FINANCIAL EXECUTIVES INSTITUTE Current Financial Reporting Issues Conference New York, New York November 11, 1997 CURRENT DEVELOPMENTS IN FINANCIAL REPORTING: Challenges and Opportunities Remarks by Michael H. Sutton Chief Accountant Office of the Chief Accountant United States Securities and Exchange Commission Washington, DC __________________________________ 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. Sutton and do not necessarily reflect the views of the Commission or the other members of the staff of the Commission. Once again, I thank you for the opportunity to share a few of my thoughts about current accounting and financial reporting issues. I'm going to begin with some perspectives on derivatives disclosures and accounting, and in doing so try to anticipate some of the questions you may have. Then I will comment on some current developments relating to business combinations, international accounting standards, and auditor independence. Derivatives Disclosures and Accounting Derivatives Disclosures For a number of years, the Commission has been concerned that the current accounting and disclosure requirements for derivatives and market risks are not meeting the needs of investors. Last year, we discussed the Commission's proposed market risk disclosure rules and the process for reviewing comments on the proposal. The final rules were issued last January, and a Question and Answer guidance document was published in July. In issuing these rules, the Commission committed to reconsider the need for the accounting policy disclosure requirements after the FASB completes its accounting project and to review the effectiveness of the quantitative and qualitative disclosures after three years. In addition, the Commission committed to review the early filings under the new rules and to report its findings one year after the effective date. The staff is now in the process of reviewing the first group of filings. In our very limited review to date, we have found that some registrants have developed very effective disclosures about their use of derivatives and their market risk exposures, and in those instances, the staff has found the disclosures to be informative and useful. We also have reviewed filings that were less informative, and in some cases, even confusing. In some cases, for example, the staff had difficulty locating the required information, particularly when it was scattered throughout the filing and cross references were not provided. In other cases, disclosures were not provided when other information in the filing seemed to indicate that a material market risk exposure might be present. I want to emphasize that the staff is in the preliminary stages of its review, and you should be hearing more about this process and our findings over the coming months. Accounting for Derivatives The other part of the equation for providing investors with the information they need is the FASB's accounting project. As the Board has approached completion of its project, much has been said in published articles, editorials, letters, and even Congressional testimony about the Board and the accounting it has proposed. You are well aware that the Commission has followed this debate closely and has a number of interests. First, the Commission's oversight responsibility demands close attention to process issues to see that the process is open, thorough, and operates in a way that serves the interests of investors and the public. Second, this is an area in which accounting standards have not kept pace with innovations in the marketplace -- one in which an ever widening gap has developed that needs to be filled. Third, some of the commentary we are hearing could suggest that there may be some problems in current filings with the Commission. Not everyone will agree with every detail of every standard. Similarly, not everyone will agree with every aspect of the process by which a specific standard is set. But, I think it is fair to say that the results of the Board's work, over a long period of time, argue that the process, by and large, is working well. Sometimes the Board is criticized for seeking change that is argued to be unnecessary. In reviewing some of the standards and current projects the Board is addressing, I think it is difficult to agree with that criticism today. The US accounting guidance on business combinations, for example, is outdated and fraught with practice problems. Surely, these rules do need to be reexamined. The arguments that the Board is trying to fix something in its derivatives project that isn't broken are especially perplexing. Those that have worked with current accounting literature in this area know that it is inconsistent, incomplete and complex. We also know that some of the accounting in practice today has permitted losses to be recorded as assets and gains as liabilities, a result that is just plain wrong. Current accounting also lacks transparency, which leaves investors in the dark about an entity's derivatives activities. Here, as with other areas of financial reporting, supplemental disclosures can help investors understand a company's derivatives activities. But, disclosures are not a substitute for good accounting. Because of the complexity and leverage of these instruments, it is important that investors be able to understand a company's use of derivatives by looking at the balance sheet and income statement, not by searching through the footnotes. Perhaps investor frustration with the accounting for derivatives was best captured by a quote from an economist in a recent Forbes article, who stated, "I compare the current standards to watching night baseball without the lights. There's a game going on and the scoreboard lights up once in a while, but you have little idea of what's actually going on down on the field." Let's look for a moment at one of the specific complaints about the Board's proposal. We have heard criticisms that the proposal is more restrictive than current accounting standards for certain macro-hedging activities. The suggestion has been that some registrants are now using hedge accounting for derivatives designated as hedges of portfolios of assets and liabilities, and that the proposed FASB standard would change that accounting. The staff has understood and has interpreted the current hedge accounting literature to require that derivatives be designated to specific assets or liabilities (or anticipated transactions, where permitted), and does not permit designation to portfolios of assets and liabilities. Interestingly, when the Board discussed this issue with its Financial Instruments Task Force, it was told by financial institution representatives, as well as others, that requiring designation to specific assets or liabilities was not only practical -- it also was appropriate. Another criticism of this project, as with others in the past, has been that the Board has not listened. Sometimes, I fear, we confuse being heard with being obeyed. They are not the same. When you consider the many steps the Board has taken on this project, including over 100 public meetings, it is difficult to accept the criticism that constituents have not been heard or that the Board has not followed an open, deliberative process. In this specific project, I think we have to acknowledge that, after listening to constituent concerns, the Board did revise its proposal to accommodate a number of recommendations. For example, I think that the Board has made a concerted effort to simplify certain provisions of the standard that were criticized as overly complex. In short, I can't recall another project in which the Board has followed greater due process or solicited greater input. Finally, some have urged a delay in the implementation date for the new standard. This request, I fear, doesn't give adequate consideration to the needs of investors. Investors need more transparent reporting, and they need it as soon as possible. In the period since the derivative losses in 1994 that took investors by surprise, and until very recently, we have enjoyed a relatively stable and positive interest rate, foreign exchange, and other market risk environment. Recent events, however, have shown that we cannot be assured that those conditions will continue indefinitely. Business Combinations The staff continues to devote a significant amount of time to business combination issues, particularly those involving poolings of interests. An issue that we have encountered with some frequency recently relates to systematic patterns of purchases of treasury stock. Accounting Series Release 146 emphasizes that treasury shares purchased in connection with recurring share distributions can be considered to be untainted only if: (1) they are purchased pursuant to a systematic pattern; and (2) there is a reasonable expectation that the shares will be reissued for their intended purpose. In establishing and maintaining a plan to purchase treasury shares under a systematic pattern, ASR 146 requires that the purchases be made pursuant to specified criteria that are sufficiently explicit to permit the pattern of actual purchases to be objectively compared to the plan. The criteria should leave little or no discretion in determining the number or timing of share purchases, and the pattern of actual purchases should match the plan. In several instances, the staff has concluded that the evidence was inadequate to demonstrate that treasury shares had been purchased pursuant to a systematic pattern. Specifically, the staff has challenged the existence of a systematic pattern when purchases have been based on discretionary criteria that require judgment to determine when or in what amount shares are to be purchased. This is just one example of the many issues that cause the staff to question the current model for business combinations, and I am encouraged that the FASB has begun deliberations on its business combinations project. International Accounting Standards International accounting and auditing, including efforts at harmonization of standards, have been in sharp focus over the last year. Yesterday, we discussed the status of the IASC's core standards work program, and I won't try to cover that ground again. I would like to follow up to emphasize that, to be considered for acceptance in foreign filings in the US, IASC standards must constitute a comprehensive, generally accepted basis of accounting, and the standards must be of high quality. Financial instruments is a critical element of what was agreed to be a comprehensive core set of standards. In my view, any set of standards that does not address the accounting for financial instruments, including derivative instruments, would not meet the needs of investors in today's markets and would not constitute a comprehensive core set of standards. While adopting US standards for financial instruments is but one approach to developing an acceptable core standard, the staff believes that the IASC standard ultimately included in the core must be, at least, of comparable high quality. Finally, I refer again to the Commission's report to Congress on the status of international harmonization efforts if you would like more detailed information. The Commission and the staff will continue to monitor these developments and provide input to the IASC as its work progresses. Independence Standards Board Over the last year, the Commission worked with the AICPA to create a new Independence Standards Board, an independent, private-sector body that has been charged with addressing auditor independence issues and establishing appropriate standards for auditors of public companies. Concerns about the potential for independence conflicts have become more intense and more public in recent years as the trends toward expansion of services provided by the accounting profession and mergers and restructurings of accounting firms have continued. From the Commission's perspective, auditor independence is all about one thing -- maintaining investor confidence in our securities markets. That was the objective of the securities laws that requires an independent audit, and it is the fundamental focus of the Commission in addressing auditor independence issues. Without a high level of confidence that an independent audit produces a totally unbiased look at a company's financial statements, investors could lose confidence in the information they receive and use for making investment decisions. And, if investors do lose confidence in the information they are provided, they, in turn, would lose confidence in the fairness and impartiality of our capital markets. Our markets are built on trust and confidence, and maintaining that trust and confidence has been and will continue to be a critical priority for the Commission. The structure of the new Independence Standards Board has been designed to provide safeguards to assure that the process will operate in the public interest. An especially important feature is the commitment and participation of strong leaders from outside the accounting profession. I refer, for example, to William Allen, former Delaware Court Chancellor and now a Professor at New York University, the Board's first Chair; John Bogle, retired Chairman of The Vanguard Group; Robert Denham, CEO of Solomon; and Manuel Johnson, former Vice Chair of the Federal Reserve and Chairman of the Financial Accounting Foundation. Also important will be an open public decision-making process, and active oversight by the Commission and its staff. As the new board takes up the issues that lie ahead, it must keep sharply in focus the expectations of an independent audit from the investor's point of view. As it considers the issues, it should ask whether a reasonable investor, with full knowledge of all of the facts and circumstances, would have confidence that the independent auditor would put the interests of investors first and that those interests would not be compromised by any conflicting interest of the auditor or the auditor's client. * * * * * * * That concludes my prepared remarks. I would be pleased to respond to your questions.