precision experience assurance gasb no. 53 – accounting for derivative instruments fgfoa...
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Precision Experience Assurance
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GASB No. 53 – Accounting For Derivative Instruments
FGFOA Conference, Orlando FL,Mark A. White, CPA, Partner, Purvis
Gray & Company LLPJim Towne, Senior VP, DerivActiv
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Statement 53
Accounting and Financial Reporting
for Derivative Instruments
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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!
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What Will We Talk About Today?
There are many different types of derivatives that exist in the markets today
Impossible to cover all possibilities todayWill cover basics of the statementWill go into more detail on Interest SwapsInterest Rate Swaps are the most common
derivative used by local governments and are a major piece of the statement
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Prior GuidanceSupersedes 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
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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!
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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)
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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)
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Excluded Instruments
Normal purchases and normal sales contractsCommodity—for example, gas or electricity used
in an activityGovernment intends to and has practice of taking
delivery or selling the commodityQuantity is consistent with volume used
Traditional insurance contractsNon exchange-traded climate contracts,
liquidated damages, etc.
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Hedging Derivative Instruments
The derivative instrument is associated with a hedgeable itemConsistency of notional amountsDerivative instrument will be reported in same fund as
hedgable itemTerm or time period consistency
The hedging derivative is effective in significantly reducing the identified financial risk using No. 53 methods
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Common Derivative Instruments
Interest Rate Swaps
Futures contracts--NYMEX
Options—exchange-traded and others
Swaptions
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Features of Futures Contracts
Exchange-traded-NYMEX, etc.Standard terms—notional amount, reference
rate/underlying, settlement datesAt the marketEntered into a no cost; however, accounts are
adjusted dailyMargin—collateral is required
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Terminating Events
Hedge accounting to cease upon terminating event;Hedging derivative is no longer effective by
applying No. 53 criteriaHedging derivative is terminatedBond refunding (interest rate swap)
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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
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How To ImplementTwo 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 methodsIf you test as of 9/30/10 and are deemed
effective; employ hedge accountingRecord derivative at FMV and defer the gain loss
at 9/30/10 valuesRe-test annually
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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 9/30/09Bring 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 9/30/09Current 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?
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Practical Considerations
If Interest Rate Swap effectiveness fails;DSC coverage problems in utility funds?
Pledge of NET RevenuesResolution definitionsTechnical defaultAdditional bonds testFAS 71 bail out?
Would not be a problem for governmental debt where gross revenues are pledged and Swap not recorded at fund level
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Methods of Evaluating Effectiveness
Consistent Critical TermsNotional amount same as principal amount Issued at FMV of zeroFormula for net settlements don’t change over the term of
the instrumentSame reference ratesBoth or neither can have cap or floorSame time interval of reference rateSame maturity dates
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Methods of Evaluating Effectiveness
Synthetic Instrument MethodDidn’t pass the CCT test, must now measure how much
difference there isTest of if the variable cash flows substantially offset, --
the synthetic fixed rate is substantially fixedDoes the difference in variable cash flows move the
fixed rate more than 10%?No—EffectiveYes– Ineffective
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Methods of Evaluating Effectiveness
Dollar Offset MethodCompares 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
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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
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Components of an Interest Swap
Time: Beginning and endReference rateNotional amountPayment frequencyReceive variable and pay fixed to counterpartyReceive fixed and pay variable to counterparty
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Swap-Cash Flow Hedge
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Swap counterpartyState or local government
Variable-rate bond holders
Variable-rate coupon payments; SIFMA
Variable payment received: 67% of 1-month LIBOR
Fixed payment 5.0%
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Consistent Critical Terms Method
Fail Due to Benchmark
Interest Rate Contract Variable Rate Demand Bonds
Swap Value at Inception 0
Swap Fixed Leg Fixed for Life of Swap
Notional Amount $ 10,000,000 Bond Principal $ 10,000,000
(no amortization) (no amortization)
Termination Date 12/1/2030 Maturity Date 12/1/2030
Variable Index 70% of 1 Month LIBOR Bechmark Interest Rate SIFMA
Frequency of Reset Weekly Frequency of Reset Wekly
Swap Payment Dates 1st Bus. Day of ea. Mo. Bond Coupon Payment Dates 1st Bus. Day of ea. Mo.
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Consistent Critical Terms Method
Pass
Interest Rate Contract Variable Rate Demand Bonds
Swap Value at Inception 0
Swap Fixed Leg Fixed for Life of Swap
Notional Amount $ 10,000,000 Bond Principal $ 10,000,000
(no amortization) (no amortization)
Termination Date 12/1/2030 Maturity Date 12/1/2030
Variable Index SIFMA Bechmark Interest Rate SIFMA
Frequency of Reset Weekly Frequency of Reset Wekly
Swap Payment Dates 1st Bus. Day of ea. Mo. Bond Coupon Payment Dates 1st Bus. Day of ea. Mo.
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Synthetic Instrument Method (Cash Flow Hedges Only-No Hybrids of Fair Value Hedges)
Swap Notional Amount $ 10,000,000 Pay Fixed - Receive Variable From Counterparty
Swap Fixed Rate 4%
SWAP Index 70% 1 Mo. LIBOR
Fixed Swap Variable Swap Net Variable
Pmnt. To Receipt From Derivative Bond Total Synthetic
FYE Counterparty Counterparty (Pmnt) Receipt Interest Payments Rate
9/30/2010 $ (400,000) $ 100,000 $ (300,000) $ (95,000) $ (395,000) 3.95%
Analysis of Synthetic Instrument Test
Synthetic Rate 3.95%
Swap Fixed Rate 4.00%
Percentage Ratio 98.75%
Is Ratio Between 90% and 111%? Pass
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Synthetic Instrument Method (Cash Flow Hedges Only-No Hybrids of Fair Value Hedges)
Swap Notional Amount $ 10,000,000 Pay Fixed - Receive Variable From Counterparty
Swap Fixed Rate 4%
SWAP Index 70% 1 Mo. LIBOR
Fixed Swap Variable Swap Net Variable
Pmnt. To Receipt From Derivative Bond Total Synthetic
FYE Counterparty Counterparty (Pmnt) Receipt Interest Payments Rate
9/30/2010 $ (400,000) $ 45,000 $ (355,000) $ (95,000) $ (450,000) 4.50%
Analysis of Synthetic Instrument Test
Synthetic Rate 4.50%
Swap Fixed Rate 4.00%
Percentage Ratio 112.50%
Is Ratio Between 90% and 111%? Fail
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Dollar Offset Method
FYE FYE Change In
9/30/2009 9/30/2010 FMV
Fair Value of Derivative $ (1,000,524) $(1,254,755) $ (254,231)
Fair Value of Item Being Hedged $ (802,445) $(1,044,589) $ (242,144)
Dollar Offset 104.992%
Does Dollar Offset Fall Within the 80% to 125% Band? Pass
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Dollar Offset Method
FYE FYE Change In
9/30/2009 9/30/2010 FMV
Fair Value of Derivative $ (1,000,524) $(1,254,755) $ (254,231)
Fair Value of Item Being Hedged $ (802,445) $ (955,447) $ (153,002)
Dollar Offset 166.162%
Does Dollar Offset Fall Within the 80% to 125% Band? Fail
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Disclosures
Summary Information;
Segregate between Hedging and Investment Derivatives
Within each category, present by type
Notional amounts
FMV and change in FMV
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Disclosures
Hedging Derivatives;ObjectivesTerms-notional amounts, reference rates, maturitiesRisks-credit risk, interest risk, basis risk, termination
risk, rollover risk, market access risk, foreign currency risk,
Investment DerivativesRisks above
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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