ms. phillips discusses the federal reserve board's views on proposed accounting standards for derivatives and risk management activities testimony of ms. susan m. phillips, a member of the board of governors of the us federal reserve system, before the subcommittee on capital markets, securities and government sponsored enterprises of the committee on banking and financial services, u. s. house of representatives, on 1 / 10 / 97. i welcome this opportunity to discuss the federal reserve board ’ s views on proposed accounting standards for derivatives and risk management activities issued by the financial accounting standards board ( fasb ). in approaching this complex matter, it should be acknowledged up front that most responsible observers and market participants share an interest in improved accounting standards and disclosure of information that is useful and relevant to the broad range of users of financial statements. thus, the desirability of meaningful disclosure is not the issue. all would agree, i think, that enhanced financial disclosure and market transparency can lead to more efficient financial markets, more accurate pricing of risks, and more effective market discipline. with respect to financial disclosures, the interests of most firm managers, investors, and other market participants are essentially the same. market participants can benefit from enhanced disclosure by being in a better position to understand the financial condition of their counterparties and competitors. investors have an obvious interest in being able to make meaningful assessments of a firm ’ s performance, underlying trends, and income - producing potential. sound, well - managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect their lower risk profiles. inadequate financial disclosures, on the other hand, could penalize well - managed firms if market participants are unable to assess their fundamental financial strength. while most market participants favor sound accounting standards and meaningful disclosure, a key question is how to ensure that accounting practices and techniques reflect, and are consistent with, how a business is run, that is, its overall business strategy. indeed, accounting methodology should measure the results of a business purpose or strategy, and not be an end in itself. for example, in the case of a company that actively trades financial instruments or other products to profit from short - term price movements, such as a securities firm, reporting trading positions at fair values appropriately measures the success or failure of that business strategy, and market participants expect this reporting treatment. however, for many other types of businesses, such as a manufacturer or a lender that funds loans with liabilities of equal maturity, market value accounting in the

primary financial statements may not accurately reflect business strategies or appropriately measure the firm ’ s underlying performance and condition. in these cases, although information about fair value can be useful in supplemental disclosures, it is questionable whether there is widespread demand for market value accounting to become the basis for the preparation of the primary financial statements. although the needs of financial statement users may vary, a critical function of financial statements is to reflect in a meaningful way underlying trends in the financial performance and condition of the firm. the application of market value accounting to business strategies where it is not appropriate, and particularly when applied on a piecemeal basis, may lead to increased volatility or fluctuation in reported results and actually obscure underlying trends or developments affecting a firm ’ s condition and performance. requiring companies to adopt market value accounting where it is not consistent with their business strategies can cause them to incur significant costs to provide information that may not reflect in a meaningful way their underlying circumstances or trends in their performance. moreover, from the standpoint of financial statement analysts and other users, having to make adjustments to remove the effects of this accounting volatility from income statements and balance sheets - - volatility that is not consistent with firm ’ s risk positions - - can also impose significant costs without offsetting benefits. these problems can be minimized by placing market values in meaningful supplemental disclosures rather than by forcing their use in the primary financial statements. such an approach would give analysts the information they need, without imposing the broader costs of having to reverse or back out the effects of artificial volatility from the primary financial statements. of course, financial statements and supplemental disclosures must be accurate and not misrepresent a firm ’ s financial circumstances - - a problem that can be minimized when financial reports are subject to thorough review by management and external auditors. federal reserve ’ s experience the federal reserve board has a long - standing interest in the quality of financial reporting. this arises from our role as the nation ’ s central bank, and as the supervisor of bank holding companies, state member banks, and the u. s. operations of foreign banking organizations ( fbos ). the federal reserve and other bank supervisors are responsible for assessing the safety and soundness of the institutions they regulate. in this regard, the federal reserve relies on off - site monitoring, on - site supervision, capital and other regulatory requirements, and policies that encourage sound risk management practices. we believe that market discipline - - supported by appropriate