# Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments and Disclosure of Quantitative and Qualitative Information About Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A97-2991 ## Record - **Collection:** Federal Register - **Document type:** Rule - **Published:** February 10, 1997 - **Citation:** 62 FR 6044 ## Text SUMMARY: The Securities and Exchange Commission (``Commission'' or ``SEC'') is amending rules and forms for domestic and foreign issuers to clarify and expand existing disclosure requirements for derivative financial instruments, other financial instruments, and derivative commodity instruments, as defined (collectively ``market risk sensitive instruments''). The amendments require enhanced disclosure of accounting policies for derivative financial instruments and derivative commodity instruments (collectively ``derivatives'') in the footnotes to the financial statements. In addition, the amendments expand existing disclosure requirements to include quantitative and qualitative information about market risk inherent in market risk sensitive instruments. The required quantitative and qualitative information should be disclosed outside the financial statements and related notes thereto. In addition, the quantitative and qualitative information will be provided safe harbor protection under a new Commission rule. Finally, this release reminds registrants that any disclosures about financial instruments, commodity positions, firm commitments, and anticipated transactions (``reported items''), should include disclosures about derivatives that directly or indirectly affect such reported items, to the extent such information is material and necessary to prevent the disclosures about the reported items from being misleading. In the aggregate, these amendments are designed to provide additional information about market risk sensitive instruments, which investors can use to better understand and evaluate the market risk exposures of a registrant. DATES: Effective Date: April 11, 1997. Compliance Dates: Sec. 210.4-08(n) of Regulation S-X and the amendment to Item 310 of Regulation S-B shall apply, and disclosures under that rule shall be required, for filings with the Commission that include financial statements for fiscal periods ending after June 15, 1997. For bank and thrift registrants, as defined, and non-bank and non-thrift registrants with market capitalizations on January 28, 1997 in excess of $2.5 billion, Item 305 of Regulation S-K and Item 9A of Form 20-F shall apply, and disclosures under those items shall be required, for filings with the Commission that include annual financial statements for fiscal years ending after June 15, 1997. For non-bank and non-thrift registrants with market capitalizations on January 28, 1997 of $2.5 billion or less, Item 305 of Regulation S-K and Item 9A of Form 20-F shall apply, and disclosures under those items shall be required, for filings with the Commission that include annual financial statements for fiscal years ending after June 15, 1998. Under Item 305 of Regulation S-K and Item 9A of Form 20-F, interim information is not required until after the first fiscal year end in which Item 305 of Regulation S-K and Item 9A of Form 20-F are effective. Item 10(g) of Regulation S-B shall apply for filings with the Commission made on or after April 11, 1997. FOR FURTHER INFORMATION CONTACT: Cathy J. Cole, Thomas J. Linsmeier, Russell B. Mallett, III, or Stephen M. Swad, at (202) 942-4400, Office of the Chief Accountant, Securities and Exchange Commission, 450 Fifth Street, N.W., Mail Stop 11-3, Washington, D.C. 20549, or Kurt R. Hohl, at (202) 942-2960, Division of Corporation Finance, Securities and Exchange Commission, 450 Fifth Street, N.W., Mail Stop 3-13, Washington, D.C. 20549. SUPPLEMENTARY INFORMATION: The Commission is amending 1 Rule 4-08 of Regulation S-X 2 and adding a new Item 305 to Regulation S- K.3 --------------------------------------------------------------------------- \1\ The amendments were proposed in Securities Act Release No. 7250; Exchange Act Release No. 36643; Investment Company Act Release No. 21625; File No. S7-35-95 (December 28, 1995) [61 FR 578]. \2\ 17 CFR 210.4-08. Item 310 of Regulation S-B, 17 CFR 228.310, also is amended to incorporate the changes to Rule 4-08 of Regulation S-X. \3\ 17 CFR Part 229. --------------------------------------------------------------------------- The Commission also is making conforming amendments to Forms S-1, S-2, S-4, S-11, and F-4 4 under the Securities Act of 1933,5 and Rule 14a-3,6 Schedule 14A,7 and Forms 10, 20-F, 10-Q, and 10-K 8 under the Securities Exchange Act of 1934.9 --------------------------------------------------------------------------- \4\ 17 CFR 239.11, 12, 25, 18, and 34. \5\ 15 U.S.C. 77a et seq. \6\ 17 CFR 240.14a-3. \7\ 17 CFR 240.14a-101. \8\ 17 CFR 249.210, 220f, 308a, and 310. \9\ 15 U.S.C. 78a et seq. --------------------------------------------------------------------------- I. Executive Summary During the last several years, the use of derivative financial instruments, other financial instruments, and derivative commodity instruments 10 increased substantially.11 The Commission recognizes that these instruments can be effective tools for managing exposures to market risk.12 However, in using market risk sensitive instruments some registrants experienced significant, and sometimes unexpected, losses. Those losses [[Page 6045]] resulted from changes in interest rates, foreign currency exchange rates, and commodity prices, among other things. In light of those losses and the substantial growth in the use of market risk sensitive instruments, the adequacy of existing disclosures about market risk emerged as an important financial reporting issue. --------------------------------------------------------------------------- \10\ See the instructions to Item 305 of Regulation S-K or Item 9A of Form 20-F, infra, for complete definitions of the terms ``derivative financial instruments,'' ``other financial instruments,'' and ``derivative commodity instruments.'' In brief, for purposes of this release: (1) Derivative financial instruments include futures, forwards, swaps, options, and other financial instruments with similar characteristics, (2) other financial instruments include, for example, investments, loans, structured notes, mortgage-backed securities, indexed debt instruments, interest-only and principal-only obligations, deposits, and other debt obligations, and (3) derivative commodity instruments include, to the extent such instruments are not derivative financial instruments, commodity futures, commodity forwards, commodity swaps, commodity options, and other commodity instruments with similar characteristics that are permitted to be settled in cash or with another financial instrument by contract or business custom. In addition, for purposes of this release, the terms (1) ``derivatives'' refer to derivative financial instruments and derivative commodity instruments, together, and (2) ``market risk sensitive instruments'' refer to derivative financial instruments, other financial instruments, and derivative commodity instruments, collectively. \11\ The worldwide notional/contract amounts for derivative financial instruments and derivative commodity instruments increased from $7.1 trillion in 1989 to $69.6 trillion in 1995. These notional amounts, while one way to measure derivative activities, do not represent a precise measure of the risk associated with these instruments. In many instances, the amount at risk is much smaller than the notional amount. See Financial Derivatives: Actions Needed to Protect the Financial System, United States General Accounting Office Report to Congressional Requesters (May 1994), and Survey of Disclosures about Trading and Derivatives Activities of Banks and Securities Firms, Basle Committee on Banking Supervision (``Basle Committee'') and the Technical Committee of the International Organisation of Securities Commissions (``IOSCO'') (November 1996). \12\ Market risk is the risk of loss arising from adverse changes in market rates and prices, such as interest rates, foreign currency exchange rates, commodity prices, and other relevant market rate or price changes (e.g., equity prices). See Group of Thirty, ``Derivatives: Practices and Principles'' (July 1993), and Financial Accounting Standards Board (``FASB''), Statement of Financial Accounting Standards No. 105, ``Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk,'' (``FAS 105'') (March 1990), for similar definitions of market risk. --------------------------------------------------------------------------- During 1994 and 1995, the SEC staff reviewed annual reports filed with the Commission by approximately 500 registrants to better understand this emerging issue. In reviewing the annual reports, the staff intended to (i) assess the quality of current disclosures about market risk sensitive instruments, (ii) improve the quality of those disclosures through the comment process, and (iii) determine what, if any, additional disclosures are needed to help investors better assess the market risk inherent in those instruments. After reviewing the annual reports, the SEC staff noted that the 1995 disclosures were more informative than the 1994 disclosures, in part because of improved FASB disclosure guidance.13 However, the staff observed three significant disclosure deficiencies, which are described in section II of this release. To address those deficiencies: \13\ See FASB, Statement of Financial Accounting Standards No. 119, ``Disclosures about Derivative Financial Instruments and Fair Value of Financial Instruments,'' (``FAS 119'') (October 1994). --------------------------------------------------------------------------- 1. The Commission is amending Rule 4-08 of Regulation S-X and Item 310 of Regulation S-B to require enhanced descriptions of accounting policies for derivatives in the footnotes to the financial statements.14 --------------------------------------------------------------------------- \14\ Those disclosure requirements are applicable only to derivatives; the requirements do not relate to other financial instruments. Accounting policy disclosure requirements for other financial instruments are prescribed by existing generally accepted accounting principles and Commission guidance (see, e.g., American Institute of Certified Public Accountants (``AICPA''), Accounting Principles Board Opinion No. 22, ``Disclosure of Accounting Policies,'' (``APB 22'') (April 1972). --------------------------------------------------------------------------- 2. The Commission is amending Regulation S-K to add Item 305 and Form 20-F to add Item 9A. Those amendments require disclosure of quantitative and qualitative information about market risk for derivatives and other financial instruments 15 and require that those disclosures be presented outside the financial statements.16 --------------------------------------------------------------------------- \15\ Items 305 and 9A do not pertain solely to derivatives, but also to other financial instruments. Thus, disclosures under those Items are required for registrants that have material amounts of other financial instruments, even when they have no derivatives. Items 305 and 9A also encourage registrants to include other market risk sensitive instruments, positions, and transactions (such as commodity positions, derivative commodity instruments that are not permitted by contract or business custom to be settled in cash or with another financial instrument, and cash flows from anticipated transactions) within the scope of their quantitative and qualitative disclosures about market risk. Registrants that select the sensitivity analysis or value at risk disclosure alternatives and voluntarily include those other market risk sensitive instruments, positions, and transactions within their quantitative disclosures about market risk are permitted to present comprehensive market risk disclosures, which reflect the combined effect of both the required and voluntarily selected instruments, positions, and transactions (see section III B.1.c.(vi) for details). Finally, if those other market risk sensitive instruments, positions, and transactions are not voluntarily included in the quantitative disclosures about market risk and, as a result, the disclosures do not fully reflect the net market risk exposures of the registrant, Items 305(a) and 9A(a) require that registrants discuss the absence of those items as a limitation of the disclosed market risk information. \16\ The term ``financial statements'' includes the footnotes to the financial statements. Therefore, the disclosures should be presented outside of the footnotes to the financial statements. See section III B.4.b., infra, for a more complete discussion about where these disclosures should appear. --------------------------------------------------------------------------- a. Items 305(a) and 9A(a) require registrants to disclose quantitative information about market risk sensitive instruments using one or more of the following alternatives: i. Tabular presentation of fair value information and contract terms relevant to determining future cash flows, categorized by expected maturity dates; ii. Sensitivity analysis expressing the potential loss in future earnings, fair values, or cash flows from selected hypothetical changes in market rates and prices; or iii. Value at risk disclosures expressing the potential loss in future earnings, fair values, or cash flows from market movements over a selected period of time and with a selected likelihood of occurrence. In preparing this quantitative information, registrants should categorize market risk sensitive instruments into instruments entered into for trading purposes 17 and instruments entered into for purposes other than trading. Within both the trading and other than trading portfolios, separate quantitative information should be presented for each market risk exposure category (i.e., interest rate risk, foreign currency exchange rate risk, commodity price risk, and other relevant market risks, such as equity price risk), to the extent material. Registrants may use different disclosure alternatives for each of the separate disclosures. --------------------------------------------------------------------------- \17\ For purposes of this release, the term ``trading purposes'' has the same meaning as defined by generally accepted accounting principles (see, e.g., FAS 119 para. 9a). --------------------------------------------------------------------------- b. Items 305(b) and 9A(b) require registrants to disclose qualitative information about market risk. Those items require disclosure of: i. a registrant's primary market risk exposures 18 at the end of the current reporting period; --------------------------------------------------------------------------- \18\ See note 58, infra, for a definition specifying how the term ``primary market risk exposures'' is used in this release. --------------------------------------------------------------------------- ii. how the registrant manages those exposures (such as a description of the objectives, general strategies, and instruments, if any, used to manage those exposures); and iii. changes in either the registrant's primary market risk exposures or how those exposures are managed, when compared to the most recent reporting period and what is known or expected in future periods. c. Items 305 and 9A state that forward looking disclosures made pursuant to those items are within the statutory safe harbor under the Securities Act of 1933 and Securities Exchange Act of 1934. 3. The Commission reminds registrants that, when they provide disclosures about financial instruments, commodity positions, firm commitments, and anticipated transactions 19 (``reported items''), disclosures about derivatives that directly or indirectly affect such reported items also are required, to the extent the effects of such information are material and necessary to prevent the disclosures about the reported items from being misleading. \19\ For purposes of this release, ``anticipated transactions'' means transactions (other than transactions involving existing assets or liabilities or transactions necessitated by existing firm commitments) an enterprise expects, but is not obligated, to carry out in the normal course of business (see, e.g., para. 9 of FASB, Statement of Financial Accounting Standards No. 80, ``Accounting for Futures Contracts,'' (``FAS 80'') (August 1984)). --------------------------------------------------------------------------- The amendments in Rule 4-08(n) and Item 310 relating to accounting policy disclosures apply to registered investment companies and small business issuers, among other registrants. In contrast, Item 305 and Item 9A do not apply to registered investment companies and small business issuers. However, if market risk represents a material known risk or uncertainty, small business issuers, like other registrants, will continue to be required to discuss those risks and uncertainties to the extent required by Management's Discussion & Analysis (``MD&A''). 20 --------------------------------------------------------------------------- \20\ See, e.g., Item 303 of Regulation S-B, 17 CFR 228.303, and Item 303 of Regulation S-K, 17 CFR 229.303. --------------------------------------------------------------------------- The amendments become effective over the next several months to provide registrants with time to respond to the new disclosure requirements. Rule 4-08(n) and the amendment to Item 310 will be effective for filings with the Commission that include financial statements for fiscal periods ending after June 15, 1997. For registrants that are likely to have experience with measuring market risk, such as banks, thrifts, and non-bank and non-thrift registrants with market capitalizations on January 28, 1997 in excess of $2.5 billion, Item 305 and Item 9A are effective for filings with the Commission that include annual financial statements for fiscal years ending after June 15, 1997. For other registrants, Item 305 and Item 9A are effective for filings with the Commission that include annual financial statements for fiscal years ending after June 15, 1998. Under Item 305 and Item 9A, interim information is [[Page 6046]] not required until after the first fiscal year end in which those Items are effective. Taken together, Rule 4-08(n), Item 310, Item 305, and Item 9A represent one step by the Commission to improve disclosures about market risk to help investors better understand and evaluate a registrant's market risk exposures. The Commission recognizes the evolving nature of market risk sensitive instruments, market risk measurement systems, and market risk management strategies and, thus, intends to continue considering how best to meet the information needs of investors. In this regard, the Commission expects to monitor continuously the effectiveness of the new rules and final disclosure items issued today, as well as the need for additional proposals. Specifically, the Commission expects to reconsider these amendments after each of the following: (i) Issuance of a new accounting standard for derivatives by the FASB; 21 (ii) development in the marketplace of new generally accepted methods for measuring market risk; and (iii) a period of three years from the initial effective date of Item 305 and Item 9A. --------------------------------------------------------------------------- \21\ The FASB currently is working on a project to improve accounting recognition, measurement, and related disclosures for derivatives. --------------------------------------------------------------------------- II. Initiatives Regarding Disclosures About Derivatives and Market Risk Certain private sector organizations expressed concerns that users of financial reports are dissatisfied with current disclosures about market risk sensitive instruments. For example, the Association for Investment Management and Research (``AIMR''), an organization of financial analysts, noted that users of financial information ``are confounded by the * * * complexity of financial instruments.'' 22 In addition, after considerable investigation into the needs of investors and creditors, the American Institute of Certified Public Accountants' (``AICPA'') Special Committee on Financial Reporting stated: \22\ See AIMR, Financial Reporting in the 1990s and Beyond, page 30, (1993). --------------------------------------------------------------------------- Users are confused. They complain that business reporting is not answering important questions, such as: * * * What [innovative financial] instruments has the company entered into, and what are their terms? How has the company accounted for those instruments, and how has that accounting affected the financial statements? What risks has the company transferred or taken on? 23 \23\ See AICPA Special Committee on Financial Reporting, Improving Business Reporting--A Customer Focus: Meeting the Information Needs of Investors and Creditors, at 76 (1994). --------------------------------------------------------------------------- In addition to identifying disclosure shortcomings, other organizations recommended improvements to disclosures about market risk sensitive instruments. These organizations include regulators, such as the General Accounting Office, 24 Group of 10 Central Bankers, 25 the Federal Reserve Bank of New York, 26 the Basle Committee and the Technical Committee of IOSCO, 27 and private sector bodies, such as the Group of Thirty 28 and a task force of the Financial Executives Institute (``FEI''). 29 --------------------------------------------------------------------------- \24\ See General Accounting Office, Financial Derivatives: Actions Taken or Proposed Since May 1994 (November 1996). \25\ See Bank for International Settlements, A Discussion Paper on Public Disclosure of Market and Credit Risks by Financial Intermediaries, prepared by working group of the Euro-currency Standing Committee of the Central Banks of the Group of Ten Countries (September 1994). \26\ See Federal Reserve Bank of New York, Public Disclosure of Risks Related to Market Activity: A Discussion Paper (November 1994). \27\ See Basle Committee and the Technical Committee of IOSCO, Framework for Supervisory Information about the Derivatives Activities of Banks and Securities Firms (May 1995). See also Basle Committee and the Technical Committee of IOSCO, Public Disclosure of the Trading and Derivatives Activities of Banks and Securities Firms (November 1995). \28\ See Group of Thirty, Derivatives: Practices and Principles (July 1993). \29\ See FEI, Derivative Financial Instruments Accounting and Disclosure Issues, (``FEI Report'') prepared by FEI CCF/CCR Derivatives Disclosure Task Force (August 1994). --------------------------------------------------------------------------- In general, those organizations stressed the need to make the risks inherent in market risk sensitive instruments more understandable. To that end, many recommended additional quantitative and qualitative disclosures about market risk. For example, the Federal Reserve Bank of New York recommended a new financial statement providing quantitative information about the overall market risk of an entity.30 In addition, the FEI task force recommended that companies ``disclose some type of information which conveys overall exposure to market risk.'' 31 The FEI task force specifically suggested two distinct approaches. One approach is to provide a high-level summary of relevant statistics about outstanding activity in market risk sensitive instruments at period end. The second approach is to communicate the potential loss that could occur under specified conditions using either value at risk or another comprehensive model for measuring market risk.32 --------------------------------------------------------------------------- \30\ See note 26, supra. \31\ See Attachment A, page 1 of FEI Report. \32\ See Attachment B, pages 5 and 6 of FEI Report. --------------------------------------------------------------------------- In October 1994, the FASB, responding in part to calls for improved disclosure, issued FAS 119 (October 1994).33 Among other things, FAS 119 prescribes disclosures in the financial statements about the policies used to account for derivative financial instruments and a discussion of the nature, terms, and cash requirements of derivative financial instruments. FAS 119 also encourages, but does not require, disclosure of quantitative information about an entity's market risk exposures.34 --------------------------------------------------------------------------- \33\ Similar standards were recently adopted by the International Accounting Standards Committee, the Canadian Institute of Chartered Accountants, and the Australian Accounting Standards Board. See International Accounting Standards No. 32, ``Financial Instruments: Disclosure and Presentation,'' (``IAS 32'') (March 1995), Section 3860 of the Handbook of the Canadian Institute of Chartered Accountants, and the Australian Accounting Standards Board's accounting standard entitled, ``Presentation and Disclosure of Financial Instruments,'' (December 1996), respectively. \34\ See FAS 119 para. 12. --------------------------------------------------------------------------- During 1994, in response, in part, to the concerns of investors, regulators, and private sector entities, the SEC staff reviewed the annual reports of approximately 500 registrants. In addition, during 1995 the SEC staff reviewed more recent annual reports to assess the effect of FAS 119 on disclosures about market risk sensitive instruments. In comparing the 1994 and 1995 annual reports, the SEC staff observed that FAS 119 had a positive effect on the quality of disclosures about derivative financial instruments. However, the staff concluded that investors still needed improved disclosures about market risk sensitive instruments. In particular, the SEC staff identified three primary disclosure issues: 1. Footnote disclosures of accounting policies for derivatives often were too general to convey adequately the diversity in accounting that exists for derivatives. Thus, it often was difficult to determine the impact of derivatives on registrants' statements of financial position, cash flows, and results of operations. 2. Disclosures about different types of market risk sensitive instruments often were reported separately. Thus, it was difficult to assess the aggregate market risk exposures inherent in these instruments. 3. Disclosure about reported items in the footnotes to the financial statements, MD&A, schedules, and selected financial data may not have reflected adequately the effect of derivatives on such reported items. Thus, information about the reported items may have been incomplete and could be misleading. The Commission designed Rule 4-08(n), Item 310, Item 305, and Item 9A to address these issues. In forming these requirements, the Commission used the following guiding principles: Disclosures should make transparent the impact of derivatives on [[Page 6047]] a registrant's statements of financial position, cash flows, and results of operations; Disclosures should provide information about a registrant's exposures to market risk; Disclosures should explain how market risk sensitive instruments are used in the context of the registrant's business; Disclosures about market risk exposures should not focus on derivatives in isolation, but rather should reflect the risk of loss inherent in all market risk sensitive instruments; Market risk disclosure requirements should be flexible enough to accommodate different types of registrants, different degrees of market risk exposure, and alternative ways of measuring market risk; Disclosures about market risk should address, where appropriate, special risks relating to leverage, option, or prepayment features; and New disclosure requirements should build on existing requirements, where possible, to minimize compliance costs. III. Discussion of Amendments A. Disclosure of Accounting Policies for Derivatives 1. Background During the last several years, a significant number of issues relating to the accounting for derivatives have been raised. The FASB is working on a project that will address comprehensively the accounting for derivatives. However, currently there is little authoritative literature on the accounting for options and complex derivatives.35 --------------------------------------------------------------------------- \35\ The authoritative accounting literature for options and complex derivatives generally is limited to a few consensuses from the FASB Emerging Issues Task Force (``EITF''), which by their nature address the accounting for specific transactions. See, e.g., EITF Issues 88-8, ``Mortgage Swaps,'' and 90-17, ``Hedging Foreign Currency Risks with Purchased Options.'' --------------------------------------------------------------------------- In the absence of comprehensive accounting literature, registrants have developed accounting practices for options and complex derivatives by analogy to the limited amount of literature that does exist. Those analogies are complicated because, under existing accounting literature, there are at least three distinctly different methods of accounting for derivatives (e.g., fair value accounting, deferral accounting, and accrual accounting).36 Further, the underlying concepts and criteria used in determining the applicability of those accounting methods are not consistent.37 As a result, during its 1994 and 1995 reviews of annual reports, the SEC staff observed that registrants with similar risk management objectives often accounted for derivatives with similar economic characteristics in different ways.38 Thus, it was difficult to ascertain and compare the financial statement effects of derivatives among registrants. --------------------------------------------------------------------------- \36\ Under the fair value method, derivatives are carried on the balance sheet at fair value with changes in that value recognized in earnings or stockholders' equity (see, e.g., FASB, Statement of Financial Accounting Standards No. 52, ``Foreign Currency Translation,'' (``FAS 52'') (December 1981), and FAS 80. Under the deferral method, gains and losses from derivatives are deferred on the balance sheet and recognized in earnings in conjunction with earnings of designated items (see, e.g., FAS 52 and FAS 80). Under the accrual method, each net payment/receipt due or owed under the derivative is recognized in earnings during the period to which the payment/receipt relates; there is no recognition on the balance sheet for changes in the derivative's fair value (see, e.g., EITF Issue 84-36, ``Interest Rate Swap Transactions''). \37\ For example, the risk reduction criterion in FAS 52 is different from the risk reduction criterion in FAS 80. FAS 52 specifies risk reduction on a transaction basis, while FAS 80 specifies risk reduction on an enterprise basis. In addition, FAS 80 permits the use of deferral accounting for futures contracts used to hedge probable, but not firmly committed, anticipated transactions, while FAS 52 prohibits deferral accounting for foreign currency forward exchange contracts used to hedge those same types of anticipated transactions. \38\ The Commission does not mean to imply by this statement that registrants may justify the use of any method of accounting for derivatives. Registrants must select appropriate accounting methods that are consistent with generally accepted accounting principles. In particular, generally accepted accounting principles require registrants using derivatives for trading, dealing, or speculative purposes to recognize those instruments on the balance sheet at fair value and to recognize changes in that value immediately in earnings (see, e.g., FAS 80 para. 3). --------------------------------------------------------------------------- To provide a better understanding of the accounting for derivative financial instruments, paragraph 8 of FAS 119 requires disclosure of the policies used to account for those instruments, pursuant to the requirements of APB 22.39 Specifically, FAS 119 emphasizes the disclosure of ``policies for recognizing (or not recognizing) and measuring derivative financial instruments * * * and when recognized, where those instruments and related gains and losses are reported in the statements of financial position and income.'' 40 Notwithstanding its helpful guidance, FAS 119 does not explicitly indicate the type of information that should be included in the accounting policies footnote to help investors understand the effects of derivatives on the statements of financial position, cash flows, and results of operations. FAS 119 also does not address disclosure of accounting policies for derivative commodity instruments. --------------------------------------------------------------------------- \39\ APB 22 para. 12 states: Disclosure of accounting policies should identify and describe the accounting policies followed by the reporting entity and the methods of applying those principles that materially affect the determination of financial position, cash flows or results of operations. In general, the disclosure should encompass important judgments as to the appropriateness of principles relating to recognition of revenue and allocation of asset costs to current and future periods; in particular, it should encompass those accounting principles and methods that involve * * * a selection from existing acceptable alternatives. The Accounting Principles Board was the predecessor to the FASB. Unless superseded by FASB Statements, APB Opinions continue to be regarded as the highest level of generally accepted accounting principles followed by the accounting profession. See generally AICPA, Statements on Auditing Standards No. 69, ``The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles in the Independent Auditor's Report,'' para. 5 (March 1992); AU Sec. 411.05. \40\ See FAS 119 para. 60. --------------------------------------------------------------------------- 2. Rule 4-08(n) of Regulation S-X and Item 310 of Regulation S-B To facilitate a more informed assessment of the effects of derivatives on financial statements, Rule 4-08(n) and Item 310 explicitly require that seven items be disclosed in the derivatives accounting policies footnote, when material. For example, Rule 4-08(n) and Item 310 require a description of the methods used to account for derivatives, the types of derivatives accounted for under each method, and the criteria required to be met for each accounting method used. See Rule 4-08(n) and Item 310 for further requirements. When assessing materiality under Rule 4-08(n) and Item 310, the Commission expects registrants to consider (i) the financial statement effects of all derivatives, including those not recognized in the statement of financial position and (ii) the relative effects of using the accounting method selected as compared to the other methods available (e.g., accrual, deferral, or fair value methods of accounting). In essence, Rule 4-08(n) and Item 310 clarify how the accounting policy disclosure requirements in FAS 119 should be applied to derivative financial instruments. They also extend those requirements to derivative commodity instruments. The Commission expects to reconsider the effectiveness of and the need for the accounting policy disclosures, prescribed under Rule 4-08(n) and Item 310, when a new accounting standard for derivatives is issued by the FASB. [[Page 6048]] B. Disclosures of Quantitative and Qualitative Information About Market Risk 1. Quantitative Information About Market Risk a. Nature of Disclosures. A primary objective of the quantitative disclosure requirements is to provide investors with forward looking information about a registrant's potential exposures to market risk. These quantitative disclosures are dependent on several choices about key model characteristics and assumptions (e.g., hypothetical changes in future market rates or prices).41 By their nature, these forward looking choices are only estimates and will be different from what actually occurs in the future. As a result, actual future gains or losses will differ from those reported in the quantitative disclosures. For example, differences between actual and reported gains and losses will arise when (i) actual market rate or price changes differ from those estimated or (ii) the portfolio of market risk sensitive instruments held during the year differs from the portfolio held at the prior year-end. --------------------------------------------------------------------------- \41\ The Commission believes that the exercise of discretion in making such choices by registrants should not subject registrants to liability with respect to private rights of action. --------------------------------------------------------------------------- Notwithstanding this limitation, the Commission believes that the reported market risk information should provide benefits to both investors and registrants. The quantitative disclosures should help investors better understand specific market risk exposures of different registrants, thereby allowing them to better manage market risks in their investment portfolios. Those disclosures also should provide a mechanism, where applicable, for registrants to disclose that their use of derivatives represents risk management, rather than speculation. Those disclosures are not precise indicators of expected future reported losses. Instead, depending on the modeling technique and assumptions used, they are indicators of remote or reasonably possible losses. Nevertheless, those disclosures should provide investors with important indicators of how a particular registrant views and manages its market risk. The Commission has provided flexibility in the quantitative and qualitative disclosure requirements to accommodate different types of registrants, different degrees of market risk exposure, and alternative ways of measuring market risk. The Commission believes, at this time, that such flexibility is necessary and important to allow risk management and reporting practices to evolve, even though such flexibility is likely to reduce the comparability of disclosures. To address this comparability issue, registrants are required to disclose the key model characteristics and assumptions used in preparing the quantitative market risk disclosures. These disclosures are designed to allow investors to evaluate the potential impact of variations in those model characteristics and assumptions on the reported information. In addition, as more standard risk management practices and methods of reporting market risk are developed, the Commission anticipates reviewing the disclosure requirements with the view to enhancing comparability. b. Background. Market risk is inherent in derivative and non- derivative instruments, including: Derivative financial instruments--futures, forwards, swaps, options, and other financial instruments with similar characteristics; Other financial instruments--non-derivative financial instruments, such as investments, loans, structured notes, mortgage- backed securities, indexed debt instruments, interest-only and principal-only obligations, deposits, and other debt obligations; Derivative commodity instruments that are permitted by contract or business custom to be settled in cash or with another financial instrument--commodity futures, commodity forwards, commodity swaps, commodity options, and other commodity instruments with similar characteristics, to the extent such instruments are not derivative financial instruments. Generally accepted accounting principles and prior Commission rules already require disclosure of certain quantitative information pertaining to some of these instruments. For example, registrants are required to disclose notional amounts of derivative financial instruments and the nature and terms of debt obligations. 42 However, this information (i) often is abbreviated, (ii) is presented piecemeal in different parts of the financial statements, and (iii) does not apply to all market risk sensitive instruments. Thus, investors often have been unable to assess the net market risk exposures inherent in these instruments. --------------------------------------------------------------------------- \42\ See, e.g., FAS 119 para. 8b and Rule 5-02 of Regulation S- X, 17 CFR 210.5-02, respectively. --------------------------------------------------------------------------- FAS 119 encourages, but does not require, disclosure of quantitative information about the market risk exposures inherent in market risk sensitive instruments.43 However, without an explicit requirement, the Commission observed that registrants often were not making these disclosures. --------------------------------------------------------------------------- \43\ In particular, FAS 119 para. 12 lists five possible quantitative methods of measuring and disclosing market risk. They are: (i) Details about current positions and perhaps activity during the period, (ii) the hypothetical effects on equity, or on annual income, of several possible changes in market price, (iii) a gap analysis of interest rate repricing or maturity dates, (iv) the duration of the financial instruments, and (v) the entity's value at risk from derivative financial instruments and from other positions at the end of the reporting period and the average value at risk during the year. --------------------------------------------------------------------------- c. Item 305(a) of Regulation S-K and Item 9A(a) of Form 20-F. In essence, Items 305(a) and 9A(a) 44 are designed to make disclosures about market risk more comprehensive by requiring disclosures of quantitative information about market risk, similar to those encouraged by FAS 119. Items 305(a) and 9A(a) apply to market risk sensitive instruments. --------------------------------------------------------------------------- \44\ Item 9A(a) of Form 20-F, like the other portions of Item 9A, is substantively identical to related sections in Item 305. --------------------------------------------------------------------------- Under these Items, registrants should furnish quantitative information about market risk using one or more of three prescribed alternative methods.45 The three alternative methods, described in detail below, are a tabular presentation, sensitivity analysis, and value at risk. --------------------------------------------------------------------------- \45\ At the current time, the Commission is not prescribing standardized methods and procedures specifying how to comply with each of these disclosure alternatives. To facilitate comparison across registrants, however, Item 305(a) requires that registrants describe the model and assumptions used to prepare quantitative market risk disclosures. --------------------------------------------------------------------------- In preparing this quantitative information, registrants should categorize market risk sensitive instruments into instruments entered into for trading purposes and instruments entered into for purposes other than trading. Within both the trading and other than trading portfolios, separate quantitative information should be presented for each market risk exposure category (i.e., interest rate risk, foreign currency exchange rate risk, commodity price risk, and other relevant market risks, such as equity price risk), when material. A registrant may use (i) the same alternative for all market risk disclosures, (ii) one alternative, such as value at risk, for all disclosures related to instruments entered into for trading purposes, and another alternative, such as sensitivity analysis, for all disclosures related to instruments entered into for other than trading purposes, or (iii) different or the same alternatives for each category of market risk within the trading and other than trading portfolios. (i) Tabular Presentation. The tabular presentation alternative permits [[Page 6049]] registrants to provide quantitative information about market risk sensitive instruments in a tabular format. The required information includes the fair values of market risk sensitive instruments and contract terms sufficient to determine the future cash flows from those instruments, categorized by expected maturity dates. These tabular disclosures should present information sufficient to allow readers of the table to determine expected cash flows from market risk sensitive instruments for each of the next five years and the aggregate cash flows expected for the remaining years thereafter.46 These tabular disclosure requirements were selected because expected cash flows are common inputs to market risk measurement methods and, therefore, are expected to help investors make estimates of a registrant's market risk exposures. --------------------------------------------------------------------------- \46\ In some instances, the tabular presentation alternative is similar to the gap analysis commonly provided by financial institutions. Thus, with minor modifications, if any, those registrants could report a gap analysis and comply with the tabular information requirements. --------------------------------------------------------------------------- To facilitate an investor's ability to make such estimates, Items 305(a) and 9A(a) require that tabular information be grouped based on common market risk characteristics. In particular, those Items require separate presentation of tabular information for instruments: (i) Entered into for trading and other than trading purposes, (ii) subject to different categories of market risk exposure (e.g., interest rate risk, foreign currency exchange rate risk, etc.), and (iii) subject to different market risk characteristics within a particular exposure category (e.g., different functional currencies, 47 different underlying commodity exposures, different instrument types, and different contractual rates or prices). See Items 305(a)(1)(i) and 9A(a)(1)(i) for further requirements. --------------------------------------------------------------------------- \47\ For purpose of Item 305 and Item 9A, functional currency means the currency of the primary economic environment in which the entity operates; normally, that is the currency of the environment in which an entity primarily generates and expends cash. This definition is the same as the definition of functional currency in FAS 52, Appendix E. --------------------------------------------------------------------------- In particular, when preparing the tabular disclosures registrants should consider whether differences in market risk would be reflected better by separately presenting tabular information for a particular instrument or group of instruments. For example, Items 305(a)(1)(i) and 9A(a)(1)(i) require the grouping of options with similar strike prices. This grouping is required because option payouts can differ significantly depending how far the option is in or out of the money. Thus, the separate presentation of tabular information for options with dissimilar strike prices should enhance an investor's ability to determine the potential market risk inherent in those instruments. Registrants should make similar evaluations when determining which instruments should be grouped together within the tabular disclosures. Items 305(a) and 9A(a) also require disclosure of information regarding the contents of the table and related assumptions necessary to understand a registrant's market risk disclosures. In this regard, registrants should describe, for example, the different amounts reported in the table for the various categories of the market sensitive instruments (e.g., principal amounts for debt, notional amounts for swaps, and the different types of reported market rates or prices) and key prepayment or reinvestment assumptions relating to the timing of reported amounts. See Items 305(a)(1)(i) and 9A(a)(1)(i) for further details. The Appendix to each of these Items provides a sample disclosure format. (ii) Sensitivity Analysis. The sensitivity analysis disclosure alternative permits registrants to express the potential loss in future earnings, fair values, or cash flows of market risk sensitive instruments resulting from one or more selected hypothetical changes in interest rates, foreign currency exchange rates, commodity prices, and other relevant market rate or price changes (e.g., equity prices) over a selected time period. 48 Items 305(a) and 9A(a) require that registrants select hypothetical changes in market rates and prices that are expected to reflect reasonably possible 49 near-term 50 changes in those rates and prices. Absent economic justification for the selection of a different amount, registrants should use changes that are not less than 10 percent of end of period market rates or prices. --------------------------------------------------------------------------- \48\ The term ``sensitivity analysis,'' as used in Items 305(a) and 9A(a), describes a general class of models that assesses the risk of loss in market risk sensitive instruments based on hypothetical changes in market rates or prices. The term sensitivity analysis is not meant to refer to any one model for quantifying market risk. Sensitivity analysis models include, for example, duration analysis or other ``sensitivity'' measures already required to be calculated for regulatory purposes for thrift institutions (see Office of Thrift Supervision, Regulatory Capital: Interest Rate Risk Component, 12 CFR 567.5(c)(4) (August 1993)). \49\ See note 67, infra, for a definition of the term ``reasonably possible.'' \50\ See note 66, infra, for a definition of the term ``near- term.'' --------------------------------------------------------------------------- Items 305(a) and 9A(a) also require a description of the model, assumptions, and parameters underlying the registrant's sensitivity analysis that are necessary to understand the registrant's market risk disclosure. In this regard, registrants are required to specify, for example, (i) how ``loss'' is defined by the model (e.g., loss in earnings, fair values, or cash flows), (ii) a general description of the modeling technique (e.g., the change in net present values arising from selected shifts in market rates or prices), (iii) the types of instruments covered by the model, and (iv) other relevant information about the model's assumptions and parameters (e.g., the magnitude and timing of selected hypothetical changes in market rates or prices used). See Items 305(a)(1)(ii) and 9A(a)(1)(ii) for further requirements. (iii) Value at Risk. The value at risk disclosure alternative permits registrants to express the potential loss in future earnings, fair values, or cash flows of market risk sensitive instruments over a selected period of time, with a selected likelihood of occurrence, from changes in interest rates, foreign currency exchange rates, commodity prices, and other relevant market rates or prices. 51 Items 305(a) and 9A(a) state that when preparing value at risk disclosures, registrants should select confidence intervals that reflect reasonably possible near-term changes in market rates and prices. In this regard, absent economic justification for the selection of different confidence intervals, registrants should use intervals that are 95 percent or higher. --------------------------------------------------------------------------- \51\ The term ``value at risk,'' as used in Items 305(a) and 9A(a), describes a general class of models that provides a probabilistic assessment of the risk of loss in market risk sensitive instruments. The term value at risk is not meant to refer to any one model for quantifying market risk. Value at risk models can be adapted to non-trading activities as well as trading activities and to non-financial institutions as well as financial institutions, depending on the model and assumptions selected by the registrant. --------------------------------------------------------------------------- For each category for which value at risk disclosures are presented, Items 305(a) and 9A(a) require registrants to provide either (i) the average, high and low amounts, or the distribution of value at risk amounts for the reporting period, (ii) the average, high and low amounts, or the distribution of actual changes in fair values, earnings, or cash flows from market risk sensitive instruments occurring during the reporting period, or (iii) the percentage or number of times the actual changes in fair values, earnings, or cash flows from market risk sensitive instruments exceeded the value at risk amounts during the reporting period. Items 305(a) and 9A(a) also require a description of the model, assumptions, and parameters underlying the [[Page 6050]] registrant's value at risk model that are necessary to understand the registrant's market risk disclosure. In this regard, registrants should specify, for example, (i) how ``loss'' is defined by the model (e.g., loss in earnings, fair values, or cash flows), (ii) the type of model used (e.g., variance/covariance, historical simulation, or Monte Carlo simulation and a description as to how optionality is addressed by the model), (iii) the types of instruments covered by the model, and (iv) other relevant information about the model's assumptions and parameters (e.g., holding periods and confidence intervals). 52 See Items 305(a)(1)(iii) and 9A(a)(1)(iii) for further requirements. --------------------------------------------------------------------------- \52\ The primary differences between the value at risk and sensitivity analysis disclosure alternatives are (i) value at risk analysis reports the potential loss arising from equally likely market movements across instruments, while sensitivity analysis reports the potential loss arising from hypothetical market movements with differing likelihoods of occurrence across instruments and (ii) value at risk explicitly adjusts the potential loss to reflect correlations between market movements, while sensitivity analysis is not designed explicitly to make such adjustments. --------------------------------------------------------------------------- (iv) An Alternative to Reporting Year-End Information. Items 305(a) and 9A(a) require disclosure of quantitative information about market risk as of the end of the latest fiscal year. Alternatively, registrants, such as those with proprietary concerns about reporting year-end information under the sensitivity analysis and value at risk disclosure alternatives, may report the average, high, and low amounts for the reporting period. In determining those average, high, and low amounts for the fiscal year, registrants should use sensitivity analysis or value at risk amounts relating to at least four equal time periods throughout the reporting period (e.g., four quarter-end amounts, 12-month-end amounts, or 52 week-end amounts). (v) Other Disclosure Requirements. Items 305(a) and 9A(a) require registrants to provide summarized quantitative information about market risk for the preceding fiscal year. In addition, registrants should discuss the reasons for material quantitative changes in market risk exposures between the current and preceding fiscal years.53 In determining the amount and type of summarized information to be provided for the preceding fiscal year, registrants should evaluate whether sufficient information is disclosed to enable investors to assess material trends in quantitative market risk information. This summary should include information relating to each market risk exposure category disclosed in the preceding or latest fiscal year. --------------------------------------------------------------------------- \53\ For transition purposes, quantitative disclosures about market risk provided in the initial year in which a registrant must present information under Item 305 is not required to contain comparable summarized information for the preceding year. Similarly, in the first fiscal year in which a registrant must present information under Item 305, a discussion of the reasons for material changes in reported amounts as compared to the preceding year is not necessary. --------------------------------------------------------------------------- In addition, Items 305(a) and 9A(a) permit registrants to change disclosure alternatives or key model characteristics, assumptions, and parameters used in providing quantitative information about market risk (e.g., changing from tabular presentation to value at risk, changing the scope of instruments included in the model, changing the definition of loss from fair values to earnings). However, if the effects of such a change are material,54 registrants should (i) explain the reasons for the change and (ii) either provide summarized comparable information, under the new disclosure method, for the year preceding the current reporting period or, in addition to providing disclosure for the current year under the new method, provide disclosure for the current year and preceding fiscal year under the method used in the preceding year. --------------------------------------------------------------------------- \54\ In this regard, the Commission believes that all changes from one disclosure alternative to another are material; however, other changes discussed in this section require judgment as to whether the effects of such changes are material. --------------------------------------------------------------------------- (vi) Encouraged Disclosures. The Commission recognizes that market risk exposures may exist in instruments, positions, and transactions other than in the market risk sensitive instruments specifically covered by Items 305 and 9A. In particular, market risk, in its broadest view, also may be inherent in the following items: Derivative commodity instruments that are not permitted by contract or business custom to be settled in cash or with another financial instrument--such as a commodity forward contract that must be settled in the commodity; Commodity positions--such as investments in corn, wheat, oil, gas, lumber, silver, gold, and other commodity inventory positions; Cash flows from anticipated transactions 55--such as cash flows from anticipated purchases and sales of inventory, and operating cash flows from non-financial and non-commodity instruments (e.g., cash flows generated by manufacturing activities); and --------------------------------------------------------------------------- \55\ See note 19, supra. --------------------------------------------------------------------------- Certain financial instruments not included among the required disclosure items--such as insurance contracts, lease contracts, and employers' and plans' obligations for pension and other post-retirement benefits. The Commission also recognizes, however, that the amount and timing of the cash flows inherent in such instruments, positions, and transactions sometimes may be difficult to estimate. In addition, it has been represented to the staff that many risk measurement systems currently do not include such instruments, positions, and transactions in their quantitative assessments of market risk. For these practical reasons, the Commission is not requiring, at this time, that these items be included in the quantitative disclosures about market risk. Registrants, however, are encouraged to include such items within their quantitative market risk disclosures. Registrants that choose the tabular presentation disclosure alternative should present voluntarily selected instruments, positions, or transactions in a manner consistent with the requirements in Items 305 and 9A for market risk sensitive instruments. Registrants selecting the sensitivity analysis or value at risk disclosure alternatives are not required to provide separate market risk disclosures for any voluntarily selected instruments, positions, or transactions. Instead, registrants selecting those disclosure alternatives are permitted to present comprehensive market risk disclosures, which reflect the combined market risk exposures inherent in both the required and any voluntarily selected instruments, position, or transactions. If a registrant elects to include voluntarily a particular type of instrument, position, or transaction in their quantitative disclosures about market risk, that registrant should include all, rather than some, of those instruments, positions, or transactions within their disclosures. For example, if a registrant holds in inventory a particular type of commodity position and elects to include that commodity position within their market risk disclosures, the registrant should include the entire commodity position, rather than only a portion thereof, in their quantitative disclosures about market risk. Finally, if instruments, positions, or transactions are not included voluntarily in the market risk disclosures and, as a result, the disclosures do not fully reflect the net market risk exposures of the registrant, the registrant should discuss the absence of those items as a limitation of the quantitative information, as discussed below.56 --------------------------------------------------------------------------- \56\ In addition, registrants should review the requirements of Item 303 of Regulation S-K, 17 CFR 229.303, to ensure their disclosures are sufficient to inform readers of material risks to which a registrant is exposed. --------------------------------------------------------------------------- [[Page 6051]] (vii) Limitations. Items 305(a) and 9A(a) require registrants to discuss limitations that cause the quantitative information about market risk not to reflect fully the net market risk exposures of the entity. This discussion is to include a description of instruments, positions, and transactions omitted from the quantitative market risk disclosure information, or the features of instruments, positions, and transactions that are included, but not reflected fully in the quantitative information disclosed. Two illustrative examples are provided. First, as just stated, certain instruments, positions, and transactions are excluded from the required quantitative disclosures about market risk, but may be included on a voluntary basis. The failure of a registrant to include voluntarily those instruments, positions, or transactions in the quantitative disclosures is a limitation of the quantitative information provided. This limitation should be discussed, if material, and a summarized description of the instruments, positions, or transactions not reflected fully within the quantitative market risk disclosures should be disclosed. Second, the prescribed quantitative disclosures may not inform investors of the degree of market risk inherent in instruments with leverage, option, or prepayment features (e.g., options, including written options, structured notes, collateralized mortgage obligations, leveraged swaps, and options embedded in swaps). Tabular information on fair values and contract terms may not necessarily indicate that instruments have such features. Similarly, if leverage, option, or prepayment features are triggered by changes in market rates or prices outside those reflected in the value at risk and sensitivity analysis disclosures, the potential loss from such market rate or price changes may be significantly larger than would be implied by a simple linear extrapolation of the reported numbers. Thus, to make investors fully aware of the market risk inherent in instruments with such features, Item 305(a) and Item 9A(a) require a discussion of this limitation, including a summarized description of the features of the instruments causing the limitation. 2. Qualitative Information About Market Risk a. Background. The Commission believes that quantitative information about market risk is more meaningful when accompanied by qualitative disclosures about a registrant's market risk exposures and how those exposures are managed. Such qualitative disclosures help investors understand a registrant's market risk management activities and help place those activities in the context of the business. FAS 119 requires qualitative disclosures about market risk management activities associated with certain derivative financial instruments. In particular, FAS 119 requires disclosure of ``the entity's objectives for holding or issuing the derivative financial instruments, the context needed to understand those objectives, and its general strategies for achieving those objectives.'' 57 However, the qualitative disclosure requirements of FAS 119 only apply to derivative financial instruments held or issued for purposes other than trading. --------------------------------------------------------------------------- \57\ See FAS 119 para. 11a. Footnote 4 of FAS 119 illustrates the qualitative disclosures required by para. 11a. That footnote states: If an entity's objective for a derivative position is to keep a risk from the entity's non-derivative assets below a specified level, the context would be a description of those assets and their risks, and a strategy might be purchasing put options in a specified proportion to the assets at risk. --------------------------------------------------------------------------- b. Item 305(b) and Item 9A(b). Items 305(b) and 9A(b) expand the qualitative market risk disclosure requirements of FAS 119 to (i) Encompass derivative commodity instruments, other financial instruments, and derivative financial instruments entered into for trading purposes and (ii) require registrants to evaluate and describe material changes in their primary risk exposures and in how those exposures are managed. In particular, Items 305(b) and 9A(b) require a description of (i) a registrant's primary market risk exposures 58 as of the end of the latest fiscal year, (ii) how those exposures are managed (such descriptions should include, but not be limited to, a discussion of the objectives, general strategies, and instruments, if any, used to manage those exposures), and (iii) changes in either the registrant's primary market risk exposures or in how those exposures are managed, when compared to what was in effect during the most recently completed fiscal year and what is known or expected to be in effect in future reporting periods. --------------------------------------------------------------------------- \58\ For purposes of Items 305(b) and 9A(b), primary market risk exposures mean (i) the following categories of market risk: Interest rate risk, foreign currency exchange rate risk, commodity price risk, and other relevant market rate or price risks (e.g., equity price risk) and (ii) within each of these categories, the particular markets that present the primary risks of loss to the registrant. For example, if a registrant (i) has a material exposure to foreign currency exchange rate risk and, within this category of market risk, (ii) is most vulnerable to changes in dollar/yen, dollar/ pound, and dollar/peso exchange rates, the registrant should disclose those exposures. --------------------------------------------------------------------------- Items 305(b) and 9A(b) apply to market risk sensitive instruments. In addition, the qualitative disclosures required by these items should be presented separately for market risk sensitive instruments entered into for trading purposes and those entered into for purposes other than trading. Finally, to help make disclosures about market risk more comprehensive, the Commission encourages registrants to include within their qualitative disclosures about market risk, certain instruments, positions, and transactions not required under Items 305(b) and 9A(b). Those instruments, positions, and transactions include derivative commodity instruments not permitted by contract or business custom to be settled in cash or with another financial instrument, commodity positions, cash flows from anticipated transactions, and certain financial instruments not included among the required disclosure items. See Items 305(b) and 9A(b) for further requirements.59 --------------------------------------------------------------------------- \59\ See section III B.1.c.(vi), supra, for a discussion as to why these instruments are encouraged, but not required, to be included in disclosures about market risk. --------------------------------------------------------------------------- If a registrant elects not to include those instruments, positions, and transactions in its qualitative disclosures about market risk, the Commission reminds registrants to consider whether qualitative disclosures about the market risk inherent in those items would be required under (i) Items 101 or 303 of Regulation S-K 60 or (ii) Rules 12b-20 under the Securities Exchange Act of 1934 (``Exchange Act'') or 408 under the Securities Act of 1933 (``Securities Act'') 61 Item 101 of Regulation S-K requires disclosures relating to a ``Description of the Business.'' Item 303 requires discussion of known risks and uncertainties within ``Management's Discussion and Analysis.'' Rule 12b-20 under the Exchange Act and Rule 408 under the Securities Act state that registrants should include in any filings or reports any material information necessary to make statements made, in light of the circumstances, not misleading. --------------------------------------------------------------------------- \60\ See 17 CFR 228.101 and 17 CFR 228.303, respectively. \61\ See 17 CFR 240.12b-20 and 17 CFR 230.408, respectively. --------------------------------------------------------------------------- 3. Safe Harbor for Forward Looking Information In the release proposing Item 305 and Item 9A, the Commission noted its intention to consider the application of an appropriate safe harbor to the [[Page 6052]] forward looking aspects of the disclosures. Such a safe harbor subsequently was proposed for public comment,62 and the Commission is adopting that provision substantially as proposed. --------------------------------------------------------------------------- \62\ Securities Act Release No. 7280; Exchange Act Release No. 37086; File No. S7-10-96 (April 9, 1996) [61 FR 16672]. --------------------------------------------------------------------------- As adopted, the safe harbors for forward looking statements provided in Section 27A of the Securities Act and Section 21E of the Exchange Act apply to quantitative information about market risk provided outside the financial statements and related notes thereto, all of which, as described further below, is deemed to be a forward looking statement for purposes of the safe harbor, pursuant to Item 305(a) or Item 9A(a); qualitative information about market risk provided outside the financial statements and related notes thereto, pursuant to Item 305(b) or Item 9A(b); and interim information provided pursuant to Item 305(c) and Item 9A(c). As proposed, the safe harbor would have applied to information disclosed pursuant to Items 305 and 9A regardless of whether the information was set forth in the notes to the financial statements or elsewhere in a registrant's required filings. As discussed below,63 the Commission has determined that information required by Items 305 and 9A should be disclosed outside of the financial statements and related notes thereto. Similarly, as adopted, the safe harbor applies only to information located in accordance with the revised rule. --------------------------------------------------------------------------- \63\ See section III B.4.b., infra, for a discussion about where these disclosures should appear. --------------------------------------------------------------------------- The safe harbors are available with respect to the specified information, regardless of whether the issuer providing it or the type of transaction otherwise is excluded from the statutory safe harbors. For example, first-time Commission registrants and those making initial public offerings are covered by the safe harbors with respect to this specific information if all other conditions are satisfied. As is the case with the statutory safe harbors, however, the safe harbors adopted pursuant to this release apply only to a forward looking statement made by: (i) An issuer, (ii) a person acting on behalf of the issuer, (iii) an outside reviewer retained by the issuer making a statement on behalf of the issuer, or (iv) an underwriter, with respect to information provided by the issuer or information derived from information provided by the issuer. The Commission recognizes that, due to the difficult nature of the disclosures, some registrants may require assistance in preparing the information required by Items 305 and 9A. For example, registrants may need assistance from third parties with respect to compiling the required information, assessing the reasonableness of management's assumptions, or testing the mathematical computations that translate the assumptions into the required disclosures. Moreover, some registrants may wish to have outside third parties review the information prior to its disclosure. The Commission considers such assistance and reviews relating to forward looking disclosure required by Items 305 and 9A to be ``made by an outside reviewer retained by the issuer making a statement on behalf of the issuer'' under the safe harbor rule. The rule now clarifies two additional points about the application of the new safe harbor rules. First, the Commission deems all information required by paragraphs (a), (b)(1)(i), (b)(1)(iii) and (c) of Items 305 and 9A to be ``forward looking statements'' for purposes of the new safe harbor rules, except for historical facts such as the terms of particular contracts and number of market risk sensitive instruments held during or at the end of the reporting period. To the extent that information provided pursuant to paragraph (b)(1)(ii) of Items 305 and 9A includes forward looking statements, those statements would be eligible for safe harbor protection. Second, the ``meaningful cautionary statements'' prong of the safe harbors will be satisfied with respect to the Items 305(a) and 9A(a) disclosures if a registrant satisfies the requirements of those Items. In this regard, the Commission notes that Items 305(a) and 9A(a) require disclosure of both the assumptions underlying, and the limitations of, the disclosure provided. For the remainder of the information required by the new items, registrants desiring to qualify for the ``meaningful cautionary statements'' prong of the safe harbor will need to consider what information should be given to alert investors to important factors that could cause actual results to differ materially from the information given in the forward looking statements.64 --------------------------------------------------------------------------- \64\ Registrants are reminded that the safe harbor requires that forward looking statements be identified as such. --------------------------------------------------------------------------- Finally, although Item 305 and Item 9A information is not required of small business issuers (as defined by Commission rule),65 the safe harbors are available to those small issuers that voluntarily choose to disclose such information. Similarly, the safe harbors are available to non-small business issuers who voluntarily disclose information under Item 305(a) and Item 9A(a) prior to the June 15, 1997 and June 15, 1998 effective dates. --------------------------------------------------------------------------- \65\ 17 CFR part 228, et seq. --------------------------------------------------------------------------- 4. Implementation Issues Relating to Quantitative and Qualitative Disclosures About Market Risk a. Disclosure Threshold. Under Items 305 and 9A, quantitative and qualitative disclosures about market risk are required, when material, for each market risk exposure category within the trading and other than trading portfolios. For purposes of assessing materiality, registrants should evaluate both (i) the materiality of the fair values of market risk sensitive instruments outstanding as of the end of the latest fiscal year and (ii) the materiality of potential near-term 66 losses in future earnings, fair values, and cash flows from reasonably possible 67 near-term changes in market rates or prices. --------------------------------------------------------------------------- \66\ For the purposes of Item 305 and Item 9A, the term ``near- term'' means a period of time going forward up to one year from the date of the financial statements. See generally AICPA, Statement of Position 94-6, Disclosure of Certain Significant Risks and Uncertainties, at paragraph 7 (December 30, 1994). \67\ For purposes of Item 305 and Item 9A, the term ``reasonably possible'' is defined by para. 3 of FASB, Statement of Financial Accounting Standards No. 5, ``Accounting for Contingencies'' (``FAS 5'') (March 1975), which states that ``reasonably possible'' means the chance of a future transaction or event occurring is more than remote but less than likely. --------------------------------------------------------------------------- If either (i) or (ii) in the previous paragraph are material, the registrant should disclose quantitative and qualitative information about market risk, if such market risk for the particular market risk exposure category is material. However, the choice of methods, model characteristics, assumptions, and parameters used to comply with the quantitative market risk disclosures remain at the election of the registrant, provided disclosure is made regarding a material risk of loss in either earnings, fair values, or cash flows. For example, if a registrant expects a material near-term loss in fair values only, that registrant should not report quantitative market risk information in terms of earnings or cash flows, rather than fair values. In these circumstances, the registrant could, of course, make additional quantitative disclosures about the loss in earnings or cash flows, but should disclose the risk of loss in fair values. In contrast, if a registrant is required to disclose market risk information because near-term losses in future earnings, fair values, and cash [[Page 6053]] flows all are material, it may report quantitative information in terms of either earnings, fair values, or cash flows. In assessing the materiality of the fair values of market risk sensitive instruments, those fair values generally should not be netted, except to the extent allowed under FASB Interpretation No. 39, ``Offsetting of Amounts Related to Certain Contracts'' (``Interpretation 39'') (March 1992).68 For example, the fair value of assets generally should not be netted with the fair value of liabilities. Instead, the fair values of such instruments should be aggregated, without netting, for purposes of assessing materiality. --------------------------------------------------------------------------- \68\ Interpretation 39 states that it is a general principle of accounting that the offsetting of assets and liabilities in the balance sheet is improper except where a right of set off exists. Interpretation 39 defines right of set off and specifies what conditions must be met to have that right. FAS 119 para. 15(d) in disclosing the fair values of instruments also prohibits the netting of fair values, except to the extent that the offsetting of carrying amounts in the statement of financial position is permitted under Interpretation 39. --------------------------------------------------------------------------- In assessing the materiality of potential near-term losses in future earnings, fair values, or cash flows from reasonably possible near-term changes in market rates or prices, registrants should consider (i) The magnitude of past market movements, (ii) the magnitude of reasonably possible, near-term market movements, and (iii) potential losses that may arise from leverage, option, and multiplier features. b. Location of Quantitative and Qualitative Disclosures. As adopted, Items 305 and 9A require that the quantitative and qualitative market risk disclosures be placed outside the financial statements and related notes thereto. As proposed, registrants would have been permitted to disclose such information in the notes to the financial statements. Because of the evolving nature of the disclosures and the FASB's pending project on accounting for derivatives, which also will address disclosures about derivatives within the financial statements, the Commission has determined that the better course, at this time, is to require that the disclosures mandated by Items 305 and 9A be located outside of the financial statements and related notes. The Commission believes that the information required by Items 305 and 9A should be included in the annual report delivered to shareholders; consequently Rule 14a-3 of the proxy rules has been amended to include this requirement. For other documents delivered to investors, the information should be included or incorporated by reference from other Commission filings. c. Cross-Referencing of Disclosures. The Commission believes it is most meaningful to disclose together, in one location, quantitative and qualitative information relating to the same market risk exposure category. However, because market risk sensitive instruments often are used to manage known risks and uncertainties in market rates and prices, the disclosures provided under Items 305 and 9A may overlap with disclosures provided under Item 303 of Regulation S-K. To the extent that the disclosures in a registrant's MD&A satisfy the requirements of Items 305 or 9A, registrants need not repeat this information elsewhere in their filings. If this information is disclosed in more than one location, however, registrants should ensure that the resulting disclosures are meaningful to investors and provide cross-references to the locations of the related disclosures. d. Application to Registrants. Items 305 and 9A are required to be followed by many different types of registrants, including, for example, commercial and industrial companies, financial institutions, broker-dealers, service companies, business development companies, and companies registering insurance contracts, such as market-value adjusted annuities and real estate funds underlying annuity contracts. Items 305 and 9A do not apply to registered investment companies and, as described further in Section IV, small business issuers. e. Reporting Frequency. Items 305 and 9A apply to all registration statements filed under the Securities Act and all reports, proxy statements, and information statements filed under the Exchange Act that are required to include or incorporate financial statements. However, for reports that include only interim financial statements (e.g., Form 10-Qs), registrants need only present market risk information if there have been material changes in reported market risks faced by the registrant since the end of the most recent fiscal year. In these circumstances, registrants should provide a discussion and analysis that enables investors to assess the sources and effects of those material changes in market risks. IV. Applicability of Amendments A. Application to Small Business Issuers The Commission believes that because of (i) The evolving nature of these disclosures and (ii) the relative costs of complying with these disclosures for small business issuers,69 it is appropriate, at this time, to exempt small business issuers from disclosing quantitative and qualitative information about market risk.70 --------------------------------------------------------------------------- \69\ ``Small business issuer'' is defined to mean any entity that (1) Has revenues of less than $25,000,000, (2) is a United States or Canadian issuer, (3) is not an investment company, and (4) if a majority owned subsidiary, the parent corporation is also a small business issuer. An entity is not a small business issuer, however, if it has a public float (the aggregate market value of the outstanding securities held by non-affiliates) of $25,000,000 or more. See 17 CFR 230.405. \70\ Small business issuers will not be required to provide these market risk disclosures whether or not they file on specially designated small business forms. In addition, as noted elsewhere in this release, the Commission has extended the safe harbor for forward looking information to Item 305 disclosures that are made voluntarily by small business issuers. --------------------------------------------------------------------------- Accordingly, at this time, the Commission is not adopting amendments to Regulation S-B to incorporate an item similar to Item 305. Small business issuers, however, are required (i) To comply with the amendment regarding accounting policies disclosures for derivatives, (ii) to comply with Rule 12b-20 under the Exchange Act and Rule 408 under the Securities Act, which require registrants to provide additional information about the material effects of derivatives on other information expressly required to be filed with the Commission, and (iii) to the extent market risk represents a known trend, event, or uncertainty, to discuss the impact of market risk on past and future financial condition and results of operations, pursuant to Item 303 of Regulation S-B. B. Application to Foreign Private Issuers Item 9A of Form 20-F requires disclosure by all foreign private issuers of quantitative and qualitative information about market risk. In addition, foreign private issuers that prepare financial statements in accordance with Item 18 of Form 20-F are required to provide all information required by U.S. generally accepted accounting principles and Regulation S-X, including descriptions in the footnotes to the financial statements of the policies used to account for derivatives. Foreign private issuers that prepare financial statements in accordance with Item 17 of Form 20-F are not required to provide financial statement disclosures required by U.S. generally accepted accounting principles and Regulation S-X. The amendments requiring disclosures of accounting policies in Rule 4-08(n) of Regulation S-X do not apply to foreign private issuers filing under Item 17 of Form 20-F. However, foreign private [[Page 6054]] issuers filing under Item 17 of Form 20-F should consider the guidance presented in Staff Accounting Bulletin Topic 1:D (``SAB Topic 1:D'') to determine if information regarding accounting policies for derivatives should be provided in MD&A.71 --------------------------------------------------------------------------- \71\ SAB Topic 1:D provides several examples of disclosures in MD&A that might be necessary to enable readers to understand the financial statements as a whole. One of those example disclosures includes significant accounting policies and measurement assumptions which may bear upon an understanding of operating trends or financial condition. --------------------------------------------------------------------------- C. Scope and Definition of Instruments The instructions to Rule 4-08(n), Item 305, and Item 9A define financial instruments, derivative financial instruments, other financial instruments, and derivative commodity instruments as follows. ``Financial instruments'' have the same meaning as defined by generally accepted accounting principles (see, e.g., FASB, Statement of Financial Accounting Standards No. 107, ``Disclosures about Fair Value of Financial Instruments,'' (``FAS 107'') paragraphs 3 and 8 (December 1991)). ``Derivative financial instruments'' are a subset of financial instruments and include futures, forwards, swaps, options, and other financial instruments with similar characteristics, as defined by generally accepted accounting principles (see, e.g., FAS 119 paragraphs 5-7 (October 1994)). See, the General Instructions to Paragraphs 305(a) and 305(b) of Item 305 or the General Instructions to Paragraphs 9A(a) and 9A(b) of Item 9A for further details. Other financial instruments include all financial instruments that must be disclosed at fair value under FAS 107, except for derivative financial instruments, as defined above. For example, other financial instruments include trade accounts receivable, investments, loans, structured notes, mortgage-backed securities, trade accounts payable, indexed debt instruments, interest-only and principal-only obligations, deposits, and other debt obligations. However, for purposes of this release, trade accounts receivable and trade accounts payable need not be considered other financial instruments when their carrying amounts approximate fair value. Other financial instruments exclude employers' and plans' obligations for pension and other post-retirement benefits, substantively extinguished debt, insurance contracts, lease contracts, warranty obligations and rights, unconditional purchase obligations, investments accounted for under the equity method, minority interests in consolidated enterprises, and equity instruments issued by the registrant and classified in stockholders' equity in the statement of financial position. Derivative commodity instruments include, to the extent such instruments are not derivative financial instruments, commodity futures, commodity forwards, commodity swaps, commodity options, and other commodity instruments with similar characteristics, that are permitted by contract or business custom to be settled in cash or with another financial instrument. Thus, the instrument definitions described above do not encompass (i) commodity positions, (ii) derivative commodity instruments that are not permitted by contract or business custom to be settled in cash or with another financial instrument (e.g., a commodity forward contract that must be settled in the commodity), (iii) cash flows from anticipated transactions, (e.g., operating cash flows from non- financial and non-commodity instruments), and/or (iv) certain financial instruments not included among the required disclosure items.72 --------------------------------------------------------------------------- \72\ See section III B.1.c.(vi), supra, for a further description of the instruments, positions, and transactions described in this paragraph. --------------------------------------------------------------------------- V. Disclosure of the Effects of Derivative Instruments on Disclosures about Financial Instruments, Commodity Positions, Firm Commitments, and Anticipated Transactions In conjunction with the adoption of Items 305 and 9A, the Commission reminds registrants that other reporting obligations also require certain disclosures about derivatives. The staff's 1994 and 1995 reviews of registrant filings suggested that some registrants are not providing sufficient disclosure about how derivatives directly or indirectly affect reported items. As a result, those disclosures may not have reflected as well as they otherwise might have such matters as the effective terms or expected cash flows of the derivatives and reported items. It is fundamental that registrants include in any filings or reports any material information necessary to make statements made, in light of the circumstances, not misleading.73 That is, registrants should provide disclosure about derivatives that affect, directly or indirectly, the terms, fair values, or cash flows of the reported items. This includes derivative transactions that are designated to reported items under generally accepted accounting principles.74 --------------------------------------------------------------------------- \73\ See, e.g., Rule 12b-20 under the Exchange Act and Rule 408 under the Securities Act. \74\ See, e.g., FAS 52 para. 21a and FAS 80 para. 4a. --------------------------------------------------------------------------- Thus, for example, information required to be disclosed in the footnotes to the financial statements about the interest rates and repricing characteristics of debt obligations should include, when material, information about the effects of derivatives. Similarly, summary information and disclosures in MD&A about the interest costs of debt obligations should include, when material, disclosure of the effects of derivatives. Likewise, when derivatives directly or indirectly affect the terms and cash flows of items such as securities held as assets, servicing rights, oil and gas reserves, loan receivables, deposit liabilities, and leases, disclosure about the terms and cash flows of those items should include, when material, disclosure of the effects of derivatives to the extent such disclosure is necessary to prevent the disclosure about the reported item from being misleading. VI. Response to Comments A. Accounting Policies 1. Disclosure Threshold In the proposing release, disclosures of accounting policies for derivatives would have been required if the fair values of derivative financial instruments and derivative commodity instruments were material. Commenters noted that the disclosure threshold in the proposing release is different than the threshold provided by generally accepted accounting principles (i.e., APB 22) and Regulation S-X. These commenters indicated that introducing a new and different threshold could add unnecessary confusion to the disclosure process. In response to those commenters, the disclosure threshold in the final rule relies on the standards of materiality present in APB 22 and Regulation S-X. APB 22 requires disclosure of accounting policies that materially affect the determination of financial position, cash flows, or results of operations. Regulation S-X limits the information to those matters about which an average prudent investor ought reasonably be informed. 2. Future Reconsideration Some commenters urged the Commission to coordinate its efforts with the FASB, especially by committing to review the accounting policies disclosure requirements after the FASB completes its derivatives and hedging project. Those commenters [[Page 6055]] suggested that when the accounting for derivatives is addressed comprehensively by the FASB, rules explicitly prescribing the content of derivative accounting policy disclosures may no longer be necessary. In response to those commenters concerns, after the FASB completes its project, the Commission will direct its staff to review Rule 4-08(n) and Item 310 and to recommend whether the Commission should amend those items. B. Quantitative Disclosures About Market Risk 1. Different Alternatives for Different Categories of Instruments A number of commenters recommended that the same quantitative market risk disclosure alternative not be required (i) For instruments entered into for trading and other than trading purposes and (ii) for each market risk exposure category (e.g., interest rates, foreign currency exchange rates, and commodity prices) within the trading and other than trading portfolios. For example, some commenters indicated that market risk inherent in trading portfolios is evaluated using one approach, such as value at risk, and market risk inherent in the other than trading portfolios is evaluated using another approach, such as sensitivity analysis. Similarly, some commenters suggested that instruments exposed to foreign currency exchange rate risk are evaluated using one approach, while instruments exposed to interest rate risk are evaluated using another approach. Those commenters suggested that Items 305(a) and 9A(a) permit the use of different quantitative disclosure alternatives for the market risks inherent in (i) The trading and other than trading portfolios and (ii) different market risk exposure categories within each of these portfolios. Due to the evolving nature of market risk management technologies, the Commission has decided it is too early to require that the same disclosure alternative be used to report market risk across (i) The trading and other than trading portfolios and (ii) each market risk exposure category within those portfolios. The Commission, therefore, has revised the disclosure items to permit the use of more than one disclosure alternative across each of those categories. 2. Use of Additional Disclosure Methods Some commenters suggested adding an alternative that would allow disclosure of quantitative information about market risk using a ``management approach''; that is, the approach that management uses internally to manage market risk. They commented that the approaches in the proposing release (i) Do not appear to allow gap and duration analyses, which are currently used by some to measure market risk and (ii) may become outdated as new measurement approaches are developed in the market place. Other commenters, however, support more consistent reporting and requested that the Commission limit the quantitative disclosure alternatives for the sake of comparability. The approach taken in the final disclosure items strikes a balance between the different commenters' perspectives. The Commission believes that the final disclosure items allow most registrants, if they so desire, to report market risk using one or more of four common methods of managing market risk. These methods are: (i) Gap analysis, (ii) duration, (iii) sensitivity analysis, and (iv) value at risk. Gap analysis is a tabular disclosure approach and with minor revision would satisfy the tabular disclosure requirements. Likewise, duration is a form of sensitivity analysis and with minor revision would satisfy the sensitivity analysis disclosure requirements. Registrants that do not internally manage market risk using any of these four common quantitative methods, however, still are required to report market risk disclosures using the methods specified by the final disclosure items. The Commission believes that reporting using a management approach outside of this framework could result in disclosures that could make it difficult for investors to assess market risk. Finally, to address commenters concerns that the alternatives for reporting market risk may become outdated, the Commission expects the staff to review the disclosure requirements periodically and to recommend amendments to those requirements, when appropriate, to reflect new developments in market risk management techniques. 3. Proprietary Information Some commenters indicated that they were concerned that the proposed quantitative disclosure requirements, particularly the tabular disclosure, would result in presentation of proprietary information. They expressed concern that the tabular information required by the proposal was so detailed and disaggregated that competitors, suppliers, and market traders potentially may be able to use the information to exploit the registrants' positions in the market. Other commenters maintained that, in certain limited circumstances, period-end reporting of sensitivity analysis and value at risk amounts also may reveal proprietary information. Of principal proprietary concern were the requirements to disclose market risk information for derivative commodity instruments at both year-end and quarter-end. After careful consideration of these comments, the Commission has determined to require disclosure of quantitative information about market risk. However, the final disclosure items include the following four provisions to address proprietary concerns. First, the final disclosure items contain two alternatives for providing quantitative information about market risk (i.e., sensitivity analysis and value at risk), which do not require disclosure of detailed information about specific positions held by the registrant at period end. Second, the final disclosure items allow registrants with concerns about reporting fiscal year-end information, to report the average, high, and low sensitivity analysis or value at risk amounts for the reporting period, instead of requiring the reporting of potentially proprietary year-end information. Third, for interim reporting, the final disclosure items require registrants to provide a discussion and analysis of the sources and effects of material changes in market risk information since the end of the preceding fiscal year, rather than requiring that registrants always furnish complete Item 305(a) or Item 9A(a) information when such material changes occur. Fourth, registrants selecting the sensitivity analysis or value at risk disclosure alternatives are not required to provide separate market risk disclosures for any voluntarily selected instruments, positions, or transactions. Instead, registrants selecting the sensitivity analysis and value at risk disclosure alternatives are permitted to present comprehensive market risk disclosures, which reflect the combined market risk exposures inherent in both the required and voluntarily selected instruments, positions, and transactions. Such comprehensive disclosures do not reveal proprietary information about the relative amount of market risk inherent in market risk sensitive instruments and any voluntarily selected instruments, positions, and transactions. 4. Static Disclosures, Dependence on Assumptions Some commenters criticized the sensitivity analysis and value at risk disclosures as being too dependent on [[Page 6056]] assumptions. They also commented that sensitivity analysis and value at risk measures are static and may not yield amounts that fairly represent the dynamic nature of market risk. The Commission has considered those comments and has determined to continue to permit use of both the sensitivity analysis and value at risk disclosure alternatives for the following primary reasons. First, the sensitivity analysis and value at risk disclosure alternatives are the most common and widely accepted methods of measuring net market risk exposures currently available in the market place. Second, while the reported quantitative information depends on assumptions, registrants are required to disclose key assumptions, which should allow investors to assess the quality of those assumptions and evaluate the potential impact of variations in those assumptions on the reported information. Third, an evaluation of reported quantitative information about market risk, over time, should help investors assess the dynamic nature of that risk. 5. Summarized Tabular Information Some commenters indicated that the proposed tabular presentation of terms and information related to market risk sensitive instruments would produce lengthy and complex disclosures. They also asserted that grouping (i) foreign currency sensitive instruments by functional currency and (ii) other instruments by the common characteristics specified in the proposing release (e.g., fixed or variable rate assets or liabilities, long or short forwards or futures, etc.) would be burdensome for registrants and the resulting information complex to analyze. Those commenters suggested that more summarized information be permitted in the tables. Finally, other commenters suggested that the proposal was unclear as to the information that must be disclosed, particularly with regard to options instruments. The Commission is concerned that highly summarized tabular information will not allow investors to analyze and develop an understanding of a registrant's market risk exposures. Thus, the grouping requirements in the proposed disclosure items have not been changed substantially in this release. However, the Commission has revised the instructions to the final disclosure items to permit combined disclosure of foreign currency sensitive instruments exposed to different functional currencies, provided that those functional currencies (i) are economically related, (ii) are managed together for internal risk management purposes, and (iii) have statistical correlations of greater than 75% over each of the past three years. In addition, the Commission has provided instructions to the final disclosure items to require the disaggregated reporting of instruments based on common characteristics only to the extent such disaggregation is material. Finally, the Commission has decided to exempt certain currency swaps and foreign currency denominated debt instruments from disclosure in the foreign currency risk exposure category if the currency swap eliminates all foreign currency exposure in the cash flows of the foreign currency denominated debt instrument. However, both the currency swap and the foreign currency denominated debt instrument still should be disclosed in the interest rate risk exposure category. With regard to the need for guidance on information to be included in the table, the Commission has clarified in the final disclosure items that the table should provide information about contract terms sufficient to estimate the future cash flows from market risk sensitive instruments, categorized by expected maturity dates. In addition, for disclosures about options in particular, the Commission has made clear in the instructions to the final disclosure items that tabular information on options with dissimilar strike prices should be disclosed separately to help reflect the different market risk exposures inherent in option instruments. 6. Sensitivity Analysis--Multiple Risk Exposures Commenters requested additional guidance on how to perform the sensitivity analysis calculations for registrants with (i) multiple foreign currency exchange rate exposures and (ii) instruments that are exposed to rate or price changes in more than one market risk exposure category (e.g., interest rate risk and foreign currency rate risk). In response to those comments, the Commission has added two clarifying instructions to the disclosure items. First, registrants with multiple foreign currency exchange rate exposures should present foreign currency sensitivity analyses that measure the aggregate sensitivity to all changes in foreign currency exchange rate exposures, including the changes in both transactional currency/functional currency exchange rate exposures and functional currency/reporting currency exchange rate exposures. 75 Second, for sensitivity analysis calculation purposes, registrants with instruments that are exposed to rate or price changes in more than one market risk exposure category should include the instrument in each market risk category to which the instrument is exposed. Similar instructions also were added to the value at risk disclosure requirements. --------------------------------------------------------------------------- \75\ For example, assume a French division of a registrant presenting its financial statements in U.S. dollars ($US) invests in a deutschmark(DM)-denominated debt security. This division determines that: (i) The French franc (FF) is its functional currency according to FAS 52, (ii) the $US is its reporting currency, and (iii) the DM is its transactional currency. In preparing the foreign currency sensitivity analysis disclosures, this registrant should report the aggregate potential loss from hypothetical changes in both the DM/FF exchange rate exposure and the FF/$US exchange rate exposure. --------------------------------------------------------------------------- 7. Value at Risk--Contextual Disclosures To help place reported value at risk amounts in context, the disclosure items in the proposing release specified that registrants should report either (i) the average or range in value at risk amounts for the current reporting period, (ii) the average or range in actual changes in fair values, earnings, or cash flows from market risk sensitive instruments occurring during the current reporting period, or (iii) the percentage of actual changes in fair values, earnings, or cash flows from market risk sensitive instruments that exceeded the reported value at risk amounts during the current reporting period ((i), (ii), and (iii) collectively are referred to as the ``contextual value at risk disclosures''). Some commenters suggested that the final disclosure items should encourage, but not require, the contextual value at risk disclosures. Those commenters stated that the Commission would be penalizing registrants for choosing the value at risk disclosure alternative by requiring contextual disclosures that are not required for the other two disclosure alternatives. Other commenters, while supporting the disclosure requirements generally, objected to one or more of the contextual value at risk disclosures. The Commission acknowledges the concerns of those commenters, but has decided not to change significantly the contextual disclosure requirements because it believes those disclosures provide investors with information that is important in evaluating the reported value at risk amounts. The disclosure items have been modified only to the extent necessary to clarify the contextual disclosure requirements. These contextual disclosures are common elements to value at risk management systems. Similar disclosures are not available for the [[Page 6057]] tabular presentation and sensitivity analysis alternatives; thus, comparable contextual disclosures are not required for those alternatives. 8. Value at Risk--Aggregated Values The proposed disclosure items would have required disclosure of an aggregate value at risk amount across all market risk sensitive instruments. A similar aggregate amount would not have been required for the other two disclosure alternatives. Some commenters suggested that it may not be practical to require an aggregate value at risk amount because most registrants do not use a single risk measurement method for all market risk exposures. Other commenters suggested that registrants providing an aggregate value at risk amount for all categories of market risk should not be required to disclose separate value at risk amounts for each market risk exposure category. Recognizing that registrants often do not use the same method internally for managing risk across the different market risk exposure categories within the trading and other than trading portfolios, the final disclosure items encourage, but do not require, reporting of aggregate value at risk (and sensitivity analysis) amounts for the trading and other than trading portfolios. Registrants also should note that they may not report aggregate value at risk amounts for the trading and other than trading portfolios in lieu of the required separate value at risk amounts for each market risk exposure category. Separate value at risk amounts provide information about a registrant's specific market risk exposures, which the Commission believes is useful for investors trying to manage specific risks in their investment portfolios. 9. Model Parameters In order to enhance the comparability of sensitivity analysis and value at risk disclosures, some commenters from the user community suggested that the Commission specify certain model parameters. In particular, those commenters suggested that the Commission establish several standard stress tests to be used to calculate sensitivity analysis disclosures, such as the greater of a 15% or 100 basis point adverse interest rate shift along the entire yield curve. Those standard stress tests would require measurement of the potential loss from reasonably expected market movements. Other commenters, however, requested that the Commission not specify model parameters at this time to allow the reporting to be responsive to the ongoing evolution in risk management systems. Due to these evolving practices, a guiding principle in the proposing release was to provide flexibility in the sensitivity analysis and value at risk market risk disclosure requirements to accommodate different types of registrants, different degrees of market risk exposure, and alternative ways of measuring market risk. The Commission continues to believe such flexibility is necessary at this time and, therefore, is not specifying uniform model parameters for the calculation of sensitivity analysis and value at risk disclosures. The need for such flexibility, however, should not result in selection of model parameters that are not realistic and meaningful measures of reasonably expected market rate and price changes. Accordingly, the Commission has included guidance in the final disclosure items on certain model parameters that should be used by registrants. In particular, this guidance requires registrants to select both hypothetical changes in market rates or prices for sensitivity analysis and confidence intervals for value at risk that reflect reasonably possible near-term changes in market rates and prices. In this regard, the disclosure items indicate that, absent economic justification for the selection of different model parameters, registrants should use hypothetical changes in market rates or prices that are not less than 10 percent of end of period market rates or prices for sensitivity analysis disclosures and confidence intervals that are 95 percent or higher for value at risk disclosures. In the long-term, as more standard risk management practices and methods of reporting market risk are developed, the Commission anticipates that it will further limit the models, assumptions, and parameters permitted in Items 305(a) and 9A(a) to enhance comparability of reported information. 10. Comparative Information Many commenters requested that, if a registrant changes its method of providing quantitative information about market risk from one year to the next, it should not be required to provide comparable summarized information for the preceding period because preparing such presentations and analyses using the new method for preceding periods would be burdensome and costly. Moreover, they suggested that the cost associated with providing comparable summarized information for the preceding year may be a sufficient disincentive to prevent change to a more sophisticated disclosure alternative. The Commission believes that information about market risk is most useful for investors when compared to one or more prior periods. For such information to be meaningful, the information needs to be prepared on a consistent basis from period-to-period. The Commission also believes that registrants should be able to change methods of preparing market risk information as their risk management practices evolve. To mitigate the costs of preparing prior period market risk disclosures, the final disclosure items provide two alternatives to registrants that change disclosure alternatives, key model characteristics, assumptions, or parameters. First, a registrant may provide summarized comparable information, under the new disclosure method, for the year preceding the current year. Alternatively, in addition to providing disclosure for the current year under the new method, the registrant may provide disclosure for the current year and preceding fiscal year under the method used in the preceding year. 11. Effective Dates Commenters suggested that time is needed to allow registrants to prepare and implement the new quantitative disclosures about market risk. The Commission agrees with those commenters and, thus, will phase in the amendments over the next several months so that registrants will have time to respond to the new disclosure requirements. For registrants that are likely to have experience with measuring market risk, such as banks, thrifts, and non-bank and non-thrift registrants with market capitalizations on January 28, 1997 in excess of $2.5 billion, Items 305 and 9A are effective for filings with the Commission that include annual financial statements for fiscal years ending after June 15, 1997. For other registrants, those Items are effective for filings with the Commission that include annual financial statements for fiscal years ending after June 15, 1998. In addition, under Items 305 and 9A, interim information is not required until after the first fiscal year end in which those Items are effective. C. Qualitative Disclosures About Market Risk 1. Proprietary Information Some commenters expressed concerns that a discussion of primary market risk exposures and how those exposures are managed would be proprietary. The [[Page 6058]] Commission acknowledges those concerns, but believes that qualitative information about market risk is important to investors. Without the disclosures required by Item 305(b) and Item 9A(b), investors would be unable to understand a registrant's exposures to market risk and unable to place that registrant's market risk management practices within the context of its business. In addition, the qualitative disclosures are not so specific as to require disclosure of the type of information (e.g., current positions) that may harm a registrant's competitive positions. For these primary reasons the Commission has decided to retain the qualitative market risk disclosure requirements. 2. Examples of How Market Risks Are Managed Proposed Items 305(b) and 9A(b) provide examples of possible disclosures regarding how a registrant manages market risk. These examples include a description of the objectives, general strategies, and instruments used to manage market risk. Some commenters inquired whether the description of one or two of these items would be sufficient. Others asked if the examples are intended to be an all- inclusive list of items required by Items 305(b) and 9A(b). In general, the examples were intended to reflect minimum disclosures that would be necessary to comply with the qualitative market risk disclosure requirements. The examples were neither meant to address all circumstances nor to be all inclusive. The final disclosure items clearly state that the listed items should be addressed within the required disclosures and that registrants also are responsible for providing any additional information necessary to describe completely their primary market risks and how those risks are managed. D. Implementation Issues 1. Scope of Disclosures Several commenters raised issues about the scope of instruments included in the proposed disclosure items. For example, some suggested that information about derivative commodity instruments should not be required because offsetting exposures relating to commodities held or owned were not required. Thus, the disclosures would be presenting only part of registrants' exposure to market risk. Furthermore, they indicated that registrants that hedge commodity exposures could be disclosing more market risk than those that do not participate in hedging activities, even though they may have less exposure to market risk. Similar arguments were made regarding (i) Hedges of anticipated transactions, foreign currency operating cash flows, and inventories and (ii) issuances of debt to fund property, plant, and equipment. In essence, those commenters suggested that the scope of the disclosure requirements is limited and as a result the information required to be disclosed is incomplete. Some commenters suggested that, to address this issue, the instruments covered by the disclosures be expanded to include all types of instruments with market risk. Other commenters suggested reducing the scope of instruments covered by the disclosures, primarily b [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A97-2991. Public record. Not legal advice.