Introduction

This Financial Reporting Alert underscores the importance of providing comprehensive and informative disclosures about (1) the effects of the current credit environment on financial statements and (2) the potential exposures associated with this environment.

In addition, this alert highlights the need for disclosures about many of the concerns expressed by the FASB, SEC, and PCAOB regarding the challenges organizations face in this environment.

This alert discusses:

• Examples of business activities that most likely will be affected by the current credit environment.
• Remarks made by an SEC commissioner and an SEC staff member at the 2007 AICPA National Conference on Current SEC and PCAOB Developments regarding accounting and disclosure considerations in the current credit environment.
• Existing disclosures required by U.S. GAAP and the SEC that focus on an organization’s exposure to credit risk and uncertainties.

Although this alert highlights a number of items preparers and auditors should consider, it is neither a comprehensive checklist nor a complete analysis. Each organization, in consultation with its professional advisers, should consider its own facts and circumstances and monitor ongoing developments to determine the adequacy and comprehensiveness of its disclosures.

The alert includes the following three appendixes, which (1) highlight the SEC staff’s areas of focus as organizations prepare their year-end notes to the financial statements and MD&A disclosures and (2) include a compilation of recently issued disclosures regarding the credit environment:

• Appendix A: Recent SEC Comments That Are Relevant to the Current Credit Environment — This appendix provides recent comments registrants have received from the SEC’s Division of Corporation Finance regarding their disclosures about the impact of the credit environment in their SEC filings. Appendix A also highlights certain disclosure considerations that the SEC staff emphasized at the 2007 AICPA National Conference on Current SEC and PCAOB Developments.
• Appendix B: Excerpts From Recent Registrant Disclosures — This appendix includes excerpts from notes to the financial statements and MD&A disclosures (addressing the impact of the credit environment) that registrants have provided in recent annual and quarterly SEC filings. Because of the timing of this alert, most of the disclosure excerpts in Appendix B are from registrants’ Forms 10-Q rather than from their annual filings. It is reasonable to expect that registrants’ Form 10-K disclosures will be more extensive.
• Appendix C: Sample SEC Letter Emphasizing Disclosures About Off-Balance-Sheet-Entities — This appendix provides a sample letter sent by the SEC staff to various registrants. The letter provides disclosures that registrants may want to consider in their Forms 10-K regarding their involvement with off-balance-sheet entities.

Examples of Business Activities Affected by the Current Credit Environment

The well-publicized effects of the continuing turbulence in the credit markets now extend beyond significant declines in the values of financial assets backed by subprime mortgage loans. As more asset classes and business activities are affected by the credit crunch, financial statement users expect organizations to provide comprehensive and informative disclosures that accurately and fairly portray their exposures to the risks associated with the current credit environment. The following are some business activities organizations should consider when evaluating the adequacy of their disclosures about the current credit environment.

Investing Activities

• Investing in financial instruments (including asset-backed securities and other structured investment products backed by subprime mortgage loans or other collateral with exposure to current credit conditions).
• Investing in loans (including subprime mortgage loans).
• Investing in auction rate securities.
• Valuations of financial instruments, especially illiquid securities with little or no price transparency.

Lending and Related Activities

• Originating loans (including subprime mortgage loans) and commitments to originate loans.
• Securitizing financial assets.
• Servicing financial assets.
• Issuing financial products.

Sponsoring Off-Balance-Sheet Entities (Including Asset-Backed Commercial Paper (ABCP) Conduits and Collateralized Debt Obligations (CDOs))

Issuing Short-Term Financing

• Issuing commercial paper (including auction rate securities and other short-term liquidity facilities).
• Liquidity and capital resources.

If an organization engages in any of the business activities listed above, it should consider expanding its disclosures about the various effects of the credit environment. These disclosures should focus on the extent of subprime exposure, including the impact of illiquid market conditions on determining fair value and related estimates.

2007 AICPA National Conference on Current SEC and PCAOB Developments

A major theme at the 2007 AICPA National Conference on Current SEC and PCAOB Developments (see Deloitte & Touche LLP’s December 20, 2007, Heads Up) was the need for registrants to provide transparent disclosures in their notes to the financial statements and MD&A about the potential for credit losses as well as about their exposures to the current credit environment.

Overview

In her keynote speech, SEC Commissioner Kathleen Casey indicated that the staff is issuing comments to registrants regarding their disclosures about recent subprime developments. Ms. Casey emphasized that disclosures must adequately address the impact of subprime loans, commercial paper markets, and other market conditions.

In her discussion of appropriate MD&A disclosures related to current credit markets, Stephanie L. Hunsaker, associate chief accountant in the SEC’s Division of Corporation Finance, noted aspects of the current credit environment in which entities are experiencing increasing loan loss allowances, write-downs and impairments of securities, credit downgrades, dividend reductions, and liquidation of CDOs or structured investment vehicles (SIVs). Ms. Hunsaker observed that registrants should provide investors with information about their:

• Subprime exposure.
• Off-balance-sheet risks.
• Structures that may need to be consolidated in the future.
• Exposure to investments without readily determinable values.

Disclosures Regarding Fair Value Measurements

Ms. Hunsaker indicated that the SEC staff believes many registrants do not provide sufficient insight into how fair value is determined, especially when fair value measurements rely on unobservable data. She remarked that the SEC staff believes registrants should consider the following disclosures when fair value measurements rely on unobservable inputs:

• The valuation models used to determine fair value.
• The significant inputs into those models.
• The assumptions that could have the greatest impact on the valuations.
• Whether, how, and why those assumptions have changed from prior periods.

Ms. Hunsaker also noted that registrants that have early adopted FASB Statement No. 157, Fair Value Measurements, should consider enhancing their disclosures about fair value measurements that, because of a lack of observable market inputs, have been reclassified from Level 2 to Level 3 measurements. She indicated that registrants should disclose the amounts and types of instruments being reclassified and the nature of the inputs that are no longer observable.

Off-Balance-Sheet Entities (e.g., Conduits and SIVs)

Ms. Hunsaker emphasized the need for registrants to consider whether the MD&A included in their quarterly and annual filings appropriately reflects their involvement with off-balance-sheet entities and SIVs. She stressed that entities should provide detailed disclosures about the nature and level of the support provided to off-balance-sheet entities, including:

• The type of involvement.
• The nature of the off-balance-sheet entity and its exposure to credit losses.
• The sponsor’s maximum potential exposure to losses as a result of the credit or other support.¹

FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities

Ms. Hunsaker reminded registrants about the requirement for a variable interest holder to disclose its maximum exposure to loss associated with its interest in a variable interest entity. She indicated that, on the basis of the SEC staff’s review of filings, it has been difficult to determine what is included in an entity’s maximum exposure to loss and which agreements were considered in making that determination. The SEC staff suggests expanding this disclosure to:

• Identify what the maximum loss amount includes, such as unfunded liquidity commitments and other contractual guarantees.
• Quantify the maximum exposure for each component.
• Describe what events would need to occur for the maximum loss amount to be incurred.

Accelerated Efforts to Mitigate Subprime Crisis — Refinancing Subprime Loans

In early January 2008, SEC Chief Accountant Conrad Hewitt issued a letter addressing the accounting implications under FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, of the American Securitization Forum’s Streamlined Foreclosure and Loss Avoidance Framework (ASF Framework). The ASF, in coordination with the Department of the Treasury, developed the Framework to encourage mortgage loan servicers to refinance or modify classes of adjustable-rate subprime mortgage loans with certain risk characteristics that make them susceptible to default. The SEC’s letter, addressed to both the Financial Executive International’s Committee on Corporate Reporting and the Center for Audit Quality’s Professional Practice Executive Committee, indicates that the Office of the Chief Accountant "will not object to continued status as a QSPE [qualifying special-purpose entity] if Segment 2 subprime ARM [adjustable-rate mortgage] loans are modified pursuant to the specific screening criteria in the ASF Framework."

Appendix A of that letter provides guidance on what disclosures the Office of the Chief Accountant and the Division of Corporation Finance believe registrants that have transferred subprime ARM loans to QSPEs should consider in future SEC filings (for a detailed listing of each disclosure, see Appendix A of this Financial Reporting Alert).

With respect to disclosures in the notes to the financial statements, Appendix A of the letter indicates that "to meet the disclosure requirements of APB Opinion No. 22, Disclosure of Accounting Policies, the SEC staff generally expects that a registrant’s disclosure of its accounting policies would need to include a discussion of the permitted activities of off-balance-sheet QSPEs, including the ability of the servicer to modify subprime mortgages when default is ‘reasonably foreseeable,’ and the adoption of the specific screening criteria in Segment 2 of the ASF Framework for purposes of determining the subprime ARM loans that are ‘reasonably foreseeable’ of default."

Existing Disclosure Requirements

U.S. GAAP and SEC literature include numerous disclosure requirements regarding fair value, credit risk, uncertainties, contingencies, and impairments. The following guidance contains disclosure requirements preparers should consider when making disclosures about the effects of the current credit environment in the notes to the financial statements and MD&A.

• FASB Statement No. 157, Fair Value Measurements (also see the Center of Audit Quality white paper, Fair Value Measurements in Illiquid (or Less Liquid) Markets, since Statement 157 is not effective for many entities as of December 31, 2007).
• FASB Statement No. 156, Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140.
• • FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities — a replacement of FASB Statement No. 125.
• FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities.
• FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities.
• FASB Statement No. 107, Disclosures About Fair Value of Financial Instruments.
• FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities — an interpretation of ARB No. 51.
• FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others — an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34.
• FASB Staff Position No. FAS 115/124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments."
• FASB Staff Position No. SOP 96-1-1, "Terms of Loan Products That May Give Rise to a Concentration of Credit Risk."
• AICPA Statement of Position 01-6, Accounting by Certain Entities (Including Entities With Trade Receivables) That Lend to or Finance the Activities of Others.
• AICPA Statement of Position 94-6, Disclosure of Certain Significant Risks and Uncertainties.
• SEC Regulation S-K, Item 303, "Management’s Discussion and Analysis of Financial Condition and Results of Operations."

The above guidance was not developed in the context of the current severe credit environment. Thus, entities should carefully consider the extent of their disclosures to determine that the objectives of the disclosure requirements are satisfied.
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 1     In a related development, in December 2007, the Division of Corporation Finance sent letters to chief financial officers of certain public companies. This letter provides disclosures that registrants may want to consider regarding their involvement with off-balance-sheet entities. A sample letter is included as Appendix C of this Financial Reporting Alert.