GASB 53: Accounting and Financial Reporting for Derivative Instruments Presented by:

1. GASB 53: Accounting and Financial Reporting for Derivative Instruments Presented by: Roger Martinez, Kathy Lai, KPMG LLP, and Ben Cheng, COAUDIT

2. Agenda Year-End GAAP Training Overview of GASB Statement No. 53 Definition of a Derivative Instrument Settlement Factors Leverage Net Settlement Scope Exceptions Hybrid Instruments What is a Derivative Recognition and Measurement Deferred Inflows and Outflows Presentation

3. Agenda Cont. Year-End GAAP Training Miscellaneous Recognition and Measurement Items Determining Fair Value What is Hedging? Types of Hedges Association with a Hedgeable Item What Can Be Hedgeable Items? Overview of Hedge Effectiveness Hedge Effectiveness Testing Methods Other Quantitative Methods Termination of Hedge Accounting Disclosures for Hedging Derivative Instruments

4. Agenda Cont. Year-End GAAP Training Effective Date and Transition CSU Survey Results Questions?

5. Overview of GASB Statement 53 Year-End GAAP Training • Statement issued in June 2008 • Effective for periods beginning after June 15, 2009 • Will require derivative instruments to be reported at fair value in financial statements prepared under the economic resources measurement focus • Reporting changes in fair value will depend on whether derivative instrument is an effective hedge • GASB has also issued a plain-language document on derivative instruments

6. Overview of GASB Statement 53 Year-End GAAP Training • Certain aspects of GASB Statement 53 are conceptually similar to FASB Statement 133, as amended: • Definition of a derivative instrument • Certain scope exceptions • Hedge accounting • Although conceptually similar, there are many differences in application: • Hedge accounting required under GASB 53 if applicable • “All or nothing” approach to reporting changes in fair value using hedge accounting • Not required to quantify ineffectiveness • Use of deferred inflows and outflows • No other comprehensive income item • Methods of testing hedge effectiveness

7. Definition of a Derivative Instrument A derivative instrument is a financial instrument or contract that has all of the following: Settlement factors One or more reference rates (underlyings) One or more notional amounts or payment provisions or both Leverage Requires little or no net investment yet responds to market changes Net settlement Contract terms require or permit net settlement Can be readily settled net outside the contract through a market mechanism; or Provides for delivery of an asset that is readily convertible to cash or is itself a derivative instrument See also Implementation Guide Year-End GAAP Training 7

8. Settlement Factors Year-End GAAP Training • Reference Rates • Reference rate can be any variable with changes that are observable or otherwise objectively verifiable (cannot be the asset or liability itself) • Value of a derivative instrument generally changes by direct reference to changes in the reference rate • Notional Amount • The number of units specified in a derivative contract (e.g. currency, shares, etc): • Amount applied to change in reference rate to determine settlement • Payment Provisions • Fixed or determinable payment made if an underlying changes in a specified manner (e.g. payment if commodity price increases 10%) • Often included in lieu of a notional amount

9. Leverage Year-End GAAP Training • No initial net investment or smaller initial investment than required for other types of contracts having a similar response to changes in market factors • Evaluated from perspective of one party to contract but determines the accounting for both parties • Commodity example: • To buy 10,000 gallons of diesel fuel today at $3 gallon, must pay $30,000 • No money required to enter into forward contract for 10,000 gallons of oil at future date at forward spot price • Fair value of both the purchased diesel fuel and forward contract change similarly with changes in market price of diesel fuel

10. Net SettlementContractual Terms Year-End GAAP Training • Net settlement characteristic has been met if neither party to the contract is required to deliver an asset that: • is associated with the underlying, and • has a principal amount, stated amount, face value, number of shares, or other determination that is equal to the notional amount in the contract • Generally contracts with only a payment provision will meet net settlement under contractual terms

11. Net SettlementMarket Mechanism Year-End GAAP Training • A market mechanism that facilitates net settlement must have ALL of the following characteristics: • Enables one party to the contract to readily liquidate its net position • Results in one party to the contract becoming fully relieved of its rights and obligations under the contract • Liquidation of net position: • Does not require significant transaction costs • Occurs without significant negotiation and due diligence • Occurs within a customary time frame

12. Net SettlementReadily Convertible to Cash Year-End GAAP Training • Puts the recipient in a position not substantially different from net settlement through the contract • Key characteristics: • Interchangeable (fungible) units • Quoted prices available in an active market • Market can rapidly absorb the quantity held by the entity without significantly affecting the quoted price • Significance of transaction costs

13. Scope Exceptions Year-End GAAP Training • Normal purchases and normal sales contracts • Insurance contracts covered under Statement 10 • Financial guarantee contracts that provide payments to the holder only for losses incurred because a specified debtor fails to make payment • Certain contracts not exchange traded with an underlying based on: • A climatic, geological or other physical variable • A price or value of a nonfinancial asset • Loan commitments

14. Hybrid Instruments Year-End GAAP Training • Derivative instruments are often free-standing instruments: • Swaps • Forward contracts • Other times, derivative instruments may accompany or be embedded within a companion instrument: • Combined instrument referred to as a hybrid instrument • Important to identify because derivative instrument may require separate reporting from the companion instrument

15. Hybrid Instruments Year-End GAAP Training • Where to look: • Financial assets and liabilities • Purchase and service contracts • Leases • What to look for: • Renewal, extension, cancellation and prepayment options • Caps, floors, collars • “If…then” contract provisions

16. Reporting Hybrid Instruments Year-End GAAP Training • The derivative and the companion instrument should be reported separately if: • Companion instrument is not measured at fair value • A separate instrument with the same terms as the embedded component would meet definition of a derivative instrument; and • Economic characteristics and risks of the derivative instrument are not closely related to those of the companion instrument • Contracts outside the scope of GASB 53 need not be evaluated as a hybrid instrument

17. Knowledge Check #1 Year-End GAAP Training • Which factor is not considered a settlement factor based on the definition of a derivative: • Reference rates • Notional amount • Leverage • Payment provisions

18. Knowledge Check #1: Answer Year-End GAAP Training C. Leverage A derivative must have settlement factors, leverage and net settlement. The settlement factors are reference rates, notional amount and payment provisions.

19. 2009 GASB 53 IMPLEMENTATION TEAM TRAINING Common Derivative Instruments Common Derivative Instruments AUDIT Year-End GAAP Training

20. What is a Derivative? • An instrument value “depends on” or is “derived from” the value of an underlying asset, reference rate, or index • GASB 53 defines derivatives based on characteristics versus listing instruments • Continued innovations in financial markets render any definitions based on listing obsolete • Understanding characteristic-based definition is essential to applying the statement Year-End GAAP Training

21. Types of Derivative Instruments • Common Types • Futures • Forwards • Swaps • Options • Combinations of the above • Synthetic financial instruments • Uncommon Types • Basket Options • Barrier Options • Contingent Forwards • Currency Translated or Quanto- products • Combinations of items from both columns Year-End GAAP Training

22. Futures/ Forward Contracts • Futures Contracts • An exchange-traded security to buy or sell a security, commodity, foreign currency, or other financial instrument at a certain future date for a specific price • Examples include: • Commodity futures (including oil and natural gas) • Interest rate futures • Forward Contracts • Contract to buy or sell a financial asset or commodity at a specified date in the future for a price agreed upon at inception • Examples include: • Forward rate agreements • Forward commodity contracts Year-End GAAP Training

23. Forward Purchase Contract Value at Maturity P = Price $400 V = Value of Contract Year-End GAAP Training

24. Swap Agreements • Agreement between two counterparties to exchange sequences of cash flows over a specified period of time (e.g. interest rate swaps, currency swaps, commodity swaps) • Exotic swaps • Forward-starting swaps • Index-amortizing swaps • Leveraged swaps • Swaptions – can be used to monetize a call feature in a bond • Swaps with embedded options Year-End GAAP Training

25. Option Contracts • Provide holder the right, but not the obligation, to buy or sell underlying instrument at a specified price • Strike price • Exercise style • American options • European options • Bermudan options* • Asian options* • Premium • Call vs. put options • Option value = time value + intrinsic value • Exotic option types (includes Bermudan and Asian) Year-End GAAP Training

26. Examples of Option Contracts • Equity options • Interest rate and currency options • Embedded options Year-End GAAP Training

27. Combinations of Options • Caps • Series of individual call options • Gives buyer the right to receive positive difference between the cap rate and reference rate • Requires payment of a premium • Floors • Series of individual put options • Gives buyer the right to receive the negative difference between the floor rate and reference rate • Collars • Combination of a purchased cap and a written floor • Combination of a written cap and a purchased floor Year-End GAAP Training

28. Valuation of Derivative Instruments • GASB 53 paragraph 21 • Zero coupon method (for swaps) • Par value method (for forwards) • SAS No. 92, Auditing Derivative Instruments, Hedging Activities, and Investment Securities • SAS No. 101, Auditing Fair Value Measurements and Disclosures Year-End GAAP Training

29. Knowledge Check #2 • An entity enters into an agreement with a supplier to purchase a quantity of heating oil at a certain future time, for a certain price, and a certain quantity. What type of derivative is this considered? • Futures Contract • Forward Contract • Option • Swap Agreement Year-End GAAP Training

30. Knowledge Check #2: Answer • B. Forward Contract • A forward contract is a contractual agreement to buy or sell a security, commodity, foreign currency, or other financial instrument, at a certain future date for a specific price. Year-End GAAP Training

31. Valuation Examples Year-End GAAP Training • Valuation is outside the scope of this course • Examples: • Valuing Forwards • Valuing Interest Rate Swaps

32. 2009 GASB 53 IMPLEMENTATION TEAM TRAINING Common Derivative Instruments Recognition and Measurement Provisions AUDIT Year-End GAAP Training

33. Recognition and MeasurementDerivative Instruments are Reported at Fair Value Generally, all derivative instruments within the scope of GASB 53 should be reported on the statement of net assets at fair value Exception for certain synthetic guaranteed investment contracts Reporting the changes in fair value depends on the classification of the derivative instrument: 1. Hedging derivative instrument (HDI) → Applyhedge accounting Entire fair value change is deferred on the statement of net assets (deferred inflow and outflow accounts) Continue to apply hedge accounting until a termination event occurs 2. Investment derivative instrument → Apply investment accounting All derivative instruments not considered HDIs are investment derivative instruments Fair value change is reported on the change statement in the period it occurs (investment revenue classification) Year-End GAAP Training

34. Recognition Under Hedge Accounting Year-End GAAP Training • For HDIs that have positive fair values: • Report HDI as an asset • Report deferred inflow (credit) offsetting the asset • For HDIs that have negative fair values: • Report HDI as a liability • Report deferred outflow (debit) offsetting the liability • Unlike under FASB 133, entire amount of the HDI is offset by the deferred inflow or outflow: • No calculation of “ineffectiveness” amount that would be reported as a current period change statement item

35. Presentation of Derivative Instruments Year-End GAAP Training • Currently, there is no specific guidance on how to present derivative instruments on the Statement of Net Assets: • Aggregated gross under “derivatives” captions within assets and liabilities sections? • Aggregated net under a single “derivatives” caption? • HDIs netted with hedged assets and liabilities? • Investment derivative instruments reported within investments captions? • Combination of all of the above? • How should derivatives be classified within the net asset categories? • Where derivatives are reported in Statement of Net Assets will be part of required note disclosures

36. Miscellaneous Recognition and Measurement Items Year-End GAAP Training Hedge accounting is mandatory under GASB 53 HDIs should be reported in the same fund as the item being hedged Transactions for exchange-traded derivatives should be accounted for based on the trade date, not the settlement date Entities applying FASB 71 for regulated utilities must still apply hedge accounting

37. Determining Fair Value Use market price if there is an active market for the derivative instrument If a market price is not available, then use a forecast of expected cash flows (discounted) Also acceptable: Formula-based methods Mathematical methods Zero-coupon method Par-value method Matrix pricing Black-Scholes-Merton Model Pricing services, provided they use the principles described above FASB 157 approach may, but is not required, to be applied Year-End GAAP Training

38. Knowledge Check #3 Except certain synthetic guaranteed investment contracts, all derivative instruments within the scope of GASB 53 should be reported on the statement of net assets at fair value True False Year-End GAAP Training

39. Knowledge Check #3: Answer A. True An entity should use market price if there is an active market for the derivative instrument to estimate fair value. If a market price is not available, then use a discounted cash flows methods. Formula or mathematical based methods or pricing services are also acceptable Year-End GAAP Training

40. 2009 GASB 53 IMPLEMENTATION TEAM TRAINING Common Derivative Instruments Hedge Accounting AUDIT Year-End GAAP Training

41. What is Hedging? Year-End GAAP Training • Hedging is a method governments employ to reduce identified financial risks: • Increases in interest costs • Increases in commodity prices • Losses due to counterparty default • Fair value declines due to changes in market interest rates • Governments use derivative instruments as a mechanism to hedge identified financial risks • Risks hedged through changes in cash flows or fair values of derivative instruments offsetting changes in cash flows or fair values of associated items

42. Types of Hedges Year-End GAAP Training • Cash flow hedges: • Address risks that arise due to prices or rates that are variable: • Manage risks by eliminating variable or market fluctuations to which the cash flows of the associated item are subject: • Majority of hedges undertaken by governments are cash flow hedges • Fair value hedges: • Address risks of changes in fair values of items that have prices or rates that are fixed or known • Manage risks by “unlocking” fixed prices and rates thereby allowing item to be valued as if it had current market rate/price

43. Hedging Derivative Instruments A Hedging Derivative Instrument (HDI) is established, and hedge accounting MUST be applied if there is: Association: Derivative instrument is associated with a hedgeable item AND Substantial Offset: Derivative instrument is effective in substantially offsetting changes in cash flows or fair value of the hedgeable item resulting from the identified financial risk hedge effectiveness Hedge accounting is NOT an option Contemporaneous documentation of the hedge is encouraged, but NOT required for application of hedge accounting Year-End GAAP Training

44. Association with a Hedgeable Item Year-End GAAP Training • Absent a documentation requirement, it may not always be apparent whether a derivative instrument is associated with a hedgeable item • Consider facts and circumstances of derivative instrument, including whether: • Notional amount of derivative instrument is consistent with principal/quantity of hedgeable item • Derivative instrument will be reported in the same fund as the hedgeable item • Term or time period of derivative instrument is consistent with that of the hedgeable item • Derivative instrument that is associated with a hedgeable item, but has yet to be determined effective is referred to in GASB 53 as a potential hedging derivative instrument (PHDI)

45. What Can Be Hedgeable Items? Year-End GAAP Training • Hedgeable items can be all or a portion of: • A single asset or liability • An entire bond issuance • $60 million of a $100 million bond issuance may be hedgeable item • Groups of similar assets and liabilities • Individual assets or liabilities in the group must be exposed to the same identified financial risk being hedged • An expected transaction • Expected bond issuance • Expected commodity purchase/sale • Assets and liabilities measured at fair value cannot be hedgeable items • Fair value of hedgeable item reported in change statement so no need for hedge accounting • Transactions within primary government cannot be hedgeable items • Transactions between primary government and discretely presented component units can be hedgeable items

46. What Can Be Hedgeable Items?Expected Transactions Year-End GAAP Training • For an expected transaction to be a hedgeable item, it should be probable of occurring • Probability should be supported by observable facts, including: • The frequency, volume and amount of past transactions • The financial, operational, and legal ability of the government to carry out the transaction • The extent of loss or disruption to a government’s activities that could result if the transaction does not occur • The government’s budget or other planning documents • If the hedgeable item is an expected transaction, the evaluation of effectiveness should consider the probable terms of the transaction

47. Knowledge Check #4 Year-End GAAP Training An entity issues fixed-rate bonds and at the same time, it enters into an interest rate swap that would swap its fixed bond payments for interest payments that are at market. What type of hedge is this? • Cash flow hedge • Fair value hedge

48. Knowledge Check #4: Answer Year-End GAAP Training B. Fair value hedge By entering into the interest rate swap, the entity would synthetically be paying the market interest rate, keeping the fair value of the bond liability consistently at par.

49. Overview of Hedge Effectiveness Year-End GAAP Training • Hedge effectiveness testing should be performed for each PHDI: • At the end of the reporting period of the inception of the hedge; and • At the end of each subsequent reporting period for as long as the hedge is effective • End of reporting period applies to interim periods if financial statements are prepared on a GAAP basis • Hedge effectiveness testing is not required at the inception of the hedge • Different testing methods may be used across the population of PHDIs

50. Hedge Effectiveness Testing Methods Year-End GAAP Training • GASB 53 provides the following methods for testing hedge effectiveness: • Consistent Critical Terms Method • Quantitative Methods • Synthetic Instrument Method • Dollar-Offset Method • Regression Analysis Method • GASB 53 also provides conceptual requirements for other quantitative methods not specified in Statement