February 1999 Issue



By Gary Illiano and Joseph Bentz

To address the Year 2000 disclosure issue, the staff of the SEC originally issued and then revised Staff Legal Bulletin No. 5. In response to continuing concerns that many companies are not providing adequate disclosures, the SEC has now issued a more forceful interpretative release, Statement of the Commission Regarding Disclosure of Year 2000 Issues and Consequences by Public Companies, Investment Advisers, Investment Companies, and Municipal Securities Issuers, which provides more extensive guidance to public companies so they can determine whether their Year 2000 issues are known material events, trends, or uncertainties that should be disclosed in the Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) section of their disclosure documents. As used in the release, the term public companies generally refers to corporate and similar issuers, rather than investment companies and investment advisers, which are separately addressed. This article addresses the requirements for such public companies only.

The guidance in this interpretative release supersedes the current staff guidance in revised Staff Legal Bulletin No. 5. The full text of the interpretative release is located at the SEC website, www.sec.gov.

Specific Guidance for Year 2000 Disclosure Under MD&A

MD&A is intended to give investors the opportunity to look at a company through the eyes of management with particular emphasis on the company's prospects for the future. The language of MD&A requirements is intentionally general to provide flexibility to companies seeking to provide meaningful disclosures. One of the few instances where forward-looking disclosure is required, MD&A requires disclosure of known material events, trends, or uncertainties.

Year 2000 disclosure is required if--

  • the company's assessment of its Year 2000 issues is not complete, or

  • management determines that the consequences of its Year 2000 issues would have a material effect on the company's business, results of operations, or financial condition, without taking into account the company's efforts to avoid those consequences.

    The SEC believes the Year 2000 problem is known to all companies due to widespread publicity. Because of the prevalence of computers and imbedded technology in virtually all businesses and the potential consequences of not adequately addressing the Year 2000 problem, the SEC believes that almost every company will need to address it. In almost all instances, companies will have material events and changes requiring updated Year 2000 disclosures in each quarterly and annual report filed with the SEC.

    In determining whether the assessment of its Year 2000 issues is complete, a company should take into account whether third parties with whom a company has material relationships are Year 2000 compliant. For vendors and suppliers, the relationship is material if there would be a material effect on the company's business, results of operations, or financial condition if they are not compliant. A company should also consider its potential liability to third parties if its systems are not Year 2000 compliant resulting in possible legal actions for breach of contract or other harm.

    In the absence of clear evidence of readiness, a company must assume that it will not be Year 2000 compliant and weigh the likely results of this determination. As part of this analysis, the company must assume that material third parties will not be ready either, unless these third parties have delivered written assurances that they expect to be Year 2000 compliant in time. The test is driven by measuring the consequences if the company is not prepared rather than the amount of money the company spent, or plans to spend, to address this issue.

    What to Disclose About
    Year 2000 Issues

    Once a company determines that it has a Year 2000 disclosure obligation, it has to decide what, specifically, to disclose. MD&A does not require categories of specific information because each company has to consider its own circumstances. For Year 2000 disclosure to be meaningful, companies will have to address the following four categories of information:

  • The company's state of readiness

  • The costs to address the company's Year 2000 issues

  • The risks of the company's Year 2000 issues

  • The company's contingency plans.

    The disclosure should be specific to each company and quantified to the extent practicable; it should avoid generalities and boilerplate disclosure. Some companies may have to provide this information by business segment or subdivision. In addition, each company must consider if its unique Year 2000 circumstances require that additional matters be disclosed.

    Company's State of Readiness. If disclosure is required, a company first has to describe the known material event, trend, or uncertainty. A company should describe its Year 2000 issues in sufficient detail and in nontechnical, plain English terms, to allow investors to fully understand the challenges it faces. So far, most companies have provided only a cursory description of their Year 2000 issues.

    A full description of a company's Year 2000 readiness should generally include the following elements:

  • Information about both information technology (IT) and non-IT systems. Non-IT systems typically include embedded technology such as microcontrollers, which are typically more difficult to assess and repair than IT systems. Microcontrollers are found in most equipment and machinery, such as elevators. In fact, companies often have to replace non-IT systems, because they cannot be repaired. To date, only a few companies have addressed non-IT issues in their disclosures.

  • The status of the process, identified by phase, of becoming ready for the Year 2000 for both IT and non-IT systems, including the progress made and the estimated timetable for completion of each remaining phase. Whether the company is fixing its systems or replacing them, the SEC is particularly concerned about the testing phase, especially about the systems tested and the methodology used. Since there are no universal definitions for the phases in a Year 2000 remediation program, companies should briefly describe how they define each phase. Disclosures should be tailored for the particular circumstances.

  • A description of the Year 2000 issues relating to third parties with which it has a material relationship. Due to the interdependence of computer systems today, each company's Year 2000 issues may affect other companies' disclosure obligations. The nature and level of importance of these material relationships should be disclosed, as well as the status of assessing these third-party risks.

    Costs to Address the Company's Year 2000 Issues. Companies must disclose material historical and estimated costs of remediation. This includes costs directly related to fixing Year 2000 issues, such as modifying software and hiring Year 2000 solution providers. In most cases, the replacement cost of a noncompliant IT system should be disclosed as an estimated Year 2000 cost, even if the company had planned to replace the system and merely accelerated the replacement date. A company does not need to include the replacement cost as a Year 2000 estimated cost if it has not accelerated the replacement due to Year 2000 issues.

    Risks of the Company's Year 2000 Issues. A public company must determine its worst case Year 2000 scenarios and describe the one most reasonably likely to occur. If a company does not know if the consequences of a known event, trend, or uncertainty are likely to be material, that uncertainty must be disclosed in MD&A, as well as the efforts made to analyze the uncertainty and how the company intends to handle it. For example, companies must disclose estimated material lost revenue due to Year 2000 issues, if known.

    Company's Contingency Plan. A public company must describe how it is preparing to handle the most reasonably likely worst case scenario. Contingency plans typically include identification of systems and third-party risks, analysis of resources and strategies to restore operations, and a recovery program that identifies participants, processes, and any significant equipment needed. The fact that a contingency plan has not yet been established should be disclosed, along with whether the company intends to create one, and the timetable for doing so.

    Suggested Disclosures

    In addition to providing the minimum level of Year 2000 disclosure set forth above, each company must consider whether its particular circumstances require disclosure of other matters. The interpretative release makes the following suggestions intended to help companies meet their disclosure obligations. While each of the suggestions may not be relevant for every company, a public company must consider whether it should--

  • disclose historical and estimated costs related to its Year 2000 issues, even if disclosure of the dollar amounts is not required because these amounts are not material

  • as of the end of each reporting period, disclose how much of the total estimated Year 2000 project costs have already been incurred

  • identify the source of funds for Year 2000 costs, including the percentage of the IT budget used for remediation. This allows investors to determine whether Year 2000 costs will reduce the company's income.

  • explain if other IT projects have been deferred due to Year 2000 efforts, and the effects of these delays on financial condition and results of operations

  • describe the use of any independent verification and validation processes to assure the reliability of its risk and cost estimates. The use of independent verification may be particularly important in the testing phase.

  • use a chart to provide Year 2000 disclosures. The chart may help investors track a company's progress over time, as it is updated, and make peer comparisons based on the same data. In addition, a chart can reduce a lengthy Year 2000 disclosure that otherwise may overwhelm other disclosures.

  • include a breakdown of the costs, such as the costs to repair software problems and problem systems and equipment.

    Illustrations of unacceptable boilerplate and meaningful Year 2000 disclosure released by the SEC staff are shown in Exhibits 1 and 2.

    Year 2000 Financial Statement Considerations

    The interpretative release also includes a recap of existing accounting and auditing guidance concerning the accounting and disclosure issues arising from the Year 2000 problem. Accounting issues addressed include--

  • costs of modifying software

  • costs of failure to be Year 2000 compliant

  • disclosure of Year 2000 related commitments

  • revenue and loss recognition

  • allowance for loan losses

  • losses from breach of contract

  • impairment of assets

  • disclosures of risk and uncertainties.

    Auditing issues addressed include--

  • conducting the audit

  • going concern issues

  • resignation of an independent auditor.

    Reference is made to the AICPA publication, The Year 2000 Issue: Current Accounting and Auditing Guidance, for further reading.

    Other Regulations

    Other Federal securities rules or regulations may require disclosure related to companies' Year 2000 issues. The interpretative release includes the following list of rules and regulations that companies should consider:

  • Description of business

  • Legal proceedings

  • Material contracts

  • Risk factors

  • Form 8-K

  • Any additional material information necessary to ensure the required disclosure is not misleading.

    Statutory Safe Harbors for Forward-Looking Information

    There are two statutory safe harbors for forward-looking information provided by the Private Securities Litigation Reform Act of 1995. Almost all of the required MD&A disclosures concerning Year 2000 problems contain forward-looking statements. For example, a company's statement regarding the estimated future costs due to business disruption caused by vendors, suppliers, customers, or even the possible loss of electric power or phone service typically would be a statement of future economic performance, as well as a projection of a financial item. Much of the description of a company's Year 2000 problems would be part of a forward-looking statement because the description contains assumptions concerning estimated costs or plans for future operations. Contingency plans that assess which scenarios are most likely would be forward-looking statements of plans and objectives of management for future operations. However, statements of historical fact are not forward-looking.

    For the statutory safe harbors to apply, material forward-looking statements must be accompanied by "meaningful cautionary statements." The safe harbors do not apply if the forward-looking statement was knowingly false when made. Furthermore, the statutory safe harbors were meant to apply only to private actions in Federal court. There are exclusions from the statutory safe harbors for specific types of filings, including initial public offerings and investment companies. Disclosures in GAAP financial statements are also excluded. Statements of estimated costs included in MD&A disclosure outside the financial statements would generally be covered; however, inclusion of those costs in the financial statements, or discussion of them in the footnotes to the financial statements, would not be covered.

    Effective Date

    The effective date for interpretative guidance was August 4, 1998. *

    Gary Illiano, CPA, is a partner and regional director of professional standards, and Joseph Bentz, CPA, an assurance manager, both with Grant Thornton LLP's national office in New York

    Gary Illiano, CPA
    Grant Thornton LLP

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