,⁴ which identifies many additional accounting estimates. While some are industry-specific, many, such as the following, are likely to be of more general applicability:

• losses on inventory purchase commitments,
  
  
• valuation of securities,
  
  
• allowance for loan losses,
  
  
• losses on sales contracts,
  
  
• revenues to be earned,
  
  
• costs to be incurred,
  
  
• lease costs and residual values,
  
  
• useful lives and residual values of productive facilities, natural resources and intangibles,
  
  
• depreciation and amortization methods,
  
  
• compensation in stock option plans and deferred plans,
  
  
• taxes on real and personal property,
  
  
• probability and amount of litigation losses,
  
  
• annual effective tax rate in interim reporting,
  
  
• imputed interest rates on receivables and payables,
  
  
• losses and net realizable value on disposal of segment or restructuring of a business,
  
  
• fair values in non-monetary exchanges, and
  
  
• interim period costs in interim reporting.

            In addition, we believe the following are likely to be considered to involve critical accounting estimates for many issuers:

• deferred taxes,
  
  
• other loss contingency reserves, such as environmental costs,
  
  
• other fair value determinations, and
  
  
• allocation of expense between capital expenditures and current costs.

            We believe a great number of issuers will conclude that there is the requisite high uncertainty and materiality associated with many of the above accounting estimates. Many of these issuers may also have industry-specific accounting estimates that they conclude are critical. The resulting volume of MD&A disclosure will not be of significant assistance to most investors.

            We believe the Commission should narrow the scope of the definition of critical accounting policies so that only the most significant and judgmental ones are required to be discussed. To implement such a change, we suggest that the Commission move from a materiality test to a super-materiality test, so that only the very few most important accounting estimates are required to be discussed.

            We also note that many issuers are likely to conclude that current estimates of future earnings affect critical accounting estimates. For example, estimates of deferred taxes or future cash flows would be based upon earnings projections. Discussion of the effect of these earnings projections on the accounting estimates could well involve disclosure of those projections, raising market confusion and liability concerns. The Commission has heretofore not mandated disclosure of earnings projections. We believe it is inappropriate to adopt rules which could result in such a major policy change without pursuing the change expressly through the public notice and comment process focused on that issue. In addition, while we believe earnings projections would fall within the safe harbor for forward-looking statements provided by the Private Securities Litigation Reform Act of 1995 and Rule 175 under the Securities Act and Rule 3b-6 under the Exchange Act (subject to the respective exceptions contained therein), we note that judicial interpretation leaves much uncertainty about the scope of that safe harbor and the extent of the required cautionary statements. As a result the safe harbor provides limited comfort to issuers. Accordingly, we believe the disclosure of earnings estimates is a problematic issue that warrants further sustained and thoughtful public debate before the Commission mandates such disclosure. At the very least, we suggest a more explicit protection of such estimates of future earnings if the Commission does proceed to mandate such disclosure.

            Quantification of Alternate Estimates Is Not Useful for Investors. The disclosure of quantified sensitivity information over a range of estimates is not likely to be useful to investors unless also accompanied by probabilities of those estimates occurring. However, probability information appears inherently impossible to obtain, given the “highly uncertain” nature of the accounting estimates. Instead, we respectfully urge the Commission to make sensitivity disclosure optional, for those situations where issuers believe the information would truly be helpful to investors.

            Summary MD&A Should Not Be Mandated. We question the usefulness to investors of a summary MD&A, which the Commission states it is considering in the Proposing Release. We do not believe mandating a summary MD&A will improve the overall quality of MD&A disclosure. A summary of MD&A disclosure may be useful to investors in some circumstances, but could merely add bulk to the disclosure in other cases. We believe, especially given the possible liability concerns, that issuers should retain the flexibility of presenting a summary of MD&A only when they believe it would enhance their MD&A disclosure. Accordingly, we suggest that the Commission not amend its rules to require a summary of MD&A or to otherwise address a summary of MD&A. Instead, we suggest that in the adopting release the Commission describe a summary of MD&A as one possible approach issuers may wish to consider in appropriate circumstances.

            Alternative: Comprehensive, Formal Review of MD&As. As previously noted, we agree with the Commission’s goal of improving MD&A disclosure. In the current environment, when public confidence in the capital markets has been threatened by accounting scandals, this goal is even more important. We believe the real problem the Commission seeks to address through the proposed MD&A disclosure of critical accounting estimates may be the overall quality of MD&A disclosure today. We do not believe this concern must necessarily be addressed by more rules. Instead, we respectfully suggest that the Commission give issuers more guidance, including but not limited to the area of critical accounting estimates, by use of specific examples of what it considers to be good MD&A disclosure. By undertaking a formal and comprehensive review of MD&A disclosure, as it did in 1987, and by providing the marketplace with specific examples of good and bad MD&A disclosure, we believe the Commission could significantly advance the objectives of MD&A disclosure, despite reducing the scope of the proposed disclosure of critical accounting estimates. Because each MD&A is different and must be tailored to the specific circumstances of the company or its industry, examples are likely to convey the Commission’s message better than a generalized prescription.

            Changes in GAAP. We encourage the Commission to consider whether disclosure of accounting estimates is better left to changes in GAAP by the appropriate standard-setting bodies than action by the Commission. As the Commission notes in the Proposing Release, existing GAAP and GAAS currently acknowledge the significant role of estimates and judgments in the accounting process.

            In addition to APB No. 20 noted above, APB Opinion No. 22, while not specifically requiring disclosure about accounting estimates, requires disclosure about the application of accounting policies which may entail generalized disclosure about estimation techniques. APB No. 22 notes that a company’s accounting principles, and their method of application, can affect significantly the presentation of its financial position, results of operations, and cash flows and accordingly requires disclosure that describes those accounting principles and a company’s methods of applying them. Specifically, APB No. 22 indicates that a company should provide disclosure when: (i) unusual or innovative applications of accounting principles materially affect the determination of financial position, results of operations or cash flows, (ii) a selection is made among alternative permissible policies, or (iii) policies are unique to the industry of the reporting company. Under APB No. 22, a company’s disclosure also should encompass important judgments as to the appropriateness of principles relating to revenue recognition and allocation of costs to current and future periods.

            Finally, some accounting standards currently prescribe specific disclosures about accounting estimates or the underlying methodologies and assumptions. For example, Statement of Financial Accounting Standards No. 132 requires specific disclosures of the assumptions used in accounting for pensions and other post-retirement benefits and Statement of Financial Accounting Standards No. 140 requires disclosure regarding the measurement of retained interests in securitized financial assets, including the methodology, assumptions and sensitivity of the assumptions used in determining their fair value.

            The foregoing discussion is merely intended to illustrate that GAAP and GAAS already recognize that estimates and judgment play a pivotal role in the accounting process and that various existing standards seek to address concerns raised by estimates and the financial statements may be a more natural place for many of the disclosures sought by the Commission’s proposals. We respectfully suggest that the Commission work with the existing standard-setting bodies to encourage them to revise their standards to broaden the required disclosures to cover many of the items in the Commission’s proposal. This could result in more focused disclosures that nevertheless address many of the issues sought to be addressed in the Proposing Release.

            More Detailed Guidance is Needed on the Application of the Proposed Rules to Different Industries. If the Commission nevertheless decides to implement the rules in the form proposed, we would urge the Commission to provide more detailed guidance on the application of the proposed rules to different industries, as the proposed rules are likely to affect different industries in very different ways. For example, insurance companies and banks are likely to be heavily affected because they use estimates to calculate insurance policy and claims reserves, deferred policy acquisition costs, hedge accounting, recognition of losses on financing receivables, accounting for pension and other post-employment obligations, the valuation of financial instruments and other assets carried at fair value, the determination of the level of credit losses and accounting for significant securitization activity.⁵ Therefore, general requirements to disclose critical accounting estimates will likely have a disproportionate effect on some industries. Furthermore, there already exists substantial required disclosure, through the Industry Guides, in the insurance, banking and oil and gas industries. It is not clear to us what additional disclosure the Commission would like to see beyond the requirements of these Guides regarding sensitivity of reserve estimates. We wonder whether quantified sensitivity disclosure would even be possible in these areas, but if so, we question how it would be meaningful.

Specific Comments

            Foreign Private Issuers. In addition to disclosures with respect to their “primary” home-country MD&A, the proposal would require foreign private issuers to provide additional disclosures concerning the application of critical accounting estimates in connection with the U.S. GAAP reconciliation process. We believe this additional requirement is not consistent with the Commission’s current disclosure regime for foreign private issuers and its policy of balancing the need to ensure that the disclosure standards for foreign private issuers are consistent with acceptable standards of investor protection while encouraging access by foreign private issuers to U.S. capital markets by respecting home-country requirements.⁶

            Extension of the proposals to the GAAP reconciliation process – above and beyond the application to a foreign private issuer’s “home country” MD&A – may create difficulties in relation to the U.S. GAAP reconciliation process. The U.S. GAAP reconciliation is often prepared after completion and sometimes public release of the home-country financial statements, typically involves less active involvement of senior management and may involve auditing personnel who are different from those who prepared the primary financial statements. Therefore, the extension of the proposals to the U.S. GAAP reconciliation of foreign private issuers not only adds a further layer of complexity and expense to the reconciliation process, but also may be less likely to provide a window into management’s thinking because the reconciliation is prepared more as a technical subsequent effort, not with a view towards presenting primary results to investors.

            At a minimum, we would suggest the Commission wait and see how the new rules work in practice before extending them to the U.S. GAAP reconciliation of foreign private issuers. Furthermore, most issuers do not discuss their U.S. GAAP reconciliation in their MD&A other than to cross-reference to the financial statement footnote where it is contained. Adding MD&A disclosure about critical accounting estimates in the U.S. GAAP reconciliation could create an unbalanced appearance.

            As a separate point, we note that the proposed rules appear to contemplate that the required disclosure about audit committee discussions concerning critical accounting policies be included in the MD&A, even though foreign private issuers in most cases have obtained exemptions from the NYSE’s audit committee requirements and are exempt from the Commission’s requirement to include in the proxy statement the audit committee report on the current financial statements. We suggest that foreign private issuers be exempted from the audit committee disclosure requirement in proposed Item 5.E.3.(e) of Form 20-F.

            Auditor Examination of MD&A Disclosure. In the Proposing Release, the Commission raises the possibility of adopting a requirement that an independent auditor must examine, in accordance with existing attestation standards, the new MD&A disclosure relating to critical accounting estimates. Currently, an auditor is only required under auditing standards to read the MD&A and consider any inconsistencies with the financial statements. As the Commission observes, subjecting the MD&A disclosure to the auditing process would require the imposition of auditing standards, including examination of the disclosure itself, application of auditing processes regarding internal controls, coverage in management representations of material relevant to the disclosure and other procedures.

            We support requiring active auditor involvement in the disclosures about critical accounting estimates. These disclosures appear so directly related to the financial statements themselves that it is unthinkable to us that the auditors should not be involved to the same extent as in examining the financial statement footnote disclosures. One way to achieve this is to require auditors to furnish an attestation report on the entire MD&A under SSAE No. 8. Another, in our view preferable, way is to require that the disclosures be placed in an audited financial statement footnote rather than in the MD&A. While we would prefer to see such a footnote requirement result from a cooperative process involving the Commission and the standard-setting bodies, we believe even a Commission-required financial statement footnote would be a more direct way to involve the auditors in the critical accounting estimate disclosure than to have the entire MD&A be subjected to SSAE No. 8 procedures.

            Initial Adoption of Accounting Policies. We support the Commission’s proposal to require disclosure of the initial adoption of accounting policies. However, it appears that this proposed disclosure is much more in the nature of a financial statement footnote disclosure than an MD&A disclosure. As such, it appears to us that the Commission’s proposal is intended to fill a perceived hole in GAAP disclosures. Accordingly, we suggest that instead of making this an MD&A disclosure the Commission seek to persuade the standard-setting bodies to require this disclosure as part of the financial statements. Failing that, the Commission could amend Regulation S-X to require such disclosure. An additional benefit to the financial statement footnote disclosure approach is the closer association of the auditors with the disclosure through the audit process.

*   *   *

             We appreciate this opportunity to comment on the Commission’s proposal, and would be happy to discuss any questions the Commission or its staff may have with respect to this letter. Any such questions may be directed to John T. Bostelman (212 558-3840), Robert E. Buckholz, Jr., (212 558-3876), David B. Harms (212 558-3882) or Robert W. Reeder, III (212 558-3755) in our New York office or Scott D. Miller (650 461-5620) in our Palo Alto office.

Very truly yours, SULLIVAN & CROMWELL

Endnotes

1	Disclosure in Management’s Discussion and Analysis about the Application of Critical Accounting Policies: Release Nos. 33-8098; 34-45907; File No. S7-16-02.
2	SEC Chairman Harvey Pitt, Address at SEC Speaks Conference in Washington, D.C. (February 22, 2002)
3	Proposing Release at note 53.
4	Proposing Release at note 10, citing Codification of Statements on Auditing Standards (including related Auditing Interpretations) §342, Auditing Accounting Estimates (“AU §342”), paragraphs 1-3.
5	For example, in the proposals the Commission has specifically identified property-casualty insurance loss reserves as an example of “accounting estimates” and, given the factors cited in the proposals, it is virtually certain that such estimates would be “critical” to any property-casualty insurer (or multiline financial services company with significant property-casualty insurance operations). Given the broad range of actuarial and other assumptions which are part of the process of establishing IBNR and case reserves in the property-casualty insurance industry, however, we believe that the quantitative disclosures described in the proposal can only lead to the type of “zero to infinity” reserve range estimates which will be meaningless, or confusing at best, to investors. By way of contrast, the Commission’s existing Industry Guide 6 requirements currently result in insurers providing extensive statistical and narrative disclosures concerning historical loss reserve developments, reserve deficiency/redundancy trends, and changes in methodologies, and are a well-understood and useful tool for analyzing property-casualty insurers’ historical results and prospects. We strongly suggest that, while the goal of improving MD&A disclosures – including through meaningful integration of an insurer’s existing Guide 6 data – is a good one, the imposition of meaningless “range” estimates in the case of property-casualty loss reserves is not the way to achieve it.
6	Under existing rules, financial statements of foreign private issuers may be prepared either in accordance with U.S. GAAP or in accordance with another comprehensive body of accounting principles, but in the latter case Items 17 and 18 of Form 20-F require a reconciliation of the financial statements to U.S. GAAP. The reconciliation must include an explanation of the principal differences between the accounting principles used and U.S. GAAP, a numerical reconciliation of the material differences in financial results and as reported under home-country accounting practices and under U.S. GAAP, and an explanation of the reasons for the differences.