Accounting and Financial Reporting for Derivative Instruments NASC Annual Conference March 25, 2009 Graylin E. Smith Managing Partner SB & Company, LLC.

Accounting and Financial Reporting for Derivative

Instruments

NASC Annual Conference

March 25, 2009

Graylin E. SmithManaging Partner

SB & Company, LLC

To provide a clear understanding of financial derivative instruments and their uses

To provide an understanding of the difference in using financial derivative instruments to hedge versus an investment security

To explain what GASB 53 requires and how its accounting for derivatives differs from that of commercial entities under FASB 133

A derivative instrument is an often complex financial arrangement in which two parties agree to make payments to each other. These obligations generally are netted, and a single net payment is made. Derivative instruments are leveraged, meaning they are entered into with little or no initial investment.

To be hedges To lower borrowing costs To generate income To manage cash flows

Interest rate and commodity swaps Interest rate locks Options (caps, floors, and collars) Swaptions Forward contracts Futures contracts

Firm commitments Forecasted transactions Transactions between a primary government

and a discretely presented component unit Risks associated with a portion of cash flows or

fair values of a financial asset or liability (provided that effectiveness could be measured).

Interfund transactions Investments that are measured at fair

value

GASB 53 provides criteria that governments can use to determine whether a derivative instrument creates an effective hedge.

Consistent critical terms (CCT)- Only evaluates hedge effectiveness at its inception Use is restricted to swaps

Synthetic instrument - Used to evaluate hedge effectiveness by

demonstrating that either synthetic rates or prices would be achieved.

May be an interest bearing instrument or an instrument for the sale or purchase of commodities.

Consist of derivatives and companion instruments.

Embedded derivatives may be a hedging derivative instrument if the applicable criteria are met.

Hybrid instruments can be recognized as a derivative instrument if:The companion instrument is not measured at fair

valueThe separate instrument would meet the definition

of a derivativeThe “economic characteristics and risks” of the

derivative instrument are not “closely related” to those of the companion instrument

Dollar offset- A change in either the hedged item or the hedging

derivative divided by a change in the other should result within a range of 80 – 125 percent.

Regression Analysis (to include changes in fair values, historic cash payments, or historic interest rates)- R-squared should be greater than or equal to .80. Regression coefficient for the slope should be

between -1.25 and -0.80.

Governments should provide information about their use of hedging derivative instruments. The information should include a government’s objective for entering into the

derivative instrument, significant terms of the derivative instrument, the net cash flows of derivative instruments that

hedge debt.

Changes in Fair Value of hedging derivatives instruments are recognized in the reporting period to which they relate.

Changes in Fair Value do not affect current investment revenue, but are instead reported as deferrals in the Balance Sheet.

Derivative instruments which are not effective hedges or are associated with investments that are already reported at fair value are classified as investment derivative instruments for financial reporting purposes. Changes in fair value are reported in investment revenue in the current reporting period.

For potential hedging derivative instruments which exist prior to the current fiscal period, the evaluation of effectiveness should be performed as of the end of the current period.

If determined to be effective, hedging derivative instruments are reported as if they were effective from their inception.

If determined to be ineffective, the potential hedging derivative instrument is evaluated as of the end of the prior reporting period.

The disclosure should highlight the risks to which derivative instruments expose a government, including:

Termination risk Credit risk Interest rate risk Basis risk Rollover risk Market-access risk Foreign currency risk

The hedge is no longer effective Likelihood of an expected transaction

occurring is no longer probable The hedged asset or liability is sold or

retired Government is re-exposed to the hedged

financial risk

After the termination of a hedge, the following actions should occur: the balance of the derivative’s deferral account

should be reported in investment income the prior hedging derivative can be associated

with another hedgeable item as long as the new relationship is accounted for separately from the previous hedging relationship

Statement 53 requires that derivatives be reported in the financial statements.

The fair value of a derivative instrument (with the exception of synthetic guaranteed investment contracts (SGICs) which are fully benefit-responsive) as of the end of the period covered by the financial statements will be reported in the statement of net assets as deferrals.

Changes in fair value should be reported in the flow of resources statements as investment gains or losses.

Governments are required to implement Statement 53 for periods beginning after June 15, 2009.

FASB 133 requires that an entity recognize the fair-value of all derivatives as assets or liabilities. In certain cases, it can also be classified as an unrecognized firm commitment.

GASB 53 FASB 133Applicability Applies only to state and local

governments, except governmental funds.Applies to all nongovernmental entities.

Scope exceptions Normal purchases and normal sales (NPNS) contracts are outside the scope of Statement 53 if physical delivery under such a contract is probable. NPNS contracts do not represent an election.

NPNS contract exception is an election that should be documented.

Hedge designation No designation documentation is required. Hedge accounting is not an election.

Formal documentation required at inception. Hedge accounting is an election.

Effectiveness assessment — frequency Requires assessment only at end of each reporting period.

Requires assessment at inception and as of each reporting date. An entity is required to consider hedge effectiveness both prospectively and retrospectively.

Effectiveness assessment — methods Permits use of the following methods:Qualitative — Consistent critical terms method.Quantitative — (1) synthetic instrument method, (2) dollar-offset method, (3) regression analysis, or (4) other quantitative methods.

Permits shortcut and critical-terms-match methods, if all criteria are met. Quantitative methods described include regression and dollar-offset. Does not include the synthetic instrument method.

GASB 53 FASB 133Effectiveness assessment — use of multiple methods

Hedges assessed under consistent critical terms method and deemed ineffective must be reevaluated using at least one of the quantitative methods

before being deemed ineffective.

Use of multiple methods is prohibited for the same hedging relationship. Method of assessment can only be changed by de-designating and re-designating a new hedging relationship.

Effectiveness measurement — recording

Changes in the fair value of hedging derivative instruments are reported as either deferred inflows or deferred outflows in the statement of net assets as long as the hedge is deemed effective. Does not differentiate between an effective or ineffective portion of a hedge.

Fair value hedges — Changes in fair value of the hedging derivative are recorded in earnings. The basis of the hedged item is adjusted by an amount equal to the effective portion of the hedge.Cash flow hedges — Changes in fair value (effective portion only) are recorded in other comprehensive income.

Fair value measurement Describes fair value as the market price in an active market; if a market price is not available, fair value should be based on expected cash flows (discounted) or formula-based

Does not describe how to measure fair value. Fair value measurement is addressed in FASB Statement No. 157, Fair Value Measurements, which employs an “exit” price presumption.

Termination triggers Policies related to counterparty collateral

requirements and netting arrangements Net exposure to credit risk Concentration of credit risk Detailed information about hedging

derivatives

Changes in Fair Value Fair Value at June 20X0

Classification Amount Classification Amount Notional

Governmental Activities:

Fair Value Hedges:

Received- fixed interest rate drop Deferred Inflow $ (277) Debt $ 1572 $ 30000

Cash flow Hedges:

Pay- fixed interest rate swaps Deferred Outflow $ (143) Debt $ (1330) $ 84000

Rate Cap Deferred Inflow $ 28 Debt $ 337 $ 10000

Investment Derivatives:

Pay- fixed interest rate swaps Investment Revenue $ 1277 Investment $ (1277) $ 18000

Business Activities:

Cash flow Hedges:

Pay-fixed interest rate swap Deferred Inflow $ (548) Debt $ 4236 $ 37000

Commodity forward Deferred Inflow $ (111) Derivative Instruments $ 111 $ 1000 MMBTUs

Fiduciary Funds

Investment Derivatives:

Foreign Currency forward Investment Revenue $ 721 Investment $ (721) £ 20000