Comprehensive Implementation Guide Supplement

Transcription

1 Comprehensive Implementation Guide Supplement December 2010 Governmental Accounting Standards Board of the Financial Accounting Foundation 401 Merritt 7, PO Box 5116, Norwalk, Connecticut

2 Copyright 2011 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.

3 FOREWORD This Supplement to the Comprehensive Implementation Guide was developed to assist financial statement preparers and attestors in the implementation and application of a number of GASB pronouncements. It presents questions and answers regarding life insurance reported as investments, credit risk disclosures, and derivative instruments. Moreover, it provides additional derivative instrument illustrations. Guidance in an Implementation Guide is limited to clarifying, explaining, or elaborating on an underlying standard (usually a Statement, Interpretation, or Technical Bulletin). The topics addressed may include issues raised by constituents in due process or as a result of subsequent application of a standard, as well as issues anticipated by the GASB staff. Generally, a GASB Statement or Interpretation would be more appropriate to address new issues or to amend existing guidance on issues previously addressed. The GASB s Implementation Guides are classified as category (d) in the hierarchy of generally accepted accounting principles, as set forth in Statement No. 55, The Hierarchy of Generally Accepted Accounting Principles for State and Local Governments, and as a result, practitioners may be called upon to justify departures from guidance contained in this guide. This supplement was prepared and published in accordance with the GASB s Implementation Guide procedures. These procedures require public announcement of the project, exposure of the proposed guide to the Board and an advisory committee, and approval of the final guide by the director of research and technical activities. Moreover, an Implementation Guide will not be published if a majority of Board members object to its issuance. In December 2010, the Board considered all changes and additions included in this supplement and cleared it for issuance. The application of GASB pronouncements is an ongoing process. A guiding principle in the GASB s mission statement addresses the need to review the effects of past decisions and to provide additional guidance when appropriate. This supplement represents just one of the many methods that the GASB uses to fulfill this important responsibility. Norwalk, Connecticut December 2010 David R. Bean Director of Research and Technical Activities

4 Chapter 1: Disclosures Related to Deposits with Financial Institutions, Investments (including Repurchase Agreements), and Reverse Repurchase Agreements Q Is a debt security issued by a federal government-sponsored enterprise (GSE) that has only the implicit guarantee of the federal government and is held by a state or local government as an investment subject to credit risk disclosures? (Q&A40-21) [Amended 2006 and 2010S] A Yes. A credit risk disclosure is required if a GSE only has the federal government s implicit guarantee (paragraph 7 of Statement 40). However, as the structure of financial markets change, whether a GSE has an implicit or an explicit guarantee may change. A credit risk disclosure is based on the status of a federal guarantee as of the date of the financial statements. Chapter 6: Accounting and Financial Reporting for Certain Investments and for External Investment Pools Q A government employer purchases life insurance covering the lives of employees and former employees with vested benefits for which the government is the beneficiary. At what amount should the government recognize its investment in life insurance for financial reporting purposes? (Q&A2010S ) A The government employer should recognize as an investment asset the amount that could be realized by that employer under the insurance contract cash surrender value as of the date of the statement of net assets. The government employer should recognize death benefits as income only upon the actual death of an insured; income from death benefits should not be recognized on an actuarially expected or projected basis. Chapter 10: Accounting and Financial Reporting for Derivative Instruments Q Some governments enter into contracts to purchase U.S. government debt securities that do not yet exist when-issued and to-be-announced securities. Are these contracts derivative instruments and within the scope of Statement No. 53, Accounting and Financial Reporting for Derivative Instruments? (Q&A53-3) [Amended 2010S] A No. The primary consideration to determine if these contracts are derivative instruments and within the scope of Statement 53 should be based on whether the when-issued or to-be-announced debt security has already been reported in full as an investment based on trade-date accounting (see question ). As the security should have been recognized in full as an investment when purchased, the security does not meet the definition of a derivative instrument because there is no leverage. For example, U.S. government treasury securities and agencies may be purchased on a when-issued basis. The obligation to purchase the securities includes specific identification of the security in the form of a committee on Uniform Security Identification Procedures number, price, date of issue, and other significant terms. That security should be recognized as an investment at its full amount with a corresponding payable. There would be no derivative instrument. 1

5 Q A public utility holds financial transmission rights (FTRs). Do these FTRs (also referred to as fixed transmission rights, transmission congestion contracts, and congestion revenue rights) meet the definition of a derivative instrument? (Q&A53-5) [Amended 2010S] A FTRs are financial contracts issued by system operators designed to mitigate variability in transmission costs by equalizing the difference in two locational marginal pricing points along the electricity grid through a payment. System operators manage or own regional power distribution either as independent service operators or regional transmission organizations. Many FTRs have characteristics that represent settlement factors, leverage, and net settlement. An FTR that has all of the characteristics of a derivative instrument should be reported as a derivative instrument. FTRs that satisfy the characteristics of a derivative instrument may meet the criteria to be considered normal purchases or normal sales contracts. See question Settlement factors. FTRs are usually for a specific amount of electricity, and payments are based on the difference between two distinct locational marginal pricing points. Such FTRs have one or more reference rates and one or more notional amounts (paragraph 7a of Statement 53), meeting the settlement factors characteristic. Leverage. FTRs may be purchased and sold through auction in a market that the system operator facilitates. In this market, both utilities and investors participate in buying and selling FTRs. The utility should determine whether the amount paid in the auction is an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors (paragraph 7b), meeting the leverage characteristic. If a system operator allocates FTRs to a utility without cost, the allocation requires no initial net investment by the utility in the FTR and such FTRs would meet the leverage characteristic. However, a utility may transfer rights to use, or ownership of, physical transmission facilities to a system operator in exchange for FTRs. Such a transfer could represent a substantial investment in the FTRs and, thus, the leverage characteristic normally would not be met. FTRs received in such an exchange could continue to be provided in future periods. If a system operator continues to provide FTRs in the future, those FTRs should be evaluated to determine whether they constitute payments under an exchange transaction representing a substantial investment in transmission facilities by the utility. That investment would result in the FTRs not meeting the leverage characteristic and, therefore, the FTRs would not be a derivative instrument. Net settlement. FTRs may be settled by either paying or receiving cash or a commodity. The value of the settlement represents the difference between the two locational marginal pricing points in the contract. If the contract can be settled in cash, the FTRs meet the net settlement characteristic in paragraph 13a. However, if the FTRs are required to be settled through the transfer of a commodity, such as electricity, the government should determine whether that commodity could be readily convertible to cash, for example, through a commodity exchange (paragraph 13c). If the commodity can be readily converted to cash, the FTRs meet the net settlement characteristic. 2

6 Q Can financial transmission rights (FTRs), discussed in question , meet the normal purchases and normal sales scope exception? (Q&A53-22) [Amended 2010S] A FTRs that are derivative instruments may meet the normal purchases and normal sales scope exception if the FTRs will be used as factors in the cost of transmission (also known as locational marginal pricing) or otherwise are intended to result in the purchase or sale of a commodity. On the other hand, derivative instrument FTRs held for sale generally cannot meet the normal purchases and normal sales scope exception because as stand-alone contracts, they do not result in electricity being bought or sold. Rather, they are separate financial contracts with payouts based on the differences in locational marginal pricing points on an electricity grid. Electricity is transferred regardless of the FTRs Q In a current refunding, a government retires $10,000,000 of variable-rate debt, paying a $200,000 call premium. Unamortized bond issuance costs related to the refunded debt are $30,000. An interest rate swap employed as a hedging derivative instrument also is terminated at that time. As of the interest rate swap s termination date, the fair value of the swap represents a liability of $750,000, and the deferred amount is $750,000. The termination requires a $750,000 payment to the counterparty by the government. How should the government account for the swap s termination payment and calculate the deferred amount on refunding as used in paragraph 4 of Statement 23? (Q&A53-40) [Amended 2010S] A The fair value of the swap should be reduced to zero through the termination payment of $750,000 a credit to cash. The net carrying amount of the refunded debt determined to calculate the deferred amount on the refunding should include the deferred amount related to the terminated hedging derivative instrument $750,000 of deferred outflows of resources, computed as of the date of refunding. In many cases, the deferred amount approximates the hedging derivative instrument s termination payment. The deferred amount on refunding in the circumstances described above is calculated as follows: Reacquisition price: Old bonds outstanding $ 10,000,000 Call premium on old bonds 200,000 Funds required to retire old bonds $ 10,200,000 Net carrying amount of old bonds: Old bonds outstanding $ (10,000,000) Unamortized bond issuance costs Net carrying amount Deferred outflow of resources 30,000 (9,970,000) 750,000 Adjusted net carrying amount (9,220,000) Deferred amount on refunding $ 980,000 If the interest rate swap is not terminated, the swap may be a potential hedging derivative instrument associated with the refunding bonds or another hedgeable item. See Appendix 10-2, Illustration

7 Q The reference rate of an interest rate swap s variable payment is 67 percent of the London Interbank Offered Rate (LIBOR). The LIBOR-based swap qualifies for hedge accounting. The reference rate of the swap s variable payment rate is changed (renegotiated or amended) during the reporting period from LIBOR-based to the Securities Industry Financial Markets Association (SIFMA) swap index. Is this modification an event that results in the termination of hedge accounting? (Q&A2010S ) A Yes. Renegotiating or amending a critical term of a hedging derivative instrument terminates hedge accounting. Any amount in the deferral account should be removed and reported in investment income (paragraph 23 of Statement 53). The renegotiated or amended swap, however, may be a potential hedging derivative instrument of a hedgeable item, including the originally hedged debt, as part of a new hedge Q A utility is exposed to market risk arising from its expected purchase of fuel 36 months in the future. A futures exchange trades contracts for this commodity only 24 months into the future. The utility hedges its exposure to price risk 36 months in the future by first purchasing futures contracts maturing 24 months forward. Can these contracts be employed as hedging derivative instruments? (Q&A2010S ) A No. The time period of the expected purchase of fuel is not consistent with the time period of the futures contracts. The time periods of this hedging derivative instrument and the hedged transaction should be consistent (paragraph 27a(3) of Statement 53) Q A government enters into an interest rate swap that is a hedging derivative instrument associated with its variable-rate bonds. The government ultimately refunds these hedged bonds with new variable-rate bonds, and the swap becomes a potential hedging derivative instrument of the new refunding variable-rate bonds. As a potential hedging derivative instrument of the new debt, how should the effectiveness of the swap be evaluated? (Q&A2010S ) A Upon the refunding, the amount in the deferral account relating to the swap s hedge of the refunded bonds should be reclassified and presented with the carrying amount of the new hedged debt (paragraph 24 of Statement 53). Fair value or cash flow changes from the time of the refunding represent changes that may make the swap an effective hedge. Those changes should be evaluated consistent with the methods of evaluating effectiveness (paragraphs 36 48). An illustration that depicts how such a swap could be employed as a hedging derivative instrument is included as Appendix 10-2, Illustration Q A government expects to issue variable-rate debt 24 months in the future. The government enters into a forward-starting swap, locking in a fixed-rate payment based on currently expected future interest rates. Calculations of swap payments start 24 months in the future, and the swap has a term to maturity of 8 years. Eightyear rates, 24 months forward are expected to be 3 percent. This swap has a payfixed rate of 3 percent and a zero fair value. How is hedge effectiveness of a forwardstarting swap evaluated? (Q&A2010S ) 4

8 A This forward-starting swap could be considered a potential hedging derivative instrument upon being entered into if the forward-starting swap can be associated with an expected transaction that is probable of occurring. In this case, the hedgeable item would be the expected issuance of the variable-rate debt. If the expected issuance of the variable-rate debt is not considered probable of occurring, there is no hedgeable item. Hedge accounting should not be applied. If the forward-starting swap is a potential hedging derivative instrument, effectiveness would be evaluated based on the terms of the forward-starting swap and the expected terms of the variable-rate debt. For evaluation methods using historical information (the synthetic instrument and regression analysis methods), hypothetical rate or cash flow information may be used in applying the method until sufficient actual information is available Q To manage its exposure to the potential for increasing interest rates arising from its outstanding variable-rate debt, a government enters into an interest rate cap. The terms of the cap are that the government begins receiving payments from the counterparty during the term of the cap to the extent that the Securities Industry Financial Markets Association swap index exceeds 2 percent. How should the government evaluate effectiveness of the cap? (Q&A2010S ) A An interest rate cap is a one-sided hedge in which effectiveness should be evaluated consistent with the objective of the potential hedging derivative instrument (paragraph 32 of Statement 53). The dollar-offset method may provide a quantitative analysis of effectiveness. That method considers whether cap payments will be effective in hedging the one-sided risk; that is, whether the cap will be effective in keeping the variable interest rate at or below 2 percent. The dollar-offset method for the evaluation of an interest rate cap is presented in detail in Appendix 10-2, Illustration Q A swap has a term to maturity of 10 years. In the first six years, the variable payment is the Securities Industry Financial Markets Association swap index. In the last 4 years, the reference rate of the variable payment is 67 percent of the London Interbank Offered Rate. Can hedge effectiveness of this swap as a potential hedging derivative instrument be evaluated under the consistent critical terms method? (Q&A2010S ) A No. A swap that includes a formula that is not the same for each net settlement does not meet the criteria to apply the consistent critical terms method (paragraphs 37d and 38c of Statement 53) (Q&A53-65) [Deleted 2010S] Q A swap has a term to maturity of 10 years. In the first six years, the variable payment is the Securities Industry Financial Markets Association swap index. In the last 4 years, the reference rate of the variable payment is 67 percent of the London Interbank Offered Rate. Can hedge effectiveness of this swap as a potential hedging derivative instrument be evaluated under the synthetic instrument method? (Q&A2010S ) 5

9 A No. A swap that includes a formula that is not the same for each net settlement does not meet the criteria to apply the synthetic instrument method (paragraph 42c of Statement 53) Q To manage its exposure to adverse changes in natural gas prices from its expected purchase of 40 million British thermal units (MMBTUs) of natural gas at the Henry Hub price point 6 months in the future, a utility enters into a commodity cap. The terms of the commodity cap are that if natural gas prices at Henry Hub exceed $10 per MMBTU, the utility receives a payment from the counterparty to the extent that the Henry Hub price at that time exceeds $10 per MMBTU. How should the utility evaluate the effectiveness of the cap? (Q&A2010S ) A A commodity cap is a one-sided hedge in which effectiveness should be evaluated consistent with the objective of the potential hedging derivative instrument (paragraph 32 of Statement 53). The dollar-offset method may provide a quantitative evaluation of effectiveness. That method considers whether the cap will be effective in hedging the one-sided risk; that is, whether the cap will be effective in keeping the price of natural gas at or below $10 per MMBTU. The dollar-offset method for the evaluation of a commodity cap is presented in detail in Appendix 10-2, Illustration Q To hedge its exposure to changing interest rates arising from its variable-rate debt, the government enters into a pay-fixed, receive-variable interest rate swap. Statement No. 38, Certain Financial Statement Note Disclosures, indicates that principal and interest requirements to maturity should be disclosed for each of the five subsequent fiscal years and in five-year increments thereafter. Interest requirements for variable-rate debt should be determined using the rate in effect at the financial statement date (paragraph 10a). When there is a hedging derivative instrument, Statement 53 indicates that the net cash flows of that derivative instrument also should be disclosed (paragraph 74). The fair value of a receivevariable leg of an interest rate swap represents the present value of future payments based on expected future rates. Should the net cash flows of the hedging derivative instrument be based on the rate in effect at the financial statement date, consistent with the requirements of Statement 38 for variable-rate debt, or the expected future rates? (Q&A2010S ) A In order to be consistent with the variable-rate debt disclosure required by Statement 38, the variable rate in effect for the hedging swap s variable-rate payment at the financial statement date should be used. An example is as follows: Hedging derivative instrument payments and hedged debt. As of June 30, 20X0, aggregate debt service requirements of the city s debt (fixed-rate and variablerate) and net receipts/payments on a hedging derivative instrument are as follows. These amounts assume that current interest rates on the variable-rate bonds and the current reference rates of the hedging derivative instrument will remain the same for their term. As these rates vary, interest payments on variable-rate bonds and the net payments on the hedging derivative instrument will vary. Refer to Note X for information on derivative instruments (amounts in thousands). 6

10 Fiscal Year Ending June 30 Principal Interest Hedging Derivative Instrument, Net Total 20X1 20X2 20X3 20X4 20X5 20X6 20Y0 20Y1 20Y5 20Y6 20Z0 20Z1 20Z3 $ 6,000 $ 7,786 $ (1,253) $ 12,533 10,000 7,525 (1,211) 16,314 27,000 7,090 (1,141) 32,949 33,000 5,916 (952) 37,964 15,000 4,480 (721) 18,759 29,000 19,140 (3,080) 45,060 15,000 12,385 1,475 28,860 14,000 9,570 (528) 23,042 30,000 6,310 (300) 36,010 Total $ 179,000 $ 80,202 $ (7,711) $ 251,491 Chapter Z: Other Implementation Guidance Z.51 Statement No. 51, Accounting and Financial Reporting for Intangible Assets Z Q How should a governmental power utility record emissions credits granted to it? (Q&A2010-Z.51.39) [Amended 2010S] A If the emissions credits will be used in operations, there is no increase in service capacity and no asset should be recognized. If the emissions credits will be sold, they are intangible assets held for income or profit with a carrying value of zero, with gains recognized when sold. (See question ) However, emissions credits held for sale that meet the definition of a derivative instrument should be reported as required by Statement No. 53, Accounting and Financial Reporting for Derivative Instruments. 7

11 Appendix 10-2 ILLUSTRATIVE EXAMPLES OF COMMON DERIVATIVE INSTRUMENT APPLICATIONS This appendix illustrates the application of Statement 53. In some instances, amounts that may be considered immaterial are used to illustrate specific requirements. No inferences about determining materiality should be drawn from these illustrations. In some illustrations, actual market data was used; in others, a flat yield curve assumption or hypothetical market prices has been used. Some calculated numbers may be different due to rounding. CONTENTS Illustration Number Evaluating Effectiveness: Consistent Critical Terms Method Page Number 1.1 Cash Flow Hedge Interest Rate Swap... [Q&A2010, App.10-2, Ill. 1] 1.2 Fair Value Hedge Interest Rate Lock... [Q&A2010, App.10-2, Ill. 2] 1.3 Fair Value Hedge Interest Rate Swap..... [Q&A2010, App.10-2, Ill. 3] 1.4 Cash Flow Hedge Commodity Forward Contract... [Q&A2010, App.10-2, Ill. 8] Evaluating Effectiveness: Synthetic Instrument Method 2.1 Cash Flow Hedge Interest Rate Swap... [Q&A2010, App.10-2, Ill. 4] 2.2 Cash Flow Hedge Interest Rate Swap, Termination of Hedge Accounting Due to New Market Conditions... [Q&A2010, App.10-2, Ill. 5] 2.3 Cash Flow Hedge Hybrid Instrument, Off-Market Interest Rate Swap... [Q&A2010, App.10-2, Ill. 6] 2.4 Cash Flow Hedge Commodity Futures Contracts... [Q&A2010, App.10-2, Ill. 9] Evaluating Effectiveness: Regression Analysis Method 3.1 Cash Flow Hedge Interest Rate Swap... [Q&A2010, App.10-2, Ill. 7] Evaluating Effectiveness: Dollar-Offset Method 4.1 Cash Flow Hedge Commodity Forward Contract... [Q&A2010, App.10-2, Ill. 10] 4.2 Cash Flow Hedge Interest Rate Swap Cash Flow Hedge Interest Rate Cap Cash Flow Hedge Commodity Cap

12 Page Number Other Illustrations 5.1 Hybrid Instrument: Swaption Option, Swap, and Borrowing [Replaces Q&A 2010, App. 10-2, Ill. 11] Off-Market Swap Hedged Debt Refunded, Hedging Swap Associated with Refunding Debt Note Disclosures for Derivative Instruments... [Q&A2010, App.10-2, Ill. 12] 9

13 ILLUSTRATION 4.2 DOLLAR-OFFSET METHOD: CASH FLOW HEDGE INTEREST RATE SWAP Overview of the Illustration This illustration depicts a cash flow hedge that uses a pay-fixed, receive-variable interest rate swap. The objective of the swap is to hedge the risk of the overall changes in cash flows associated with variable-rate bonds. The potential hedging derivative instrument is an interest rate swap. The hedgeable items are the variable-rate bonds. Each reporting period, the government determines that the swap is an effective hedging derivative instrument using the dollar-offset method. Because the hedge is effective, the changes in fair value of the swap are reported as deferrals in the statement of net assets over the life of the swap. This illustration provides two approaches, either may be suitable. Approach 1 Changes in Variable Cash Flows The dollar-offset method may use changes in variable cash flows to evaluate effectiveness by dividing the present value in absolute terms of the change in remaining cash flows of the swap by the present value in absolute terms of the change in remaining cash flows of the hedged item. Although the approach depicted here uses present values, expected cash flows under the dollar-offset method are not required to be discounted (Comprehensive Implementation Guide, question ). Assumptions This approach is based on the following assumptions: a. On 1/1/X1, a government enters into a pay-fixed, receive-variable interest rate swap. b. The pay-fixed rate is percent. c. The receive-variable rate on the swap is based on 67 percent of the London Interbank Offered Rate (LIBOR). d. The pay-variable rate on the bonds is based on the Securities Industry and Financial Markets Association (SIFMA) swap index. e. The swap s initial fair value is zero. f. The yield curve is not flat but increases by 25 basis points per year based on 67 percent of LIBOR as of the end of each year, December 31. g. Interest rates change on the last day of the year. h. The discount rates used to calculate present values are based on 67 percent of LIBOR as of the end of each year, December 31. Swap Inputs Notional $ 10,000,000 Pay-fixed rate % Receive-variable rate 67 percent of LIBOR 10

14 Bond Inputs Principal $ 10,000,000 Variable coupon rate SIFMA swap index Number of payments 5 Present Value of Expected Future Cash Flows as of 1/1/X1 * On 1/1/X1, the at-the-market rate for a swap that has a variable rate of 67 percent of LIBOR equals a fixed rate of 5.00 percent. The at-the-market rate for a swap that has a variable rate of the SIFMA swap index equals 4.75 percent. Present Values of Receive-Variable (67 percent of LIBOR) as of 1/1/X1 Expected Future Variable Rates Present Value Factors (5.00%) Present Values of Receive-Variable 12/31/X1 5.00% $ 476,190 12/31/X2 5.25% ,190 12/31/X3 5.50% ,111 12/31/X4 5.75% ,054 12/31/X5 6.00% ,116 Total $ 2,370,661 Present Values of Variable to Bondholders (SIFMA swap index) as of 1/1/X1 Expected Future Variable Rates Present Value Factors (5.00%) Present Values of Variable to Bondholders 12/31/X1 4.75% $ (452,381) 12/31/X2 5.00% (453,515) 12/31/X3 5.25% (453,515) 12/31/X4 5.50% (452,486) 12/31/X5 5.75% (450,528) Total $ (2,262,425) * At inception, evaluating a potential hedging derivative instrument for effectiveness is not required. The hedge is evaluated for effectiveness as of the end of each reporting period (paragraph 31 of Statement 53). The 1/1/X1 information is necessary as the change of that information from 1/1/X1 to 12/31/X1 forms the basis for the hedge effectiveness calculation. 11

15 Present Values of Future Swap Pay-Fixed Receive- Variable Present Values of Variable to Bondholders 12/31/X1 $ (521,489) $ 476,190 $ (45,299) $ (452,381) 12/31/X2 (496,656) 476,190 (20,466) (453,515) 12/31/X3 (473,006) 475,111 2,105 (453,515) 12/31/X4 (450,481) 473,054 22,573 (452,486) 12/31/X5 (429,030) 470,116 41,086 (450,528) Total $ (2,370,661) $ 2,370,661 $ - $ (2,262,425) Present values of variable payments to bondholders may be determined by comparison of a government s actual variable payments compared to an appropriate benchmark interest rate such as the SIFMA swap index. For example, a government may observe that its bonds price at the SIFMA swap index plus 10 basis points. This observation would suggest that the present values of variable payments to bondholders may be determined by using the SIFMA swap index forward curve plus 10 basis points. On the other hand, if a government elects to hedge interest rate risk, the present values of variable payments to bondholders could be replaced with the present values based on the SIFMA swap index forward curve. Present Values of Expected Future Cash Flows as of 12/31/X1 On 12/31/X1, the at-the-market rate for a swap that has a variable rate of 67 percent of LIBOR equals a fixed rate of 4.50 percent. The at-the-market rate for a swap that has a variable rate of the SIFMA swap index equals 4.30 percent. Present Values of Receive-Variable (67 percent of LIBOR) as of 12/31/X1 Expected Future Variable Rates Present Value Factors (4.50%) Present Values of Receive-Variable 12/31/X2 4.50% $ 430,622 12/31/X3 4.75% ,972 12/31/X4 5.00% ,148 12/31/X5 5.25% ,245 Total $ 1,743,987 12

16 Present Values of Variable to Bondholders (SIFMA swap index) as of 12/31/X1 Expected Future Variable Rates Present Value Factors (4.50%) Present Values of Variable to Bondholders 12/31/X2 4.30% $ (411,483) 12/31/X3 4.55% (416,657) 12/31/X4 4.80% (420,622) 12/31/X5 5.05% (423,473) Total $ (1,672,235) Present Values of Future Swap Pay-Fixed Receive- Variable Present Values of Variable to Bondholders 12/31/X2 $ (523,984) $ 430,622 $ (93,362) $ (411,483) 12/31/X3 (501,420) 434,972 (66,448) (416,657) 12/31/X4 (479,828) 438,148 (41,680) (420,622) 12/31/X5 (459,165) 440,245 (18,920) (423,473) Total $ (1,964,397) $ 1,743,987 $ (220,410) $ (1,672,235) Evaluating Hedge Effectiveness as of 12/31/X1 Present value in absolute terms of the change in remaining cash flows of the swap as of 12/31/X1 Present value in absolute terms of the change in remaining cash flows of the hedged item as of 12/31/X1 $1,743,987 ($2,370,661 $476,190) -$1,672,235 (-$2,262,425 -$452,381) $-150,484 = = 109.2% $137,809 Present Value of Expected Future Cash Flows as of 12/31/X2 On 12/31/X2, the at-the-market rate for a swap that has a variable rate of 67 percent of LIBOR equals a fixed rate of 4.00 percent. The at-the-market rate for a swap that has a variable rate of the SIFMA swap index equals 3.80 percent. 13

17 Present Values of Receive-Variable (67 percent of LIBOR) as of 12/31/X2 Expected Future Variable Rates Present Value Factors (4.00%) Present Values of Receive-Variable 12/31/X3 4.00% $ 384,615 12/31/X4 4.25% ,936 12/31/X5 4.50% ,048 Total $ 1,177,599 Present Values of Variable to Bondholders (SIFMA swap index) as of 12/31/X2 Expected Future Variable Rates Present Value Factors (4.00%) Present Values of Variable to Bondholders 12/31/X3 3.80% $ (365,385) 12/31/X4 4.05% (374,445) 12/31/X5 4.30% (382,268) Total $ (1,122,098) Present Values of Future Swap Pay-Fixed Receive- Variable Present Values of Variable to Bondholders 12/31/X3 $ (526,503) $ 384,615 $ (141,888) $ (365,385) 12/31/X4 (506,253) 392,936 (113,317) (374,445) 12/31/X5 (486,782) 400,048 (86,734) (382,268) Total $ (1,519,538) $ 1,177,599 $ (341,939) $ (1,122,098) Evaluating Hedge Effectiveness as of 12/31/X2 Present value in absolute terms of the change in remaining cash flows of the swap as of 12/31/X2 Present value in absolute terms of the change in remaining cash flows of the hedged item as of 12/31/X2 $1,177,599 ($1,743,987 $430,622) -$1,122,098 (-$1,672,235 -$411,483) = -$135,766 $138,655 = 97.9% Present Values of Expected Future Cash Flows as of 12/31/X3 On 12/31/X3, the at-the-market rate for a swap that has a variable rate of 67 percent of LIBOR equals a fixed rate of 3.50 percent. The at-the-market rate for a swap that has a variable rate of the SIFMA swap index equals 3.25 percent. 14

18 Present Values of Receive-Variable (67 percent of LIBOR) as of 12/31/X3 Expected Future Variable Rates Present Value Factors (3.50%) Present Values of Receive-Variable 12/31/X4 3.50% $ 338,164 12/31/X5 3.75% ,067 Total $ 688,231 Present Values of Variable to Bondholders (SIFMA swap index) as of 12/31/X3 Expected Future Variable Rates Present Value Factors (3.50%) Present Values of Variable to Bondholders 12/31/X4 3.25% $ (314,010) 12/31/X5 3.50% (326,729) Total $ (640,739) Present Values of Future Swap Pay-Fixed Receive- Variable Present Values of Variable to Bondholders 12/31/X4 $ (529,046) $ 338,164 $ (190,882) $ (314,010) 12/31/X5 (511,156) 350,067 (161,089) (326,729) Total $ (1,040,202) $ 688,231 $ (351,971) $ (640,739) Evaluating Hedge Effectiveness as of 12/31/X3 Present value in absolute terms of the change in remaining cash flows of the swap as of 12/31/X3 Present value in absolute terms of the change in remaining cash flows of the hedged item as of 12/31/X3 $688,231 ($1,177,599 $384,615) -$640,739 (-$1,122,098 -$365,385) = -$104,753 $115,974 = 90.3% Present Value of Expected Future Cash Flow as of 12/31/X4 On 12/31/X4, the at-the-market rate for a swap that has a variable rate of 67 percent of LIBOR equals a fixed rate of 3.00 percent. The at-the-market rate for a swap that has a variable rate of the SIFMA swap index equals 2.65 percent. 15

19 Present Value of Receive-Variable Payment (67 percent of LIBOR) as of 12/31/X4 Expected Future Variable Rate Present Value Factor (3.00%) Present Value of Receive-Variable Payment 12/31/X5 3.00% $ 291,262 Total $ 291,262 Present Value of Variable Payment to Bondholders (SIFMA swap index) as of 12/31/X4 Expected Future Variable Rate Present Value Factor (3.00%) Present Value of Variable Payment to Bondholders 12/31/X5 2.65% $ (257,282) Total $ (257,282) Present Value of Future Swap Payment Pay-Fixed Receive- Variable Payment Present Value of Variable Payment to Bondholders 12/31/X5 $ (531,615) $ 291,262 $ (240,352) $ (257,282) Total $ (531,615) $ 291,262 $ (240,352) $ (257,282) Evaluating Hedge Effectiveness as of 12/31/X4 Present value in absolute terms of the change in remaining cash flows of the swap as of 12/31/X4 Present value in absolute terms of the change in remaining cash flows of the hedged item as of 12/31/X4 $291,262 ($688,231 $338,164) -$257,282 (-$640,739 -$314,010) = -$58,805 $69,447 = 84.7% Evaluating Hedge Effectiveness as of 12/31/X5 On 12/31/X5, the at-the-market rate for a swap that has a variable rate of 67 percent of LIBOR equals a fixed rate of 2.50 percent. The at-the-market rate for a swap that has a variable rate of the SIFMA swap index equals 2.00 percent. Testing hedge effectiveness at the date the hedging relationship terminates is not required. If a hedging relationship is effective at the end of the reporting period prior to termination, the hedging relationship is considered to be effective until the termination date (Comprehensive Implementation Guide, question ). 16

20 Source of Information Presented in the Following Journal Entries and Financial Statement Presentation Table Fair Values and Changes in Fair Value of the Swap Fair Values* Net Changes in Fair Value Gross Changes in Fair Value 12/31/X1 $ (220,410) $ (220,410) $ (97,563) $ (317,973) 12/31/X2 (341,939) (121,529) (147,563) (269,092) 12/31/X3 (351,971) (10,032) (197,563) (207,595) 12/31/X4 (240,352) 111,619 (247,563) (135,944) 12/31/X5-240,352 (297,563) (57,211) *Fair values are equal to the total of the present value of the net swap payments. and Variable to Bondholders Pay-Fixed Receive- Variable Interest Rates Receive- Variable Variable Interest Rates Bond Variable to Bondholders 12/31/X1 $ (547,563) 4.50% $ 450,000 $ (97,563) 4.30% $ (430,000) 12/31/X2 (547,563) 4.00% 400,000 (147,563) 3.80% (380,000) 12/31/X3 (547,563) 3.50% 350,000 (197,563) 3.25% (325,000) 12/31/X4 (547,563) 3.00% 300,000 (247,563) 2.65% (265,000) 12/31/X5 (547,563) 2.50% 250,000 (297,563) 2.00% (200,000) The swap notional and the bond principal amounts equal $10,000,

21 Journal Entries and Financial Statement Presentation Hedged Bonds Swap Deferral Cash Change Statement Interest Expense 1/1/X1 Issuance of bonds $ (10,000,000) $ 10,000,000 (10,000,000) $ - $ - 10,000,000 $ - 12/31/X1 Interest payment to bondholders (430,000) $ 430,000 Gross change in swap fair value (317,973) 317,973 Swap payment 97,563 (97,563) Deferral adjustment for hedged transaction (97,563) 97,563 (10,000,000) (220,410) 220,410 9,472,437 $ 527,563 12/31/X2 Interest payment to bondholders (380,000) $ 380,000 Gross change in swap fair value (269,092) 269,092 Swap payment 147,563 (147,563) Deferral adjustment for hedged transaction (147,563) 147,563 (10,000,000) (341,939) 341,939 8,944,874 $ 527,563 12/31/X3 Interest payment to bondholders (325,000) $ 325,000 Gross change in swap fair value (207,595) 207,595 Swap payment 197,563 (197,563) Deferral adjustment for hedged transaction (197,563) 197,563 (10,000,000) (351,971) 351,971 8,422,311 $ 522,563 12/31/X4 Interest payment to bondholders (265,000) $ 265,000 Gross change in swap fair value (135,944) 135,944 Swap payment 247,563 (247,563) Deferral adjustment for hedged transaction (247,563) 247,563 (10,000,000) (240,352) 240,352 7,909,748 $ 512,563 12/31/X5 Interest payment to bondholders (200,000) $ 200,000 Gross change in swap fair value (57,211) 57,211 Swap payment 297,563 (297,563) Deferral adjustment for hedged transaction (297,563) 297,563 Payment of bond principal 10,000,000 (10,000,000) $ - $ - $ - $ (2,587,815) $ 497,563 18

22 Approach 2 Hypothetical Derivative Instrument The dollar-offset method may use a hypothetical derivative instrument a hypothetical swap that evaluates effectiveness by dividing the fair value change in absolute terms of the actual swap by the fair value change in absolute terms of a hypothetical derivative instrument. The hypothetical derivative instrument is the derivative instrument that if entered into would have no ineffectiveness. In this illustration, the hypothetical derivative instrument has a variable payment based on the Securities Industry and Financial Markets Association (SIFMA) swap index and a pay-fixed rate of percent. Assumptions This approach is based on the following assumptions: a. On 1/1/X1, a government enters into a pay-fixed, receive-variable interest rate swap. b. The objective of this swap is to hedge the risk of changes in cash flows associated with variable-rate bonds. c. The pay-fixed rate is percent. d. The receive-variable rate on the swap is based on 67 percent of the London Interbank Offered Rate (LIBOR). e. The pay-variable rate on the bonds is based on the SIFMA swap index. f. The swap s initial fair value is zero. g. The yield curve is not flat but increases by 25 basis points per year based on 67 percent of LIBOR as of the end of each year, December 31. h. Interest rates change on the last day of the year. i. The discount rates used to calculate present values are based on 67 percent of LIBOR as of the end of each year, December 31. j. The pay-fixed rate of the hypothetical derivative instrument is determined by solving for the fixed rate that produces a present value equal to the present value of the variable payments of the hypothetical derivative instrument. The combined present value of pay-fixed rate and receive-variable rate creates a hypothetical derivative instrument equal to zero. In other words, $2,262,425 is equal to the present value of a series of 5 annual payments, discounted at 5 percent when the annual payment is equal to $10,000,000 times a fixed rate of percent. Actual Swap Inputs Notional $ 10,000,000 Fixed rate % Variable rate 67 percent of LIBOR Bond Inputs Principal $ 10,000,000 Variable coupon rate SIFMA swap index Number of payments 5 19

23 Hypothetical Swap Inputs Notional $ 10,000,000 Fixed rate % Variable rate SIFMA swap index Present Values of Expected Future Cash Flows as of 1/1/X1 * On 1/1/X1, the at-the-market rate for a swap that has a variable rate of 67 percent of LIBOR equals a fixed rate of 5.00 percent. The at-the-market rate for a swap that has a variable rate of the SIFMA swap index equals 4.75 percent. Present Values of Future Swap Pay-Fixed Receive- Variable 12/31/X1 $ (521,489) $ 476,190 $ (45,299) 12/31/X2 (496,656) 476,190 (20,466) 12/31/X3 (473,006) 475,111 2,105 12/31/X4 (450,481) 473,054 22,573 12/31/X5 (429,029) 470,116 41,087 Total $ (2,370,661) $ 2,370,661 $ - Present Values of Receive-Variable (67 percent of LIBOR) as of 1/1/X1 Expected Future Variable Rates Present Value Factors (5.00%) Present Values of Receive-Variable 12/31/X1 5.00% $ 476,190 12/31/X2 5.25% ,190 12/31/X3 5.50% ,111 12/31/X4 5.75% ,054 12/31/X5 6.00% ,116 Total $ 2,370,661 * At inception, evaluating a potential hedging derivative instrument for effectiveness is not required. The hedge is evaluated for effectiveness as of the end of each reporting period (paragraph 31 of Statement 53). The 1/1/X1 information is necessary as the change of that information from 1/1/X1 to 12/31/X1 forms the basis for the hedge effectiveness calculation. 20

24 Present Values of Hypothetical Swap Pay-Fixed Variable to Bondholders 12/31/X1 $ (497,679) $ (452,381) $ (45,298) 12/31/X2 (473,980) (453,515) (20,465) 12/31/X3 (451,410) (453,515) 2,105 12/31/X4 (429,914) (452,486) 22,572 12/31/X5 (409,442) (450,528) 41,086 Total $ (2,262,425) $ (2,262,425) $ - Present Values of Variable to Bondholders (SIFMA swap index) as of 1/1/X1 Expected Future Variable Rates Present Value Factors (5.00%) Present Values of Variable to Bondholders 12/31/X1 4.75% $ (452,381) 12/31/X2 5.00% (453,515) 12/31/X3 5.25% (453,515) 12/31/X4 5.50% (452,486) 12/31/X5 5.75% (450,528) Total $ (2,262,425) Present values of variable payments to bondholders may be determined by comparison of a government s actual variable payments compared to an appropriate benchmark interest rate such as the SIFMA swap index. For example, a government may observe that its bonds price at the SIFMA swap index plus 10 basis points. This observation would suggest that the present values of variable payments to bondholders may be determined by using the SIFMA swap index forward curve plus 10 basis points. On the other hand, if a government elects to hedge interest rate risk, the present values of variable payments to bondholders could be replaced with the present values based on the SIFMA swap index forward curve. Present Values of Expected Future Cash Flows as of 12/31/X1 On 12/31/X1, the at-the-market rate for a swap that has a variable rate of 67 percent of LIBOR equals a fixed rate of 4.50 percent. The at-the-market rate for a swap that has a variable rate of the SIFMA swap index equals 4.30 percent. 21

25 Present Values of Future Swap Pay-Fixed Receive- Variable 12/31/X2 $ (523,984) $ 430,622 $ (93,362) 12/31/X3 (501,420) 434,972 (66,448) 12/31/X4 (479,828) 438,148 (41,680) 12/31/X5 (459,165) 440,245 (18,920) Total $ (1,964,397) $ 1,743,987 $ (220,410) Present Values of Receive-Variable (67 percent of LIBOR) as of 12/31/X1 Expected Future Variable Rates Present Value Factors (4.50%) Present Values of Receive-Variable 12/31/X2 4.50% $ 430,622 12/31/X3 4.75% ,972 12/31/X4 5.00% ,148 12/31/X5 5.25% ,245 Total $ 1,743,987 Present Values of Hypothetical Swap Pay-Fixed Variable to Bondholders 12/31/X2 $ (500,060) $ (411,483) $ (88,577) 12/31/X3 (478,527) (416,657) (61,870) 12/31/X4 (457,920) (420,622) (37,298) 12/31/X5 (438,201) (423,473) (14,728) Total $ (1,874,708) $ (1,672,235) $ (202,473) Present Values of Variable to Bondholders (SIFMA swap index) as of 12/31/X1 Expected Future Variable Rates Present Value Factors (4.50%) Present Values of Variable to Bondholders 12/31/X2 4.30% $ (411,483) 12/31/X3 4.55% (416,657) 12/31/X4 4.80% (420,622) 12/31/X5 5.05% (423,473) Total $ (1,672,235) 22

26 Evaluating Hedge Effectiveness as of 12/31/X1 Fair value change in absolute terms of the actual swap as of 12/31/X1 Fair value change in absolute terms of the hypothetical swap as of 12/31/X1 -$220,410 ($0 -$45,299) -$202,473 ($0 -$45,298) -$265,709 = -$247,771 = 107.2% Present Values of Expected Future Cash Flows as of 12/31/X2 On 12/31/X2, the at-the-market rate for a swap that has a variable rate of 67 percent of LIBOR equals a fixed rate of 4.00 percent. The at-the-market rate for a swap that has a variable rate of the SIFMA swap index equals 3.80 percent. Present Values of Future Swap Pay-Fixed Receive- Variable 12/31/X3 $ (526,503) $ 384,615 $ (141,888) 12/31/X4 (506,253) 392,936 (113,317) 12/31/X5 (486,782) 400,048 (86,734) Total $ (1,519,538) $ 1,177,599 $ (341,939) Present Values of Receive-Variable (67 percent of LIBOR) as of 12/31/X2 Expected Future Variable Rates Present Value Factors (4.00%) Present Values of Receive-Variable 12/31/X3 4.00% $ 384,615 12/31/X4 4.25% ,936 12/31/X5 4.50% ,048 Total $ 1,177,599 Present Values of Hypothetical Swap Pay-Fixed Variable to Bondholders 12/31/X3 $ (502,464) $ (365,385) $ (137,080) 12/31/X4 (483,139) (374,445) (108,694) 12/31/X5 (464,557) (382,268) (82,288) Total $ (1,450,160) $ (1,122,098) $ (328,062) 23

27 Present Values of Variable to Bondholders (SIFMA swap index) as of 12/31/X2 Expected Future Variable Rates Present Value Factors (4.00%) Present Values of Variable to Bondholders 12/31/X3 3.80% $ (365,385) 12/31/X4 4.05% (374,445) 12/31/X5 4.30% (382,268) Total $ (1,122,098) Evaluating Hedge Effectiveness as of 12/31/X2 Fair value change in absolute terms of the actual swap as of 12/31/X2 Fair value change in absolute terms of the hypothetical swap as of 12/31/X2 -$341,939 (-$220,410 -$93,362) -$328,062 (-$202,473 -$88,577) = -$214,891 -$214,166 = 100.3% Present Values of Expected Future Cash Flows as of 12/31/X3 On 12/31/X3, the at-the-market rate for a swap that has a variable rate of 67 percent of LIBOR equals a fixed rate of 3.50 percent. The at-the-market rate for a swap that has a variable rate of the SIFMA swap index equals 3.25 percent. Present Values of Future Swap Pay-Fixed Receive- Variable 12/31/X4 $ (529,046) $ 338,164 $ (190,882) 12/31/X5 (511,156) 350,067 (161,089) Total $ (1,040,202) $ 688,231 $ (351,971) Present Values of Receive-Variable (67 percent of LIBOR) as of 12/31/X3 Expected Future Variable Rates Present Value Factors (3.50%) Present Values of Receive-Variable 12/31/X4 3.50% $ 338,164 12/31/X5 3.75% ,067 Total $ 688,231 24

28 Present Values of Hypothetical Swap Pay-Fixed Variable to Bondholders 12/31/X4 $ (504,892) $ (314,010) $ (190,882) 12/31/X5 (487,818) (326,729) (161,089) Total $ (992,710) $ (640,739) $ (351,971) Present Values of Variable to Bondholders (SIFMA swap index) as of 12/31/X3 Expected Future Variable Rates Present Value Factors (3.50%) Present Values of Variable to Bondholders 12/31/X4 3.25% $ (314,010) 12/31/X5 3.50% (326,729) Total $ (640,739) Evaluating Hedge Effectiveness as of 12/31/X3 Fair value change in absolute terms of the actual swap as of 12/31/X3 Fair value change in absolute terms of the hypothetical swap as of 12/31/X3 -$351,971 (-$341,939 -$141,888) -$351,971 (-$328,062 -$137,080) = -$151,920 -$160,989 = 94.4% Present Value of Expected Future Cash Flows as of 12/31/X4 On 12/31/X4, the at-the-market rate for a swap that has a variable rate of 67 percent of LIBOR equals a fixed rate of 3.00 percent. The at-the-market rate for a swap that has a variable rate of the SIFMA swap index equals 2.65 percent. Present Value of Future Swap Payment Pay-Fixed Receive-Variable Payment 12/31/X5 $ (531,615) $ 291,262 $ (240,352) Total $ (531,615) $ 291,262 $ (240,352) Present Value of Receive-Variable Payment (67 percent of LIBOR) as of 12/31/X4 Expected Future Variable Rate Present Value Factor (3.00%) Present Value of Receive-Variable Payment 12/31/X5 3.00% $ 291,262 Total $ 291,262 25

29 Present Value of Hypothetical Swap Payment Pay-Fixed Variable Payment to Bondholders Payment 12/31/X5 $ (507,343) $ (257,282) $ (250,061) Total $ (507,343) $ (257,282) $ (250,061) Present Value of Variable Payment to Bondholders (SIFMA swap index) as of 12/31/X4 Expected Future Variable Rate Present Value Factor (3.00%) Present Value of Variable Payment to Bondholders 12/31/X5 2.65% $ (257,282) Total $ (257,282) Evaluating Hedge Effectiveness as of 12/31/X4 Fair value change in absolute terms of the actual swap as of 12/31/X4 Fair value change in absolute terms of the hypothetical swap as of 12/31/X4 -$240,352 (-$351,971 -$190,882) -$250,061 (-$351,972 -$190,882) -$79,263 = -$88,972 = 89.1% Evaluating Hedge Effectiveness as of 12/31/X5 On 12/31/X5, the at-the-market rate for a swap that has a variable rate of 67 percent of LIBOR equals a fixed rate of 2.50 percent. The at-the-market rate for a swap that has a variable rate of the SIFMA swap index equals 2.00 percent. Testing hedge effectiveness at the date the hedging relationship terminates is not required. If a hedging relationship is effective at the end of the reporting period prior to termination, the hedging relationship is considered to be effective until the termination date (Comprehensive Implementation Guide, question ). Source of Information Presented in the Following Journal Entries and Financial Statement Presentation Table Fair Values and Changes in Fair Value of the Swap Fair Values* Net Changes in Fair Value Gross Changes in Fair Value 12/31/X1 $ (220,410) $ (220,410) $ (97,563) $ (317,973) 12/31/X2 (341,939) (121,529) (147,563) (269,092) 12/31/X3 (351,971) (10,032) (197,563) (207,595) 12/31/X4 (240,352) 111,619 (247,563) (135,944) 12/31/X5-240,352 (297,563) (57,211) *Fair values are equal to the total of the present value of the net swap payments. 26