For release on December 11 1996 1996 Twenty-Fourth Annual National Conference on Current SEC Developments December 11, 1996 Remarks by Stephen M. Swad Deputy Chief Accountant Current Accounting Projects Office of the Chief Accountant U.S. Securities and Exchange Commission (c) Copyright 1996. All rights reserved. As a matter of policy, the Commission disclaims responsibility for any private publications or statements by any of its employees. The views expressed are those of the author, and do not necessarily represent the views of the Commission or the author's colleagues on the staff. INTRODUCTION Good morning. Chairman Levitt, Commissioner Wallman, and Mike Sutton all have talked about global issues facing registrants and the profession. As someone responsible for the day-to-day operations and workload of the Office of the Chief Accountant, I thought it would be appropriate for me to discuss some of the projects currently in process as well as areas that are gaining the attention of the staff. Perhaps the best way to characterize my presentation, is that I plan to give you an executive summary of the papers in my in-box. BEST PRACTICES Before I begin describing some projects currently underway, let me share with you an overview of the Office's current workload. This is a rather easy way for me to begin because it is something I deal with everyday. In addition, I have become rather proficient in describing the Office's workload -- we are swamped. Over the past year, we have seen dramatic increases in both the standard setting activities that we monitor and the volume of questions that we receive from other divisions within the Commission and from registrants. This may be due, in part, to an overall increase in market activity as well as an increase in the complexity of business transactions. Whatever the reason, the fact is the volume of questions is up. One of the goals of the Office is to provide a timely response on each registrant inquiry that we receive. Since the size of our staff is relatively fixed, we are continually searching for ways to increase the efficiency and effectiveness of the registrant inquiry process. One thing that I think will help is the "best practices" guidance that is being developed by the AICPA's SEC Regulations Committee. Although this guidance is still in draft form, one of its objectives is to provide helpful guidance for improving the efficiency and effectiveness of communications between registrants and the staff. In essence, it's a "how to guide" on dealing with the SEC staff. This guidance covers many practical topics such as what should be included in written communications to the staff and when should National Office personnel be involved in issues. Overall, I think it includes a lot of good ideas and, when complete, should improve the registrant inquiry process. Let's move on, starting with the portion of my in-box labeled "in-process." At the top of the box is the derivatives release. DERIVATIVES RELEASE As most of you know, in late 1995 the Commission issued for comment a release designed to improve disclosures about derivatives and other financial instruments. The release called for more explicit accounting policy footnote disclosures for derivatives and disclosure of qualitative and quantitative information about market risk inherent in derivatives and other financial instruments. The comment period for the release ended in May and about 100 comment letters were received from users of financial information, like analysts, preparers, and auditors. In general, users were supportive of the proposal. They generally commented, for example, that quantitative information about market risk would be useful. Many corporate preparers, however, generally were not supportive. They often were critical of the quantitative disclosures, principally because they thought that market risk is not one of their primary business exposures. Some also suggested that disclosures about market risk could reveal proprietary information, which may be used in a harmful way by competitors. The views of auditors and financial institution preparers fell in between users and corporate preparers. These two groups generally were supportive of the proposal, but made recommendations on how to improve it. Some commented, for example, that registrants should not be restricted solely to the three proposed methods for presenting quantitative information about market risk. Instead, they recommended that market risk disclosures be made using a "management approach" -- that is, the approach used by management to monitor market risk. Also, some suggested that the disclosures should be revised to allow different disclosure alternatives for reporting quantitative information about trading and non-trading portfolios. For example, they commented that a bank should be able to choose to use value at risk for disclosures about its trading portfolio and sensitivity analysis for disclosures about its asset/liability management portfolio, rather than using one or the other disclosure alternative for both portfolios. The staff is currently in the process of finalizing its recommendations to the Commission on how to proceed. Our objective is to have something to the Commission in the next few weeks. Because year-end 1996 is fast approaching, the staff is not planning to recommend that quantitative information about market risk be required for 1996 year-end reporting. On the other hand, the interpretive section of the release is effective for 1996. At this time, the applicability of the remaining portions of the release to 1996 year-end disclosures is dependent on the timing of the issuance of the final rules. In the meantime, the staff is reminding registrants of their reporting obligations under MD&A, FAS 119, and APB 22 and the impact those requirements have on the need to provide qualitative disclosures about market risk and informative disclosures about derivatives accounting policies. Let's move on. The next item in my in-box is a project relating to the Private Securities Litigation Reform Act of 1995. PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 In late 1995, Congress passed the Private Securities Litigation Reform Act of 1995. This legislation included a new Section 10A of the Securities Exchange Act of 1934, which expands the obligations of auditors to report, in a timely manner, certain uncorrected illegal acts. In August 1996, the Commission proposed a rule that describes how to implement the reporting requirements of the new law. The comment period for this proposal ended in October. The Commission received 8 comment letters. The proposed rule specifies that registrants and auditors should submit any notice or report required by section 10A in a written confidential communication to the Office of the Chief Accountant. The report would include information identifying the issuer and the auditor, and would be exempt from the Freedom of Information Act to the same extent as Commission investigative records. The staff currently is completing its recommendations to the Commission. Our goal is to recommend a final release to the Commission in early 1997. A third project that is in-process relates to Industry Guide 3. INDUSTRY GUIDE 3 Guide 3 was originally enacted in 1976 to improve the disclosures for banks and thrifts. Since it was last revised, which was over ten years ago, there have been many changes -- both in accounting standards and in the way banks conduct business. For example, over the past few years the accounting and disclosure requirements for loans, securities, mortgage servicing rights, and securitizations have changed. Also, balance sheets and income statements have changed by the use of securitizations, derivatives, and off-balance sheet financing techniques. As a consequence, the staff has been prompted to undertake a fundamental reexamination of the Guide 3 requirements. The staff recently completed the first stage of a fairly intensive review of financial institution filings to identify best practices and determine how registrants are complying with existing Guide 3 requirements. While it would be premature to describe a final proposal, I would like to walk through some preliminary observations. At a minimum there is a need to modify the disclosure requirements of the Guide to conform with the requirements in the current accounting standards. Also, there seems to be room to remove some redundant disclosures that exist between Guide 3 and GAAP. Another idea being considered, because banks and thrifts are comparable to other financial intermediaries, is to expand the scope of the Guide beyond banks and thrifts, to encompass all financial intermediaries with significant lending, investing, or deposit-taking activities. After all, it doesn't seem to make sense to have registrants with similar activities be subject to different disclosure rules. Lastly, the staff has observed wide variations in the quality of forward-looking disclosures relating to credit risk. Some registrants, for example, provide insightful disclosures about loans and other assets that are of concern to management, but not yet considered impaired or troubled. This type of disclosure seems to provide informative, early-warning signals that could help investors better anticipate potential problems or losses. Unfortunately, others provide very little in the way of disclosure in this area. Thus, it seems that Guide 3 could do a better job of prescribing disclosures in this important area. As I mentioned earlier, the staff is just beginning its work and has a number of issues to consider. Before any specific recommendations are made or a proposal is released for comment, these areas and others will be need to be analyzed further. I would like to conclude with some words about poolings. As you probably could guess, a speech about the day-to-day operations of the Office wouldn't be complete without some discussion about pooling of interests accounting. POOLING OF INTERESTS ACCOUNTING The deepest portion of my in-box and the single largest area where the staff receives questions is related to poolings. With the increase in stock prices, the use of common stock as a form of consideration in a business combination appears to have become more popular. And, when all stock deals become popular, the desire to use pooling of interests accounting increases. As a consequence, many registrants and their auditors increasingly find themselves evaluating the appropriateness of applying pooling of interests accounting to a given business combination. That is no easy task, particularly because the pooling rules often require much interpretation and the application of a lot of judgment. Not surprisingly, two of the more subjective paragraphs of APB 16 seem to be where the staff spends most of its time. One paragraph -- 47c -- relates to the prohibition of pooling accounting if equity interests are altered in contemplation of a pooling and the other paragraph -- 48c -- prohibits pooling when there are plans to dispose of a significant amount of assets. Current practice recognizes that transactions "in contemplation" of a pooling or those "planned" to occur after a pooling cause problems. Where the diversity seems to exist is in interpreting if a transaction is "planned" or "in contemplation." That is, when is the transaction related to the pooling? Most accountants, including the staff, analyze these transactions based on facts and circumstances surrounding specific transactions. In practice, a lot of emphasis is placed on the timing of the transaction relative to the initiation and consummation of the business combination. From a timing perspective, transactions can fall into one of five categories: (i) well before initiation, (ii) just before initiation, (iii) between initiation and consummation, (iv) just after consummation, and (v) well after consummation. Some practitioners suggest that transactions that fall within the first and last category -- either well before initiation or well after consummation -- generally are not a problem. However, transactions that fall into the other categories cause a pooling violation, unless evidence exists that demonstrates that the transactions were made for reasons unrelated to the business combination. When the staff encounters these issues, we tend to scrutinize transactions falling in those middle three categories -- transactions that fall right before initiation, between initiation and consummation, and right after consummation. The staff tries to evaluate whether there is clear, objectively verifiable evidence that overcomes the presumption that those transactions were related to the combination. The problem is that it is difficult to conclude that a transaction that occurs relatively close to the pooling was not related, at least in part, to the pooling. After all, if a business combination is on the horizon or was just recently completed, how can it be clear that a transaction or a planned transaction was not influenced by the combination? Without some clarification of the application of this part of the literature, the staff is becoming increasingly concerned that practice will erode not just the letter, but also the spirit, of the pooling literature. The staff is encouraged that the FASB recently has agreed to take up the accounting for business combinations. However, as a interim solution, the staff is considering whether there is a need to issue guidance to improve the consistency of interpretations of paragraphs 47c and 48c of APB 16. Perhaps guidance similar to that in SAB 96 would be helpful and improve practice in this area. CONCLUSION In conclusion, as work progresses on the derivatives release, section 10A, and Guide 3, the amount of space dedicated to these topics in my in-box will certainly decline. Also, as the AICPA's Regulations Committee's efforts on best practices begin to take hold, my in-box just has to benefit. As for poolings, however, I expect that an inordinate amount of space in my in-box will continue to be consumed, until some better guidance is provided. I look forward to additional discussions with you in these areas and I appreciate your attention.