Derivatives From an Accounting Perspective Public Pension Financial Forum 6 th  Annual Conference - 2009
Objectives & Overview <ul><li>To provide an understanding of financial derivative instruments </li></ul><ul><li>To provide...
GASB 53 – Accounting & Financial Reporting for Derivative Instruments <ul><li>Effective for financial statements for perio...
GASB 53 Summary <ul><li>Derivative instruments are reported on the statement of net assets and measured according to their...
Classifications of Derivatives <ul><li>Two classifications of derivatives: </li></ul><ul><ul><li>Hedging derivatives – cha...
Question <ul><li>To what extent will public pensions be affected by GASB 53 reporting requirements? </li></ul>
Answer <ul><li>Not Much </li></ul>
GASB 53 – Implementation Guide ¶ 109 <ul><li>109. Assets and liabilities that are measured at fair value in a government’s...
What is a Derivative Instrument for Financial Reporting Purposes? <ul><li>A derivative instrument has: </li></ul><ul><ul><...
Scope Outs <ul><li>Investments </li></ul><ul><li>Normal purchases and normal sales contracts </li></ul><ul><li>Traditional...
Examples of Derivatives <ul><li>Forward contract –  Contractual agreement to buy or </li></ul><ul><li>sell security, commo...
Examples of Derivatives (cont’d) <ul><li>Futures contract –  An exchange-traded security to buy or sell a </li></ul><ul><l...
Examples of Derivatives (cont’d) <ul><li>Option –  Contract that gives its holder right but not obligation to buy or sell ...
Examples of Derivatives (cont’d) <ul><li>Swaption –  An option to enter into a swap. When swaption is an interest rate opt...
Examples of Derivatives (cont’d) <ul><li>Take-or-pay contracts –  Agreement between  </li></ul><ul><li>buyer & seller in w...
Risks <ul><li>Credit risk  - the chance that the firm on the other side of the derivative instrument will not make good on...
Risks, (cont’d) <ul><li>Termination risk  - the possibility that a derivative instrument may end earlier than expected, th...
Risks, (cont’d) <ul><li>Market-access risk  - the chance that a government will not be able to issue debt  </li></ul><ul><...
Recognition & Measurement of Derivative Instruments <ul><li>Changes in fair values of  investment derivative instruments  ...
Recognition & Measurement of Derivative Instruments, (cont’d) <ul><li>Fair values  developed by pricing services  are acce...
Notes to Financial Statements <ul><li>Statement 53 requires a note disclosure that includes summary information about a go...
Notes to Financial Statements, (cont’d) <ul><li>Disaggregate information unless similar derivative instrument types exist ...
Notes to Financial Statements, (cont’d) <ul><li>For all hedging derivative instruments </li></ul><ul><ul><li>Objectives fo...
Notes to Financial Statements, (cont’d) <ul><ul><li>Hedged debt – disclose hedging derivative instrument’s net cash flows ...
Notes to Financial Statements, (cont’d) <ul><li>IMPORTANT CONSIDERATION </li></ul><ul><li>Rather than apply the hedging de...
Other Guidance <ul><li>GASB’s staff has prepared a  Guide to </li></ul><ul><li>Implementation of GASB Statement 53 on </li...
Other Guidance, (cont’d) <ul><li>Questions 49-56 deal with timing & methods of </li></ul><ul><li>evaluating effectiveness ...
GASB 53 Summary Reminder <ul><li>Shouldn’t have a major impact on Public Pension Financial Reporting </li></ul><ul><li>Non...
<ul><li>Questions? </li></ul>
<ul><li>Thomas R. Rey, Jr. CPA </li></ul><ul><li>Clifton Gunderson LLP </li></ul><ul><li>Baltimore, Maryland </li></ul><ul...
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  1. 1. Derivatives From an Accounting Perspective Public Pension Financial Forum 6 th Annual Conference - 2009
  2. 2. Objectives & Overview <ul><li>To provide an understanding of financial derivative instruments </li></ul><ul><li>To provide an understanding of the difference in using financial derivative instruments to hedge versus an investment security </li></ul><ul><li>Accounting for Derivatives </li></ul><ul><li>Recognize the importance of defining requirements for inclusion in GASB 53 reporting </li></ul>
  3. 3. GASB 53 – Accounting & Financial Reporting for Derivative Instruments <ul><li>Effective for financial statements for periods beginning after June 15, 2009 </li></ul><ul><li>Earlier application is encouraged </li></ul><ul><li>Apply accounting changes necessary to conform </li></ul><ul><li>to this statement retroactively by restating </li></ul><ul><li>financial statements, for all periods presented – </li></ul><ul><li>if restatement is not practical, the cumulative </li></ul><ul><li>effect of applying GASB 53, if any, should be </li></ul><ul><li>reported as a restatement of beginning net </li></ul><ul><li>assets, fund balance, or fund net assets, for </li></ul><ul><li>earliest period restated </li></ul>
  4. 4. GASB 53 Summary <ul><li>Derivative instruments are reported on the statement of net assets and measured according to their fair values </li></ul><ul><li>Fair value changes are reported on the change statement, provided a derivative instrument is not a hedging derivative </li></ul><ul><li>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 </li></ul>
  5. 5. Classifications of Derivatives <ul><li>Two classifications of derivatives: </li></ul><ul><ul><li>Hedging derivatives – changes in fair value apply to future accounting periods-> Hedge Accounting </li></ul></ul><ul><ul><li>Investment derivatives – changes in fair value apply to the current accounting period-> Investment Accounting </li></ul></ul>
  6. 6. Question <ul><li>To what extent will public pensions be affected by GASB 53 reporting requirements? </li></ul>
  7. 7. Answer <ul><li>Not Much </li></ul>
  8. 8. GASB 53 – Implementation Guide ¶ 109 <ul><li>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. </li></ul>
  9. 9. What is a Derivative Instrument for Financial Reporting Purposes? <ul><li>A derivative instrument has: </li></ul><ul><ul><li>One or more reference rates (underlyings) and one or more notional amounts </li></ul></ul><ul><ul><li>Leverage </li></ul></ul><ul><ul><li>Net settlement </li></ul></ul>
  10. 10. Scope Outs <ul><li>Investments </li></ul><ul><li>Normal purchases and normal sales contracts </li></ul><ul><li>Traditional insurance contracts </li></ul><ul><li>Traditional financial guarantee contracts </li></ul><ul><li>Non-exchange-traded climate contracts, liquidated damages, etc. </li></ul>
  11. 11. Examples of Derivatives <ul><li>Forward contract – Contractual agreement to buy or </li></ul><ul><li>sell security, commodity, foreign currency, or other </li></ul><ul><li>financial instrument, at certain future date for </li></ul><ul><li>specific price </li></ul><ul><li>Agreement with a supplier to purchase a quantity of </li></ul><ul><li>heating oil at certain future time, for certain price & a </li></ul><ul><li>certain quantity is an example. As an additional </li></ul><ul><li>example, Party A agrees to sell one million Euro in </li></ul><ul><li>six months at $1.0007 </li></ul><ul><li>They are not securities & are not exchange-traded </li></ul>
  12. 12. Examples of Derivatives (cont’d) <ul><li>Futures contract – An exchange-traded security to buy or sell a </li></ul><ul><li>security, commodity, foreign currency, or other financial instrument, at </li></ul><ul><li>certain future date for specific price. A futures contract obligates buyer to </li></ul><ul><li>purchase commodity or financial instrument & seller to sell it, unless an </li></ul><ul><li>offsetting contract is entered into to offset one’s obligation </li></ul><ul><li>Example of futures contract would be if Party A sells 10 contracts that set </li></ul><ul><li>price of S&P Index at 1500 in October – if price falls below 1500 then Party </li></ul><ul><li>A will profit by amount price is below 1500 & if price rises above 1500, then </li></ul><ul><li>Party A loses by amount price exceeds 1500 </li></ul><ul><li>Swap – Type of derivative instrument in which there is agreement to </li></ul><ul><li>exchange future cash flows. These cash flows may be either fixed or </li></ul><ul><li>variable & may be either received or paid. Variable cash flows depend on </li></ul><ul><li>reference rate. Interest rate swap is a swap that has variable payment </li></ul><ul><li>based on price of underlying interest rate or index </li></ul>
  13. 13. Examples of Derivatives (cont’d) <ul><li>Option – 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 of time </li></ul><ul><li>A “call option” grants holder right, but not obligation, to buy </li></ul><ul><li>at specified strike price & so it pays off to the holder if </li></ul><ul><li>market price for underlying item rises above that mark. A </li></ul><ul><li>call option is “in-the-money” when it has market price </li></ul><ul><li>above its strike price </li></ul><ul><li>A “put option” grants holder right, but not the obligation, to </li></ul><ul><li>sell at specified strike price & pays off to the holder when </li></ul><ul><li>market price falls below strike price. A put option is “in-the- </li></ul><ul><li>money” when it has market price below its strike price </li></ul>
  14. 14. Examples of Derivatives (cont’d) <ul><li>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 </li></ul><ul><li>Structured note – Hybrid instrument that </li></ul><ul><li>combines bond or loan with derivative. Traditional </li></ul><ul><li>type of structured note is a callable bond . Return </li></ul><ul><li>performance of structured note will track that of </li></ul><ul><li>underlying debt obligation & derivative embedded </li></ul><ul><li>within it </li></ul>
  15. 15. Examples of Derivatives (cont’d) <ul><li>Take-or-pay contracts – Agreement between </li></ul><ul><li>buyer & seller in which buyer will still pay some </li></ul><ul><li>amount even if product or service is not provided. </li></ul><ul><li>These contracts are most often used in utility </li></ul><ul><li>industry </li></ul><ul><li>Commodity swaps – Contracts that have variable </li></ul><ul><li>payment based on price or index of underlying </li></ul><ul><li>commodity </li></ul><ul><li>Interest rate locks – Contracts that allow one party to fix interest rate for specified period of time </li></ul>
  16. 16. Risks <ul><li>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 </li></ul><ul><li>Interest rate risk - the risk that changes in interest rates could reduce the value of the derivative instrument to the government </li></ul><ul><li>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 </li></ul>
  17. 17. Risks, (cont’d) <ul><li>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 </li></ul><ul><li>Rollover risk - the maturity of the derivative instrument is shorter than the maturity of the associated debt, leaving the government unprotected in the future </li></ul>
  18. 18. Risks, (cont’d) <ul><li>Market-access risk - the chance that a government will not be able to issue debt </li></ul><ul><li>Foreign currency risk - the possibility that changes in exchange rates will adversely affect the value of a derivative instrument </li></ul><ul><li>Headline/Reputation Risk – Enough said </li></ul>
  19. 19. Recognition & Measurement of Derivative Instruments <ul><li>Changes in fair values of investment derivative instruments (derivative </li></ul><ul><li>instrument entered into primarily for obtaining income or profit or one that </li></ul><ul><li>does not meet criteria for use of hedge accounting), including derivative </li></ul><ul><li>instruments that are determined to be ineffective, should be reported </li></ul><ul><li>within investment income in statement of activities (flow of resources </li></ul><ul><li>statement) </li></ul><ul><li>Changes in fair values of hedging derivative instruments should be </li></ul><ul><li>recognized through application of hedge accounting – changes in fair value </li></ul><ul><li>reported as either “deferred inflow of resources” or “deferred outflow of </li></ul><ul><li>resources” on statement of net assets </li></ul><ul><li>Report hedging instrument in same fund that reports hedged item </li></ul><ul><li>Hedge accounting should be applied beginning in period that hedging derivative instrument is established & until termination event occurs </li></ul>
  20. 20. Recognition & Measurement of Derivative Instruments, (cont’d) <ul><li>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 </li></ul>
  21. 21. Notes to Financial Statements <ul><li>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 . </li></ul>
  22. 22. Notes to Financial Statements, (cont’d) <ul><li>Disaggregate information unless similar derivative instrument types exist </li></ul><ul><li>Summary of derivative instrument activity during reporting period (year) & balances at end of reporting period (year) </li></ul><ul><li>Organize information by governmental activities, business-type activities & fiduciary funds </li></ul><ul><li>Aggregate by type – e.g., receive-fixed swaps, pay-fixed swaps, swaptions, rate caps, basis swaps or futures contracts </li></ul><ul><li>Present notional amount, changes in fair value during </li></ul><ul><li>reporting period & where reported, fair values at end of </li></ul><ul><li>reporting period & where reported & fair values of derivative </li></ul><ul><li>instruments reclassified from hedging derivative instrument </li></ul><ul><li>to investment derivative instrument </li></ul>
  23. 23. Notes to Financial Statements, (cont’d) <ul><li>For all hedging derivative instruments </li></ul><ul><ul><li>Objectives for entering into instrument(s) </li></ul></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>Risks – credit risks, interest rate risk, basis risk, termination risk, rollover risk, market-access risk & foreign currency risk </li></ul></ul>
  24. 24. Notes to Financial Statements, (cont’d) <ul><ul><li>Hedged debt – disclose hedging derivative instrument’s net cash flows based on requirements established under GASB 38 </li></ul></ul><ul><ul><li>Other quantitative method of evaluating effectiveness </li></ul></ul><ul><li>For investment derivative instruments </li></ul><ul><ul><li>For derivative instruments held at end of reporting period – credit risk, interest rate risk & foreign currency risk </li></ul></ul><ul><li>Contingent features </li></ul><ul><li>Hybrid instruments </li></ul><ul><li>Synthetic guaranteed investment contracts </li></ul>
  25. 25. Notes to Financial Statements, (cont’d) <ul><li>IMPORTANT CONSIDERATION </li></ul><ul><li>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. </li></ul>
  26. 26. Other Guidance <ul><li>GASB’s staff has prepared a Guide to </li></ul><ul><li>Implementation of GASB Statement 53 on </li></ul><ul><li>Accounting and Financial Reporting for Derivative </li></ul><ul><li>Instruments </li></ul><ul><li>Questions 28-34 address certain recognition & </li></ul><ul><li>measurement of derivative instrument issues, </li></ul><ul><li>including certain issues that differ from FAS 133 </li></ul><ul><li>requirements </li></ul><ul><li>Questions 39 & 40 address debt refundings that </li></ul><ul><li>have swap terminations associated with </li></ul><ul><li>refundings </li></ul>
  27. 27. Other Guidance, (cont’d) <ul><li>Questions 49-56 deal with timing & methods of </li></ul><ul><li>evaluating effectiveness </li></ul><ul><li>Question 94 addresses separate accounting for </li></ul><ul><li>embedded derivative (embedded non-option </li></ul><ul><li>contracts and embedded option contracts) </li></ul><ul><li>Questions 98-106 outline requirements for notes </li></ul><ul><li>to financials statements </li></ul><ul><li>Questions 107-110 answer certain effective date </li></ul><ul><li>& transition questions </li></ul>
  28. 28. GASB 53 Summary Reminder <ul><li>Shouldn’t have a major impact on Public Pension Financial Reporting </li></ul><ul><li>Nonetheless, accountants will require more information on derivative contracts in order to properly perform the accounting </li></ul><ul><li>Reconciliation procedures must be performed </li></ul><ul><li>Derivative and other investment footnote disclosures will likely need enhancement </li></ul><ul><li>Increased due diligence efforts </li></ul><ul><li>Valuation could be difficult for certain instruments </li></ul><ul><li>Increased risk depending on extent of derivative instruments </li></ul>
  29. 29. <ul><li>Questions? </li></ul>
  30. 30. <ul><li>Thomas R. Rey, Jr. CPA </li></ul><ul><li>Clifton Gunderson LLP </li></ul><ul><li>Baltimore, Maryland </li></ul><ul><li>(P) 410-453-0900 </li></ul><ul><li>[email_address] </li></ul>Contact
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