SEC to Corporates: Get Quantitative
The SEC wants derivatives users to use footnotes with sensitivity
analysis or VAR numbers.
Although the SEC has gained plaudits for its recent efforts to ease and
simplify regulatory and paperwork burdens, when it comes to derivatives
it has gone in the opposite direction and piled on reporting and accounting
burdens on users. That is the lesson from the new SEC regulations released
Many corporates had vociferously argued for regs that would limit disclosure to "qualitative" statements of how derivatives are used. But an
unbending SEC has demanded that quantitative measures of risk exposure be
introduced into the footnote revelations as well. In the mean time, it deflected
criticism a little by giving preparers some greater freedoms of choice in
how those numbers get computed. "There was just too much pressure on
the SEC for them to let the quantitative stuff go away," says Robert
Herz, a partner at Coopers & Lybrand.
The menu of paliatives is nothing to sneeze at, however. As in its original proposal, there are three quantification options: a) listing fair value
of derivatives holdings in a table, from which future cash flows can be
calculated; b) sensitivity analysis of potential loss in earnings, fair
values or cash flows for the entire portfolio; or c) a VAR treatment.
Originally, preparers had to pick one of these paths and apply it to
all derivatives. Now they don't. A mishmash of all three approaches is acceptable
depending on the risks involved, which users and preparers are unanimous
in praising as more reflective of real economics. In addition to classic
derivatives like futures, forwards, swaps and options, the new accounting
measures cover structured notes, loan receivables, debt obligations and
deposit liabilities, as defined in FAS 107.
The intent of the tabular format was to allow companies with only a handful of derivatives to list them alongside some current valuation ed notes, loan
receivables, debt obligations and deposit liabilities, as defined in FAS
"In order to do the sensitivity you need the same information as
the tabular, but the tabular takes up a lot more room in an annual report,"
says Herz. "As a result, we may find that some companies will take
that information and go the one step further to the sensitivity phase."
Another reason preparers might want to avoid the tabular listing is that it presents only a one-sided view, revealing the derivative but not the
offsetting asset or liability, leaving analysts to impute those as best
they can. "Companies might find it better to show some sensitivity
analysis, or VAR, so that they can build in some operating forecasts that
would not hide, but overlay the effects of derivatives as they'd be presented
in the tabular form," says Michael Joseph of Ernst & Young.
Too Little, Too Late
Corporates may have a number of reasons for ducking such questions, some of them legitimate. For one thing, as Michael Moran, a partner KPMG Peat
Marwick points out, by the time this information is released in an annual
report it may be obsolete. "I personally am not sure that publishing
a series of numbers anywhere from eight to 12 weeks later, when the annual
report comes out, will be all that helpful because market conditions may
very likely have changed." Even if they were current, Moran feels,
they might not be very revealing except to a knowledgeable observer. "As
an analyst I'd be much more concerned about how a company plans to react
to things in the future, rather than how they may have reacted in the past,"
Chances are, however, that many corporations will not use year-end data, since the revised regulations permit averaging of high and low values during
the year. A small but influential group of corporates, spearheaded by Hershey
Foods, had complained that competitors would gain material advantage from
a knowledge of year-end derivative holdings, thus putting some U.S. companies
at a competitive disadvantage in global markets.
This objection did not go unheard on Capitol Hill. Sen. Phil Gramm (R-Texas) and Rep. Mike Oxley (R-Ohio) both did a little saber-rattling. The former
threatened oversight hearings on the SEC's work on this matter. The latter,
who is also chairman of the House Finance Subcommittee, has made an information
request for a briefing on how the SEC arrived at its decision, which carried
by unanimous vote among the commissioners. The representative also wants
to know how the SEC calculated the total cost of this requirement to be
$40 million. Having established their identification with Corporate America,
both men then seemed to reduce their ire. "You don't want to get into
politicizing accounting," said an aide to Sen. Gramm.
Politics, of course, is at the heart of this whole business, with the
SEC simultaneously conciliating corporates and singling out derivatives
for exceptional disclosure. In the former role, it relaxed the timing of
the new requirements to apply to companies with a market capitalization
of $2.5 billion or more for fiscal years after July 1997, and to smaller
firms a year later. In the latter role, it maintained what some observers
feel could be a truly vexing requirement-comprehensive descriptions of accounting
policies for derivatives.
Here the SEC took the opportunity to clarify and elaborate on FAS 119.
It expands those requirements to include derivative commodity instruments.
The new rules call for a description of "each method used to account
for derivatives and the criteria to be met for the accounting method used,
such as the criteria to be met to use accrual accounting for interest rate
swaps." The intent of this measure is to permit comparison of registrants
who account for instruments with similar economic characteristics in different
"This could be very onerous," observes Joseph. "Depending on how you interpret it, a company might be obligated to disclose accounting
principles for things a company has never done, or never intended to do."
He is concerned that the SEC may be wanting a statement of accounting methodology,
for instance, on a derivative transaction that is not a hedge, or from a
company that has terminated a hedge early. "A lot of companies terminate
early, but they don't think much about the actual accounting until they
do it, or contemplate doing it," he notes.
Clearly, disclosures of accounting policies will freight this footnote
with a lot of verbiage of dubious value. Those who want to read the SEC's
mind should check the registration of initial public offerings in the coming
months, Joseph advises. With IPOs the SEC has considerable leverage in shaping
accounting treatments. "The SEC could start looking to them as a good
example of what companies should do in this area," he says.