TESTIMONY OF ARTHUR LEVITT, CHAIRMAN U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING FASB'S PROPOSED ACCOUNTING RULES FOR DERIVATIVE FINANCIAL CONTRACTS BEFORE THE SUBCOMMITTEE ON CAPITAL MARKETS, SECURITIES AND GOVERNMENT SPONSORED ENTERPRISES COMMITTEE ON BANKING AND FINANCIAL SERVICES U.S. HOUSE OF REPRESENTATIVES OCTOBER 1, 1997 Chairman Baker and Members of the Subcommittee: I am pleased to appear today to testify on behalf of the Securities and Exchange Commission ("Commission" or "SEC") regarding the Commission's oversight of the Financial Accounting Standards Board ("FASB"), and, in particular, its project to improve the accounting standards for derivative instruments and hedging activities.<(1)> Five years ago, few Americans knew what a derivative was. Today, these complex instruments play a fundamental role in our markets: the notional amount of derivatives outstanding at the end of 1995 on a worldwide basis was $69.9 trillion, and in the United States the notional amount was $23.7 trillion, more than three times the Gross Domestic Product. Not only are derivatives a vital tool in modern financial markets, they are used on a daily basis by Corporate America to manage <(1)> In general terms, a derivative is an instrument that derives its value from the value of something else, such as stocks, bonds, currencies, or commodities. Entities may use derivatives to speculate on price changes in the underlying instrument, currency or commodity or referenced index, or as part of a risk management strategy. risks that arise in customary business activities. At the same time, these trillion dollar markets represent a significant enough vulnerability for the U.S. corporations that participate in these markets that the public interest requires that the derivatives holdings of U.S. corporations be brought into the light of day through disclosure and improved accounting standards. The serious shortcomings of the previous accounting and disclosure guidelines became obvious in 1994, when many Americans saw millions of their investment dollars disappear as major derivatives positions caused losses at such well-known companies as Gibson Greetings and Proctor and Gamble.<(2)> Losses, of course, are a fact of life in the capital markets. The problem, however, was not just the losses, but the fact that they took both individual investors and sophisticated market analysts by surprise. At the time, noting that much of the danger from derivatives was <(2)> On October 6, 1994, The Washington Post reported the following derivatives losses by public companies: Showa Shell Sekiyu - $1,580 million; Codelco - $206 million; Proctor and Gamble - $157 million; United Services - $93.25 million; Harris Trust and Savings - $51.3 million; Independent Bancorp - $39 million; Dell Computer - $35 million; and Gibson Greetings - $20 million. Brett D. Fromson, "Rules Sought for Derivative Trading," The Washington Post, Oct. 6, 1994, at D13. Other entities reporting losses during the same time frame included Metallgesellschaft, Air Products & Chemicals, Eastman Kodak, Piper Jaffray, Mead, and Caterpillar. Many funds experienced losses, such as those managed by BankAmerica and Soros Fund Management. Municipalities also reported significant losses from investments in derivatives, such as those investing in funds managed by Orange County, California, and the Wisconsin Investment Board. See generally, Philippe Jorion, Value at Risk: The New Benchmark for Controlling Market Risk, 25-27 (1997). ======END OF PAGE 2====== hidden from view, Fortune wrote, "Like alligators in a swamp, derivatives lurk in the global economy."<(3)> Many of these sometimes spectacular losses propelled derivatives into the headlines. Describing the $157 million loss by Proctor and Gamble from undisclosed derivatives contracts, Forbes magazine noted, "[I]f a soapmaker speculates on a scale out of proportion to its business needs, shareholders should be told. People buy P&G stock because they want to invest in a soapmaker; if they want a business that plays derivatives full time, they will buy Salomon, Inc. Problem is, it's not easy to know whether a company is using derivatives on a large scale."<(4)> At the time, there were many calls for restrictions on the use of derivatives, including several from Congress. The Commission resisted these calls for regulation and chose instead to study how to ensure that derivatives and their potential risk are better described to investors and to continue to encourage the FASB to improve accounting principles applicable to these instruments. In studying the issue, the FASB, under the Commission's oversight, underwent a thorough and open deliberative process, which began over a decade ago. FASB provided numerous opportunities for the public to participate in the development of, and comment on, its proposal. FASB met with a wide range of commenters, including issuers, banks, and investors, and made significant changes in the proposal to accommodate commenters' concerns. <(3)> Carol J. Loomis, "The Risk That Won't Go Away," Fortune, Mar. 7, 1994, at 40. <(4)> Rita Kosekla, "Safe When Used Properly," Forbes, Aug. 15, 1994, at 47. ======END OF PAGE 3====== The disclosure requirements recently adopted by the Commission<(5)> and the revised accounting standard proposed by the FASB represent a basic principle of our capital markets: if a company is going to ask American investors for their money, it had better be straight with them about how that money is and may be used and the risks involved. The FASB's project is an important step in bringing derivatives out of the shadows and into the full view of U.S. investors. This is especially important today, with one in three American households investing in our capital markets. The Commission believes that the FASB's revised proposal, which currently is out for public comments once again, is a reasonable approach that has been developed with full sensitivity to private sector interests and concerns. It represents a significant improvement over current accounting practices and will provide investors with access to information that is important in selecting and understanding their investments. I. The Commission's Role and Oversight of the FASB Before turning to the discussion of the FASB's derivatives project, it is important to understand the FASB's process in developing accounting standards and the Commission's oversight of the FASB. The Federal securities laws require issuers of securities, broker- dealers, public utility holding companies, investment companies, and others to file audited financial statements with the Commission. The Commission <(5)> "Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments and Disclosure of Quantitative and Qualitative Information About Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments," Securities Act Release No. 7386 (Jan. 31, 1997); 62 FR 6044 (Feb. 10, 1997). ======END OF PAGE 4====== has the authority to prescribe the accounting principles to be used in the preparation of these financial statements.<(6)> From its inception, however, the Commission has recognized the benefits of private sector leadership and self-regulation in setting accounting standards, and has looked to the accounting profession to take the lead in establishing those standards. Since 1938, when the Commission first announced this policy,<(7)> the Commission has noted the expertise, energy, and resources that the private sector, operating under the Commission's watch, could bring to bear on complex accounting issues.<(8)> In overseeing the FASB's standard-setting projects, the Commission staff seeks to ensure that the FASB is operating in the public interest and that the results of its work are credible and are the product of an independent and unbiased process. In setting standards, the FASB follows a thorough deliberative process.<(9)> That process requires open meetings when proposed standards are discussed. Prior to taking action on any significant accounting standard, the FASB issues for public comment a discussion <(6)> Specifically, the Commission may prescribe the form in which financial information filed with the Commission shall be set forth, the items to be shown in the balance sheet and the income statement, and the methods to be followed. The Commission also may define accounting terms. Sections 7 and 19(a) and Schedule A of the Securities Act of 1933; Sections 3(b), 12(b) and 13(b) of the Securities Exchange Act of 1934; Sections 5(b), 14, 15 and 20 of the Public Utility Holding Company Act of 1935; and Sections 8, 30(e), 31 and 38(a) of the Investment Company Act of 1940. <(7)> Accounting Series Release ("ASR") No. 4 (Apr. 25, 1938). <(8)> See ASR No. 150 (Dec. 20, 1973). <(9)> FASB, Rules of Procedure (May 1, 1991). ======END OF PAGE 5====== memorandum or similar document exploring all the issues.<(10)> Public hearings may be held, an exposure draft of the proposed standard is published for public comment, and the proposal often is "field tested." During this process, each FASB member typically reads every comment letter received by the FASB. The FASB studies the information received before issuing a final standard, and often revises the standard based on comments received. FASB's process is an exceptionally open and transparent decision-making process. The SEC diligently oversees this process. Each of the projects on the FASB's standard-setting agenda is assigned to Commission staff members who: (i) follow project developments; (ii) review comment letters submitted to the FASB; (iii) attend FASB meetings and public hearings on the project; and (iv) confer with FASB members and staff. Senior members of the Commission's Office of the Chief Accountant and the Division of Corporation Finance are observers to various FASB task forces. Once a standard is adopted, the SEC staff continues to consult with the FASB staff on implementation issues and whether interpretations or changes in the standard may be necessary to achieve the objectives of the standard.<(11)> The Commission also meets periodically with the FASB <(10)> Discussion memoranda are neutral documents with no conclusions. "Preliminary views" documents and drafts of proposed standards exposed for public comments contain preliminary conclusions reached by the FASB. <(11)> While the Commission looks to the private sector for standard setting, the Commission also maintains its own accounting regulations, which often serve to supplement and clarify the FASB's pronouncements for Commission registrants. The principal Commission accounting regulation is Regulation S-X (17 CFR  210) which was adopted in 1940 and periodically is updated. Regulation S-X provides guidance as to the form and (continued...) ======END OF PAGE 6====== in open meetings to discuss matters of mutual interest, including ongoing FASB projects. Additionally, the Commission's Chief Accountant is directly involved in oversight of the FASB. He participates in quarterly meetings of the Financial Accounting Standards Advisory Council ("FASAC"), which consults with the FASB on major policy issues, technical issues and project priorities. He also meets with the FASAC Agenda Advisory Committee, which evaluates potential projects to be added to the FASB's agenda. Finally, the Chief Accountant serves as an observer, with the right to the floor, to the FASB's Emerging Issues Task Force ("EITF").<(12)> II. FASB Project on Accounting for Derivative Instruments and Hedging Transactions A. The Need for Disclosure Rules and Accounting Standards for Derivatives <(11)>(...continued) content of required financial statements, and specifies footnotes and schedules in addition to those required by generally accepted accounting principles ("GAAP") that must be filed with registrants' financial statements. Regulation S-X also addresses the qualifications of accountants to practice before the Commission and accountants' reports on financial statements. The Commission staff also has promulgated various "Industry Guides" to specify disclosures of supplemental financial information in certain areas. Further, the staff periodically issues Staff Accounting Bulletins that inform the financial community of its views on accounting and disclosure issues. <(12)> The EITF, a committee of accounting practitioners, assists the FASB in providing timely guidance on emerging issues and the implementation of existing standards. If the EITF reaches a consensus solution to an emerging or implementation issue, Commission or FASB action may not be considered necessary. The Chief Accountant also participates in the agenda committee of the EITF. ======END OF PAGE 7====== In 1985, it became apparent to the Commission that the financial statements of many entities, including savings and loans and other financial institutions, were not reflecting those entities' exposure to interest rate, foreign exchange, and other market risks. At that time, the Commission and constituencies of the FASB asked the FASB to study the appropriate accounting for financial instruments, including derivatives. Recent actions have improved disclosures about derivatives. For example, as noted above, this year the Commission adopted rules requiring disclosures about market risks of derivatives. In October 1994, the FASB adopted FAS No. 119<(13)> that requires qualitative disclosures about certain, but not all, derivative instruments. However, the accounting principles that existed in 1985 generally continue to govern practice today. These principles are incomplete because only a few types of derivatives are specifically addressed in accounting standards. They also are inconsistent because the standards that do exist call for different accounting based on the type of derivative instrument and the holder's intentions to use the derivative as a hedging instrument.<(14)> The result is that similar financial instruments <(13)> FASB, Statement of Financial Accounting Standards No. 119, Disclosure About Derivative Financial Instruments and Fair Value of Financial Instruments (Oct. 1994). <(14)> For example, if the derivative is being used as a hedge, the accounting may vary based on the type of derivative, what is being hedged (e.g., an asset, liability, or anticipated cash flow from expected transactions) and the type of risk being hedged (e.g., changes in interest rates, foreign currency exchange rates, or commodity prices). ======END OF PAGE 8====== and hedging transactions often receive very different accounting.<(15)> As noted by Martin Mayer in Barron's, "One of the many oddities about derivatives is the lack of a standard way of accounting for most of them, and different non-standard ways show very different results."<(16)> As noted above, the problems inherent in the existing accounting treatment for derivative instruments were made clear in 1994 when a number of large companies, without warning to investors, reported that they had lost millions of dollars in derivative transactions. The problem was not simply the magnitude of the losses, but the fact that they took both individual investors and sophisticated market analysts by surprise.<(17)> <(15)> In the area of derivatives and hedging activities, depending on the type of derivative, the item being hedged and the risk being hedged, a company may account for a derivative financial instrument using fair value accounting, deferral accounting, or settlement (accrual) accounting. Under fair value accounting, the fair market value of the instrument is presented on the balance sheet and changes in fair value are presented in the income statement. Under deferral accounting, the fair market value of the instrument is presented on the balance sheet and changes in the fair value of that instrument are deferred (the changes are used to adjust the value of the instrument or transaction that is being hedged). Under settlement accounting, instruments are presented on the balance sheet at their cost to the company, and, because the initial cost of many derivatives (except for a small fee) is zero, they are never recognized in the balance sheet. <(16)> Martin Mayer, "Hiding Places: Banks Aren't Coming Clean on Derivatives Damages," Barron's, June 20, 1994, at 33. <(17)> See generally, Carol J. Loomis, "Untangling the Derivatives Mess," Fortune, Mar. 20, 1995, at 50; Loomis, supra note 3. ======END OF PAGE 9====== The Commission believes that derivatives, when used properly, can provide significant benefits to corporations, financial institutions, and institutional investors in managing the risks facing their businesses or assets. However, as the Commission has previously testified, the complexity and leverage inherent in these instruments require special scrutiny of their use.<(18)> In today's business environment, investors simply cannot evaluate the risks that a company faces without understanding whether, and to what extent and for what purpose, the company uses derivatives and other financial instruments. This view is generally shared by the General Accounting Office ("GAO") and the Group of Thirty.<(19)> In fact, the Group of Thirty have suggested that the current inadequacies in accounting standards have deterred organizations from pursuing reasonable risk management strategies.<(20)> For financial statements to provide the comparable, reliable information that investors and other decision makers <(18)> Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning Derivative Financial Instruments, Before the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce, at 1-2 (May 25, 1994). <(19)> In November 1996, the GAO reiterated its concerns about the "serious shortcoming" in the current accounting standards for derivatives. The GAO noted its support for the FASB's proposed standard as "a significant step in the right direction" and "a reasonable interim accounting solution." United States General Accounting Office, Pub. No. 97-8, Financial Derivatives: Actions Taken or Proposed Since May 1994, 103-4 (Nov. 1996). The Group of Thirty is an international financial policy organization whose members include representatives of central banks, international banks and securities firms, and academia. <(20)> Group of Thirty, "Derivatives: Practices and Principles," 24 (1993). ======END OF PAGE 10====== need to reach informed conclusions, it is necessary to have meaningful and consistent accounting practices that are applied in a like manner by companies in like circumstances. In the context of derivatives, users of financial statements have complained that the current accounting, to the contrary, is incomprehensible and opaque.<(21)> B. FASB's Deliberative Process in Developing the Derivatives Accounting Standard Beginning in 1985, the Commission asked the FASB to study accounting for financial instruments in general. The FASB undertook an examination of financial instruments, and in the Fall of 1991 issued two documents providing comprehensive discussion of hedge accounting and the recognition and measurement of financial instruments, including derivatives.<(22)> In January 1992, the FASB began deliberating on the accounting for derivatives and hedging activities. In the Summer of 1993, FASB presented its preliminary views in a report on its deliberations.<(23)> Between 1992 and June 1996, the FASB held over 100 public meetings on those issues, including many involving outside representatives such as derivative dealers, including banks, and end-users. In June 1996, the FASB published for public comment an exposure draft on <(21)> See, e.g., Special Committee on Financial Reporting of the American Institute of Certified Public Accountants, "Improving Business Reporting - A Customer Focus: Meeting the Information Needs of Investors and Creditors," at 76, 77 (1994). <(22)> FASB, Discussion Memorandum on Recognition and Measurement of Financial Instruments (Nov. 1991); FASB, Research Report, "Hedge Accounting: An Exploratory Study of the Underlying Issues" (Sept. 1991). <(23)> FASB, "A Report on Deliberations, Including Tentative Conclusions on Certain Issues Relating to Accounting for Hedging and Other Risk-adjusting Activities" (June 1993). ======END OF PAGE 11====== derivatives and hedging. Since that time, the FASB, principally in response to comments it received, has been revising its proposal. The FASB has invited all those who commented on the original proposal, and others, to provide additional comments on the revised proposal during a 45-day comment period ending October 14, 1997. The FASB anticipates adopting a final standard by the end of 1997, to be effective for 1999 financial statements. Many commenters have voiced strong support for the FASB's process and timetable for adopting a new accounting standard. For example, a letter submitted by General Motors Corporation states, . . . [We] believe that the proposed standard, in its current state, represents a significant improvement to the accounting model for derivatives and hedging activities and we support its issuance without reexposure.<(24)> The Association for Investment Management and Research ("AIMR"), an organization of over 70,000 investment analysts, portfolio managers, and other investment decision makers, noted the openness of the FASB's process, the FASB's diligence in responding to concerns expressed by commenters, and the need to adopt the standard promptly, The [AIMR] has closely followed the FASB's diligent deliberations on accounting for derivatives and similar financial instruments. It is difficult to imagine a FASB project in which greater due process has been exercised. All interested parties have repeatedly received, and most have taken, the opportunity to express their views. The FASB has listened carefully and made changes in response to the comments it has received.... We believe the process is complete and the time finally to issue a standard is at hand.... The Proposed Standard promises to create a level of transparency to assist users of financial statements to provide the advice or make the investment decisions that enable <(24)> Letter dated August 1, 1997 from Peter R. Bible, Chief Accounting Officer, General Motors Corporation, to Mr. Timothy S. Lucas, Director of FASB Research and Technical Activities. ======END OF PAGE 12====== American capital markets to operate efficiently in allocating scarce financial resources to their best use.<(25)> III. What the Proposal Will Mean to Investors Many companies and financial institutions possess critical information regarding the market values of derivative instruments and how those derivatives impact or protect the values on their balance sheet and their earnings. They often compute these values in deciding whether to enter into derivative contracts and for other management and regulatory purposes. Some even sell their market value models to others. The problem is, important components of that information are never given to investors. An article appearing in the October 22, 1993 issue of the American Banker discussed Banc One's $31 billion in off-balance-sheet derivatives transactions and noted, Further muddying the waters, derivatives don't show up on bank balance sheets, and standardized supplemental reports have not yet been put into place. That often leaves everyone from accountants to analysts, investors, and regulators guessing about the risks being taken by an institution.<(26)> As noted elsewhere, improved disclosures have helped, but they do not tell the whole story. It is time to bring these transactions, which have the potential to dominate a company's or institution's financial position, into the full financial picture presented in the financial statements. <(25)> Letter dated August 15, 1997, from Peter H. Knutson, Chairman, Financial Accounting Policy Committee of AIMR, to Mr. Edmund L. Jenkins, Chairman, FASB. <(26)> Steve Klinkerman, "Banc One's McCoy Tries to Calm Fears over Heavy Use of Derivatives," American Banker, Oct. 22, 1993, at 4. ======END OF PAGE 13====== What the proposal will do is assure that a company's financial statements reflect the fair value of the company's derivative positions in the balance sheet. This is not a new concept, but merely another step in the FASB's efforts to improve the accounting for financial instruments. Earlier efforts by the FASB to require that financial statements reflect the fair value, rather than the historical cost, of most marketable securities were similarly criticized. Even in these earlier efforts, commenters expressed concern that reflecting these securities in financial statements at their fair values would create volatility in companies' financial statements. The FASB responded to those criticisms, worked with commenters, and developed reasonable provisions that require that marketable securities, designated as either "trading" or "available for sale," be reflected in the financial statements at their market value.<(27)> As is common with many FASB proposals, once this standard was implemented, marking these securities to market in the financial statements did not have the dire consequences that some commenters feared. Instead, financial statements became more transparent. Under the new standard, investors now more easily assess a company's financial position and its investment activities and more readily evaluate how those activities could affect the value of their own individual investment in the securities of the company. Similarly, the FASB's current proposal to account for derivatives and hedging transactions is intended to provide investors with more transparent <(27)> FASB, Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (May 1993). ======END OF PAGE 14====== financial reporting for those activities. To illustrate the importance of more transparent accounting, assume that an investor looks at the income statement for a public company and sees that the company's net income is $250 million. However, the investor happens to look at the footnotes to the financial statements and sees that the footnotes show unrealized losses on derivatives holdings of $100 million. With that disclosure alone, the investor would be confused about how those holdings affect the company's financial position or operating performance. The unrealized losses might have been the result of the company attempting to use swaps as a hedge against market risk, or it might be the result of speculation. An investor should be able to understand whether the company is engaging in derivatives transactions in order to hedge risks inherent in the company's business or, alternatively, engaging in derivatives transactions for speculative purposes. The investor would then be able to determine whether the company's strategy is consistent with his or her own investment goals. Under the FASB proposal, all derivatives will be reported in the balance sheet at fair value, and all changes in those fair values will be reported in earnings or in "other comprehensive income" in the shareholders' equity section of the balance sheet. As a result, a company's use of derivatives, and their economic effect on the company, will be more apparent to investors. IV. FASB's Changes to the Standard in Response to Certain Concerns As may be expected with any rulemaking or standard-setting project, however, certain commenters have been critical of the FASB's proposal. The FASB has carefully considered the concerns raised by different constituencies, including banks and investors, and has responded to many of ======END OF PAGE 15====== the issues raised by commenters. The major issues that have been raised are discussed briefly below. Is Disclosure Enough? As a preliminary matter, those opposing the FASB's project have suggested that derivatives disclosures, such as those made under the Commission's new rules, or in the footnotes to the financial statements or in supplemental statements, are sufficient. They argue that disclosure would provide adequate notice to investors without the need for transparency of these holdings and transactions in the financial statements. The Commission, however, long has believed that although good disclosure is very important it does not cure bad accounting.<(28)> An approach that would use disclosure to attempt to remedy deficient accounting methods could lead to confusing disclosures, could make it difficult for investors to compare financial statements from company to company, and would open the door to manipulation of the amounts reported in the financial statements.<(29)> In addition, merely disclosing losses in footnotes forces an investor to do mental gymnastics to see the real bottom line. Concerns About Volatility. Another concern is that the FASB's proposal could add volatility to companies' financial statements. <(28)> See ASR No. 4, supra note 7. <(29)> George Weiss Center for Institutional Financial Research, Wharton School, University of Pennsylvania and CIBC Wood Gundy, "1995 Survey of Derivatives Usage by U.S. Non-Financial Firms Report," at 6 (Apr. 1996), which states that 42% of the respondents to their 1995 survey indicated that managing fluctuations in accounting earnings is the "'most important' objective of their hedging strategy." ======END OF PAGE 16====== Commenters argue that the potential lack of predictability of earnings may cause the market to penalize the company's stock price. The FASB considered this concern carefully, and in response made revisions to its proposal. Under the FASB's revised proposal, when there is an attempt to hedge future cash flows (known as "cash flow hedges"), gains or losses on the cash flow hedge will be recognized when the hedged transaction actually affects earnings. That is, the gains and losses from the instrument being used as a hedge will be stored temporarily in other comprehensive income, which is a component of shareholders' equity on the balance sheet, until the reporting period in which the anticipated transaction occurs. Thus, when a cash flow hedge is properly implemented, there should be no impact on net income or earnings per share and no lasting impact on shareholders' equity beyond that which management intended when entering into the hedge. Similarly, an effective hedging program using "fair value hedges" will not increase volatility. Gains or losses on derivatives used to hedge existing assets, liabilities, or firm commitments, and gains or losses on those designated underlying assets, liabilities, or firm commitments (known as "fair value hedges") will be reported in earnings in the same period. Because these amounts should offset one another, fair value hedges, when properly implemented, should have little or no effect on equity or earnings. Moreover, it is important to understand that the FASB's accounting proposal would not "create" volatility -- the volatility is a natural consequence of investing in products sensitive to changes in rates and prices set in fluid markets. Volatility, therefore, already exists; it merely is not reflected in the financial statements. By exposing positions ======END OF PAGE 17====== that are not protected by a properly matched hedge, investors will become more aware of companies' risk management and speculative activities. This will allow investors to assess the volatility that already exists in their investments. Investors will be better able to compare an issuer's willingness to assume market risks with their own appetite for risk in their investment portfolio. FASB's Evolutionary Approach. Some commenters have suggested that the FASB has taken a piecemeal approach that results in an inappropriate mix of fair value and historical cost in financial statements. Some commenters also want any final standard on derivatives to be delayed until the FASB can address the use of fair value accounting for financial instruments on a more comprehensive basis. As a general matter, current accounting standards already mix historical cost and fair market value accounting. As noted above, the FASB has been working on improvements in the accounting for financial instruments since 1985. It previously addressed disclosures in financial statement footnotes of certain financial instruments and of the nature and terms of derivative instruments, and in 1991 required companies to account for most marketable securities at fair value. Now, the FASB is considering the appropriate accounting for derivatives and hedging transactions. In the future, the FASB will consider the use of fair value accounting for all financial instruments. It simply is not feasible to address all of the issues in this highly complex area at one time. Unfortunately, such a project could take years to complete. Given the importance of derivatives and the growth in the derivatives market, the Commission does not believe that waiting for a comprehensive solution is in the best interest of the public. ======END OF PAGE 18====== Will the Proposal Discourage Risk Management? Some commenters are concerned that more transparent accounting might discourage the use of market risk management techniques. Currently, firms use risk management techniques to address possible changes in interest rates, commodity prices, and foreign currency exchange rates. The FASB's derivatives project is not intended to change or discourage risk management techniques, but to provide better communication about those techniques so investors may understand them and how they are implemented. Under the FASB's proposal, some marginal users of derivatives may decide that uncertainties and costs of changing their information systems and developing disclosures that their investors readily would understand may outweigh the benefits they receive from entering into derivatives transactions. Past experience indicates, however, that such concerns tend to dissipate over time as issuers and investors gain experience with a new accounting standard.<(30)> This may be especially true for derivatives because the development of the information systems and data contemplated by the accounting standard, which many institutions already have in place for internal management or regulatory purposes, may lead to <(30)> For example, FASB, Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions (Dec. 1990), was roundly criticized during its development and immediately following its passage. Now, after several years of experience with it, many consider it one of the best standards passed by the FASB. At a December 1996 conference co-sponsored by the FASB and the American Accounting Association, 57 participants were asked to list the three best and three worst accounting standards. Statement 106 received 21 votes as best, 12 votes as second best, and 4 votes as third best standard. ======END OF PAGE 19====== better management of a company's hedging strategies. Consequently, it is unlikely that many issuers will forego those important risk management techniques merely to avoid transparent accounting. The Need to Make Systems Changes. Some commenters expressed concern about the need to make systems changes in response to a new accounting standard at the same time they are facing other, unrelated systems issues, such as the "Year 2000" problem. As noted above, many entities' computer systems already produce the information that would be called for under the revised proposal, for use in internal management activities or regulatory reports. However, some entities may have to make changes in their computer systems to capture the specific information needed to comply with the proposed accounting standard. The extent of the changes necessary will vary from company to company depending on the number and type of the company's derivatives instruments and hedging activities and the capabilities of the systems currently being used. To provide adequate time to make these changes, the FASB anticipates that there will be approximately one year from the date the standard is adopted to the date it becomes effective. As a practical matter, if companies are currently undergoing systems changes to respond to the Year 2000, it may make some sense for companies to make any systems changes necessary to respond to the FASB's proposal at the same time, rather than run the risk of another round of computer systems changes at a later date. Impact on the Economy. Finally, commenters expressed concern about the general impact of the FASB's proposal on the economy and the securities markets. They are concerned that any regulation of derivatives activities ======END OF PAGE 20====== would hinder capital formation by reducing companies' financial flexibility. The Commission long has believed that the capital markets and the economy are best served by cost effective<(31)> accounting standards that serve the interests of investors. To serve investors, financial statements must be credible. To be credible, they must produce relevant and reliable information that is useful to investors. To be useful, the information must be consistent, must allow investors to compare one entity or reporting period with another, and must be transparent to the extent of providing an honest, unbiased view of underlying transactions and events. Current accounting conventions for derivatives and hedging fail these tests; they have not kept pace with the developments in the markets and with the extraordinary growth in the use of derivatives and market risk management techniques. Establishing accounting standards that provide relevant and reliable financial information to investors should make the markets and the allocation of capital among entities more efficient. In fact, the Secretary-General of the International Accounting Standards Committee ("IASC") has announced that during the next IASC meeting in November, the IASC staff and Executive Committee will recommend <(31)> The Commission expects that costs associated with valuing derivative instruments will continue to decline, as methods of measuring market risks and calculating the price of derivatives continue to be improved and distributed. See, e.g., Peter Heap, "Inside Derivatives: Lehman Team Demystifies Calculating Derivatives Price," The Bond Buyer, Apr. 25, 1995, at 9; Michael R. Sesit, "Morgan Unveils the Way It Measures Market Risk," The Wall Street Journal, Oct. 11, 1994, at C1; Michael R. Sesit, "J.P. Morgan's Risk Analysis Gains Support: Backing May Help Create Standard for Measuring, Managing Credit Risk," The Wall Street Journal, June 30, 1997, at A10D. ======END OF PAGE 21====== to the IASC Board that the IASC adopt the United States standards on financial instruments as an interim step.<(32)> They intend to invite national standard setters, including the FASB, to work with the IASC during the next few years to agree on a harmonized international standard. The U.S. standards that the IASC would adopt would include FASB's current project on derivative instruments and hedging transactions. V. Further Delay - Extension of Comment Period On August 29, the FASB published significant portions of the revised proposal for public comment. The comment period will expire October 14, 1997. Due to the prolonged deliberations and constant public input on this project, a longer comment period would not be productive and would serve only to delay investors receipt of much needed financial information. Of course, since the 45-day comment period is not yet closed, the Commission will be interested to see what new issues, if any, are raised by commenters. Before issuing the revised proposed standard in August, members of FASAC were asked whether the FASB should reexpose a complete revised proposal for an extensive comment period before it adopts a final standard. Although responses were mixed, many who thought that a reexposure for public comment was appropriate also believed that a short reexposure period, similar to that currently being undertaken by the FASB, would suffice. Many responses to the questionnaire reflect strong support for the FASB proposal. For example, Mr. James R. Bunt, Vice President and Treasurer for General Electric Company, stated, <(32)> IASC Press Release, "IASC Announces Proposals on Financial Instruments" (Sept. 8, 1997). ======END OF PAGE 22====== I and my associates at General Electric are in full agreement not to reexpose.... Additionally, we believe that those who want to reexpose are really using the time-tested tactic of delay, merely to avoid implementation. Finally, we believe the [FASB] can in full conscience support the fact that this project has received thorough due diligence. <(33)> Mr. Marc D. Hamburg, Vice President, Treasurer, and Chief Financial Officer for Berkshire Hathaway, Inc., stated, . . . I do not support reexposing the draft.... I do not believe, based on what I heard at the last Council meeting, that the Board will become any better educated or form different opinions as a result of comments which would arise from a revised Exposure Draft. . . . [A]mple due process has been given to the project and . . . the changes, which in certain areas may be deemed by some to be significant, are responsive to comments received. <(34)> The accounting framework on which the current FASB proposals are based has been ten years in the making. During this period, the FASB has held numerous open meetings in which accounting theories related to financial instruments have been scrutinized and dissected. After much debate, the FASB published an exposure draft standard on derivatives and hedging in June 1996 and, since that time, has revised the proposal in response to the comments it received. The FASB deliberated the revisions in meetings that were open to public view, and the public continually has provided its input to the FASB. Finally, once again, the FASB has solicited the public's views in a comment period ending on October 14. As part of this process, one revision <(33)> FASAC, Summary of Responses to Postmeeting Questionnaire, "Derivatives and Hedging, Segment Disclosures, and Disclosure Effectiveness," at 5 (May 1997). <(34)> Id. at 7-8. Others, not on FASAC, also encouraged the FASB to adopt a revised standard without delay. See, e.g., Letter dated August 11, 1997 from Richard P. Howard, Vice President, T. Rowe Price Associates, Inc., to Mr. Edmund Jenkins, Chairman, FASB. ======END OF PAGE 23====== already accepted by the FASB is a one-year delay in the implementation date. As revised, the proposal would be effective for 1999 financial statements, rather than 1998 financial statements as originally proposed. Further delays serve only to deprive investors of the disclosure called for by the FASB proposal. VI. Conclusion In the era of global securities markets, it is all the more important for the U.S. to have a strong and independent body standing guard over our accounting standards. The FASB effectively and credibly carries out that mission. The FASB's revised proposal, developed under the Commission's oversight and with the public's active participation, solidifies the accounting for derivatives and will help make companies' financial statements work for the benefit of U.S. investors, business, and markets. It is time to bring this project, which has been actively pursued for more than a decade, to a conclusion. Thank you. ======END OF PAGE 24======