SEC Digs Into Short-Term Borrowing

The Securities and Exchange Commission might have had banks foremost in mind when it proposed new rules for disclosing short-term debt, but the end result seems likely to leave all manner of public companies owing investors more of an explanation about their borrowing habits.

The rules, proposed by the SEC on Sept. 17, would require all public companies to disclose more details about their short-term borrowing in the Management Discussion and Analysis sections of their periodic reports. Firms defined as “financial companies” will have the most requirements to meet, but any public company that uses commercial paper, repurchase agreements, letters of credit, promissory notes, or factoring arrangements to meet liquidity needs will be subject to the new requirements as well.

Hodges

“For non-financial companies, this is going to have a more significant effect than maybe is expected,” says Bridgette Hodges, a partner at accounting firm Grant Thornton. “Specifically, requiring this disclosure is going to add a significant level of effort for non-financial companies to comply.”

Take retail or manufacturing companies as an example. Those businesses can have large swings in borrowing and liquidity levels throughout a reporting period to fund their operations; they will be subject to the new disclosure, but might not have the same sophisticated tracking tools that banks use to track the data the SEC plans to require, Hodges explains.

On the other hand, financial companies that manage short-term borrowing closely as part of their risk-management strategies probably have all the data and information they need to meet the disclosure requirements.

Smaller companies will probably have more trouble meeting the disclosure requirements too, says Keith Barber, a director at advisory firm CFO Consulting Partners. But, he says, “smaller companies also have fewer lines of credit to deal with. A large manufacturing company could have lines of credit all over the world, but in a smaller company it’s all in the hands of a treasurer, who is sitting across the hall from the CFO.”

The objective of the new requirement, SEC Chairman Mary Schapiro said, is to end the practice of “window dressing” the balance sheet, where some companies may reduce their short-term borrowings just before a financial reporting date to make their overall liquidity look healthier to regulators and investors. Lehman Brothers used precisely such shell games to prop up its balance sheet until it collapsed in September 2008, contributing to the financial crisis. Cynics say many other Wall Street banks have done the same.

The new requirement will close a disclosure gap, Schapiro said, making it easier for investors to distinguish between actual short-term borrowing activity during a reporting period and what’s reported on the closing date. “With this information, investors would be better able to evaluate the company’s ongoing liquidity and leverage risks,” she said at the SEC’s May 17 meeting.

Arcy

“For non-financial companies, this is going to have a more significant effect than maybe is expected.”

—Bridgette Hodges,

Partner,

Grant Thornton

Jerry Arcy, managing director at investment advisory firm Duff & Phelps says the rule is necessary, even if it brings unintended consequences. He says there’s little doubt that liquidity crises and failures at major financial institutions, such as Bear Stearns and Lehman Brothers, drove the SEC to develop the new disclosures. “Is there sufficient disclosure on counter-party risk and liquidity management?” he says. “Understanding liquidity is often more important than the profitability of an entity.”

Details of the Proposal

Under the SEC’s proposal, companies would be required to provide data in the MD&A for each type of short-term debt it taps during a reporting period, including the amount outstanding at the end of the period, the average amount outstanding during the period, and the weighted average interest rate on each of those amounts, plus the maximum amount outstanding during the period.

The SEC proposal also would require companies to provide a general description of their borrowing arrangements, including the business purpose for the debt, and their importance to liquidity, capital resources, market risk, and credit risk. Finally, companies would need to explain why it hit the maximum levels that it reports, and why there might be any material differences between borrowings at the end of the period compared with borrowings throughout the period.

In addition to the new disclosure requirements, the SEC also published guidance to remind companies of disclosures they’re already required to make about their liquidity circumstances. It reiterates that companies are not allowed to use financing structures on or off the balance sheet with the specific purpose of obscuring reported financial results.

Casey

SCHAPIRO COMMENTS

The following expert from SEC Chairman Mary Schapiro’s opening statement at the SEC’s open meeting are in regards to the Commission’s proposed rules on short-term borrowings:

The proposed rules we are considering today, if adopted, would shed greater light on a company’s short-term borrowings, including a practice some refer to as balance sheet “window-dressing.” Under these proposals, investors would have better information about a company’s financing activities during the course of a reporting period—not just a period-end snapshot. With this information, investors would be better able to evaluate the company’s ongoing liquidity and leverage risks.

As the Commission has long advised, disclosure about liquidity and capital resources is critical to assessing a company’s prospects for the future, and even the likelihood of its survival. This principle was borne out during the recent financial crisis, when many business failures were the direct result of liquidity constraints. Short-term borrowings represent an important piece of a company’s overall liquidity and capital resources picture.

Illiquidity in the markets as a whole can impact short-term borrowing, often severely and rapidly. When market liquidity is low, for example, financing rates may increase or terms may become unfavorable; it may be more costly or even impossible to roll over short-term borrowings; and for financial institutions, demand depositors may withdraw funds.

But even when market conditions are stable, short-term financing arrangements can present complex accounting and disclosure issues. Due to their short-term nature, a company’s use of these arrangements can fluctuate significantly during a reporting period. As a result, presentation of period-end amounts alone may not adequately reflect that company’s funding needs or activities during the period.

Short-term borrowings, and variations in the timing of these transactions, occur across many industry sectors. For example, a bank that routinely enters into repurchase transactions during the quarter may limit that activity at quarter-end. This can result in disclosure of a period-end amount of outstanding borrowings that does not necessarily reflect the bank’s ongoing business operations or related risks.

Likewise, a retailer may have significant short-term borrowing during the year to finance inventory. If those borrowings are repaid by year-end, the year-end disclosure may not fully inform investors of the importance to the company of this type of borrowing.

We are not suggesting there is anything wrong with these borrowing practices—indeed, they may reflect the best financing alternatives available to a company. But investors should have the tools to better understand how companies finance their businesses and how much risk they take on through borrowings that, simply because of timing, do not show up on the balance sheet.

I believe that investors will benefit from additional transparency in this area, particularly when the difference between short-term borrowing during a reporting period varies significantly from the snapshot that is presented at period-end. The proposed rule amendments before us today should address this gap in our current disclosure requirements.

Source

Mary Schapiro Comments on New Requirements (Sept. 17, 2010).

The SEC will open the comment period for 60 days after the proposal is published in the Federal Register. It is seeking feedback on whether the new requirement would be too onerous for non-financial or smaller companies and has signaled that changes could still be made to address such concerns. Commissioner Kathleen Casey said the proposed disclosure requirement is “a good starting point” for considering how to improve disclosures on short-term borrowings.

“The release contains extensive questions on both the value of these additional disclosures to investors and the costs and burdens of providing them,” Casey said. “I will be keenly interested in comments regarding whether we have properly balanced these considerations.”

Whatever the burden, the silver lining for every company, Hodges says, is that the disclosure requirement won’t be subject to the same audit rigor as the rest of the financial statements. It is information that will be presented to investors in the MD&A, so it will not be subject to audit testing or an assessment of internal controls, she says.

“There is a need for disclosures outside financial statements to be consistent with disclosures inside the financial statements,” but that will be the extent of auditor scrutiny, she adds.

Not everyone thinks the proposal will have much effect on non-financial companies. Carol Stacey, vice president of the SEC Institute and a former chief accountant for the SEC, says the new disclosure requirements aren’t much of a burden to those outside the financial sector. “I don’t think this is going to be a huge deal,” says Stacey.

Hanson

Jay Hanson, national director of accounting for McGladrey & Pullen, disagrees. He says the real burden is the incremental effect of complying with new rules on top of everything else that is going on. There are a number of new accounting pronouncements and disclosure requirements that are in place or pending for this year-end, he says, focusing on areas such as revenue recognition, contingencies, multi-employer pension plans, and loan losses. “When you add those up, holy cow, there is just a lot of stuff for this year-end,” he says. “It’s that pile-on mentality. You might say any individual piece is not that burdensome, but when you add it all together just when you’re trying to cut down on costs and staff and run your business, it’s almost untenable.”