Are Agricultural Derivatives Weapons of Mass Destruction

Are Agricultural Futures Weapons of Mass Destruction? By Charles Hattingh CA(SA) Chartered Financial Analyst In his letter to shareholders dated 21 February 2003, Mr Warren Buffett, chairman of Berkshire Hathaway, devotes over two pages to the problems he has with derivatives, which he refers to as time bombs. Some of the problems he highlights are: 1. The ultimate value of a derivative depends on the creditworthiness of the counter parties to the contract. 2. Once a derivative contract is written it is often difficult to escape from it in the future. Some derivative contracts can take years before they are settled making the assessment of the risk exposures difficult to quantify. 3. There have been cases where companies have had credit rating downgrades resulting in additional margin calls being required causing further financial stress in these companies. Such an event could cause a domino effect. 4. Valuing derivatives requires assumptions to be made and these assumptions can result in large differences in values. Where management bonuses depend on these values, the assumptions can become tainted. 5. Parties to derivatives have enormous incentives to cheat when accounting for them. He concludes his discussion by stating that derivatives are financial weapons of mass destruction carrying dangers that are potentially lethal. His predictions are invariably on target. But do they apply to the market for agricultural futures in South Africa? I think (and hope) not. Credit worthiness of counter parties If you wish to buy or sell an agricultural future through Safex (the South African Futures Exchange) you are required to deposit cash (a margin call) to cover any loss resulting from default on your part. If the market price of the future moves against you, you must pay, in cash, the full amount of the loss and the margin call may have to be increased. If the market price of the future moves in your favour, you will receive the gain in cash. So the credit risk inherent in these derivatives is minimal. Difficult to get out of the contract in future Safex’s derivatives are all standardised and expire after pre-determined periods so this is not an issue. Implications of credit rating downgrades This is not a major issue in agriculture futures as any loss exposures result in cash outflows. The margin call is usually under 10% for these contracts. It is unlikely that the credit rating downgrading of any one player in this market could have a cascading effect on the market as a whole in South Africa. Valuation subjectivity There is an active market for these futures and the prices are available in daily newspapers and in various on-line quotation services. There is an outside possibility that in a thin market a company could manipulate the market prices on the last day of its financial year to manage its profits. The auditors should be alert to this possibility. Accounting manipulation South African companies have either converted, or are in the process of converting, to international accounting standards on financial instruments so it is doubtful whether this aspect could be a problem. There is, of course, always the possibility that management may deceive the auditors in this regard. Because of the complexity of these contracts, this possibility is always present and auditors will have to be especially vigilant in this regard. The accounting issues The first issue is whether or not agricultural futures are within the scope of the statement on financial instruments: recognition and measurement. AC133.07 includes within the scope of the statement commodity-based contracts that give either party the right to settle in cash or some other financial instrument with the exception of commodity contracts that meet all the following conditions: 1. They were entered into and continue to meet the enterprise’s expected purchase, sale or usage requirements. 2. They were designated for that purpose at their inception. 3. They are to be settled by delivery. According to the advertising material of Safex, less than 1% of agricultural futures are settled by delivery so clearly agricultural futures fall within the scope of AC133. The second issue is whether or not they meet the definition of a derivative. Three criteria must be met before a financial instrument can meet the definition of a derivative: 1. The value thereof should change in response to some underlying. 2. There should be little or no initial net investment. 3. Settlement should be at a future date. All three criteria are met so agricultural futures do meet the definition of a derivative. The third issue is whether the purpose of acquiring these futures was to hedge an exposure to a risk or whether the intent was to speculate. It will be necessary to study the circumstances surrounding the derivative to determine whether the purpose was to hedge or to speculate. The fourth issue is whether or not a derivative that is considered to be a hedge can be accounted for as such. For hedge accounting to be applied the entity must comply with five onerous criteria (see AC133.143), i.e.: 1. At the inception of the hedge there should be formal documentation setting out, among other things:  The hedging relationship  The risk objective and strategy for undertaking the hedge  The identification of the hedging instrument and the related hedge item or transaction  The nature of the risk being hedged  How the hedging effectiveness will be assessed. 2. The hedge should be highly effective. 3. For a cash flow hedge, the forecasted transaction should be highly probable. 4. The effectiveness of the hedge can be reliably measured. 5. The hedge was, on an ongoing basis, highly effective. Clearly the standard setters have gone out of their way to make it as difficult as possible to use hedge accounting. This aspect is the cause of much conflict between companies and their auditors. The main players in the agricultural futures game are the farmers, the silo operators, the users of the products and the bankers. In next month’s article I will give examples of the accounting entries in the books of each of the four parties. One aspect of agricultural futures that could be a time bomb waiting to happen is the tax implications of these transactions. I have had informal discussions with SARS on this aspect and their interpretation of the Income Tax Act, which is probably correct, could result in hardship for the players in this game. In the past it was not necessary to account for the derivatives. However, with the advent of AC133, the existence of these assets and liabilities will be exposed and SARS is sitting in the wings watching with interest. Dear Uncle C I read your article on the nightmare financial advisor and was shocked to see that you had recommended a scheme that contravened the Income Tax Act. I am a student of tax and understand that if you donate money to your wife with the sole purpose of avoiding tax on interest, the income will be taxed in your hands. Dear Student of Tax, You are quite right. I assumed that they were married in community of property. (Whew, got out of that almost intact!). Dear Uncle C, The suggested financial plan in your article on the nightmare financial advisor does not cater for inflation. Dear Does Not Allow For Inflation, If you retire on only R850 000, you cannot afford to provide for inflation. With an average dividend yield on listed shares of 3,5% at present, your cash income will be only R2 500 p.m. You can only consider the luxury of providing for inflation with a nest egg of over R1 million. The first million should be used to provide for present needs. I am afraid that if you retire on less than R1 million, you will have to reduce your standard of living as inflation destroys the value of your income.