AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS The 21st Annual National Conference on Banks and Savings Institutions November 8, 1996 CURRENT FINANCIAL REPORTING ISSUES Remarks by Michael H. Sutton Chief Accountant Office of the Chief Accountant United States Securities and Exchange Commission ____________________________________ 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.