GASB 53: Accounting and Financial Reporting for Derivative Instruments Presented by:

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GASB 53: Accounting and Financial Reporting for Derivative Instruments

Presented by:

Roger Martinez, Kathy Lai, KPMG LLP, and Ben Cheng, CO

AUDIT

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Agenda

Overview of GASB Statement No. 53

Definition of a Derivative Instrument

Settlement Factors

Leverage

Net Settlement

Scope Exceptions

Hybrid Instruments

What is a Derivative

Recognition and Measurement

Deferred Inflows and Outflows

Presentation

2May 2010Year-End GAAP Training

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Agenda Cont.

Miscellaneous Recognition and Measurement Items

Determining Fair Value

What is Hedging?

Types of Hedges

Association with a Hedgeable Item

What Can Be Hedgeable Items?

Overview of Hedge Effectiveness

Hedge Effectiveness Testing Methods

Other Quantitative Methods

Termination of Hedge Accounting

Disclosures for Hedging Derivative Instruments


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Agenda Cont.

Effective Date and Transition

CSU Survey Results

Questions?


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Overview of GASB Statement 53

Statement issued in June 2008

Effective for periods beginning after June 15, 2009

Will require derivative instruments to be reported at fair value in financial statements prepared under the economic resources measurement focus

Reporting changes in fair value will depend on whether derivative instrument is an effective hedge

GASB has also issued a plain-language document on derivative instruments


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Overview of GASB Statement 53

Certain aspects of GASB Statement 53 are conceptually similar to FASB Statement 133, as amended:

– Definition of a derivative instrument

– Certain scope exceptions

– Hedge accounting

Although conceptually similar, there are many differences in application:

– Hedge accounting required under GASB 53 if applicable

– “All or nothing” approach to reporting changes in fair value using hedge accounting

Not required to quantify ineffectiveness

– Use of deferred inflows and outflows No other comprehensive income item

– Methods of testing hedge effectiveness


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7

Definition of a Derivative Instrument A derivative instrument is a financial instrument or contract that

has all of the following:

– Settlement factors One or more reference rates (underlyings)

One or more notional amounts or payment provisions or both

– Leverage Requires little or no net investment yet responds to market changes

– Net settlement Contract terms require or permit net settlement

Can be readily settled net outside the contract through a market mechanism; or

Provides for delivery of an asset that is readily convertible to cash or is itself a derivative instrument

See also Implementation Guide

7

May 2010 Year-End GAAP Training

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Settlement FactorsReference Rates

– Reference rate can be any variable with changes that are observable or otherwise objectively verifiable (cannot be the asset or liability itself)

– Value of a derivative instrument generally changes by direct reference to changes in the reference rate

Notional Amount

– The number of units specified in a derivative contract (e.g. currency, shares, etc):

– Amount applied to change in reference rate to determine settlement

Payment Provisions

– Fixed or determinable payment made if an underlying changes in a specified manner (e.g. payment if commodity price increases 10%)

– Often included in lieu of a notional amount


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Leverage

No initial net investment or smaller initial investment than required for other types of contracts having a similar response to changes in market factors

Evaluated from perspective of one party to contract but determines the accounting for both parties

Commodity example:

– To buy 10,000 gallons of diesel fuel today at $3 gallon, must pay $30,000

– No money required to enter into forward contract for 10,000 gallons of oil at future date at forward spot price

– Fair value of both the purchased diesel fuel and forward contract change similarly with changes in market price of diesel fuel


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Net SettlementContractual Terms

Net settlement characteristic has been met if neither party to the contract is required to deliver an asset that:

– is associated with the underlying, and

– has a principal amount, stated amount, face value, number of shares, or other determination that is equal to the notional amount in the contract

Generally contracts with only a payment provision will meet net settlement under contractual terms


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Net SettlementMarket Mechanism

A market mechanism that facilitates net settlement must have ALL of the following characteristics:

– Enables one party to the contract to readily liquidate its net position

– Results in one party to the contract becoming fully relieved of its rights and obligations under the contract

– Liquidation of net position: Does not require significant transaction costs

Occurs without significant negotiation and due diligence

Occurs within a customary time frame


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Net SettlementReadily Convertible to Cash

Puts the recipient in a position not substantially different from net settlement through the contract

Key characteristics:– Interchangeable (fungible) units

– Quoted prices available in an active market

– Market can rapidly absorb the quantity held by the entity without significantly affecting the quoted price

– Significance of transaction costs


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Scope Exceptions

Normal purchases and normal sales contracts Insurance contracts covered under Statement 10Financial guarantee contracts that provide payments to the

holder only for losses incurred because a specified debtor fails to make payment

Certain contracts not exchange traded with an underlying based on:

– A climatic, geological or other physical variable– A price or value of a nonfinancial asset

Loan commitments


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Hybrid Instruments

Derivative instruments are often free-standing instruments:

– Swaps

– Forward contracts

Other times, derivative instruments may accompany or be embedded within a companion instrument:

– Combined instrument referred to as a hybrid instrument

– Important to identify because derivative instrument may require separate reporting from the companion instrument


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Hybrid Instruments

Where to look:

– Financial assets and liabilities

– Purchase and service contracts

– Leases

What to look for:

– Renewal, extension, cancellation and prepayment options

– Caps, floors, collars

– “If…then” contract provisions


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Reporting Hybrid Instruments

The derivative and the companion instrument should be reported separately if:

– Companion instrument is not measured at fair value– A separate instrument with the same terms as the embedded

component would meet definition of a derivative instrument; and– Economic characteristics and risks of the derivative instrument

are not closely related to those of the companion instrument

Contracts outside the scope of GASB 53 need not be evaluated as a hybrid instrument


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Knowledge Check #1

Which factor is not considered a settlement factor based on the definition of a derivative:

A. Reference rates

B. Notional amount

C. Leverage

D. Payment provisions


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Knowledge Check #1: Answer

C. Leverage

A derivative must have settlement factors, leverage and net settlement. The settlement factors are reference rates, notional amount and payment provisions.


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Common Derivative Instruments Common Derivative Instruments

AUDIT

2009 GASB 53 IMPLEMENTATION TEAM TRAINING


May 2010 19Year-End GAAP Training

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What is a Derivative?

An instrument value “depends on” or is “derived from” the value of an underlying asset, reference rate, or index

GASB 53 defines derivatives based on characteristics versus listing instruments

Continued innovations in financial markets render any definitions based on listing obsolete

Understanding characteristic-based definition is essential to applying the statement

May 201020

Year-End GAAP Training

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Types of Derivative Instruments

Common Types

– Futures

– Forwards

– Swaps

– Options

– Combinations of the above Synthetic financial

instruments

Uncommon Types

– Basket Options

– Barrier Options

– Contingent Forwards

– Currency Translated or Quanto- products

– Combinations of items from both columns

May 201021


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Futures/ Forward Contracts

Futures ContractsAn exchange-traded security to buy or sell a security, commodity, foreign currency, or other financial instrument at a certain future date for a specific price

Examples include:Commodity futures (including oil and natural gas)

Interest rate futures

Forward ContractsContract to buy or sell a financial asset or commodity at a specified date in the future for a price agreed upon at inception

Examples include:Forward rate agreements

Forward commodity contracts

May 201022


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Forward Purchase Contract Value at Maturity

V = Value of Contract

P = Price$400

May 201023


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Swap Agreements

Agreement between two counterparties to exchange sequences of cash flows over a specified period of time (e.g. interest rate swaps, currency swaps, commodity swaps)

Exotic swapsForward-starting swaps

Index-amortizing swaps

Leveraged swaps

Swaptions – can be used to monetize a call feature in a bond

Swaps with embedded options

May 201024


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Option Contracts

Provide holder the right, but not the obligation, to buy or sell underlying instrument at a specified price

Strike price

Exercise styleAmerican options

European options

Bermudan options*

Asian options*

Premium

Call vs. put options

Option value = time value + intrinsic value

Exotic option types (includes Bermudan and Asian)

May 201025


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Examples of Option Contracts

Equity options

Interest rate and currency options

Embedded options

May 201026


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Combinations of Options

CapsSeries of individual call options

Gives buyer the right to receive positive difference between the cap rate and reference rate

Requires payment of a premium

FloorsSeries of individual put options

Gives buyer the right to receive the negative difference between the floor rate and reference rate

CollarsCombination of a purchased cap and a written floor

Combination of a written cap and a purchased floor

May 201027


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Valuation of Derivative Instruments

GASB 53 paragraph 21Zero coupon method (for swaps)

Par value method (for forwards)

SAS No. 92, Auditing Derivative Instruments, Hedging Activities, and Investment Securities

SAS No. 101, Auditing Fair Value Measurements and Disclosures

May 201028


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Knowledge Check #2

29

An entity enters into an agreement with a supplier to purchase a quantity of heating oil at a certain future time, for a certain price, and a certain quantity. What type of derivative is this considered?

A. Futures Contract

B. Forward Contract

C. Option

D. Swap Agreement


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30

B. Forward Contract

A forward contract is a contractual agreement to buy or sell a security, commodity, foreign currency, or other financial instrument, at a certain future date for a specific price.


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Valuation Examples

Valuation is outside the scope of this course

Examples:

– Valuing Forwards

– Valuing Interest Rate Swaps


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AUDIT


Recognition and Measurement ProvisionsRecognition and Measurement Provisions


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33

Recognition and MeasurementDerivative Instruments are Reported at Fair Value

Generally, all derivative instruments within the scope of GASB 53 should be reported on the statement of net assets at fair value

– Exception for certain synthetic guaranteed investment contracts

Reporting the changes in fair value depends on the classification of the derivative instrument:

1. Hedging derivative instrument (HDI) → Apply hedge accounting Entire fair value change is deferred on the statement of net assets

(deferred inflow and outflow accounts)

Continue to apply hedge accounting until a termination event occurs

2. Investment derivative instrument → Apply investment accounting

All derivative instruments not considered HDIs are investment derivative instruments

Fair value change is reported on the change statement in the period it occurs (investment revenue classification)


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Recognition Under Hedge Accounting

For HDIs that have positive fair values:

– Report HDI as an asset

– Report deferred inflow (credit) offsetting the asset

For HDIs that have negative fair values:

– Report HDI as a liability

– Report deferred outflow (debit) offsetting the liability

Unlike under FASB 133, entire amount of the HDI is offset by the deferred inflow or outflow:

– No calculation of “ineffectiveness” amount that would be reported as a current period change statement item


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Presentation of Derivative Instruments

Currently, there is no specific guidance on how to present derivative instruments on the Statement of Net Assets:

– Aggregated gross under “derivatives” captions within assets and liabilities sections?

– Aggregated net under a single “derivatives” caption?

– HDIs netted with hedged assets and liabilities?

– Investment derivative instruments reported within investments captions?

– Combination of all of the above?

– How should derivatives be classified within the net asset categories?

Where derivatives are reported in Statement of Net Assets will be part of required note disclosures


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Miscellaneous Recognition and Measurement Items

Hedge accounting is mandatory under GASB 53

HDIs should be reported in the same fund as the item being hedged

Transactions for exchange-traded derivatives should be accounted for based on the trade date, not the settlement date

Entities applying FASB 71 for regulated utilities must still apply hedge accounting


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37

Determining Fair Value

Use market price if there is an active market for the derivative instrument

If a market price is not available, then use a forecast of expected cash flows (discounted)

Also acceptable:

– Formula-based methods

– Mathematical methods Zero-coupon method

Par-value method

Matrix pricing

Black-Scholes-Merton Model

– Pricing services, provided they use the principles described above

FASB 157 approach may, but is not required, to be applied


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38

Knowledge Check #3

Except certain synthetic guaranteed investment contracts, all derivative instruments within the scope of GASB 53 should be reported on the statement of net assets at fair value

A. True

B. False


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39


A. True

An entity should use market price if there is an active market for the derivative instrument to estimate fair value. If a market price is not available, then use a discounted cash flows methods. Formula or mathematical based methods or pricing services are also acceptable


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AUDIT


Hedge Accounting Hedge Accounting


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What is Hedging?

Hedging is a method governments employ to reduce identified financial risks:

– Increases in interest costs

– Increases in commodity prices

– Losses due to counterparty default

– Fair value declines due to changes in market interest rates

Governments use derivative instruments as a mechanism to hedge identified financial risks

– Risks hedged through changes in cash flows or fair values of derivative instruments offsetting changes in cash flows or fair values of associated items


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Types of Hedges

Cash flow hedges:– Address risks that arise due to prices or rates that are variable:

– Manage risks by eliminating variable or market fluctuations to which the cash flows of the associated item are subject:

– Majority of hedges undertaken by governments are cash flow hedges

Fair value hedges:

– Address risks of changes in fair values of items that have prices or rates that are fixed or known

– Manage risks by “unlocking” fixed prices and rates thereby allowing item to be valued as if it had current market rate/price


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43

Hedging Derivative Instruments

A Hedging Derivative Instrument (HDI) is established, and hedge accounting MUST be applied if there is:

– Association: Derivative instrument is associated with a hedgeable item

AND

– Substantial Offset: Derivative instrument is effective in substantially offsetting changes in cash flows or fair value of the hedgeable item resulting from the identified financial risk hedge effectiveness

Hedge accounting is NOT an option

Contemporaneous documentation of the hedge is encouraged, but NOT required for application of hedge accounting


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Association with a Hedgeable Item

Absent a documentation requirement, it may not always be apparent whether a derivative instrument is associated with a hedgeable item

Consider facts and circumstances of derivative instrument, including whether:

– Notional amount of derivative instrument is consistent with principal/quantity of hedgeable item

– Derivative instrument will be reported in the same fund as the hedgeable item

– Term or time period of derivative instrument is consistent with that of the hedgeable item

Derivative instrument that is associated with a hedgeable item, but has yet to be determined effective is referred to in GASB 53 as a potential hedging derivative instrument (PHDI)


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What Can Be Hedgeable Items?

Hedgeable items can be all or a portion of:– A single asset or liability

An entire bond issuance $60 million of a $100 million bond issuance may be hedgeable item

– Groups of similar assets and liabilities Individual assets or liabilities in the group must be exposed to the same identified

financial risk being hedged

– An expected transaction Expected bond issuance Expected commodity purchase/sale

Assets and liabilities measured at fair value cannot be hedgeable items– Fair value of hedgeable item reported in change statement so no need for

hedge accounting

Transactions within primary government cannot be hedgeable items

Transactions between primary government and discretely presented component units can be hedgeable items


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What Can Be Hedgeable Items?Expected Transactions

For an expected transaction to be a hedgeable item, it should be probable of occurring

Probability should be supported by observable facts, including:

– The frequency, volume and amount of past transactions

– The financial, operational, and legal ability of the government to carry out the transaction

– The extent of loss or disruption to a government’s activities that could result if the transaction does not occur

– The government’s budget or other planning documents

If the hedgeable item is an expected transaction, the evaluation of effectiveness should consider the probable terms of the transaction


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Knowledge Check #4

An entity issues fixed-rate bonds and at the same time, it enters into an interest rate swap that would swap its fixed bond payments for interest payments that are at market. What type of hedge is this?

A. Cash flow hedge

B. Fair value hedge


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B. Fair value hedge

By entering into the interest rate swap, the entity would synthetically be paying the market interest rate, keeping the fair value of the bond liability consistently at par.


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Overview of Hedge Effectiveness

Hedge effectiveness testing should be performed for each PHDI:

– At the end of the reporting period of the inception of the hedge; and

– At the end of each subsequent reporting period for as long as the hedge is effective

End of reporting period applies to interim periods if financial statements are prepared on a GAAP basis

Hedge effectiveness testing is not required at the inception of the hedge

Different testing methods may be used across the population of PHDIs


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Hedge Effectiveness Testing Methods

GASB 53 provides the following methods for testing hedge effectiveness:

– Consistent Critical Terms Method

– Quantitative Methods Synthetic Instrument Method

Dollar-Offset Method

Regression Analysis Method

GASB 53 also provides conceptual requirements for other quantitative methods not specified in Statement


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51

Overview of Hedge EffectivenessOrder of Application of Methods

The methods for testing hedge effectiveness should be applied as follows:

First Reporting Period

If use CCT first and it fails MUST use at least one quantitative method before concluding the relationship is ineffective

If use quantitative method first and it fails MAY, but not required to use other methods before concluding the relationship is ineffective

Subsequent Reporting Periods

First use method applied in previous period if fails, MAY, but not required to use other methods before concluding the relationship is ineffective


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52

Evaluation of Hedge EffectivenessNew Market Conditions

New market conditions are caused by events that significantly change the historical relationship between the derivative and the hedgeable item

Examples of new market conditions:

– Changes in income tax rates that affect the demand for tax-exempt debt

– Natural disaster that upsets the supply of a commodity

If new market conditions occur, only hedge effectiveness methods that use forward-looking data should be used:

– Dollar-offset method (change in fair values or expected cash flows)

– In some instances, regression analysis that uses fair values


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53

Other Quantitative Methods

GASB 53 allows for use of other quantitative methodsTo be used, method should:

– Demonstrate through analysis of quantitative critical terms that hedged changes in cash flows or fair values of PHDI offset those of hedgeable item

– Generate replicable, consistent evaluations of effectiveness such that different evaluators would achieve similar results

– Incorporate consideration of substantive characteristics of PHDI and hedgeable item that could affect cash flows or fair values

If used, details of method should be disclosedTo date, GASB has not specifically identified any other

quantitative methods


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54

Knowledge Check #5

If an entity uses a quantitative method first (in the first reporting period) and it fails they are required to use other methods

before concluding the relationship is ineffective.

A. True

B. False


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55


B. False

If an entity uses a quantitative method first (in the first reporting period) and it fails, they MAY, but are not required to use other methods before concluding the relationship is ineffective


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56

Termination of Hedge Accounting

GASB 53 identifies 6 events that result in termination of hedge accounting:

a. HDI is no longer effective

b. Likelihood that a hedged expected transaction will occur is no longer probable

c. Hedged asset or liability is sold or retired, but not refunded or defeased

d. HDI is terminated

e. Hedged debt is refunded or defeased

f. Hedged expected transaction occurs

Key decision to be made when hedge accounting is terminated is how to dispose of the related deferred inflow or outflow

Disposition depends on the event resulting in the termination of hedge accounting


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AUDIT


Required Note DisclosuresRequired Note Disclosures


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58

Summary of Derivative Instrument Activity

Summary of derivative instrument activity provided by:1. Governmental activities, business-type activities, and fiduciary

activities

2. Then by fair value hedges, cash flow hedges, and investment derivatives

3. Then by type: Receive-fixed interest rate swap Rate caps Futures contracts


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Summary should include the following information:– Notional amount– Fair values and changes in fair value and where such

amounts are reported in the financial statements– Fair values of derivatives reclassified from hedging to

investment derivatives and the deferral amount reported in investment revenue upon termination of hedge accounting


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60


Change in Fair ValueChange in Fair Value Fair Value at June 30, 2008Fair Value at June 30, 2008

Dr. (Cr.)Dr. (Cr.) Dr. (Cr.)Dr. (Cr.)

NotionalNotional ClassificationClassification AmountAmount ClassificationClassification AmountAmount

Governmental Governmental activitiesactivities

Fair value hedgesFair value hedges Receive-fixed interest Receive-fixed interest

rate swaprate swap$ 30,000$ 30,000 DeferralDeferral $(277)$(277) DebtDebt $ 1,572$ 1,572

Cash flow hedgesCash flow hedges Pay-fixed interest rate Pay-fixed interest rate

swapsswaps$ 84,000$ 84,000 DeferralDeferral (143)(143) DebtDebt (1,253)(1,253)

Rate capRate cap $ 10,000$ 10,000 DeferralDeferral 2828 DebtDebt 7777

Investment derivativesInvestment derivatives Pay-fixed interest rate Pay-fixed interest rate

swapswap$ 18,000$ 18,000 Investment Investment

incomeincome1,2771,277 Investment Investment (1,277)(1,277)

Business-type Business-type activitiesactivities

Cash flow hedgesCash flow hedges Pay-fixed interest rate Pay-fixed interest rate

swapswap$ 37,000$ 37,000 DeferralDeferral (548)(548) DebtDebt 4,2364,236

Commodity forward Commodity forward 1,000,000 1,000,000 MMBTUsMMBTUs

DeferralDeferral (111)(111) DerivativesDerivatives 111111

Fiduciary fundsFiduciary funds Investment derivativesInvestment derivatives Foreign currency Foreign currency

forwardforward20,000UK20,000UK Investment Investment

incomeincome721721 InvestmentInvestment (721)(721)

The pay-fixed interest rate swap listed as an investment derivative under governmental activities was evaluated to be an The pay-fixed interest rate swap listed as an investment derivative under governmental activities was evaluated to be an ineffective hedge for accounting and financial reporting purposes during fiscal year 2008. Accordingly, the changes in fair value ineffective hedge for accounting and financial reporting purposes during fiscal year 2008. Accordingly, the changes in fair value of the swap that had been deferred through June 30, 2007 of $(1,409) along with the change in fair value of the swap in fiscal of the swap that had been deferred through June 30, 2007 of $(1,409) along with the change in fair value of the swap in fiscal year 2008 of $132 have been recorded as investment income for the year ended June 30, 2008.year 2008 of $132 have been recorded as investment income for the year ended June 30, 2008.


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If derivative instrument fair values are determined by other than quoted prices, disclose methods and significant assumptions used to estimate fair value

If fair value determined by pricing service, not required to disclose significant assumptions if pricing service:

– Considers them proprietary; and

– Declines to make information available

Disclose pricing service would not make information available


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Disclosures in the following areas should be provided for hedging derivative instruments (HDIs):

– Objectives and strategies

– Terms

– Financial risks

– Impact on cash flows related to hedged debt


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Credit risk

Interest Rate Risk

Basis Risk

Termination Risk

Rollover Risk and Market Access Risk

Foreign Currency Risk


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Knowledge Check #6

Which of the following risk(s) is/are required disclosures under GASB 53?

A. Credit Risk

B. Interest Risk

C. Basis Risk

D. All of the above


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D. All of the above

Credit risk, interest rate risk, and basis risk are all required disclosures in addition to termination risk, rollover risk, market access risk and foreign currency risk.


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Other Disclosure Requirements

Disclosures for Hedging Derivative Instruments—Use of Other Quantitative Method

Disclosures for Investment Derivative Instruments

Contingent Features

Other Required Disclosures

Miscellaneous Disclosure Items


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67

Effective Date and Transition

Effective for financial statements for periods beginning after June 15, 2009

Provisions should be retroactively applied; restate prior periods presented if practical

Perform effectiveness testing of existing HDIs at the end of the period of implementation:

– If effective, apply as if effective since inception– If ineffective, test as of end of prior period:

If effective, write-off deferral during implementation period If ineffective, fair value incorporated into cumulative effect of change

in accountingTake note of retroactive application for hybrid instruments and

termination of hedge accounting provisions


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CSU Applicability Survey Results

68

Campus Auxiliaries

1 Bakersfi eld No No

2 Chancellor’s Offi ce No No

3 Channel I slands No No

4 Chico No No

5 Dominguez Hills No No

6 Fresno No No

7 Fullerton No Yes

8 East Bay / Hayward No No

9 Humboldt No No

10 Long Beach No No

11 Los Angeles No No

12 Maritime Academy No No

13 Monterey Bay No No

14 Northridge No No

15 Pomona No No

16 Sacramento No No

17 San Bernardino No Yes

18 San Diego No No

19 San Francisco No No

20 San J ose No No

21 San Luis Obispo No No

22 San Marcos No Yes23 Sonoma No No

24 Stanislaus No No

May 2010Year-End GAAP Training

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Presenters

Roger Martinez

KPMG Partner

(213) 955-8671

[email protected]

Kathy V. Lai

KPMG Senior Manager

(949) 885-5516

[email protected]

Ben Cheng

Sr. Financial Reporting Manager

(562) 951-4548

[email protected]


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Questions?


GASB 53: Accounting and Financial Reporting for Derivative Instruments Presented by:

Documents

Transcript of GASB 53: Accounting and Financial Reporting for Derivative Instruments Presented by: