Interpretive Guidance Regarding Liquidity Disclosure in MD&A

By Cydney Posner

The SEC has also posted, as a companion to its proposed rulemaking on liquidity disclosure, its new interpretive guidance intended to improve the MD&A discussion of liquidity and capital resources with regard to liquidity and funding risks.  Essentially, the SEC's objective is to advise companies that they cannot use financing structures or leverage ratios to mask or obscure financial condition.

Liquidity Disclosure

The SEC believes that it has become increasingly important, as companies have expanded the methods and management tools they use for funding and managing liquidity, that companies satisfy the requirements of Item 303(a)(1) of Reg S-K. That item requires companies to "identify and separately describe internal and external sources of liquidity, and briefly discuss any material unused sources of liquidity." In the context of liquidity, this item requires disclosure of known trends or any known demands, commitments, events or uncertainties that will result in, or that are reasonably likely to result in, a material increase or decrease in a company's liquidity. Companies are encouraged to review the SEC's 2003 interpretive MD&A guidance, especially as it relates to cash, debt and trend issues. In addition, companies should consider the following other potential trends:

• difficulties accessing the debt markets;
• reliance on commercial paper or other short-term financing arrangements;
• maturity mismatches between borrowing sources and the assets funded by those sources;
• changes in terms requested by counterparties; <br>• changes in the valuation of collateral; and
• counterparty risk.

Additional narrative may also be required if, because of a known trend, demand, commitment, event or uncertainty, a company's financial statements do not adequately convey its financing arrangements or the impact of those arrangements on liquidity (e.g., intra-period variations in borrowings if materially different from end-of-period borrowings). In addition, short-term financings that are not otherwise fully captured in period-end balance sheets (such as repurchase transactions that are accounted for as sales, securities lending transactions or any other transactions accounted for as sales involving the transfer of financial assets with an obligation to repurchase) may also require disclosure if the transactions are reasonably likely to result in the use of a material amount of cash or other liquid assets, especially if not otherwise disclosed under off-balance sheet arrangements or in the contractual obligations table.

To provide context, companies should also consider describing cash management and risk management policies that are relevant to an assessment of their financial condition, particularly if a company's cash and other investments are a material source of liquidity. Disclosure should include information regarding the nature and composition of the portfolio, including a description of the assets held and any related market risk, settlement risk or other risk exposure, the nature of any limits or restrictions and their effect on the company's ability to use or to access those assets to fund its business operations. Additional disclosure may be required as circumstances and risks evolve.

Leverage Ratios

When companies disclose in SEC filings capital or leverage ratios where there are no regulatory requirements prescribing the calculation of those ratios or the ratios are calculated using a methodology that is modified from its prescribed form, they must assess whether the measures are financial measures and, if so, whether they are non-GAAP financial measures. In any event, companies should clearly explain the calculation methodology, including the following: 

• the treatment of any inputs that are unusual, infrequent or non-recurring or that are otherwise adjusted so that the ratio is calculated differently from directly comparable measures;
• if the financial measure differs from those commonly used in the industry, a discussion of those differences or presentation of those measures (where necessary to make the disclosures not misleading);
• reasons for presenting the particular financial measure; and
• why the measure is useful to understanding the company's financial condition.

Contractual Obligations Table

This table is intended to present "a meaningful snapshot of cash requirements arising from contractual payment obligations," and each company is "encouraged to develop a presentation method that is clear, understandable and appropriately reflects the categories of obligations that are meaningful in light of its capital structure and business," highlighting any changes made from period to period. However, companies have developed divergent practices for disclosures in the table. Companies should address questions that have arisen regarding treatment of various obligations by keeping in mind that the "purpose of the contractual obligations table is to provide aggregated information about contractual obligations and contingent liabilities and commitments in a single location so as to improve transparency of a registrant's short-term and long-term liquidity and capital resources needs and to provide context for investors to assess the relative role of off-balance sheet arrangements." (Now there's some "meaningful" guidance that should really facilitate the analysis….) Add explanatory footnotes where helpful.

This content is provided for general informational purposes only, and your access or use of the content does not create an attorney-client relationship between you or your organization and Cooley LLP, Cooley (UK) LLP, or any other affiliated practice or entity (collectively referred to as “Cooley”). By accessing this content, you agree that the information provided does not constitute legal or other professional advice. This content is not a substitute for obtaining legal advice from a qualified attorney licensed in your jurisdiction and you should not act or refrain from acting based on this content. This content may be changed without notice. It is not guaranteed to be complete, correct or up to date, and it may not reflect the most current legal developments. Prior results do not guarantee a similar outcome. Do not send any confidential information to Cooley, as we do not have any duty to keep any information you provide to us confidential. This content may be considered Attorney Advertising and is subject to our legal notices.