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There is an increasing crisis of confidence in the financial disclosure system to which all public companies need to react. While Congress and the SEC are likely to come forward with a series of reforms governing accountants, accounting and audit standards and financial reporting obligations, public issuers should not wait for such reforms, or for SEC inquiries and filing reviews, to improve the clarity of their financial disclosures. In addition to taking steps to ensure the integrity of the audit process, there is also much that can be done to put a company’s financial position in a clearer light and to explain to shareholders and the public in plain English the key factors that drive profitability and the key risks to future profitability and liquidity. We are at the perfect time in the reporting cycle for public companies to improve the clarity of their financial disclosures. Most companies with a fiscal year ending on December 31st have recently reported their earnings for the year, but have yet to finalize their detailed disclosure documents relating to those results. The Annual Report, Proxy Statement and Form 10-K for the year ended December 31, 2001 offer companies the ideal opportunity to provide a clearer analysis of their accounting policies, earnings trends and risks related to earnings and liquidity. Audit committee members can use the process of reviewing these documents as a means of exercising diligence over the company’s auditing practices, accounting policies and related financial disclosures. Here are some suggestions in this regard: 1. Draft on a Clean Page, Don’t Just Mark Up Last Year’s Boilerplate.The Annual Report, Proxy Statement and Form 10-K are meant to provide a comprehensive overview of the company’s business strategy, management and board, historical financial performance and anticipated financial prospects and trends. While significant attention is typically paid to the Chairman’s message and the details of the financial disclosures, too often the exercise of preparing such documents involves largely marking up last year’s documents. Companies should rethink the disclosure anew each year, especially this year (in addition to recent press revelations and market turmoil regarding disclosure issues, the SEC’s Division of Corporation Finance has indicated that it will focus on monitoring and examining the 2002 filings of Fortune 500 companies). Consider starting with a clean piece of paper and thinking about the type of disclosure document that will tell the clearest and most complete disclosure story. Also, it may be helpful to start this process by determining the several overarching messages or big picture concepts that must emerge — through the many detailed disclosures that will follow — in order to create an integrated disclosure document and to give investors a more understandable picture of the company’s financial position and risks. 2. Don’t Look to Just Disclose the Minimum Required By Law.The financial reporting rules are quite complex and accountants, lawyers and issuers have all become adept at crafting disclosures that meet the bare minimum requirements. In all years, and especially in this one, companies should strive to go beyond the minimum requirements to convey the full financial picture. The SEC will likely be working to revise disclosure rules to close some of the gaps in current reporting requirements. Companies shouldn’t wait for such revisions and should err on the side of more disclosure rather than less. Significant developments should be disclosed clearly when they occur, not only on a preset and potentially stale schedule dictated by SEC periodic disclosure rules. Areas of special attention should include: off-balance sheet structures; insider and affiliated party transactions; board relationships; accounting policies; auditor relationships. In performing the analysis of what and when to disclose, materiality thresholds should be assessed not merely against revenues, profits or other quantitative metrics, but in view of qualitative factors, particularly where earnings trends or the like could be masked. 3. Use the MD&A to Tell a Complete Picture About the Company’s Financial Condition.A well-written MD&A (Management’s Discussion and Analysis of Financial Condition and Results of Operations) can go a long way toward protecting issuers from fallout relating to subsequent earnings hits and liquidity contractions. Even in its best application, accounting is far from an exact science. Issuers and the public should understand the limitations inherent in any set of reported financials. No matter how much improvement there may be in applying more conservative accounting principles prospectively, historical income statements and balance sheet presentations can never on their own fully capture the earnings and balance sheet risks inherent in a complex company. MD&A is the place where management and the board can fully explain all of the key factors and assumptions driving earnings, capital, and liquidity, and all of the risks inherent in the Company’s business model. 4. Consider Adding a Fuller Risk Factors Section to the Form 10-K.In addition to a thorough MD&A, issuers should consider adding a fuller risk factors or special considerations section to their Form 10-K. Form 10-Ks already contain a condensed version of risk factors: the forward looking disclaimer language which has been added in response to the safe harbor provisions of the Private Securities Litigation Reform Act. Often, however, these sections are more boilerplate than substantive. A thorough section that fully addresses the risks inherent in the Company’s business model and reported financials would have two strong benefits. First, it would improve the quality of public disclosures. Second, it would provide a platform for management, the board and the Company’s outside advisors to examine on a regular basis the clarity and completeness of the Company’s financial disclosures. The same rigor should apply to drafting the risk factors for the Form 10-K as would apply in the context of an IPO or rights offering. 5. Use More Plain English.A couple of years ago the SEC launched a major initiative to require plain English disclosures. While there were a lot of complaints at first, the rules have actually work quite well, and it is much easier now to understand the textual discussions in merger proxies and debt prospectuses than in the past (although there is still room for improvement on this front). The current plain English requirements do not, however, apply to Form 10-Q and Form 10-K filings or to MD&A and financial statement footnotes. Accounting rules have grown increasingly complex and disclosures at Enron and elsewhere provide painful current lessons as to how simple economic facts can often be obscured through complex accounting rules. Companies should try harder to tell their financial stories in simpler terms. They should also ask whether or not MD&A and financial footnote disclosure provides adequate context and appropriate emphasis so that investors can reasonably be expected to understand the significance of the facts that are being disclosed. It shouldn’t take an advanced accounting degree or a forensic study by a sophisticated financial analyst to decode financial statement disclosures and related MD&A. 6. Consider Asking the Company’s Outside Financial Advisors to Provide Suggestions for Expanded Disclosures.Even the most sophisticated directors can use help in understanding the financial statement disclosures of complex corporate organizations. While good directors will ask tough, penetrating questions of management and the outside auditors, there are sources of additional help that it may make sense to call upon, especially in the current environment. Investment banking firms are not auditors and they should not be expected to take on the responsibilities or liabilities of the Company’s auditors. Bankers can, however, provide a useful service to firms by helping management and the board ask the right questions and providing a fresh outside perspective on the clarity and completeness of proposed disclosure language. An audit committee might even consider inviting one or more financial analysts that cover their Company for a discussion with the committee concerning ways in which the Company could provide more fulsome and useful disclosures to the public. Care will need to be taken in any such meetings to avoid selective disclosure of material nonpublic information. 7. Seek Guidance from Both the Audit Partner and the National Office Staff.While the lead audit partner will by necessity be the main contact between the audit committee and the outside auditors, the audit committee should also try to develop an independent relationship with the auditor’s national office staff. The audit team needs to audit and the national office cannot add much to the audit function beyond policing the integrity of their auditors and making sure that there are proper rotations, the absence of conflicts, and the like. The national office can, however, add a great deal to the process of ensuring that accounting standards are being applied properly and on a consistent basis with other peer companies. Audit committees should insist on access to the national office staff as a source of comfort that the lead audit partner is providing the correct analysis and judgments. Assurances should be obtained that the audit staff assigned to the engagement are current on relevant practices and principles and are prepared to skeptically challenge accounting practices when appropriate. When complex issues arise, the committee should also consider seeking confirmation that other leading accounting firms would follow the same practices being proposed by their auditors. Companies must be willing to pay the fair cost of such additional access and advice. It is well worth the extra fees, even premium fees, to have a thorough review and analysis of the appropriateness of the Company’s accounting practices. 8. Make Sure There is Ample Time for Senior Management, Outside Advisors and the Board to Review and Comment on the Disclosure Documents.Too often, disclosure documents are distributed to directors at the last minute and the directors are not provided with a meaningful opportunity to review, let alone comment on, these documents. This year especially, management should have a detailed discussion with the audit committee concerning the proposed approach to the annual disclosure documents well in advance of the filing deadlines. Drafts and outlines should be shared with the audit committee members at the earliest practical times. All directors, not only the members of the audit committee, should be offered the opportunity to participate in discussions concerning the disclosure documents and be provided with advanced drafts of the documents. 9. Be Open to Outside Suggestions for Improving the Clarity of Disclosures.Companies should be open to outside suggestions for how they can improve financial disclosures and should watch what other companies are doing as well. Shareholders and financial analysts can also be invited to make suggestions for how the Company can improve the clarity of their financial disclosures. Not all of those suggestions will be good ones, and by no means do all of those suggestions need to be followed. Beyond the specifics of any particular disclosure practice, there is an important tonal message that companies can send to the Street, as well as their regulators and other key constituency groups, that they are adopting an open attitude on all financial disclosure matters. 10. Make Sure All Relationships that Could Give Rise to Any Perceived Conflicts are Fully Disclosed.Lastly, and perhaps most importantly, companies need to give extra consideration to disclosing all relationships (by management or their family members, by directors and their affiliates, and by the auditors) that could give rise to any appearance of conflict. If a company or individual would not wish to proceed forward with a given transaction if all of its terms needed to be fully disclosed to the public, perhaps the transaction in question is one that is best avoided. The preceding list of suggestions by no means represents the only approach to better disclosure and we recognize that all companies are not similarly situated. Many companies already do an excellent job of providing comprehensive and clear financial disclosures. Most others, while having room for improvement, more than satisfy the requirements for full and fair disclosure. We should all be mindful of the fact of a few bad practices by isolated companies does not mean that the current reporting system is fundamentally flawed or that investors have been deprived of meaningful information in many instances. Having said that, a fresh look at disclosure practices is almost always a good idea, and this year a fresh look is clearly warranted. Edward D. Herlihy, Craig M. Wasserman and Lawrence S. Makow are partners at the law firm Wachtell, Lipton, Rosen & Katz. Nicholas G. Demmo is an associate at the firm.

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