Financial Instruments and Off-Balance Sheet Financing

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19. Financial Instruments and Off-Balance-Sheet Financing

As part of its oversight activities, the Oversight Committee of the Financial Accounting Foundation interviewed and requested written comments (collectively, "the interviews") from thought leaders among the FASB's constituencies. There were 107 interviews in total, including 12 with representatives of financial statement users and 17 with regulators (a special class of financial statement users). [FASOversight, p. 1]

While the interviews were not designed to elicit criticisms of financial reporting, in general, or to identify the needs of users of financial information, interviewees did comment on those matters. [FASOversight, p. 1]

Following is a summary of the principal comments received [on the subject] from users and regulators relating to . . . the needs of users. [FASOversight, p. 1]

Additional disclosure of risks and uncertainties, commitments, and off-balance-sheet transactions should be made in the financial statements. [Also included in 9 and 10] [FASOversight, p. 2]

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[Context] The AIMR position paper provides a summary of the section (pages 11-20) entitled "The Changing World and Its Implications for Analysis," which describes the effects on financial analysis and financial reporting of three major phenomena:

The world constantly is changing and everyone must adjust to accommodate those forces over which they have no control. The nature and implications of three major phenomena that are expected to affect financial analysis and analysts are considered here. Those matters also have considerable influence on the views and conclusions expressed later in the paper. . . . [Also included in 7(b), 16(a), and 18(a)] [AIMR/FAPC92, p. vi]

Third, the accounting model used today was developed to fit enterprises whose economic activity was primarily in manufacturing or merchandising. Today, services of all types constitute a major portion of economic endeavors. Financial assets play a larger and larger role as more and more funds are saved and invested than ever before. The current accounting model has been challenged on many fronts. Our conclusion is, however, that it is fundamentally sound but there are many ways in which it could be employed more efficaciously than it is today. Much of the remainder of the paper is devoted to describing our suggestions for improvement. [Also included in 7(b)] [AIMR/FAPC92, p. vii]

[Context] Those two paragraphs introduce the following excerpts pertaining to the third major phenomenon listed. Excerpts pertaining to the other two phenomena are included primarily in 18(a)-International harmonization of standards and 16(a)-Databases.

Financial Services and the Proliferation of Financial Instruments

Financial services firms, primarily financial institutions and other intermediaries, are like other service firms in that tangible assets are insignificant to them. But their other assets are different, being composed almost entirely of financial instruments. Most of those instruments represent diverse contractual arrangements with heterogeneous counterparties, with equity investments constituting the remainder. Financial firms also have substantial liabilities in the form of financial instruments. The success or failure of such a firm is to a large extent dependent of how well its management matches, from one side of the balance sheet to the other, maturities, yields, and other characteristics of its financial asset and liability positions. None of this is new. [AIMR/FAPC92, p. 18]

What is new are two related matters of current and continuing concern. First is the proliferation of new and exotic financial instruments, many of which do not now appear on balance sheets or, if they do, understate the potential for loss that they engender. Analysts also are confounded by the interrelationships and complexity of financial instruments. For example, how can risks be assessed intelligently for a financial institution that is extensively arbitraged against multiple other financial institutions worldwide? Those risks are at least to be disclosed under the provisions of FASB Statement 105, but the disclosures are scattered throughout the financial statement notes and are understandable only to relatively sophisticated and tenacious financial statement readers. [AIMR/FAPC92, p. 18]

Complex and sophisticated financial instruments are used for a variety of purposes and their propagation continues unabated. Some divide single instruments into component parts to serve the specialized needs of certain providers of capital who otherwise could not invest in a particular activity. Others bundle multiple instruments into a single package, again to serve specific investor demands. Many have been designed to shift risks to those willing to undertake them and provide hedging to their counterparties. Others have been designed and are used for more nefarious reasons, such as skirting the boundaries of accounting standards, rules and practices. As additional standards are written, new instruments seem to be created to evade them. At least that is the perception of many financial analysts. [AIMR/FAPC92, p. 18]

We commend the FASB for undertaking its gargantuan financial instruments project. In many of its facets we are being forced to face up to the deficiencies arising from application of historic cost accounting to financial instruments. In the worst cases, historic cost accounting has allowed financial enterprises to manipulate reported income by recognizing gains (and less frequently, losses) when they wish rather than when they occurred. Cognate to that is the resultant inclusion on balance sheets of historic costs that bear no relationship to their current value and that too many times conceal the fact that the financial instruments they purport to portray are "under water." [AIMR/FAPC92, p. 18-19]

The second major issue pertaining to financial services is whether "mark-to-market" accounting is the remedy for the deficiencies of historic cost as applied to financial instruments. Some analysts support it wholeheartedly and believe that it should supplant historic cost on the financial statements. Others have reservations about or are opposed to market value accounting. None is opposed to disclosure of market values and most believe that it is vital. Some urge caution to avoid disclosures that are incomplete or that imply that market value disclosure can easily be substituted for the historic valuations that appear on financial statements now. In sum, analysts are agreed that information about market values is important, but differ as to the degree of importance and the extent to which they should be incorporated in financial reports. This topic is discussed at greater length later in this report. [Also included in 4] [AIMR/FAPC92, p. 19]

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[Context] Meeting of the Investor Discussion Group on October 16, 1992. During the discussion on the types of information investors use to achieve their objectives and also at the end of the meeting in response to a direct question, some participants commented on problems raised by financial instruments and off-balance-sheet financing.

Participant I-12

With the environment of the last 20 years, there has been a lot of off-balance-sheet financing. We have evolved and we now have ways to hedge against all kinds of balance sheet and income statement risks. What companies are trying to do is to take the volatility of prices out of their basic business so they can focus on their business. Another segment of our economy, the financial companies, are taking care of the volatility; you have a whole business (swaps, derivatives) that is highly misunderstood by investors where there is virtually no meaningful disclosures. From our viewpoint looking in at [names deleted], it is sort of like a black box. Anybody who gets into that business is going to get a discount because we don't understand it. [TI 10/16, p. 43]

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Participant I-2

If we go back to the point made earlier about hedging. Probably irrelevant for two-thirds of the businesses but for us it is imperative. There is a company, [name deleted], who sold forward aluminum at a high price at the peak of the market, very clever on management's part, and the market collapsed and they got 2 or 3 years of phenomenal profitability long after the commodity price had collapsed. They felt that they would be able to dovetail that with a recovery in the market but the market never recovered. So what you had was a surreal situation where they had very strong profitability in an environment where that was not going to be duplicated. Unless you knew that, it wasn't obvious to you and you could make a major mistake. Our companies are now doing much more hedging and they won't tell us what they pay for a hedge; it's important to us to be able to make a judgment as to whether they paid a smart price for the hedge. It's also important to consider how long they're hedged for. [Also included in 1(b)] [TI 10/16, p. 56-57]

Participant I-12

And I would add financial instruments to the list. [Also included in 1(b)] [TI 10/16, p. 57]

__________

Committee/Staff/Observer

The FASB is currently dealing with the subject of hedging and it's a complex area. Is your interest in whether a company hedges or not for economic reasons or are you more concerned about what kind of accounting they're doing through hedging? [TI 10/16, p. 60]

Participant I-2

We're more concerned with understanding what they have done. We're not so concerned about their accounting for it. We'd like to understand the ability of the company to make money and the revenue stream they are going to have. We're interested to know what things are going to look like versus what they would have been if there were no hedging, and understand how the hedging has changed the cash flow stream. [TI 10/16, p. 61]

Participant I-3

Obviously, it is something we should be asking. Companies usually tell us it's competitive information. Then you learn that they are 75% hedged and you happen to think that the price of the commodity is going up and they're hedged at today's price; it may look a lot less attractive as a company versus a company that is less hedged. [TI 10/16, p. 61]

Participant I-6

The accounting aspects are very important too because some of the companies will run that incremental revenue through normal revenue when in fact it is related to a loan that is financing the project. [TI 10/16, p. 61]

[Context] Meeting of the Investor Discussion Group on January 13, 1993. Part of the meeting was devoted to the topic of disclosure about operating opportunities and risks. During the discussion, comments were made on the risks associated with financial instruments and off-balance-sheet transactions.

Participant I-12

Where does the notion of steps the company has taken to mitigate risks come up? I'm thinking particularly about swaps and derivatives. [Also included in 10(a)] [TI 1/13, p. 44]

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Participant I-12

The big problem I have with current disclosure on derivatives is that it is highly misleading, that is, to disclose notional amounts in a business where the principal is truly not at risk. For most derivatives, it's not a principal risk business; cash flows are being exchanged and it's more of an interest rate risk business (at least for swaps). The current disclosure overstates the risks in some contracts and understates the risks in other contracts. It's very difficult to understand what the huge lump sum number being disclosed mean. What are the real risks and opportunities? [Also included in 10(b)] [TI 1/13, p. 50]

Committee/Staff/Observer

One of the reasons for the problems with the disclosure is that we don't have agreement on what the right accounting should be. Until we get that, it's a little hard to address these risks. [Also included in 19] [TI 1/13, p. 50]

Committee/Staff/Observer

Is it possible, [participant I-12], that some kind of a sensitivity analysis, or a stress test, on those instruments would be more meaningful in terms of how they move in relation to interest rate changes and how they are related to the instruments they're linked to? [Also included in 10(b) and 10(c)] [TI 1/13, p. 51]

Participant I-12

I think that something along those lines could be very useful. There are people who are using those instruments who I suspect haven't the foggiest notion of what they've got. There is a lot of work that needs to be done. [Also included in 10(b) and 10(c)] [TI 1/13, p. 51]

Participant I-11

[Participant I-12], isn't part of the problem on that issue the fact that even the participants don't understand the risks? We've seen a number of cases in the past few years where some risk-reducing derivative transaction proved not to work, like portfolio insurance. From my perspective, I think the understanding of the nature of the risks in that whole business is very poor. [Also included in 10(b)] [TI 1/13, p. 51]

Participant I-12

I think there is a dealer community that really does understand what they're doing. And there are some unscrupulous people who are selling these things to companies who don't know what they're doing. Maybe by having an accounting that makes better sense, it would point out to them that they're getting into something they don't understand. [Also included in 10(b)] [TI 1/13, p. 51]

Participant I-5

The dealer community may know the risks for derivatives that have been around for 5 years, but every year there is something new that comes out and they may not know so well what the risks are. [Also included in 10(b)] [TI 1/13, p. 51]

Committee/Staff/Observer

Do you adjust core earnings for items that you think are hedges but are not accounted for as hedges, or vice versa? Or do you generally go along with the accounting for these instruments? [Also included in 5(a)] [TI 1/13, p. 51]

Participant I-7

To the extent that some of my companies operating in the international markets try to currency hedge, I won't change the accounting unless it's significantly material (for me, above 5%). I won't make a change in my written material. [Also included in 5(a)] [TI 1/13, p. 52]

Participant I-14

When you get into the big international pharmaceutical or consumer goods companies, especially in a year where there has been a huge currency change, I question whether hedging will do everything. I think that's going to be a very big issue. I don't know how many companies will be very clear about the effects of currency fluctuations on their results. [Also included in 10(b)] [TI 1/13, p. 52]

Participant I-12

It's not only the big international companies. I was looking recently at a small thrift ($200 million in assets) that had 2 or 3 million dollars in contracts; if the yield curve changed its shape, this company could have real problems or huge gains. [Also included in 10(b)] [TI 1/13, p. 52]

[Context] Meeting of the Investor Discussion Group on March 17, 1993. Part of the meeting was devoted to the topic of auditor involvement. During the discussion, a comment was made on financial instruments.

Participant I-12

Both. I cover financial companies. There are lots of financial control systems, for example the hedging system, asset and liability management systems; these are critical systems for these companies to run their businesses. It's very difficult for an analyst to know what they're doing; are they controlling the business, do they have open positions or are they speculating? From the existing information we have, we don't know. Some assessment of those control systems, the amount of latitude that it leaves management to engage in speculation in financial markets, would be useful. Maybe I'm asking too much but this is the heart and soul of the businesses that I cover. It's very difficult from the outside to make any assessment of it. Auditors would run across those systems a great deal during the course of their work and they could give us some input. Any business that does hedging nowadays has to have some financial control systems to keep order. [Also included in 17(c)] [TI 3/17, p. 14]

[Context] Meeting of the Creditors Discussion Group on December 8, 1992. Part of the meeting was devoted to the topic of creditors' objectives and approaches. During the discussion, comments were made on financial instruments and off-balance-sheet financing.

Participant C-9

Another issue I would be interested in getting more information to work with is the off balance sheet information regarding swaps, derivatives, futures, etc. I think [name deleted] has set a standard of disclosure for others to strive toward, but I think there is a lot more that could be reported, and we're talking very significant dollar flows. I mean you look at [names deleted], we're talking trillions of dollars that aren't even on the balance sheet, and you have very little information. [Also included in 15] [TC 12/8, p. 29]

Participant C-11

I agree totally with you, but what we've got so far from that opinion from the FASB (Statement 105) is just aggregate numbers with no qualitative handles on it at all. Do you have a sense as to how we can better report the risks on the off-balance-sheet items? I don't. [TC 12/8, p. 29]

Participant C-9

I think that we might prefer to have information on the actual types of breakdown and the composition of the types of instruments that are being entered into. You could look at maturity ranges, what the offsets are, what the credit underwriting is of the counterparties. That's just for starters. [TC 12/8, p. 29]

Participant C-3

What you're saying is exactly right on. I think there is a lot of information in the derivatives business that isn't being reported to the users of financial statements, especially the creditworthiness of the counterparties. That's key. [TC 12/8, p. 29]

Participant C-14

What I want to know from a company is if there is 100 basis point movement in interest rates, what's the net cash flow impact? Or if there is a certain percentage change in the Deutschemark to the dollar, what is the cash impact in the foreign exchange hedging position? I want something that's tangible, and then I can sit there as an analyst and say all right, I'm expecting interest rates to be gradually rising, so these people are either not -- it's going to be a net disadvantage or advantage to have the position they have. [TC 12/8, p. 29-30]

Participant C-13

It seems to me that one way you can approach this question is to disclose one, two, three, or four major variables, be they interest rates, the Deutschmark, sterling Yen, whatever it happens to be, and then some sense of sensitivity impact of those major variables. [TC 12/8, p. 30]

Participant C-9

I'd like to see more information on liquidity (for example, gaping). [TC 12/8, p. 30]

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Participant C-14

I perceive a lot of the overload to be in the footnotes, but I also find the footnotes to be the most useful part of the financial statements. And I tried to think of how to enhance the understandability of that information, and I think we started to touch on it when we said well, in the footnotes you find the nominal amount of the swaps, but you really don't know what the impact could be. We also need information on the assumptions used by a company or the reasoning for the assumptions they chose in their accounting methods. For instance, why did [one company] pick a 12% return on plant assets, it's 11 or 12%, when inflation is you know, 3 or 4%? Or why did [another company] depreciate its video over 36 months when the economic life is only four months? I'd like to know more about why they choose those kind of things. Or other examples would be why they've changed accounting standards. [Also included in 1(b), 2(a), 2(c), and 9] [TC 12/8, p. 41]

Participant C-11

I just would like to emphasize the same point that [participant C-14] made. I think that the newer accounting opinions are all complicated, and each one of them seems to require a page of footnote. The example that we were talking about before, I think, is a very good one, and that's the off-balance-sheet liabilities. It goes on forever, it's boilerplate, and it doesn't give any analytical information whatsoever. All you know is that there's lots of stuff out there. This is not an easy thing to implement, but I think that as new accounting opinions come and new footnotes have to be written, I think the question has to be what is the most important information to be found or disclosed on this subject matter. If there is not analytical content in the footnote that it's not really worthwhile. [Also included in 1(b)] [TC 12/8, p. 42]

[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of value information. During the discussion, a comment was made on hedging.

Participant C-4

You do run the risk of information overload here, too, at times. You've got to remember that the typical analyst has to get into separating those two elements out. We have some significant borrowers who have been pretty effective in locking in costs by hedging commodity prices or whatever. And that's part of what we would consider operating management. Is that truly manufacturing efficiency that allows you to take that commodity and turn it into a product at a low cost? Or is it your effectiveness of your hedging strategy such that you lock in early commodity prices? We look at it as one big operating process and the quality of management is all a part of that activity. We're pretty good at analyzing numbers but I could get into information overload if you gave me too much. [Also included in 4 and 5(a)] [TC 2/2, p. 10-11]

[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of display. During the discussion, comments were made on hedging.

Participant C-5

I would go back to [participant C-14]'s comments about the hedging activities associated with the current liability structure and the way those things are hedged or even the term liability structure with swaps, caps, and collars, and so forth. Tying to, rather than separate, disclosures about aggregate and totals of these liabilities and off-balance-sheet items will allow you to better understand the variability of the interest charges. [Also included in 5(b)] [TC 2/2, p. 21]

Participant C-14

The way I understood what you just said is perhaps you take each of those potential contracts and tie them to the specific instrument that they relate to? [Also included in 5(b)] [TC 2/2, p. 21]

Participant C-5

Bundled as opposed to unbundled, that's right. I do realize that certain companies don't ever connect the two instruments together. They hedge in aggregate. And, therefore, you'd never be able to tie it back as an accountant. But in situations where there is a feel that this is a direct link contract, it is beneficial. [Also included in 5(b)] [TC 2/2, p. 21]

[Context] Meeting of the Creditor Discussion Group on March 11, 1993. Part of the meeting was devoted to the topic of auditor involvement. During the discussion, comments were made on financial instruments and off-balance-sheet financing.

Participant C-11

I think it's good to know that the auditors must be nervous about the fact that somebody might sue them, and use a little bit more diligence than they might otherwise do. So I think the auditors should feel a little nervous. That they'd better really get into the stuff or they might be sued. I think that is helpful. On the internal controls, I do think that there's some difficult areas that I would want to feel comfort about, as to what kind of examination really did take place. And I'm thinking of some of these huge off-balance sheet items, such as the foreign exchange contracts, hedging type things. I think it's an interesting avenue to think about. The standard audit letter does not give any feeling one way or another that the critical areas have been looked at in depth. [Also included in 17(a), 17(c), and 18(b)] [TC 3/11, p. 4]

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Committee/Staff/Observer

Let me pursue this off balance sheet topic that some of you have raised. There is off balance sheet disclosure now. I'd like to have a better feel in terms of what you view the auditor relationship with that off balance sheet information as it exists now is. Do you see that as either ill-defined, well-defined, or needs redefining? [Also included in 17(b)] [TC 3/11, p. 5]

Participant C-11

The off balance sheet disclosure that we now have just recently been getting is not useful to me. It's just a bunch of big numbers and it doesn't get into the qualitative aspects of the risks. But addressing the question you're speaking of, I was not necessarily speaking of off balance sheet items versus on balance sheet items. I was thinking of critical areas where, in the case of financial institutions, a massive number of individual transactions take place, and those can be audited on an on-the-spot basis. What is more critical to me is that the whole process of whatever those transactions are, be analyzed as a process, in terms of whether the right data is captured. For instance, are there really hedging transactions being captured or are there a combination of hedging and speculation? So, it's not the individual transaction I'm thinking of. It's the whole process or business that's being undertaken, and whether the proper information is coming in an aggregate form in the right way. And whether the systems involved do capture things properly. And that could be on and off balance sheet. [Also included in 17(b)] [TC 3/11, p. 5]

Participant C-12

I think maybe off balance sheet is a whole separate discussion. What we're getting now is minimal information of substantial exposures. And we're getting no explanation of what's involved in these exposures. What the financial risk is, what the credit risk is, how it breaks down. But I think that's a separate topic altogether. [Also included in 17(b)] [TC 3/11, p. 6]

Participant C-5

I would agree that current disclosure doesn't give us a view of what the risks are. I will also confess in regular conversations with peer institutions on the very subject that, as we measure our risk to each other, everyone has a slightly different approach. The basic approach is similar, but the numbers all come out differently based on how we quantify risk. We are all moving increasingly towards some commonality in that area, but the idea that you would give an opinion and say that what's been presented is a fair representation, without allowing me to know the differences and have the raw data to make a determination of my own, is troubling. I know my aggregate positions with any other counterpart but I have no concept of their aggregate exposure. And the raw information which is provided is clearly insufficient to make some determinations or risk calculations. Whether it's something as complicated as options, forwards, and swaps, or something as simple as purchased intangibles, like servicing rights. Just in the last year, the dynamics of that market have been so significant that we have been throwing credits out of our committee because our own people don't even know the detail behind the numbers. And we have difficulty getting them. Management can't provide them. If they can't provide them to us as a negotiating creditor, I doubt the auditors have been able to get that kind of information, or really have reviewed it in the right kind of depth. [Also included in 17(b)] [TC 3/11, p. 6]

Participant C-13

There are two issues here. I agree with everything that has been said about disclosure and availability of information for off balance sheet items and liabilities and assets and contingent liabilities. But the other issue is the audit and control issues concerning those items. And I think everything that you've heard in the last three minutes suggests that there's a concern, a serious concern, about the controls that exist. There have been numerous instances of surprises or failure of controls among very large companies. That would suggest that the users are very interested in the audit functions of these off balance sheet items. [Also included in 17(b)] [TC 3/11, p. 6-7]

Participant C-14

I was going to try to differentiate off balance sheet items like swaps and hedges that we talked about in other meetings, because I think we've suggested that there may be better ways to account for them in the financial statements, to present them differently. I distinguish that from things like legal and environmental contingencies where I see a real challenge on the part of the auditors. My understanding is that companies don't want to disclose that kind of information because it helps set up the case for the people coming against the company. I don't know what the answers are but I see that as a more difficult issue to handle than other off balance sheet items. [Also included in 2(d) and 17(b)] [TC 3/11, p. 7]

[Context] Meeting of the Creditor Discussion Group on March 11, 1993. Part of the meeting was devoted to the topic of priority of improvements needed in external reporting. During the discussion, comments were made on financial instruments and off-balance-sheet financing.

Participant C-4

I had three circled, one being the core earnings. We find it very difficult to pick out what core earnings truly are on a consistent basis. I also had ten; we see a real need to get more information about off balance sheet activity including particularly operating risks. And disclosure of measurement uncertainties is the final area that I circled. [Also included in 5(a) and 15] [TC 3/11, p. 69]

Participant C-13

I also picked core earnings as one of my three. I'm not sure that we need specific rule changes but improved disclosure under existing rules would probably be adequate. Secondly, I chose interim reporting because I think a rule change for a reporting segment would be a major step forward. And thirdly, I chose number thirteen, off balance sheet financing and hedge accounting. I think practice is ahead of theory in this sphere and we need some codification. [Also included in 3(d), 11(c), and 15] [TC 3/11, p. 69]

Participant C-14

9, 11 and 13. And no particular order. Starting with number 9, display of financial information. We at one time talked about more focus in the balance sheet on liquidity going from maybe differentiating current liabilities rather than just something that matures under one year but get into how much of it is truly interest rate sensitive and how much is reflex roll over or refinancing risk. So I'd want to stress that. And also stress the things we talked about in the cash flow statement. We talked about going to a direct cash flow statement and I'm still in favor of that. 11, core earnings. I think everybody's said enough about that that covers my views. 13 (financial instruments); it is very important to find a new way to assess the company's cash flow sensitivity to all those items related to financial off-balance-sheet transactions that are difficult for us to understand as they're presented today. [Also included in 5(b), 5(c), and 15] [TC 3/11, p. 69-70]

Committee/Staff/Observer

[Participant C-14], do you have the ability to get some of that data from your customers? In other words, does it have to be reported in the GAAP financial statements or can you ask for and receive it? [TC 3/11, p. 70]

Participant C-14

The first thing I brought up about maturities and interest rate sensitivity, we can usually get that. The swaps, I don't always have the impression that management has as good a handle on what their sensitivity is to their swaps as I'd like to get. And I don't know if that's because it changes day to day and they can't tell me or if they really, at the level of the people we talk to, don't have a handle on it. [TC 3/11, p. 70]

Participant C-15

I'll go with number 11 (core earnings) as my first choice. And 13 (financial instruments) is my second choice. [W]e always ask the questions and we meet with financial institutions and increasingly with industrial companies and so on about their off-balance-sheet financing, in particular swaps and other types of instruments. And I think that we find at the senior management level, CFO level, that we deal with that they broadly understand the issues. But when it comes down to getting into specifics, they say that they have somebody locked away in a corner room someplace who is really doing all this work. Something going forward which I think is going to be increasingly important are these environmental liabilities (number 14). They're kind of difficult to get your hands around but these are the types of things, if you look at a company like [name deleted] for example, that just came out of the clear blue. You looked at their balance sheet and income statement, you didn't have a hint anything was wrong with the company. Well, you knew something was wrong by reading the footnotes that they had these asbestos related liabilities but the next thing they're on their way over to bankruptcy court. I think that disclosure of those types of liabilities going forward is going to be increasingly important. [Also included in 10(b) and 15] [TC 3/11, p. 70-71]

Participant C-5

I would agree with the core earnings. On the hedging things, knowing on the other side of the world how this operates, the users of the information are not even close enough for your disclosure. We need some increased disclosure but we're ten years, fifteen years from being able to turn it into user-friendly information that the users could understand and really value. The whole issue of what's current value is one thing. The other is what's its sensitivity to future changes and the combination of changes, the volatilities that drive swaps and options. I actually am a little uncomfortable with the accounting profession that views hedge accounting and some of the hedge accounting rules right now. Hedging really operates in aggregate in this concept that you can only, you know, direct match hedging. I just spent two and a half days going through a credit process to approve a whole new set of financial transactions to shift to an accounting focus because we weren't allowed to recognize hedge accounting on something we had done pretty successfully over the last seven or nine months but realizing that we're getting killed on the accounting side of it. I'm still very perturbed with business combination practices and the flexibility that's allowed there. That's either two or three for me. And fair market values, I don't like it from the bank side but I think it's good supplemental disclosure and I wouldn't expect financials to be prepared on that basis. And I mixed that with impairment. To me, impairment is fair market value to some extent. [Also included in 4, 8(b), and 15] [TC 3/11, p. 71-72]

Participant C-11

11 (core earnings), 3 (unconsolidated entities) as it encompasses also annual and interim segment reporting by business, major business segments. And also 13 (financial instruments) but only if you really can get something related to the risk aspects of those matters as opposed to just lots more numbers. And I don't know if that's possible so I really want to put it with that caveat, that more information that is not analytically useful in terms of understanding risk is not helpful. [Also included in 15] [TC 3/11, p. 73]

Committee/Staff/Observer

In other words, it's not quantitative, it's qualitative. [TC 3/11, p. 73]

Participant C-11

Yes. [TC 3/11, p. 73]

Participant C-17

I'm not going to expound on what's already been said about the categories, just add whatever addition or comment that seems appropriate. Number 11, core earnings, is my first choice. And I really felt that number 9 (display) was almost an integral part of that. And then from there, I looked at number 13 (financial instruments) as second in order because I am not convinced that even senior management of the company really truly understands what it's all about. So it's sort of a backdoor way of getting their attention. There are too many instances where they've had surprises that they were totally unaware of because they didn't completely understand. And then 10 (operating opportunities and risks) for the obvious reasons. [Also included in 15] [TC 3/11, p. 73-74]

Committee/Staff/Observer

I have a specific question on 13 which is accounting for financial instruments including off balance-sheet-financing. Those who ranked that in the top three, did you include off-balance-sheet leases or weren't you thinking about it? [Also included in 8(c) and 15] [TC 3/11, p. 74]

Participant C-11

Not in the same context. For different reasons, I think this classifies as off-balance-sheet. I think they're very different risks. [Also included in 8(c) and 15] [TC 3/11, p. 74]

Committee/Staff/Observer

So would you also encompass in 13 changes in accounting or information about off-balance-sheet leases? [Also included in 8(c) and 15] [TC 3/11, p. 75]

Participant C-11

I think it should be on balance sheet myself but . . . [Also included in 8(c) and 15] [TC 3/11, p. 75]

Committee/Staff/Observer

But the reason is not because of the qualitative questions you had with respect to everything else that's off-balance-sheet? [Also included in 8(c) and 15] [TC 3/11, p. 75]

Participant C-17

I don't think anybody's mystified about what an operating lease is all about. I think there's a great deal more esoteric around the hedging situation. I'm not certain that the management itself always has the sophistication or focus that they ought to. [Also included in 8(c) and 15] [TC 3/11, p. 75]

[Context] Responses to the postmeeting questionnaire to the March 17, 1993 Investor Discussion Group meeting.

QUESTION 17

At the end of the meeting, some participants mentioned that off-balance-sheet financing was near the top of their list of issues that need urgent attention.

For purposes of the following questions, "off-balance-sheet" refers to assets and/or liabilities that are 1) never reported on the balance sheet, 2) a significant portion of the risks and benefits associated with those items are not reported on the balance sheet, or 3) some previously reported assets and/or liabilities are removed from the balance sheet. Common examples of offbalancesheet financing arrangements include:

Securitization and factoring of receivablesWhen receivables are sold to a third party but the entity retains some of the risks associated with the receivables by guaranteeing their ultimate collection (recourse provision).

Insubstance defeasance of debtWhen certain securities are purchased and placed in an irrevocable trust, the sole purpose of the assets being to provide for the timely payment of principal and interest of one of the entity's liabilities.

Operating lease arrangementsWhen a lease contract does not meet the criteria for recognition under current accounting literature, and, therefore, the lessee does not capitalize the leased asset on the balance sheet.

Certain financial instruments -- When the instruments are not accounted for, or only partially accounted for, on the balance sheet, including: interest rate swaps, forward contracts, guarantees and commitments, etc.

a. Do you find the lack of consistent reporting and disclosure practices for off-balance-sheet instruments and transactions a significant impediment to your investment analysis work?

YES 4                                                                    

NO 1

If YES, why?

Participant I-16: Off-balance-sheet financing understates the assets required to conduct the company's businesses and understates risks by ignoring potential liabilities and/or volatility.

Participant I-9: In retailing in particular, companies try to understand their sale leaseback responsibilities to have better debt equity ratios. In any industry that requires on-going financing for expansion on a routine basis, managements try their best to make their balances appear better than they should be to cover their capital cost.

Participant I-7: Carry risk that can come back to materially affect net.

b. How should problems associated with off-balance-sheet financing be solved? (Choose ONE.)

1.  By developing accounting         1                                    
methods that will record those                                            
items in the financial statements                                         
in a consistent manner?                                                   

2.  By extending the quantitative    1                                    
information that should be                                                
disclosed about those items in the                                        
notes to the financial statements?                                        

3.  By requiring qualitative                                              
information that should be                                                
disclosed about those items in the                                        
notes to the financial statements?                                        

4.  By a combination of accounting   2                                    
methods and disclosure                                                    
requirements?  Describe:                                                  
Participant I-16:  Where                                                  
off-balance-sheet liabilities are                                         
reasonably measurable they should                                         
be included on the balance sheet.                                         
Other off-balance-sheet items                                             
should be described as well as                                            
possible, quantitatively and                                              
qualitatively.

Any comments on the approach you selected above?

Participant I-9: All leases of retailers that are not annually (1 year) reviewed should be treated the same way.

Participant I-11: I think most of these issues usually arise with financial institutions. I don't do any work in this area, and don't feel competent to speak on the issue.

[PMQI 3/17, p. 30-32]

[Context] Responses to the postmeeting questionnaire of the March 11, 1993 Creditor Discussion Group meeting.

QUESTION 17

At the end of the meeting, several participants mentioned that offbalancesheet financing was near the top of their lists of issues that need urgent attention.

For purposes of the following questions, "off-balance-sheet" refers to assets and/or liabilities that are 1) never reported on the balance sheet, 2) a significant portion of the risks and benefits associated with these items are not reported on the balance sheet, or 3) some previously reported assets and/or liabilities are removed from the balance sheet. Common examples of offbalancesheet financing arrangements include:

a. Do you find the lack of consistent reporting and disclosure practices for offbalancesheet instruments and transactions a significant impediment to your credit analysis work?

10 YES 3 NO

If YES, why?

Participant C-8: This is where getting additional disclosure from management is different and the information is often not complete. Full disclosure in the financial statement will allow creditors to better assess the risk.

Participant C-15: Derivatives not fully disclosed. Could represent substantial risk.

Participant C-13: I would describe it more as a significant inconvenience than impediment. The lack of consistency, in some cases, makes adjustments for comparability difficult. In other cases, (financial instruments), lack of disclosure that is adequate leaves the credit analyst in the dark.

Participant C-14: So little information is provided that no real emphasis can be done; we have to know what is at risk.

Participant C-12: Many banks now report more credit risk exposure from foreign exchange and swaps than from lending. However, whereas loan portfolio detail includes 5-10 pages of detail, only the gross exposure number is given for foreign exchange and swaps.

Participant C-11: 1) Securitization - footnote should disclose when credits securitized with come back to the company unless resecuritized. 2) Leases - should be recorded on the statement as debt. 3) Past losses on swaps and guarantees should be recorded like loan losses.

Participant C-21: Because these items can have a detrimental effect on the company's ability to service bank debt. And you do not have third party verification if not disclosed in footnotes.

Participant C-17: Tough to indicate consistency from year to year.

Participant C-9: Given the limited, static footnote information it is difficult to assess the ongoing risk profile (market and credit) to compare or contrast with management's presentation of strategy and practice.

b. How should problems associated with offbalancesheet financing be solved? (Choose ONE)

0 1. By developing accounting methods that will record these items in the financial statements?

7 2. By extending the quantitative information that should be disclosed about those items in the notes to the financial statements?

Participant C-14: Definitely.

5 3. By requiring qualitative information that should be disclosed about those items in the notes to the financial statements?

4 4. By a combination of accounting methods and disclosure requirements?

Participant C-14: Maybe.

Participant C-11: See 17a.

Describe:

Participant C-13: Average in accounting methods in some cases (leases); expanded quantitative disclosure in others.

Note: Some participants marked more than one item.

Any comments on the approach you selected above?

Participant C-14: Measure risk for disclosure in terms of cash flow sensitivity of net positions in hedging securities accompanied by management discussion of why the net position exists and how it may be offset.

Participant C-12: Once the credit risk on financial statements ("off" balance sheet or "on") reaches some size relative to loans, e.g., 20%, then the detail provided on financial instruments should approximate that provided for loans.

Participant C-9: Netting, average outstandings, high-lo, volatility, by type of contracts, by counterparties, margin calls, renegotiated.

[PMQC 3/11, p. 27-30]

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