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GASB No. 53,

GASB No. 53,. Accounting and Financial Reporting for Derivative Instruments. NASC Annual Conference March 25, 2009 Graylin E. Smith Managing Partner SB & Company, LLC. Objectives. To provide a clear understanding of financial derivative instruments and their uses

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GASB No. 53,

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  1. GASB No. 53, Accounting and Financial Reporting for Derivative Instruments NASC Annual Conference March 25, 2009 Graylin E. Smith Managing Partner SB & Company, LLC

  2. Objectives 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

  3. What are financial derivative instruments? • 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.

  4. Why are Derivatives used by state and local governments? To be hedges To lower borrowing costs To generate income To manage cash flows

  5. Common Derivatives used by governments Interest rate and commodity swaps Interest rate locks Options (caps, floors, and collars) Swaptions Forward contracts Futures contracts

  6. What is hedgeable? 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).

  7. What cannot be hedged? Interfund transactions Investments that are measured at fair value

  8. Do Derivatives Result in an effective hedge? • GASB 53 provides criteria that governments can use to determine whether a derivative instrument creates an effective hedge.

  9. Methods for evaluating hedge effectiveness • 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.

  10. Hybrid instruments Consist of derivatives and companion instruments. Embedded derivatives may be a hedging derivative instrument if the applicable criteria are met.

  11. Hybrid instruments • Hybrid instruments can be recognized as a derivative instrument if: • The companion instrument is not measured at fair value • The separate instrument would meet the definition of a derivative • The “economic characteristics and risks” of the derivative instrument are not “closely related” to those of the companion instrument

  12. Methods for evaluating hedge effectiveness • 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.

  13. Hedging Disclosure • 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.

  14. Accounting for Hedge Derivative instruments 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.

  15. Accounting for Hedge derivative instruments (continued) 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.

  16. Accounting for Hedge derivative instruments (continued) 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.

  17. Hedge risks 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

  18. Termination events 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

  19. Termination of a hedge • 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

  20. GASB 53 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.

  21. GASB 53 (Continued) 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.

  22. GASB 53 and Fasb 133 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.

  23. Comparing Gasb 53 and fasb 133

  24. Items to be disclosed in the notes to the financial statements 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

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