AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS 1997 National Conference on Banks and Savings Institutions Washington, DC November 7, 1997 CURRENT DEVELOPMENTS IN FINANCIAL REPORTING: Perspectives from the SEC Remarks by Michael H. Sutton Chief Accountant Office of the Chief Accountant United States Securities and Exchange Commission Washington, DC __________________________________ The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Sutton and do not necessarily reflect the views of the Commission or the other members of the staff of the Commission. Introduction Once again, I appreciate the opportunity to participate in this annual conference and to share a few thoughts about current accounting and financial reporting issues. I'm going to begin with some perspectives on derivatives disclosures and accounting, and in doing so try to anticipate some of the questions you may have. Then I will comment on some current developments relating to several other matters of concern to the staff, including loan loss allowances, business combinations and international accounting standards. Derivatives Disclosures and Accounting Derivatives Disclosures For a number of years, the Commission has been concerned that the current accounting and disclosure requirements for derivatives and market risks are not meeting the needs of investors. Last year, I discussed the Commission's proposed market risk disclosure rules and the process for reviewing comments on that proposal. The final rules, issued last January, require new disclosures about the accounting policies for derivatives and quantitative and qualitative information about market risk exposures in derivatives and other financial instruments. In July, the staff published a Question and Answer document that addresses a number of questions frequently asked about the rules. In issuing these rules, the Commission committed to reconsider the need for the accounting policy disclosure requirements after the FASB completes its accounting project and to review the effectiveness of the quantitative and qualitative disclosures after three years. In addition, the Commission committed to review the early filings under the new rules and to report its findings one year after the effective date. We are now in the process of reviewing the first group of filings. In our very limited review to date, we have found that some registrants have developed very effective disclosures about their use of derivatives and their market risk exposures, and in those instances, the staff has found the disclosures to be informative and useful. We also have reviewed filings that were less informative, and in some cases, even confusing. In some cases, for example, the staff had difficulty locating the required information, particularly when it was scattered throughout the filing and cross references were not provided. In other cases, disclosures were not provided when other information in the filing seemed to indicate that a material market risk exposure might be present. I want to emphasize that the staff is in the preliminary stages of its review, and you should be hearing more about this process and our findings over the coming months. Accounting for Derivatives The other part of the equation for providing investors with the information they need is the FASB's accounting project. As the Board has approached completion of its project, much has been said in published articles, editorials, letters, and even Congressional testimony about the Board and the accounting it has proposed. You are well aware that the Commission has followed this debate closely and has a number of interests. First, the Commission's oversight responsibility demands close attention to process issues to see that the process is open, thorough, and operates in a way that serves the interests of investors and the public. Second, this is an area in which accounting standards have not kept pace with innovations in the marketplace -- one in which an ever widening gap has developed that needs to be filled. And, finally, some of the commentary we are now hearing suggests that there may be some problems in current filings with the Commission. Not everyone will agree with every detail of every standard. Similarly, not everyone will agree with every aspect of the process by which a specific standard is set. But, I think it is fair to say that the results of the Board's work, over a long period of time, argue that the process, by and large, is working well. Sometimes the Board is criticized for seeking change that is argued to be unnecessary. In reviewing some of the standards and current projects the Board is addressing, I think it is difficult to agree with that criticism today. The US accounting guidance on business combinations, for example, is outdated and fraught with practice problems. Surely, these rules do need to be reexamined. It is especially perplexing to hear arguments that the Board is trying to fix something in its derivatives project that isn't broken. Those that have worked with current accounting literature know it is inconsistent, incomplete and complex. We also know that some of the accounting in practice today has permitted losses to be recorded as assets and gains as liabilities -- a result that is just plain wrong. Current accounting also lacks transparency, which leaves investors in the dark about an entity's derivatives activities. Here, as with other areas of financial reporting, supplemental disclosures can help investors understand a company's derivatives activities. But, disclosures are not a substitute for good accounting. Because of the complexity and leverage of these instruments, it is important that investors be able to understand a company's use of derivatives by looking at the balance sheet and income statement -- not by searching through the footnotes. Perhaps investor frustration with the accounting for derivatives was best be captured by a quote from an economist in a recent Forbes article, who stated, "I compare the current standards to watching night baseball without the lights. There's a game going on and the scoreboard lights up once in a while, but you have little idea of what's actually going on down on the field." Let's look for a moment at one of the specific complaints about the Board's proposal. We have heard criticisms that the proposal is more restrictive than current accounting standards for certain macro-hedging activities. The suggestion has been that some registrants are now using hedge accounting for derivatives designated as hedges of portfolios of assets and liabilities, and that the proposed FASB standard would change that accounting. The staff has understood and has interpreted the current hedge accounting literature to require that derivatives be designated to specific assets or liabilities -- or anticipated transactions, where permitted -- and does not permit designation to portfolios of assets and liabilities. Interestingly, when the Board discussed this issue with its Financial Instruments Task Force, it was told by financial institution representatives, as well as others, that requiring designation to specific assets or liabilities was not only practical -- it was also appropriate. Another criticism of this project, as with others in the past, has been that the Board has not listened. Sometimes, I fear, we confuse being heard with being obeyed. They are not the same. When you consider the many steps the Board has taken on this project, including over 100 public meetings, it is difficult to accept the criticism that constituents have not been heard or that the Board has not followed an open deliberative process. In this specific project, I think we have to acknowledge that, after listening to constituent concerns, the Board did revise its proposal to accommodate a number of recommendations. For example, I think that the Board has made a concerted effort to simplify certain provisions of the standard that were criticized as overly complex. In short, I can't recall another project in which the Board has followed greater due process or solicited greater input. Finally, some have urged a delay in the implementation date for the new standard. This request, I fear, doesn't give adequate consideration to the needs of investors. Investors need more transparent reporting, and they need it as soon as possible. In the period since the derivative losses in 1994 that took investors by surprise, and until very recently, we have enjoyed a relatively stable and positive interest rate, foreign exchange, and other market risk environment. Recent events, however, have shown that we cannot be assured that those conditions will continue indefinitely. Allowance for Loan Losses We have received a number of inquiries, both domestically and internationally, that suggest that allowances for loan losses reported by some US banks may be overstated. It has been observed, for example, that in some cases, the current allowances exceed non-performing loans by several multiples and are many times annual net charge-offs for recent years. As you know, this is an area involving significant judgment, and it is difficult to assess whether these allowances are appropriate without full knowledge of the facts and circumstances. Allowances for loan losses should be adequate to cover probable credit losses related to specifically identified loans, as well as probable credit losses inherent in the balance of the loan portfolio. It should be noted, however, that FASB Statements 5 and 114 require that the allowances be provided for losses that have been incurred as of the balance sheet date. Thus, allowances should be based on past events and current economic conditions, and should not include the effects of expected losses on specific loans or groups of loans that are related to future events or expected changes in economic conditions. Business Combinations The staff continues to devote a significant amount of time to business combination issues, particularly those involving poolings of interests, including a number of questions relating to bank mergers. One of the most common of the current issues relates to systematic patterns of purchases of treasury stock. Accounting Series Release 146 emphasizes that treasury shares purchased in connection with recurring share distributions can be considered to be untainted only if: (1) they are purchased pursuant to a systematic pattern; and (2) there is a reasonable expectation that the shares will be reissued for their intended purpose. In establishing and maintaining a plan to purchase treasury shares under a systematic pattern, ASR 146 requires that the purchases be made pursuant to specified criteria that are sufficiently explicit to permit the pattern of actual purchases to be objectively compared to the plan. The criteria should leave little or no discretion in determining the number or timing of share purchases, and the pattern of actual purchases should match the plan. In several instances, the staff has concluded that the evidence presented was insufficient to demonstrate that treasury shares had been purchased pursuant to a systematic pattern. Specifically, the staff has challenged the existence of a systematic pattern when the purchases have been based on discretionary criteria that require judgment to determine when or in what amount shares are to be purchased. This is just one example of the many issues that cause the staff to question the current model for business combinations, and I am encouraged that the FASB has begun deliberations on its business combinations project. Updates of Certain SEC Guidance You may be aware that the staff presently is reconsidering SEC disclosure requirements and interpretive guidance relating to segments and earnings per share as a result of the FASB's recent pronouncements on earnings per share (Statement 128) and segment disclosures (Statement 131). The staff review has included certain sections of Regulations S-X and S-K as well as several Staff Accounting Bulletins. The staff's goal is to have conforming revisions effective by the effective dates of the FASB's new Statements. Disclosures about the Year 2000 Virtually all companies and organizations are devoting resources to address the so-called "year 2000 problem." Banks specifically have stated in various forums that this is a critical problem for the industry that will consume a significant amount of resources. To provide guidance as to the disclosures that registrants are expected to make about this exposure, the Division of Corporation Finance has issued Staff Legal Bulletin No. 5. That bulletin provides that registrants should make appropriate disclosures in their management discussion and analysis if: 1. The expected costs of addressing the year 2000 issue indicate that it is a material event or uncertainty, or 2. The consequences of incomplete or untimely resolution of the year 2000 issue represent a known material event or uncertainty. In addition, if Year 2000 issues materially affect a registrant's products, services, or competitive conditions, a registrant may need to disclose that uncertainty in its "Description of Business." With respect to the accounting for these costs, the Emerging Issues Task Force reached a consensus in EITF Issue 96-14 that external and internal costs of modifying internal-use software for the year 2000 should be charged to expense as incurred. In addition, year 2000 modification costs should not be accrued before those costs are incurred. International Accounting Standards In recent years, the Commission, as a member of the International Organization of Securities Commissions, has worked with the International Accounting Standards Committee on a project to develop a core set of international accounting standards that could be used in cross-border securities offerings. Last month, the Commission issued a report to Congress that discusses the background and goals of those international harmonization efforts and progress to date. That report is available to the public through the Commission's public reference room. Many of you are aware that the IASC staff had proposed that the IASC adopt US accounting standards for financial instruments as an interim measure until a more comprehensive financial instruments standard could be developed. At its meeting in Paris earlier this week, the IASC board decided to not pursue that approach and instructed the staff to develop an alternative proposal. In its April 1996 statement of support for the goal of international harmonization, the Commission stated that, to be considered for acceptance in foreign filings in the US, the IASC core standards must constitute a comprehensive generally accepted basis of accounting, and the standards must be of high quality. In my view, any set of standards that does not address the accounting for financial instruments, including derivative instruments, would not meet the needs of investors in today's markets and would not constitute a comprehensive core set of standards. While adopting US standards for financial instruments is but one approach to developing an acceptable core standard, the staff believes that any IASC standards for financial instruments must, at least, be of comparable high quality. We will continue to monitor these developments and provide our input to the IASC as its work progresses. * * * * * * * That concludes my prepared remarks. I would be pleased to respond to your questions.