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Accounting and Financial Reporting for Derivative Instruments. Derivatives Notional amounts outstanding, 1987-present. $683.7 trillion in June 2008. Source: International Swaps and Derivatives Association, Inc., 2008. Types of Derivatives that Accountants Encounter.

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Accounting and Financial Reporting for Derivative Instruments

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Accounting and financial reporting for derivative instruments l.jpg

Accounting and Financial Reporting for Derivative Instruments


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Derivatives Notional amounts outstanding, 1987-present

$683.7 trillion in June 2008

Source: International Swaps and Derivatives Association, Inc., 2008


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Types of Derivatives that Accountants Encounter

% of notional amounts outstanding – as of June 2008 – Source Bank for International Settlements


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Executive Summary of GASB Statement No. 53

  • Complex statement that:

    • Defines derivatives and exclusions.

    • Presents requirements for recognition and measurement of derivatives.

    • Describes and calculates hedge accounting, efficient and inefficient hedge accounting.

    • Contains a full set of examples and note disclosures, as well as transition guidance.

  • Supersedes Technical Bulletin 2003-1.

  • Amends pieces of Statement Nos. 7, 23, 25, 31, 40 and 43.


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Executive Summary of GASB Statement No. 53

  • What is a derivative?

    • It is a contract that has settlement factors which could be

      • one or more reference rates.

      • notional amounts.

      • payment provisions or any combination.

    • It has leverage.

    • It can be settled net.


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Executive Summary of GASB Statement No. 53

  • What are settlement factors?

    • Reference Rate – an interest rate, security price, commodity price, exchange rate, other variables.

    • Notional Amount(s) – the face amount of the contract, which includes the number of units, shares, bushels, pounds, etc.


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Executive Summary of GASB Statement No. 53

  • Requirements of the statement:

    • Derivatives should be reported on the statement of net assets at fair value except for synthetic guaranteed investment contracts.

    • Unless hedging derivative, changes in fair values are part of investment revenue in statement of activities, changes, etc.

      • If hedging, then changes are deferred inflows or outflows.

      • If hedged derivative is terminated, P&L event.


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Executive Summary of GASB Statement No. 53

  • How to measure fair value:

    • Market price if there is a market.

    • Discounted expected cash flows.

    • One of a number of different pricing models and methods.

      • IF using a pricing service and the method to calculate is NOT disclosed by the service, then management must make an assessment of propriety based on the information received.


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Executive Summary of GASB Statement No. 53

  • Termination occurs when:

    • Hedging derivative not effective.

    • Government becomes exposed to adverse changes in fair values or cash flows.

    • Hedged asset or liability is sold or retired, refunded or defeased.

    • Derivative is terminated.

    • Forward transaction occurs (e.g., sale of bonds or purchase of commodity).

  • Reporting – investment revenue, balance sheet activity caption “increase (decrease) upon hedge termination.”


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What is a hedge?

  • A hedgeis a contract entered into to reduce some form of risk in cash flows or fair values.

  • Hedges that accomplish the goal of reducing risk as expected are commonly referred to as effective.


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What is a hedge?

  • It must be associated with a hedgeable item

    • Asset, liability, expected transaction (swaption, forward, etc.)

  • Notional amount = principal amount.

  • Derivative is in the same fund as hedgeable item.

  • Term or time period is consistent between derivative and hedgeable item.

  • It is effective in reducing the risk.


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How to evaluate effectiveness?

  • Initial year:

    • If terms of derivative (years, amounts, rates) are consistent with debt, asset etc., then automatically effective – known as consistent critical terms.

    • If inconsistent, then at least one of many quantitative methods must be used.

  • Subsequent years:

    • Use the same method as first year, but can use other method.

  • Evaluation of effectiveness is done by measuring cash flows or overall changes in fair values.


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How to evaluate effectiveness?

  • Quantitative methods include:

    • Synthetic instrument method (combine debt cash flows and derivative to create a third item).

    • Dollar offset method (measure changes in expected cash flows).

    • Regression analysis method (statistical relationship between debt and derivative changes).

    • Can use other quantitative methods.


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Synthetic instrument method

Dollar Offset

Regression analysis

Synthetic rate should be within 90% - 111% of fixed rate.

Derivative cash flows 80% - 125% of debt.

R2 (measure of the proportion of the variance in a dependent variable about its mean that can be explained by changes in the independent variable.) must be ≥ 0.80.

F-statistic (confidence level) must have 95% confidence.

Corridor must be80% - 125% of debt.

Effectiveness Corridors


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Note Disclosure

  • Summary table of information:

    • Organized by governmental, BTA, fiduciary funds:

      • Subdivisions for hedging derivatives and investment derivatives.

      • Within each category – aggregate information by type (received fixed swaps, pay fixed swaps, swaptions, caps, basis swaps, futures, etc.).


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Example 1 -- Calculating Effectiveness

  • Assumptions:

    • Auction rate bonds issued for $100MM on 7/1/xx. Bonds mature 6/30/x4.

    • Semiannual coupons reset weekly.

    • On 7/1/xx, the government enters into a $100MM, notional, pay fixed, receive variable swap that terminates 6/30/x4. FMV at 7/1/xx=$0.

    • Semiannual variable payment reset weekly.

    • The variable payment is 49.96% of LIBOR + 78 basis points.

    • The fixed payment is 3.58782%.


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Step 1 – Diagram the transaction

Fixed pay 3.57872%

Government

Counterparty

Variable receive – 49.96% of LIBOR + 78bps

Auction rate paid

Note that the actual synthetic rate paid will vary depending on the difference between the auction rate paid and the variable rate received.

Bondholders


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Step 2 -- Calculate the cash flows and values


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Step 3 -- Divide and measure

From Assumptions

Since these are between 90 and 111%, then derivative is effective – changes reflected only in statement of net assets.


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Journal Entries – HIGHLY SIMPLIFIED – Year 1


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Journal Entries – HIGHLY SIMPLIFIED – Year 2


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Journal Entries – HIGHLY SIMPLIFIED – Year 4 (final year)


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What if the swap terminates?

  • What if in the 3rd year, the state passes a change in taxes that causes the swap to no longer be effective? What happens?

  • Assume the same facts in the previous illustration.


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Step 2 -- Spreadsheet the cash flows and values

Way out of corridor (2.81% ÷ 3.58% = 78.49%)


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What if the swap terminates?

  • In year 4

    • Change in fair value now a component of investment income / expense.

    • Any deferred outflows / inflows also become a component of investment income / expense (no more statement of net assets account).


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Example 2 – A Swaption

  • Assumptions:

    • A state enters into a swaption with an investment bank; the bank has the right, but not the obligation, to force the state to enter into a pay-fixed, variable rate swap in the future.

    • The state receives an up-front payment of $11,016,200 on 7/1 of year 0.

    • The fixed rate the state receives is above the market rate - 5.5%.

    • The 2-year forward rate is 3%.

    • The variable rate is SIFMA.

    • The notional amount is $100 million.

    • The swap may have a volatility of up to 30%.

    • At year 1, the one year forward rate is 2.85%.

    • At year 2, the rate is 2.80%.

    • The day after year 2, the bank exercises its option; the rate continues to be 2.80%.


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Example 2 – A Swaption

Fair value is calculated by taking the net present value of the cash flows at 3%. Fair value of the derivative is the swaption, less the borrowing. The change in fair value is the current year’s less the previous year’s fair value.


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Example 2 – A Swaption

The beginning balance is the original fair value of the borrowing. The interest accrual is the beginning fair value x 3% x (180/360). The swap payments are after the exercise date. Ending balance = beginning + interest – payments. The $1,250,000 starts in 2½ years until maturity.


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Example 2 -- A Swaption


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Statement of Net Assets Presentation for Swaption and Swap

Not supposed to foot unless counting statement of activities


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Statement of Net Assets Presentation for Swaption and Swap

Not supposed to foot unless counting statement of net assets


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Journal Entries – HIGHLY SIMPLIFIED


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Journal Entries – HIGHLY SIMPLIFIED


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Journal Entries – HIGHLY SIMPLIFIED


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Note Disclosure

  • Summary table of information

    • Information includes:

      • Notional amounts.

      • Changes in fair value and where it is reported in the financial statements.

      • Fair values at the end of the year.

      • Reclassifications from hedging to investment derivatives during the period.

      • Deferral amounts in investment revenue.

    • Can be narrative if small number of contacts.


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Note Disclosure

  • Narratives include:

    • Objectives of derivatives.

    • Terms of derivatives include:

      • Notional amounts.

      • Reference rates, indexes, etc.

      • Any embedded options (caps, floors collars).

      • Date of contract and termination or maturity.

      • Any cash paid or received.

    • TB 2003-1 risks (credit, interest rate, basis, termination, rollover, market access, foreign currency).


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Note Disclosure

  • Other:

    • Hedged debt: follow GASB 38, disclose net cash flows.

    • If using other quantitative method identify any notable features of the method.

  • Investment derivatives:

    • TB 2003-1 disclosures along with GASB 40 disclosures.


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Note Disclosure – June 30, Year 1


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Disclosure

  • After table, note the following:

    • Terms not in table.

    • How fair values were calculated.

    • Risks and ratings of counterparties.

    • Contingencies on derivatives.

    • Table of all payments and hedged debt.


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Disclosure – 2nd table


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Transition

  • For financial statements for periods BEGINNING AFTER June 15, 2009.

  • Retroactive application for all periods presented.

  • Perform hedge effectiveness evaluation as of the END of the CURRENT PERIOD ONLY. If effective now, assume effective as of the beginning of the contract.


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Other items included in the Statement

  • Huge (11 page) glossary.

  • 12 robust illustrations:

    • Consistent critical terms.

    • Interest rate swaps – synthetic method.

    • Interest rate swaps – terminations due to market conditions.

    • Regression analysis.

    • Dollar offset method.


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Other items included in the Statement

  • 12 robust illustrations (continued):

    • Swaptions.

    • Full set of note disclosures.

  • Flowchart of hedge effectiveness decisions.

  • Codification instructions.

  • Still to Come – Implementation Guide – Watch for it in 2009!


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Questions?

Contact Information:

Eric S. Berman, CPA

Deputy Comptroller

Commonwealth of Massachusetts

[email protected]

617-973-2602


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