Office of the Chief Accountant:
Letter from SEC Chief Accountant to Joint Working Group of Standard Setters (c/o Tim Lucas, FASB) re: Draft Standard "Recommendations on Accounting for Financial Instruments and Similar Items"

July 24, 2001

Mr. Timothy Lucas
Director of Research and Technical Activities
Financial Accounting Standards Board
401 Merritt 7, P.O. Box 5116
Norwalk, CT 06856-5116

Dear Mr. Lucas:

The staff of the United States Securities and Exchange Commission (the staff) has reviewed, and is pleased to provide its comments on, the December 22, 2000 Special Report that presents the Joint Working Group of Standard Setters' Recommendations on Accounting for Financial Instruments and Similar Items (JWG paper or Draft Standard). The staff supports the Joint Working Group's efforts to move financial reporting towards measurement of financial instruments at fair value and to improve disclosures about financial instruments and financial risks. The staff's general comments on the concepts in the JWG Paper are presented below. The attached appendix contains the staff's more specific comments intended to enhance the clarity and operationality of a final document that may be issued by the FASB or other accounting standard setters.

General Comments

Regulators and others often speak of the benefits of market discipline on public companies. Greater market discipline can lead to lower cost of capital and greater liquidity in the market. In order for market discipline to be effective, investors must be provided with transparent financial information. In order to have transparency, financial reporting must be of high quality and must report and reflect economic reality. Often, reality is volatile; the accounting and reporting should faithfully represent that reality. Surprises to the market can create significant volatility for individual firms and for the financial system. We believe transparent financial reporting, based on fair value accounting for financial instruments, should help to mitigate the effect of "surprises" on the market and on investors.

The staff agrees with the JWG paper that fair value is the most relevant measure for financial instruments. The staff believes this is true for all companies that record financial instruments on their balance sheets (i.e., there should not be a carve-out for particular industry groups). Although some industry segments believe they are different, transparency in financial statements should transcend industry groupings.

The staff believes that, when appropriate controls are in place, fair value accounting should not create more, or new, opportunities for manipulation. Instead, the staff believes that fair value, when gauged together with information on risk positions, capital, and cash flows, can be of great value in evaluating a company's performance, direction, and risk profile. Users of financial statements have shown that they are able to understand current market values of financial instruments, and to act rationally in response to (true) volatility. For many years, investors have used the reported financial results of mutual funds and other investment enterprises that carry their investments at current market values to make informed investment decisions.

We believe implementation of fair value accounting for financial instruments would remove many of the problems that have resulted from the mixed attribute model. Under current accounting and reporting requirements, preparers and users face the complexities of FASB Statement No. 133 and IAS No. 39 and the financial engineering associated with FASB Statement No. 115 and 140 and IAS No. 39, among others. Although fair value accounting will not remove all complexity and financial engineering, we believe it will represent an improvement over the current system, provided that a clear, complete accounting model is developed, including all necessary implementation guidance.

Fair value measurements should be reliable and transparent. We believe it is important for the profession to complete guidance in a timely fashion that would ensure that fair value measurements are reliable. In particular, accounting and auditing standard setters need to provide more detailed, "how-to" accounting, valuation, and auditing guidance. To move this effort forward, I sent a letter, in November 2000, to the AICPA in which I encouraged the AICPA to take a larger leadership role in developing detailed, broad-based guidance on valuation models and methodologies used (a) to measure fair value, under the oversight of the FASB, and (b) in auditing fair value estimates. If the accounting standard setters and profession do not put forth the effort now to develop better guidance on determining the fair value of financial instruments, progress toward fair value accounting could be affected, to the detriment of the investing public. I feel strongly that preparers, users, and auditors of financial information must not waste the current opportunity to develop reliable fair value measures of financial instruments.

Some have argued that companies, to effectively manage their businesses, have already developed models for determining fair values. We know that businesses manage their operations, among other methods, by managing risks. Risks are managed by managing changes in value. A risk management process often requires measurement of fair values of contracts, financial instruments, and risk positions. I believe that if these measures of fair value are reasonable enough to be used for business purposes, they should be given serious consideration for financial reporting.

When considering how fair value information should be presented in the financial statements, the staff believes it is important to consider what type of financial information investors want. There are indications that some investors desire both fair value information and historical cost information. The staff suggests that one reasonable presentation approach may be to report historical cost and fair value numbers side by side, at least for some period of time.

We do not believe that supplemental disclosure of fair value is sufficient. Our experience with disclosures under FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, has shown that investors have doubts about the reliability of the fair values that companies currently disclose. Last fall, I made the following comments on this issue:

...I hear from investors, analysts and other regulators that sometimes the [fair] values they see being reported on, quite frankly lack credibility. They question whether the numbers are in fact the "real" numbers that have been subjected to a rigorous examination by the auditor....¹

One of the issues affecting the credibility of fair value disclosures is that a number of companies include cautionary remarks (or "health warnings") with their FASB Statement No. 107 disclosures indicating that the information is not used by management. This language may contribute to users believing that the fair value disclosures today lack credibility. If financial instruments were required to be reported at fair value in the financial statements, management would likely be motivated to put more effort into their fair value measurements.

We commend the Joint Working Group for its work on the Draft Standard. We look forward to working with accounting standard setters in the U.S. and elsewhere to provide financial reporting, based on fair value measurements for financial instruments, that will uphold and enhance the transparency and usefulness of financial reporting for the benefit of investors and efficient capital markets. We encourage accounting standard setters to formulate and implement plans for field testing fair value measurements in the near future. We also urge the accounting profession and accounting standard setters to emphasize the need for user, preparer, and auditor education on matters related to financial instruments, particularly fair value measurements.

Sincerely yours,

Lynn E. Turner
Chief Accountant

cc: Sir David Tweedie, IASB
Mr. Edmund Jenkins, FASB
Mr. Jackson Day, SEC

Attachment

APPENDIX
DETAILED COMMENTS

Scope and Definitions

• We believe the guidance should apply to all enterprises (i.e., no special exceptions for certain industry groups).

• We believe fair value is a relevant measure for insurance contracts. We are aware that the separate IASC Issues Paper on insurance, issued in November 1999, attempted to deal with some of the unique aspects of accounting for insurance contracts. We believe that progress on the insurance paper should be kept in lock-step with this paper so that work on insurance contracts does not fall behind the work of measuring the larger population of financial instruments at fair value. This is important for maintaining a level playing field among all financial institutions.

• Although we generally believe the scope of a final standard should be focused on financial instruments, we agree with the Draft Standard's proposal to include servicing assets and servicing liabilities within the scope of the project.

• We agree with the proposed treatment of hybrid contracts but believe additional implementation guidance and examples should be provided. For example, for convertible debt, more guidance is needed as to what is an equity component; the reference to IAS No. 32 in paragraph 2.31 of the Basis for Conclusions is insufficient guidance. There may be a need to pursue guidance similar to that in EITF Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock.

• Additionally, paragraph 4.12 in the Basis for Conclusions describes what is known as the with-and-without method of separating components of a hybrid instrument. While the paper notes that this approach is simpler, we believe a final standard should illustrate why this method is superior to the relative fair value method (which begins to be described in paragraph 4.13 of the Basis for Conclusions).

• The definitions are helpful and should be retained in a final standard.

Recognition and Derecognition

• We found the flowchart format (as shown on page 85 of the JWG Paper) to be very helpful in conveying the Draft Standard's guidance on recognition and derecognition, and we recommend that this format be used in a final standard to convey the final guidance in this area.

• The guidance on transfers of financial assets appears to be similar to the approach taken by the FASB in Statement No. 125 (which has been superseded by Statement No. 140). In developing a final standard, accounting standard setters may want to consider the reasons for the FASB's decision to supersede Statement No. 125 (i.e., areas where there were problems in Statement No. 125) and consider the impact on the Draft Standard.

• We note the guidance in paragraph 36 that a transfer has substance only if either (1) the transferee is an entity that conducts substantial business with parties other than the transferor or (2) the components transferred have been isolated from the transferor. We believe legal isolation of transferred components should always be required in order for a transfer to have substance. We believe a final standard should provide further guidance, and examples, on legal isolation. However, we also believe that if an entity retains significant economic risks or rewards, the transaction should not be accounted for as a sale or a transfer that has substance.

• We believe it is important for a final standard to include useful example transactions and application guidance, as has been done in the Application Supplement. The Application Supplement already contains some example securitization transactions, and accounting standard setters may want to consider providing additional guidance on transferring to SPEs and the interaction with achieving legal isolation of transferred financial assets.

• We agree with the guidance in paragraph 231 that derecognition requirements are not intended to alter the requirements of consolidation standards. In drafting a final standard, accounting standard setters may want to consider referencing or incorporating the guidance in Standing Interpretations Committee Issue No. 12, Consolidation - Special Purpose Entities. We are aware that some have raised implementation questions about Interpretation SIC-12. However, we believe the Interpretation provides useful guidance for determining when an entity controls an SPE and consequently should consolidate that SPE, because it, in part, considers the risks and rewards of the transaction or situation.

Measurement

• Although we do not necessarily disagree with the Draft Standard's definition of fair value, we believe accounting standard setters may want to consider whether this definition is the definition used by market participants. In particular, we believe the portion of the definition that indicates that the exchange should be "motivated by normal business considerations" should be clarified. The definition of fair value in FASB documents appears to be a more accepted definition. [That definition is "The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale."]

• We agree with the Draft Standard's measurement of fair value as the estimated market exit price with no adjustment for selling costs. This measurement guidance is consistent with the Commission's Accounting Series Release No. 118 (ASR No. 118).

• We question whether the bid-ask spread guidance in paragraphs 80-83 is superior to using the mid-point in the range, as is allowed by the Commission's ASR No. 118.

• It seems to us that, in cases where market quotes exist, there may be reliability problems with allowing exceptions to using those market quotes (such as when market prices are not determined by normal market interactions or result from infrequent transactions). For example, some argue that a large block of stock should receive a blockage "discount" while others ascribe a "premium" to holding a large block of stock. Comparability, consistency, verifiability, neutrality, and representational faithfulness in financial reporting are all more likely to be achieved through the use of quoted market prices. The judgment exercised in arriving at fair value by deviating from a market quote may result in different entities measuring the same financial instrument at a different (and perhaps materially different) fair value amount.

• We believe it would enhance the clarity of a final standard to include a flowchart on the fair value hierarchy that should be followed in valuing financial instruments.

• When quoted market prices are available, we believe those prices should be used without discounts or premiums subtracted or added. Accordingly, we agree with the guidance in paragraphs 102-103 of the Draft Standard that instructs enterprises to not adjust available market exit prices for the expected effect of selling a large block of an instrument.

Balance Sheet and Income Statement Presentation

• We believe the balance sheet and income statement presentation guidance represents one reasonable approach to presentation. We recommend that accounting standard setters continue to conduct discussions to determine what line items would be useful to investors. We believe information obtained during field tests of the Draft Standard would also provide insights into improving financial statement presentation.

  Disclosures

• We have found that examples can help significantly in enabling preparers to consistently apply a standard. We therefore recommend that accounting standard setters, in developing a final standard, consider providing more, and different, disclosure examples (beyond the example in paragraph 412).

Transition and Implementation

• The Joint Working Group has proposed a two-year period between issuance of a final standard and the effective date. While we do not disagree with the two-year transition period, we recommend that standard setters actively encourage preparers, auditors, analysts, investors, and other constituent groups to utilize effectively the time until a final standard is issued to prepare for implementation of fair value accounting for financial instruments.

• As mentioned above, we have recommended to the AICPA that it take on a larger leadership role in developing detailed, broad-based guidance on valuation models and methodologies used (a) to measure fair value, under the oversight of the FASB, and (b) in auditing fair value estimates. We are continuing to communicate with the AICPA about their plans and progress in this area.

• One approach to transition would be a presentation approach that shows side-by-side or parallel financial statements, with one set based on existing accounting requirements and one set based on measuring financial instruments at fair value. However, as stated above, we recommend that accounting standard setters continue to conduct research to determine the type of financial statement presentation, including financial statement line items, that would be useful to investors. We also encourage standard setters to conduct field tests of the Draft Standard to provide insights into improving financial statement presentation.

• Paragraph 192(d)(i) would benefit from additional clarity. For example, we believe a final standard should clarify what level of detail would be expected in a description of financial assets or financial liabilities that would have required recognition under the Draft Standard but that were derecognized under previous accounting.

Closing Comment

• We recognize the difficulties of the task ahead, but we urge accounting standard setters to write an accounting standard for financial instruments that incorporates a comprehensive and understandable model and includes numerous illustrations and examples to provide for consistent and comparable application. To the extent that standard setters can "get the standard right the first time," without the need for extensive subsequent implementation guides and amendments soon after issuance, we believe financial reporting will be enhanced to the benefit of investors, preparers, and auditors. We also strongly believe that complexity will be reduced by standard setters avoiding "compromises" that fail to result in the final product reflecting the economics inherent in the underlying financial transactions.

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