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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 January 28.

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.

Multiple Choice

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 107.

"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," he says.

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 ways.

"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.