Remarks of Terry D. Warfield Academic Accounting Fellow Office of the Chief Accountant U.S. Securities & Exchange Commission At 1996 AICPA Conference on SEC Developments Washington D.C. February 15, 1996 Introduction Good afternoon! It is a pleasure to be here today and to speak to you. My remarks today address i) the efforts currently underway to review Industry Guide 3 - "Statistical Disclosure by Bank Holding Companies" and ii) an initiative within the Commission and the Office of the Chief Accountant to explore the future of financial reporting. A. Guide 3 Review 1. Background / History Industry Guide 3 - Statistical Disclosure by Bank Holding Companies (Guide 3 hereafter) was originally enacted in 1976. In general, this industry guide was intended to provide registrants with a reference in preparing disclosures required by the Division of Corporate Finance at the SEC.1 When enacted, it generally was believed that existing required bank disclosures were not providing the information needed by investors to assess the risks and rewards associated with different bank activities.2 In response to these needs, Guide 3 focuses on disclosures about changes in certain risk characteristics of bank assets and liabilities. For example, the Guide requires disclosure of: a. distribution of balance sheet amounts, including an analysis of net interest income based on average yields for asset and liability components. b. types, maturities, and average yields on investments and loans, including a comparison of market value to book value for investment securities. c. credit risk elements related to the loan portfolio, including disclosure of non-accrual, past due and restructured loans, and concentration of loans to industries and in geographic regions. d. information on deposit concentrations and certain ratios, such as return on assets, return on equity, dividend payout and equity to asset ratios, and any other ratios deemed necessary to explain operations. In summary, by providing information about balance sheet amounts such as the loan portfolio and other major asset and liability items, the guide is intended to facilitate analysis and comparison of sources of income and exposures to risk. More specifically, it assists investors in evaluating the potential impact of future events on the earnings of the bank and to assess the bank's ability to move into or out of situations with favorable or unfavorable risk/return characteristics. While the original provisions in, and subsequent amendments to, the Guide 3 requirements were responsive to the needs of investors, given the economic, accounting, and regulatory environments faced by bank holding companies at that time, effective and efficient regulation should be responsive to changes in these environments.3 Several recent changes have occurred in the economic and reporting environments facing bank holding companies suggesting a review for Guide 3 is now needed. In response to these changes, the Staff is undertaking such a review to evaluate potential changes to the Guide to improve the usefulness of financial institution disclosures. 2. Impetus for Review Let me discuss in more detail some of the changes affecting banks and financial institutions that provide the impetus for the review and the elements of the review itself. Recent Accounting Changes The first area of change concerns recent changes in accounting standards for banks and other entities. Exhibit one in the appendix to my written remarks summarizes these changes and their relationships to Guide 3 requirements, and highlights the need to evaluate some of the requirements in the guide for one of two reasons. First, certain of these recent accounting standards are disclosure-oriented. As a result, in complying with the provisions in the accounting standard, the need to include certain Guide 3 disclosures may be eliminated. For example, Statement 107 requires disclosure of the fair values of all financial assets and liabilities. Thus, the requirements in this standard subsume certain Guide 3 requirements related to disclosure of fair values of investment securities. A second set of Guide 3 considerations are illustrated by the provisions of Statements 114 and 115. These standards changed the accounting for certain loans and investments and have introduced new classifications for these assets. These changes suggest the obvious need to modify classifications in Guide 3 to conform with these new rules (e.g., available-for- sale securities, impaired loans).4 Furthermore, the instructions for certain of the yield and ratio calculations should be reviewed to clarify whether they should be based on balance sheet amounts reflected at historical costs or fair values, given the multi-attribute measurements for investment securities under Statement 115. Proposed Disclosure Rules In addition to currently enacted accounting standards that potentially affect Guide 3 provisions, we are also evaluating Guide 3 requirements in light of certain proposed disclosure regulations. Exhibit 2 in the appendix to my prepared remarks summarizes these proposed changes and their potential relevance to a review of Guide 3. In this regard, the FASB is considering a disaggregated disclosure model that may obviate the need for some of the specific geographic disclosures required within Guide 3. In addition, the SEC derivatives release also may result in disclosures that supersede some Guide 3 disclosures. For example, the proposed disclosures call for both qualitative and quantitative information about entities' market risk exposures. These requirements may substantively meet some Guide 3 disclosure requirements for certain assets or liabilities. We plan to monitor developments on these proposals in developing recommendations on Guide 3 revisions. Industry Factors An additional impetus for reviewing Guide 3 requirements arises from recent changes in the economic environment facing banks and questions concerning the continued relevance of Guide 3 disclosures in reporting on bank activities in this environment. Indeed, the original Guide 3 provisions were adopted partly in response to the changing nature of bank activities at that time and the need for additional information on the effects of these activities on bank financial position. Most would agree that the financial services industry is in a state of transition, characterized by rapid consolidation. For example, no less than 55% of the banks followed by Value Line Investment Survey were involved in some type of merger or acquisition activity in the past year. These transactions either involved entire banks being merged or banks purchasing certain financial operations of other banks or financial institutions.5 These merger and consolidation trends have led to combined banks operating in broader geographic regions and generating a larger proportion of income from non-interest income sources, such as credit card, trust, and other fund management services. For example, many banks' investment service departments have grown in recent years, as have activities in the mortgage banking area. Some evidence of the growth of non-interest sources of income is provided in exhibit 3. This exhibit presents a time series comparison of average net interest income and bank revenue from other sources for 69 large banks over the period 1976-1994 - the period since Guide 3 was originally adopted. Note the steadily increasing proportion of non-interest revenue as a proportion of assets over this period (from 1.3 % of assets in 1976 to 2.2% of assets in 1994). Thus, developments in the financial institution operating environments suggest that part of the evaluation of Guide 3 should examine whether current Guide 3 disclosures adequately report on the scope of bank holding company activities in today's economy. Furthermore, changes in the financial services industry over the past decade also have resulted in increased similarities between banks and other financial intermediaries. To the extent that the activities of non-bank holding companies are similar to those of banks, revised Guide 3 disclosures might also be useful for these entities. Our review will also examine the extension of the revised provisions to non-bank holding company financial institutions that are involved in similar activities. Proposed Evaluation In summary, each of these developments in the bank industry and financial reporting environment raises questions about the usefulness of the Guide 3 disclosures for users of bank holding company financial statements. In consideration of these developments, and consistent with other initiatives evaluating regulation, the Staff has undertaken a comprehensive review of the Guide 3 disclosure requirements.6The structure of the staff's evaluation has two major components. First, the staff is currently conducting a review of bank and other financial institution filings to document how registrants are complying with the Guide 3 requirements and the disclosures that are required by other standards or rules. This analysis is designed to document how these "joint" disclosure requirements are being met by registrants and document the "best practices" of registrants in meeting both the spirit and technical requirements of Guide 3 and other disclosure requirements. Secondly, the staff is examining whether the disclosures meet users' needs at a reasonable cost. In this regard, we are reviewing analyst, academic, and practice literatures to determine what information is useful in evaluating banks today, and assessing costs associated with Guide 3 disclosures, including direct costs of preparation as well as other indirect costs.7 The aim is to reduce the costs of preparing these reports, while at the same time providing disclosures consistent with the public interest and the protection of investors.While we are early in the evaluation process, there appears to be a clear need to modify the Guide to conform existing classifications to those reflected in the new accounting standards. With respect to expansion or elimination of disclosures required by Guide 3, recommendations in these areas will be developed after more information is gathered within the evaluation steps discussed earlier. This completes my discussion of Staff efforts with respect to the Guide 3 review - Note that the Guide 3 review represents a response to changes in the accounting and reporting environment - a project that we hope leads to an improvement in reporting by banks and other financial institutions. I would like to turn next to a discussion of another initiative being facilitated by the Commission and which represents a more future-oriented approach to improving financial reporting. B. Future of Financial Reporting 1. Overview As some here may know, Staff from the Chief Accountants office is working with Commissioner Wallman to he organize a symposium on the future of financial reporting. This conference is planned for April and will examine the valuation and reporting of intangible or other "soft assets". 2. Some background This past June, Commissioner Wallman and Chief Accountant Mike Sutton invited representatives from practice, preparer and analyst communities, regulators and academe to a round-table discussion of future-oriented financial reporting issues. The idea was to have participants think about how the financial reporting environment will look in 10-15 years and reflect on some of the financial reporting problems that might arise in such a setting. From that 2-3 hour meeting, participants identified three areas as deserving additional discussion: intangible or "soft" assets, the effects of technology on financial reporting, and the recommendations of the AICPA special committee (Jenkins Committee) on financial reporting. In response to feedback from that group, we offered to facilitate conferences as one way to further discuss these topics. 3. Current Status of Symposia We are well into the planning process for a symposium on intangible assets, which is planned for early April. A steering committee has been formed to help plan the agenda for the forum and to identify panelists. Preliminary plans call for sessions representing users, preparers, auditors, academic researchers, and standard-setters to explore issues related to the financial reporting challenges of intangible assets. Within the symposium, it is hoped that discussion within a broadly representative group from various financial reporting constituencies will: - better define the problem, - identify potential solutions to the problems identified, - identify obstacles to various solutions, as well as ways to overcome those obstacles, - identify areas where research or further study is needed. Again, the thinking is that by looking a bit into the future and attempting to anticipate some of the challenges to financial reporting, we can begin to move towards solutions, and hopefully ensure the relevance of financial reporting in future environments. The intangible asset symposia will be conducted as an open meeting at the Commission. More information will be forthcoming concerning how you can attend the symposium once plans are more definite. While planning for other symposia is in more preliminary stages, we are working closely with the AICPA Jenkins report Coordinating Committee and the FASB in developing a framework for that forum. This concludes my prepared remarks on two initiatives within the Office of the Chief Accountant for evaluating and improving the financial reporting model. NOTE _ The exhibits referred to in the speech are not available electronically