[Completely Superseded] GASB Technical Bulletin No. 94-1

Transcription

1 NO. 117-C DECEMBER 1994 Governmental Accounting Standards Series [Completely Superseded] GASB Technical Bulletin No Title: Disclosures about Derivatives and Similar Debt and Investment Transactions References: NCGA Statement 1, Governmental Accounting and Financial Reporting Principles NCGA Interpretation 6, Notes to the Financial Statements Disclosure GASB Statement No. 20, Accounting and Financial Reporting for Proprietary Funds and Other Governmental Entities That Use Proprietary Fund Accounting FASB Statement No. 52, Foreign Currency Translation FASB Statement No. 80, Accounting for Futures Contracts Question 1 1. What types of disclosures should be presented in the financial statements for derivatives and similar debt and investment transactions? 1 1 Derivatives are generally defined as contracts whose value depends on, or derives from, the value of an underlying asset, reference rate, or index. This Technical Bulletin also applies to similar transactions, such as structured financial instruments (for example, mortgage-backed securities). GOVERNMENTAL ACCOUNTING STANDARDS BOARD OF THE FINANCIAL ACCOUNTING FOUNDATION 401 MERRITT 7, PO BOX 5116, NORWALK, CONNECTICUT

2 Response 2. In accordance with NCGA Statement 1, paragraph 158, and NCGA Interpretation 6, paragraphs 4 6, disclosures should include a discussion of the relevant accounting policies in the summary of significant accounting policies and any other information necessary to keep the financial statements from being misleading. Furthermore, in accordance with NCGA Interpretation 6, paragraph 4, disclosures are required if an entity has violated legal, regulatory, or contractual provisions by using, holding, or writing (selling) certain derivatives. Disclosures are also required for contingencies and for the effects of subsequent events. 3. Thus, if derivatives have been used, held, or written during the period covered by the financial statements (regardless of whether the assets or liabilities resulting from these transactions are reported on the balance sheet), the nature of the transactions and the reasons for entering into them should be explained. This explanation should include a discussion of the entity s exposure to credit risk, 2 market risk, 3 and legal risk 4 ; however, the discussion of risk should be made only to the extent that these risks are above and beyond those risks that are apparent in the financial statements or are otherwise disclosed in the notes to the financial statements. (For example, if an instrument is disclosed as bearing an interest rate that varies directly with a particular published index or rate, no additional disclosure of the market risk related to changing interest rates would generally be necessary.) 4. To the extent that information is available to an entity, the disclosures in paragraphs 2 and 3 are applicable if the entity is exposed to risk by indirectly using, holding, or writing derivatives, such as through participation in a mutual fund or investment pool that holds derivatives. If this information is not available, that fact should be disclosed. 5. These disclosures should be made in addition to, not in place of, specific disclosures required by other GASB pronouncements. 2 Credit risk is the exposure to the default of another party to the transaction (the counterparty). 3 Market risk is the exposure to changes in the market, such as a change in interest rates or a change in the price or principal value of a security. 4 Legal risk is the exposure to a transaction s being determined to be prohibited by law, regulation, or contract. 2

3 Question 2 6. Are there special accounting and financial reporting requirements for derivatives of proprietary activities 5 and nonexpendable trust funds? Response 7. The requirements in FASB Statements 52 and 80 for hedging of foreign currency transactions and futures contracts, respectively, should be applied to proprietary activities and nonexpendable trust funds. In addition, all proprietary activities that apply paragraph 7 of Statement 20 should also follow the provisions in FASB Statements and Interpretations issued after November 30, 1989, to the extent that those FASB pronouncements do not conflict with or contradict GASB pronouncements. 6 Those FASB Statements and Interpretations, if applicable, may require specific disclosures on certain transactions in addition to the disclosures discussed in this Technical Bulletin. Effective Date 8. The provisions of this Technical Bulletin are effective for financial statements for periods ending after December 15, Earlier application is encouraged. The Governmental Accounting Standards Board has authorized its staff to prepare GASB Technical Bulletins to provide timely guidance on certain financial accounting and reporting problems, in accordance with the procedures described in Technical Bulletin No. 84-1, Purpose and Scope of GASB Technical Bulletins and Procedures for Issuance. The provisions of Technical Bulletins need not be applied to immaterial items. The GASB has reviewed this Technical Bulletin and a majority of its members do not object to its issuance. 5 Proprietary activities include proprietary (enterprise and internal service) funds and other governmental entities that use proprietary fund accounting. Furthermore, NCGA Statement 1, paragraph 18(3), states that nonexpendable trust funds are accounted for in essentially the same manner as proprietary funds. 6 GASB Statement 20, paragraph 7, permits, but does not require, proprietary activities to apply all FASB Statements and Interpretations issued after November 30, 1989, that do not conflict with or contradict GASB pronouncements. 3

4 Appendix 1 BACKGROUND INFORMATION Introduction 9. Some governmental entities use derivatives and similar transactions for debt, investment, and other purposes. 7 With regard to their debt, governmental entities may enter into interest rate swaps, or they may issue debt with features such as inverse floatingrate securities; interest rate caps, floors, or collars; and the like. These transactions may be used to take advantage of changes in interest rates, to change the character of debt (for example, to convert it from variable-rate debt to fixed-rate debt to mitigate the market risk of volatile interest rates), to lower issuance costs, or to make the debt more attractive to investors. 10. With regard to investments, governmental entities may purchase futures contracts and options on financial exchanges and forward contracts, options, and swaps (for example, interest rate swaps or foreign currency swaps) on the over-the-counter markets; may invest in various mortgage-backed securities, such as collateralized mortgage obligations, principal-only strips, and interest-only strips; and may write (sell) forward contracts or options. All of these various securities may be used to modify exposure to certain risks, to enhance yields on investments, or to effect changes in investment portfolios without significantly affecting liquidity. Furthermore, governmental entities may invest in these securities indirectly (for example, through an investment pool or a mutual fund). 11. Governmental entities also use derivatives and similar transactions for other purposes. For example, these entities may enter into futures contracts, forward contracts, or options on certain commodities. These contracts may be used to fix the price of certain commodities and lessen the governmental entities exposure to rising prices. 7 Debt and investment authority for governmental entities is generally governed by legal or contractual provisions. As noted in NCGA Statement 1, paragraph 6, legal provisions include those arising from constitutions, charters, ordinances, resolutions, governing body orders, and intergovernmental grant or contract regulations. 4

5 12. There continues to be innovation in the derivatives market. The types of derivatives and similar transactions listed in paragraphs 9 through 11 are not intended to be allinclusive. Objectives 13. The purpose of this Technical Bulletin is to address financial statement disclosure about derivatives and similar transactions in a general manner. The responses in this Technical Bulletin are based in part on the financial reporting objectives in GASB Concepts Statement No. 1, Objectives of Financial Reporting, paragraphs 78b and 79c. Paragraph 78b states that financial reporting should provide information about how the governmental entity financed its activities and met its cash requirements. Paragraph 79c states that financial reporting should disclose legal or contractual restrictions on resources and risks of potential loss of resources. 5

6 Appendix 2 NONAUTHORITATIVE ILLUSTRATIONS OF DISCLOSURES 14. Paragraph 3 in the response to question 1 states that... the discussion of risk should be made only to the extent that these risks are above and beyond those risks that are apparent in the financial statements or are otherwise disclosed in the notes to the financial statements. That statement is intended to provide for disclosure of only relevant additional information. Concepts Statement 1, paragraph 65, states that information is relevant if it is capable of making a difference in a user s assessment of a problem, condition, or event. The discussions and accompanying excerpts of disclosures in this appendix are designed to illustrate the provisions in paragraphs 2 and 3. Each illustration is based on particular circumstances; it generally would be inappropriate to use the wording verbatim for actual situations. The facts assumed in these examples are illustrative only and are not intended to modify or limit the provisions of this Technical Bulletin or to indicate endorsement of the policies or practices shown. Application of the provisions of this Technical Bulletin may require disclosures and formats other than those illustrated here. Interest Rate Swap 15. If a bond payable is described as being a variable-rate (floating-rate) instrument, most readers understand the implication that a change in interest rates (a market risk) will affect the entity s debt service; therefore, other than an indication of the debt s floatingrate characteristic, no discussion of market risk would normally be necessary. However, if an entity has entered into an interest rate swap arrangement to modify its actual interest costs and discloses its debt as being fixed-rate, the disclosure should include the nature and terms of the floating- to fixed-rate swap. Although this disclosure may also include factors that mitigate risk, the entity s exposure to credit and market risks 8 may be apparent from the disclosure of the nature of the swap agreement. The following illustrates disclosures provided for by this Technical Bulletin. 8 Credit risk is related to the potential for the counterparty s failure to fulfill its part of the transaction, and market risk is related to the potential for additional interest costs due to (a) variances between the floating rate paid by the entity to the debt holders and the floating rate paid by the counterparty to the entity or (b) variances between the fixed rate paid by the entity to the counterparty and the floating rate paid by the counterparty to the entity. 6

7 Excerpts from Note Disclosures [In the Summary of Significant Accounting Policies note:]... The City enters into interest rate swap agreements to modify interest rates on outstanding debt. Other than the net interest expenditures resulting from these agreements, no amounts are recorded in the financial statements. [In the Debt note:]... The City has entered into a ten-year interest rate swap agreement for $50 million of its variable-rate 1992 Series general obligation bonds. Based on the swap agreement, the City owes interest calculated at a fixed rate of 6.0% to the counterparty to the swap. In return, the counterparty owes the City interest based on a variable rate that matches the rate required by the bonds. Only the net difference in interest payments is actually exchanged with the counterparty. The $50 million in bond principal is not exchanged; it is only the basis on which the interest payments are calculated. The City continues to pay interest to the bondholders at the variable rate provided by the bonds. However, during the term of the swap agreement, the City effectively pays a fixed rate on the debt. The debt service requirements to maturity for these bonds [presented in this note] are based on that fixed rate. The City will be exposed to variable rates if the counterparty to the swap defaults or if the swap is terminated. A termination of the swap agreement may also result in the City s making or receiving a termination payment. Interest-Only Strips 16. If interest-only strips are or have been in a governmental entity s investment portfolio during the fiscal year, the market risk related to the effects of changing interest rates on the cash flows from those securities and, therefore, on the value of the securities should be explained when that risk is not apparent on the balance sheet or in disclosures about investments. The following illustrates disclosures provided for by this Technical Bulletin. Excerpts from Note Disclosures [In the Summary of Significant Accounting Policies note:]... In accordance with authorized investment laws, the County invests in various mortgage-backed securities, 7

8 such as collateralized mortgage obligations, interest-only strips, and principal-only strips. These securities are reported at cost in the balance sheet. They are reported in aggregate as mortgage-backed securities in the disclosure of custodial credit risk. (See Note X on Investments.) [In the Investments note:]... The County invests in interest-only strips (a form of mortgage-backed securities) in part to maximize yields and in part to hedge against a rise in interest rates. These securities are based on cash flows from interest payments on underlying mortgages. Therefore, they are sensitive to prepayments by mortgagees, which may result from a decline in interest rates. For example, if interest rates decline and homeowners refinance mortgages, thereby prepaying the mortgages underlying these securities, the cash flows from interest payments are reduced and the value of these securities declines. Likewise, if homeowners pay on mortgages longer than anticipated, the cash flows are greater and the return on the initial investment would be higher than anticipated. [In the Subsequent Events note:]... Since June 30, 199X, interest rates have continued to decline. As a result, the County s investment in interest-only strips as of June 30, 199X, was sold for a $Y loss on September ZZ, 199X. [Other disclosures may be necessary for the collateralized mortgage obligations and principal-only strips.] Forward Contracts 17. If a governmental entity enters into futures or forward contracts to fix the price of certain commodities in the future, those contracts should be disclosed and explained when the market risk related to changes in commodity prices and the credit risk related to counterparty performance are not apparent in the financial statements or in disclosures about commitments. The following illustrates disclosures provided for by this Technical Bulletin. Excerpts from Note Disclosures [In the Summary of Significant Accounting Policies note:]... Forward contracts for the purchase of certain commodities are reported at cost in the balance sheet. Obligations to purchase the commodities are not recognized until the commodities are deliverable. 8

9 [In the Commitments and Contingencies note:]... The Authority has entered into forward contracts to purchase fuel oil at a specified time in the future at a guaranteed price [generally the market price at the time the contract commences]. The Authority enters into these contracts to help plan its fuel oil costs for the year and to protect itself against an increase in the market price of the commodity. It is possible that the market price before or at the specified time to purchase fuel oil may be lower than the price at which the Authority is committed to buy. This would reduce the value of the contract. The Authority could sell the forward contract at a loss, or if it were to continue to hold the contract, the Authority may make a termination payment to the counterparty to cancel its obligation under the contract and then buy fuel oil on the open market. The Authority is also exposed to the failure of the counterparty to fulfill the contract. The terms of the contract include provisions for recovering the cost in excess of the guaranteed price from the counterparty should the Authority have to procure fuel oil on the open market. 9

10 Appendix 3 CODIFICATION INSTRUCTIONS 18. The sections that follow update the June 30, 1994, Codification of Governmental Accounting and Financial Reporting Standards for the effects of this Technical Bulletin. Only the paragraph number is listed if the paragraph will be cited in full in the Codification. * * * LONG-TERM LIABILITIES SECTION 1500 [Add the following:] TECHNICAL BULLETIN EFFECTIVE AFTER MARCH 15, 1992 Disclosures about Derivatives and Similar Debt and Investment Transactions.603 GASB Technical Bulletin No. 94-1, Disclosures about Derivatives and Similar Debt and Investment Transactions, provides additional disclosure guidance on certain debt transactions. (See Section 2300, paragraphs.108 and.601.) * * * NOTES TO FINANCIAL STATEMENTS SECTION 2300 Sources: [Add the following:] GASB Technical Bulletin [Add the following at the end of the paragraph:] (Paragraph.601 provides Technical Bulletin guidance on disclosures about derivatives and similar debt and investment transactions.) [Add the following:] 10

11 TECHNICAL BULLETIN EFFECTIVE AFTER MARCH 15, 1992 Disclosures about Derivatives and Similar Debt and Investment Transactions.601 This paragraph provides Technical Bulletin guidance on disclosures about derivatives and similar debt and investment transactions. (See paragraphs for illustrations of disclosures.) Question 1 [GASBTB 94-1, 1] Response [GASBTB 94-1, 2 5] [Change cross-references.] Question 2 [GASBTB 94-1, 6] Response [GASBTB 94-1, 7] [Change cross-reference.] [Add the following:] Illustrations of Disclosures about Derivatives and Similar Debt and Investment Transactions [GASBTB 94-1, 14 17] [Change cross-references.] * * * DEMAND BONDS SECTION D30 [Add the following:] 11

12 TECHNICAL BULLETIN EFFECTIVE AFTER MARCH 15, 1992 Disclosures about Derivatives and Similar Debt and Investment Transactions.601 Technical Bulletin No. 94-1, Disclosures about Derivatives and Similar Debt and Investment Transactions, provides additional disclosure guidance on certain debt transactions. (See Section 2300, paragraphs.108 and.601.) * * * INVESTMENTS INCLUDING REPURCHASE AGREEMENTS SECTION I [Add the following at the end of the paragraph:] (Section 2300, Notes to Financial Statements, paragraph.601, provides Technical Bulletin guidance on disclosures about derivatives and similar investment transactions.) For additional copies of this Technical Bulletin 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. GTB94-1. The GASB website can be accessed at Copyright 1994 by Financial Accounting Foundation. All rights reserved. Content copyrighted by Financial Accounting Foundation may not 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 Financial Accounting Foundation. 12