Demystifying Derivatives?

By: Eric S. Berman, CPA

Eric S. Berman, CPA, a member of AGA’s Greater Boston Chapter, is a deputy comptroller of the Commonwealth of Massachusetts. He is AGA’s representative to the Governmental Accounting Standards Advisory Council to GASB (GASAC) and a member of the Financial Management Standards Board.

I am proud to be your representative to GASAC, and I encourage you to give me your feedback.

You’ve read about them in your local newspapers and seen them in other forms of media. You’ve seen financial giants crumble because of them and housing foreclosures skyrocket. Of course we are talking about derivatives. Yet, many financial managers, even those that sign derivative contracts, know little if anything about them.

Why?

As accountants, we are used to debits on the left, credits on the right. We like to debit interest expense, credit interest payable and we’d better pay interest every 180 days and principal annually or you get a call from Aunt Martha who owns $10,000 of your government’s bonds in Jimmy’s college fund.

But the last year or so has not been kind to the little things that some financial whiz kid said when it was issued, “Oh don’t worry about that variable rate bond. I’ll buy it up for my mutual fund, and I’ll sell you a variable rate swap that will pay you a variable rate interest stream so that you effectively pay me fixed rate interest.” The whiz kid drew some squiggly lines on your white board and arrows and they matched. A few days later, a stack of bond documents, a smiling lawyer and underwriter later and you were in the variable rate bond business. Oh yes, to be extra safe, you bought some insurance.

Well, the best laid plans… You’ve just got a call from your bond lawyer and it seems that your insurance company is in financial trouble because it too sold a derivative to lower its risk. But that derivative failed because someone else along the chain failed. The mutual fund just called and the swap cannot pay because the market that it exists in has interest rates that have doubled or tripled in the past few days. And all you want to do is not to have to take a call from Aunt Martha because Jimmy’s check is due.

For governments, the goal of any derivative is to lower risk, unless the intent is on speculation. The purpose of a derivative is to fulfill the need of someone else in the market for what an issuer is selling – namely your government. An investor may demand a variable rate bond, but your government doesn’t have to effectively pay that variable interest rate if they contract with an investment provider to offset that variable rate. If the markets work, the derivatives work.

One of the more interesting set of quotes about derivatives is by Warren Buffett in his 2002 annual report:

“The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. Or say you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. No problem—at a price, you will easily find an obliging counterparty.”

In the same report, Buffett remarked that derivatives were “financial weapons of mass destruction” and they “generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years.” Finally he says “[L]arge amounts of risk have become concentrated in the hands of relatively few derivatives dealers ... which can trigger serious systemic problems.” These quotes were from 2003. Five years later, what have we learned?

GASB is about to issue standards for accounting and reporting derivative transactions. Derivatives are found not just in debt. If your government has bought fuel in advance, fixing a price based on an index, it is a derivative. If you know of a farmer who sells a commodity in advance of delivery, that is a derivative. Both of these are called normal sales contracts and are out of the scope of the exposure draft, but they are derivational in nature.

GASB will also issue a Comprehensive Implementation Guide to the new standards, with loads of questions, examples, tables, journal entries and a full glossary.

How should GASB and AGA best train you, your staff and your stakeholders about the upcoming accounting and disclosure rules and best practices with regard to these contracts? Even if the implementation date is a year from now, would you consider early implementation for the sake of transparency in reporting if you understand the accounting and disclosure needs?

TOMORROW: Jeff Steinhoff, retired managing director, Financial Management and Assurance, GAO, and AGA Past National President on "It's Never Too Late for Certification—Learning is a Lifelong Journey"

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