Speech by SEC Staff:
Current Accounting Projects

Remarks by

Joe Godwin

Academic Accounting Fellow
Office of the Chief Accountant
U.S. Securities & Exchange Commission

1998 Twenty-Sixth Annual National Conference on Current SEC Developments

December 9, 1998

The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This article expresses the authors' views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.

Introduction

Good morning, I want to thank the AICPA for inviting me to speak at this conference. I will be giving you some observations about registrant compliance with the market risk disclosure rules that were adopted by the Commission in January 1997 as well as plans to consider amending those rules in light of the issuance of SFAS 133.

As you know, these rules were to be adopted by registrants in two phases. In the first phase, all banks, thrifts, and other companies with market capitalization in excess of $2.5 billion were required to disclose certain information about market risks in financial statements for fiscal years ending after June 15, 1997. Remaining registrants are required to comply with the requirements of the rules in financial statements for fiscal years ended after June 15, 1998.

Shortly after the market risk disclosure rules were issued, SEC Chairman Arthur Levitt agreed with certain members of Congress that the staff would perform a limited review of first-phase filings under the rule. This past summer, the staff completed this review. The staff spoke with various interested users and preparers of financial statements, including: registrants, analysts, accountants, academics, attorneys and investor groups. While many of these parties indicated that it was too early to arrive at definitive conclusions, the principal findings of the review are:

• The disclosures provide investors with new and useful information that previously was not available to the public. In particular, analysts and institutional investors stated that the new disclosures are very useful in assessing a registrant's use of market sensitive instruments and in assessing a registrant's strengths and vulnerabilities in market risk exposures and risk management practices;
• Incremental costs associated with the disclosures varied widely depending on the level of a registrant's involvement in derivatives and other factors. However, first-phase registrants generally did not consider the disclosures to be terribly costly. For example, an American Bankers Association survey indicated that 71% of 28 respondents estimated that the total costs each incurred to prepare the required disclosures were less than $50,000;
• The consensus view among dealers, registrants and analysts was that the disclosures have not impacted registrants' risk management programs;
• Most registrants did not anticipate competitive harm from the rules. For example, 93% of banks responding to the American Bankers Association survey indicated that they did not experience competitive harm as a result of the disclosures; and
• While registrants generally complied with the disclosure requirements, it will be necessary for the staff to seek to improve the quality of the disclosures in the review and comment process.

Quantitative Information

Under the rules, registrants are required to disclose quantitative information about market risk sensitive instruments, using either a tabular presentation, a sensitivity analysis, or value at risk. Recall that Item 305 of Regulation S-K requires an entity to segregate its financial instruments and derivatives into trading and non-trading portfolios, and then to further segregate these portfolios into 4 risk buckets. Potentially, there could be one bucket for each market risk exposure category: interest rate risk, foreign currency risk, commodity risk, and other risks, including equity price risk. Note that an instrument may be in more than one bucket as it may have several risks. Then, if exposure to risk of loss in any of these buckets is material in terms of fair value, earnings, or cash flows, the registrant must disclose its market risk exposure for each material category.

When providing the required information in tabular format, instruments should be further grouped by common characteristics - for example, swaps for which a company receives fixed and pays variable should be segregated from receive variable and pay fixed swaps; long forwards and futures should be segregated from short forwards and futures.

Qualitative Information

Registrants are also required to disclose qualitative information about their primary market risks. These disclosures should provide a description of the objectives, general strategies, and instruments that are used to manage exposures. The registrant should also discuss changes that occur in either the primary market risk exposures or the way those exposures are managed, in comparison to the most recent fiscal year. These disclosures should also address known or expected changes to be in effect in future periods.

Instances of Noncompliance

Some of the most frequent instances of noncompliance with the rules observed by the staff include:

1. The quantitative and qualitative disclosures are not being provided outside of the financial statements. The rule requires that this information be presented outside of the financial statement footnotes. Although the information does not have to be provided in Item 7A, which was created by the rule specifically for this information, Item 7A does have to appear in the Form 10-K. If all or part of the information is disclosed elsewhere (e.g., MD&A), a cross reference should appear. It should be noted that the safe harbor protection provided by the rule is only applicable if the information is presented outside the financial statements (i.e., if disclosures of market risk are presented as part of the basic financial statement no safe harbor protection will be provided). This is one of the points stressed in the staff publication "Questions and Answers About the New Market Risk' Disclosure Rules" available at the SEC website, www.sec.gov/divisions/corpfin/guidance/derivfaq.htm.

2.When the information is being provided in a tabular format, registrants are not providing adequate details about the relevant terms of the instruments and assumptions used in determining the estimated fair value, cash flows and future variable rates. Additionally, registrants are not adequately segregating instruments by common characteristics and by risk classifications.

Illustration 1 reflects part of a registrants tabular disclosure and provides an example that demonstrates several problems. This registrant is apparently exposed to both interest rate and foreign exchange rate risk. The tabular disclosures however, do not give effect to separate risk categories. The rule requires that "market risk sensitive instruments that are exposed to rate or price changes in more than one market risk exposure category should be presented within the tabular information for each of the risk exposure categories to which the instruments are exposed."

Illustration 1 also demonstrates a problem that can arise if information is provided in more than one location. Refer to the line related to interest rate swaps. This table does not provide sufficient information to determine swap related cash flows. Registrants should provide "contract terms sufficient to determine future cash flows from those instruments, categorized by expected maturity dates. The rule goes on to suggest that, for swaps, the contract terms should include "notional amounts, weighted average pay rates or prices, and weighted average receive rates or prices." In this case, cross referencing to a table that exists 25 pages earlier in the annual report could have led the reader to precisely the type information contemplated by the rule. Registrants should provide sufficient cross reference to help readers tie such disclosures together.

Illustration 1

Expected Maturity Dates (in millions)	1998	1999	2000	2001	2002	Subsequent	Total	Fair Value June 30
DEBT
Current - sterling denominated	136						136	141
Average interest rates	5.6%
Interest rate swaps	26			100				2
Non current - yen denominated					$196		196	200
Average interest rates					5.3%
Non current - US $ denominated				134	200	$16	350	366
Average interest rates - fixed				7.8%	8.8%	9.8%
Average interest rates - variable						4.3%

3. When using sensitivity analysis and value-at-risk (VAR), registrants are not disclosing sufficient information about the types of instruments and the offsetting positions, if any, included in the analysis. Registrants should disclose the type of instrument included in the analysis (e.g., derivative financial instruments, other financial instruments, derivative commodity instruments). In addition, registrants are not providing adequate disclosures about the specific model or significant assumptions used such as the magnitude and timing of selected hypothetical changes in market prices, method for determining discount rates, or key prepayment or reinvestment assumptions. Registrants should indicate whether or not other instruments that are outside the scope of the rule, such as certain commodity instruments or cash flows from anticipated transactions, are included voluntarily. The release requires these items to be reported in order for readers to be able to better assess the comparability of information between companies.

4. The qualitative disclosures are not clearly disclosing how the registrant manages its material market risk exposures including the objectives, general strategies and instruments, if any, used to manage those exposures during the year in comparison to the prior year. In addition, they are not disclosing any known or anticipated changes in the future.

5. Registrants may need to discuss a material exposure under the rule even though they do not invest in derivatives. For example, registrants that have investments in debt securities only, or have issued long-term debt, should discuss risk exposure if the impact of reasonably possible changes in interest rates would be material. Likewise, registrants that have invested or borrowed amounts in a currency different from their functional currency should also discuss risk exposure if the impact of reasonably possible changes in exchange rates would be material.

Accounting Policy Disclosures

For the accounting policy disclosures, the SEC's rule attempted to clarify specific items the staff expected disclosed under SFAS 119 and extended the SFAS 119 disclosures to commodity derivatives. The rule sets out seven specific disclosures to be included in a registrant's accounting policy footnote. Because of the confusion created by the many different methods of accounting for derivatives, the first six related to the different methods. That is, for each method of accounting for derivatives that an entity used, it was required to disclose, if material, (1) a description of the method, (2) type of derivative accounted for by each method, (3) criteria for use, including hedge accounting, (4) the accounting if the criteria were not met, (5) the accounting for termination of the derivative and (6) accounting when the hedged item matured, was sold, terminated, etc. The seventh item is a disclosure about where and when derivatives and their related gains and losses are reported in the financial statements.

Amending the Rules

The Commission agreed, in the release adopting the market risk disclosure requirements, that it would assess the need for all of the enhanced accounting policy disclosures after the FASB issued its derivative accounting standard. Since the FASB issued SFAS 133 this past June, the staff has begun a review of the market risk disclosure rules.

While it is still too early to tell how the staff will amend the market risk disclosure rules in light of the FASB's new derivative standard, it may be helpful to draw some comparisons between SFAS 133 and the Commission's rules. The most obvious difference is that SFAS 133 standardized methods so it does not require all of the disclosures about accounting policy that the market risk rules require.

However, the accounting policy disclosure is not the only item the staff needs to look at. The definition of a derivative in the Commission's rules for accounting policies and for quantitative and qualitative disclosures follows SFAS 119, not SFAS 133. In addition, the quantitative and qualitative disclosures are segregated between trading and non-trading portfolios as that distinction came from SFAS 119. This distinction is eliminated in SFAS 133. The general description required in SFAS 133 is very similar to qualitative disclosures under the Commission's market risk rules but there are some important distinctions. For example, the market risk rules include non-derivative financial instruments, and report exposures by risk category, not by type of hedge.

These are just some of the issues the staff must address to amend the market risk disclosure rules. My expectation is that any proposed amendments would be out for comment by the time of SFAS 133's required effective date.

The Commission also stated in the adopting release that it will undertake a review of the market risk disclosure rules after three years from the date of their adoption. The staff will wait to determine the scope of that review until after everyone has more experience with the rules.

http://www.sec.gov/news/speech/speecharchive/1998/spch240.htm