GASB—Derivatives and Other Topics

1. GASB—Derivatives and Other Topics Wesley Galloway April 22, 2005 APPA Business and Financial Spring Meeting

2. Overview • Derivative disclosures: Technical Bulletin 2003-1, Disclosure Requirements for Derivatives Not Presented at Fair Value on the Statement of Net Assets • Reporting derivatives on the financial statements: the Derivatives and Hedging Project • “Matched book” topic • Securitizations

3. Objective of TB Clarifies guidance on derivative disclosures • Supersedes Technical Bulletin 94-1 • Considered interim guidance pending the completion of the GASB’s Derivatives and Hedging project • Applies only to derivatives that are not reported at fair value on the statement of net assets (or balance sheet)

4. Note Disclosures Governments that, as of the date of the financial statements, are party to a derivative that was not reported at fair value on the statement of net assets should disclose certain information: • Objective(s) of derivative • Significant terms • Fair value • Risks • Associated debt

5. Objective of Derivative • Objective for entering into derivative • Context needed to understand objective • Strategies for achieving objective • Indicate types of derivatives used–including options purchased or sold

6. Significant Terms • Notional, face, or contract amount • Interest rates—including terms such as: • Caps • Collars • Embedded options • Date derivative became effective and when it is scheduled to terminate or mature

7. Fair Value Fair value at reporting date • Use quoted market prices if an active market • If no quoted market prices, disclose method used to determine fair value and significant assumptions of that method

8. What Are Acceptable Methods for Determining Fair Value? • Dealer quotes • Discounted expected future cash flows • Zero-coupon method • Option pricing models

9. Risks • Credit risk—risk that a counterparty will not fulfill its obligations • Credit quality rating of counterparty • Maximum potential “credit risk” loss • Collateral that supports derivatives • Master netting arrangements that mitigate risk • Counterparty’s diversification

10. Risks • Interest rate risk • Basis risk—risk that when variable interest rates on a derivative and associated bond are based on different indexes. • Termination risk—risk that a derivative’s unscheduled end affects a government’s asset/liability strategy or results in potentially significant unscheduled payments to the counterparty.

11. Risks • Rollover risk—risk that a derivative associated with a government’s variable-rate bond does not extend to the bond’s maturity. • Market-access risk—risk that a government will not be able to enter credit markets or that credit will become more costly.

12. Associated Debt Some derivatives are issued with the intention of effectively making the variable rate of an associated debt obligation pay a synthetic interest rate, as in the case of a variable-to-fixed interest rate swap. • Derivative’s net cash flow should be disclosed in addition to the debt service requirements of the associated debt.

13. Associated Debt

14. Effective Date • Effective date for Technical Bulletin: For periods ending after June 15, 2003

15. Derivatives and Hedging Project Objective: To consider establishing additional financial reporting and disclosure requirements for derivatives and hedge accounting.

16. Reporting Derivatives on the Financial Statements—Possibilities • Measure derivatives at fair value, without “special accounting” Special accounting possibilities: • Hedge accounting: Report derivatives at fair value, derivative gains and losses as deferred charges or deferred credits • A context-based measurement

17. Hedge Accounting • Hedging is common. Hedge accounting is not. • Hedge accounting is the suspension of the accounting rules to arrive at a predetermined outcome. Gains and losses of one transaction are managed to match losses and gains of another.

18. Hedge Accounting • Deferral hedge accounting. • Derivatives gains and losses are reported as deferred credits or deferred charges, respectively.

19. Context-Based Measurement • A derivative would be measured according to the measurement of its associated transactions. The two most likely measurements are historic price or fair value. • Examples: Association Measurement Debt Historical price Investment Fair value

20. Context-Based Measurement • If there is no associated transaction, the derivative would be measured at fair value. • Notwithstanding the foregoing, a derivative would be measured at fair value if either party intends to terminate the derivative.

21. Criteria for Special Accounting • If there is to be a provision for “special accounting,” what would be the specifics? • Would special accounting be an option or a requirement?

22. Matched Book • Arises when investments are measured at fair value and a matching liability is measured at its historical price • Mixed attribute model • HFAs, lotteries, and some trust and reserve funds are examples

23. Project Timetable • Preliminary Views document planned for first quarter of 2006 • Public hearing on Preliminary Views document • Exposure Draft first quarter of 2007 • Final standard fourth quarter of 2007

24. Randal J. Finden rjfinden@gasb.org 203.956.5240 The views expressed in this presentation are those of the speaker. Official positions of the GASB are determined only after extensive due process and deliberation.