Accounting and Financial Reporting for Derivative Instruments.

Accounting and Financial Reporting for Derivative Instruments

Derivatives Notional amounts outstanding, 1987-present

$0

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

$700,000

Mil

lio

ns

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Source: International Swaps and Derivatives Association, Inc., 2008

$683.7 trillion in June 2008

Types of Derivatives that Accountants Encounter

12% 9%

68%2%

1%

8%

Foreign Exchange Contracts Interest Rate Contracts

Equity - Linked Contracts Commodity Contracts

Credit Default Swaps Other

% of notional amounts outstanding – as of June 2008 – Source Bank for International Settlements

Executive Summary of GASB Statement No. 53 Complex statement that:

Defines derivatives and exclusions. Presents requirements for recognition and measurement of

derivatives. Describes and calculates hedge accounting, efficient and

inefficient hedge accounting. Contains a full set of examples and note disclosures, as

well as transition guidance. Supersedes Technical Bulletin 2003-1. Amends pieces of Statement Nos. 7, 23, 25, 31, 40

and 43.

Executive Summary of GASB Statement No. 53 What is a derivative?

It is a contract that has settlement factors which could be one or more reference rates. notional amounts. payment provisions or any combination.

It has leverage. It can be settled net.

Executive Summary of GASB Statement No. 53 What are settlement factors?

Reference Rate – an interest rate, security price, commodity price, exchange rate, other variables.

Notional Amount(s) – the face amount of the contract, which includes the number of units, shares, bushels, pounds, etc.

Executive Summary of GASB Statement No. 53 Requirements of the statement:

Derivatives should be reported on the statement of net assets at fair value except for synthetic guaranteed investment contracts.

Unless hedging derivative, changes in fair values are part of investment revenue in statement of activities, changes, etc. If hedging, then changes are deferred inflows

or outflows. If hedged derivative is terminated, P&L event.

Executive Summary of GASB Statement No. 53 How to measure fair value:

Market price if there is a market. Discounted expected cash flows. One of a number of different pricing models

and methods. IF using a pricing service and the method to

calculate is NOT disclosed by the service, then management must make an assessment of propriety based on the information received.

Executive Summary of GASB Statement No. 53 Termination occurs when:

Hedging derivative not effective. Government becomes exposed to adverse changes in

fair values or cash flows. Hedged asset or liability is sold or retired, refunded or

defeased. Derivative is terminated. Forward transaction occurs (e.g., sale of bonds or

purchase of commodity). Reporting – investment revenue, balance sheet

activity caption “increase (decrease) upon hedge termination.”

What is a hedge? A hedge is a contract

entered into to reduce some form of risk in cash flows or fair values.

Hedges that accomplish the goal of reducing risk as expected are commonly referred to as effective.

What is a hedge?

It must be associated with a hedgeable item Asset, liability, expected transaction (swaption,

forward, etc.) Notional amount = principal amount. Derivative is in the same fund as hedgeable

item. Term or time period is consistent between

derivative and hedgeable item. It is effective in reducing the risk.

How to evaluate effectiveness? Initial year:

If terms of derivative (years, amounts, rates) are consistent with debt, asset etc., then automatically effective – known as consistent critical terms.

If inconsistent, then at least one of many quantitative methods must be used.

Subsequent years: Use the same method as first year, but can use other

method. Evaluation of effectiveness is done by measuring

cash flows or overall changes in fair values.

How to evaluate effectiveness? Quantitative methods include:

Synthetic instrument method (combine debt cash flows and derivative to create a third item).

Dollar offset method (measure changes in expected cash flows).

Regression analysis method (statistical relationship between debt and derivative changes).

Can use other quantitative methods.

Effectiveness Corridors Synthetic instrument

method

Dollar Offset

Regression analysis

Synthetic rate should be within 90% - 111% of fixed rate.

Derivative cash flows 80% - 125% of debt.

R2 (measure of the proportion of the variance in a dependent variable about its mean that can be explained by changes in the independent variable.) must be ≥ 0.80.

F-statistic (confidence level) must have 95% confidence.

Corridor must be 80% - 125% of debt.

Note Disclosure

Summary table of information: Organized by governmental, BTA, fiduciary

funds: Subdivisions for hedging derivatives and

investment derivatives. Within each category – aggregate information

by type (received fixed swaps, pay fixed swaps, swaptions, caps, basis swaps, futures, etc.).

Example 1 -- Calculating Effectiveness Assumptions:

Auction rate bonds issued for $100MM on 7/1/xx. Bonds mature 6/30/x4.

Semiannual coupons reset weekly. On 7/1/xx, the government enters into a $100MM, notional,

pay fixed, receive variable swap that terminates 6/30/x4. FMV at 7/1/xx=$0.

Semiannual variable payment reset weekly. The variable payment is 49.96% of LIBOR + 78 basis

points. The fixed payment is 3.58782%.

Step 1 – Diagram the transactionGovernment Counterparty

Fixed pay 3.57872%

Variable receive – 49.96% of LIBOR + 78bps

Bondholders

Auction rate paid

Note that the actual synthetic rate paid will vary depending on the difference between the auction rate paid and the variable rate received.

Step 2 -- Calculate the cash flows and values

Fair Value Change in Fair Value

1 (2,487,390)$ (2,487,390)$ 2 (4,000,154) (1,512,764) 3 (1,536,286) 2,463,868 4 - 1,536,286

Step 3 -- Divide and measure

From Assumptions

Since these are between 90 and 111%, then derivative is effective – changes reflected only in statement of net assets.

Journal Entries – HIGHLY SIMPLIFIED – Year 1

Swap Payment to Counterparty

Dr. Interest Expense $3,578,720

Cr. Cash $3,578,720

Swap Payment from Counterparty (can also be combined with payment above)

Dr. Cash $2,031,713

Cr. Interest Revenue $2,031,713

Payment to Bond Holders

Dr. Interest Expense $1,789,314

Cr. Cash $1,789,314

Change in Fair Value

Dr. Deferred Outflow of Resources

$2,487,390

Cr. Interest Rate Swap $2,487,390

Journal Entries – HIGHLY SIMPLIFIED – Year 2

Swap Payment to Counterparty

Dr. Interest Expense $3,578,720

Cr. Cash $3,578,720

Swap Payment from Counterparty (can also be combined with payment above)

Dr. Cash $1,575,995

Cr. Interest Revenue $1,575,995

Payment to Bond Holders

Dr. Interest Expense $1,359,205

Cr. Cash $1,359,205

Change in Fair Value

Dr. Deferred Outflow of Resources

$1,512,764

Cr. Interest Rate Swap $1,512,764

Journal Entries – HIGHLY SIMPLIFIED – Year 4 (final year)Swap Payment to Counterparty

Dr. Interest Expense $3,578,720

Cr. Cash $3,578,720

Swap Payment from Counterparty (can also be combined with payment above)

Dr. Cash $1,940,223

Cr. Interest Revenue $1,940,223

Payment to Bond Holders

Dr. Investment Expense $1,930,405

Cr. Cash $1,930,405

Change in Fair Value

Dr. Interest Rate Swap $1,536,286

Cr. Deferred Outflow of Resources

$1,536,286

What if the swap terminates?

What if in the 3rd year, the state passes a change in taxes that causes the swap to no longer be effective? What happens?

Assume the same facts in the previous illustration.

Step 2 -- Spreadsheet the cash flows and values

Fair Value Change in Fair Value

1 (2,487,390)$ (2,487,390)$ 2 (4,000,154) (1,512,764) 3 (1,536,286) 2,463,868 4 - 1,536,286

Way out of corridor (2.81% ÷ 3.58% = 78.49%)

What if the swap terminates?

In year 4 Change in fair value now a component of

investment income / expense. Any deferred outflows / inflows also become a

component of investment income / expense (no more statement of net assets account).

Example 2 – A Swaption

Assumptions: A state enters into a swaption with an investment bank; the bank

has the right, but not the obligation, to force the state to enter into a pay-fixed, variable rate swap in the future.

The state receives an up-front payment of $11,016,200 on 7/1 of year 0.

The fixed rate the state receives is above the market rate - 5.5%. The 2-year forward rate is 3%. The variable rate is SIFMA. The notional amount is $100 million. The swap may have a volatility of up to 30%. At year 1, the one year forward rate is 2.85%. At year 2, the rate is 2.80%. The day after year 2, the bank exercises its option; the rate

continues to be 2.80%.

Example 2 – A SwaptionFair Value

of Borrowing Fair Change inSwaption Using NPV Value Fair Value

1-Jul-00 11,016,200$ 10,861,246$ 154,954$ -$ FYE 1 11,853,615 11,250,737 602,878 (447,924) FYE 2 12,516,164 11,589,040 927,124 (324,246) FYE 3 10,150,169 9,398,505 751,664 175,460 FYE 4 7,717,464 7,145,780 571,684 179,980 FYE 5 5,216,165 4,829,783 386,382 185,302 FYE 6 2,644,340 2,448,463 195,877 190,505 FYE 7 - - - 195,877

Embedded Derivative

Fair value is calculated by taking the net present value of the cash flows at 3%. Fair value of the derivative is the swaption, less the borrowing. The change in fair value is the current year’s less the previous year’s fair value.

Example 2 – A SwaptionBeginning Interest Ending

Balance Accrual Payment Balance

1-Jul-006 months 10,861,246$ 162,919$ -$ 11,024,165$ FYE 1 11,024,165 165,362 - 11,189,527 18 months 11,189,527 167,843 - 11,357,370 FYE 2 11,357,370 170,361 - 11,527,731 30 months 11,527,731 172,916 1,250,000 10,450,647 FYE 3 10,450,647 156,760 1,250,000 9,357,406 42 months 9,357,406 140,361 1,250,000 8,247,767 FYE 4 8,247,767 123,717 1,250,000 7,121,484 54 months 7,121,484 106,822 1,250,000 5,978,306 FYE 5 5,978,306 89,675 1,250,000 4,817,981 66 months 4,817,981 72,270 1,250,000 3,640,250 FYE 6 3,640,250 54,604 1,250,000 2,444,854 78 months 2,444,854 36,673 1,250,000 1,231,527 FYE 7 1,231,527 18,473 1,250,000 -

The beginning balance is the original fair value of the borrowing. The interest accrual is the beginning fair value x 3% x (180/360). The swap payments are after the exercise date. Ending balance = beginning + interest – payments. The $1,250,000 starts in 2½ years until maturity.

Example 2 -- A Swaption

Change in InterestFair Value Expense Swaption Borrowing

FYE 1 (447,924)$ 328,281$ (602,878)$ (11,189,527)$ FYE 2 (324,246) 338,203 (927,124) (11,527,731) FYE 3 175,460 329,676 (751,664) (9,357,406) FYE 4 179,980 264,078 (571,684) (7,121,484) FYE 5 185,302 196,497 (386,382) (4,817,981) FYE 6 190,505 126,873 (195,877) (2,444,854) FYE 7 195,877 55,146 - -

Statement of Net Assets Presentation for Swaption and SwapDR / (Cr) As of and for the Fiscal Year Ending:

1 2 3 4 5 6

Statement of Net Assets

Cash $11,016,200 $11,016,200 $8,516,200 $6,016,200 $3,516,200 $1,016,200

Derivative Instrument - Swaption

(602,878) (927,124) - - - -

Derivative Instrument – Swap

- - (751,864) (571,664) (386,382) (195,877)

Borrowing Payable

11,189,527 11,527,731 9,357,406 7,121,484 4,817,981 2,444,854

Not supposed to foot unless counting statement of activities

Statement of Net Assets Presentation for Swaption and SwapDR / (Cr) As of and for the Fiscal Year Ending:

1 2 3 4 5 6

Statement of Activities

Interest Revenue

(447,924) DR

(324,426) DR

175,460 cr

180,200 cr

185,282 cr 190,505 cr

Interest Expense

328,281 338,203 329,676 264,078 196,497 126,873

Not supposed to foot unless counting statement of net assets

Journal Entries – HIGHLY SIMPLIFIED

Initiation of Swaption

Dr. Cash $11,016,200

Cr. Embedded Derivative – Swaption

$154,954

Cr. Borrowing Payable $10,861,246

FYE 1

Dr. Investment Revenue $447,924

Cr. Embedded Derivative – Swaption

$447,924

Dr. Interest Expense $328,281

Cr. Borrowing Payable $328,281

Journal Entries – HIGHLY SIMPLIFIED

Year 3 – Beginning of Year July 1 – Swaption exercise

Dr. Embedded Derivative – Swaption

$927,124

Cr. Derivative Instrument – Interest Rate Swap

$927,124

Skip forward to FYE 6

Dr. Derivative Instrument – Interest Rate Swap

$190,505

Cr. Interest Revenue $190,505

Dr. Interest Expense $126,874

Dr. Borrowing Payable $2,373,126

Cr. Cash $2,500,000

Journal Entries – HIGHLY SIMPLIFIEDFinal FY – FYE 7

Dr. Interest Expense $55,146

Dr. Borrowing Payable $2,444,854

Dr. Derivative Instrument – Interest Rate Swap

$195,877

Cr. Interest Revenue $195,877

Cr. Cash $2,500,000

Note Disclosure

Summary table of information Information includes:

Notional amounts. Changes in fair value and where it is reported in the

financial statements. Fair values at the end of the year. Reclassifications from hedging to investment derivatives

during the period. Deferral amounts in investment revenue.

Can be narrative if small number of contacts.

Note Disclosure

Narratives include: Objectives of derivatives. Terms of derivatives include:

Notional amounts. Reference rates, indexes, etc. Any embedded options (caps, floors collars). Date of contract and termination or maturity. Any cash paid or received.

TB 2003-1 risks (credit, interest rate, basis, termination, rollover, market access, foreign currency).

Note Disclosure

Other: Hedged debt: follow GASB 38, disclose

net cash flows. If using other quantitative method identify

any notable features of the method. Investment derivatives:

TB 2003-1 disclosures along with GASB 40 disclosures.

Note Disclosure – June 30, Year 1Item Type Objective

Notional Amount

(000’s)Effective

Date Matures Terms

FMV

(000s)

A Variable Receive Interest Rate Swap

Hedge of changes in cash flows of series XX bonds

$100,000 7/1/xx 6/30/x4 Receive 49.96% of LIBOR + 78bps, pay 3.57872%

($2,487)

B Fuel contract Hedge oil market price changes

1 MBTUs 4/30/x0 12/31/x0 Pay $7.50 MBTU, based on pricing point at expiration

111

Disclosure

After table, note the following: Terms not in table. How fair values were calculated. Risks and ratings of counterparties. Contingencies on derivatives. Table of all payments and hedged

debt.

Disclosure – 2nd table

Changes in Fair Value Fair Value at June 30,xx

Governmental Activities

Classification Amount

(000s)

Classification Amount

(000s)

Notional

(000s)

Variable Receive Interest Rate Swap

Deferred Outflow

($2,487) Debt ($2,487) $100,000

Commodity Forward

Deferred Inflow

111 Derivative Instruments

111 1,000 MMBTUs

Transition For financial statements for periods

BEGINNING AFTER June 15, 2009. Retroactive application for all periods

presented. Perform hedge effectiveness evaluation

as of the END of the CURRENT PERIOD ONLY. If effective now, assume effective as of the beginning of the contract.

Other items included in the Statement Huge (11 page) glossary. 12 robust illustrations:

Consistent critical terms. Interest rate swaps – synthetic method. Interest rate swaps – terminations due to market

conditions. Regression analysis. Dollar offset method.

Other items included in the Statement 12 robust illustrations (continued):

Swaptions. Full set of note disclosures.

Flowchart of hedge effectiveness decisions. Codification instructions. Still to Come – Implementation Guide –

Watch for it in 2009!

Questions?

Contact Information:

Eric S. Berman, CPA

Deputy Comptroller

Commonwealth of Massachusetts

[email protected]

617-973-2602