GASB No. 53 – Accounting For Derivative Instruments

1. GASB No. 53 – Accounting For Derivative Instruments FGFOA Conference, Orlando FL, Mark A. White, CPA, Partner, Purvis Gray & Company LLP Jim Towne, Senior VP, DerivActiv

2. Statement 53Accounting and Financial Reporting for Derivative Instruments

3. 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!

4. What Will We Talk About Today? • There are many different types of derivatives that exist in the markets today • Impossible to cover all possibilities today • Will cover basics of the statement • Will go into more detail on Interest Swaps • Interest Rate Swaps are the most common derivative used by local governments and are a major piece of the statement

5. Prior Guidance • Supersedes 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

6. 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!

7. 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)

8. 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)

9. Excluded Instruments • Normal purchases and normal sales contracts • Commodity—for example, gas or electricity used in an activity • Government intends to and has practice of taking delivery or selling the commodity • Quantity is consistent with volume used • Traditional insurance contracts • Non exchange-traded climate contracts, liquidated damages, etc.

10. Hedging Derivative Instruments • The derivative instrument is associated with a hedgeable item • Consistency of notional amounts • Derivative instrument will be reported in same fund as hedgable item • Term or time period consistency • The hedging derivative is effective in significantly reducing the identified financial risk using No. 53 methods

11. Common Derivative Instruments • Interest Rate Swaps • Futures contracts--NYMEX • Options—exchange-traded and others • Swaptions

12. Features of Futures Contracts • Exchange-traded-NYMEX, etc. • Standard terms—notional amount, reference rate/underlying, settlement dates • At the market • Entered into a no cost; however, accounts are adjusted daily • Margin—collateral is required

13. Terminating Events • Hedge accounting to cease upon terminating event; • Hedging derivative is no longer effective by applying No. 53 criteria • Hedging derivative is terminated • Bond refunding (interest rate swap)

14. 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

15. How To Implement • Two 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 methods • If you test as of 9/30/10 and are deemed effective; employ hedge accounting • Record derivative at FMV and defer the gain loss at 9/30/10 values • Re-test annually

16. 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 9/30/09 • Bring 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 9/30/09 • Current 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?

17. Practical Considerations • If Interest Rate Swap effectiveness fails; • DSC coverage problems in utility funds? • Pledge of NET Revenues • Resolution definitions • Technical default • Additional bonds test • FAS 71 bail out? • Would not be a problem for governmental debt where gross revenues are pledged and Swap not recorded at fund level

18. Methods of Evaluating Effectiveness • Consistent Critical Terms • Notional amount same as principal amount • Issued at FMV of zero • Formula for net settlements don’t change over the term of the instrument • Same reference rates • Both or neither can have cap or floor • Same time interval of reference rate • Same maturity dates

19. Methods of Evaluating Effectiveness • Synthetic Instrument Method • Didn’t pass the CCT test, must now measure how much difference there is • Test of if the variable cash flows substantially offset, -- the synthetic fixed rate is substantially fixed • Does the difference in variable cash flows move the fixed rate more than 10%? • No—Effective • Yes– Ineffective

20. Methods of Evaluating Effectiveness • Dollar Offset Method • Compares 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

21. Methods of Evaluating Effectiveness • 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

22. Components of an Interest Swap • Time: Beginning and end • Reference rate • Notional amount • Payment frequency • Receive variable and pay fixed to counterparty • Receive fixed and pay variable to counterparty

23. Swap-Cash Flow Hedge Fixed payment 5.0% State or local government Swap counterparty Variable-rate coupon payments; SIFMA Variable payment received: 67% of 1-month LIBOR Variable-rate bond holders

30. Disclosures • Summary Information; • Segregate between Hedging and Investment Derivatives • Within each category, present by type • Notional amounts • FMV and change in FMV

31. Disclosures • Hedging Derivatives; • Objectives • Terms-notional amounts, reference rates, maturities • Risks-credit risk, interest risk, basis risk, termination risk, rollover risk, market access risk, foreign currency risk, • Investment Derivatives • Risks above

32. 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