precision experience assurance gasb no. 53 – accounting for derivative instruments fgfoa...

Precision Experience Assurance

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GASB No. 53 – Accounting For Derivative Instruments

FGFOA Conference, Orlando FL,Mark A. White, CPA, Partner, Purvis

Gray & Company LLPJim Towne, Senior VP, DerivActiv


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Statement 53

Accounting and Financial Reporting

for Derivative Instruments


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Attribution and Acknowledgment

We would like to acknowledge and thank both David Bean of GASB and Stephen Gauthier of GFOA for sharing some of their presentation materials on this subject with us. Much of the material contained in this presentation comes from information that they have provided, we hope to do it some justice!


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What Will We Talk About Today?

There are many different types of derivatives that exist in the markets today

Impossible to cover all possibilities todayWill cover basics of the statementWill go into more detail on Interest SwapsInterest Rate Swaps are the most common

derivative used by local governments and are a major piece of the statement


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Prior GuidanceSupersedes Technical Bulletin No. 2003-1, Disclosure

Requirements for Derivatives Not Reported at Fair Value on SONA

Amends Statement No. 7, Advance Refundings Resulting in Defeasance of Debt, paragraph 11

Amends Statement No, 23, Accounting and Financial Reporting for Refundings of Debt Reported by Proprietary Activities

Various other less used areas


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One Page Summary of No. 53

Derivatives generally fit into two general categories;Hedging derivative if effectiveness test is met

Record at FMV and defer the gain or loss Investment derivative if effectiveness test is not met

Record at FMV and recognize investment gain or loss OUCH!!

Thus most of the statement deals with meeting hedge effectiveness—the prize!


What is a Derivative Instrument for Financial Reporting Purposes?

A financial instrument or contract that has all of the following characteristics:

One or more reference rates (underlying) and one or more notional amounts or payment provisions

LIBOR, SIFMA Currency or other units specified in the derivative Currency units, shares, pounds, MMBTUs

Leverage Little or no initial cash investment

Net settlement Terms require or permit settlement net Not required to take delivery of commodity Can be settled with another derivative (swaption)

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How Does a Derivative Differ From a Traditional Financial Instrument?

Investment instruments—generally do not meet the second characteristic (initial investment is not leveraged)

Debt instruments—generally do not meet the third characteristic (not net settled)

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Excluded Instruments

Normal purchases and normal sales contractsCommodity—for example, gas or electricity used

in an activityGovernment intends to and has practice of taking

delivery or selling the commodityQuantity is consistent with volume used

Traditional insurance contractsNon exchange-traded climate contracts,

liquidated damages, etc.

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Hedging Derivative Instruments

The derivative instrument is associated with a hedgeable itemConsistency of notional amountsDerivative instrument will be reported in same fund as

hedgable itemTerm or time period consistency

The hedging derivative is effective in significantly reducing the identified financial risk using No. 53 methods


Common Derivative Instruments

Interest Rate Swaps

Futures contracts--NYMEX

Options—exchange-traded and others

Swaptions

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Features of Futures Contracts

Exchange-traded-NYMEX, etc.Standard terms—notional amount, reference

rate/underlying, settlement datesAt the marketEntered into a no cost; however, accounts are

adjusted dailyMargin—collateral is required

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Terminating Events

Hedge accounting to cease upon terminating event;Hedging derivative is no longer effective by

applying No. 53 criteriaHedging derivative is terminatedBond refunding (interest rate swap)


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Terminating Events

Balance in deferral account should be reported in flow of resources statement within investment revenue - no more hedge accounting

If refunding or advance refunding of hedged debt, the balance in the deferral account is considered carrying value of old debt for gain or loss on refunding

If debt is remarketed—no gain/loss deferral must go to investment gain/loss


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How To ImplementTwo ways to calculate effectiveness;

End of first year of adoption (FYE 9/30/10)Life to date of derivative through end of first year

of adoption (5/14/04 through 9/30/10) Must have information available from inception

Annual test, can use any of the approved methodsIf you test as of 9/30/10 and are deemed

effective; employ hedge accountingRecord derivative at FMV and defer the gain loss

at 9/30/10 valuesRe-test annually


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How To Implement If 9/30/10 effectiveness fails;

Test effectiveness as of 9/30/09, if effective; Record at FMV and defer gain/loss as of 9/30/09Bring deferred gain/loss into Investment Income in 2010

Test effectiveness as of 9/30/09, if ineffective; Record at FMV and restate equity as of 9/30/09Current year change in FMV—investment gain/loss

What about retesting next year if ineffective this year?Too bad forever, unless terms of instrument substantially modified

Record at fund level or entity wide?


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Practical Considerations

If Interest Rate Swap effectiveness fails;DSC coverage problems in utility funds?

Pledge of NET RevenuesResolution definitionsTechnical defaultAdditional bonds testFAS 71 bail out?

Would not be a problem for governmental debt where gross revenues are pledged and Swap not recorded at fund level


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Methods of Evaluating Effectiveness

Consistent Critical TermsNotional amount same as principal amount Issued at FMV of zeroFormula for net settlements don’t change over the term of

the instrumentSame reference ratesBoth or neither can have cap or floorSame time interval of reference rateSame maturity dates


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Synthetic Instrument MethodDidn’t pass the CCT test, must now measure how much

difference there isTest of if the variable cash flows substantially offset, --

the synthetic fixed rate is substantially fixedDoes the difference in variable cash flows move the

fixed rate more than 10%?No—EffectiveYes– Ineffective


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Dollar Offset MethodCompares the changes in expected cash flows or fair

values of the hedging derivative to the same for the hedgable item

Can be applied YTD or LTD

Has to fall within 80 to 125% in absolute terms


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Regression Analysis

Other quantitative methods

These methods are too detailed to go into today, they are in the statement and implementation guide and Jim Towne can answer any question you might have on them after the presentation


Components of an Interest Swap

Time: Beginning and endReference rateNotional amountPayment frequencyReceive variable and pay fixed to counterpartyReceive fixed and pay variable to counterparty

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Swap-Cash Flow Hedge

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Swap counterpartyState or local government

Variable-rate bond holders

Variable-rate coupon payments; SIFMA

Variable payment received: 67% of 1-month LIBOR

Fixed payment 5.0%


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Consistent Critical Terms Method

Fail Due to Benchmark

Interest Rate Contract Variable Rate Demand Bonds

Swap Value at Inception 0

Swap Fixed Leg Fixed for Life of Swap

Notional Amount $ 10,000,000 Bond Principal $ 10,000,000

(no amortization) (no amortization)

Termination Date 12/1/2030 Maturity Date 12/1/2030

Variable Index 70% of 1 Month LIBOR Bechmark Interest Rate SIFMA

Frequency of Reset Weekly Frequency of Reset Wekly

Swap Payment Dates 1st Bus. Day of ea. Mo. Bond Coupon Payment Dates 1st Bus. Day of ea. Mo.


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Consistent Critical Terms Method

Pass

Interest Rate Contract Variable Rate Demand Bonds

Swap Value at Inception 0

Swap Fixed Leg Fixed for Life of Swap

Notional Amount $ 10,000,000 Bond Principal $ 10,000,000

(no amortization) (no amortization)

Termination Date 12/1/2030 Maturity Date 12/1/2030

Variable Index SIFMA Bechmark Interest Rate SIFMA

Frequency of Reset Weekly Frequency of Reset Wekly

Swap Payment Dates 1st Bus. Day of ea. Mo. Bond Coupon Payment Dates 1st Bus. Day of ea. Mo.


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Synthetic Instrument Method (Cash Flow Hedges Only-No Hybrids of Fair Value Hedges)

Swap Notional Amount $ 10,000,000 Pay Fixed - Receive Variable From Counterparty

Swap Fixed Rate 4%

SWAP Index 70% 1 Mo. LIBOR

Fixed Swap Variable Swap Net Variable

Pmnt. To Receipt From Derivative Bond Total Synthetic

FYE Counterparty Counterparty (Pmnt) Receipt Interest Payments Rate

9/30/2010 $ (400,000) $ 100,000 $ (300,000) $ (95,000) $ (395,000) 3.95%

Analysis of Synthetic Instrument Test

Synthetic Rate 3.95%

Swap Fixed Rate 4.00%

Percentage Ratio 98.75%

Is Ratio Between 90% and 111%? Pass


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Synthetic Instrument Method (Cash Flow Hedges Only-No Hybrids of Fair Value Hedges)

Swap Notional Amount $ 10,000,000 Pay Fixed - Receive Variable From Counterparty

Swap Fixed Rate 4%

SWAP Index 70% 1 Mo. LIBOR

Fixed Swap Variable Swap Net Variable

Pmnt. To Receipt From Derivative Bond Total Synthetic

FYE Counterparty Counterparty (Pmnt) Receipt Interest Payments Rate

9/30/2010 $ (400,000) $ 45,000 $ (355,000) $ (95,000) $ (450,000) 4.50%

Analysis of Synthetic Instrument Test

Synthetic Rate 4.50%

Swap Fixed Rate 4.00%

Percentage Ratio 112.50%

Is Ratio Between 90% and 111%? Fail


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Dollar Offset Method

FYE FYE Change In

9/30/2009 9/30/2010 FMV

Fair Value of Derivative $ (1,000,524) $(1,254,755) $ (254,231)

Fair Value of Item Being Hedged $ (802,445) $(1,044,589) $ (242,144)

Dollar Offset 104.992%

Does Dollar Offset Fall Within the 80% to 125% Band? Pass


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Dollar Offset Method

FYE FYE Change In

9/30/2009 9/30/2010 FMV

Fair Value of Derivative $ (1,000,524) $(1,254,755) $ (254,231)

Fair Value of Item Being Hedged $ (802,445) $ (955,447) $ (153,002)

Dollar Offset 166.162%

Does Dollar Offset Fall Within the 80% to 125% Band? Fail


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Disclosures

Summary Information;

Segregate between Hedging and Investment Derivatives

Within each category, present by type

Notional amounts

FMV and change in FMV


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Disclosures

Hedging Derivatives;ObjectivesTerms-notional amounts, reference rates, maturitiesRisks-credit risk, interest risk, basis risk, termination

risk, rollover risk, market access risk, foreign currency risk,

Investment DerivativesRisks above


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GASB No. 53 – Accounting For Derivative Instruments

FGFOA Conference, Orlando FL,Mark A. White, CPA, Partner Purvis Gray & Company

LLP, 888-378-2463

Jim Towne, Senior VP, DerivActiv, 952-746-6049

precision experience assurance gasb no. 53 – accounting for derivative instruments fgfoa...

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