by Glenn Cheney

Norwalk, Conn. - The world has become a riskier place, and not just from the threat of traditional weapons of mass destruction. The budget crises faced by American state and municipal governments have led them to take a few chances in their financial dealings, from investments in equities to the issuing of bonds.

Increased exposure to risk and the need to increase the yield of loans has ushered in an increased use of derivatives. Some derivatives manage risk. Others incur new risk. No matter what they do, they are complicated and hard to explain.

The value and risks of derivatives should be easier to disclose in a clear and consistent manner with the issuance of a Governmental Accounting Standards Board technical bulletin dedicated to that purpose. The bulletin changes neither the accounting for nor the disclosure of derivatives. Rather, it clarifies the questions that disclosures must answer: what the derivatives do, how they do it, what they’re worth and what the risks are.

The 45-page document, “Disclosure Requirements for Derivatives Not Presented at Fair Value on the Statement of Net Assets,” extrapolates from the principles that were established in a three-page document issued almost 10 years ago.

“What we had before was very general,” said GASB project manager Randal J. Finden. “The principles were very solid, but the technical bulletin didn’t have a lot of specifics. It has become apparent that people need more guidance on what the disclosures about derivatives need to be.”

The GASB document makes it clear that disclosures should specify the objectives and terms of derivatives, related debt, fair value and associated risks, such as interest rate risk, basis risk, termination risk, rollover risk and market access risk. Elements that were not specified in the 1994 document, a technical bulletin titled “Disclosures About Derivatives and Similar Debt and Investment Transactions,” are spelled out specifically and illustrated with models.

“If you want details and answers, we’ve got them,” Finden said.

Though the bulletin is rich in specifics, it is still less than a full-fledged statement. GASB has begun working on a statement on derivatives, but it is not expected to reach completion for another two years.

The Government Finance Officers Association took issue with the limited due process that technical bulletins receive. In its comment letter on the proposed technical bulletin, the association wrote:

“We believe that the change being proposed is significant, and that significant changes ought not to be brought about in a manner that deprives both the board and its constituents of the proven benefits of full due process. There is simply no emergency at present to justify allowing only three months between the first issuance of a proposal of this complexity and its final implementation.”

Eric Berman, deputy comptroller of Massachusetts, is on the task force working on the statement. He had general praise for the new bulletin, but questions how well the bulletin helps determine fair value.

“From the perspective of Massachusetts, we were generally favorable on the technical bulletin, though we had some concerns with valuation and auditing valuation,” Berman said. “Basically, under this bulletin, you ask a counter party to develop a fair value for the derivative. But where does an auditor value the derivative? You can’t open a newspaper and see the market value. You have to do a bank confirmation, and that might not be the most independent way of doing it. Auditing needs to be considered with each new standard.”

Berman was also concerned about the effective date, which was immediate upon the bulletin’s issuance. Like many preparers of financial statements, he is already well into the planning of his annual audit, and his footnote disclosures have already been prepared. Now they may be subject to change.>

The GFOA also objected to the immediacy of the effective date. The association had recommended that the effective date be held off for a year to allow for the education of government finance officers, auditors and the users of financial information.

Finden explained that there was no reason to postpone the effective date, as the bulletin is simply a clarification of an existing standard.

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