GASB Issues Statement No. 53, Accounting and Financial Reporting for Derivative Instruments

“By requiring the fair values of derivative instruments to be reported on the face of financial statements prepared using the accrual basis of accounting, Statement 53 brings additional transparency to those transactions," said Robert Attmore, chairman of the GASB. “The application of the financial reporting standards required by this Statement gives the users of financial statements a clearer look into the risks their governments are sometimes exposed to when they enter into these transactions and how those risks are managed.”

Governments often enter into derivative instruments as hedges of identified financial risks associated with specific assets or liabilities, or expected transactions (that is, hedgeable items). Many of these hedges are intended to effectively offset changes in interest rates or commodity prices. While derivative instruments can be an effective risk management or investment tool, they also can expose governments to significant risks and liabilities. The new standard provides specific criteria that governments will use to determine whether a derivative instrument results in an effective hedge. Changes in fair value for effective hedges that are achieved with derivative instruments will be recognized in the reporting period to which they relate. The changes in fair value of these hedging derivative instruments do not affect current investment revenue, but are instead reported as deferrals in the statement of net assets or the balance sheet. Derivative instruments that either do not meet the criteria for an effective hedge 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 of those derivative instruments are reported as part of investment revenue in the current reporting period. Statement 53 also improves disclosures, providing a summary of the government’s derivative instrument activity, its objectives for entering into derivative instruments, and their significant terms and risks.

More information about GASB Statement 53- including a question and answer document, fact sheet, and plain language article-is available at www.gasb.org.

About the Governmental Accounting Standards Board

The GASB is the independent, not-for-profit organization formed in 1984 that establishes and improves financial accounting and reporting standards for state and local governments. Its seven members are drawn from the Board’s diverse constituency, including preparers and auditors of government financial statements, users of those statements and members of the academic community. More information about the GASB can be found at its website www.gasb.org.

JUNE 2008

GASB Derivatives Standard to Bring Enhanced Consistency and Transparency to Governmental Finacial Statements

The use of derivative instruments by state and local governments has become significantly more prevalent over the past several years. These instruments, though sometimes highly complex and requiring special expertise and ongoing monitoring, can help governments more effectively and predictably manage their exposure to a specific risk. By entering into these arrangements, governments can take advantage of the economics of an underlying transaction without actually entering into the transaction itself (for example, a utility company enters into a natural gas futures contract to lock in a fixed price without actually having to buy the gas). But at the same time, derivatives may expose a government to significant risks that it would not otherwise face. For example, when a government enters into an interest rate swap, it may be exposed to credit risk.

Derivative instruments are rooted in, or derive from, how market prices change in the separate transaction or agreement. A typical derivative instrument is entered into with little or no initial payment, can be settled with a cash payment or the transfer of an equivalent asset, and has a value based on a separate transaction or agreement. That is, the cash flows and fair values of derivative instruments are determined by market prices, such as bond or commodity prices. Some derivative instruments may even provide an up-front cash payment to a government.

In summary, derivative instruments offer governments a broader array of options than would otherwise be available for achieving a number of desired results, including reducing and managing various economic risks, lowering borrowing costs, and generating income. As noted earlier, derivative instruments also may expose a government to significant risks.

REPORTING DERIVATIVE INSTRUMENTS IN THE FINANCIAL STATEMENTS

By requiring that derivative instruments be reported on the face of the financial statements of state and local governments, Statement 53 makes these arrangements more consistent and transparent for users of governmental financial statements. Ultimately, Statement 53 gives financial statement users access to information needed to evaluate the inherent risks that derivative instruments can potentially pose to the financial health of governments, and to better understand the nature of these transactions, including how their value and cash flows change over time. Consequently, users will now have access to a more complete picture of a government’s finances, allowing them to make better informed decisions about those finances.

In general, the fair value of a derivative instrument as of the end of the period covered by the financial statements will be reported in the statement of net assets (balance sheets). Changes in fair value should be reported in the flow of resources statements (such as the statement of activities) as investment gains or losses. However, the annual changes in the fair value of a hedging derivative instrument should be reported as deferred inflows or deferred outflows on the statements of net assets.

HEDGING DERIVATIVE INSTRUMENTS

The Board concluded that deferring changes in the fair value of hedging derivative instruments provides a better measure of interperiod equity than recognizing them in the current period. In other words, the benefit to or burden on taxpayers resulting from the fair value changes will not occur until a point in the future (such as when the derivative instrument ends) and therefore the changes should not flow through the flow of resources statements until that time.

Deferral of changes in fair value will last until the hedging derivative instrument ends or ceases to significantly reduce risk, at which time most deferred gains or losses will be reported in the change statements.

REQUIRED NOTES TO THE FINANCIAL STATEMENTS

Governments should provide additional 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, and the net cash flows of derivative instruments that hedge debt. The disclosure also should highlight the risks to which derivative instruments expose a government, including:

• Termination risk-the possibility that a derivative instrument may end earlier than expected, thus depriving the government of the protection from risk and potentially requiring it to make a significant termination payment
• Credit risk-the chance that the firm on the other side of the derivative instrument will not make good on its promise to pay the government
• Interest rate risk-the risk that changes in interest rates could reduce the value of the derivative instrument to the government
• Basis risk-the possibility the government may lose cash flows because of differences in the indexes upon which a derivative instrument and the item it hedges are based-for example, the London Interbank Offered Rate versus the AAA general obligations index
• Rollover risk-the maturity of the derivative instrument is.shorter than the maturity of the associated debt, leaving the government unprotected in the future
• Market-access risk-the chance that a government will not be able to issue debt
• Foreign currency risk-the possibility that changes in exchange rates will adversely affect the value of a derivative instrument.

Rather than apply the hedging derivative instrument disclosures, derivative instruments that are considered investments will be disclosed according to the requirements set forth in GASB Statement No. 40, Deposit and Investment Risk Disclosures.

INCORPORATING FEEDBACK

Most significantly, the Board decided not to address the issue of reporting derivative instruments at fair value in the governmental fund statements in this Statement. The Board will reserve consideration of this issue for its conceptual framework project on recognition and measurement attributes. Also, the Board decided that further elaboration was necessary regarding the meaning of what "on or about" means in the context of the repricing dates of a hedging interest rate under the consistent critical terms method. In addition, the Board decided that financial guarantee contracts, loan commitments, and insurance contracts are outside of the scope of the Statement.

WHEN DOES THE STANDARD TAKE EFFECT?

• Order Statement 53
• Read the news release
• Read more about the Derivative Instruments project

Accounting and Financial Reporting for Derivative Instruments

WHAT IS THE GASB?

The Governmental Accounting Standards Board or GASB is a private, independent, not-forprofit organization. (It is not a federal agency, nor is it associated with the Federal government.) The GASB, through an open and thorough due process, establishes and improves standards of financial accounting and reporting for state and local governments.

The GASB has issued a new Statement to improve the accounting and financial reporting of derivative instruments that will result in greater consistency and transparency of those transactions.

WHAT IS A DERIVATIVE INSTRUMENT AND HOW DOES IT AFFECT A STATE OR LOCAL GOVERNMENT?

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. Most derivative instruments are entered into by governments with the intent to lower the costs of borrowing, lock-in prices, or lower price volatility.

WHAT RISKS DO DERIVATIVE INSTRUMENTS PRESENT?

While a valuable financial instrument, derivative instruments also present significant risks to governments that users of financial statements should be aware of

• Termination risk-the possibility that a derivative instrument may end earlier than expected, thus depriving the government of the protection from risk and potentially requiring it to make a significant termination payment
• Credit risk-the chance that the firm on the other side of the derivative instrument will not make good on its promise to pay the government
• Interest rate risk-the risk that changes in interest rates could reduce the value of the derivative instrument to the government
• Basis risk-the possibility the government may lose cash flows because of differences in the indexes upon which a derivative instrument and the item it hedges are based-for example, the London Interbank Offered Rate versus the AAA general obligations index
• Rollover risk-the maturity of the derivative instrument is shorter than the maturity of the associated debt, leaving the government unprotected in the future
• Market-access risk-the chance that a government will not be able to issue debt
• Foreign currency risk-the possibility that changes in exchange rates will adversely affect the value of a derivative instrument.

WHY IS AN ACCOUNTING STANDARD ON DERIVATIVE INSTRUMENTS FOR GOVERNMENTS NECESSARY?

The use of derivative instruments by governments has become much more prevalent over the past several years and current accounting standards for derivative instruments are not consistent. Many derivative instruments are reported on the financial statements only when their associated cash payments are made or received. On the other hand, some derivative instruments are reported at their fair values. In all cases, current standards require governments to disclose information about their derivative instruments to financial statement users in the notes to the financial statements.

Derivative instruments can represent significant resources to governments or claims against governmental resources. For example, termination of a derivative instrument can have a significant impact on a government’s financial position. Accordingly, the GASB believes that the best way to inform financial statement readers about the use of these instruments is to report them on the face of the accrual basis of accounting financial statements in a consistent manner that reflects their current prices or fair values.

HOW WILL DERIVATIVE INSTRUMENTS BE REPORTED IN THE FINANCIAL STATEMENTS?

As previously noted, the new Statement requires that most derivative instruments be reported on the financial statements at their fair values. The changes in fair values of hedging derivative instruments are reported as deferred inflows and deferred outflows on the statement of net assets. A hedging derivative instrument significantly reduces an identified financial risk by substantially offsetting the changes in cash flows or fair values of its associated item. The changes in fair value of other derivative instruments that are investment derivative instruments, including those that are ineffective hedges, are reported as income or loss in the investment revenue classification in the current year.

HOW WAS THE STATEMENT TAILORED FOR THE STATE AND LOCAL GOVERNMENT FINANCIAL REPORTING ENVIRONMENT?

A key consideration of the state and local government reporting environment is whether the current year’s resources were sufficient to cover the current year’s costs. When employed as hedges that are determined to be effective based on the criteria provided in the Statement, the fair value gains and losses of derivative instruments do not relate to the current year, but to future periods. In that case, those fair value changes would be deferred and reported as inflows or outflows of resources in future periods, not distorting the current year assessment of interperiod equity.

HOW WAS THE FINAL STATEMENT CHANGED FROM WHAT WAS IN THE EXPOSURE DRAFT THAT THE GASB ISSUED IN JUNE 2007?

Other GASB projects are addressing how governmental funds measure and report transactions. Accordingly, the final Statement does not address how governmental funds (which employ the current financial resources measurement focus) should report derivative instruments. Also, the Board decided that further elaboration was necessary regarding the meaning of what "on or about" means in the context of the' repricing dates of a hedging interest rate under the consistent critical terms method. In addition, the Board decided that financial guarantee contracts, loan commitments, and insurance contracts are outside of the scope of the Statement.

HOW IS THE GASB ASSISTING PREPARERS, AUDITORS, AND FINANCIAL STATEMENT USERS TO UNDERSTAND THE STATEMENT?

An Implementation Guide on this standard is being prepared and is expected to be issued in the first quarter of 2009. And the GASB members and staff will continue to provide training at seminars and conferences to inform financial users, preparers, and auditors about these important changes.