Speech by SEC Staff:
Current Projects of the Office of the Chief Accountant
U.S. Securities and Exchange Commission
Colorado State Society of
Certified Public Accountants
1998 SEC Conference
December 3, 1998
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any publication or statement by its employees. The views expressed herein are those of Mr. Schuetze and do not necessarily reflect the views of the Commission or the other staff of the Commission.
Let me start by first thanking the Colorado State Society of CPAs for extending me an invitation to speak at this yearís annual SEC Reporting Conference. I have participated at this conference in the past as a member of the SEC staff, as a partner from Coopers & Lybrand, L.L.P., and as a CFO serving on the organizing conference. Without a doubt, I believe it has a tradition of being one of the truly outstanding best conferences in the Rocky Mountain Region on the topic of financial reporting. Certainly, the Colorado Society has a reputation for being one of the leaders in the profession when it comes to continuing education.
Today, the Office of the Chief Accountant is dealing with many key issues and projects. I would like to share with you thoughts on a few of these projects.
Increasing the Level of Professionalism in Public Accounting and Financial Management
The press has published several articles this year with titles such as "Pick a Number, Any Number," "Accounting Abracadabra," "The Auditors Are Always Last to Know," and "Earnings Hocus Pocus, How Companies Come Up With the Numbers They Want." A survey of CFOs at a conference this summer reported that 67% of the CFOs had been asked to misrepresent results by other executives, and 12% had in fact done so. While this was a small and unscientific survey, it is nonetheless cause for concern. Perhaps even more of a concern was a loss by investors of over $20 billion dollars in a single instance that, according to the press, was due to a company publishing financial statements with errors of approximately half a billion dollars, including errors in the cash accounts.
The investing public has come to expect high quality in the financial reporting by companies in the U.S. capital markets. Investors also expect to receive financial statements that have been subject to independent, high quality audits that have been performed with a great deal of integrity and objectivity.
I believe many members of the public accounting profession and financial management community live up to the expectations of the public markets. However, there is a great need today for leadership that can take financial reporting and auditing into the 21st Century. This leadership must be willing to challenge the status quo and look for new ways to make audits more effective, to improve upon our financial reporting model, to meet the expanding globalization of the capital markets, to protect and ensure the integrity and independence of our private standard setting process, and to meet the demands of ever changing technology. These leaders, in meeting these challenges, must be willing to put investors and professionalism first. They must stand tall in the saddle when the temptation arises to meet an earnings forecast or do a business deal that conflicts with the needs of investors.
Such a leader was Leonard Spacek who in the 50s and 60s, to the chagrin of many members in public accounting, challenged the profession for not showing leadership and meeting the expectations of its largest constituency, the investing public. He demonstrated vision and an ability to challenge others around him to move to a higher level. In 1956, Spacek stated:
"I would like to tell you that our profession is standing steadfast to our principles and responsibilities. This I cannot do. . . . I find that the most serious problems of our profession are caused by our own indulgence . . . proper accounting has never in any notable way been the subject of advance planning by the profession or the public. . . . We must wait for the catastrophe, because we do not have a sufficiently strong or self-appraising accounting profession to right this public wrong--before, not after, serious injury results."
While some leveled severe criticism at Spacek for his innovative thinking, ultimately his leadership resulted in positive changes. His leadership lead to necessary changes being made, prior to a catastrophe.
As the Chief Accountant of the SEC, I am focusing on and hope we may once again see such leadership. I hope we will see leaders who understand and believe that sound decisions based on professionalism will be good for business, but not all business decisions are good for the profession. Perhaps, it was best said by former SEC Commissioner Byron Woodside, who in 1965 eloquently expressed:
"History, common sense and experience tell us that at the heart of our whole system of securities market . . . are faith and trust in the honesty of corporate financial records, and the honest, objective and timely distillation of those records in published financial statements. . . . One who weakens that trust without good cause does no one a service. One who trusts a system which really is not serving well its purposes may on occasion be deceived."
Let me briefly touch on a few, and I believe somewhat limited, instances I have seen over the years as a member of the public accounting profession, a CFO, and a member of the SEC staff that would cause me to challenge our level of professionalism.
The first involves rigorous and proper implementation of accounting standards. Every once in a while I have seen circumstances where GAAP has not been followed and a practice has developed that is inconsistent with the written literature. In a recent conversation with a national office partner about such a situation, the partner noted what the literature required, but indicated he felt the practice that had developed was not that egregious. Another situation was the result of deliberate action of a CFO. This action involved the CFO causing an error to be recorded in the financial statements contrary to the advice of his Companyís auditors. His rationale was that the error, which was not the result of a problem in systems but rather a "hard" adjustment for which the data had to be accumulated was not material, although it was in the tens of millions. A final example Iíll cite, came out of a meeting I held with financial analysts. They pointed out that the financial statements they rely on do not always include the disclosures required by consensuses for EITF Issues 94-3 and 95-3 and as required by Regulation S-X in the Schedule for Valuation and Qualifying Accounts. Notwithstanding this lack of compliance with GAAP, the auditors still issued an unqualified opinion.
My belief is that a professional, whether in public accounting or in financial management, is an individual who strives to achieve a level of doing things right, to perform to best of their ability, and to be proud of their efforts and accomplishments. My 20 plus years of experience lead me to believe most of my fellow CPAs and financial executives subscribe to this high level of ethics.
However, for whatever reason, there are those few who taint the reputations of the rest of us when they do not follow GAAP, do not make the required disclosures, or are not strong and disciplined enough to require their clients to do so or are willing to try to find ways to get around the rules. For example, how often have you heard the phrase, "show me in the literature where it says I canít do this."
I believe these actions are not those of a person who should be referred to as a professional. I believe such actions are unacceptable and ask that you join us in addressing such behavior. For those who decide to continue down such a thorny path, when they are asked what they lose sleep over at night, they should be thinking about those of us who strive to flush out and deal with them in an appropriate fashion.
I also will add here, as noted in our letter to the AICPA this year regarding Audit Risk Alert topics, the staff intends to review closely and ensure that there is proper and rigorous implementation of new accounting standards, including those addressing segment disclosures and accounting for derivatives. You may find this letter at www.sec.gov/offices/account/ACLR1009.htm.
Leadership must be demonstrated on each and every audit. The engagement and concurring partners are the individuals responsible for providing that leadership.
The engagement partner must ensure the audit is supervised effectively from the beginning of the planning process until the issuance of the auditorís opinion. This requires active involvement of the partner on a continuous basis. It is unrealistic to assume that effective audits can be done by junior staff without active supervision. We have noted the need for personnel with the appropriate level of knowledge, to be actively involved in the details of an audit throughout the audit. Further information on this point is included in our letter to the AICPA cited above as well as the letter to the Public Oversight Board ("POB") on audit effectiveness.
One key role that the partner must fill is to ensure that transactions involving difficult accounting issues are identified and a proper conclusion is reached. Often it is advisable to use a firmís consulting network to address unusual or complex transactions. Many of the accounting firms have invested considerable sums of money in their national office technical accounting and auditing programs. My past experience has shown that these consulting resources are invaluable. I believe that using all of oneís firmís resources will add value to the audit process and to the clientís financial reporting and ultimately to investor protection. As a result when presented with a registrant issue, I typically ask registrants and the engagement partner whether an issue presented to us has been discussed on a timely basis with the firmís national office. In a way, I look at it like a pack of wolves. Those who hunt with the pack are usually successful. Those who donít have a difficult time surviving.
Speaking of wolves, trying to survive today as a CFO or Controller in a market that is driven by consensus estimates of quarterly earnings is no small task. The pressure to meet market expectations is tremendous and has started to create a culture that should be of concern to all of us from or in the business community.
In meetings with various members of the business community, people have stated a strong desire to deal with the issue which I will call "earnings management." While people understand there are legitimate ways to affect earnings, such as to time the sale of asset for a specific period, that is not what people are all concerned about. Instead, people are frustrated by:
- Analysts who reduce market capitalization by large amounts when earnings estimates are missed by a penny, even when record sales and income are reported.
- Pressure from senior management to use accounting gimmickry to "make the numbers" rather then doing it the old fashioned way with real business results.
- Selective disclosures to an individual or few analysts, rather than to all investors.
- Audit committees who lack qualified individuals and who fail to ask the tough and difficult questions of the company, its senior and financial management teams, and the auditors.
- Ineffective audits that fail to detect massive cases of financial fraud and that taint an entire profession when the press writes, "Where were the auditors?"
Chairman Levitt made a speech in September that highlighted a set of issues we both feel passionate about. That speech has received a great deal of attention nationally and I would strongly encourage you to review it if you have not yet had a chance to do so. It is available on the SEC website at SEC.gov. Some of the earnings management abuses that are of concern to the Chairman, myself, and others I have met with, include:
- Cookie jar reserves: Simply put, these are reserves set aside in good times or under the guise of a large one time charge. Later on they are often bled back into earnings when needed. Improper loss accruals, excess inventory reserves, and tax "cushions" are prime examples.
- Misuse of materiality: You will find very few instances in GAAP where materiality is defined as a specified amount. Instead, both the legal standards and accounting literature spell out clearly both qualitative and quantitative factors that must be considered when assessing materiality. This is an area in GAAP where professional judgment is required. But it is also an area where the commission staff has seen numerous instances of non-GAAP entries, in some cases intentionally made, that changed earnings trends or perhaps allowed the company to make the earnings forecast for the quarter. The argument we have heard to justify these entries, both from companies and their auditors, is that the amounts are less than a rule of thumb 5% or 6% of net income, or whatever test they use for materiality.
- Revenue recognition: As one analyst summed it up, "the number of reported instances of companies improperly booking revenues has become an embarrassment to all of the accounting profession." A substantial majority of our accounting-related enforcement cases involve revenue recognition. It seems as if all too often we are seeing instances of revenue recognized improperly when:
- Delivery of the product to the end userís site has not occurred.
- Agreements have not yet been accepted and executed by the customer.
- The seller has to complete remaining obligations, such as installation or training.
- The customer unilaterally can terminate or cancel the agreement.
- A year for accounting purposes has been "extended" beyond 365 days.
- "Just in time" arrangements exist, with FOB delivery terms, and revenue is recognized prior to arrival at the delivery destination.
- Upfront fees are recognized immediately upon receipt notwithstanding an agreement to provide services, discounts or products during an ensuing membership period.
In the Chairmanís speech in September, he stated a belief that abusive earnings management practices are a financial community problem that calls for a financial community response. To date, the response has been tremendous. Business leaders, attorneys, academics, managing partners of the major accounting firms, and the AICPA have all commended the Chairman for undertaking this bold initiative.
The financial community also has commenced work on the action plan outlined by the Chairman. Let me summarize for you that action plan and the progress to date.
The NYSE and NASD have formed a blue ribbon committee co-chaired by Ira Millstein, one of the most experienced corporate governance attorneys of our time, and John Whitehead, former co-chairman of Goldman Sachs and Undersecretary of State. This 11 person panel is comprised of the chairs of the exchanges, leading CFOs from the FEI, managing partners from two of the five largest accounting firms, and executives of an institutional investor and of the business community. This panel is expected to propose recommendations to the business community, regulators, and the exchanges for strengthening the role and performance of audit committees. On December 9th, in New York, the panel will hold public hearings and solicit comments on ways to improve audit committees. I look forward to receiving their findings and recommendations.
The Independence Standards Board also tentatively has agreed to recommend a full discussion each year between auditors and audit committees regarding auditorsí services, fees, and independence. This new proposal, which both the SEC staff and POB strongly support, should result in a robust discussion about the auditorís fees and services and how those impact the independence of the auditor.
I firmly believe that the role of the audit committee in corporate governance is important. I believe that audit committees must work closely with financial management and auditors, as a team, to ensure the quality of our financial reporting. The audit committee meetings should focus on matters such as the quality of financial reporting, the quality of internal controls, and the adjustments, both booked and unbooked, arising from the audit. That is why I now ask the question of each registrant who visits with us, "Have you discussed this issue with your audit committee?"
Personally, I wonder if the audit process has kept pace with the quickly evolving and changing ways we do business. While the auditing firms hire some of the brightest graduates from our universities, I wonder if these new staff, who typically have zero to six years of auditing or business experience, and who perform more than 80% of the audit work, have an adequate understanding and knowledge of both auditing procedures and business operations to dig deep enough into a complex business, its operations, and the resulting numbers.
To address this concern, the pob has announced the creation of a committee to investigate the effectiveness of audits. Never before has a committee comprised of such distinguished individuals, a majority of which are from outside the auditing profession, undertaken such an important task. This panel, comprised of a former CEO of one of the major accounting firms, a former executive of AMEX, two former SEC Commissioners, representatives of the academic community, and a ceo from industry, are expected to complete their study in 1999.
Needless to say, the very integrity of the auditing profession rests on the objective review of the numbers prepared by financial management, and an ability to stand tall when the difficult issues and questions arise. We do not need any more articles with the question, "Where Were The Auditors?"
The Accounting and Auditing Standard Setters
The AICPA is in the process of developing a tool kit, for accountants and auditors alike, on revenue recognition. The AICPA also has recently issued Practice Alert No. 98-3, Revenue Recognition Issues. Subsequent to the development of the tool kit, the Auditing Standards Board has been asked to reexamine the auditing standards related to auditing revenue and liabilities for loss accruals. The AICPA is to be commended for their prompt response to this significant issue.
The AICPA has also formed a task force to provide guidance for the valuation of acquired research and development. While some accountants have challenged the propriety of the accounting standard for research and development acquired in a business acquisition, the staff will leave the accounting up to the standard setters. Instead, the focus of the staff and the AICPA Task Force is the proper implementation of the existing standard. That standard requires that acquired in process research and development be valued at its fair value as of the date of acquisition.
Many of the concerns about earnings management will be highlighted in upcoming AICPA audit risk alerts, to be published soon. I recommend that you review the documents once they are available. We have provided the AICPA with a letter, which is available on their website at AICPA.ORG and our website http://www.sec.gov/offices/account/aclr1009.htm, that identifies issues the staff expects to be looking at closely in the course of our reviews of this yearsí filings.
Also, we are monitoring closely the FASBís projects, currently underway, which will define more clearly what transactions should be recorded as a liability. The Board and its staff met recently on this issue and are actively working on a timely decision.
SEC Action Plan
The SECís action plan is comprised of both rulemaking activities and further staff guidance. We are working on a rule proposal to expand the required disclosures of loss accruals, sometimes loosely referred to as reserves. This is most likely to come in the form of a recommended change to the current Regulation S-X Schedule for Valuation and Qualifying Accounts.
We also expect to issue shortly, staff accounting bulletins addressing (1) revenue recognition, (2) recognition of loss accruals, such as restructuring charges and asset impairments, and (3) materiality. This additional guidance is expected to focus on general revenue recognition concepts; the specificity needed in plans in order to recognize a restructuring charge; a time frame in which those plans must be completed if an accrual is to be made; greater delineation of the types of costs that can or can not be accrued for; guidance on proper adjustment of asset lives; and factors that should be considered when assessing materiality.
In addition, the Division of Corporation Finance has formed an earnings management task force to coordinate and focus our filing reviews on abusive financial reporting practices. The Division of Enforcement also has stepped up their focus on earnings management, and currently has several significant cases under investigation.
Change in Culture and Business Ethics
Finally, and perhaps more importantly, we are calling for a change in our business culture and how all of us interact with the different members of the financial community.
Analysts and investment bankers need to reexamine how they react to narrow misses in quarterly earnings. CEOís need to be sure the focus is on numbers that reflect the underlying economics of the business and stop putting pressure on CFOs to move the numbers around to meet analystsí quarterly earnings forecasts. Likewise, CFOs need to step it up to ensure the quality of our financial reporting provides investors with all the information they need on a timely basis.
We have all heard people from time to time discuss the topic of business ethics. The universities have courses on it, companies have ethics officials, and auditors certainly focus on the topic. Yet, I think the notion of business ethics is misleading. It conveys a sense that those of us who are in or have been in business have a different level of ethics than others. I certainly hope that is not the case. I believe we can have only one level of ethics, and that is a standard of the highest level. Nothing less should suffice.
Many years ago, there were a series of meetings of the AICPA. The meetings were held to discuss and debate the issue of whether auditors should be permitted to have financial interests in clients, including an ownership, in the stock of clients. Towards the end of this debate, which took years, a meeting was held at which one of the AICPA members said what I think is still so appropriate today:
" We are all very proud of our accomplishments, but it seems to me that as we grow in numbers we should grow in stature. . . . I honestly donít see how this organization can turn their own selfish interests and the way it effects their own individual practices in front of the good of the profession as a whole."
The profession initially rejected the prohibition of stock ownership, but after the resulting public denunciation of this move, the profession reversed their initial position and ultimately adopted the rule that still exists today. That is, members are prohibited from holding financial interests in clients.
The subject of auditors independence is just as emotional an issue today as it was 40 years ago. With many firms undergoing fundamental changes and auditing revenues now accounting for less than half of the total firm revenues, we are seeing increasing pressures to relax the current independence requirements.
However, I look at the issue from a different perspective. Having been an audit practice partner in the field, I believe the crux of the issue is (1) whether the auditors making the critical decisions are in an environment where they are totally free from pressures that might negatively affect their integrity and objectivity in making a difficult decision and (2) whether the investors would also perceive the auditor to be free of potential and financial conflicts and independent. With respect to the engagement partner when faced with a difficult financial reporting issue and/or client, he or she should have the total support of the firm and partners to make the right decision that will best serve investor protection. Engagement partners should be able to make such decisions without concern that they may lose compensation, their partnership, their status in the office, or receive a lower evaluation as a result of such a decision.
Likewise, it is important to our markets that investors perceive that auditors have high integrity and objectivity. That is why today, the staff and Commissioners at the SEC are following closely, with a great deal of interest and concern, the work of the Independence Standards Board. Its deliberations include such topics as (1) alternative firm structures, (2) the ability of members to take financial interests in clients (3) the ability to audit accounting information the accounting firm itself might generate when doing valuations, and (4) the ability of the audit firm to do an audit when it is part of or has designed the clientís internal control structure. The ISBís deliberations are crucial to maintaining investor confidence in the integrity and objectivity of the profession, as well as to establishing the ISB as a standard setter that puts the good of investors ahead of the interests of others.
Recently, the staff also sent a letter to the AICPA SEC Practice Section, the Chairman of the Independence Standards Board, and the Public Oversight Board. The letter discusses the quality controls accounting firms currently have in place to monitor compliance with the AICPAís and SECís independence rules. In some instances, these controls may not have been changed to reflect the business and operational changes going on in the profession. For example, there are many more foreign filers today being audited by foreign offices or affiliates of the U.S. firms. In addition, within the U.S., the firms have significantly more nonaudit personnel who may not have been subject to the same level of training on independence that auditors received in college and thereafter.
The staff is concerned because we have recently seen a number of violations of the existing independence rules including where auditors provided proscribed services. We are asking the firms and profession to address this issue on a timely basis.
There is another matter that I would like to address. In May of this year, the Chairman of the SEC addressed the Board of Directors of the AICPA and expressed his concern over certain aspects of the AICPAís disciplinary mechanism. As some of you may know, the disciplinary mechanism of the AICPA is operated within the Professional Ethics Executive Committee. The stated object of the Committee is, "To develop standards of ethics, promote understanding and voluntary compliance with such standards, establish and present apparent violations of the standards and the AICPAís bylaws to the Joint Trail Board for disciplinary action in cooperation with State Societies under the Joint Ethics Enforcement Program ("JEEP"), improve the professionís enforcement procedures and coordinate the and of the Professional Ethics Division." Since part of the AICPAís stated objective in this area is to work with State Societies, I thought this matter would be of particular interest to the each of you.
In his address to the AICPA, the Chairman expressed his concern, which the staff share, that the AICPAís disciplinary mechanism lacked credibility and urged the AICPA to re-evaluate this process. The Chairman suggested that the AICPA consider alternatives to improve the timeliness and effectiveness of the disciplinary mechanism and also provide more disclosure and analysis of ongoing proceedings and actions. The Chairman also asked that the AICPA consider more public representation in this process.
The SEC staff has also met with the Professional Ethics Executive Committee and re-iterated the Chairmanís concerns. In response, the Committee has agreed to review its processes and compare those processes to other self-regulatory bodies and consider recommendations to improve that process. The SEC looks forward to hearing the Committeeís recommendations for improving this process. On a side note, I encourage each of you to provide any suggestions you might have for improving the disciplinary process to representatives of the Committee.
Let me switch for a moment from the challenges facing us in the United States to a more global issue -- that of harmonization of International Accounting and Auditing Standards.
Some people the IASC is completing its work this month with the completion of the standard on accounting for derivatives. However, there remains a few loose ends that have yet to be completed on the core standards project.
Even more important though, is the fact that the environment that preparers of financial statements operate in today is continuously undergoing significant changes. As a result, I believe the work of international accounting and auditing standard setters will not cease soon, but rather will continue into the future if we are to have high quality standards that meet the needs of investors.
We must all contribute to the future evolution of the international accounting and auditing standards, while at the same time assuring:
- A comprehensive set of standards;
- A set of high quality standards that result in transparency for the underlying economics of the businesses;
- That the final standards are rigorously interpreted and implemented.
This is no longer a project that public accountants and CFOs in America can ignore. It is very relevant to all of us.
I offer as an example the accounting rules for business combinations worldwide. Some people believe, and I think with some justification, that some of the standards used in other countries are of a higher quality than those currently used in the U.S. In addition, it is difficult for foreign filers to reconcile the differences between U.S. GAAP and the GAAP they use to report in their home countries. As a result, it makes all of the sense in the world for the FASB to work closely with other national standards setters to come up with global, harmonized standards. One potential outcome of harmonizing the various worldwide standards would be to eliminate the use of accounting alternatives and pooling accounting.
Accordingly, I encourage you to become engaged in the debate on international accounting standards. I actively am seeking the financial communityís perspectives on the issues and would certainly welcome your input on the tough decisions I will face shortly, such as:
- What will be the impact on U.S. filers if IASC standards are adopted?
- Do investors benefit from the information in the current U.S. GAAP reconciliation? Does this reconciliation provide a useful tool for "leveling" the competitive playing field for U.S. and foreign companies?
- Is there a sufficient infrastructure worldwide today, including quality international auditing and independence standards, to ensure the rigorous implementation of the IASC standards?
On this last question, I must mention the concerns that have been expressed by the World Bank with respect to the quality of audits in some foreign countries. They are concerned that if a major accounting firm uses its own name on the audit opinion on a foreign company, but it has not applied rigorous audit standards indicative of a high quality audit, investors and lenders may be misled. I share the concern of the World Bank regarding this issue. I believe global harmonization should apply to auditing and quality control standards as well as the accounting standards. What good will high quality accounting standards do us if they are not rigorously applied through high quality auditing on a worldwide basis?
Market Risk Disclosures
New market risk disclosure rules were adopted by the Commission in January 1997. As you know, these rules call for enhanced accounting policy disclosures and presentation of quantitative and qualitative information about market risks. The rules were phased in, and all registrants are now required to comply with these requirements in their financial statements for fiscal years ended after June 15, 1998.
Since the FASB issued SFAS 133 this past June, the staff has begun a review of the market risk disclosure rules consistent with the commitment it made in the ruleís adopting release.
While it is still too early to tell how, if at all, the staff will recommend to the Commission that the market risk disclosure rules be amended in light of the FASBís new derivative standard, it may be helpful to draw some comparisons between SFAS 133 and the Commissionís rules. The most obvious difference is that SFAS 133 does not require all of the disclosures about the method for accounting that the market risk rules require.
However, the accounting policies are not the only item the staff needs to look at.
The definition of derivative in the Commissionís rules for accounting policies and for quantitative and qualitative disclosures is the same as SFAS 119, not SFAS 133. In addition, the quantitative and qualitative disclosures are segregated between trading and non-trading portfolios as that distinction is expressed in SFAS 119. This distinction is eliminated in SFAS 133. The general description required in SFAS 133 is very similar to qualitative disclosures under the Commissionís market risk rules but there are some important distinctions. For example, the market risk rules (1) include non-derivative financial instruments, and (2) report exposures by risk category, not type of hedge.
These are just some of the issues that the staff must address in looking to amend the market risk disclosure rules. My expectation is that any amendments will be out for comment sometime in 1999.
The Commission also stated in the adopting release that it will undertake a review of the market risk disclosure rules three years from the date of their adoption. The staff will wait to determine the scope of that review until after filers have experience with the rules.
In July 1998, the staff completed an initial review and report of the first phase of filings that included the new market risk disclosures. In the review, the staff learned that while analysts and investors have supported the rules as providing new, useful information, it is too early to tell whether the disclosures are as cost-efficient as originally anticipated or whether changes should be made in the disclosure requirements.
Some of the most frequent issues cited by staff to date in their review of filings have included:
- The quantitative and qualitative disclosures are not being provided outside of the financial statements as required to qualify for the safe harbor protection provided by the rule. This is one of the points stressed in a staff Q&A publication available at the SEC website, www.sec.gov/divisions/corpfin/guidance/derivfaq.htm.
- When the information is being provided in a tabular format, registrants are not providing adequate details about the relevant terms of the instruments and assumptions used to determine estimated fair values, cash flows and future variable rates. Additionally, registrants are not adequately segregating instruments by common characteristics and by risk classifications.
Recall that the Rule requires an entity to segregate its financial instruments and derivatives into trading and non-trading portfolios, and then to further segregate these portfolios into four risk buckets. Potentially, there could be one bucket for each market risk exposure category: interest rate risk, foreign currency risk, commodity risk, and other risks, which includes equity price risk. Then, if exposure to risk of loss in any of these bucket categories is material in terms of fair value, earnings, or cash flows, the registrant must disclose its market risk exposure for each material category.
When providing the required information in tabular format, instruments should be further grouped by common characteristics - for example, receive fixed and pay variable swaps should be segregated from receive variable and pay fixed swaps.
- When using sensitivity analysis and value-at-risk (VAR), registrants are not disclosing sufficient information about the types of instruments or any offsetting positions included in the analysis. In addition, registrants are not providing adequate disclosures about the specific model or significant assumptions used. Registrants should also indicate whether other instruments are included voluntarily, such as certain commodity instruments and positions, cash flows from anticipated transactions, etc., that are outside the scope of the rule.
- The qualitative disclosures required by registrants are not clearly disclosing how the registrant manages its material market risk exposures including the objectives, general strategies and instruments, if any, used to manage those exposures.
- Registrants may need to discuss a material exposure under the Item even though they do not invest in derivatives. For example, registrants that have investments in debt securities or have issued longĖterm debt should discuss risk exposure if the impact of reasonably possible changes in interest rates would be material.
The rule clarified specific items the staff expected to be disclosed under SFAS 119 and extended the SFAS 119 disclosures to commodity derivatives. The rule sets out seven specific disclosures to be included in a registrantís accounting policy footnote. Because of the confusion created by the many different methods of accounting for derivatives, six items related to the different methods. The seventh item is a disclosure of where and when derivatives and their gains and losses are reported in the financial statements.
I hope I have covered many of the topics and questions that are on your mind today. Certainly, these issues are getting the attention of the SEC staff and Commission.