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Speech by SEC Staff:
Call Them As You See Them

by Jackson M. Day

Deputy Chief Accountant
U.S. Securities & Exchange Commission

AICPA National Conference on Banks and Savings Institutions

November 2, 2000

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Day and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

Good morning. I would like to thank the AICPA for this opportunity to speak to you concerning recent activities in the Office of the Chief Accountant at the SEC.

But, before I go on, let me remind you that the views expressed today are my own and do not necessarily reflect the views of the Commission or of the Commission staff.

As some of you may know, I was recently appointed Deputy Chief Accountant. I learned that when you become a Deputy Chief Accountant at the SEC, many people call to offer congratulations ---- and along with those calls of congratulations comes a lot of "wisdom" free of charge.

I recall one conversation in particular. A senior partner of an accounting firm called to wish me well. Eventually, the discussion found its way to his explanation of why he had stuck it out all these years. His answer --- "Well, the pay is good and all I have to do is call them like I see them." At the time, that comment seemed to be insightful enough but it was only after thinking about it a while that I realized how insightful it really was. I would like all of you to hold that thought while I discuss several areas that the SEC staff has been focusing on recently.

My comments this morning will be directed to disclosures within Managementís Discussion and Analysis (MD&A), loan loss accounting, segment disclosures, and a discussion of the impact of recently issued, but not yet adopted accounting literature. Then I will wrap-up with a few thoughts for year-end.

MD&A Disclosures

I would like to begin with a registrantís disclosures within MD&A. Item 303 of Regulation S-K requires a discussion of liquidity, capital resources, results of operations and other information. This disclosure is necessary to gain an understanding of a registrantís financial condition, changes in financial condition and results of operations. In other words, MD&A should "give investors an opportunity to look at the registrant through the eyes of management by providing a historical and prospective analysis of the registrantís financial condition and results of operations, with a particular emphasis on the registrantís prospects for the future."

All too often, companies merely repeat, in MD&A, the amounts or disclosures included in the financial statements, or merely recalculate new amounts from those provided in the financial statements. These practices fall short of providing investors with the required disclosures. Registrants are urged to review Financial Reporting Release No. 36, including the examples set forth in that release, which summarized the results of a project to evaluate compliance with MD&A requirements.

MD&A discussions should clearly explain, in plain English, the known trends, demands, events, commitments and uncertainties that are reasonably likely to materially affect a registrantís liquidity, capital resources, and results of operations. In making these disclosures, it is important that the reasons for the trends, demands, events, commitments, and uncertainties are discussed, in addition to quantifying the related effects. With todayís volatile markets, I urge you to focus this year on the quality of disclosures within MD&A, especially its forward-looking statements. Preparers of MD&A should ask themselves these questions: Is the investorís "view" of the company that is portrayed in MD&A the same as managementís? Is it clear? Does it provide the investor a transparent vision of what is happening with the business? Or is the readerís "vision" clouded with unnecessary language?

What issues might be appropriate to address in MD&A this year? Several. A number of recent developments have occurred in our economy and business environment that are likely to affect financial institution registrants and require disclosure in MD&A. Depending on a particular registrantís circumstances, these developments might include:

  • Increasing interest rates;
  • Potential credit deterioration in loan portfolios;
  • Participation in highly leveraged transactions that can significantly increase a lenderís exposure to risk associated with changes in the borrowers business, industry and economic developments;
  • Liquidity or short-term funding issues;
  • Changes in the value of the euro and U.S. dollar which may impact institutions with significant foreign operations or those companies to which a financial institution has extended credit;
  • Acquisitions by companies of their own stock, which may materially impact trends in earnings per share, and, if financed by incurring debt, may affect companiesí liquidity, financial condition, and current and future operations due to increased borrowing costs;
  • Market changes which may affect pension assets and related returns thereon;
  • Changes in trends of revenue growth;
  • Acquisitions of businesses resulting in new segments; and
  • The effect of increasing oil prices on those companies a financial institution has extended credit to.

After reading MD&A, an investor should understand your business as you see it. Are the readers of your financial statements in this position? "Call them like you see them," so the investor knows as well.

Loan Losses

The second topic I would like to comment on is accounting for loan losses. Recent reports from bank regulators seem to indicate that credit risk within loan portfolios may be increasing. In light of this, financial institutions experiencing this trend need to be particularly mindful of internal controls and processes associated with the allowances for loan losses to ensure timely and appropriate allowance amounts.

The concept in GAAP is that impairment of receivables should be recognized when, based on all available information, it is probable that a loss has been incurred based on past events and conditions existing at the balance sheet date. In plain English, the allowance for loan losses must reflect, on a timely basis, the changes in the credit quality of an institutionís loan portfolio. As credit quality deteriorates, the allowance should be adjusted upward in a timely fashion to reflect the additional losses that have been incurred. Likewise, as the credit quality of an institutionís loan portfolio improves, there should be a corresponding change downward in the amount of the necessary allowance. Simply put, an institution with a higher percentage of troubled loans and an institution with a high credit quality portfolio should have loan loss allowances and provisions that look distinctly different to investors.

That is why it is important preparers clearly discuss and disclose in MD&A all the developments that are affecting the credit quality of the loan portfolio. Those disclosures must give investors a transparent picture of the trends and developments that are affecting the portfolioís credit quality and the resulting impact on liquidity, financial condition and operating results. Those disclosures should also indicate the movements being recorded in the allowance for loan losses in the financial statements.

Expect questions when loan portfolio and loan loss allowance information appears to contradict or to be inconsistent with other available information within MD&A. For example, MD&A may highlight a registrantís declining loan quality or increasing level of non-performing assets, yet the allowance as a percentage of the loan portfolio has remained steady or the provision for loan losses has decreased. Similarly, MD&A may indicate a decline in problem loans, while the allowance continues to increase.

The Division of Corporation Financeís Current Accounting and Disclosure Issues outline, available at http://www.sec.gov/offices/corpfin/acctdisc.htm, outlines the staffís views on what information about the allowance for loan loss disclosures that registrants should provide in their filings with the Commission. Filings with the Commission should describe the registrantís accounting policies for determining the amount of the allowance in a level of detail sufficient to explain and describe the systematic analysis and procedural discipline applied.

Further, financial institutions should have internal accounting controls that ensure timely and accurate reporting for financial reporting purposes, in accordance with GAAP, including reporting of losses and changes in the credit quality of the loan portfolio in the periods in which those changes occur. Those internal accounting controls should also ensure proper preparation and maintenance of documentation to support loan loss allowances, in accordance with Financial Reporting Release No. 28 (FRR 28). Institutions should ensure that their internal controls incorporate the systematic analysis and procedural discipline required by FRR 28 in determining the allowance for loan losses.

While we are on the topic of internal controls, let me make a few additional observations. The report and recommendations of the Panel on Audit Effectiveness stated that audit committees should devote additional time and attention to discussions of internal control with management as well as with the independent auditors. Specifically, the Panel recommended that audit committees, "obtain a written report from management on the effectiveness of internal control over financial reporting." For financial institutions, a report on the effectiveness of internal controls would surely encompass the internal controls in place over the preparation of financial information concerning the loan portfolio and the allowance for loan losses. Each and every audit committee should consider it carefully.

To summarize, the determination of the allowance for loan losses involves judgment. With that said, financial institutions should follow GAAP. Loan loss provisions should be recognized for probable losses that exist as of the balance sheet date, applying a rational methodology that is documented consistent with FRR No. 28 and that is consistent with full disclosure in MD&A. MD&A should include the applicable trends, events, and uncertainties that lead a registrant to the determination of the appropriate provision in accordance with GAAP.

For example, if factors exist such as:

  • deterioration in an industry segment;
  • a concentration of loans in an economically depressed region; or,
  • an indication of increasing trends in losses,

and those factors and trends are the reason for an increase in the allowance for loan losses, then those factors should be disclosed in MD&A as you see them.

Segment Disclosures

Segment Disclosures. Since the effective date of Statement 131, the staff has seen instances in which the MD&A disclosures or press releases of registrants describe business segments that differ from the business segments identified and disclosed in the footnotes to the financial statements. Those cases often lead to questions. Why? Because all aspects of Statement 131 should be compiled with. While Statement 131 is a disclosure standard, that does not diminish its importance or the level of compliance required by financial statement preparers.

So how far will we go? Well, during routine reviews of filings including segment disclosures, the staff commonly requests registrants to provide copies of the reports or other materials supplied to the "chief operating decision maker" of the company. We do that to see if the segment information included in these reports and other information correlates with the segment information disclosed in the external financial statements. We also review analystsí reports, interviews by management with the press, and other public information to evaluate the consistency between the manner in which the company is portrayed in these other forums and in the financial statements. Then we compare the information obtained to the segment footnote.

For example, when reviewing press releases and other public information, the staff may note prominent discussion of how a particular business line such as the asset management or venture capital group is doing. We then look for that operation to be identified as a reportable segment in the companyís financial statements. This is especially the case when that business provided significant earnings or revenue growth or was commented on in the chairmanís letter accompanying the annual report.

When segment disclosures in the financial statements do not reflect a consistent identification of the companyís segments as evidenced in the internal and external reports and materials used by the chief operating decision maker, we have requested registrants to amend their financial statement filings. That practice is not likely to change. Save yourself time by disclosing the segments as you see them.

Recently Issued Accountants Standards

The next topic I would like to comment on is disclosures concerning recently issued, but not yet adopted accounting standards. Staff Accounting Bulletin No. 74 states that filings with the SEC that include financial statements for a period ending after the issuance of an accounting standard, but before the required date of adoption of that accounting standard, should include disclosure of the expected impact that the recently issued accounting standard will have on the financial position and results of operations of the registrant as you see them. So letís talk about new standards.

First, Statement 133 on accounting for derivative instruments and hedging activities. Statement 133 is effective January 1, 2001 for calendar year companies. Accordingly, quantitative disclosure of the expected effect of Statement 133 generally should be made in the third quarter 10-Q filings for those companies.

Some have raised concerns about implementation of Statement 133 in light of the activities of the Derivatives Implementation Group and its process referred to as the DIG. Their concerns include questions as to what instruments are within the scope of Statement 133 and how the transition amounts are to be determined.

For the past two years we have encouraged registrants and their auditors to identify potential issues and submit them to the DIG. Accordingly, we are very supportive of the DIG and its role. We believe the DIG is critical to the process of implementing a standard that addresses transactions as complex as derivatives.

Further, we understand that the DIG may clarify the accounting for certain past transactions that it had not previously or fully addressed. In evaluating the accounting for those transactions, we consider if the rationale for the previous accounting treatment is reasonable and not inconsistent with Statement 133 and previously resolved DIG issues. In addition, we are working with the FASB staff to develop reasonable transition for DIG issues resolved after adoption of Statement 133.

Letís talk now about FASB Statement 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a replacement of Statement 125. Some of Statement 140ís disclosure requirements are effective for fiscal years ending after December 15, 2000. Registrants with calendar year-ends should be in full compliance with those disclosure requirements in their December 31, 2000 Form 10-K filings. Furthermore, registrants should also make SAB 74 disclosures on the anticipated effect of Statement 140 when fully adopted in April 2001.

A little more on Statement 140. SPE transactions continue to be a source of problems. After adoption of Statement 140 registrants should comply with all of Statement 140ís SPE rules. Another area of focus associated with Statements 125 and 140 is assigning appropriate valuations to retained interests. This has been and continues to be a problem area.

As the FASB continues to move closer and closer towards its goal of recording all financial instruments at fair value, preparers and auditors must become more proficient at estimating fair values. This means additional training to gain new skills. Soon all accountants should know how to build yield curves and know the meaning of volatility. Expect to hear more on estimating and auditing fair values.

In the mean time, the lack of sufficient, objective, verifiable evidence supporting registrants Statement 107 fair value disclosures also raises a concern. This concern includes a lack of appropriate testing of these disclosures by auditors. As a reminder, footnote disclosures must also be subjected to sufficient audit procedures in order for the auditor to issue a "clean" opinion.

A couple of more thoughts before I go. Paragraph 16 of Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities," specifies that "If the decline in fair value [for a security below its cost] is judged to be other than temporary, the cost basis of the individual security shall be written down to fair value as a new cost basis and the amount of the write down shall be included in earnings (that is, accounted for as a realized loss)."

SAB 59, "Accounting for Noncurrent Marketable Equity Securities," identifies the factors that should be considered to determine whether a decline in the value of a security is other than temporary. SAB 59 also states that other than temporary does not mean permanent. SAB 59 essentially requires that a registrant have evidence to support that the amortized cost of a security will be realized. Unless such evidence exists, a write-down accounted for as a realized loss should be recorded.

Let me wrap up by observing that you can read more about the issues I mentioned today and other hot topics in our year-end audit risk letter sent by the chief accountant of the SEC to the AICPA. This letter is available on the SEC website. The address is http://www.sec.gov/offices/account/audrsk2k.htm.

And donít forget Ė call them as you see them.

That concludes my prepared comments. I would be pleased to answer any questions you might have during the Q and A.