“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

Good morning.  Thank you for inviting me to be here and to share
a few thoughts about current financial reporting issues from the
perspective of the Office of the Chief Accountant.  Today, I am
going to focus on recent developments relating to three issues --
auditor independence, accounting and disclosure for derivatives,
and international accounting standards.

Before I begin, as is customary, I am obliged to remind you that
the views I express are my own and are not necessarily the views
of the Commission or others on the staff.

Auditor Independence

I believe most everyone here is aware that, last week, the
Commission and the AICPA announced the creation of the
Independence Standards Board, a new, private-sector body that
will be charged with responsibility for addressing auditor
independence issues and establishing independence standards for
auditors of public companies.  That announcement capped a
cooperative effort between the accounting profession and the
Commission to find ways to preserve and strengthen public
confidence in the independent audit.

As accounting firms have expanded into new service areas and
merged and restructured their operations, and as business and
professional relationships have become more complex, the existing
processes for addressing issues relating to the fact and
appearance of auditor independence have been strained.  Indeed,
we have been through a time in which questions have been raised
on a number of fronts -- questions about relationships that might
involve auditors too directly in management functions, questions
about whether auditors have been advocates for the views of their
clients in financial reporting matters, and questions about
whether management has too much control over the audit
relationship and how the relationship with independent directors
and the audit committee can be strengthened.

As these issues have come into focus, it has become increasingly
clear that many of today’s independence regulations -- some
developed years ago -- don’t provide adequate guidance for
today’s environment.

I am very encouraged by the initiative and the commitment to the
public interest that the accounting profession has shown by
taking this important step.  The substantial public participation
in this new process is encouraging.  It also is reassuring that
the new Board will have at its helm a Chairman of the caliber of
Chancellor William Allen.

Here are a few key facts about the new Board:

*    The Board will have eight members -- four practicing CPAs
  and four public members -- prominent individuals of high
  integrity and reputation -- who understand the importance of
  investor protection and the important roles the accounting
  profession and the independent audit play in US capital markets.

*    Standard-setting meetings will be open to the public, and
  proposed standards will be exposed for public comment.

*    The Board will be assisted by a nine-member Independence
  Issues Committee, made up of CPAs from firms that audit public
  companies, that will help with the timely identification and
  discussion of independence issues for consideration by the Board.

*    The Commission expects to recognize the Board as the private-
  sector body responsible for establishing independence standards
  for auditors of public companies and to consider its standards to
  have substantial authoritative support.

*    The Commission and its staff will oversee the work of the
Board, and the SEC’s existing statutory authority over auditor
independence matters, including the ability to bring enforcement
actions, will continue.

This is a tremendously important development for the public, for
the profession and for self regulation.  It offers an opportunity
to take a fresh look at -- and find solutions for -- knotty
issues that have become more and more challenging over the years.

The model for this public/ private sector partnership was the
FASB, and my hope is that this process will be equally
successful.  I look forward to working with the new Board as it
undertakes its challenging assignment.

Derivatives Accounting and Disclosure

When I came to the Commission about two years ago, the financial
reporting issue commanding the most attention and highest
priority was accounting and disclosure for derivatives.  It was a
time when a series of highly-publicized derivatives losses had
caught investors by surprise, and public awareness of the
dramatic growth of derivatives activities was increasing.
That growth has continued, and I am told that by the end of 1995,
the notional amount of derivatives outstanding in the US had
surpassed $20 trillion.

What became apparent then, and continues as a priority issue
today, is the realization that our accounting and disclosure
system has not kept pace with the expanding role these
instruments play as risk management tools for American business.
As you know, the Commission and the FASB have been pressing ahead
with important initiatives to address this financial reporting
gap.

Derivatives Accounting

The FASB has pursued the accounting issues through an exposure
draft that sets forth a proposed new model, and since January,
the Board has been re-deliberating its proposals.  It is
encouraging to hear that the Board expects to complete its study
in the next few months.

I think it is important to recognize that, during its
deliberations, the FASB has decided on a number of changes in
response to issues raised in comment letters and during its
public hearings.  It seems to me that the Board has worked hard
to try to address the legitimate concerns of its constituents
without undermining the integrity of its proposal.

Despite these changes, however, some of the most vocal critics
continue to argue that more needs to be done.  Some continue to
say, for example, that the changes will result in artificial
volatility in earnings and equity, or that the new model will
favor inefficient -- rather than efficient -- risk management
tools.  I will offer a few thoughts about those arguments.

First, we must acknowledge that when a derivative used as a
hedging instrument is not an effective hedge, the new model will
report earnings volatility.  It seems to me, however, that, in
fact, earnings are more volatile when a derivative is not
effective at offsetting the risk that the derivative is supposed
to hedge.  Thus, reporting the real, rather than expected,
outcome of hedging activities may, at times, result in earnings
volatility.  Reporting that volatility, however, is not the same
as reporting artificial volatility.  Rather, it is capturing, in
the financial statements, real economic events that often are not
reported today.

With respect to the impact on equity of hedges of forecasted
transactions, the Board has a bit of an accounting dilemma to
deal with -- the same dilemma that we have today in our mixed
attribute accounting model.  Because we have different accounting
for different types of financial instruments and transactions,
including derivatives, changes in the values of economically
hedged positions sometimes are recognized in different periods
than changes in the values of the hedge instruments.  In this
financial reporting environment, improving the relevance of
derivatives accounting requires tolerating some equity
volatility.  This is not a new issue -- the Board has faced this
trade-off in a number of its past projects.

I believe that improving the relevance of financial reporting by
recording all derivatives on the balance sheet, at fair value, is
a reasonable and necessary decision.  In essence, this move will
bring derivatives out of the footnotes and into plain view.  The
necessary price for that improvement will be some trade off --
until the Board considers the accounting for financial
instruments more broadly.

With respect to any alleged favorable treatment for some types of
risk management tools, at the expense of others, I think that it
is important to recognize -- again in the context of our current
mixed attribute model -- that once the Board decided to permit
hedge accounting, it effectively committed to a series of rules
that would likely accommodate some, but not all, hedging
activities.

The same thing can be said for our accounting rules today,
however.  For example, currently we have hedge accounting rules
for futures that are different than the rules for swaps and
different rules for foreign currency forwards than for foreign
currency options.

I see nothing in the Board’s proposal that supports a conclusion
that the new accounting model will create the kind of chaos in
financial reporting -- and therefore in our capital markets --
that some fear.  Nothing in the proposal would prohibit companies
from engaging in the risk management activities they choose --
prudent or otherwise -- and explaining those strategies and their
accounting impact in the financial statements.

We all should keep in mind that, with every major change in
accounting standards that the FASB has made, some have predicted
dire consequences, and we should assess those claims objectively.

Derivatives Disclosure

As you know, in January 1997, the Commission adopted a Rule that
calls for new forward looking disclosures about derivatives and
other financial instruments.  In recent weeks, there have been a
number of press reports about various groups, including some
Congressional committees, that have been critical of the Rule and
have questioned whether its benefits justify its cost.  Some of
those reports have even suggested that the Rule has been
overturned or otherwise delayed -- which is not true.

Rather than attempting to articulate -- or respond to -- the
specific criticisms here, I will only reiterate why the Rule was
adopted.  Very simply, the Rule was an effort to make the market
risks inherent in derivatives and other financial instruments
more transparent to investors.  It is expected to provide
investors with a reasonable amount of information at a reasonable
cost.  As a result, investors should be able, for example, to
distinguish the risks of a portfolio of 30-year assets from the
risks of a portfolio of 30-day assets.

To recognize that the Rule breaks new ground in disclosure of
market risks, the Commission built in a three-year review period,
after which it will assess how well the Rule is working and
whether changes are needed.  In response to concerns raised by
some members of Congress, the Commission also has undertaken to
review the operation of the Rule about one year after
implementation.  As part of that review, the staff will analyze
the disclosure and other data received from this first group of
filings.

The staff also will continue to discuss the impact and
effectiveness of this Rule with registrants, investors, analysts,
academics, and other interested participants.  We expect to
complete our review of these early filings around June 1998.

International Accounting Standards

The International Accounting Standards Committee, or IASC,
currently is working to establish a core set of accounting
standards to facilitate cross-border filings.  Many groups around
the world -- including the International Organization of
Securities Commissions, or IOSCO -- have supported these efforts
because we all are looking for ways to reduce unnecessary
inefficiencies in cross-border capital flows.

As a result, today there is significantly increased coordination
among standard setters around the world -- not only through the
IASC, but also through separate, important efforts like “G-4,” an
informal group composed of national standard setters in the US,
UK, Australia, and Canada.  These groups share the objective of
getting standard-setting bodies working on consistent objectives
and from similar points of view.  Standard setters around the
world already are reaping benefits from this work as they share
resources and focus on common problems.

One complaint frequently heard in the process of developing
international standards is that US standards too often are the
benchmark.  I believe that US standards tend to be emulated
because they were developed to be responsive to the needs of
investors and capital markets.  US capital markets are
characterized by widespread participation of individual
investors, either directly or through mutual funds.  These highly
liquid, public markets have been a primary source of capital for
American businesses and have created a public equity market
culture.  In other countries, banks and insurance companies often
are the primary source of capital, and accounting standards that
have evolved in those countries tend to reflect different primary
audiences.  I think we need to acknowledge that US standards,
while demanding, have satisfied the needs of our capital markets
very, very well.

A frequent criticism of US standards has been that they are a
“cookbook” -- that they preclude application of professional
judgment.  I think most realize that this an overstatement.  No
standard can eliminate the need for interpretation and judgment;
the business environment changes too fast.  The number of
interpretive issues addressed each year by the EITF and the SEC
staff is clear evidence.

Undeniably, US standards are more prescriptive than those in
other parts of the world -- in large part because our capital
markets place a high premium on comparability.
While no standard can assure complete comparability, it is
critical that standards be developed that measure comparable
transactions and events in comparable ways.  To do this, the
standards must provide clear and unambiguous guidance, and they
must be consistently interpreted and applied.
It is particularly important to keep this expectation in mind as
the IASC’s core standards project addresses the most difficult
issues on its agenda, including, for example, financial
instruments, intangible assets, and impairments
.
While international standards are a desirable goal for US markets
and companies, they are just that -- a goal and not a necessity.
Our financial reporting system has served the US capital markets
well, and it has been a widely accepted passport for US companies
accessing markets in other countries.  The acceptance achieved by
US standards in other capital markets, I believe, attests to the
high quality of our accounting and disclosure system.

This does not mean that the development of international
accounting standards is not important.  We should not ignore the
fact that markets are becoming more interconnected -- and we have
to look for ways to improve the efficiency of capital flows
between markets, while still protecting investors in the US
markets.  But it does bear repeating that acceptance of
international standards in filings in the US is not a foregone
conclusion.

Certainly, it would be easier to connect separate markets if we
all spoke the same language -- in the same way it is easier to
network a group of computers if they all use the same software.
But agreeing on a common language will not provide benefits if it
becomes merely a search for the lowest common denominator, or an
excuse to dilute demanding, but effective, national standards.
Our participation in efforts to improve international accounting
standards is a cooperative effort to build a framework for the
21st century -- a framework that should enhance -- not compromise
-- the strength and stability of US capital markets.

Conclusion

Again, thank you for asking me to be here today.
                                
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