“Current Financial Reporting Issues”

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.

Introduction

I appreciate the opportunity to be here again and to share with
you a few thoughts about accounting and financial reporting.
Before I begin, I must remind you that these comments are my own
and do not necessarily represent the views of the Commission or
others on the staff.

This morning, I will comment on derivatives accounting and
disclosures, comprehensive income, earnings per share, and,
finally, business combinations and Staff Accounting Bulletin 96.

Derivatives Accounting and Disclosure

Derivatives Accounting

As both providers and end-users of derivatives, the banking
industry is well aware of the continuing growth in the use of
derivatives.  With expanded use, it follows that the number of
constituents that have a stake in the accounting for derivatives
has increased, and many of the stakeholders have very conflicting
interests in the accounting for derivatives.  So, while improving
accounting in this complex area has become increasingly
important, achieving improvements has become increasingly
challenging.  Indeed, some are calling for preservation of the
status quo or only modest refinements to the current accounting
model.  My view is that our current accounting model is in need
of more than modest refinements.

It is important to realize that the use of derivatives has grown
without a matching development of an accounting framework for
financial instruments.  Swaps, forwards, futures, and other
derivative instruments are no longer the province of Wall Street
specialists -- they’ve become basic risk-management tools that
every corporate manager -- and therefore investor -- has
confronted or will confront.

For some, it is hard to appreciate the degree to which accounting
has been playing  catch-up with the sophisticated risk management
strategies that have developed in the last 10 years.  While the
change required to catch up is significant, the biggest leap is
also the most necessary one -- bringing financial instruments out
of the notes and onto the balance sheet -- and carrying them on
the balance sheet at fair value.  A proposal that fails to go
that far would, in my view, have a fundamental shortcoming that
could not be redressed by disclosure.

Standard setters and regulators for years have been wrestling
with a laundry list of anomalies in practice, and there have been
many frustrating and failed attempts to address those problems.
In retrospect, perhaps we’ve been too focused, for too long, on
trying to resolve those anomalies within the existing framework,
rather than recognizing that it may be time to adopt a new
framework.

As you know, the Financial Accounting Standards Board (FASB), has
issued an exposure draft that sets forth a new framework.  The
comment period ended only few weeks ago, and public hearings are
scheduled to take place later this month.  So it is a bit early
to draw conclusions about the responses received by the Board.
There are, however, several points that will influence the way
the SEC staff analyzes and evaluates those comments.
Some call the Board’s proposed framework radical -- too major a
change from current practice.  From my perspective, the Board’s
approach is an important shift in our accounting model that
should provide a better framework for improving the accounting
for derivatives and other financial instruments than we have
today.  First, it is comprehensive in scope so that the
accounting guidance will be applicable to all derivatives.

Second, these instruments will be recognized at fair value, which
will provide enhanced transparency to users of financial
statements. Third,  written options will be recorded at fair
value and not be afforded hedge accounting treatment.
Some are especially concerned that the Board’s proposal would
limit the use of hedge accounting, but the staff believes some
limitations are necessary and desirable.  Hedge accounting can
raise significant investor protection concerns because it can
lead to situations in which assets are recorded as a result of
incurring losses.  Specifically, consistent with those concerns,
the staff believes that deferral of losses on derivative
instruments should be permitted only in very limited
circumstances.  Thus, we believe that it is appropriate for the
Board’s hedge accounting model to include restrictive criteria
that can be objectively evaluated and rigorously applied.
I also think that it is important to recognize that once the
Board decided to permit hedge accounting in its model, it
effectively committed to a series of rules that would accommodate
some, but not all, of the many accounting anomalies that exist in
our current mixed attribute accounting model.  With that decision
it is axiomatic that -- in this limited project -- some anomalies
will get resolved while others will not, and some new anomalies
will be created.

Derivatives Disclosure

In December 1995, the Commission issued for comment a release
that calls for new disclosures about derivatives and other
financial instruments.  I think that the specifics of the release
are fairly well known, but I would like to share with you some of
the comments we have received.

The most basic point to be made about the proposal is the
Commission’s objective in issuing it -- and that is to provide
disclosures that will help investors better assess the market
risks that registrants are undertaking -- and better understand
how those risks are managed.

The comment period ended in May 1996, and about 100 comment
letters were received from users, prepares and auditors. The
staff is completing its analysis of the comment letters, and a
number of letters included thoughtful analyses and observations
that reflect significant investments of time by the authors.  The
responses also reflect the significance of derivatives reporting
issues to understanding financial statements of both dealers and
end users.

In general, users of financial information support the proposal,
but want more uniform presentations and methodology.
Corporate preparers are critical of the proposal, in part because
they believe that market risks are not their primary business
exposures.  They expressed some concern that the proposed
disclosure requirements overemphasized this aspect of their
operations.

Auditors and financial institutions perceive a need for more
information about market risks and generally are supportive of
the proposal, but they have suggestions about alternative
methodologies for providing quantitative information.
We are currently in the process of considering the comments and
how the Commission should proceed.

Comprehensive Income

It is understandable that, as the number and significance of
items recorded directly as an adjustment to shareholders’ equity
continues to grow, there is a parallel need for a more
comprehensive analysis of changes in shareholders’ equity -- in
particular, changes that are not the result of capital
transactions with shareholders.

The focus on comprehensive income significantly increased with
the issuance of FASB Statement 115, which requires an adjustment
directly to shareholders’ equity to record changes in the fair
value of securities classified as available for sale.  The
proposal in the Board’s hedging and derivatives project to record
changes in the fair value of hedges of forecasted transactions as
components of comprehensive income created a further incentive
for the Board to address the need for a better presentation.  So,
I share the sentiment of the Board that a better display of those
equity adjustments is needed.

Like a number of commentators on the Board’s Exposure Draft, I
believe it is important to address the need for a conceptual
framework for comprehensive income.  However, I don’t believe
that the development of that framework is a necessary
prerequisite for a standard that addresses display.  The Board,
with the support of its many constituents, already has made
decisions to record a number of items directly in shareholders’
equity, and it seems to me that there is a real need for
enhancement in display.

I want to comment on one of the criticisms I’ve heard about the
Board’s comprehensive income proposal -- and that is, by giving
equal prominence to comprehensive income, the volatility of
economic performance will be emphasized.  Some commentators
criticized the Exposure Draft by arguing that the effect is a
volatile income statement, which is something that current
literature tries to avoid.

I think we need to be cautious about the proposition that
accounting should avoid reporting inherent economic volatility.
A primary characteristic of financial reporting should be
representational faithfulness.  If an entity’s activities expose
it to volatility in the measurement of its assets and
liabilities, financial statements that reflect that volatility
are likely to be more useful to investors than financial
statements that omit or downplay it.

Earnings per Share

It seems that all, or almost all, recognize that the current EPS
standard is unwieldy, requiring numerous interpretations and EITF
issues, and I think the Board’s efforts to simplify the earnings
per share calculation are commendable.  I also agree that it
provides an opportunity to harmonize US standards with those of
international standard setters.

Having observed the discussions of this issue at the IASC, I
appreciate the challenges faced by standard setters working in
the international arena.  While US financial statement users
focus on fully diluted EPS as an important measure of both
performance and potential future dilution, European analysts seem
to rely more on basic EPS as a measure of current performance,
with extensive disclosure about potential conversion and exercise
rights that allow investors to make informed judgments about the
possible effects of future dilution.

I’d like to anticipate one question that may be raised later.  In
this project, the Board decided not to address “numerator” issues
like those covered in four or five Staff Accounting Bulletins and
SEC Observer comments at EITF meetings.  And, a number of
commentators have asked the Board to provide guidance in this
area.  The SEC staff will, of course, revisit its SAB’s and SEC
Observer comments as the FASB finalizes its document.  However,
our preliminary analysis is consistent with the views expressed
by the Board -- that the issues addressed in our guidance relate
more to the Board’s project on liabilities and equity than to
EPS.

The SEC staff guidance was put in place as an interim measure to
ensure that all distributions to preferred shareholders, whether
characterized as dividends, redemption premiums or conversion
enhancements, are treated in an evenhanded fashion.  I would not
expect to see a significant change in SEC staff positions before
more guidance is provided for distinguishing between liabilities
and equity.

Business Combinations

As you know, currently the principle accounting literature for
business combinations is APB 16.  And, APB 16 has some major
design flaws -- especially its pooling of interests provisions --
that have created unexplainable anomalies in practice and an
endless stream of practice problems.

The types of “pooling versus purchase” issues that consume much
staff time have very little to do with assessing whether there is
a mutual sharing of risks and rewards by the shareholders of the
combined entity.  Rather, they have quite a lot to do with how an
acquisition of one company by another can be shoe-horned into the
complicated interpretive structure that has been built --
somewhat shakily -- on the 12 “tests” enumerated in APB 16.

Current practice, described recently by a journalist as requiring
“much unproductive time [devoted] to angels-on-a-pin debates,”
ignores what is recognized elsewhere in the world as the only
logical justification for pooling of interests accounting, and
that is a business combination in which an acquirer cannot be
identified.

While we take pride in the quality of US accounting standards, I
think this is an area where we must acknowledge that we are
trailing world opinion in permitting an accounting practice that
largely is precluded in the rest of the world.  Our neighbors in
Canada, for example, are concerned that the permissive US
accounting practices create an uneven playing field for Canadian
companies who seek to compete in the US capital market.

I am pleased that the FASB recently added this topic to its
agenda, and that the FASB has identified this project as a chance
to harmonize US standards with those of other countries.

SAB 96

The past few years have seen significant business combinations
activity -- in the banking industry as well as in the business
community generally -- much of which involves transactions
structured to achieve pooling of interests accounting.  During
this same time period, many registrants have looked at their
capital structures and have concluded that they are
overcapitalized.  And, in those situations, management often
contemplates active share repurchase programs as a way of
managing capital and maintaining shareholder value.

For some time, many, including the staff, have been concerned
about the impact on the pooling rules of plans to manage capital
through, among other things, share repurchases.  For example,
significant planned repurchases may have the effect of providing
a floor price, or a cash exit vehicle, to those receiving shares
in the combination -- a consequence that conflicts with the
fundamental “sharing of risks and rights” pooling principle.
Moreover, planned repurchases may affect the voting decision of
shareholders that might oppose to the combination absent such a
repurchase program  -- again a consequence that conflicts with
pooling principles.

To address those issues, the staff was asked to provide more
guidance, because there was too much room for varying
interpretations of the literature.  So, in March of this year the
staff issued SAB 96 to articulate its views about when a plan to
repurchase treasury stock results in a pooling violation.
The general spirit of SAB 96 is that plans to repurchase treasury
shares after a business combination are inconsistent with the
pooling of interests criteria, and in applying that test,
treasury stock transactions made within six months after a
pooling should be presumed to have been planned as part of the
business combination.

In addition, following the guidance in Accounting Standards
Release 146, the SAB requires all tainted shares purchased or
planned to be purchased, regardless of the business purpose for
the repurchase, to be considered when evaluating compliance with
the pooling criteria.  In other words, in applying the pooling
rules, the staff will look only to whether the shares repurchased
are tainted or untainted, and all tainted shares repurchased need
to be considered in evaluating compliance with the pooling
criteria.

                          * * * * * * *

That concludes my prepared remarks.  I would be pleased to
respond to your questions.