Proposed Accounting for Derivatives

1. Proposed Accounting for Derivatives NASACT Audio Conference June 27, 2007

2. Why Is It So Hard? • Different instruments & countless products • Discounting, present value,yield curve,implied forward rate,volatility,option pricing, gamma,theta • Jargon • Hedging: offsets versus outcomes • Accounting model • Mixed attribute model • Expected transactions are not recognized in the accounting model 2

3. GASB Environment—Derivative Users • Pensions and endowments: foreign exchange derivatives • Utilities and transit agencies: energy derivatives • Governments active in debt market: interest rate swaps 3

4. Some History • Technical Bulletin 94-1, Disclosures about Derivatives and Similar Debt and Investment Transactions • Statement No. 31, Accounting and Financial Reporting for Certain Investments and for External Investment Pools • Technical Bulletin 2003-1, Disclosure Requirements for Derivatives Not Reported at Fair Value on the Statement of Net Assets 4

5. What is a Derivative for Financial Reporting Purposes? A derivative has: 1. One or more reference rates (underlyings) and one or more notional amounts 2. Leverage 3. Net settlement 5

6. Examples of Derivatives • Interest rate swap • Variable-rate to fixed-rate • Fixed-rate to variable-rate • Basis swap • Exchange payments based on the changes of two variable rates • Swaption • Gives the purchaser of the option the right, but not the obligation, to enter into an interest rate swap • Commodity swap • Reduce exposure to a commodity’s price risk 6

7. Hybrid Instruments • Hybrid instruments consist of a companion instrument (not measured at fair value) and a derivative (measured at fair value) • This is a substance over form issue: A derivative should be treated as a derivative regardless of whether it is a stand-alone instrument or included in another instrument, such as a bond, insurance contract, or a purchase or sale contract • Example: off-market swap. That is, a swap that presents a government with an up-front payment. 7

8. Excluded Instruments • Normal purchases & normal sales contracts • Commodity (e.g., gas or electricity) • Government intends to and has practice of taking delivery or selling the commodity • Quantity is consistent with volume used • Traditional insurance contracts • Traditional financial guarantee contracts • Non exchange-traded climate contracts, liquidated damages, etc. 8

9. Fair Value Based on either: • Market-observed prices or • Models, such as from a Bloomberg terminal 9

10. Proposed Accounting Fair value with hedge accounting • Derivatives would be measured on the statement of net assets at fair value • Fair value changes would be reported on the “change statement” as investment income • Exception: Effective HEDGES! • Changes in fair value of derivative would be reported on the balance sheet as deferrals—either deferred charges or deferred credits • Swap asset, deferred credit • Swap liability, deferred charge 11

11. Hedge FinancialStatement Presentation 12

12. Drivers of the Proposed Accounting • Derivatives should be measured at fair value • If the derivative instrument is effective, hedge accounting should be applied • Effectiveness is determined by using an acceptable method of evaluating hedges • If a method subsequently renders hedge ineffective, another method may be used 13

13. What is a Hedge? • Derivative is associated with a hedgeable item • The derivative is effective in providing changes in cash flows or fair values that substantially offset the cash flow or fair value changes of the hedgeable item • No documentation of management’s intent 14

14. Hedgeable Items • Single asset or liability • Groups of similar assets or liabilities must have same risk exposure • Expected transaction—occurrence should be probable • Transactions within the primary government do not qualify for hedge accounting 15

15. Methods of Evaluating Effectiveness • Qualitative method • Consistent critical terms method • Quantitative methods • Synthetic instrument method • Linear regression method • Dollar offset method • Other method 16

16. Consistent Critical Terms Method • Notional and principal amounts should be the same • Fair value of derivative should be zero at date of inception • Benchmark rates based on the same index such as SIFMA to SIFMA • Additional requirements based on whether it is a: • Fair value hedge • Cash flow hedge 17

17. Consistent Critical Terms Method • Effectiveness must be evaluated every year 18

18. Consistent Critical Terms Method Hedged Hedging Debt Derivative Principal/notional $1,000 $1,000 Term 10 years 10 years Payments, Every 6 months 6 months Variable payment SIFMA SIFMA 19

19. Synthetic Instrument Method • Based on notion that the combined cash flows of a swap and hedged debt create a third instrument—a synthetic fixed-rate instrument • Comes from consistent critical terms method, but used when benchmark rates are not the same, such as a % of LIBOR swap 20

20. Synthetic Instrument Method • Uses the rate in the fixed-leg of the swap as the fixed rate. • As long as actual payments travel within a range of 90% to 111% of the fixed rate, the derivative is effective. • Swap-based hedge use the fixed payment of the swap • Commodity hedges use the fixed rate established by the hedge 21

21. Dollar Offset Method • The change in fair values or cash flows of the hedging derivative is divided by the same changes of the hedged item. The result should be within the range of 80 to 125 percent • This method is similar to the economic notion of elasticity 22

22. Dollar Offset Example Fair Value Changes Change Hedged debt $1,000 Interest rate swap (1,150) ($1,000/$1,150) 86.96% 23

23. Regression Method Evaluation of effectiveness should indicate that the hedged item and the hedging derivative regress such that: • R-squared statistic is at least 0.80 • F-statistic is at least 95 percent confidence interval • Slope coefficient is between –1.25 and –0.80 24

24. Other Evaluation Method Method must: • Be consistent with fair value • Demonstrate that the changes of cash flows or fair values of the derivative substantially offset the changes in cash flows or fair value of the hedgeable item 25

25. Disclosures • Similar derivatives may be aggregated • Summary of derivative activity by: • Government activities, business-type activities, and fiduciary activities • Then by fair value hedges, cash flow hedges, and investment derivatives • Then by type: • Notional amount • Fair values & changes and where reported • Fair values & amounts reclassified from hedge to investment 26

26. Disclosures • Disclosures for HEDGING derivatives • Application of TB-2003 disclosures • Significant terms • Risks: Credit, Interest Rate, Basis, Termination, Rollover, Market-access, Foreign Currency • If an “other evaluation method” is used, the identity of that method and its critical values • No disclosure of hedge ineffectiveness • Disclosures for INVESTMENT derivatives • Risks: Credit, Interest Rate, Foreign Currency 27

27. Disclosures • Contingencies (e.g., collateral postings) • Fair value of derivatives with feature • Amount of all potential settlements • Amounts posted • Hedged debt • Synthetic guaranteed investment contracts • Description and nature • Fair values • Wrapper • Underlying investments 28

28. Summary • Derivatives would be reported on the balance sheet and measured according to their fair values. Fair value changes would be reported on the change statement, provided a derivative is not a hedging derivative. • If a derivative is a hedging derivative, its fair value changes would be deferred on the balance sheet until the hedged transaction occurs. • Test effectiveness • Disclose 29

29. Looking Forward • Exposure Draft on web site by June 29, 2007 • Final standard second quarter of 2008 • Proposed Standard would be effective for reporting periods beginning after June 15, 2009 • Retroactive 30

30. Questions? Randal Finden—203.956.5240 rjfinden@gasb.org Web site—www.gasb.org The views expressed in this presentation are those of the GASB’s staff. Official positions of the GASB are determined only after extensive due process and deliberation 31