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Fed Gov. Bies Cautions on Adequacy of Derivatives Disclosure

The increasing use and complexity of derivatives raises a serious concern about the adequacy of financial reporting, in the view of Federal Reserve Board Governor Susan Schmidt Bies, who urged companies to at least give a summary disclosure of their risk exposure. She also emphasized that companies should be completely transparent in their application of accounting and disclosure standards to specific transactions. In many situations, she cautioned, financial reports have neither reflected nor been consistent with the way the business has actually been run or the risks to which the business has actually been exposed by the use of derivatives.

In remarks to the American Graduate School of International Management, Gov. Bies said that auditors have focused on form over substance when looking at risk-transfer activities. Gov. Bies formerly served as a corporate chief financial officer and risk and audit manager, primarily in the banking industry, and for six years was a member of the Emerging Issues Task Force of the Financial Accounting Standards Board.

Derivatives are an important tool that firms use to manage risk exposures. In the ordinary course of business, firms are exposed to credit risk and the risk of price fluctuations in currency, commodity, and interest rate markets. Firms can now use derivatives such as options and futures to mitigate their exposure to some of these risks. The risk can be transferred to a counterparty that is more willing to bear it. Gov. Bies predicted that in the coming years businesses will use almost limitless configurations of derivatives and other sophisticated financial structures. In her view, however, a byproduct of this development will leave investors with ever more difficulty understanding the risk positions of many large, complex organizations. In addition, traditional financial reporting, which provides a snapshot at a particular moment, will be even less meaningful than it is today.

The consequences of the opaqueness that comes with complexity raise serious issues for financial reporting and corporate governance, warned the Federal Reserve official. Effective governance requires investors and creditors to hold firms accountable for their decisions, she reasoned, but a critical component of accountability is knowledge of the risks that the firm is bearing and those that it has transferred to others.

With sufficient, timely, accurate, and relevant information, she posited, market participants can evaluate a firm's risk profile and adjust the availability and pricing of funds to promote a better allocation of financial resources. Lenders and investors have an interest in accurately assessing a firm's risk-management performance, the underlying trends in its earnings and cash flow, and its income-producing potential. In this regard, Gov. Bies views transparency as essential to providing market participants with the information they need to effect market discipline.

The Sarbanes-Oxley Act reforms are encouraging in this regard, she said, but they only go so far. Another important and necessary reform, now absent from the regulatory agenda, is the need for higher professional standards for corporate financial officers and outside auditors that emphasize consistent compliance with the fundamental principles underlying accounting standards. Accounting policies used by companies must clearly and faithfully represent the economic substance of business transactions, she emphasized. Principles-based accounting standards, she stated, cannot succeed without strong professional ethics, since they rely on the business judgment of preparers and auditors. In her opinion, until the American Institute of Certified Public Accountants takes a stronger role to enforce its code of conduct, or until the new Public Company Accounting Oversight Board mandated by the Sarbanes-Oxley Act becomes an effective regulatory body, principles-based accounting cannot successfully restore the consistency in financial reporting that the capital markets require.

Besides applying sound accounting treatments, she continued, company managers must ensure that disclosures clearly identify all significant risk exposures, both on or off the balance sheet, and their effect on the firm's financial condition and performance, cash flow, and earnings potential. With regard to derivatives, and other innovative risk-transfer instruments, traditional accounting disclosures of a corporate balance sheet at any one time may be insufficient to convey the full impact of a company's financial prospects. Equally important are disclosures about how risks are being managed and the underlying basis for values and other estimates that are included in financial reports. Unlike typical accounting reports, information generated by risk management tends to be oriented less to a particular time and more to a description of the risks.

Complex organizations should continue to improve their risk-management and reporting functions. When they are comfortable with the reliability and consistency of the information in these reports, they should begin publicly disclosing this information, perhaps in summary form, paying due attention to the need for keeping proprietary business data confidential. This disclosure would provide more qualitative and quantitative information about the firm's current risk exposure to the market, she believes, while simultaneously helping the market assess the quality of the risk oversight and risk appetite of the organization.

Moreover, a sound risk-management system in a complex organization should continually monitor all relevant risks, including credit, market, liquidity, operational, and reputational risks. Reputational risk, which recent events have shown can make or break a company, becomes especially hard to manage when off-balance-sheet activities conducted in a separate legal entity can affect the parent firm's reputation. For all these risks, disclosures consistent with the information used internally by risk managers could be very beneficial to market participants. Companies should ensure that not only do they meet the letter of the standards that exist, she reminded, but also that their financial reports focus on what is really essential to help investors understand their businesses.

Finally, Gov. Bies particularly highlighted that disclosure need not be in a standard accounting framework nor exactly the same for all organizations. Rather, each entity should disclose the information its stakeholders need to evaluate its risk profile. Companies should be less concerned about the vehicle of disclosure and more concerned with the substance of the information made publicly available. In her view, disclosure without context may not be meaningful.