Recent evidence turns these arguments on their head. Over the past several years, quite a few firms have been caught short-handed with respect to their accounting for derivatives. They have been lambasted by the Securities and Exchange Commission, by the press, by shareholders, and by the government. The issue is that managers don't seem to comprehend the extent of risks that are involved with some of these financial instruments. Recent cases at AIG, Merrill Lynch, Citigroup, General Electric, and Bear Stearns—as well as many others—do not bode well for the continued use of derivatives.

PricewaterhouseCoopers, AIG's outside auditors, recently concluded that AIG had a material weakness in its internal controls over accounting relating to the fair valuation of credit default swap portfolio obligations of AIG Financial Products. It makes one question whether AIG can manage these complex financial instruments.

Merrill Lynch realized losses over $7 billion on Collateralized Debt Obligations (CDOs) because they became overexposed in the subprime mortgage business. Besides wondering whether managers truly understand these complex financial instruments, one marvels at the inability to manage risk, which is a bedrock rationale for the utilization of these and other derivatives.

Citicorp recently had a quarterly loss of almost $10 billion, caused chiefly by losses on its derivatives. Executives at this firm were likewise unable to manage their derivatives. The losses may in fact grow to some truly staggering amounts.

Some time ago, General Electric disclosed a $343 million restatement because of errors involved in its hedging of commercial paper. It was not their first restatement related to derivatives, and it won't be their last.

In fact, at least 200 firms have recently restated their financials because of problems with derivatives accounting. This large number of course suggests troubles with derivatives accounting and the complexity of implementing Statement No. 133. But, the losses at AIG and many banks suggests a deeper concern—perhaps management no longer has sufficient control over the derivatives themselves. Maybe they never did.

And now Bear Stearns has evaporated into the mists of JP Morgan because of problems in the subprime mortgage market and its inability to totally comprehend the myriad of economic facets associated with these activities. Bear Stearns was intimately involved in the credit derivatives market, but showed no sign of wisdom or expertise in recent times. Not counting the prize for who can approach corporate bankruptcy the fastest.

Perhaps it is time to admit that derivatives are not the vehicles to manage risk that they are touted to be. Instead, they seem to be a way for overpaid managers to gamble with other people's money. Unfortunately, such thrill-seeking leads to pain and suffering for others. This list includes the taxpayers who have to foot the bill for the nationalization of Bear Stearns.

Maybe business enterprises should simplify their business. They should stick to the fundamentals and try to earn money the old-fashioned way: Work for it. The get-richer-scheme of derivatives is backfiring too often and too spectacularly.

Policy makers should examine and debate at least three issues with reference to derivatives. One of the most basic issues surrounds the credit risk of counterparties, those who are committed to make cash payments when certain conditions occur.  CDOs are huge; and the put options written on CDOs are huge. Only a few firms can serve as counterparties, and the concentration of risk becomes a concern. Clearly, the default risk by counterparties is not nearly as low as claimed in financial reports. Perhaps auditors should start examining these assertions by managers.

Policy makers should examine and debate claims about risk management. It is time to question corporate statements that derivatives help managers to reduce risk. Events of the past several years, especially the events in the subprime sector, question any such claims by managers. In other words, some hedges might in fact not be hedges but speculative positions. In this case usage of derivatives might be giving only an illusion of security, for the derivatives are actually adding to the risk of the portfolio.

Policy makers should examine and debate whether fancy financial instruments are too complex to understand and to operate and to manage. Not only are the mathematical models extraordinarily complex, but they rely on a myriad of assumptions that too frequently are based on intuition and guesswork instead of data. What data they do employ has low reliability and is uncorrelated with objective market data. Who really knows what is going on in the derivatives markets?

When the Congress decides to do some real work, it should investigate the impact of derivatives on the U.S. economy because losses from their use are hurtful to many citizens, especially taxpayers who currently are not in a position to rescue the American banking system. For starters, Congress should require firms that continue to use financial derivatives to obtain a license from the Nevada Gaming Commission. Let's at least inform investors, such as Bear Stearns' investors, that this market is really a casino.

Return to The Accounting Cycle

J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries. He is the co-author of a monograph, Fair Value Measurements: Valuation Principles and Auditing Techniques (with Mark Zyla, Managing Director, Acuitas, Inc.) to be published by BNA.