Derivatives From an Accounting Perspective

Public Pension Financial Forum 6 th Annual Conference - 2009

Objectives & Overview

• To provide an understanding of financial derivative instruments • To provide an understanding of the difference in using financial derivative instruments to hedge versus an investment security • Accounting for Derivatives • Recognize the importance of defining requirements for inclusion in GASB 53 reporting

GASB 53 – Accounting & Financial Reporting for Derivative Instruments

• Effective for financial statements for periods beginning after June 15, 2009 • Earlier application is encouraged • Apply accounting changes necessary to conform to this statement retroactively by restating financial statements, for all periods presented – if restatement is not practical, the cumulative effect of applying GASB 53, if any, should be reported as a restatement of beginning net assets, fund balance, or fund net assets, for earliest period restated

GASB 53 Summary

• Derivative instruments are reported on the statement of net assets and measured according to their fair values • Fair value changes are reported on the change statement, provided a derivative instrument is

not

a hedging derivative • If a derivative instrument is a hedging derivative instrument, its fair value changes are deferred on the statement of net assets until the hedged transaction occurs

Classifications of Derivatives

• Two classifications of derivatives: 1. Hedging derivatives – changes in fair value apply to future accounting periods→

Hedge Accounting

2. Investment derivatives – changes in fair value apply to the current accounting period→

Investment Accounting

Question

To what extent will public pensions be affected by GASB 53 reporting requirements?

Answer

Not Much

GASB 53 – Implementation Guide ¶ 109

• 109. Assets and liabilities that are measured at fair value in a government’s statement of net assets do not qualify as hedgeable items for the purpose of determining whether a hedging derivative instrument exists. Because such assets and liabilities are measured at fair value, the periodic changes in their fair values already are reported in a government’s flow of resources statements. The Board believes that the changes in the fair values of derivative instruments that are related to these assets and liabilities also should be reported in the flow of resources statements. This financial reporting treatment will result in offsetting the changes in the cash flows or fair values of the asset or liability with the changes in the cash flows or fair values of the derivative instrument in a government’s flow of resources statements.

What is a Derivative Instrument for Financial Reporting Purposes?

A derivative instrument has: 1. One or more reference rates (underlyings) and one or more notional amounts 2. Leverage 3. Net settlement

Scope Outs

• Investments • Normal purchases and normal sales contracts • Traditional insurance contracts • Traditional financial guarantee contracts • Non-exchange-traded climate contracts, liquidated damages, etc.

Examples of Derivatives

•

Forward contract –

Contractual agreement to buy or sell security, commodity, foreign currency, or other financial instrument,

at certain future date for specific price

Agreement with a supplier to purchase a quantity of heating oil at certain future time, for certain price & a certain quantity is an example. As an additional example, Party A agrees to sell one million Euro in six months at $1.0007

They are not securities & are not exchange-traded

•

Examples of Derivatives (cont’d)

Futures contract –

An exchange-traded security to buy or sell a security, commodity, foreign currency, or other financial instrument, at certain future date for specific price. A futures contract obligates buyer to purchase commodity or financial instrument & seller to sell it, unless an offsetting contract is entered into to offset one’s obligation • Example of futures contract would be if Party A sells 10 contracts that set price of S&P Index at 1500 in October

–

if price falls below 1500 then Party A will profit by amount price is below 1500 & if price rises above 1500, then Party A loses by amount price exceeds 1500

Swap –

Type of derivative instrument in which there is agreement to exchange future cash flows. These cash flows may be either fixed or variable & may be either received or paid. Variable cash flows depend on reference rate. Interest rate swap is a swap that has variable payment based on price of underlying interest rate or index

•

Examples of Derivatives (cont’d)

Option

of time

–

Contract that gives its holder right but not obligation to buy or sell a financial instrument or commodity at certain price (“strike price” or “exercise price”) for period A “call option” grants holder right, but not obligation, to buy at specified strike price & so it pays off to the holder if market price for underlying item rises above that mark. A call option is

“in-the-money”

when it has market price above its strike price A “put option” grants holder right, but not the obligation, to sell at specified strike price & pays off to the holder when market price falls below strike price. A put option is

“in-the money”

when it has market price below its strike price

•

Examples of Derivatives (cont’d)

Swaption –

An option to enter into a swap. When swaption is an interest rate option, it may be used to hedge long-term debt. When government sells swaption (also called writing a swaption), a cash payment may be received •

Structured note –

Hybrid instrument that combines bond or loan with derivative. Traditional type of structured note is a

callable bond

. Return performance of structured note will track that of underlying debt obligation & derivative embedded within it

•

Examples of Derivatives (cont’d)

Take-or-pay contracts –

Agreement between buyer & seller in which buyer will still pay some amount even if product or service is not provided. These contracts are most often used in utility industry •

Commodity swaps –

Contracts that have variable payment based on price or index of underlying commodity •

Interest rate locks –

Contracts that allow one party to fix interest rate for specified period of time

Risks

•

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

could reduce the value of the derivative instrument to the government - the risk that changes in interest rates •

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

Risks, (cont’d)

•

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 •

Rollover risk

- the maturity of the derivative instrument is shorter than the maturity of the associated debt, leaving the government unprotected in the future

Risks, (cont’d)

•

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 •

Headline/Reputation Risk

– Enough said

• • • •

Recognition & Measurement of Derivative Instruments

Changes in fair values of

investment derivative instruments

(derivative instrument entered into primarily for obtaining income or profit or one that does not meet criteria for use of hedge accounting), including derivative instruments that are determined to be ineffective,

should be reported within investment income

in

statement of activities

(flow of resources statement) Changes in fair values of hedging derivative instruments should be recognized through application of hedge accounting resources” on

statement of net assets

– changes in fair value reported as either “deferred inflow of resources” or “deferred outflow of Report hedging instrument in same fund that reports hedged item Hedge accounting should be applied beginning in period that hedging derivative instrument is established & until termination event occurs

Recognition & Measurement of Derivative Instruments, (cont’d)

• Fair values

developed by pricing services

are acceptable for calculating fair values,

provided that those values are developed using prescribed methods

. INSTRUCTIONAL NOTE: Many times pricing service will not share its fair value calculation methodology for various reasons. First, determine if they will share required information before you retain them or request that they perform the calculations. Secondly, if you use them & they do not share the required information, GASB 53 requires that you perform assessment based on information received

Notes to Financial Statements

Statement 53 requires a note disclosure that includes summary information about a government’s derivative instruments. The government’s derivative instruments are divided among those related to governmental activities, business-type activities, and fiduciary funds. Within each of those three groups, the derivative instruments are presented in the following categories (a) hedging derivative. instruments (distinguishing between fair value hedges and cash flow hedges) and (b)

investment derivative instruments, including hedges that were determined to not be effective

.

Notes to Financial Statements, (cont’d)

• Disaggregate information unless similar derivative instrument types exist • Summary of derivative instrument activity during reporting period (year) & balances at end of reporting period (year) • Organize information by governmental activities, business type activities & fiduciary funds • Aggregate by type – contracts

e.g.,

receive-fixed swaps, pay-fixed swaps, swaptions, rate caps, basis swaps or futures • Present notional amount, changes in fair value during reporting period & where reported, fair values at end of reporting period & where reported & fair values of derivative instruments reclassified from hedging derivative instrument to investment derivative instrument

Notes to Financial Statements, (cont’d)

• For all hedging derivative instruments – Objectives for entering into instrument(s) – Terms – notional amount, reference rate, embedded options, date entered into & termination date & amount of cash paid or received, if any, when instrument was entered into – Risks – credit risks, interest rate risk, basis risk, termination risk, rollover risk, market access risk & foreign currency risk

Notes to Financial Statements, (cont’d)

– Hedged debt – disclose hedging derivative instrument’s net cash flows based on requirements established under GASB 38 – Other quantitative method of evaluating effectiveness • For investment derivative instruments – For derivative instruments held at end of reporting period – credit risk, interest rate risk & foreign currency risk • Contingent features • Hybrid instruments • Synthetic guaranteed investment contracts

Notes to Financial Statements, (cont’d)

IMPORTANT CONSIDERATION

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.

Other Guidance

• GASB’s staff has prepared a

Guide to Implementation of GASB Statement 53 on Accounting and Financial Reporting for Derivative Instruments

• Questions 28-34 address certain recognition & measurement of derivative instrument issues, including certain issues that differ from FAS 133 requirements • Questions 39 & 40 address debt refundings that have swap terminations associated with refundings

Other Guidance, (cont’d)

• Questions 49-56 deal with timing & methods of evaluating effectiveness • Question 94 addresses separate accounting for embedded derivative (embedded non-option contracts and embedded option contracts) • Questions 98-106 outline requirements for notes to financials statements • Questions 107-110 answer certain effective date & transition questions

GASB 53 Summary Reminder

• Shouldn’t have a major impact on Public Pension Financial Reporting • Nonetheless, accountants will require more information on derivative contracts in order to properly perform the accounting • Reconciliation procedures must be performed • Derivative and other investment footnote disclosures will likely need enhancement • Increased due diligence efforts • Valuation could be difficult for certain instruments • Increased risk depending on extent of derivative instruments

Questions?

Contact

Thomas R. Rey, Jr. CPA Clifton Gunderson LLP Baltimore, Maryland (P) 410-453-0900 [email protected]