Presentation on theme: "Accounting and Financial Reporting for Derivative Instruments"— Presentation transcript:
1 Accounting and Financial Reporting for Derivative Instruments
2 Derivatives Notional amounts outstanding, 1987-present $683.7 trillion in June 2008The amount of derivatives issued is seemingly limitless.Source: International Swaps and Derivatives Association, Inc., 2008
3 Types of Derivatives that Accountants Encounter Foreign exchange includes currencies and forwardsInterest rates include forward rates, options and swaps – Swaps by far the most prevalent -52% of all derivativesEquities are linked to stocks, mainly stock optionsCommodities include gold options and other – mainly oil, crops etc.Credit defaults are insurance risk contractsForeign exchange and interest rate contracts are the most% of notional amounts outstanding – as of June 2008 – Source Bank for International Settlements
4 Executive Summary of GASB Statement No. 53 Complex statement that:Defines derivatives and exclusions.Presents requirements for recognition and measurement of derivatives.Describes and calculates hedge accounting, efficient and inefficient hedge accounting.Contains a full set of examples and note disclosures, as well as transition guidance.Supersedes Technical BulletinAmends pieces of Statement Nos. 7, 23, 25, 31, 40 and 43.
5 Executive Summary of GASB Statement No. 53 What is a derivative?It is a contract that has settlement factors which could beone or more reference rates.notional amounts.payment provisions or any combination.It has leverage.It can be settled net.Common rates include SIFMA, LIBOR, AAA general obligations index, price of No. 2 heating oil at the New York City harbor pricing point.Leverage means no initial or little initial net investmentNet settlement has one of the following:neither party is required to deliver an asset that is associated with the rate and that has a principal amount, stated amount, face value, share amount or other items.One of the parties has to deliver an asset, principal amount stated amount etc.The item delivered has to be converted to cash or is itself a derivative – could be a forward contract (requires delivery of a bond) or a swaption (option to enter into a swap.)
6 Executive Summary of GASB Statement No. 53 What are settlement factors?Reference Rate – an interest rate, security price, commodity price, exchange rate, other variables.Notional Amount(s) – the face amount of the contract, which includes the number of units, shares, bushels, pounds, etc.The reference rate may be called an underlyingA “notional amount” is a fixed or determinable quantity specified in the instrument or contract. The notional is typically expressed in dollars, shares of stock, bushels, units of a commodity (bushels, pounds, barrels, etc.). The notional amount does not have to be fixed; rather, it can be subject to change as long as it is reliably determinable – however if it does, GASB 53 requires further transactions to prove whether the contract is an investment or a not. Therefore, a contract that specifies a notional amount that is based on historical or expected quantities, averages, minimums and/or maximums, such notional amount would be considered reliably determinable. If the notional amount is not reliably determinable, then this characteristic is not met and the contract would not be considered a derivative.
7 Executive Summary of GASB Statement No. 53 Requirements of the statement:Derivatives should be reported on the statement of net assets at fair value except for synthetic guaranteed investment contracts.Unless hedging derivative, changes in fair values are part of investment revenue in statement of activities, changes, etc.If hedging, then changes are deferred inflows or outflows.If hedged derivative is terminated, P&L event.Well get to the fair value determination in a minuteNow the goal would be to have the derivative be a hedging derivative or else you do have a change to investment revenue / expense due to fair value changes. We’ll talk about hedging in a bit – but being judged a hedging derivative is key if indeed that is the goal of the contract...
8 Executive Summary of GASB Statement No. 53 How to measure fair value:Market price if there is a market.Discounted expected cash flows.One of a number of different pricing models and methods.IF using a pricing service and the method to calculate is NOT disclosed by the service, then management must make an assessment of propriety based on the information received.Fair value is not readily determined unless you are heavily into calculus – usually governments hire a pricing service to determine fair value. The easiest thing is if there is a market for the contract derivativeOr if cash flows are known and if a discount rate is known, then a present value calculation can be performed -
9 Executive Summary of GASB Statement No. 53 Termination occurs when:Hedging derivative not effective.Government becomes exposed to adverse changes in fair values or cash flows.Hedged asset or liability is sold or retired, refunded or defeased.Derivative is terminated.Forward transaction occurs (e.g., sale of bonds or purchase of commodity).Reporting – investment revenue, balance sheet activity caption “increase (decrease) upon hedge termination.”Why is this important? – if hedge accounting ceases, then all changes in fair value and built up deferred changes in fair value flow to the statement of activities and fund based change statements.This is what’s happening to a lot of governments, especially those that issue student loans or mortgages, or that are effected by these types of activities. Because these contracts are terminated, they are marked to market and that can dramatically effect investment revenue and will raise debt service expense – something a government may not be planning on
10 What is a hedge?A hedge is a contract entered into to reduce some form of risk in cash flows or fair values.Hedges that accomplish the goal of reducing risk as expected are commonly referred to as effective.So we talked about the desire to have an effective hedgeEffective Hedges are commonly described as having cash flows that offset between 80 and 120% of related indebtedness’ cash flow.Hedges are deemed effective under GASB’s rules if:The hedging instrument is a derivative instrument, referred to as a hedging derivative instrument (further described in paragraph 22).b. The hedging derivative instrument is associated with a hedgeable item. (Hedgeable items are further described in paragraph 26–26.) Association is established by consideration of the facts and circumstances of the potential hedge including whether:(1) The notional amount of the derivative instrument is consistent with the principal amount of the issued debt or the quantity of the commodity.(2) The derivative instrument will be reported in the same fund as the hedgeable item.(3) The term of the derivative instrument is consistent with the term of the hedgeable item.c. The hedge is effective (further described in paragraphs 27–42).Hedges can be between a government and a component unit, but not WITHIN a government (e.g. between a city and a city utility department.)
11 What is a hedge? It must be associated with a hedgeable item Asset, liability, expected transaction (swaption, forward, etc.)Notional amount = principal amount.Derivative is in the same fund as hedgeable item.Term or time period is consistent between derivative and hedgeable item.It is effective in reducing the risk.If the notional amount = the principal amount and the years and terms are fixed, then it is automatically presumed to be effective. Derivatives should be in the same fund as the hedgeable item –For example, a government should not have a derivative contract in a fiduciary fund that is hedging debt
12 How to evaluate effectiveness? Initial year:If terms of derivative (years, amounts, rates) are consistent with debt, asset etc., then automatically effective – known as consistent critical terms.If inconsistent, then at least one of many quantitative methods must be used.Subsequent years:Use the same method as first year, but can use other method.Evaluation of effectiveness is done by measuring cash flows or overall changes in fair values.
13 How to evaluate effectiveness? Quantitative methods include:Synthetic instrument method (combine debt cash flows and derivative to create a third item).Dollar offset method (measure changes in expected cash flows).Regression analysis method (statistical relationship between debt and derivative changes).Can use other quantitative methods.At least four different methods could be used to measure effectiveness – the easiest being regression analysis – remember that from cost accounting class?Other methods includea. Through identification and analysis of critical terms, the method demonstrates that the changes in cash flows or fair values of the potential hedging derivative instrument substantially offset the changes in cash flows or fair values of the hedgeable item.b. Replicable evaluations of effectiveness are generated that are sufficiently complete and documented such that different evaluators using the same method and assumptions would reach substantially similar results.c. Substantive characteristics of the hedgeable item and the potential hedging derivative instrument that could affect their cash flows or fair values are considered.
14 Effectiveness Corridors Synthetic instrument methodDollar OffsetRegression analysisSynthetic rate should be within 90% - 111% of fixed rate.Derivative cash flows 80% - 125% of debt.R2 (measure of the proportion of the variance in a dependent variable about its mean that can be explained by changes in the independent variable.) must be ≥ 0.80.F-statistic (confidence level) must have 95% confidence.Corridor must be 80% - 125% of debt.
15 Note Disclosure Summary table of information: Organized by governmental, BTA, fiduciary funds:Subdivisions for hedging derivatives and investment derivatives.Within each category – aggregate information by type (received fixed swaps, pay fixed swaps, swaptions, caps, basis swaps, futures, etc.).
16 Example 1 -- Calculating Effectiveness Assumptions:Auction rate bonds issued for $100MM on 7/1/xx. Bonds mature 6/30/x4.Semiannual coupons reset weekly.On 7/1/xx, the government enters into a $100MM, notional, pay fixed, receive variable swap that terminates 6/30/x4. FMV at 7/1/xx=$0.Semiannual variable payment reset weekly.The variable payment is 49.96% of LIBOR + 78 basis points.The fixed payment is %.
17 Step 1 – Diagram the transaction Fixed pay %GovernmentCounterpartyVariable receive – 49.96% of LIBOR + 78bpsAuction rate paidNote that the actual synthetic rate paid will vary depending on the difference between the auction rate paid and the variable rate received.Bondholders
19 Step 3 -- Divide and measure From AssumptionsSince these are between 90 and 111%, then derivative is effective – changes reflected only in statement of net assets.
20 Journal Entries – HIGHLY SIMPLIFIED – Year 1 Swap Payment to CounterpartyDr.Interest Expense$3,578,720Cr.CashSwap Payment from Counterparty (can also be combined with payment above)$2,031,713Interest RevenuePayment to Bond HoldersDr.Interest Expense$1,789,314Cr.CashChange in Fair ValueDeferred Outflow of Resources$2,487,390Interest Rate Swap
21 Journal Entries – HIGHLY SIMPLIFIED – Year 2 Swap Payment to CounterpartyDr.Interest Expense$3,578,720Cr.CashSwap Payment from Counterparty (can also be combined with payment above)$1,575,995Interest RevenuePayment to Bond HoldersDr.Interest Expense$1,359,205Cr.CashChange in Fair ValueDeferred Outflow of Resources$1,512,764Interest Rate Swap
22 Journal Entries – HIGHLY SIMPLIFIED – Year 4 (final year) Swap Payment to CounterpartyDr.Interest Expense$3,578,720Cr.CashSwap Payment from Counterparty (can also be combined with payment above)$1,940,223Interest RevenuePayment to Bond HoldersDr.Investment Expense$1,930,405Cr.CashChange in Fair ValueInterest Rate Swap$1,536,286Deferred Outflow of Resources
23 What if the swap terminates? What if in the 3rd year, the state passes a change in taxes that causes the swap to no longer be effective? What happens?Assume the same facts in the previous illustration.
24 Step 2 -- Spreadsheet the cash flows and values Way out of corridor (2.81% ÷ 3.58% = 78.49%)
25 What if the swap terminates? In year 4Change in fair value now a component of investment income / expense.Any deferred outflows / inflows also become a component of investment income / expense (no more statement of net assets account).
26 Example 2 – A Swaption Assumptions: A state enters into a swaption with an investment bank; the bank has the right, but not the obligation, to force the state to enter into a pay-fixed, variable rate swap in the future.The state receives an up-front payment of $11,016,200 on 7/1 of year 0.The fixed rate the state receives is above the market rate - 5.5%.The 2-year forward rate is 3%.The variable rate is SIFMA.The notional amount is $100 million.The swap may have a volatility of up to 30%.At year 1, the one year forward rate is 2.85%.At year 2, the rate is 2.80%.The day after year 2, the bank exercises its option; the rate continues to be 2.80%.
27 Example 2 – A SwaptionFair value is calculated by taking the net present value of the cash flows at 3%. Fair value of the derivative is the swaption, less the borrowing. The change in fair value is the current year’s less the previous year’s fair value.
28 Example 2 – A SwaptionThe beginning balance is the original fair value of the borrowing. The interest accrual is the beginning fair value x 3% x (180/360). The swap payments are after the exercise date. Ending balance = beginning + interest – payments. The $1,250,000 starts in 2½ years until maturity.
30 Statement of Net Assets Presentation for Swaption and Swap DR / (Cr)As of and for the Fiscal Year Ending:123456Statement of Net AssetsCash$11,016,200$8,516,200$6,016,200$3,516,200$1,016,200Derivative Instrument - Swaption(602,878)(927,124)-Derivative Instrument – Swap(751,864)(571,664)(386,382)(195,877)Borrowing Payable11,189,52711,527,7319,357,4067,121,4844,817,9812,444,854Not supposed to foot unless counting statement of activities
31 Statement of Net Assets Presentation for Swaption and Swap DR / (Cr)As of and for the Fiscal Year Ending:123456Statement of ActivitiesInterest Revenue(447,924) DR(324,426) DR175,460 cr180,200 cr185,282 cr190,505 crInterest Expense328,281338,203329,676264,078196,497126,873Not supposed to foot unless counting statement of net assets
35 Note Disclosure Summary table of information Information includes: Notional amounts.Changes in fair value and where it is reported in the financial statements.Fair values at the end of the year.Reclassifications from hedging to investment derivatives during the period.Deferral amounts in investment revenue.Can be narrative if small number of contacts.
36 Note Disclosure Narratives include: Objectives of derivatives. Terms of derivatives include:Notional amounts.Reference rates, indexes, etc.Any embedded options (caps, floors collars).Date of contract and termination or maturity.Any cash paid or received.TB risks (credit, interest rate, basis, termination, rollover, market access, foreign currency).
37 Note Disclosure Other: Investment derivatives: Hedged debt: follow GASB 38, disclose net cash flows.If using other quantitative method identify any notable features of the method.Investment derivatives:TB disclosures along with GASB 40 disclosures.
38 Note Disclosure – June 30, Year 1 ItemTypeObjectiveNotional Amount(000’s)Effective DateMaturesTermsFMV(000s)AVariable Receive Interest Rate SwapHedge of changes in cash flows of series XX bonds$100,0007/1/xx6/30/x4Receive 49.96% of LIBOR + 78bps, pay %($2,487)BFuel contractHedge oil market price changes1 MBTUs4/30/x012/31/x0Pay $7.50 MBTU, based on pricing point at expiration111
39 Disclosure After table, note the following: Terms not in table. How fair values were calculated.Risks and ratings of counterparties.Contingencies on derivatives.Table of all payments and hedged debt.
40 Governmental Activities Disclosure – 2nd tableChanges in Fair ValueFair Value at June 30,xxGovernmental ActivitiesClassificationAmount(000s)NotionalVariable Receive Interest Rate SwapDeferred Outflow($2,487)Debt$100,000Commodity ForwardDeferred Inflow111Derivative Instruments1,000 MMBTUs
41 TransitionFor financial statements for periods BEGINNING AFTER June 15, 2009.Retroactive application for all periods presented.Perform hedge effectiveness evaluation as of the END of the CURRENT PERIOD ONLY. If effective now, assume effective as of the beginning of the contract.
42 Other items included in the Statement Huge (11 page) glossary.12 robust illustrations:Consistent critical terms.Interest rate swaps – synthetic method.Interest rate swaps – terminations due to market conditions.Regression analysis.Dollar offset method.
43 Other items included in the Statement 12 robust illustrations (continued):Swaptions.Full set of note disclosures.Flowchart of hedge effectiveness decisions.Codification instructions.Still to Come – Implementation Guide – Watch for it in 2009!
44 Questions?Contact Information:Eric S. Berman, CPADeputy ComptrollerCommonwealth of Massachusetts