GASB 53 Podcast

Jim Towne, Senior Vice President of DerivActiv covers the nuts and bolts of GASB 53, including which governmental entities will need to comply, the four methods used for hedge effectiveness testing, and new disclosure requirements. 01/18/2010 18 min. 23 sec.

Cynthia–  Jim, why don't you tell us first what GASB [53] is, what type of government entity it applies to, and when did it become effective.

 

Jim–GASB 53 is the Governmental Accounting Standards Boards statement for accounting and financial reporting of derivative instruments.  It was created by GASB to increase transparency in financial reporting due to the large volume of derivative transactions that have occurred by governmental entities during the past ten years.  Adoption for this standard is not optional so in other words governmental entities are going to be required to either determine that their derivatives are effective hedges or investment derivatives.  It's critical that that calculation be made by each governmental entity for each derivative transaction independently.  GASB 53 applies to all governmental entities that report their financial condition using governmental accounting standards.  Those would be cities, counties, states, state agencies, governmental hospitals, governmental subdivisions, all those types of entities out there using GASB accounting.  The statement is effective for financial reports that are issued after June 15, 2010.  So first entities to report under this new GASB 53 statement will be those that have a June 30, 2010 fiscal year end. 

 

Cynthia–  So GASB applies to state and local governments that use derivatives.  What is GASB’s definition of a derivative?

 

Jim–Under GASB 53 a derivative is defined as a financial arrangement in which two parties agree to exchange payments with one another.  They define four characteristics that must occur for the item to be considered a derivative.  Number one, one or more reference rates have to be used in the contract.  So something like in an interest rate derivate, LIBOR, SIFMA, MMD.  In a commodity derivative there's the Henry Hub National Gas Index, or the New York Harbor Index for heating oil.  Those are typical type reference rates.  The second item is notional amounts.  Notional amounts can be dollars in an interest rate derivative, or currency units in a currency hedge, or commodity quantities like barrels of oil, for example, if the governmental entity is hedging that particular commodity.  Third is leverage.  In other words in order to enter into the contract no cash or initial investment is required.  The transactions occur on paper for the purpose of hedging a particular risk.  And the fourth or last item is net settlements occur.  In other words the derivative contracts that exist contain clauses for net settlement of the cashflows.  And that contract can be terminated early for a termination price or termination value.  So those are the four characteristics that GASB defines as making up the definition of a derivative instrument. 

 

Cynthia–  Can you give me examples of why and how some common derivatives are used by state and local governments?

 

Jim–Well governmental entities use derivatives to hedge a variety of risks.  Some of those risks are interest rate risk, commodity risk like the cost of a particular commodity like heating oil or diesel fuel, and foreign currency risk or other types of risks that that particular governmental entity has to hedge.  Examples would be items like a futures contract, or a forward contract to enter into certain types of transactions.  It may be interest rate related or commodity related, but those types of contracts.  Other examples would be interest rate swaps, or commodity swaps, or currency swaps.  And then option products, the option to enter into a particular transaction in the future.  A lot of times governmental entities use derivative transactions to lower the cost of something.  So for example an entity may want to lower the cost of capital for a borrowing transaction.  That might take place where a governmental entity issues variable rate bonds and then enters into an interest rate swap to receive a variable rate in exchange for a fixed rate and that effect on the governmental entity is to lock in a fixed cost of borrowing.  Another example might be where a governmental entity issues fixed rate bonds but wants to convert that obligation into a floating rate.  So in that case a fair value hedge exists where the governmental entity receives a fixed rate from a counterparty in an interest rate swap and pays a floating rate.  Those items can be classified or are classified as derivatives and can be effective under GASB 53.  The last way that governmental entities use derivatives is to generate income.  So for example governmental entity may want to receive a cashflow, an upfront payment, in exchange for a future obligation to enter into a transaction.  That would typically be a swaption or a off-market interest rate swap.  Those are ways that governmental entities use derivative transactions to hedge certain risks.  And obviously there are lots of other examples out there, but that's just a few that I can think of. 

 

Cynthia–  Okay, so if a city has a derivative in place and it needs to comply with GASB 53, first it has to determine whether or not it's an effective hedge.  How is that done?

 

Jim–Well going forward all derivatives will need to be measured against the criteria established in GASB 53 to make the determination, as you said, whether the derivative is a hedging derivative, if it qualifies for hedge effectiveness, or if it's an investment derivative.  And that would be an ineffective hedge.  GASB 53 is basically a road map for being able to make that determination.  As a general rule, governmental entities will want to record their hedges as effective hedges because as GASB 53 points out, the effective hedges are allowed to be deferred.  The changes in fair value on those hedges are allowed to be deferred as long as the hedge is deemed effective under the testing methods on GASB 53.  All derivative instruments are going to be measured on the statement of net assets at fair value.  And fair value changes if that derivative is an investment derivative will have to be reported in the flows or the changes statement, in other words the income statement, as investment income.  So an entity that doesn't reach the conclusion that the hedge is effective, will have swings in their income statement on a regular basis, on a periodic basis as they report the changes in value of their derivative instruments.

 

Cynthia–  So government entity wants the hedge to be effective.  What are some of the types of hedge effectiveness tests that the entity has to do in order to comply with GASB 53?

 

Jim–Well GASB 53 outlines four methods for testing whether a derivative is an effective hedge or not.  One nice feature of GASB is that for each calculation you're allowed to continue to run the tests until one of the tests passes.  So for example an entity can fail three of the four tests but as long as one of the tests is positive, or they pass, that derivative can be declared an effective hedge.  So the four methods are:  consistent critical terms, synthetic instrument method, dollar offset, and regression analysis.  Consistent critical terms is a non-quantitative method.  In effect we compare the terms of the derivative product with the terms of the hedged item.  For example, an interest rate swap where the governmental entity pays a fixed rate and receives floating is compared against a variable rate demand bond to see if all of the critical terms of that derivative match the hedged item.  If that is the case, that derivative is presumed to be effective and no other testing needs to be completed.  The three quantitative methods: synthetic instrument, dollar offset, and regression, are a little more complicated.  Synthetic instrument is a calculation approach where the actual cashflows of the transaction are added together, the hedged item plus the derivative are added together to determine what the synthetic rate is.  This only works with cashflow hedges, it does not work with fair value type hedges.  The combination of the cashflows is calculated to produce the synthetic rate.  If that rate is between 90% and 111% of the fixed rate on the swap, then the hedge is determined to be effective and no other methods need to be calculated.  Typical transactions where this type of calculation can be applied would be cashflow hedges where an interest rate swap is used to hedge a floating rate bond for example.  Dollar offset and regression analysis require a little bit more in-depth analysis.  The dollar offset method is a method where changes in fair value of the hedged item and changes in fair value of the hedge are compared, and if the ratio between the change in fair value of the hedged item and the change in fair value of the hedge itself falls within an 80% to 125% band width, the hedge is considered effective.  Now for this calculation and for all the calculations in GASB 53, we can use the prior one-year’s period information or we can use life to date, which is the trade date of the derivative all the way to the end of the reporting period.  So we can run this dollar offset calculation based on a couple different calculations to determine whether it passes the dollar offset test.  And then finally regression analysis is the last calculation and that is a statistical calculation where we measure the relationship between changes in rates, cashflows, or fair value of the hedged item versus the derivative.  And that relationship is run through a regression test and if the R²  is greater than or equal to .8 and the regression coefficients meet the GASB 53 criteria and the statistical significance is calculated to be in a 95% confidence interval, then the regression analysis will pass the test.  Now with respect to regression analysis, there are many different ways to do that calculation in terms of the volume of data that you use to provide the inputs.  For example we can use the end of day values from the inception of the swap and bond, we can use end of week, we can use end of month data.  There are very many alternatives for this calculation so it's important to test every possible scenario to determine whether the derivative can be classified as an effective hedge or not under this method. 

 

Cynthia–  You've described three quantitative methods for testing hedge effectiveness.  Can other methods be used?

 

Jim–Under GASB 53 they do leave open the possibility for other quantitative methods and the way it's described in the text of GASB 53 is other quantitative methods so long as they are based on established principals of financial economic theory.  I've not heard of any other methods that are being accepted by auditors, but GASB 53 is still very new and so most people haven't had a change to look at or other methods haven't evolved in the industry yet.  So I would think that if there is an acceptable other method under GASB 53, that we'll have to go through a process where auditors will review that method and ultimately the GASB Board will have to decide whether its an acceptable method or not.  I can't imagine auditors accepting any other methods that aren't really fully described in GASB 53.

 

Cynthia–  So what happens if a derivative fails the hedge effectiveness tests?

 

Jim–So if a derivative fails all of the tests, because you can run every test for the derivative, and if it fails all of the tests, it will be classified as an investment derivative.  And hedge effectiveness will no longer be an option for that particular transaction.  Once the derivative fails the test, and is declared an investment derivative, the government entity must record the periodic changes in fair value, in its income statement.  And that will be classified as investment income or investment loss, depending on which direction the interest rate derivative moves during the period measured.

 

Cynthia–  How frequently do the hedge effectiveness tests need to be done?

 

Jim–GASB 53 calculations are performed at a minimum at each fiscal year end.  So for each derivative that is effective, the calculation has to be done every fiscal year.  Some entities may want to keep track of their effectiveness on an ongoing basis and elect to run their calculations on a quarterly basis.  That would be optional since most governmental entities do not report financial statements more than once per fiscal year.

 

Cynthia–  What does an entity do if it has a hybrid swap in place such as a swap with a cash payment to the government entity?

 

Jim–Hybrid instruments are a little bit unique in that those types of derivatives are really the paired instruments, the combination of a derivative and a companion instrument.  So a typical example might be an interest rate swap where the governmental entity received a cash payment upfront.  That type of swap would be considered an off-market swap so that the transaction was entered into at an interest rate on the swap that was higher than the market or off the market.  When we do the analysis for a hybrid instrument like that type of transaction, we have to split out the portion of the swap that is at the market versus the portion of the swap that is the cash payment.  The at the market swap is run through the same scenarios as we've described, the same four calculation scenarios, and a determination is made whether the at the market swap is effective or not.  With respect to the portion that is the cash upfront payment that is classified as a loan and it's called a companion instrument but it's classified as a loan and the loan is reported separately from the derivative.  Just like any other loan will be reported under GASB Accounting Rules.  Other types of hybrid instruments that entities may use, swaptions, where there's an option to enter into a swap are another example and one other note, basis swaps and constant maturity swaps, which are other types of derivative products that are used by governmental entities, would always be considered investment derivatives under GASB 53 rules.  Those are not hybrid instruments, those are clearly investment derivatives under GASB 53. 

 

Cynthia–  There are several disclosure requirements under GASB 53 where the government entity must report, sort of, why and how they are using the derivatives.  Can you tell us what type of information must be provided?

 

Jim–Most entities already provide some disclosure in their financial footnotes about their derivatives.  GASB 53 expands the requirements and lays out some specific information that is required.  So some of the information that needs to be included would be the objectives for entering into the derivative or the derivative positions, a summary of each derivative transaction broken down by type of derivative, by hedging derivative instrument versus an investment derivative, some of the significant terms of the derivative and then if the derivative hedges debt, a net cash flow table is required to be inserted into the disclosures.  And then the last thing is the risk or risks that the governmental entity is exposed to as a result of entering into the derivative. 

 

Cynthia–  What would some of those risks be?

 

Jim–Some of those risks would be termination risk, credit risk, basis risk, interest rate risk, rollover risk, market access risk, foreign currency risk.  Those are some of the risks that would be required to be disclosed and a description of what each of those risks entail would be included in the disclosure items in the financial statements. 

 

Cynthia–  So in addition to all the things that you've already mentioned, are there any other disclosures that we haven't covered yet?

 

Jim–Some of the transactions would also put the governmental entity into a contingent liability or in other words a liability that is out there maybe not currently, but if a certain event happens, most commonly collateral posting provisions would be considered contingent liabilities.  So if the governmental entity is responsible for posting collateral at certain thresholds under its documentation for its derivatives, all of the information related to the potential for that collateral posting would have to be included in the footnotes, as well as termination triggers that exist in the documentation for the derivative.  And then the last item is concentration of credit risk or net exposure to credit risk.  So who are the entities or counterparties that the governmental entity is dealing with and is that credit risk to those counterparties, is that risk concentrated in a single provider or is it spread across various providers.

 

Cynthia–  What would cause a government entity to lose hedge effectiveness and be required to include all market changes in the income statement?

 

Jim–A swap or a derivative maybe determined to be effective in year one, year two, year three, but at some point in time running the testing as we've described may fail.  If all the tests fail, that hedge would no longer be determined to be an effective hedge under GASB 53.  At that point if there's a failure of all the tests that hedge would be deemed an investment derivative and again would have to run through the income statement.  If there's a transaction where the ultimate hedged item is retired or sold, that hedge would no longer be effective.  And if there is a future hedging relationship for a transaction, so for an example a governmental entity is hedging an anticipated financing transaction  and that financing transaction doesn't occur, then that hedge could no longer be an effective hedge because there's no hedged item associated with that hedge.  So those are some examples of times or events that could occur when a hedge may be effective for a period of time but then determined to be ineffective later.