GASB 53, Accounting and Financial Reporting for Derivative Instruments. Xihao Hu AERS Partner Deloitte & Touche, LLP May 3, 2010

Transcription

1 GASB 53, Accounting and Financial Reporting for Derivative Instruments Xihao Hu AERS Partner Deloitte & Touche, LLP May 3, 2010

2 This presentation contains general information only and Deloitte is not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This presentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte, its affiliates and related entities shall not be responsible for any loss sustained by any person who relies on this presentation. As used in this document, Deloitte means Deloitte & Touche LLP, a subsidiary of Deloitte LLP. Please see for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. 1

3 Table of Contents Hedge Accounting Termination of Hedge Accounting Notes to Financial Statements Case Study 1 Interest Rate Swap Wrap up Case Study 2 Case Study 2 FX Hedging Wrap up Case Study 3 Implementation Considerations Q&A s 2

4 Introduction Xihao Hu Partner Xihao has 13 years of experience serving financial services companies. He has extensive experience in the application of U.S. GAAP and IFRS to complex transactions involving financial instruments and consolidation. Xihao currently serves as Deloitte s Southeast regional leader for the Financial Instruments and Valuation Subject Matter Resource ( SMR ) program and was also the Deputy Leader for the Banking Industry within former Regulatory & Capital Markets Consulting Group. Xihao currently leads the Accounting Policy team on an audit engagement over one of the largest US financial institutions. Prior to joining the Valuation & Analytics Services group, Xihao Hu served as a manager in the Accounting Consultation group of Deloitte s National Office (including Deloitte s US IFRS Centre of Excellence), responsible for consultations with engagement teams, assisting in preparing the firm s comment letters, and drafting Q&As for the firm s accounting manual in the areas of financial instruments and consolidation. 3

5 Hedge Accounting

6 Hedging Derivative Instrument Hedging is a method employed to reduce identified financial risks by offsetting changes in cash flows/fair values of associated items A hedging derivative exists if both the following are met: 1) The derivative instrument is associated with a hedgeable item (defined on next slide): Notional of derivative instrument is consistent with principal or quantity of hedgeable item Derivative instrument is reported in the same fund, if applicable, as hedgeable item Term of instrument is consistent with time period of hedgeable item 2) The hedging derivative instrument is effective in significantly reducing the identified financial risk Effectiveness is established if changes in cash flows or fair values of the hedge substantially offsets the changes in cash flows or fair value of hedgeable item Evaluation of effectiveness is discussed later In-the money written option is considered as a potential hedging derivative instrument if certain conditions are met (IG Q&A 41) A derivative instrument with a notional greater than the underlying hedged item can be employed as a hedging derivative instrument if it passes one of the effectiveness methods under GASB 53. Note that the entire notional of the derivative and the hedged item should be considered (IG Q&A 42) Basis swaps cannot be considered as a potential hedging derivative instrument (IG Q&A 43) 5

7 Hedgeable Items Hedgeable items expose an entity to risk in the form of adverse changes in cash flows or fair value. They can be all or a specific portion of: A single asset / liability (e.g. an entire bond issue or specific portion of bond issue) o Hedging only interest rate risk rather than the overall cash flows of a bond is permitted, if the effect of interest rates is readily determinable o A fair value and cash flow hedging relationship may be established when the hedgeable item and the potential hedging derivative instrument have different risk exposure limits, provided that both of these relationships meet the effectiveness criteria under GASB 53 (IG Q&A 59 and 60) Group of similar assets or liabilities; assets / liabilities grouped together as a hedgeable item are required to be exposed to same identifiable risk being hedged An expected (i.e. forecasted) transaction o Hedge accounting for commodity components is available, but that analysis should focus on the hedgeable item as a whole (i.e. the commodity component should qualify as a hedgeable item on a stand alone basis). o For e.g. an entity that purchases gasoline cannot hedge the ethanol component of the risk associated with changes in price of gasoline; natural gas used in the manufacture of steel can be a hedgeable item Note: Assets and liabilities already measured at fair value do NOT qualify as hedgeable items 6

8 Hedgeable Items (cont.) Hedged expected transaction should be probable of occurring and supported by observable facts such as Frequency, volume and amount of past transactions Financial, operational and legal ability of the entity to carry out the transaction Extent of loss or disruption to an entity s activities that could result if transaction does not occur Entity s budget or other planning documents If there is uncertainty around the timing of the forecasted transaction, the best estimate should be used (IG Q&A 45) Hedges of intracompany transactions A transaction or expected transaction between a primary government and discretely presented component unit can be a hedgeable item A transaction wholly within a primary government cannot be a hedgeable item (e.g., transaction to sell electricity by enterprise fund to the general fund ) 7

9 Evaluating Effectiveness Potential hedging derivative instruments should be evaluated for effectiveness as of the end of each reporting period for which financial statements are prepared in conformity with GAAP (IG Q&A 49) Effectiveness need only be evaluated at the end of each reporting period Evaluation of effectiveness in first reporting period: Evaluate the potential hedging derivative instrument using consistent critical terms method (discussed later) If deemed ineffective using consistent terms method, at least one quantitative method (discussed later) should be applied to determine if it is an effective hedge If deemed ineffective using one of the quantitative methods, the entity may (not required) apply other methods to evaluate effectiveness If potential hedging instrument deemed ineffective, evaluation of effectiveness in subsequent periods is not required Evaluation of effectiveness in subsequent reporting periods All potential derivative instruments determined to be hedging derivative instruments (based on an effective conclusion from assessment in first reporting period) should be reevaluated as of the end of each subsequent reporting period If the hedging derivative instrument is deemed ineffective in the subsequent period using the method previously used; government may (not required) apply other methods before concluding the hedging instrument to be no longer effective (IG Q&A 52) 8

10 Evaluating Effectiveness (cont.) Options - the potential hedge may be an option, which has a purpose of only providing one sided protection Effectiveness of options should be assessed consistent with the objective of the derivative instrument. For example, if the hedge s purpose is to limit the entity s fuel cost to no more than $3/gal, effectiveness should be evaluated in terms of whether the entity s costs are capped at $3.00/gal Evaluation of effectiveness of all potential hedges should be evaluated by considering overall changes in fair value or cash flows of the potential hedging derivative instrument However, separation of the total value into time value or interest is permissible for some potential hedges that meet either of the below criteria: The potential hedge is an option and effectiveness is evaluated by consideration of only change in either Option s intrinsic value excluding option s change in time value Option s minimum value excluding options change in volatility value; option s minimum value is its intrinsic value adjusted for effect of discounting. The potential hedge is a forward contract effectiveness is evaluated by consideration of only change in spot prices 9

11 Evaluating Effectiveness (cont.) When hedging interest rate risk, the evaluation of effectiveness should be based on benchmark interest rate SIFMA swap index and AAA general obligations index are appropriate benchmark interest rates for tax exempt debt Interest rate on direct treasury obligation of US government and LIBOR are appropriate benchmark interest rates for taxable debt If LIBOR or percentage of LIBOR is employed as a hedge of tax exempt debt, hedge effectiveness should be evaluated using quantitative methods (discussed later) Different methods to evaluate effectiveness can be employed for different hedging derivative instruments (IG Q&A 51) A change in the method of evaluating effectiveness is not a change in accounting principle (IG Q&A 53) A government should assess the possibility of counterparty default taking into consideration the impact of any related collateralization or financial guarantees. If the likelihood that the counterparty will not default ceases to be probable, the government should no longer conclude that the derivative instrument is effective (IG Q&A 54) If a government changes the mode of variable coupon payment from an auction rate to a rate based on short-term index without any changes to the hedging interest rate swap, then the evaluation of effectiveness should incorporate the modified terms of the bond. It may also be necessary to apply a different method of evaluating effectiveness i.e. for e.g. from consistent critical terms method to synthetic instrument method (IG Q&A 55) The evaluation of effectiveness of a hedging instrument should be based on all terms of the complete interest rate swap including any termination option (IG Q&A 56) 10

12 Evaluating Effectiveness (cont.) Effectiveness can be evaluated using one of the following methods: Consistent critical terms method If the consistent critical terms method does not apply, three specific quantitative methods exist to evaluate effectiveness: Synthetic instrument method Dollar-offset method Regression analysis method Other quantitative method If a derivative instrument is not effective under the chosen method, further analyses under the remaining methods is not required prior to concluding the derivative instrument is not an effective hedging instrument. (IG Q&A 52) 11

13 Consistent Critical Terms Consistent critical terms method Interest Rate Swap example Interest Rate Swaps Cash flow hedge Interest Rate Swaps Fair value hedge Notional amount of the interest rate swap should be same as that of hedged item Interest rate swap should have a fair value of zero upon association with hedgeable item Fixed rate and floating rate index are the same throughout the term of interest rate swap for computing net settlements The variable rate of the swap matches the variable rate on the hedgeable item (including credit spread if any) There should be no caps and floors in the swap unless there are any in the hedgeable item The interest receipt/payments occur during the term of the hedgeable item The designated maturities of variable rate should be the same as the hedgeable item; Stub periods (i.e. time interval between the entry and exit from a LIBOR based swap and the reset or payment date do not prohibit the swap from being evaluated under the consistent critical terms method The rate reset dates of the interest rate swap are within 6 days of the rate reset dates of the hedgeable item -The hedgeable item is not prepayable; if the hedgeable item has a call option, the interest rate swap should have a mirror image call option - Repayment at fixed amount is considered prepayable - Repayment at the then FV is not considered prepayable The expiration date of swap is on or about the maturity date of the hedgeable item such that there is no exposure to interest rate or market risk The reference rate of the swap resets every 90 days so that the variable payment/receipt is considered to be at market rate The periodic interest rate swap payments are within 15 days of the periodic payments of the hedgeable item 12

14 Evaluating Effectiveness Consistent Critical Terms (Commodity Swaps) Commodity Swaps Refer below for requirements for application of consistent critical terms method for commodity swaps Commodity Swaps Cash flow hedge Commodity Swaps Fair value hedge Commodity swap is for the same quantity as the hedgeable item at the same time and location Commodity swap should have a fair value of zero upon association with hedgeable item Reference rate of the commodity swap and the hedgeable item are the same i.e. if purchases are made with reference to Henry Hub, the swap should also have the same reference. The hedgeable item is not prepayable i.e. neither party can settle before the scheduled maturity; if the hedgeable item has a call option, the commodity swap should have a mirror image call option The commodity swap does not have a cap and floor, unless the hedgeable item has a cap and floor The expiration date of swap is on or about the maturity date of the hedgeable item such that there is no exposure to interest rate or market risk The reference rate does not have a cap or a floor The reference rate of the swap resets every 90 days so that the variable payment/receipt is considered to be at market rate 13

15 Consistent Critical Terms - Example The above is an example of an interest rate cash flow swap that qualifies as a hedge under the consistent critical terms match method of effectiveness Notional, reference rates, time interval of reference rate, and frequency of rate resets all agree The rate reset dates occur within six days of each other (swap every week on Wednesday, bond every week on Thursday) The payment dates are within 15 days of each other (swap on the 11 th, bond on 18 th ) 14

16 Synthetic Instrument Method Evaluate effectiveness by combining hedgeable item and potential hedging derivative instrument to simulate a third synthetic instrument Only applicable to cash flow hedge strategies and only if the risk of changes in total cash flows is the identified risk being hedged (IG Q&A 70) This method may be applied if the following criteria are met: Commodity and interest rate hedges: 1. Notional of the hedge is the same as that of hedged item throughout the life of the relationship A derivative instrument potentially hedging only a % of the government s exposure if certain criteria are met (IG Q&A 84). 2. Potential hedging derivative instrument should have a fair value of zero or the forward price is at-the-market, upon association with hedgeable item In addition, for interest rate hedges: 3. Fixed rate and floating rate index of the hedge instrument is the same throughout the term, including constant adjustments, if any, to produce consistent net settlement calculations of the hedge 4. The interest receipt/payments of the hedge occur during the term of the hedgeable item and no payments/receipts on the hedge occur after the term of the hedgeable item 15

17 Synthetic Instrument Method (cont.) The potential hedging derivative instrument is effective if the actual synthetic rate/price is substantially fixed Commodity hedge: The synthetic price as of the evaluation date is compared to the synthetic price expected at the establishment of the hedge by calculation of an effectiveness percentage. If the percentage is within a range of 90 to 111 percent, the synthetic price is substantively fixed. Financial instrument hedge: Actual synthetic rate (ASR) represents the aggregate payment experience of the hedgeable item and potential hedging derivative instrument ASR should be within 90 to 111 percent of the fixed rate of the potential hedge to be considered substantially fixed; results should be evaluated as follows If ASR is within the required range for current period; ASR is substantially fixed If ASR is outside the required range for current period, calculate life to date ASR, and if the LTD ASR is within range, then ASR is substantially fixed If ASR is outside the range and a short time period has elapsed since inception, then an entity can include hypothetical payments such that the hedge had been established at an earlier date in calculating the percentage to determine effectiveness 16

18 Synthetic Instrument Method - Example Below is an example of an interest rate swap entered into by City and designated as a cash flow hedge of its variable rate bonds City has entered in to a receive variable, pay fixed swap with counterparty. City will pay the variable rate received from counterparty to the bondholders and pay a fixed rate to the counterparty; thus achieving a fixed rate payment on its bonds. City will calculate a synthetic rate each balance sheet date and compare it to the fixed rate on the swap to evaluate effectiveness of the hedging relationship. As the percentage ratio is always around 93%, it is deemed that the hedge is highly effective 17

19 Dollar Offset Method Evaluate effectiveness by comparing changes in expected cash flows or fair values of the hedge instrument with those of the hedgeable item (IG Q&A 73) Note that there is no requirement to discount expected cash flows (IG Q&A 74 and Q&A 86) Can use changes in the current period or on a life-to-date basis Changes in fair values or cash flows of hedge or hedged item are divided by the other If the above results are within a range of 80 to 125 percent in absolute terms, then the changes substantially offset and the potential hedging instrument is effective. For example: Change in hedge FV = ($120) Change in FV of hedged item = $100 Dollar offset = $120/$100 = 120% or $100/$120 = 83% Both situations represent an effective hedge 18

20 Regression Analysis Method Evaluate effectiveness by considering statistical relationship between cash flows or fair values of the hedge instrument and the hedgeable item The relationship will be deemed effective if the regression shows the following results: R-squared is at least 0.80 F-statistic is at 95 percent confidence level Regression coefficient for the slope is between and The independent variable is cash flows/fair values/rates of the hedge, the dependent variable is cash flow/fair value/rate of the hedged item Regression should be based on sufficient data the period of time the hedge instrument is expected to hedge the identified risk in the future should be considered Other results of regression analysis may need to be considered to determine effectiveness Regression analysis applied by the government prior to issuing a bond and entering into a hedging interest rate swap can be used to evaluate effectiveness if all other criteria as laid out by GASB 53 are met. Also, at the end of each reporting period, new data should be added to the existing data used in the analysis (IG Q&A 76) If an amortizing notional swap is used to hedge amortizing bonds, the government can use regression analysis to evaluate effectiveness based only on the interest rates used to calculate the cash flows instead of the cash flows themselves (IG Q&A 77) Note paragraph 46 and 47, and 60 and 61, of GASB 53 provides the exact method to perform a regression analysis for cash flow and fair value hedges, including creating a hypothetical derivative (consistent with IG Q&A 78 for interest rate swaps and Q&A 88 for commodity swaps) 19

21 Regression Results Results herein are the output when run regression using Excel regression tool X variable = hedge item, Y variable = hedged instrument R2: Should be > 0.8 Slope: Should be -0.8 < x < F-stat: Should be < 5% 20

22 Other Quantitative Methods An entity may use other statistical methods for evaluating effectiveness if the method meets all of the following criteria: 1. 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 2. 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 3. Substantive characteristics of the hedgeable item and the potential hedging derivative instrument that could affect their cash flows or fair values are considered 21

23 Termination of Hedge Accounting

24 Termination of Hedge Accounting Hedge accounting should cease upon the occurrence of the below events: Events triggering termination Hedging derivative no longer effective Expected transaction no longer probable of occurring Hedged Asset/Liability is sold or retired but not reported as a current or advanced refunding resulting in a defeasance of debt Hedging instrument is terminated Current or advanced refunding resulting in the defeasance of the hedged debt is executed Specific Accounting Treatment -Balance in deferral account should be reported on the flow of resources statement within investment revenue classification - If reported separately within invm rev, the removal of the balance in the deferral account should be captioned as as increase (decrease) upon hedge termination -Upon termination, hedge accounting should not be reapplied to that hedging relationship -However, derivative from a terminated hedge can be employed as a hedging instrument in a new hedge -Balance in deferral account should be included in the net carrying amount of old debt for purposes of calculating the difference between that amount and the reacquisition price of the old debt -The effects of the hedge should be included in the calculation of: diff in cash flows required to service the old and het debt, complete the refunding, and economic gains/losses on the transaction Hedged transaction occurs If the expected transaction results in financial instrument : -If government is re-exposed to hedged risk; deferral balance is recognized on the flow or resources statement within investment revenue classification -If government not re-exposed to hedged risk; deferral balance is recognized on the flow of resources statement consistent with the hedged item s recognition/presentation\ Expected transaction results in commodity purchase/sale: -Balance in deferral account is removed and reported as an adjustment to the actual transaction (i.e. adjustment to the cost of commodity purchased) 23

25 Termination of Hedge Accounting Interpretive Guidance Interpretive guidance around the termination of hedge accounting includes the following: A government does not need to test effectiveness at the date the hedging relationship terminates (IG Q&A 36) Derivative instruments that are no longer hedging derivative instruments should be considered investment derivative instruments. Disclosure requirements of GASB 40, Deposit and Investment Risk Disclosures and paragraphs 69d and 76 of GASB 53 should be applied (IG Q&A 37) The fair value increase or decrease on a hedging derivative instrument that is terminated prior to the occurrence of the expected transaction should be reported within the investment revenue classification (IG Q&A 38) The calculation of reacquisition price is not affected by the swap s termination payment. However, when calculating the deferred amount of refunding, the deferred inflow or outflow of resources account related to the interest rate swap should be included in the net carrying amount of bonds/debt (IG Q&A 39) 24

26 Notes to Financial Statements

27 Notes to Financial Statements Information disclosed should be organized by governmental activities, business type activities and fiduciary funds Derivatives activity should be divided into hedging derivative instrument (distinguish between cash flow and fair value hedges) and investment derivative instruments Within each category, the derivatives should be aggregated by instrument type The disclosures for each category should include: Notional amount Change in FV during the reporting period and classification where those changes are reported FV at the end of reporting period and classification in FS where those are reported If FV is based on other than quoted market prices; the methods and significant assumptions used to estimate the FV FV of derivative instruments reclassified from a hedging derivative instrument to an investment derivative instrument as well as the deferral amount that was reported within investment revenue upon reclassification Note that GASB 53 does not require disclosure of the identity of counterparties (IG Q&A 99) 26

28 Notes to Financials - Hedges Disclosures for all hedging activity include: Objectives: the objectives for entering into a contract and the context needed to understand them, strategies to achieve those objectives, and types of derivative instruments entered into Terms: significant terms including notional, reference rates (indexes or interest rates), embedded options, date hedge was executed and will terminate/mature, amount of cash paid/received at inception of the contract Risks: any exposure to risks that could give rise to financial loss, including credit risk, interest rate risk, termination risk, basis risk, rollover risk, market-access risk and foreign currency risk Hedged debt: if the hedged item is a debt obligation, should disclose the hedge s net cash flows based on requirements established by GASB 38 (para. 10 and 11) Other quantitative method of evaluating effectiveness: if method used for evaluation of effectiveness is not specifically identified by this statement, should disclose the identity and characteristics of the method used, range of critical terms tolerated, and the actual critical terms of hedge Appendix C of GASB 53 provides illustrations related to the disclosure requirements 27

29 Notes to Financials Investment Derivatives The following disclosures are required for all investment derivative instruments that are reported as of the end of the reporting period: The following risks that could give rise to financial loss should be disclosed: Credit risk: if the investment derivative is reported as an asset, then credit risk must be disclosed, consistent with the hedging instrument credit risk disclosure requirements Interest rate risk: disclose requirements of GASB 40 par 14 and 15, as well as FV, notional, reference rate and embedded options of any investment interest rate swap instruments Foreign currency risk: disclose requirements of GASB 40 par 17 To the extent the government s participation in derivative instruments represent investments, the government s policy for entering into those transactions should be included in the investment policy disclosure as required by para 65 of GASB 3, para 6 of GASB 40 and para 76 of GASB 53 (IG Q&A 106) 28

30 Notes to Financials (other items) For derivative instruments with contingent features held as of the end of reporting period, disclosure should include: Existence, nature and trigger of the feature Aggregate FV of derivative instruments with such features Aggregate FV of assets to be posted as collateral or transferred in accordance with triggering of contingent liabilities Amount posted by government as collateral as of the end of the reporting period Hybrid Instruments disclosures of the companion instrument should be consistent with disclosures required of similar transactions The existence of an embedded derivative should be mentioned in the disclosure of the companion instrument Synthetic Guaranteed Investment Contracts For fully benefit-responsive SGIC, government s should disclose the following: Description and nature of the SGIC The SGICs fair value (including separate disclosure of the FV of the wrap contract and the FV of the corresponding underlying investments) 29

31 Notes to Financials Example These provide a high level example of disclosure examples of hedging derivative instruments The figure above on the left provides an overview of type, objective, critical terms and the fair value of the hedging instrument at reporting date. The figure on the right provides assessment of credit rating of counterparties 30

32 Notes to Financials Example (cont.) Table below provides an overview of classification of change in fair value and the fair values at the balance sheet date. 31

33 Case Study 1 Interest Rate Swap

34 Case Study #1: Interest Rate Swap Overview On July 1, 2010, a city issues variable-rate demand bonds of $100 million. The bonds mature on June 30, The coupon is remarketed weekly. At the same time, the city enters into a $100 million notional, pay-fixed, receive-variable interest rate swap. The monthly variable payment is based on a variable rate that resets weekly. The variable rate is 68 percent of the London Interbank Offered Rate (LIBOR). The fixed rate is percent, and the swap terminates on June 30, Upon association with the variable-rate demand bonds (at the inception of the swap), the fair value of the swap is zero. The city currently applies regression analysis to demonstrate compliance with tax laws. 33

35 Case Study #1: Interest Rate Swap Supplemental Data Payments and receipts on the swap and the interest payments on the variable-rate demand bonds are summarized as follows: Fiscal Year Ended Counterparty Swap Payment To From Net Interest Payments to Bondholders Total Payments 6/30/2011 $ (2,841,323) $ 1,069,828 $ (1,771,495) $ (1,357,836) $ (3,129,331) 6/30/2012 $ (2,841,323) $ 775,085 $ (2,066,238) $ (1,079,203) $ (3,145,441) 6/30/2013 $ (2,841,323) $ 1,617,573 $ (1,223,750) $ (1,937,695) $ (3,161,445) 6/30/2014 $ (2,841,323) $ 2,994,241 $ 152,918 $ (3,074,110) $ (2,921,192) Total $ (11,365,292) $ 6,456,727 $ (4,908,565) $ (7,448,844) $(12,357,409) The fair values and changes in fair values of the swap are as follows: As of and for the Fiscal Year Ended 6/30/2011 6/30/2012 6/30/2013 6/30/2014 Fair Value $ (4,627,892) $ (1,646,101) $ (269,849) - Change in Fair Value $ (4,627,892) $ 2,981,791 $ 1,376,252 $ 269,849 The results of the evaluation of effectiveness method using the regression analysis method are as follows: Fiscal Year Ended R-Squared Statistic Regression Coefficient 6/30/ /30/ /30/ /30/

36 Case Study #1: Interest Rate Swap Supplemental Data The following journal entry example is for events related to the swap and hedged bonds as reported in the government-wide financial statements for the fiscal year ended June 30, # Particulars Debit Amount Credit Amount 1 Cash $100,000,000 Bonds Payable $100,000,000 To record the issuance of the variable-rate bonds 2 Interest Expense $1,771,495 Cash $1,771,495 To record the net swap payment 3 Interest Expense $1,357,836 Cash $1,357,836 To record the interest payment to bondholders 4 Deferred outflow of resources $4,627,892 Derivative Instrument interest rate swap $4,627,892 To record the change in fair value of the interest rate swap Financial statement presentation for the fiscal year ended June 30, /30/2011 Statement of Net Assets: Cash $96,870,669 Deferred outflow of resources $4,627,892 Derivative instrument liability $4,627,892 Bonds Payable $100,000,000 Statement of Activities: Interest expense $3,129,331 35

37 Wrap UP Case Study 1

38 Case Study #1: Interest Rate Swap Solutions 1) Prepare the journal entries for the Fiscal Year Ended June 30, # Particulars Debit Amount Credit Amount 1 Interest expense $2,066,238 Cash $2,066,238 To record net swap payment 2 Interest expense $1,079,203 Cash $1,079,203 To record the interest payment to bondholders 3 Derivative instrument - interest rate swap $2,981,791 Deferred outflow of resources $2,981,791 To record the change in fair value of the interest rate swap 2) Prepare the journal entries for the Fiscal Year Ended June 30, # Particulars Debit Amount Credit Amount 1 Interest expense $1,223,750 Cash $1,223,750 To record net swap payment 2 Interest expense $1,937,695 Cash $1,937,695 To record the interest payment to bondholders 3 Derivative instrument - interest rate swap $1,376,252 Deferred outflow of resources $1,376,252 To record the change in fair value of the interest rate swap 37

39 Case Study #1: Interest Rate Swap Solutions 3) Prepare the journal entries for the Fiscal Year Ended June 30, # Particulars Debit Amount Credit Amount 1 Cash $152,918 Interest expense $152,918 To record net swap payment 2 Interest expense $3,074,110 Cash $3,074,110 To record the interest payment to bondholders 3 Derivative instrument - interest rate swap $269,849 Deferred outflow of resources $269,849 To record the change in fair value of the interest rate swap, clearing the deferral account 4 Bonds payable $100,000,000 Cash $100,000,000 To retire the variable-rate bonds 4) Prepare the financial statement presentation for the fiscal years ending June 30, 2012 through June 30, As of and for the Fiscal Year Ended 6/30/2011 6/30/2012 6/30/2013 6/30/2014 Statement of Net Assets: Cash $96,870,669 $93,725,228 $90,563,783 $(12,357,409) Deferred outflow of resources $4,627,892 $1,646,101 $269,849 $0 Derivative instrument liability $4,627,892 $1,646,101 $269,849 $0 Bonds Payable $100,000,000 $100,000,000 $100,000,000 $0 Statement of Activities: Interest expense $3,129,331 $3,145,441 $3,161,445 $2,921,192 38

40 Case Study 2 FX Hedging

41 Case Study #2: Foreign Currency Overview On January 1, 2010 a U.S. municipal government forecasted the purchase of 1 million Euros of inventory on June 30, The U.S. municipality enters into a forward contract on January 1 to sell $980,873 USD and buy 1 million Euro on June 30, 2010 that it designates as a hedge of its forecasted payment of Euro on June 30, Also, the broker requires the municipality to post $8,000 in margin. 40

42 Case Study #2: Foreign Currency Supplemental Data The following table shows the changes in fair value of the forward transaction. 1/1/2010 1/31/2010 2/28/2010 3/31/10 4/30/2010 5/31/2010 6/30/2010 Spot Rates Forward Rates 6 month month month month month month.9398 Change in Fair Value $0 $38,200 $9,000 $11,000 $45,700 ($24,200) ($12,700) Effectiveness Analysis using the Consistent Critical Terms method Foreign Currency Forward Notional: 1 million Euros/$980,873 USD Foreign Currency Exposure Notional: 1 million Euros/$980,873 USD Termination: June 30, 2010 Termination: June 30, 2010 Variable Rate: USD exchange rate Floor or Cap: No Frequency: Last day of each month Swap Payment Date: Date of Maturity Variable Rate: USD exchange rate Floor or Cap: No Frequency: Last day of each month Swap Payment Date: Date of Maturity 41

43 Case Study #2: Foreign Currency Supplemental Data The following journal entries will be made by the municipality to reflect the events related entering the forward transaction and the forward transaction for the months ending January, February, and March # Particulars Debit Amount Credit Amount 1 Due from broker - margin deposit $8,000 Cash $8,000 To record the margin deposit required for the purchase of the futures contracts on January 1, # Particulars Debit Amount Credit Amount 2 Derivative Asset $38,200 Deferred inflow of resources $38,200 To record the aggregate increase in fair value on the forward transaction from inception through January 31, # Particulars Debit Amount Credit Amount 3 Derivative Asset $9,000 Deferred inflow of resources $9,000 To record the aggregate increase in fair value on the forward transaction from January 31, 2010 through February 28, # Particulars Debit Amount Credit Amount 4 Derivative Asset $11,000 Deferred inflow of resources $11,000 To record the aggregate increase in fair value on the forward transaction from February 28, 2010 through March 31, Financial statement presentation for the months ending January, February, and March /31/10 2/28/10 3/31/10 Statement of net assets: Cash ($8,000) ($8,000) ($8,000) Due from broker - margin deposit $8,000 $8,000 $8,000 Deferred inflow of resources $38,200 $47,200 $58,200 Derivative Asset ($38,200) ($47,200) ($58,200) Statement of activities: Other expense $0 $0 $0 42

44 Wrap UP Case Study 2

45 Case Study #2: Foreign Currency Solutions 1) Complete the following journal entries for the municipality to reflect the events related to the forward transaction for the months ending April and May # Particulars Debit Amount Credit Amount 1 Derivative Asset $45,700 Deferred inflow of resources $45,700 To record the aggregate increase in fair value on the forward transaction from March 31, 2010 through April 30, # Particulars Debit Amount Credit Amount 1 Deferred inflow of resources $24,200 Derivative Asset $24,200 To record the aggregate decrease in fair value on the forward transaction from April 30, 2010 through May 31, ) Complete the following journal entries for the municipality to reflect the events related to the forward transaction for the months ending June # Particulars Debit Amount Credit Amount 1 Deferred inflow of resources $12,700 Derivative Asset $12,700 To record the aggregate decrease in fair value on the forward transaction from May 31, 2010 through June 30, Cash $67,000 Derivative Asset $67,000 To record the change in fair value of the derivative asset from inception through June 30, Deferred inflow of resources $67,000 Income Statement $67,000 To record the change in fair value on the forward transaction from inception through June 30, Income Statement $980,873 Cash $980,873 To record the forward amount due in order to execute the forward contract. 5 Cash $8,000 Due from broker margin deposit $8,000 To close out the margin account when the forward transaction has matured 44

46 Case Study #2: Foreign Currency Solutions 3) Prepare the financial statement presentation for the months ending April 30, 2010 through June 30, Statement of net assets: As of and for the Month Ended 1/31/10 2/28/10 3/31/10 4/30/10 5/31/10 6/30/10 Cash ($8,000) ($8,000) ($8,000) ($8,000) ($8,000) ($913,873) Due from broker - margin deposit $8,000 $8,000 $8,000 $8,000 $8,000 $0 Deferred inflow of resources $38,200 $47,200 $58,200 $103,900 $79,700 $0 Derivative Asset ($38,200) ($47,200) ($58,200) ($103,900) ($79,700) $0 Statement of activities: Other expense $0 $0 $0 $0 $0 $913,870 45

47 Implementation Considerations

48 Why It Matters Broad impacts GASB 53 affects numerous and far-reaching areas of acute interest to various entities. This scope is likely not fully appreciated by many entities. Affected areas include, but not limited to, derivatives instruments (accounting and valuation), normal purchase/sale commodity contracts, insurance contracts, certain financial guarantee contracts. Policy implications Cross functional teaming Effects on FS geography Pervasive systems issues The standard introduces accounting concepts (deferral of changes in FV of effective financial instruments, scope exception of certain contracts). Each of these areas require new policy decisions by the entity to be documented as part of Risk Management and Derivative Accounting Policy. The scope of the standard includes reporting and accounting of financial derivative instruments, non-financial physical supply agreements, insurance and debt agreements. Teaming across various functions (e.g., treasury, information technology, purchase/procurement department) becomes imperative for successful transitioning and implementation of the standard. Changes in fair value of hedging derivative instruments are reported as either deferred inflows or deferred outflows in the statement of net assets. Changes in fair values of investment or ineffective derivative instruments should be reported within the investment revenue on the flow of resources statement. Current systems may be inadequate for valuation and to determine if the derivative instrument is effective or not, inadequate systems to capture required data inputs and inventorying of various financial and physical derivative contracts. Raises tough questions around offline updates and related internal controls considerations. 47

49 Considerations Evaluation of Effectiveness Refer below for a few implementation impediments relating to evaluating effectiveness Description Consistent Critical Terms Synthetic Instrument method Level of effort High Medium Considerations - Application of consistent critical terms requires technical analysis of critical terms of both the hedged item and hedging instrument - Certain small differences can lead to ineligibility to apply this method - Anytime the floating rate of swap is a % of LIBOR, consistent critical terms method is prohibited - Only applicable when the overall changes in cash flow is hedged; only applicable to cash flow hedges - Most interest rate swaps would only hedge changes in benchmark LIBOR, hence this method is considered restrictive - Appears to be more applicable to commodity hedging relationships 48

50 Considerations Evaluation of Effectiveness (cont.) Refer below for a few implementation impediments relating to evaluating effectiveness Description Level of effort Considerations Dollar Offset Medium - Requires UOM to calculate change in expected cash flow of the derivative and the underlying hedged item - This method is considered to non statistical - Dollar offset is considered a restrictive method due to the impact of law of small numbers Regression Analysis High - Requires a series of historical data points to perform regression - The standard requires developing a hypothetical derivative which mirrors the actual underlying hedged item for regression purposes - Developing historical fair value of the actual and hypothetical swap requires significant amount of data gathering (especially for commodity derivatives) - Historical fair values require sophisticated systems such as Bloomberg (refer to case study # 2 for an e.g. of regression analysis 49

51 Considerations Pervasive Issues Refer below for a few pervasive issues with regards to implementing GASB 53 Description Level of effort Considerations Internal Controls High - Internal controls surrounding review of existing and new contracts need to be identified for accurate FS reporting - Controls need to be developed to ensure that the appropriate level of scrutiny and validation of the forward price curves is performed by the entity for complete and accurate FS reporting - Evaluation of effectiveness at each balance sheet date requires review and approval - Develop Risk Management Policy which outlines approved use of derivative instruments, provides level of authority to execute transactions, provides guidance on notional and tenor limits, etc. System Constraints High - Tracking various hedging instruments with associated hedged items require adequate systems - Developing fair values may require access to Bloomberg and other models i.e. Black Scholes model - Evaluating effectiveness (especially using regression analysis) requires significant system requirements including generating historical information - Release of amounts from statement of deferred inflows/outflows to statement of activities due to termination of hedge accounting require tracking settlements - Enhanced disclosure requirements may also require system capabilities - Use of spreadsheets is prone to end user control issues Technical Knowledge High - Knowledge of technical accounting is required at each stage to perform analysis i.e. determination of derivative, recognition and measurement, evaluating effectiveness, termination of hedge accounting and disclosures - A basic level of understanding is required even in functions outside of accounting i.e. treasury, procurement, front office, etc. 50

52 Recent Activities and Deloitte GASB 53 Team

53 Recent Activities GASB issued an implementation guide for GASB 53 in June 2009, which clarified certain interpretive issues of this standard (some of these interpretive issues are included within this slide deck) GASB issued a plain language summary of GASB 53, can be accessed at AVA in the process of setting up an Subject Matter Resource (SMR) team to help D&T audit teams navigate through the implementation of GASB 53 Creation of Pamphlet to provide an overview of GASB 53 to clients (both A space and R space) GASB 53 Overview 52

54 GASB 53 Team Xihao Hu, Partner, Accounting, Valuation & Analytics Services (AVA) McLean Derek Bradfield, Partner, AVA Chicago Tim Schott, Partner, AVA Chicago Erin Donovan, Senior Manager, AVA Houston Aditya Gandhi, Manager, AVA Chicago 53

55 Question and Answer

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