GASB—Derivatives GASB—Derivatives and Other Topicsand Other Topics

Wesley GallowayWesley GallowayApril 22, 2005April 22, 2005

APPA Business and Financial Spring APPA Business and Financial Spring MeetingMeeting

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OverviewOverview

Derivative disclosures: Technical Bulletin Derivative disclosures: Technical Bulletin 2003-1, 2003-1, Disclosure Requirements for Disclosure Requirements for Derivatives Not Presented at Fair Value on Derivatives Not Presented at Fair Value on the Statement of Net Assetsthe Statement of Net Assets Reporting derivatives on the financial Reporting derivatives on the financial statements: the Derivatives and Hedging statements: the Derivatives and Hedging ProjectProject““Matched book” topicMatched book” topicSecuritizationsSecuritizations

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Objective of TBObjective of TB

Clarifies guidance on derivative disclosuresClarifies guidance on derivative disclosures Supersedes Technical Bulletin 94-1Supersedes Technical Bulletin 94-1 Considered interim guidance pending the Considered interim guidance pending the

completion of the GASB’s Derivatives and completion of the GASB’s Derivatives and Hedging projectHedging project

Applies only to derivatives that are not Applies only to derivatives that are not reported at fair value on the statement of net reported at fair value on the statement of net assets (or balance sheet)assets (or balance sheet)

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Note DisclosuresNote Disclosures

Governments that, as of the date of the Governments that, as of the date of the financial statements, are party to a financial statements, are party to a derivative that derivative that was not reported at fair was not reported at fair valuevalue on the statement of net assets should on the statement of net assets should disclose certain information:disclose certain information: Objective(s) of derivativeObjective(s) of derivative Significant termsSignificant terms Fair valueFair value RisksRisks Associated debtAssociated debt

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Objective of DerivativeObjective of Derivative

Objective for entering into derivativeObjective for entering into derivative

Context needed to understand objectiveContext needed to understand objective

Strategies for achieving objectiveStrategies for achieving objective Indicate types of derivatives used–including Indicate types of derivatives used–including

options purchased or soldoptions purchased or sold

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Significant TermsSignificant Terms

Notional, face, or contract amountNotional, face, or contract amountInterest rates—including terms such as:Interest rates—including terms such as: CapsCaps CollarsCollars

Embedded optionsEmbedded optionsDate derivative became effective and when Date derivative became effective and when it is scheduled to terminate or matureit is scheduled to terminate or mature

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Fair ValueFair Value

Fair value at reporting dateFair value at reporting date

Use quoted market prices if an active Use quoted market prices if an active marketmarket

If no quoted market prices, disclose If no quoted market prices, disclose method used to determine fair value and method used to determine fair value and significant assumptions of that methodsignificant assumptions of that method

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What Are Acceptable Methods for What Are Acceptable Methods for Determining Fair Value?Determining Fair Value?

Dealer quotesDealer quotes

Discounted expected future cash flowsDiscounted expected future cash flows Zero-coupon methodZero-coupon method

Option pricing modelsOption pricing models

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RisksRisks

Credit risk—risk that a counterparty will Credit risk—risk that a counterparty will not fulfill its obligationsnot fulfill its obligations Credit quality rating of counterpartyCredit quality rating of counterparty Maximum potential “credit risk” lossMaximum potential “credit risk” loss Collateral that supports derivativesCollateral that supports derivatives Master netting arrangements that mitigate riskMaster netting arrangements that mitigate risk Counterparty’s diversificationCounterparty’s diversification

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Risks Risks Interest rate riskInterest rate riskBasis risk—risk that when variable interest Basis risk—risk that when variable interest rates on a derivative and associated bond rates on a derivative and associated bond are based on different indexes.are based on different indexes.Termination risk—risk that a derivative’s Termination risk—risk that a derivative’s unscheduled end affects a government’s unscheduled end affects a government’s asset/liability strategy or results in asset/liability strategy or results in potentially significant unscheduled potentially significant unscheduled payments to the counterparty.payments to the counterparty.

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RisksRisks

Rollover risk—risk that a derivative Rollover risk—risk that a derivative associated with a government’s variable-associated with a government’s variable-rate bond does not extend to the bond’s rate bond does not extend to the bond’s maturity.maturity.

Market-access risk—risk that a Market-access risk—risk that a government will not be able to enter credit government will not be able to enter credit markets or that credit will become more markets or that credit will become more costly.costly.

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Associated DebtAssociated Debt

Some derivatives are issued with the Some derivatives are issued with the intention of effectively making the variable intention of effectively making the variable rate of an associated debt obligation pay a rate of an associated debt obligation pay a synthetic interest rate, as in the case of a synthetic interest rate, as in the case of a variable-to-fixed interest rate swap.variable-to-fixed interest rate swap. Derivative’s net cash flow should be Derivative’s net cash flow should be

disclosed in addition to the debt service disclosed in addition to the debt service requirements of the associated debt. requirements of the associated debt.

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Associated DebtAssociated Debt

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Effective DateEffective Date

Effective date for Technical Bulletin:Effective date for Technical Bulletin:

For periods ending after June 15, 2003For periods ending after June 15, 2003

Derivatives and Hedging ProjectDerivatives and Hedging Project

Objective: To consider establishing additional financial reporting and disclosure requirements for derivatives and hedge accounting.

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Reporting Derivatives on the Reporting Derivatives on the Financial Statements—Financial Statements—

PossibilitiesPossibilities1.1. Measure derivatives at fair value, without Measure derivatives at fair value, without

“special accounting”“special accounting”

Special accounting possibilities:Special accounting possibilities:

2.2. Hedge accounting: Report derivatives at fair Hedge accounting: Report derivatives at fair value, derivative gains and losses as deferred value, derivative gains and losses as deferred charges or deferred creditscharges or deferred credits

3.3. A context-based measurementA context-based measurement

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Hedge AccountingHedge Accounting

Hedging is common. Hedge accounting is Hedging is common. Hedge accounting is not.not.

Hedge accounting is the suspension of the Hedge accounting is the suspension of the accounting rules to arrive at a accounting rules to arrive at a predetermined outcome. Gains and predetermined outcome. Gains and losses of one transaction are managed to losses of one transaction are managed to match losses and gains of another.match losses and gains of another.

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Hedge AccountingHedge Accounting

Deferral hedge accounting.Deferral hedge accounting. Derivatives gains and losses are reported as Derivatives gains and losses are reported as

deferred credits or deferred charges, deferred credits or deferred charges, respectively.respectively.

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Context-Based MeasurementContext-Based Measurement

A derivative would be measured according to A derivative would be measured according to the measurement of its associated the measurement of its associated transactions. The two most likely transactions. The two most likely measurements are historic price or fair value.measurements are historic price or fair value.

Examples: Examples:

AssociationAssociation Measurement Measurement

DebtDebt Historical price Historical price

InvestmentInvestment Fair value Fair value

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Context-Based MeasurementContext-Based Measurement

If there is no associated transaction, the If there is no associated transaction, the derivative would be measured at fair derivative would be measured at fair value.value.

Notwithstanding the foregoing, a derivative Notwithstanding the foregoing, a derivative would be measured at fair value if either would be measured at fair value if either party intends to terminate the derivative.party intends to terminate the derivative.

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Criteria for Special AccountingCriteria for Special Accounting

If there is to be a provision for “special If there is to be a provision for “special accounting,” what would be the specifics?accounting,” what would be the specifics?

Would special accounting be an option or Would special accounting be an option or a requirement?a requirement?

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Matched Book Matched Book

Arises when investments are measured at Arises when investments are measured at fair value and a matching liability is fair value and a matching liability is measured at its historical pricemeasured at its historical price

Mixed attribute model Mixed attribute model

HFAs, lotteries, and some trust and HFAs, lotteries, and some trust and reserve funds are examplesreserve funds are examples

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Project TimetableProject Timetable

Preliminary Views document planned for Preliminary Views document planned for first quarter of 2006first quarter of 2006

Public hearing on Preliminary Views Public hearing on Preliminary Views documentdocument

Exposure Draft first quarter of 2007Exposure Draft first quarter of 2007

Final standard fourth quarter of 2007Final standard fourth quarter of 2007

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Randal J. Findenrjfinden@gasb.org203.956.5240

The views expressed in this presentation are those of the speaker. Official positions of the GASB are determined only after extensive due process and deliberation.