Mr. Chairman, members of the subcommittee, I am Edmund Jenkins, Chairman of the Financial Accounting Standards Board, and with me is Robert Wilkins, one of the project managers on the subject of today's hearing. We are pleased to be here today. I plan to discuss the due process of the Financial Accounting Standards Board and our proposed standard on accounting for derivatives. I have brief prepared remarks, and I would like to have my full statement and supporting materials entered into the public record.
Let me begin by telling you a little about the FASB. We are an independent organization that is funded entirely by the private sector. Our mission is to set accounting and reporting standards to protect the consumers of financial information most notably, investors and creditors. Those consumers rely heavily on credible, concise, and understandable financial information for effective participation in capital markets. The FASB attempts to ensure that financial reports inform consumers about an enterprise's financial condition and activities and do not distort the facts to influence behavior in any particular direction.
Our standards affect many organizations, not just banks and public companies, but also small businesses and nonprofit organizations. Our decision-making process has to be fair. We operate under Rules of Procedure that require an extensive due process modeled on the Federal Administrative Procedure Act.
In our derivatives and hedging project, we have gone well beyond even that extensive due process. For example, we have given our constituents five opportunities to provide comments even though our Rules of Procedure require only one. We have done that because we wanted to consider carefully the views of allinterested parties. Those views are all important and we accepted a number of their recommendations as we amended the proposal included in our Exposure Draft on derivatives.
However, we did not accept every recommendation. Ultimately, the value of accounting and reporting standards is determined by how useful the information will be to investors and creditors. To protect the consumers of financial information, which include millions of small individual investors who are the backbone of our economy, we must avoid placing the interests of any particular group over the consumers' interests.
What the proposed standard on derivatives is all about is the public's right to know. Consumers have demanded more information about derivatives and hedging. A recent editorial in Pensions & Investments said: "If ever a case can be made for reporting something in more detail, it is for derivatives." The Association for Investment Management and Research, which is an organization representing investment analysts, portfolio managers, and other investment decision makers, told us in a letter that "accounting for derivative instruments and hedging activities remains a significant deficiency in current [accounting standards]."
The potential effects of derivatives are well documented. Several times over the past few years, investors and creditors have been surprised by large unexpected losses on derivatives Taxpayers, too, have been adversely affected as the situation in Orange County, California amply demonstrated. In fact, a few years ago, Congress was considering a ban on certain types of derivative activities because of those spectacular losses. Instead, Congress, the SEC, and others urged the FASB to accelerate its project to develop standards for derivatives and hedging activities.
The FASB started working on derivatives and hedging in 1991. In June 1996, after 100 public meetings on derivatives and hedging, we published an Exposure Draft of our proposed rules. Our constituents sent us literally hundreds of letters commenting on the Exposure Draft.
After we received the comment letters, we spent another 23 public meetings, including a 4-day public hearing, considering those comments and making changes to our proposal. Interested parties have had several ways to follow our progress during that stage of the project. For those who cannot attend the meetings, we made most of them available by telephone. There have been press reports of each meeting in some business publications. We published our own weekly newsletter with the results of each meeting, and we maintained an updated summary of the proposal on our website. Many interested parties wrote us letters or contacted us by telephone with comments during that process.
During the later stages of our due process (this past spring and summer) we asked several particularly knowledgeable individuals, including representatives from major banks, about the specific changes we were considering. We listened carefully to their advice and incorporated a number of their suggestions.
We are now in the final stages of our work on an accounting standard for derivative instruments and hedging activities. In August of this year, we circulated widely our proposed standard. We asked for comments by October 14, which is longer period than usual for a task force draft. We expect to complete our work and issue a final standard in December 1997. To allow time for enterprises to understand and apply the standard, the requirements will not be effective until calendar year 1999.
The underlying cause of the problems that we are trying to correct is that there are no specific reporting standards for many of the types of derivatives and hedging activities in use today. As a result, current reporting practices often do not help a consumer understand an enterprise's derivative and hedging activities or compare those activities to similar activities of another enterprise. For example:
Our proposal is intended to correct those problems.
As I said, we received hundreds of comments on our 1996 Exposure Draft nearly 500 in fact.
The proposed standard that we circulated in August incorporates many of the recommendations in those comment letters. It retains more of the best features of existing reporting practices, and earnings will be less volatile than under the Exposure Draft. But we retained the two aspects of the proposal in the Exposure Draft that we thought were the most important: all derivatives will be reported on balance sheets at fair value, and losses and gains on derivatives will not be reported as assets and liabilities. In our view, those are the essential elements of the public's right to know and to make informed investment decisions.
Some have suggested that derivatives should not be reported in the financial statements at fair value. They have said that reporting them at cost and disclosing fair value information in notes to the financial statements would be sufficient. We do not agree. Information is harder to find back in the notes, and it would leave investors and creditors wondering whether to believe the financial statements or the notes. More important, gains and losses are not explicitly disclosed today, and their effect on earnings is difficult, if not impossible, for an investor or creditor to determine. Again, we believe that the public has a right to know.
The editorial in Pensions & Investments that I mentioned earlier put it this way: "Better understanding of these complex tools will be less likely if they are shoved to the back of financial reports."
As for reporting derivatives losses on the balance sheet, that is blatantly misleading and wrong. To put it simply, assets are good things things that benefit an enterprise. A loss is a bad thing. You cannot sell a loss and there is no other way to get a benefit from it.
However, we listened to financial institutions and other interested parties when they said gains and losses on derivatives used as hedges should not affect earnings. Our proposed standard provides for optional hedge accounting for many derivatives. Gains or losses on derivatives that qualify for hedge accounting should have little or no net effect on a company's earnings. They will be offset by comparable losses or gains on the thing that is being hedged and the result is little or no volatility in earnings.
Mr. Chairman, let me quickly summarize:
Thank you, Mr. Chairman. I very much appreciate this opportunity and now
would be pleased to respond to questions.
Mr. Chairman, members of the subcommittee, I am Edmund Jenkins, chairman of the Financial Accounting Standards Board, and with me is Robert Wilkins, one of the project managers on the subject of today's hearing. We are pleased to be here today. I plan to discuss the due process of the Financial Accounting Standards Board and our proposed standard on accounting for derivatives. I have brief prepared remarks, and I would like to have my full statement and supporting materials entered into the public record.
What Is the FASB and What Does It Do?
The FASB is an independent private-sector organization. We are funded entirely from private-sector sources, primarily voluntary contributions and sales of publications.
Our mission is to establish and improve standards of financial accounting and reporting for both public and private enterprises. Those standards are essential to the efficient functioning of the economy because investors and creditors rely heavily on credible, concise, and understandable financial information.
The FASB's authority with respect to public enterprises comes from the Securities and Exchange Commission. The SEC has the statutory authority to establish financial accounting and reporting standards for publicly held enterprises. For 60 years the SEC has delegated that responsibility to the private sector. Therefore, the FASB may be viewed as a voluntary private-sector alternative to government regulation.
The focus of the FASB is on consumers users of financial information such as investors, creditors, and others. We attempt to ensure that corporate financial reports give consumers an informative picture of an enterprise's financial condition and activities and do not color the image to influence behavior in any particular direction.
To provide an informative picture, financial reports should portray similar transactions and circumstances similarly and different transactions and circumstances differently. Items reported as assets should represent future benefits to the reporting enterprise. Items reported as liabilities should represent obligations of the enterprise. Reported income should represent the changes in the assets and liabilities of the enterprise. Those basic accounting concepts are just common sense.
The FASB sets standards only when, in its judgment, there is a significant need and the costs the standards impose are justified by the overall benefits. Of course, the assessment of benefits and costs is very subjective. It is rarely possible to make a reliable quantitative cost-benefit comparison.
What Process Did the FASB Follow in Developing Its Proposed Standard?
Because the actions of the FASB affect so many organizations, its decision-making process must be fair. The FASB carefully considers the views of all interested parties users, issuers, and auditors of financial information. Our Rules of Procedure require an extensive due process that was modeled on the Federal Administrative Procedure Act but is broader and more open in several ways. It involves public meetings, public hearings, and exposure of our proposed standards to external scrutiny and public comment. Final decisions are made by the Board after carefully considering, understanding, and taking into account the views of all parties.
The FASB's due process for developing a new financial reporting standard typically is as follows:
The FASB publishes, for public comment, a discussion document setting forth the issues and possible solutions.
Due process takes several years for a major project like derivatives and hedging. The Board's meetings are open to public observation, and a public record is maintained. Some of the Board's meetings, including several meetings on derivatives and hedging, are available by telephone. The results of each meeting are announced publicly. The project staff frequently provides information about the results of meetings to interested parties who call to request it.
In an attempt to discredit the proposed standard on derivatives and hedging, some have criticized the absence of due process. That is nonsense. The due process that led to the proposed standard included all of the usual steps plus others. For example, we have requested comments from interested parties on five separate occasions, four more than our Rules of Procedure require.
Some of the specifics of the due process on the derivatives and hedging project are as follows:
In August of this year, we distributed to our task force a draft of the proposed standard, as revised. We also made that draft available on our website and have announced in press releases and our newsletter that we will send a copy to anyone who requests it. We asked for comments within 45 days. The distribution was wider and the comment period is longer than usual for a task force draft.
We are now in the final stages of our work on an accounting standard for derivative instruments and hedging activities. We expect to complete our work and issue a standard in December 1997. It will be effective in calendar year 1999.
What Are Derivatives and Hedging Activities?
Generally, a derivative is a contract between two or more parties that involves little or no up-front exchange of assets. The contract obligates one party to give up cash (or other assets) later and entitles the other party to receive the cash. The amount of cash to be exchanged is derived from two factors specified in the contract. They are commonly called an underlying and a notional amount. An underlying is a variable usually a price index, an interest rate or interest rate index, a foreign exchange rate, or the price of a financial instrument or commodity. A notional amount is an amount of currency or a physical quantity (for example, a number of bushels or pounds). The product of the two (the underlying times the notional amount) determines the amount of cash to be exchanged. Some common examples of derivatives are options, swaps, forward contracts, and futures contracts.
Many derivatives are freestanding, but a derivative may be included in the provisions of another contract. That derivative is called an embedded derivative, and the contract it is embedded in is called the host contract.
Derivatives have been criticized because of the large unexpected losses that some enterprises have incurred. However, derivatives are not inherently bad. Investors use the instruments as an efficient way to seek extra returns (speculation) or to offset what could be a costly decline in the value of their other investments (hedging). Of course, a derivative usually is a two-edged sword. Most derivatives offer as much potential for loss as for gain.
If derivatives are not effective as hedges, the gains or losses from the speculation are not offset and can have a dramatic effect on the financial position of the holder of the derivatives. The laxity of current reporting standards in that area offers a large potential for abuse by enterprises that are not required to provide information about their derivatives and hedging activities in their financial statements. Losses on derivatives that have not been reported in financial statements are unwelcome surprises to investors and creditors who made investment decisions without access to sufficient information.
What's Wrong with the Present Accounting for Derivatives and Hedging Activities?
"If ever a case can be made for reporting something in more detail, it is for derivatives," stated a recent editorial in Pensions & Investments. It went on to say: "Derivatives indeed are complicated instruments. They are difficult to understand. Even some big users fail to understand them, with spectacular consequences. But better understanding of these complex tools will be less likely if they are shoved to the back of financial reports. The purpose and extent of their use and their impact on the financial statements of users should be disclosed."
Several times over the past few years, investors and creditors have been surprised by large unexpected losses on derivatives by enterprises that reported them at historical cost or did not report them at all. In fact, a few years ago, Congress was considering a ban on certain types of derivative activities because of those spectacular losses. Instead, Congress, the SEC, and others urged the FASB to accelerate its project develop appropriate standards of reporting for derivatives and hedging activities as soon as possible.
The quotation from Pensions & Investments highlights serious problems. Standards of accounting and reporting for derivatives and hedging activities are incomplete. There are no specific reporting standards for many types of derivatives and hedging activities in use today. Where standards exist, they are inconsistent with each other. Where they do not exist, the practices that have developed vary widely. As a result, the financial statements of enterprises that use derivatives do not report the derivative and hedging activities in a way that investors and creditors can readily understand.
Many enterprises report only the current cash payment or receipt on the derivative. For example, users of interest rate swaps usually report only the amount of the next payment or receipt. Reporting only the next payment does not accurately represent the financial position of the users of the swap. If interest rates have changed significantly since the initiation of the swap, one party can expect to make relatively large future payments and the other can expect to receive them. One has an unrecorded asset and the other has an unrecorded liability.
Some other results of the incomplete standards and inconsistent practices are:
Who Will Benefit from a Change in Accounting for Derivatives and How?
Improved standards on reporting of derivatives and hedging activities will benefit the public investors, creditors, and other users of financial statements as well as issuers and auditors of financial statements. A recent editorial in Pensions & Investmentsstates: "Accounting for [derivatives] will help financial report readers, as well as users themselves, understand them. You can't begin to understand them until you start accounting for them."
Improved standards will benefit investors, creditors, and other financial statement users by providing information necessary to assess the risks that an enterprise has assumed by using derivatives. Improved standards also will benefit investors and creditors by improving the consistency of financial reporting, thereby making it possible to compare derivative activities of different enterprises.
The Association for Investment Management and Research, an organization that represents investment analysts, portfolio managers, and other investment decision makers, stated in a letter to the FASB that it views the proposed standard as "a significant step forward for the Board. Accounting for derivative instruments and hedging activities remains a significant deficiency in current [accounting standards]."
The proposed standard will benefit issuers and auditors of financial statements by providing, in one document, a clearer and more consistent set of rules for derivatives and hedging activities. It also will yield long-term benefits to enterprises participating in capital markets by increasing investor and creditor confidence, which reduces the cost of capital in general.
What Does the Proposed Standard Require and How Has It Changed since the Exposure Draft?
We listened carefully to the respondents to our Exposure Draft and accepted most of their recommendations especially those from financial institutions. Attachment 4 provides a summary of significant comments and recommendations made by large financial institutions and their representative organizations and our response to those comments. In comparison to the Exposure Draft, the proposed standard will change existing practices less, it will permit more hedge accounting, and it will reduce the volatility in earnings.
The key requirements of the proposed standard are:
Both requirements are changes to existing practices. They are very important for the primary consumers of financial statement information investors and creditors. Investors and creditors expect financial statements to portray the financial position and activities of the reporting enterprise accurately and in an understandable way.
A derivative obligates one party to give up cash or other assets and entitles another party to receive that cash or those assets. If an enterprise does not report the derivatives as liabilities and assets, investors are deprived of important information. The values of the derivatives may be disclosed in notes to the financial statements, but the information is harder to find there and the effects are not as easy to understand. For example, gains and losses are not explicitly disclosed and their effect on earnings is difficult, if not impossible, for a reader to determine. Information in notes also may seem less important or be confusing because the notes seem to conflict with the financial statements.
Losses on derivatives do not provide any present or future benefits, nor do gains create present or future obligations. Reporting losses and gains as assets and liabilities misleads investors and creditors and is wrong.
Some other important changes we made in response to constituent's comments are as follows:
Hedges of Expected Future Transactions
One important change involves hedges of expected future transactions. The Exposure Draft would have required that gains and losses on derivatives that qualify as hedges of expected future transactions be reported in earnings when the hedged transaction was originally projected to occur. Respondents said that would have caused unwarranted volatility in earnings because the hedged transaction may occur or affect earnings at a different time. For example, a hedged sale that was expected to occur in the last month of year 1 might not occur until the first month of year 2. Gains or losses on the derivative would be reported in year 1 earnings, but the sale would not be reported until year 2.
Under the proposed standard, gains or losses on the derivative will be reported in earnings at the same time that the hedged transaction affects earnings even if the transaction was originally expected to occur at a different time. That reduces the volatility in earnings.
Rollover Strategies
Many respondents to the Exposure Draft wanted to use hedge accounting for rollover strategies. For example, they wanted to hedge a transaction forecasted to occur in a year with a series of 3-month derivatives instead of a single 12-month derivative. The Exposure Draft would have permitted hedge accounting only for the 12-month derivative. The proposed standard permits hedge accounting for both strategies and thereby reduces the volatility in earnings for enterprises that use rollover strategies.
Hedges of Only One Risk
The Exposure Draft would have permitted hedge accounting only for hedged items with readily determinable fair values. All gains or losses on a hedged item would have been reported in earnings, regardless of the reason for the gain or loss. Respondents objected to both of those requirements.
First, fair values of many assets or liabilities are not readily determinable. Loans are an example. If an enterprise wanted to hedge gains and losses on a loan because of changes in interest rates, it would have needed to know the loan's fair value. Even though gains and losses because of changes in interest rates are relatively easy to determine using present value calculations, the total fair value of the loan depends on other factors, for example, the supply of loans on the market. The enterprise may find it difficult, expensive, or impossible to evaluate the effect of factors other than interest rates on the fair value of the loan.
Second, in some cases, hedge accounting would have increased earnings volatility instead of reducing it. For example, an enterprise might use an interest rate swap to hedge the interest rate risk on a loan. All gains or losses on the hedged loan would have been reported in earnings immediately. Gains or losses on the swap would have offset the losses or gains on the loan due to interest rate changes. But other gains and losses on the loan would not have been offset, and earnings would have been affected.
We changed both of those requirements to make it easier to qualify for hedge accounting and reduce earnings volatility. Under the proposed standard, an enterprise will need to know only the gains and losses on the hedge asset due to the hedged risk (for example, interest rate changes). In addition, gains and losses due to factors other than the hedged risk will not be reported in earnings (unless another accounting standard already requires reporting them).
Effective Date
The Exposure Draft proposed that the standard be effective for years beginning after December 15, 1997 (that is, 1998 calendar years). Respondents argued, and the FASB agreed, that issuers of financial statements will need approximately a full year to implement the standard. Because the final standard is expected to be issued in December 1997, the FASB moved the effective date back one year. It is important that the standard be issued by the end of 1997 to provide a full year for implementation.
Federal Reserve Board Alternative
In a letter dated July 31, 1997, the Federal Reserve Board suggested an alternative to the FASB's proposed standard that would essentially involve starting over with a new approach. That alternative would replace existing reporting practices for derivatives and hedging activities with an unspecified "simple" approach to reporting certain derivative transactions that are deemed to be abusive. Larger market participants but only those participants would be required to supplement the basic financial statements with a balance sheet and an income statement based on reporting all financial instruments at fair value.
The letter revealed that the FASB and Federal Reserve Board agree on the fundamentals surrounding derivatives. We both agree that:
The difference between the FASB's position and the Federal Reserve Board's position seems to be largely related to timing, that is, when the above fundamentals should be put in place. The FASB believes that, for derivatives, the time is now, not later.
In fact, with the changes the FASB has made to its proposed standard, the results are much closer to what the Federal Reserve Board has in mind with its "simple" approach to reporting certain derivative transactions. Therefore, the biggest remaining difference is the Federal Reserve Board's suggestion that additional information be provided in the form of full supplemental fair value financial statements for certain financial institutions. We doubt that those institutions would look forward to that.
What Happens Next?
We are continuing our due process. On August 29, 1997, we sent a draft of the proposed standard, along with numerous examples illustrating its application, to members of our task force. In addition, we made the draft available to other interested parties both by mail and on our website. On September 12, 1997, we also made available on our website a major portion of our basis for conclusions in the standard. We asked that interested parties submit comments by October 14, 1997, which gives them 45 days.
We will read all letters of comment as they arrive, and our staff will analyze the letters and summarize the results for us. We will hold as many public meetings as necessary to discuss the results of the comment process and to decide what further modifications or clarifications of the requirements are appropriate. If there are no significant unexpected results from that undertaking, we expect to issue the final Statement in December 1997.
Conclusion
Mr. Chairman, let me quickly summarize:
Thank you, Mr. Chairman. I very much appreciate this opportunity and now would
be pleased to respond to questions.
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