Statement No. 28 of the. Governmental Accounting Standards Board. Accounting and Financial Reporting for Securities Lending Transactions

Transcription

1 NO. 122-A MAY 1995 Governmental Accounting Standards Series Statement No. 28 of the Governmental Accounting Standards Board Accounting and Financial Reporting for Securities Lending Transactions Governmental Accounting Standards Board of the Financial Accounting Foundation

2 For additional copies of this Statement and information on applicable prices and discount rates, contact: Order Department Governmental Accounting Standards Board 401 Merritt 7 PO Box 5116 Norwalk, CT Telephone Orders: Please ask for our Product Code No. GS28.

3 Summary This Statement establishes accounting and financial reporting standards for securities lending transactions. In these transactions, governmental entities transfer their securities to broker-dealers and other entities for collateral which may be cash, securities, or letters of credit and simultaneously agree to return the collateral for the same securities in the future. Governmental entities should report securities lent (the underlying securities) as assets in their balance sheets. Cash received as collateral on securities lending transactions and investments made with that cash should be reported as assets. Securities received as collateral also should be reported as assets if the governmental entity has the ability to pledge or sell them without a borrower default. Liabilities resulting from these transactions should be reported in the balance sheet. Securities lending transactions collateralized by letters of credit or by securities that the governmental entity does not have the ability to pledge or sell unless the borrower defaults should not be reported as assets and liabilities. The costs of securities lending transactions, such as borrower rebates (interest costs) and agent fees, should be reported as expenditures or expenses. These costs should not be netted with interest revenue or income from the investment of cash collateral, any other related investments, or loan premiums or fees. This Statement requires disclosure of the source of legal or contractual authorization for the use of securities lending transactions, any significant violations of those provisions during the period, whether the maturities of the investments made with cash collateral generally match the maturities of the securities loans, and summary information about the credit risk associated with the transactions at the balance sheet date. Disclosure of general information about the transactions also is required, such as the types of securities lent, the types of collateral received, whether the government has the i

4 ability to pledge or sell collateral securities without a borrower default, the amount by which the value of the collateral provided is required to exceed the value of the underlying securities, any restrictions on the amount of the loans that can be made, and any loss indemnification provided to the entity by its securities lending agents. Disclosure also is required of the carrying amount and market or fair values of underlying securities at the balance sheet date. This Statement also provides guidance for classifying securities lending collateral and the underlying securities in the categories of custodial credit risk required by GASB Statement No. 3, Deposits with Financial Institutions, Investments (including Repurchase Agreements), and Reverse Repurchase Agreements. The provisions of this Statement are effective for financial statements for periods beginning after December 15, Earlier application is encouraged. Unless otherwise specified, pronouncements of the GASB apply to financial reports of all state and local governmental entities, including general purpose governments, public benefit corporations and authorities, public employee retirement systems, utilities, hospitals and other healthcare providers, and colleges and universities. Paragraph 3 discusses the applicability of this Statement. ii

5 Statement No. 28 of the Governmental Accounting Standards Board Accounting and Financial Reporting for Securities Lending Transactions May 1995 Governmental Accounting Standards Board of the Financial Accounting Foundation 401 Merritt 7, PO Box 5116, Norwalk, Connecticut iii

6 Copyright 1995 by Governmental Accounting Standards Board. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the Governmental Accounting Standards Board. iv

7 Statement No. 28 of the Governmental Accounting Standards Board Accounting and Financial Reporting for Securities Lending Transactions May 1995 CONTENTS Paragraph Numbers Introduction Standards of Governmental Accounting and Financial Reporting Scope and Applicability of This Statement... 3 Level of Presentation... 4 Accounting for Securities Lending Transactions Disclosures of Securities Lending Transactions Effective Date and Transition Glossary Appendix A: Background Information Appendix B: Basis for Conclusions Appendix C: Illustration of Note Disclosures for Securities Lending Transactions Cash Received as Collateral Appendix D: Illustration of Note Disclosures for Securities Lending Transactions Securities and Letters of Credit Received as Collateral Appendix E: Illustration of Note Disclosures for Securities Lending Transactions Cash and Securities Received as Collateral Appendix F: Codification Instructions v

8 Statement No. 28 of the Governmental Accounting Standards Board Accounting and Financial Reporting for Securities Lending Transactions May 1995 INTRODUCTION 1. In securities lending transactions, 1 governmental entities transfer their securities (the underlying securities) to broker-dealers and other entities for collateral which may be cash, securities, or letters of credit and simultaneously agree to return the collateral for the same securities in the future. Governmental lenders invest the cash received as collateral and, if the returns on those investments exceed the rebate paid to the borrowers of the securities, the securities lending transactions generate income for the government. However, if the investment of the cash collateral does not provide a return exceeding the rebate or if the investment incurs a loss in principal, part of the payment to the borrower would come from the government s resources. When securities or letters of credit are the collateral, the borrower will pay the lender a loan premium or fee for the securities loan. In some cases, the government may have the ability to pledge or sell the collateral securities before being required to return them to the borrower at the end of the loan. 2. There previously were no governmental accounting standards addressing the accounting and financial reporting for securities lending transactions. Governmental practice has been to continue to report the underlying securities in the balance sheet, but not to report assets and liabilities arising from the lending transactions. Governments also generally have disclosed information about the transactions, including in many cases 1 Terms defined in the glossary (paragraph 18) are printed in boldface type the first time they are used in this Statement. 1

9 information about the amount of securities lent at the balance sheet date and the amount and type of collateral received for those loans. GASB Statement No. 3, Deposits with Financial Institutions, Investments (including Repurchase Agreements), and Reverse Repurchase Agreements, provides accounting and financial reporting standards for reverse repurchase agreements transactions that are similar in economic substance to lending securities for cash collateral. Statement 3 requires governmental sellers to account for reverse repurchase agreements in the balance sheet as financing transactions by reporting assets for the cash received (and subsequently invested) and liabilities to the buyers to return the cash. STANDARDS OF GOVERNMENTAL ACCOUNTING AND FINANCIAL REPORTING Scope and Applicability of This Statement 3. This Statement establishes standards of accounting and financial reporting for securities lending transactions in which governmental entities (lenders) transfer their securities to broker-dealers and other entities (borrowers) for collateral and simultaneously agree to return the collateral for the same securities in the future. It applies to all state and local governmental entities that have had securities lending transactions during the period. Level of Presentation 4. The disclosures required by this Statement generally should be made for the primary government, including its blended component units, and, separately, for the total of those discretely presented component units for which disclosure is essential to fair presentation 2

10 of the financial reporting entity s general purpose financial statements. 2 Additional or separate presentation by fund, fund type, component unit, or one or more employee benefit plans is not precluded for any disclosures required by this Statement. Accounting for Securities Lending Transactions 5. Governmental entities should report securities lent (the underlying securities) as assets in their balance sheets Cash received as collateral on securities lending transactions and investments made with that cash should be reported as assets. 4 Securities received as collateral should be reported as assets if the governmental entity has the ability to pledge or sell them without a borrower default. 5 Liabilities resulting from these securities lending transactions also should be reported in the balance sheet. 7. Securities lending transactions collateralized by letters of credit or by securities that the governmental entity does not have the ability to pledge or sell unless the borrower defaults should not be reported as assets and liabilities in the balance sheet. 2 Determining which component unit disclosures are essential to fair presentation is a matter of professional judgment and should be done on a component unit by component unit basis. A specific type of disclosure might be essential for one component unit but not for another depending on the component unit s significance relative to the total component units included in the component units column(s) and the individual component unit s relationship with the primary government. 3 For purposes of this Statement, the term balance sheet includes the statement of plan net assets required for defined benefit pension plans by GASB Statement No. 25, Financial Reporting for Defined Benefit Pension Plans and Note Disclosures for Defined Contribution Plans. 4 In certain cases, a lender may not have the right to invest cash collateral. Specifically, a borrower may be allowed to replace securities collateral with cash collateral during the business day. When the borrower delivers cash that the lender does not have the right to invest, the transaction should be accounted for as involving securities collateral rather than cash collateral. 5 Governmental lenders are considered to have the ability to pledge or sell collateral securities without a borrower default if the securities lending contract specifically allows it. If the contract does not address whether the lender can pledge or sell the collateral securities without a borrower default, it should be deemed not to have the ability to do so unless it has previously demonstrated that ability or there is some other indication of the ability to pledge or sell the collateral securities. 3

11 8. The costs of securities lending transactions should be reported as expenditures or expenses in the operating statement. 6 These costs include borrower rebates (which should be reported as interest expenditures or expenses) and agent fees. The costs of lending securities should not be netted with interest revenue or income from the investment of cash collateral, any other related investments, or loan premiums or fees If a government pools money from several funds for investment purposes and the pool, rather than the individual funds, has securities lending transactions, the government should report the assets and liabilities arising from the securities lending transactions in the balance sheets of the funds that have the risk of loss on the collateral assets. In many cases, this will involve a pro rata allocation to the various funds based on their equity in the pool. 10. Similarly, the income and costs arising from pooled securities lending transactions should be reported in operating statements of the funds. If the income from lending pool securities that represent equity owned by one fund becomes the assets of another fund because of legal 8 or contractual provisions, the reporting treatment should be based on the specific language of those provisions. 9 If, however, the amounts become the assets of another fund for reasons other than legal or contractual provisions for example, 6 For purposes of this Statement, the term operating statement includes the statement of changes in plan net assets that Statement 25 requires for defined benefit pension plans. 7 This Statement does not change Statement 25, which provides that investment expenses of defined benefit pension plans are included in the additions section of the statement of changes in plan net assets. 8 According to NCGA Statement 1, Governmental Accounting and Financial Reporting Principles, paragraph 6, legal provisions include those arising from constitutions, statutes, charters, ordinances, resolutions, governing body orders, and intergovernmental grant or contract regulations. 9 That is, if the legal or contractual provision requires a transfer of the amounts to another fund, the income and costs should be reported in the fund that owns the equity, with an operating transfer to the recipient fund. If, however, the legal or contractual provisions require that the securities lending income be that of another fund, no transfer of resources should be reported. Instead, the amounts should be reported as income and costs in the recipient fund. 4

12 management decision the income and costs should be recognized in the fund that reports the equity. The transfer of those amounts to the recipient fund should be reported as an operating transfer. Disclosures of Securities Lending Transactions 11. Governmental entities should disclose in the notes to the financial statements the source of legal or contractual authorization for the use of securities lending transactions and any significant violations of those provisions that occurred during the period. 12. Governmental entities also should disclose in the notes to the financial statements a general description of their securities lending transactions during the period, including the types of securities lent, the types of collateral received, whether the government has the ability to pledge or sell collateral securities without a borrower default, the amount by which the value of the collateral provided is required to exceed the value of the underlying securities, any restrictions on the amount of the loans that can be made, and any loss indemnification provided to the entity by its securities lending agents. The entity also should disclose the carrying amount and market or fair values of underlying securities at the balance sheet date. 13. Governmental entities should disclose whether the maturities of the investments made with cash collateral generally match the maturities of their securities loans, as well as the extent of such matching at the balance sheet date. 14. The amount of credit risk, if any, related to the securities lending transactions at the balance sheet date should be disclosed. Credit risk is calculated as the aggregate of the lender s exposures to individual borrowers or on individual loans, depending on whether individual loans to the same borrower can be aggregated for purposes of offset in the event 5

13 of default. A lender has exposure if the amount a borrower owes the lender 10 exceeds the amount the lender owes the borrower. 11 If the governmental lender has no credit risk, that fact should be stated, and disclosure of the net amounts owed to the borrowers is not required. 15. Governmental entities should disclose the amount of any losses on their securities lending transactions during the period resulting from the default of a borrower or lending agent and amounts recovered from prior-period losses, if not separately displayed in the operating statement Disclosures required by Statement 3 should be made for securities lending collateral that is reported in the balance sheet and for the underlying securities. Therefore, the carrying amounts and market or fair values of these investments should be disclosed by type of investment, as required by paragraph 68 of Statement a. Collateral that is reported in the balance sheet should be classified by category of custodial credit risk as defined in paragraph 68 of Statement 3, unless it has been invested in a securities lending collateral investment pool or another type of investment that is not classified, as provided in paragraph 69 of that Statement. b. Underlying securities should not be classified by category of custodial credit risk if the collateral for those loans is reported in the balance sheet. c. Underlying securities should be classified by category of custodial credit risk if the collateral for those loans is not reported in the balance sheet. The categories in which 10 The amount the borrower owes the lender includes the market value of the underlying securities (including accrued interest), unpaid income distributions on the underlying securities, and accrued loan premiums or fees. 11 The amount the lender owes the borrower includes the cash collateral received, the market value of collateral securities (including accrued interest), the face value of letters of credit, unpaid income distributions on collateral securities, and accrued borrower rebates. 12 Disclosure of default losses and recoveries in accordance with this Statement does not constitute a disclosure of realized gains and losses that under paragraph 29, footnote 10, of Statement 25 would require disclosure of all realized gains and losses for the year. 13 Cash collateral in deposit accounts with financial institutions is subject to the provisions of paragraph 67 of Statement 3. 6

14 the underlying securities are classified should be based on the type of collateral and the custodial arrangements for the collateral securities. EFFECTIVE DATE AND TRANSITION 17. The provisions of this Statement are effective for financial statements for periods beginning after December 15, Earlier application is encouraged. Accounting changes adopted to conform to the provisions of this Statement should be applied retroactively, if practical, by restating financial statements for all prior periods presented. If restatement of financial statements for prior periods presented is not practical, the cumulative effect of applying this Statement, if any, should be reported as a restatement of beginning fund balance or retained earnings, as appropriate, for the earliest period restated. In the period this Statement is first applied, the financial statements should disclose the nature of any restatement and its effect. Also, the reason for not restating prior periods presented should be explained. The provisions of this Statement need not be applied to immaterial items. This Statement was adopted by unanimous vote of the five members of the Governmental Accounting Standards Board: James F. Antonio, Chairman Tom L. Allen Robert J. Freeman Barbara A. Henderson Edward M. Klasny 7

15 GLOSSARY 18. This paragraph contains definitions of certain terms as they are used in this Statement; the terms may have different meanings in other contexts. Agent fees Amounts paid by a lender to its securities lending agent as compensation for managing its securities lending transactions. Borrower A broker-dealer or other entity that transfers collateral to a governmental entity in a securities lending transaction. Borrower rebate Payments from the lender to the borrower as compensation for the use of the cash collateral provided by the borrower. Collateral The cash, securities, or letters of credit received by the lender from the borrower as protection against the borrower s failure to return the underlying securities. Collateral investment pool An agent-managed pool that for investment purposes commingles the cash collateral provided on the securities lending transactions of more than one lender. Credit risk The aggregate of the lender s exposures to the borrowers of its securities. Income distributions Interest, dividends, stock splits, and other distributions made by an issuer of securities. Income distributions on underlying securities are payable from the borrower to the 8

16 lender, and income distributions on collateral securities are payable from the lender to the borrower. Indemnification A securities lending agent s guarantee that it will protect the lender from certain losses. Lender A governmental entity that transfers its securities to a broker-dealer or other entity in a securities lending transaction. Loan premium or fee Payments from the borrower to the lender as compensation for the use of the underlying securities when the borrower provides securities or letters of credit as collateral. Securities lending agent An entity that arranges the terms and conditions of loans, monitors the market values of the securities lent and the collateral received, and often directs the investment of cash collateral. Securities lending transactions Transactions in which governmental entities transfer their securities to broker-dealers and other entities for collateral which may be cash, securities, or letters of credit and simultaneously agree to return the collateral for the same securities in the future. Underlying securities The securities lent by the lender to the borrower. 9

17 Appendix A BACKGROUND INFORMATION 19. Initial issues about securities lending transactions resulted from technical inquiries concerning how to account for and disclose securities lending transactions and whether Statement 3 applies to those transactions. Although the staff considered those issues when developing the Statement 3 Implementation Guide (referred to as a Q&A), the GASB added an agenda project on securities lending transactions because the scope of the issues was beyond what could be addressed in a Q&A. 20. As research for this project, the Board reviewed securities lending accounting and disclosure practices and examples of the securities lending contracts used by state and local governmental entities. It also compared securities lending transactions to reverse repurchase agreement transactions. A task force of eleven persons representing government, public accounting, financial statement users, and the securities lending industry assisted the Board with this project. 21. In December 1994, the Board issued an Exposure Draft (ED) of a proposed Statement, Accounting and Financial Reporting for Securities Lending Transactions. The Board received fifty-nine comment letters on the ED, a majority of which supported its provisions. Certain changes have been made to this Statement, however, as a result of respondent recommendations. Nature of Securities Lending Transactions 22. Governmental entities that lend securities are usually long-term investors with large investment portfolios such as pension funds, state treasurers, state investment boards, and college and university endowment funds that want to earn additional income. They lend their securities to entities dealing in securities broker-dealers and financial 10

18 institutions that need to borrow them to cover a short position (that is, they sold a security without owning it) or to avoid a failure to receive a security they purchased for delivery to a buyer. 23. Governmental entities usually lend their securities through lending agents entities that arrange the terms and conditions of the loans, monitor the market values of the securities lent and the collateral received (daily marking-to-market ), and often direct the investment of cash received as collateral. An agent may be the financial institution that handles the custody of the lender s portfolio or it may be a financial institution or an independent lending agent that manages the lending from a portfolio in the custody of another entity. 24. Governmental entities sometimes lend their securities directly to a borrower without using a lending agent. In this case, the lender and the borrower may arrange for a thirdparty financial institution to settle the transfers of the underlying securities and collateral, provide custody services for the collateral, and mark-to-market. 25. The types of securities that governments lend include U.S. government and agency securities, domestic and foreign corporate equity and fixed-income securities, and foreign government fixed-income securities. Governmental lenders usually receive cash as collateral, although many also accept certain securities as collateral usually U.S. government and agency securities and some also accept irrevocable letters of credit from approved banks. The governmental lender normally receives collateral equal to 102 percent of the market value of the securities lent (including or plus accrued interest) for loans of domestic securities and 105 percent for loans of foreign securities. (This excess value is referred to as a margin. ) The collateral and the securities lent are marked-tomarket daily, and the value received and given is adjusted as needed. If the collateral is cash, its value in this evaluation remains the amount of cash given, not the value of any 11

19 subsequent investment of the cash. Often, the margin required for additional collateral during the loan differs from the original margin. For example, additional collateral may be required only if the collateral value falls to less than 100 percent of the value of the underlying securities. 26. Securities lending contracts provide that the transaction is a loan of securities, and some even specifically state that the transaction should not be construed to be a sale of securities. Nevertheless, most contracts provide that the lender gives up the right to vote stock while it is on loan and that the borrowers have all incidents of ownership over the securities lent, including the right to transfer or pledge them. However, the lender retains beneficial ownership of the securities lent. The lender is able to recall the securities to sell them and has the contractual right to receive identical securities at the end of the loan. Some lenders also recall stock to vote it. The borrower also compensates the lender for any income distributions (interest, dividends, and so forth) made by the issuer of the underlying securities during the loan. Similarly, the lender compensates the borrower for any income distributions on collateral securities. 27. If the borrower provides cash collateral, the lender is compensated for making the loan by the earnings on investing the collateral, and the borrower is compensated with a rebate an interest rate paid by the lender on the cash collateral given. If the lender s investment of the collateral fails to provide enough income to pay the rebate, the lender has to provide the difference from its own resources. If the borrower instead provides securities or letters of credit as collateral for the securities lent, it receives no rebate from the lender but pays the lender a loan premium or fee either at the termination of the loan or monthly. In agent-managed programs, the borrower compensates the agent by splitting the net earnings with it in a preestablished ratio, such as 60:40 or 70:30. Some agents also receive a separate management fee for investing cash collateral. 12

20 28. The lender generally bears the risk of any loss of principal from investing cash collateral. In an agent-managed program, collateral can be invested in a separate account for the lender or as part of a pool that for investment purposes commingles the cash collateral provided on the securities lending transactions of more than one lender. Cash collateral usually is invested in fixed-income securities that are expected to carry little credit risk, such as U.S. government and agency securities, commercial paper, bankers acceptances, certificates of deposit, time deposits, and repurchase agreements traditional money market instruments. The term to maturity of these investments is usually kept short to reduce interest rate risk that is, the exposure to an unfavorable change in interest rates. 29. A lender s position in a collateral investment pool usually is calculated on an amortized-cost basis (rather than on a market-value basis), the same as with a money market mutual fund registered with the Securities and Exchange Commission (SEC). 14 These pools generally mismatch the maturities of the securities loans and the collateral investments to take advantage of the normal yield curve. (Investments of a longer term yield more than shorter-term investments.) The separate investment accounts of some lending agents also may mismatch maturities but some provide matched maturities between the loan and the investment. Matching maturities seeks net earnings for the lender 14 The SEC permits money market mutual funds to be accounted for on an amortized-cost basis provided that certain requirements are met, including requirements relating to the types and maturities of investments that the fund can hold. (See 17 Code of Federal Regulations [CFR] 270.2a-7.) For example, the fund may not own securities with a term to maturity of over 397 days or a dollar-weighted average maturity of over 90 days. These requirements help to ensure that the value of the fund does not differ significantly from market value. If, however, the value of the fund deviates from its market value by more than 0.5 percent, the fund s board of directors is required to take appropriate actions to eliminate or reduce material dilution or other unfair results to investors or existing shareholders to the extent reasonably practicable. Regulation 9 of the Office of the Comptroller of the Currency (12 CFR 9.18) also restricts the types and maturities of investments that can be held by national bank collective investment funds that are accounted for at amortized cost, although it does not provide for action if the value deviates from market value. Some securities lending collateral investment pools are not subject to Regulation 9 and, thus, are unregulated as to investment types and maturities. Therefore, although accounted for on an amortized-cost basis, these pools may include investments that would not meet regulatory requirements for share pricing on an amortized-cost basis. The basis of these pools may differ significantly from market value. 13

21 through methods other than by using the yield curve for example, by lending securities of higher credit quality than the collateral investments 15 or by lending securities that are in high demand When loan maturities and collateral investment maturities are mismatched, the lender (or the agent) is forced to maintain a level amount of loans outstanding. Rebate rates paid to borrowers generally change according to changes in short-term interest rates. Therefore, during periods of rising rates, the rebate rates generally will rise faster than the investment yield. As a result, earnings will be reduced and for short periods of time the spreads may even be negative, resulting in losses instead of earnings. If the lender would choose not to make new loans or not to renegotiate existing loans at the negative spreads, it would be forced to liquidate collateral investments to raise the cash needed to return to the borrower. Generally, a significant portion of the collateral portfolio is invested in overnight securities. However, if the lender is forced to liquidate longer-term securities before their maturity dates, a principal loss could be incurred. 31. In certain situations, a borrower provides cash collateral but the lender does not have the right to invest that cash. When a borrower delivers cash that the lender does not have the right to invest, the lender does not derive income from investing the cash collateral or pay the borrower a rebate. Instead, the borrower pays the lender a loan premium or fee. Specifically, a borrower delivers cash that the lender might not have the right to invest when the borrower is allowed to replace securities collateral with cash collateral during the business day. This ability to replace securities with cash gives the borrower the 15 For example, the underlying securities would be those of the U.S. government and the cash collateral would be invested in highly rated commercial paper. 16 Lending securities that are in high demand causes the lender to pay the borrower a lower rebate rate or receive from it a higher loan premium. 14

22 flexibility to trade those securities during the day and to finance its securities positions overnight. 32. Many securities lending agents provide indemnification to the lender for certain risks, such as the risk that the borrower will not return the underlying securities or will not pay income distributions on them. If an act of default takes place and the borrower does not return the underlying securities, the agent will use the collateral to replace them or their value as of the date the loan was to have terminated. If the collateral is deficient, the indemnification agent has to use its own resources to make up the difference and then subrogates to the lender s right in the underlying securities. Any excess collateral would be returned to the borrower, net of costs incurred by the lender or the agent in remedying the default. Acts of borrower default generally include failure to return underlying securities, pay income distributions, or make margin calls; acts of insolvency; and suspension by the SEC, an exchange, or a self-regulatory association. 33. Securities lending agents generally provide governmental lenders with information about the loans that are made either or both daily transaction advices and periodic reports. The agents also do or can provide lenders with information about how cash collateral is invested. 15

23 Appendix B BASIS FOR CONCLUSIONS Introduction 34. This appendix discusses factors considered significant by Board members in reaching the conclusions in this Statement. It includes discussion of the alternatives considered and the Board s reasons for accepting some and rejecting others. Individual Board members gave greater weight to some factors than to others. Accounting for Securities Lending 35. The Board has observed no substantive economic difference between a government s selling securities under reverse repurchase agreements (described in Statement 3) and its lending them under securities lending agreements for cash collateral. There are some differences in legal form and federal tax treatment between reverse repurchase agreement and securities lending transactions, 17 and some believe there are differences in the motivations for entering into one transaction versus the other, 18 but the two transactions are treated in a similar manner under the bankruptcy law and, ultimately, both have the same effect on the government. 17 As to legal form, reverse repurchase agreement contracts provide for the sale of securities, and securities lending contracts provide for their loan. As to federal tax treatment for taxable entities, income distributions to the seller under reverse repurchase agreements retain their original form, which may result in preferential tax treatment (for example, as tax-exempt interest income), whereas income distributions to the lender under securities loans are taxed as ordinary income. 18 Some view reverse repurchase agreements as a borrowing of cash (collateralized by securities) and securities lending as a lending of securities (collateralized by cash or other forms of value). Therefore, a government s motivation for entering into a reverse repurchase agreement transaction would be to borrow cash and its motivation for entering into a securities lending transaction would be to earn incremental income for lending securities. However, some governmental entities use the two transactions for the same purpose to earn additional income on their portfolios. 16

24 Balance Sheet Reporting 36. The Board believes that, like securities sold under reverse repurchase agreements, securities lent should remain in the government s balance sheet. Although the borrower receives all incidents of ownership, the government has beneficial ownership it retains the risks and rewards of changes in the value of the underlying securities during the term of the loan, has a contractual right to the income distributions, and retains the right to sell the securities. No respondents to the ED disagree with retaining the underlying securities in the government s balance sheet. 37. The Board also believes that securities lending transactions with cash collateral should be accounted for in the balance sheet as financing transactions reporting assets for the cash received (and subsequently invested) and liabilities to the borrowers to return the cash. In virtually all cases, the government has the risk of investing cash collateral received from a loan. 19 If the investment fails to obtain or retain enough value to repay the borrower its collateral and the borrower rebate, the government provides the necessary amount from its own resources. The government also has the reward of the revenue or income from the investments even though some of that amount is paid to the borrower for providing the cash and to the agent for managing the loan and investing the collateral. Risk and reward generally are characteristics associated with assets reported in a government s balance sheet. The Board believes that not reporting these investments as assets has the potential for misleading financial statement users about the full risk a 19 In some cases, the securities lending agent retains the risk of loss in investing cash collateral. That is, if the value of the collateral investment is insufficient to pay the borrower both its original cash amount and the borrower rebate, the agent makes up the difference. The Board believes that in such situations, the governmental lender still should report the collateral investments as assets. Although the government has no risk on the investment, it does have the reward. Also, the Board does not believe the agent would consider that investment as its own asset; rather, it would view the contractual obligation to assume the risk as an indemnification provision. In this situation, the governmental lender should disclose the agent s indemnification against the loss in the value of the collateral investments as required by paragraph 12 of this Statement. 17

25 government faces with these transactions. Reporting liabilities to return the collateral is necessary when the collateral is reported as assets. 38. When collateral is received in the form of securities, a government should report the securities lending transactions in the balance sheet if it has the potential for risk or reward from the securities. This would be the case if the government, without a borrower default, has the ability to obtain or control the economic benefits represented by the securities by pledging or selling them before returning them to the borrower. Reporting collateral securities as assets is not a matter of whether the government avails itself of the risks and rewards, but whether it has the ability to do so. Therefore, if the securities lending contract allows the government to pledge or sell the collateral securities without a borrower default, or if there is some other indication of such ability, those securities and a liability for the obligation to return them should be reported in the government s balance sheet. 39. Securities lending collateral is not reported in the balance sheet if the governmental lender does not have risk or reward associated with changes in its value. Such collateral includes letters of credit, which have no economic benefit or value to the governmental lender unless the borrower defaults. It also includes collateral securities that the government does not have the ability to pledge or sell unless the borrower defaults. Not reporting this collateral in the balance sheet is consistent with a government s not reporting assets for collateral on deposits with financial institutions. With deposit collateral, the government cannot pledge or sell the collateral securities unless the pledging financial institution defaults. Certain transitory cash collateral, as discussed in paragraph 31, also is not reported in the balance sheet because the lender does not have the right to invest the cash and therefore does not have the risk or reward associated with changes in its value. 18

26 40. A majority of the respondents to the ED agree with this balance sheet reporting. They believe this reporting will more fully disclose the transactions to financial statement users, will provide consistent and comparable reporting, and will fairly present the economic substance of the transactions. They agree that there is no substantive economic difference between lending securities for cash collateral and reverse repurchase agreements. 41. Some ED respondents disagree with reporting any securities lending collateral in the balance sheet because they believe it inflates the balance sheet and provides an inaccurate perception of the true assets of the governmental entity. They believe the balance sheet should report only those investments that are owned and managed by the government. Other respondents disagree with reporting securities lending collateral in the balance sheet if the lending is managed by an agent and the lender has no direct control over the collateral. The Board believes that investments made with cash collateral (and collateral securities that the government has the ability to pledge or sell) are assets of the government in that they affect the government s risk of loss and opportunity for gain. Even though governments usually will restrict the use of these collateral-derived investments to securities lending transactions, these investments are as much a part of a government s investment portfolio as any other investment the government has purchased. These facts do not change because a lending agent has custody of the assets. 42. Some ED respondents also believe that accounting for securities lending transactions differently depending on the type of collateral received is inconsistent and will confuse financial statement users, especially when one entity receives both types of collateral. This supports their position that securities lending collateral (and obligations to return the collateral) never should be reported in the balance sheet. The Board and many other respondents disagree, believing that there are substantially different economic effects on the governmental lender depending on the type of collateral it accepts. In accepting cash 19

27 collateral, the government is faced with risks and opportunities it does not face if it accepts collateral that it cannot access unless the borrower defaults. Accounting differently for transactions with different economic effects is not inconsistent; rather, it is representationally faithful providing a correspondence between the accounting numbers and the resources or events those numbers purport to represent. Operating Statement Reporting 43. Paragraph 82 of Statement 3 requires the interest cost of reverse repurchase agreements to be reported as expenditures or expenses and not netted with the income earned on any related investments. This Statement requires the same reporting for borrower rebates, agent fees, and other costs of securities lending transactions. The Board believes that when a governmental lender receives cash collateral, the investing of that cash is a transaction separate from the lending of the underlying securities. Therefore, the Board believes that the income a government earns from investing the cash should be reported separately from the costs it pays the borrower for the use of the cash or the agent for managing the securities loans. Accounting does not offset the costs of financing an investment with the revenue or income earned on the investment. Some ED respondents disagree with this reporting because they believe the only benefit from the transaction is the income net of borrower rebates and agent fees, or they are concerned about distorting or overstating investment costs. However, a majority of respondents agree with separately reporting the income and costs for the reasons stated above. They also believe separate reporting is consistent with reporting the assets and liabilities in the balance sheet. Investment Pools 44. Paragraph 9 of this Statement provides that securities lending transactions that meet the criteria for reporting in the balance sheet and that are conducted in investment pools should be reported in the balance sheets of the funds that have the risk of loss on the 20

28 collateral assets. In many cases, this will involve a pro rata allocation to the various funds based on their equity in the pool. (If ratable allocation would be immaterial in some funds, the assets and liabilities arising from the transactions could be allocated only to those funds with material equity in the investment pool.) If the securities lending assets and liabilities were not reported in the funds, they would not appear on the financial statements, because an internal investment pool generally is not reported as a separate fund in the financial statements. This guidance generally is consistent with the guidance in question 119 of the Statement 3 Q&A for reverse repurchase agreement transactions. Similarly, paragraph 10 requires the income and costs arising from lending pooled securities to be reported in the operating statements of the funds. 45. The ED had proposed to require that securities lending assets and liabilities be ratably allocated among the funds with equity in the pool. However, some ED respondents indicated that the net income from securities lending is credited to certain funds based on the provisions of law rather than shared among the funds and entities that participate in the pool based on their equity positions. Therefore, the requirements of this Statement were adjusted to address these situations as well as other potential situations in which the net income from securities lending is shared on a disproportionate basis because of management discretion rather than legal provisions. The Board is aware that in applying this requirement, governments will have to determine which funds have the risk of loss on the collateral assets. However, the Board believes this determination is necessary to appropriately report the financial position of the funds. 46. One respondent questioned whether this Statement requires participating entities that are legally separate from a government that sponsors an investment pool with securities lending transactions to report their share of securities lending assets, liabilities, income, and costs. The respondent questioned how those entities could obtain the information needed for such reporting. The paragraph 9 and 10 provisions for reporting securities 21

29 lending in investment pools apply to the financial statements of the governmental reporting entity sponsoring the pool; this Statement s requirements do not extend to legally separate entities participating in the pool. Financial Statement Classification 47. Some ED respondents questioned whether securities lending assets, liabilities, income, and costs could or should be presented in separate financial statement classifications. This Statement does not prohibit such separate classification, nor does it require it. The Board believes that separate classification should be guided by the similarity of the accounts to other accounts, materiality, and professional judgment. Disclosures of Securities Lending Transactions 48. The disclosures required by this Statement are designed to provide financial statement users with useful information about securities lending transactions and to provide consistency with disclosures required by Statement 3. These disclosures are required if a governmental entity has securities lending transactions during the reporting period, even if it has no securities on loan at the end of the period. 49. To help financial statement users understand the government s securities lending transactions, this Statement requires the disclosure of basic information about the securities lent and the collateral received. To provide the users with information about the risks a government faces in securities lending transactions, the Statement also requires disclosures about loss indemnifications to be provided by securities lending agents, information about whether the maturities of the investments made with cash collateral match the maturities of the securities loans, and a measure of any credit risk exposure to the borrowers. The Board is aware that many governmental entities will not have credit risk exposure on securities lending transactions because the borrowers generally provide more in collateral than they receive in underlying securities. In that case, the Statement 22

30 requires only disclosure of that fact without a measure of the net amount the lender owes the borrowers. 50. To provide consistency with disclosures required by paragraphs 76, 77, and 80 of Statement 3 for reverse repurchase agreements, this Statement requires disclosure of the sources of legal or contractual authorization for the use of securities lending transactions, significant violations of those provisions during the period, and, if not separately displayed in the operating statement, losses during the period resulting from the default of a borrower or lending agent and recoveries of prior-period losses. 51. A large majority of ED respondents agree that disclosures should be made about securities lending transactions, and most agree with the disclosures proposed in the ED. This Statement replaces two disclosures proposed in the ED the types of investments made with cash collateral and the nature of transactions undertaken with any collateral securities the entity has the ability to pledge or sell with a requirement to disclose whether the maturities of the investments made with cash collateral generally match the maturities of the securities loans. After further considering other disclosure requirements for investment transactions as well as the risks involved in securities lending transactions, the Board agreed that information about maturity matching, which was suggested by some respondents, would require little additional effort and would be highly useful to financial statement users. This disclosure is not required by Statement 3 for reverse repurchase agreements, but the Board is considering adopting a project to resolve this inconsistency between the disclosure requirements for securities lending and those for reverse repurchase agreement transactions. 52. This Statement does not require the disclosure of maturity matching to include a precise calculation of the extent to which matching exists, but only a general indication. For example, if a governmental lender has a policy to match maturities and such a match 23