Speech by SEC Staff:
Current Accounting Topics
Jane B. Adams
Deputy Chief Accountant, Office of the Chief Accountant,
U.S. Securities and Exchange Commission
at the 17th Annual SEC and Financial Reporting Institute Conference, Leventhal School of Accounting, University of Southern California, Los Angeles
May 14, 1998
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.
Good morning. I am pleased to be here and to represent the Office of the Chief Accountant (OCA, although I'm looking forward to the day when I can do that as the Deputy with a Chief Accountant to get all the complaining phone calls about any inflammatory remarks I might make. That day will be coming soon. Regardless, I must start with the standard caveat that the views that I express today are my own and do not necessarily represent the views of the Commission or other staff members.
For today I've prepared a few remarks in several project areas where the OCA staff is spending a substantial portion of its time. These areas are:
As always, the SEC staff continues to spend lots of time resolving interpretive issues on particular registrant fact patterns, especially in the area of purchase versus pooling. But since it's hard to find a unifying concept for those issues, I'll limit my remarks on that topic to a plea for rapid progress on the FASB's business combinations project.
recent financial instrument issues;
SEC market risk disclosure requirements;
international activities; and
the Independence Standards Board.
So let me turn first, then to...
Recent Financial Instruments Issues
One aspect that I'd like to cover is...
SEC Staff announcements at EITF meetings
From time to time the SEC staff will make announcements at EITF meetings to describe recent issues addressed by the staff. Sometimes an announcement is developed after discussion during an EITF agenda call of an issue where the staff has concluded that only one approach would be appropriate. Other times announcements are done in response to requests from registrants or auditors who have discussed specific fact patterns or practices with the staff, and the staff believes that practice would benefit through knowledge of its position.
Let me give one illustration of this activity by looking at an announcement regarding FASB Statement No. 125,
Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,
on transfers of financial assets and sub-prime lenders.
This past winter SEC staff members saw a number of press reports suggesting that Statement 125 was being interpreted in a way that made gain recognition optional on sales of subprime loans. One article described how this was accomplished by one company, an SEC registrant, by adjusting its discount rate assumptions applied in estimating the fair value of certain interests from 12-1/2% to 33% in one month. In follow-up conversations with accounting firms the staff was encouraged to provide guidance to limit diversity in practice in this area. As a result, a staff announcement was made at the March 1998 EITF meeting that focused on basic requirements of Statement 125, highlighting the following 4 items:
While some might regard this type of announcement as a "no-brainer," the perceived need to issue it raised some concerns with the staff. It is unusual for an announcement to repeat requirements of existing standards without seeking to resolve some uncertainty. This announcement was not interpretive. It did not contain any new information. The points made could be traced back, nearly word for word, to FASB statements.
Recognition of gains or losses on the sale of financial assets is not elective.
In estimating the fair value of retained or new interests, the assumptions used in those valuations must be consistent with market conditions; and
Assumptions and methodologies used in estimating the fair value of similar instruments should be consistent.
Significant assumptions used in estimating the fair value of retained and new interests at the balance sheet date should be disclosed, and generally should include quantitative amounts or rates of default, prepayment and interest.
Yet, we were encouraged by accountants in the field to make this announcement to demonstrate that we believed that the words of Statement 125 should be applied as written. Certainly, with each new standard it may take some time for practice to "settle down." But I would not want to be a registrant defending the acceptability of an accounting practice on the basis that the staff did not refute press reports of interpretations that were fundamentally at odds with the words and spirit of a standard.
Statement 115, 125 Qs and As
A variation on the same theme relates to some of the questions that the FASB covers in its Implementation Guides on FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, and soon for Statement 125. Jim Leisenring, FASB Vice Chairman, observed at the April 1998 FASAC meeting that a significant portion of the questions included in the Statement 115 Implementation Guide were specifically addressed in the standard itself.
History seems to be repeating itself with the Statement 125 Implementation Guide that currently is being drafted. Jim Leisenring estimated that 50 percent of the questions are answered explicitly in Statement 125.
The staff is feeling increasing discomfort as to why there are so many questions of this type; this discomfort is heightened as we become aware of other interpretive issues being raised and the approach to their analysis.
One recent interpretive issue relates to the recording of collateral by secured lenders in standard repurchase agreements. Statement 125 permits repurchase agreements to continue to be accounted for as secured borrowings if certain criteria are met. It also addresses when the lender should record the collateral received as an asset in its own financial statements. The availability of this special accounting depends on whether "the secured party has taken control over the collateral and on the rights and obligations that result from the collateral arrangement."1
The secured party is required to recognize the collateral as its asset if "(1) the secured party is permitted by contract or custom to sell or repledge the collateral and (2) the debtor does not have the right and ability to redeem the collateral on short notice, for example, by substituting other collateral or terminating the contract."2
This reasoning is discussed in the basis for conclusions of Statement 125. One consideration noted by the Board was that if that collateral was excluded from the balance sheet, assets, which secured parties can use to generate income, would not be recognized, resulting in the understatement of assets and the overstatement of return on assets. The Board noted that these rights are substantially different from cases where noncash collateral is provided that secured parties are not able to sell or repledge and cannot be used to generate cash or otherwise benefit the secured party.3
The FASB also analyzed the recording of collateral by the secured party based on the rights retained by the debtor. It noted that the secured party's rights are significantly constrained if the debtor has the right and ability to redeem the collateral on short notice. The Board reasoned that a debtor that can redeem its pledged collateral on short notice has not surrendered control of the transferred assets. The Board explained that although a lender may be able to use the transferred assets in certain ways to earn a return during the period of the agreement, the value of those assets may be very limited because of the debtor's ability to require return of those assets on short notice.4
Standard repurchase agreements which were rewritten after Statement 125 was issued are used by banks and broker dealers and now include terms that allow a debtor to call its collateral on short notice. As a result, these agreements appear to fall into the provision in Statement 125 exempting a lender from having to record the collateral received as an asset. However, these agreements also contain provisions allowing the lender to charge the debtor an amount not specified at inception for exercising this right. This surcharge seems to contradict the spirit of the collateral provisions in Statement 125.
When we asked how Statement 125 was being read to conclude that the secured party did not have to recognize an asset, we were told that the provisions of the repurchase agreement were being analyzed solely against the literal words of paragraph 15(a) within the Standard. One firm indicated that they did not read the basis for conclusions when determining how to apply a standard.
In this particular case, while the basis for conclusions clarifies the FASB's intent to have the secured party record the collateral as its asset when it has important rights over the asset like the ability to sell or repledge the asset or leverage the value of the asset in an unconstrained manner it was argued that that notion was not contained in the standard and therefore was not required to be considered.
We have asked the FASB to consider these agreements and the collateral provisions in their current Statement 125 interpretations project.
In the meantime, however, I want to express concern about the implications. Let me try to articulate our concerns:
As the staff has written to the International Accounting Standards Committee (IASC), including a basis for conclusions is a very important component for communicating a standard's requirements. The basis helps in achieving consistent understanding and comparable implementation of a standard across companies by adding dimension to the words. It also provides a context in which the words should be read.
The conceptual objective of a document its substance is being subsumed by desires to achieve a particular treatment which is being justified by reading the words in a standard in an artificial, out-of-context manner.
It also seems that there is some denial going on..."The FASB couldn't have meant this....!"
Preparers, practitioners, and the SEC staff are likely to come into increasing conflict over the accounting prescribed by a standard if one group reads only the standard rather than both the standard and the basis for conclusions.
Derivatives and Financial Instruments
I would be remiss if I didn't discuss the SEC's rules on market risk disclosures. The SEC's Market Risk Disclosure Release was issued in January 1997, and was designed to provide additional information about market risk sensitive instruments to improve investors' understanding of and ability to evaluate the market risk exposures of a registrant.
The release boosted the disclosures about accounting policies of a registrant for derivative instruments and specified additional quantitative and qualitative disclosures that a registrant should provide about material market risk exposures outside of the financial statements. These disclosures are widely recognized as revolutionary in the sense that it is the first time the Commission has required registrants to disclose a quantitative measure of risk.
I won't repeat the detailed requirements of the Release, which are available from the Release itself. However, there are two on-going activities that may affect the Release that I would like to share with you. The first is that the staff has committed to review the disclosures made pursuant to the Release and assess the effectiveness of the requirements. Second, the FASB is nearing completion of its standard on hedging and derivatives. As a result, the staff has been receiving inquiries about the impact of that standard on the policy disclosures specified in the Release.
The Commission indicated in the release adopting the Market Risk Disclosure requirements that these disclosure requirements will be reviewed three years after adoption. We subsequently committed to perform an initial review of the disclosures received from the first group of filers. This one-year review will include discussions with various interested market participants (registrants, dealers (ISDA), regulators, analysts, academics, and investors) of the impact and effectiveness of the Release requirements.
Market Risk Disclosure One-Year Review
Meetings and surveys have focused on questions such as
- What have been the incremental costs incurred by registrants to comply with the rule?
- What have been the incremental benefits, such as better risk management by companies, better analyses by analysts and investors, and better regulatory capability for regulators?
- Have any portions of the rule been particularly hard to implement?
- Are there disclosures made pursuant to the rule which are difficult to interpret? Are the disclosures truly reflective of the risks facing the registrant?
It may take time for registrants to refine their disclosures and for investors and analysts to become comfortable with the new disclosures. Nonetheless, it is our expectation that after a little experience with the disclosures, they will be recognized as a useful tool for both investors and management. OCA is working with several other Divisions and Offices of the Commission in this review. The anticipated completion date is this summer.
Let me share with you some preliminary observations, including common mistakes noted, relating to the implementation of the rule
- The rule covers all market risks (interest rate, commodity price, foreign exchange rate, and equity price) from financial instruments, not just from derivatives.
- For tabular presentation include all relevant terms of the related market sensitive instruments.
- For sensitivity and value-at-risk (VAR) analyses, disclose the types of instruments included and provide an adequate description of the model and the significant assumptions used.
- Qualitative disclosures explain clearly how the Company manages its primary market risk exposures, including
- general strategies
- instruments used to manage exposures
- any changes in how the Company manages its exposures in comparison to the previous years and any known or expected changes in the future.
Some Practical Tips and Reminders for Second-Year Disclosures:
Visit the SEC website and read or download a copy of the questions and answers about the market risk rule if you haven't already done so
Companies who have completed their first year's required disclosures should consider second/continuing year requirements. For example, for VAR disclosures, include average, high, and low, or distributional data about preceding year
For all, summarized market risk data for the preceding year
Interim statements must include a discussion and analysis related to material changes from market risk disclosures presented in the preceding fiscal year-end filings
For fiscal years ending after June 15, 1998, the rule is effective for all SEC registrants other than small business issuers.
Impact of FASB Standard
As I mentioned, the Commission stated in the Release that it will assess the need for all of the enhanced accounting policy disclosures after the FASB completes its standard on derivatives and hedging.
Until the FASB completes its project we will not be in a position to identify the disclosure requirements included in the Release that will be outdated or superseded by the new derivatives standard. Some potential candidates for change, however, are obvious.
For example, under current generally accepted accounting principles, there are several methods for accounting for derivatives. The Release requires registrants to disclose each method used to account for derivatives and the criteria that must be met to qualify for the accounting method used. In its current form, the FASB project reduces the accounting choices available, for example by specifying that all derivative financial instruments will be recognized and measured at fair value, consequently certain of the Commission's accounting policy disclosures may be unnecessary.
And, while I'm on the topic of the FASB derivatives standard, let me touch on recent efforts to have Congress intercede in the accounting standards-setting process.
FASB and Private Sector Standard Setting
Some parties who disagreed with FASB's position on derivatives and hedging activities have asked Congress to stop or change this project. The result has been two Congressional hearings and two proposed bills.
Both of these bills represent a potential significant change to the private sector standards-setting process, which while not perfect, has served the profession and investors well for many years. These efforts would dismantle private sector standards setting as we know it. It is not surprising that those who provide support and input into the current process for example, each of the Big 6 have written to Congress and raised concerns about the changes being considered.
Capital Market Regulation in the US
Regulation of capital markets in the US is based on a system that prescribes initial and continuing disclosures by companies that seek capital from the investing public. The regulatory goal is to promote informed investment decisions based on full and fair disclosures and to prevent misleading or incomplete disclosure.
High quality accounting standards are not a cost to US markets, but a benefit. High quality accounting and disclosure standards are critical to the effectiveness and efficiency of US markets and the interests of US investors. Companies that meet these standards are rewarded with a lower cost of capital
The SEC's involvement in the IASC core standards work program grows out of an ongoing initiative within IOSCO - the International Organization of Securities Commissions - to develop what sometimes is referred to as a universal passport for companies - a single document that could be taken to any capital market and used for listing or offering securities. IOSCO has pursued this objective on three fronts:
a. financial statements;
b. non-financial statement disclosures; and
c. auditing requirements.
The financial statement leg of this project has focused on development of a core set of accounting principles that would provide a framework for preparing financial statements for cross-border offerings. IOSCO has looked to the efforts of an existing private sector group - the IASC - rather than attempt to compile or draft these standards itself.
In April 1996, the Commission released a statement in support of the efforts of IOSCO and the IASC. That statement articulated the key elements that will guide the SEC's assessment of the acceptability of the IASC core standards. Specifically, the Commission will consider
The scope of this project is limited in a couple of important ways. First, it is focused on creating a core set of international standards for cross-border offerings - this is not seen as an effort to replace the FASB or any other national accounting standard setter. Second, it is not intended to cover companies with specialized industry accounting standards. Specialized industry standards - for example, those used by oil and gas companies and insurance companies - are outside its scope.
whether the standards constitute a comprehensive basis of accounting;
whether they are of high quality - that is, whether they result in transparency and comparability and provide for full disclosure; and
whether they can be and will be rigorously interpreted and applied.
Other IOSCO Efforts
As I mentioned earlier, IOSCO also is working on a project to harmonize non-financial disclosure requirements for offering and listing documents. This project is nearing completion.
IOSCO also is discussing efforts to harmonize audit requirements. Last year, IOSCO reviewed and commented on 10 of the international standards on auditing issued by the International Auditing Practices Committee's of the International Federation of Accountants. This review was performed with the eventual goal of considering future endorsement of international standards on auditing.
However, at this time a work program to develop a core set of generally accepted international auditing standards has not been undertaken by IOSCO, primarily due to the significant resources being dedicated to the IASC core standards work program.
With that background, let me return to focus on the accounting standards work.
Completion of the Core Standards Work Program
When the core standards are completed, both IOSCO and the SEC will assess the completed standards. Assessment by the SEC staff is expected to overlap with and build on the IOSCO assessment.
Let me mention some possible outcomes ...
If, after assessment of the completed core standards, the SEC staff concludes that the current reconciliation requirements should be reduced or removed, the staff will need to bring a rule proposal to the Commission to amend the current filing requirements for foreign private issuers.
If the Commission supports the staff's recommendations it would publish proposed amendments for public comment. The staff then would analyze the comments received and make final recommendations to the Commission, which then would be included, if approved by the Commission, in an adopting release.
Let me now focus for a few minutes on key issues that are expected to be considered in assessing the completed core standards. When the Commission considers changes to its accounting and disclosure requirements, it must evaluate the impact of potential changes on capital formation, including the possible impact on the cost of capital for domestic companies, and, critically, on investor protection.
These basic concerns helped shape the three criteria for assessment of the completed standards announced by the SEC in April 1996. What I'd like to do now is cover some more detailed points that have been identified to date. I'd like to point out that these issues, along with further details of the development of the core standards work program, are covered in a
Report to Congress
issued by the SEC in October 1997 and available on the SEC website.
Even if financial statements produced using the completed core standards may be judged acceptable for cross-border offerings and listings, historical financial statements prepared in accordance with prior standards will not reflect the improvements achieved by the core standards program. Thus, the timing of acceptance of international standards will need to be addressed, and those decisions will be affected by the IASC's transition provisions.
Interpretive and Application Issues
Because IASC standards tend to provide less explicit guidance than US standards, some additional guidance for filings in US markets likely will be needed before they are acceptable for cross-border trading. An open question is whether the additional interpretive issues will be so significant that the core standards may not be fully operational, either because they cannot be uniformly applied or because the extent of the additional guidance required would be so great that endorsement would not improve significantly the efficiency of cross-border filings.
Currently, the Commission's supplemental interpretive and disclosure requirements apply to both domestic and foreign registrants. As it evaluates the IASC core standards, the Commission will need to consider whether these supplemental requirements - for example, the minimum line item requirements of Regulation S-X - should continue to apply, regardless of the basis of accounting used to prepare the financial statements.
Independence Standards Board
Independence of the auditor continues to be a concern of the staff and the Commission. For the last six decades, the securities markets have benefited from the added investor confidence derived from having an independent third party examine and render a report on the financial statements that management prepares. This confidence depends on the reasonable investor perceiving the auditor to be an independent professional.
The staff is hopeful that the new Independence Standards Board will be successful in resolving complex independence issues while establishing a conceptual framework to assist in evaluating issues of independence. While it is too early to guarantee success or predict failure, the ISB and its staff have a unique opportunity to establish and control the context for the debate.
The ISB can elevate the discussion and analysis of issues above the perceived factionalized environment in which the debate has been occurring. The objective should be to achieve a comprehensive discussion of issues and their alternative solutions, with a neutral and complete discussion of the pros and cons of each.
Certainly, important major constituencies like the AICPA can provide input and the SEC can provide its perspective to balance the debate, but the opportunity that the ISB has is to strip away the authorship, evaluate the arguments, and synthesize them in a balanced manner that invites reasoned responses based on the merits of the positions articulated.
The ISB is comprised of talented individuals. I am hopeful of their success.
That concludes my prepared remarks. I would be happy to respond to any questions.
1Statement 125, paragraph 15.
3See Statement 125, paragraph 157.
4 See Statement 125, paragraph 166.
5The first bill, proposed by Senator Faircloth, would exempt banks from the derivatives standard unless the banking regulators affirmatively certify that FASB's standard on derivatives would not discourage banks from using these instruments in risk management activities. The second bill, the Financial Accounting Fairness Act proposed by Representative Baker, is much more extensive than the Senate bill in that it would affect all public companies and all future accounting standards. This bill would require the Commission to vote on all accounting pronouncements before companies would be required to comply with them. This bill also would provide judicial review for those affected by the accounting rule.