John wiley sons managers guide to compliance apr 2006 tlf

SOX Section 401: Off-Balance Sheet Arrangements 5is not consolidated with the company is a party, under which thecompany, whether or not a party to the arrangement, has, or in thefuture

to Compliance

Sarbanes-Oxley, COSO, ERM, COBIT, IFRS, BASEL II, OMB A-123, ASX 10, OECD Principles, Turnbull Guidance, Best Practices, and Case Studies

ANTHONY TARANTINO

John Wiley & Sons, Inc

Manager’s Guide

to Compliance

Manager’s Guide

to Compliance

Sarbanes-Oxley, COSO, ERM, COBIT, IFRS, BASEL II, OMB A-123, ASX 10, OECD Principles, Turnbull Guidance, Best Practices, and Case Studies

ANTHONY TARANTINO

John Wiley & Sons, Inc

Manager’s Guide

Copyright © 2006 by John Wiley & Sons, Inc All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data

Tarantino, Anthony,

1949-Manager’s guide to compliance : Sarbanes-Oxley, COSO, ERM, COBIT, IFRS, BASEL

II, OMB A-123, ASX 10, OECD principles, Turnbull guidance, best practices, and case studies / Anthony Tarantino.

KF1357.T37 2006

346.73'06648 dc22

2005034272 Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

Ted and Allie

NOTE TO THE READER

In providing the information contained in this book, the author andcontributors are not engaged in rendering legal or other professionaladvice and services As such, this text should not be used as a substi-tute for consultation with professional, legal, or other competentadvisers All information is provided herein “as is.”

Preface

The massive U.S corporate scandals of the last several years have led

to a huge change in the way organizations are governed At its heartwas a failure of leadership, ethics, and morality on several levels,which led to a breakdown in investor confidence The failuresoccurred among corporate executives, boards of directors, regulatoryagencies, rating agencies, and the press One could argue this wascaused by a lack of virtue and a breaking of a social contract betweenorganizations (public and private) and those who invest in and rely

on them These are age-old concepts In his Analects, the great

Chinese sage Confucius (551–479 B.C.) argued virtue was the keycharacteristic of superior leadership Virtue provides a moral powerthat allows one to win a following without resorting to physical forceand enables a leader to maintain good order Mencius (372–289 B.C.),

is often referred to as the second great Chinese sage, and he oped the notion of a social contract in which one rules by a mandate

devel-of heaven If a leader broke the social contract, then his followerswould be absolved of all loyalty and might be required to overthrowhim Enron, WorldCom, Parmalat, Ahold, and others broke the man-date of heaven in corporate America and Europe and exposed thelack of virtue in those entrusted with good corporate governance These events have spawned a move toward more robust compli-ance on a global level, which will require much improved internalcontrols and will change the nature of business in fundamental ways.The struggle for improved compliance is nothing new Investors havealways sought greater transparency as organizations have sought tolimit transparency to protect competitive information Scandals havealways acted as a catalyst to force improved corporate governanceand transparency The South Sea Bubble scandal in the early 1700sfostered improved accounting standards in British companies U.S.states began enacting blue-sky laws in the early 1900s as the result ofshady stock promotions Of course, the greatest reforms came as a

result of the great stock market crash of 1929 and depression duringthe 1930s This led to the passage of federal security legislation in

1933 and 1934 and the creation of the Securities and ExchangeCommission (SEC).1Reforms have continued, but were greatly accel-erated by scandals of the late 1990s So there is little chance for a sig-nificant rollback in compliance requirements, especially when mostinvestors do not place much faith in corporate boards to provideviable oversight A Wall Street Journal/Harris poll found about two-thirds of investors expressing doubts in the ability of corporateboards of directors to provide effective oversight.2

Many skeptics have made analogies with Year 2000 (Y2K) andInternational Organization for Standardization (ISO) certifications,suggesting that this is only a passing fad or an American-based over-reaction to Enron-type scandals Though the argument about anoverreaction has some merit, this is no passing fad Though the U.S.Sarbanes-Oxley Act (SOX) has received the lion’s share of attention,initiatives are underway in almost every global region and industry toimprove transparency in financial reporting In spite of ongoing com-plaints from U.S companies above excessive compliance costs, theWall Street Journal/Harris online poll found that most U.S investorsstill believe corporate governance regulations remain too lenient Thesame poll found only 6% of investors believing corporate governance

to be too strict This skepticism about the effectiveness of corporategovernance has led nearly one-third of investors to reduce or todivest their stake in various companies due to concerns about thequality of their corporate governance.3

The reasons for the wave of compliance initiatives and the needfor improved internal controls are simple We are fast approaching aglobal marketplace in which investors will demand a level playingfield in comparing financial results whether companies or industriesare based in the United States, the European Union (EU), Russia,China, or other Third World countries Privates and nonprofits arefeeling the pressure to improve internal controls from their insurersand bankers if they want to get the most competitive rates This is not

1John Emshwiller, “Opening the Books,” Wall Street Journal, October 17, 2005.

2 Becky Bright, “Investors Are Skeptical of Success of Sarbanes-Oxley, Poll Finds,” Wall Street Journal/Harris On Line Poll, October, 14, 2005.

3 Becky Bright, “Investors Are Skeptical of Success of Sarbanes-Oxley, Poll Finds,” Wall Street Journal/Harris On Line Poll, October, 14, 2005.

to say bumps will not occur along the way Years of sloppy businesspractices, weak internal and external audits, and lackluster enforce-ment will make this a painful process In Third World countrieswhere most businesses are family run and/or closely held, this willpresent additional challenges.

A major debate is underway as to whether mandatory ment regulations with severe criminal and criminal penalties, such asSOX, are needed to improve governance and internal controls, orwhether principles-based guidelines, advocated in Europe, will suf-fice New York’s Attorney General, Eliot Spitzer, has referencedPresident Teddy Roosevelt, who advocated 100 years ago that gov-ernment alone must oversee marketplaces and that self-regulationwas doomed to fail “Teddy Roosevelt understood the marketplace that in order to preserve dynamism in the marketplace there needed

govern-to be that force govern-to ensure competition and a level playing field,” hesays “That’s the role we play on Wall Street That’s what we’ve done

in terms of labor markets and the environment.”4

The major U.S scandals at Enron, Tyco, WorldCom, Riggs Banks,Fannie Mae, ImClone, HealthSouth, Marsh & McClennan, andEuropean scandals at Ahold and Parmalat would suggest the futility

of voluntary measures, but it is still early in the process and not yetclear if SOX will have the desired effect and the benefits will outweighthe costs Post-SOX scandals such as Refco, the largest independentfutures brokerage firm, will also raise the debate that all the detailedoversight and higher audit standards can still miss major corruption,

in this case poor due diligence for Refco’s August 2005 IPO.5

Today’s managers face a growing challenge and dilemma in theglobal thrust to improve governance and compliance, which at its corerequires robust internal controls The dilemma comes in how to com-ply in a manner that does not punish operational efficiencies and competitiveness This will be true for privately and publicly held com-panies throughout the globe and even for nonprofit institutions Down to the U.S state level (California’s AB 1386 protects individualidentities) and at federal government agency level (US OMB’s A-128applies SOX to federal agencies), compliance initiatives will become

role models bound to spread to other U.S states, local governmentagencies, and international governments.

The good news in global compliance efforts is the acceptance ofCOSO-like standards to improve internal controls Improved internalcontrols are at the core of almost all compliance regulations Though

a healthy debate continues between the use of voluntary guidelinesversus compulsory regulations, there is widespread acceptance forthe need to improve internal controls using the Committee ofSponsoring Organizations (COSO) definition and approach COSOused a commonsense approach to internal controls, which includesdefining and categorizing the criticality of business processes, the risksassociated with business processes, and the means to mitigate risks.The mitigation process includes assigning its owners, and then testing,auditing, and certifying the adequacy of controls

We will begin with an introduction to SOX, which is technicallycalled the Public Company Accounting Reform and Investor ProtectionAct of 2002 SOX was sponsored by Senator Paul Sarbanes(Democrat–Maryland), then chairman of the Committee on Banking,Housing and Urban Affairs in the Senate, and Representative MichaelOxley (Republican–Ohio), the Financial Services Committee chair inthe House It passed the Senate unanimously, won easy approval inthe House, and President Bush signed it into law on July 30, 2002.The internal control provisions went into effect for larger companies

in 2004 Smaller companies and foreign filers are given more time, withdeadlines pushed from July 2005 to July 2007

The SEC has delivered several final rulings defining its SOX pretation Based on the final rulings, the intent is to expand ratherthan to limit the reach of the act William H Donaldson, the formerchairman of the SEC, made it clear in his September 2003 testimony,that SOX is essential in restoring investor confidence by providingtransparency in financial reporting He summarized the events of the1990s and made an ominous comparison with the events of 1929:

inter-“The low points in this story are now household names, not justEnron, but also WorldCom, Tyco, Adelphia, and others There wasother serious misconduct as well, including in the once-celebrated IPOmarket, which in too many cases lacked both fairness and integrity.The cost of this corner cutting to investors has been enormous Whilethankfully we have not witnessed the same intensity of human suffer-ing that came with the depression of the 1930s, the most recent down-turn in the market directly affected many more investors than the

1929 market crash, because many more individuals had much more

of their savings invested in the stock market.”6

We will provide a more detailed look at SOX Sections 401, 404,

406, and 409 and then discuss the impact of SOX on small and eign filers, privates, and nonprofits This will be followed by anoverview of SOX-like legislation coming to U.S federal agencies,Australia, Canada, and the UK We will include a discussion ofefforts to improve internal controls in the following industries: health(HIPPA), banking (GLB and Basel II), and insurers (Solvency II) Themovement to create principles-based guidelines by the OECD andglobal Generally Accepted Accounting Principles (GAAP) by theIFRS will be compared to SOX and U.S GAAP The impact on out-sourcing will include an explanation of the Statement on AuditingStandards No 70 (SAS 70) audit process The civil and criminalpenalties for noncompliance will demonstrate the major changesbrought about by the U.S corporate scandals Best practices in inter-nal controls will be offered that include several case studies and therole technology can play in automating compliance Finally, we willprovide a cost versus benefits analysis This text is designed to be anintroductory guide and handbook for professionals in informationtechnology (IT), operations, finance, and supply chain It may behelpful to internal and external auditors but is not designed to pro-vide a framework for the audit process It may help regulators as ahigh-level overview of the many compliance and governance initia-tives underway throughout the world Finally, it may also be helpful

for-to invesfor-tors who seek for-to evaluate the merits of the compliance tives in mitigating risks in companies, industries, and regions theyare considering

initia-Note: Throughout the text we have used auditing examples andcase studies around the procure-to-pay (P2P) process since it is typi-cally well understood by accounting, operations, and IT professionals

ACKNOWLEDGMENTS

The author gratefully acknowledges the following individuals fortheir invaluable input and expertise:

Koti Ancha, MSIE, Six Sigma Black Belt, Senior Program

Manager, Supply Chain Strategy, Seagate Technology, Scotts Valley,

CA For assistance in providing case studies and general editing

Mark Stebelton, CPA, Senior Program Manager, Compliance

Softwares and SOX SME, Logical Apps, Irvine, CA For sharingexpertise, specifically regarding SAS 70

Holly Tran, CISSP, CISM, MSEE, Manager, BearingPoint For

system security and compliance practice support

Greg Henzel, MBA, Manager, BearingPoint For contributions to

mapping the following standards: COSO, ERM, and PCAOB

Richard Marti, Manager, BearingPoint For contributions to

mapping the following standards: COSO, ERM, and PCAOB

Shirley Cui, MSCS For indexing and general editing support.

U.S SOX Section 401: Off-Balance

Sheet Arrangements INTRODUCTION1

Christopher Cox replaced William Donaldson as SEC Chairman in

2005 Since assuming his chairmanship, Cox has advocated arethinking of regulations, arguing that they are overly complex andthis complexity is partly to blame for the accounting scandals of the1990s Maybe the best evidence of this is the convoluted and confus-ing regulations and guidance around off-balance sheet (OBS)arrangements This chapter will detail the current state of the U.S.regulations It appears that the current regulations invite abuse andmisunderstanding, and do not assure investors that Enron-typeabuses are a thing of the past

Section 401 of the Sarbanes-Oxley Act of 2002 requires the listing

of off-balance sheet (OBS) arrangements, transactions, and tions (including contingent obligations) that may have a materialeffect, current or future, on financial conditions, changes in financialresults in operations, liquidity capital expenditures, capital resources,

obliga-or significant components obliga-or revenues obliga-or expenses The SEC final ing requires the disclosure of “the nature and business purpose of theOBS arrangements, why and how they are needed in running a busi-ness.” For those wondering why this is an area of concern, a one-wordexplanation should suffice—Enron It was Enron’s horrible abuse,and Arthur Andersen’s blessing such OBS arrangements, that led tothe most infamous and globally recognized scandal in a generation The problems stem from the complexity and resulting confusion

rul-in how to account for OBS arrangements Unfortunately, the SEC hasnot simplified the process to the extent to preclude significant abuse

Even a process as seemingly straightforward as procurement is givenalternative interpretations With U.S GAAP’s taking a rules-basedapproach (as opposed to principles-based as favored by theInternational Financial Reporting Standards (IFRS)), it is curioushow rules and guidance can be issued which are not clear andstraightforward One cynical interpretation is that the complexity is

by design serving those who make their living interpreting the lations and those using the complexity of the regulations to minimizetheir tax exposure A less cynical interpretation is that U.S tax lawcontinues to evolve to the point that even the brightest financialexperts struggle in understanding it

regu-After reading this section, ask yourself if these regulations arestraightforward enough to assure their consistent application bycompanies of all sizes and complexities and to avoid Enron-typeabuses of the past

The following are some simple examples of OBS obligations thatmay need to be accounted for:

long-term purchase agreements to assure a reliable source of ply for goods and services at the lowest price Many companiesare moving their direct material programs to Vendor/SupplierManaged Inventory (VMI) programs, which are controlled bylong-term purchase agreements Section 401 clearly requires atime-phased listing of obligations (Year 1, Years 2–3, etc.) in atabular format specified by the SEC

defining the requirement to list time-phased obligations, ing and cancellation charges are not mentioned specifically inSection 401 but are listed as new triggering events requiring an 8-K filing “any material early termination penalties” underSection 409 Most long-term agreements include such provisions.Though the SEC’s intent is unclear, a company suffering a majordownturn and paying restocking and/or cancellation charges willhave trouble defending not listing these as OBS obligations

Capital and Operating Lease obligations should be listed as OBSobligations Fees incurred due to early termination of agreementswill need to be accounted for as well

Even more complex is the requirement to account for contingentOBS obligations The SEC provides an instruction “that a companymust provide the disclosure required regarding off-balance sheetarrangements, whether or not the company is also a party to thetransaction or agreement creating the contingent obligation arisingunder the off-balance sheet arrangement In the event that neither thecompany nor any affiliate of the company is a party to the transaction

or agreement creating the contingent obligation arising under the balance arrangement in question, the four-business-day period forreporting the event under this item would begin on the earlier of

off-■ The fourth business day after the contingent obligation is created

on Contingent OBS obligations may come into play for those whohave outsourced manufacturing, distribution/logistics, and design.Obviously stung by the terrible abuses of Enron, the SEC has laidout a comprehensive process for companies to explain OBS transac-tions and obligations

The SEC’s definition of OBS arrangements addresses certainguarantees that may be a source of potential risk to a company’sfuture liquidity, capital resources, and results of operations, regard-less of whether or not they are recorded as liabilities The SEC hasruled that this may include “contracts that contingently require theguarantor to make payments to the guaranteed party based onanother entity’s failure to perform under an obligating agreement(e.g., a performance guarantee).”

Accounting for OBS arrangements is not enough The SEC hasruled that companies will have to explain the nature and business pur-pose of such arrangements “The disclosure should explain toinvestors why a company engages in off-balance sheet arrangementsand should provide the information that investors need to understandthe business activities advanced through a company’s off-balance sheetU.S SOX Section 401: Off-Balance Sheet Arrangements 3

arrangements For example, a company may indicate that the ments enable the company to lease certain facilities rather than acquirethem, where the latter would require the company to recognize a lia-bility for the financing Other possible disclosures under this require-ment may indicate the off-balance sheet arrangement enables thecompany to obtain cash through sales of groups of loans to a trust; tofinance inventory, transportation, or research and development costswithout recognizing a liability; or to lower borrowing costs of uncon-solidated affiliates by extending guarantees to their creditors.”

arrange-The SEC requires companies to explain the impact on their uidity, capital resources, market risk support, credit risk support orother benefits This disclosure should provide investors with anunderstanding of the importance of off-balance sheet arrangements tothe company as a financial matter Together with the other dis-closure requirements, companies should provide information suffi-cient for investors to assess the extent of the risks that have beentransferred and retained as a result of the arrangements.”

“liq-The SEC goes further “In addition, the disclosure should provideinvestors with insight into the overall magnitude of a company’s off-balance sheet activities, the specific material impact of the arrangements

on a company, and the circumstances that could cause material gent obligations or liabilities to come to fruition Disclosure is required

contin-to the extent material and necessary contin-to invescontin-tors’ understanding of

■ The amounts of revenues, expenses, and cash flows of the pany arising from the arrangements,

com-■ The nature and total amount of any interests retained, securitiesissued and other indebtedness incurred by the company in con-nection with such arrangements, and

■ The nature and amount of any other obligations or liabilities(including contingent obligations or liabilities) of the companyarising from the arrangements that is, or is reasonably likely tobecome, material and the triggering events or circumstances thatcould cause them to arise.”

DEFINITION OF OBS ARRANGEMENTS2

The SEC has defined the term OBS arrangement as “any transaction,agreement or other contractual arrangement to which an entity that

U.S SOX Section 401: Off-Balance Sheet Arrangements 5

is not consolidated with the company is a party, under which thecompany, whether or not a party to the arrangement, has, or in thefuture may have:

■ Any obligation under a direct or indirect guarantee or similararrangement,

■ A retained or contingent interest in assets transferred to anunconsolidated entity or similar arrangement,

■ Derivatives, to the extent that the fair value thereof is not fullyreflected as a liability or asset in the financial statements, and

■ Any obligation or liability, including a contingent obligation orliability, to the extent that it is not fully reflected in the financialstatements (excluding the footnotes thereto).”

In particular, the proposals require a disclosure where the hood of the occurrence of a future event implicating an OBSarrangement or its material effect was higher than remote As men-tioned above, the SEC noted, “the disclosure threshold departedfrom the existing MD&A threshold, under which a companymust disclose information that is ‘reasonably likely’ to have a material effect on financial condition, changes in financial condition

likeli-or results of operations.” While this is an improvement, there is still

an ambiguity as to the dividing line between “reasonably likely” and

“remote.”

The SEC requires disclosure of enumerated items only “to theextent necessary to an understanding of the company’s off-balancesheet arrangements and their effect on financial condition, changes infinancial condition and results of operations.” Specifically, the SECrequires a company to disclose

■ “The nature and business purpose of the company’s off-balancesheet arrangements;

■ The significant terms and conditions of the arrangements;

■ The nature and amount of the total assets and of the total ations and liabilities of an unconsolidated entity that conductsoff-balance sheet activities;

oblig-■ The amounts of revenues, expenses and cash flows, the natureand amount of any retained interests, securities issued or otherindebtedness incurred, or any other obligations or liabilities(including contingent obligations or liabilities) of the company

arising from the arrangements that are, or may become, materialand the circumstances under which they could arise;

■ Management’s analysis of the material effects of the above items,including an analysis of the degree to which the company relies onoff-balance sheet arrangements for its liquidity and capitalresources or market risk or credit risk support or other benefits; and

■ A reasonably likely termination or material reduction in the fits of an off-balance sheet arrangement and any material effects.”

bene-The SEC specifies the need to account for “amounts of a pany’s known contractual obligations, aggregated by type of obliga-tion and by time period in which payments are due.” The SEC rejectsrequests to exclude “purchase orders and contracts for goods andservices in the ordinary course of business.” It requires “disclosure ofthe amounts of a company’s purchase obligations without regard towhether notes, drafts, acceptances, bills of exchange, or other com-mercial instruments will be used to satisfy such obligations becausethose instruments could have a significant effect on the company’sliquidity.”

com-The SEC specifies that the categories of contractual obligationspartly include

■ Long-term debt obligations,

■ Capital lease obligations,

■ Operating lease obligations,

■ Purchase obligations, and

■ Other long-term liabilities reflected on the company’s balancesheet under its Generally Accepted Accounting Principles (GAAP)

OBS ENTITIES3

In 2005, the SEC issued its “Report and RecommendationsPursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 OnArrangements with Off-Balance Sheet Implications, Special PurposeEntities, and Transparency of Filings by Issuers,” which added muchneeded clarification and expanded examples for purchase orders,leases, derivatives, and contingent OBS obligations The SEC’s introduction underscores the complexity around OBS: “Issuers are

U.S SOX Section 401: Off-Balance Sheet Arrangements 7

involved in any number of contractual obligations, including debtobligations, retirement obligations, compensation agreements, leases,guarantees, derivatives, and obligations to purchase goods and ser-vices In many cases, liabilities are recognized on the balance sheet atthe inception of the contract, because one party has performed Forexample, if an issuer borrows money, it recognizes a liability uponreceipt of the funds In other cases, liabilities are recognized as timepasses, as in the case of interest related to the borrowed funds In stillother cases, contractual obligations remain off the balance sheet.Examples of these obligations may include operating leases, portions

of obligations related to retirement plans, certain guarantees, and tain derivatives.”

cer-The 2005 SEC Report and Recommendations provide muchneeded additional background on OBS entities and obligations TheSEC’s initial ruling was weak in providing examples and scenarios

“Companies have used off-balance-sheet entities responsibly andirresponsibly for some time These separate legal entities were per-missible under Generally Accepted Accounting Principles (GAAP)and tax laws so that companies could finance business ventures bytransferring the risk of these ventures from the parent to the off-bal-ance-sheet subsidiary This was also helpful to investors who did notwant to invest in these other ventures.”

In a major understatement, the SEC noted in its 2005 Report thatEnron and similar scandals have given OBS a bad reputation assomething underhanded “or at least less than fully transparent Theinsinuation is that something that should be on the balance sheet isnot, and that the reporting issuer has designed the transaction orarrangement to produce that result However, questions aboutwhether items should be reflected on the balance sheet do not ariseonly when there is an attempt to deceive financial statement users.” The SEC defends OBS by noting that “many legitimate transac-tions generate such questions, and there are, of course, bounds as towhat should be included on a balance sheet It is this broader, more-inclusive question of the proper bounds of what should be included

on the balance sheet” that are addressed in its 2005 Report.According to the SEC, the common characteristic of OBS is their cre-ation of a condition “in which there may be a legal or economicnexus between the issuer and risks, rewards, rights or obligations notreflected (or not fully-reflected) on the balance sheet.”

The SEC describes how OBS can refer to many things: includingseparate legal entities, i.e., separate companies of which the parentholds less than 100% ownership, or contingent liabilities such as let-ters of credit or loans to separate legal entities that are guaranteed bythe parent Under U.S GAAP, these items can be excluded from theparent’s financial statements, but usually they must be described infootnotes Ironically, Enron did list their OBS arrangements, buttheir implications were missed by Arthur Andersen and the SEC While U.S GAAP and U.S tax laws do allow off-balance-sheetentities for valid reasons, they can be abused by those wishing to hideobligations and thus overstate earnings In the case of Enron, OBSvehicles were used to grossly inflate financial results by fraudulentlycreating earnings to cover bad trades

The SEC defines a balance sheet as portraying the financial tion of an organization at a point in time It is made up of three basiccomponents:

posi-1 Assets, which are ‘probable future economic benefits obtained

or controlled by a particular entity as a result of past tions or events’;

transac-2 Liabilities, which are ‘probable future sacrifices of economic

benefits arising from present obligations of a particular entity totransfer assets or provide services to other entities in the future

as a result of past transactions or events’; and

3 Equity, which is ‘the residual interests in the assets of an entity

that remains after deducting its liabilities.’”

U.S SOX Section 401: Off-Balance Sheet Arrangements 9

whether or not to consolidate However, more complex structureshave developed in business practice for which these two differentphilosophies produce different answers.”

Examples of off-balance obligations include purchase orders,leases, derivatives, and contingent OBS, which we will describe ingreater detail

PURCHASE ORDERS4

In its 2005 Report the SEC explains that a purchase obligation could

be as simple as a standard one-time purchase order, or as complex aslong-term contracts for goods and services for deliveries over anextended period The major accounting and regulator issue is aroundthe rights and obligations inherent in a contract, and when they takeeffect—upon signing, or later when performance against the contractoccurs

“Upon signing the contract, the purchaser could record anasset (e.g., ‘inventory receivable’) and a liability (e.g., ‘PurchaseObligation’) The seller could also record an asset for the cash to bereceived and a liability reflecting its obligation to deliver the inven-tory However, at this point in time, nothing has been delivered and

no payment has been made Nonetheless, one could argue that, eventhough no performance has occurred, the issuers have many ofthe same risks and rewards as if the exchange had already been completed, and thus should recognize the related assets and liabili-ties Under this view, it could be argued that binding contracts giverise to assets and liabilities in advance of any performance under thecontract.”

This seems straightforward until the SEC explains the contraryview: “The contrary view is that assets and liabilities should only berecognized to the extent performance has occurred—that is, to theextent that one or both parties have carried out the actions (duties)agreed to in the contract, such as delivering or paying for the goods.Under this view, until some amount of performance has occurred on

a contract, the buyer does not have an asset for the goods or services

to be received nor a liability (i.e., a present obligation) to pay forthem, and the seller does not have a recognizable asset for the right

to collect the contractual payments.” With this approach assets andliabilities would not be recorded “until some performance hasoccurred.” For example, if the purchaser of the inventory paid for it

in advance, the purchaser’s obligation to pay would be consideredperformed, and the purchaser would at that time record an asset torecognize its right to receive inventory “The latter view underlies themore common financial reporting treatment Thus, signing a con-tract for the sale/purchase of goods generally does not result in therecognition of an asset or liability by either party.” The problem withthe SEC’s explanation is that nothing is mentioned about the obliga-tions in canceling the contract or purchase agreement

The SEC explains exceptions to this approach “Two of themajor exceptions are addressed in separate sections of this report:leases and derivatives In yet other cases, while the assets and liabili-ties related to an unperformed contract are not separately recog-nized, losses embedded in those contracts are recognized This socalled ‘loss contract’ accounting is required when an issuer has com-mitted to purchase inventory at prices that ensure a loss on resale ofthat inventory, and when a long-term construction contract isexpected to result in a loss.”

In January 2002, the SEC released FR-61, “Commission ment about Management’s Discussion and Analysis of FinancialCondition and Results of Operations,” which described the views ofthe Commission regarding certain disclosures that should be consid-ered by issuers, including disclosures about contractual obligationsand commercial commitments This guidance was updated in the 2003revision by the Commission of Item 303(A) (4) of Regulation S-K.Item 303(A) (4) requires disclosures about certain OBS arrangements,including certain contractual obligations Specifically, these new rulesrequire tabular disclosure in Management Discussion and Analysis(MD&A) of contractual obligations, including open purchase orders,which will result in future cash payments

State-This disclosure is intended to provide financial statement userswith information about unrecognized and recognized obligations.Though the disclosures do not provide information about therelated assets to be received as a result of those cash payments,the disclosures are an attempt to portray contractual obligationsbroadly

U.S SOX Section 401: Off-Balance Sheet Arrangements 11

OBS Issues in Accounting for Contractual Obligations

The SEC provides for ways to account for unperformed contractualobligations “For example, all contractual rights and obligationscould be recognized as assets and liabilities This would recognize thefact that once an entity enters into a firm contract to buy or sell some-thing, the entity is generally subject to many of the same risks andrewards as if the transaction had already been completed For exam-ple, once an issuer has entered into a firm fixed-price contract to pur-chase inventory, future declines in the value of that inventory affectthe issuer Similarly, once an issuer has agreed to sell inventory for aparticular price, future decreases in the value of that inventory do notaffect the issuer.”

Unfortunately, the SEC’s guidance may provide too many optionsand add to the confusion in how to account for OBS arrangements:

“However, to the extent neither party to a contract has performed,each party’s rights and obligations are, at least implicitly, contingentupon the other party’s As such, some assert the rights and obliga-tions in the contract do not qualify as assets and liabilities becausethey do not result from past transactions Others believe that,because the rights and obligations are contingent upon one another,they should be accounted for only as a group, that is, the ‘unit ofaccount’ would be the contract as a whole, rather than the assets andliabilities individually In this analysis, the assets and liabilities would

be offset against one another Assuming the contract represents anexchange of equal values, the values of the assets and liabilitieswould likely net to zero, thus effectively resulting in no impact on thebalance sheet Although standard-setters have almost invariablydetermined that such unperformed contracts should not result in therecording of assets and liabilities, the basis for these decisions is notalways stated For example, as mentioned above, losses on certaincontractual commitments, such as inventory purchases and construc-tion contracts are required to be recognized before performanceoccurs Conceptually, the loss in these contracts might be viewed asakin to an asset impairment loss, even though the rights in these con-tracts have not previously been reported as assets.”

The SEC Report and Recommendations does discuss the tial confusion: “Another potentially confusing aspect of accounting

poten-for loss contracts is that the accounting is applied far beyond the uations specifically addressed in the accounting guidance Althoughthis guidance specifically applies to very narrow classes of transac-tions, issuers and auditors have often applied it by analogy to otherunperformed contractual obligations These analogies have beenapplied sporadically, meaning that losses inherent in some unper-formed contracts are recorded, while others are not.”

as a rental contract We concentrate on the case where an issuer is thelessee, that is, where the issuer is the party using the asset, as this is thescenario most likely to result in no elements of the lease or leased assetbeing on the balance sheet.”

Capital and Operating Leases

The SEC explains the difference between rental leases and capitalleases: “Leases can transfer control of the asset from the lessor to thelessee for as much of the asset’s life as desired, and can also transfer

as many of the risks and rewards of ownership as desired Leasing

U.S SOX Section 401: Off-Balance Sheet Arrangements 13

transactions can take many forms and include many different terms.Yet, despite this diversity in leasing arrangements, all leases receiveone of two opposing accounting treatments; either the lease is treated

as if it were a sale or as if it were a rental If ‘most’ of the risks andrewards of ownership are transferred to an issuer leasing an asset,the lease is treated as a sale of the entire asset by the owner (i.e., thelessor) and a purchase of an asset financed with debt by the issuerusing the asset (referred to as the ‘whole-of-the-asset’ approach).This kind of lease is called a ‘capital lease’ In these cases, the lessorremoves the cost of the asset from its balance sheet and reports a sale

of the asset for proceeds equal to the present value of the requiredlease payments, plus the expected remaining value of the leased asset

at the end of the lease term The issuer using the asset records theasset and a related liability for the present value of the required leasepayments on its balance sheet If the lease does not transfer sufficientrisks and rewards to the lessee to be treated as a sale and purchase, it

is instead treated like a rental contract This kind of lease is called an

‘operating lease’ In this case, the owner of the asset retains the asset

on its balance sheet and records lease rental revenue (as well asdepreciation, property taxes, etc.) in its income statement on aperiod-by-period basis The issuer using the asset does not record theasset, or a related liability for the future contractual rental payments,

on its balance sheet, but records leasing expense in its income ment, also on a period-by-period basis SFAS No 13 specifies that alease is a capital lease if:

state-■ The lease transfers ownership to the issuer (i.e., the lessee) usingthe asset by the end of the lease term;

■ The lease contains an option whereby the issuer can purchase theleased property at a price sufficiently lower than the expected fairvalue of the leased property at the end of the lease term; or theterm of the lease is equal to or greater than 75% of the estimatedeconomic life of the leased property; or

■ The present value of the minimum lease payments to be made bythe issuer is equal to or greater than 90% of the fair value of theleased property

The SEC does discuss the potential confusion and potential forerrors in accounting for leases: “While in the majority of cases the

evaluation of whether these criteria have been met is straightforward,

in certain circumstances it can be challenging, as leases sometimescontain contingent or variable payment requirements, optional termextensions, and other clauses that affect the calculations under one ormore of the tests described above However, such determinations arevery important, as they can completely change the accounting for thelease The identification of which agreements should be accountedfor as leases, and thus subject to the tests listed above, is also chal-lenging in some situations In order to reduce the chances of likearrangements being accounted for differently, the accounting guid-ance defines leases by their characteristics, not by their label Thus,any contract, or portion of a contract, that meets the definition of alease must be accounted for as one While most leases are indeedexplicitly identified as such, some are not The accounting guidancealso includes extensive disclosure requirements for leases Theserequirements vary based upon the type of lease and whether theissuer is the lessor or lessee.”

OBS Issues in Accounting for Leases

Compliance Week reported in its May 2005 issue that lease-related

problems accounted for about one quarter of April’s material nesses, up from 10% in March Many of these stemmed from a letter

weak-by the SEC’s chief accountant, Donald T Nicolaisen, to a professionalaccounting group The letter was written after a wave of restatements

to correct lease-related accounting errors, reiterated the rules

According to Compliance Week: “The letter focused on three issues

related to lease accounting: depreciation of the costs to improveleased property, how to recognize periods of free or reduced rent, andhow to account for landlord incentives to make improvements.”The SEC explains that OBS issues arise from the contractualobligations that leases impose and “whether to record the rights andobligations inherent in the contracts as assets and liabilities when nei-ther party to the contract has performed With respect to leases, how-ever, the question is really how to assess whether performance hasoccurred As noted above, the current lease accounting standardsfocus on a determination as to which party to a lease agreement has

U.S SOX Section 401: Off-Balance Sheet Arrangements 15

the risks and rewards of ownership of the leased asset This, in turn,determines whether the owner is deemed to have sold the asset andwhether the issuer using the asset is deemed to have purchased theasset As a consequence of this approach, the issuer leasing the assetwill either recognize the entire leased asset on its books and a liabil-ity for all of its contractually required payments, or it will recognize

no asset and no liability The lease accounting guidance either treatsthe contract as if all of the performance occurs at the beginning of thelease, or as if none of it does The intention is to treat those leasesthat are economically equivalent to sales as sales, and to treat otherleases similar to service contracts This approach, while a significantimprovement from previous lease accounting, which rarely if everrequired recognition of a capital lease, does not allow the balancesheet to show the fact that, in just about every lease, both partieshave some interest in the asset, as well as some interest in one ormore financial receivables or payables The ‘all-or-nothing’nature of the guidance means that economically similar arrange-ments may receive different accounting, if they are just to one side

or the other of the bright line test For example, most would agreethat there is little economic difference between a lease that commits

an issuer to payments equaling 89% of an asset’s fair value vs 90%

of an asset’s fair value Nonetheless, because of the bright-line nature

of the lease classification tests, this small difference in economics cancompletely change the accounting Conversely, economically differ-ent transactions may be treated similarly.”

The SEC does acknowledge the complexity and potential forerrors: “The significant amount of structuring of leases also makesanalyzing potential changes to the lease guidance very difficult.Indeed, the current accounting guidance, which is criticized by many,would likely be held in much higher regard were it being applied tothe lease arrangements that existed when it was debated and created.Changes in lease terms in response to the accounting guidance havecaused undue focus on the weaknesses of the guidance The fact thatlease structuring based on the accounting guidance has become soprevalent will likely mean that there will be strong resistance to sig-nificant changes to the leasing guidance, both from preparers whohave become accustomed to designing leases that achieve variousreporting goals, and from other parties that assist those preparers.”

In its 2005 “Report and Recommendations Pursuant to Section401(c) of the Sarbanes-Oxley Act,” the SEC references Robert L.McDonald, (Derivatives Markets, 2003) to explain derivatives as

“simply a financial instrument (or even more simply, an agreementbetween two people) which has a value determined by the price ofsomething else For example, a stock option contract derives itsvalue, at least in part, from the price of the underlying stock; simi-larly, a gold futures contract derives its value from the price of theunderlying gold; an interest rate swap derives its value from theunderlying interest rates Derivatives permit issuers to mitigate andtake on risk, and also to select which risks they want to retain andmanage, and which they want to shift to others willing to bear them.For example, a manufacturer that requires oil as an input to produc-tion is exposed to the risk of an oil price increase If oil prices doincrease, cost of production increases and the manufacturer’s prof-itability may suffer Such an issuer may choose to contract withanother party to effectively fix the price it will pay for oil at somefuture date through a “forward” contract In this case, the issuer has

“hedged” its exposure, and is protected from the negative economiceffects of an adverse change in oil prices Of course, locking in aprice through such a forward contract also precludes any cost savingsthe issuer might have experienced from a beneficial change in oilprices.”

The current accounting guidance for derivatives has been ineffect since 2001 It was a much needed update to an outdatedaccounting standard that the SEC maintains did not keep pace withchanges in global financial markets and related financial innovations.According to the SEC, the current financial reporting for derivativescenters around three main issues:

1 Should derivative contracts be recognized on issuer balance

sheets?

2 Should the changes in the value of derivative contracts be

recog-nized in the income statement?

3 How should the overall sensitivity of the issuer to changes in

important variables be conveyed?

U.S SOX Section 401: Off-Balance Sheet Arrangements 17

Accounting for Derivatives

The SEC explains the accounting for derivatives as follows: “In eral SFAS No 133 requires that derivatives be recorded as assets orliabilities on the balance sheet at fair value, and re-measured eachperiod with changes in fair value reflected in earnings In part, therationale for this approach was FASB’s view that recognizing deriva-tives on the balance sheet based on measurements other than fairvalue was generally less relevant and understandable For example, ifhistorical cost were used to measure derivatives, many would bereported at a value of zero because no payment is made at the incep-tion of the contract (e.g., most forward contracts).”

gen-Hedge Accounting

The SEC explains hedge accounting of derivates as follows: “Manyissuers utilize derivative instruments to hedge their exposure to cer-tain economic risks When a derivative is used to hedge an exposure,the value of the derivative should have an inverse relation to the value

of the exposure it is hedging.” The SEC notes that the core principleunder SFAS No 133 is to recognize changes in the value of derivatives

in the income statement, but it also provides for an exception toaddress potential timing differences in recognizing offsetting gainsand losses “These timing differences occur in part because GAAP uti-lizes a ‘mixed-attribute’ approach where some items are recognized athistorical cost, others at the lower of cost or market, and still others

at fair value As a consequence, changes in the value of a derivativemay not be reflected in earnings at the same time as changes in thevalue of the hedged exposure unless hedge accounting is used.”CONTINGENT OBS OBLIGATIONS7

In its 2005 Report on Section 401, the SEC describes contingent OBSobligations as “situations where uncertainty exists about whether anobligation to transfer cash or other assets has arisen and/or theamount that will be required to settle such obligation.” Examplesinclude an organization which is:

■ A party in a lawsuit and any payment is contingent upon the come of a settlement or an administrative or court proceeding;

out-■ Providing a warranty for goods and services sold in which ment is contingent on the number of items that actually becomedefective and qualify for benefits under the warranty

pay-■ Acting as a guarantor on a loan for another organization and ment is contingent on whether the other organization defaults.All these are examples of contingent OBS that present the poten-tial for confusion, errors, and fraud The issue is what, if any, liabil-ity should be recognized before such contingencies are resolved TheSEC notes that SFAS No 5, Accounting for Contingencies, providesguidance for contingent OBS treating them in one of three ways Tobegin with, a decision is made as to whether the loss itself is deemed

pay-“probable” to occur and whether the loss amount is estimable.Recognition of a liability is required if the loss is deemed probableand estimable

No contingent OBS liability is recognized on a balance sheet, butfinancial reporting must note the existence of the potential loss if it isprobable but the amount is not easily estimated, or if the loss is rea-sonably possible, but not probable Of course the thresholds for “rea-sonable” and “probable” are not easily quantified and very muchopen to interpretation, which will be discussed in the next section.The SEC acknowledges the lack of a consensus in how to handleOBS issues: “In contrast to the SFAS No 5 approach, some recentaccounting guidance requires that certain obligations that includecontingencies be recognized at fair value Under a fair valueapproach, the degree of uncertainty associated with a contingent lia-bility is reflected in the measurement of the liability, rather than inthe determination of whether a liability is recognized.”

OBS Issues in Accounting for Contingent Obligations

U.S SOX Section 401: Off-Balance Sheet Arrangements 19

shareholders In addition, the items on the balance sheet would bereported at the amount most likely to be paid or received.”

But the SEC acknowledges that this treatment creates severalissues: “First, while the SFAS No 5 accounting results in the record-ing of a liability that reflects the most likely payment, the balancesheet reflects information about only that outcome Informationabout the other potential outcomes is ignored for the purpose ofrecording the liability While disclosures in the notes to the financialstatements might help to provide this information, in practice thosedisclosures are rarely detailed enough to allow an investor to takeinto account multiple possible loss outcomes.”

It is ironic that the SEC is so open in admitting to potential forabuse and errors in its treatment of contingent OBS The SECacknowledges the problems in relying on what may be a subjectivemanagement analysis of whether a loss is probable This makes theaudit process very difficult as well

The SEC’s Section 401 Report discusses their long-term advocacy

of improvements in OBS reporting Some of this is the obvious rassment over the Enron scandal in which OBS and SPEs were used tohide a majority of the firm’s debt The outrageous abuse of OBSarrangements and obligations and its certification by Arthur Andersenstand as one of the most embarrassing failures in regulations in U.S.corporate history Ironically, the SEC does not reference any comments

embar-it made advocating improvements in OBS accounting prior to Enron.8

Sadly, after all the reports and recommendations by the SEC,there is little to prevent the continued abuse of OBS and SPEs Therules are so complex that unethical companies have a great deal ofweasel room to hide problems and inflate earnings For ethical orga-nizations, the rules are open to conflicting interpretations for evenprocesses as straightforward as purchasing

ENDNOTES

1 This section extensively quotes and references the SEC’s “Reportand Recommendations Pursuant to Section 401(c) of theSarbanes-Oxley Act of 2002 On Arrangements with Off-BalanceSheet Implications, Special Purpose Entities, and Transparency

of Filings by Issuers.”

2 This section extensively quotes and references the SEC’s “Reportand Recommendations Pursuant to Section 401(c) of theSarbanes-Oxley Act of 2002 On Arrangements with Off-BalanceSheet Implications, Special Purpose Entities, and Transparency

of Filings by Issuers.”

3 This section extensively quotes and references the SEC’s “Reportand Recommendations Pursuant to Section 401(c) of theSarbanes-Oxley Act of 2002 On Arrangements with Off-BalanceSheet Implications, Special Purpose Entities, and Transparency

of Filings by Issuers.”

4 This section extensively quotes and references the SEC’s “Reportand Recommendations Pursuant to Section 401(c) of theSarbanes-Oxley Act of 2002 On Arrangements with Off-BalanceSheet Implications, Special Purpose Entities, and Transparency

of Filings by Issuers.”

5 This section extensively quotes and references the SEC’s “Reportand Recommendations Pursuant to Section 401(c) of theSarbanes-Oxley Act of 2002 On Arrangements with Off-BalanceSheet Implications, Special Purpose Entities, and Transparency

of Filings by Issuers.”

6 This section extensively quotes and references the SEC’s “Reportand Recommendations Pursuant to Section 401(c) of theSarbanes-Oxley Act of 2002 On Arrangements with Off-BalanceSheet Implications, Special Purpose Entities, and Transparency

of Filings by Issuers.”

7 This section extensively quotes and references the SEC’s “Reportand Recommendations Pursuant to Section 401(c) of theSarbanes-Oxley Act of 2002 On Arrangements with Off-BalanceSheet Implications, Special Purpose Entities, and Transparency

of Filings by Issuers.”

8 SEC “Report and Recommendations Pursuant to Section 401(c)

of the Sarbanes-Oxley Act of 2002 On Arrangements with Balance Sheet Implications, Special Purpose Entities, andTransparency of Filings by Issuers.”