“Current Developments in Financial Reporting: Perspectives from the SEC”

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

Once again, I appreciate the opportunity to participate in
this annual conference and to share a few 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 several
other matters of concern to the staff, including loan loss
allowances, business combinations and international
accounting standards.

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, I discussed the Commission’s proposed market risk
disclosure rules and the process for reviewing comments on
that proposal.  The final rules, issued last January,
require new disclosures about the accounting policies for
derivatives and quantitative and qualitative information
about market risk exposures in derivatives and other
financial instruments.  In July, the staff published a
Question and Answer document that addresses a number of
questions frequently asked about the rules.

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.  We are 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.  And, finally, some of the commentary we are now
hearing suggests 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.

It is especially perplexing to hear arguments that the Board
is trying to fix something in its derivatives project that
isn’t broken.  Those that have worked with current
accounting literature know 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 be 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 was also 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.

Allowance for Loan Losses

We have received a number of inquiries, both domestically
and internationally, that suggest that allowances for loan
losses reported by some US banks may be overstated.  It has
been observed, for example, that in some cases, the current
allowances exceed non-performing loans by several multiples
and are many times annual net charge-offs for recent years.

As you know, this is an area involving significant judgment,
and it is difficult to assess whether these allowances are
appropriate without full knowledge of the facts and
circumstances.

Allowances for loan losses should be adequate to cover
probable credit losses related to specifically identified
loans, as well as probable credit losses inherent in the
balance of the loan portfolio.  It should be noted, however,
that FASB Statements 5 and 114 require that the allowances
be provided for losses that have been incurred as of the
balance sheet date.  Thus, allowances should be based on
past events and current economic conditions, and should not
include the effects of expected losses on specific loans or
groups of loans that are related to future events or
expected changes in economic conditions.

Business Combinations

The staff continues to devote a significant amount of time
to business combination issues, particularly those involving
poolings of interests, including a number of questions
relating to bank mergers.  One of the most common of the
current issues 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
presented was insufficient 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 the 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.

Updates of Certain SEC Guidance

You may be aware that the staff presently is reconsidering
SEC disclosure requirements and interpretive guidance
relating to segments and earnings per share as a result of
the FASB’s recent pronouncements on earnings per share
(Statement 128) and segment disclosures (Statement 131).
The staff review has included certain sections of
Regulations S-X and S-K as well as several Staff Accounting
Bulletins.  The staff’s goal is to have conforming revisions
effective by the effective dates of the FASB’s new
Statements.

Disclosures about the Year 2000

Virtually all companies and organizations are devoting
resources to address the so-called “year 2000 problem.”
Banks specifically have stated in various forums that this
is a critical problem for the industry that will consume a
significant amount of resources.  To provide guidance as to
the disclosures that registrants are expected to make about
this exposure, the Division of Corporation Finance has
issued Staff Legal Bulletin No. 5.

That bulletin provides that registrants should make
appropriate disclosures in their management discussion and
analysis if:

  1.   The expected costs of addressing the year 2000 issue
  indicate that it is a material event or uncertainty, or
  
  2.   The consequences of incomplete or untimely resolution
  of the year 2000 issue represent a known material event or
  uncertainty.

In addition, if Year 2000 issues materially affect a
registrant’s products, services, or competitive conditions,
a registrant may need to disclose that uncertainty in its
“Description of Business.”

With respect to the accounting for these costs, the Emerging
Issues Task Force reached a consensus in EITF Issue 96-14
that external and internal costs of modifying internal-use
software for the year 2000 should be charged to expense as
incurred.  In addition, year 2000 modification costs should
not be accrued before those costs are incurred.

International Accounting Standards

In recent years, the Commission, as a member of the
International Organization of Securities Commissions, has
worked with the International Accounting Standards Committee
on a project to develop a core set of international
accounting standards that could be used in cross-border
securities offerings.  Last month, the Commission issued a
report to Congress that discusses the background and goals
of those international harmonization efforts and progress to
date.  That report is available to the public through the
Commission’s public reference room.

Many of you are aware that the IASC staff had proposed that
the IASC adopt US accounting standards for financial
instruments as an interim measure until a more comprehensive
financial instruments standard could be developed.  At its
meeting in Paris earlier this week, the IASC board decided
to not pursue that approach and instructed the staff to
develop an alternative proposal.

In its April 1996 statement of support for the goal of
international harmonization, the Commission stated that, to
be considered for acceptance in foreign filings in the US,
the IASC core standards must constitute a comprehensive
generally accepted basis of accounting, and the standards
must be of high quality.  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 any IASC standards for financial
instruments must, at least, be of comparable high quality.

We will continue to monitor these developments and provide
our input to the IASC as its work progresses.

                        * * * * * * *

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