Final GASB guidance on derivatives: a number of arrangements that might otherwise qualify as derivatives have been excluded from

This past June, the Governmental Accounting Standards Board (GASB) released Statement No. 53, Accounting and Financial Reporting for Derivative Instruments. The provisions of this new standard become mandatory for the fiscal year ending June 30, 2010.

Background. In essence, a derivative is an arrangement to receive or make payments based on market prices without actually entering into the related financial or commodity transactions. Sometimes a derivative will function economically as an investment. At other times, derivatives are used to offset potential volatility in cash flows or fair value, or as a means of lowering the cost of borrowing. Technically speaking, an arrangement must possess three characteristics to qualify as a derivative:

* Settlement features. A derivative always involves an objectively verifiable reference rate. This reference rate may be a specific price, a specific rate, or an index of prices or rates. It could also be the occurrence or nonoccurrence of an event. In addition, a derivative will always involve either a notional amount, a payment provision, or both. A notional amount is the value to which the reference rate is applied to determine the amount of the payment. A payment provision specifies the amount of the resulting payment should a reference rate behave in a predetermined fashion.

* Leverage. Another characteristic of a derivative is that the contracting parties are able to achieve a given economic effect at only a fraction of the investment of resources normally required to do so. In an interestrate swap, for example, a government is able to achieve a result equivalent to refinancing its debt without generating anything near the cash flows that would normally be required to do so.

* Net settlement. A third characteristic of a derivative is that it can be settled for cash at substantially less than the notional amount.

Common examples of derivatives found in the public sector include interest-rate swaps, basis swaps, "swaptions," and commodities contracts.

A number of arrangements that might otherwise qualify as derivatives have been excluded from the scope of GASB Statement No. 53: normal purchase and sales contracts; insurance contracts; financial guarantee contracts contingent upon default; certain contracts that are not exchange-traded; and loan commitments.

Basic approach. The financial reporting guidance in GASB Statement No. 53 (as opposed to its disclosure requirements) applies solely to the government-wide financial statements, proprietary fund financial statements, and fiduciary fund financial statements. It does not apply to governmental fund financial statements (which use the current financial resources measurement focus and modified accrual basis of accounting).The basic approach can be summarized as follows:

* Fair value. Report derivatives at their fair value.

* Changes in fair value. Report changes in the fair value of derivatives as part of investment income in the period in which the changes occur (except for certain hedges).

* Deferred recognition for certain hedges. Defer recognition of changes in the fair value of derivatives involved in effective hedges of items not reported at fair value (i.e., report the change in fair value as a deferred item in the statement of position rather than as part of investment income of the period).

Hedging. A hedge is an arrangement in which a derivative is associated with an asset, liability, or expected transaction in such a way as to substantially offset changes in cash flows or fair value affecting the associated item. Typically, there is an inverse relationship between the fair value of a hedging derivative and the fair value of the associated hedged item.

As long as a hedging derivative and the associated hedged item are both reported at fair value in the financial statements, changes in the fair value of the one should essentially counterbalance changes in the fair value of the other. This natural counterbalancing would not occur, however, if the derivative (reported at fair value) were associated with a hedged item not reported at fair value. To avoid a potential mismatch, GASB Statement No. 53 requires that the recognition of changes in the fair value of derivatives be deferred in this latter case (i.e., reported on the statement of position, like an asset or liability, rather than as part of investment income). To qualify for this specialized treatment, a derivative instrument must meet certain criteria to prove that it is associated with the hedgeable item. In addition, the hedging arrangement must be demonstrably effective at achieving its objective of offsetting changes in the cash flows or fair values of the hedged item. Consequently, at the end of each period, a government must use either the consistent critical terms method or an acceptable quantitative method to demonstrate effectiveness:

* The consistent critical terms method compares the terms of the derivative instrument with the terms of the hedgeable item to determine that they are either the same or essentially similar.

* The synthetic instrument method determines the effectiveness of a potential hedge by treating a derivative instrument and an associated hedgeable item as a single synthetic instrument and then comparing actual performance to intended performance to determine that the former approximates the latter (i.e., actual results/intended results 90 percent and 111 percent).

* The dollar-offset method determines the effectiveness of a potential hedge by directly comparing changes in cash flows or changes in fair values of the derivative and of the item with which it is associated. To qualify as effective, the results of dividing one by the other must be 80 percent and 125 percent.

* Regression analysis is used to establish statistically that a hedge is effective, which requires that 1) the R-squared be .80, 2) the F-statistic demonstrate significance using a 95 percent confidence interval, and 3) the regression coefficient for the slope be -1.25 and -0.80.

Governments are permitted to use other quantitative methods not discussed in GASB Statement No. 53, provided that any such method possesses the essential characteristics of those just described (e.g., replicability),

Once a hedging arrangement has come to an end (e.g., the hedge is determined to be ineffective or the hedged asset or liability is sold or retired), the derivative instrument (if still outstanding) is treated as an investment, and any related deferred amounts closed to investment income (except in a few limited cases, such as refundings resulting in defeasance).

Note disclosure. Derivatives that function as investments must generally provide the disclosures mandated by GASB Statement No. 40, Deposit and Investment Risk Disclosures (an amendment of GASB Statement No. 3). For derivatives involved in hedges, GASB Statement No. 53 has essentially incorporated the disclosure requirements of GASB Technical Bulletin (TB) 2003-1, Disclosure Requirements for Derivatives Not Reported at Fair Value on the Statement of Net Assets. All the same, the credit risk disclosures of GASB Statement No. 53 will apply in all cases. Likewise, governments are always required to provide a summary of their derivative instrument activity during the reporting period and balances at the end of the reporting period.

STEPHEN J. GAUTHIER is director of the GFOA's Technical Services Center in Chicago, Illinois.

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