Governmental Accounting Standards Series

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1 NO. 315-C JUNE 2011 Governmental Accounting Standards Series Statement No. 64 of the Governmental Accounting Standards Board Derivative Instruments: Application of Hedge Accounting Termination Provisions an amendment of GASB Statement No. 53 Governmental Accounting Standards Board of the Financial Accounting Foundation

2 For additional copies of this Statement and information on applicable prices and discount rates, contact: Order Department Governmental Accounting Standards Board 401 Merritt 7 PO Box 5116 Norwalk, CT Telephone Orders: Please ask for our Product Code No. GS64. The GASB website can be accessed at

3 Summary Some governments have entered into interest rate swap agreements and commodity swap agreements in which a swap counterparty, or the swap counterparty s credit support provider, commits or experiences either an act of default or a termination event as both are described in the swap agreement. Many of those governments have replaced their swap counterparty, or swap counterparty s credit support providers, either by amending existing swap agreements or by entering into new swap agreements. When these swap agreements have been reported as hedging instruments, questions have arisen regarding the application of the termination of hedge accounting provisions in Statement No. 53, Accounting and Financial Reporting for Derivative Instruments. Those provisions require a government to cease hedge accounting upon the termination of the hedging derivative instrument, resulting in the immediate recognition of the deferred outflows of resources or deferred inflows of resources as a component of investment income. The objective of this Statement is to clarify whether an effective hedging relationship continues after the replacement of a swap counterparty or a swap counterparty s credit support provider. This Statement sets forth criteria that establish when the effective hedging relationship continues and hedge accounting should continue to be applied. The provisions of this Statement are effective for financial statements for periods beginning after June 15, Earlier application is encouraged. i

4 How the Changes in This Statement Improve Financial Reporting The requirements of this Statement enhance comparability and improve financial reporting by clarifying the circumstances in which hedge accounting should continue when a swap counterparty, or a swap counterparty s credit support provider, is replaced. Unless otherwise specified, pronouncements of the GASB apply to financial reports of all state and local governmental entities, including general purpose governments; public benefit corporations and authorities; public employee retirement systems; and public utilities, hospitals and other healthcare providers, and colleges and universities. Paragraph 3 discusses the applicability of this Statement. ii

5 Statement No. 64 of the Governmental Accounting Standards Board Derivative Instruments: Application of Hedge Accounting Termination Provisions an amendment of GASB Statement No. 53 June 2011 Governmental Accounting Standards Board of the Financial Accounting Foundation 401 Merritt 7, PO Box 5116, Norwalk, Connecticut iii

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7 Statement No. 64 of the Governmental Accounting Standards Board Derivative Instruments: Application of Hedge Accounting Termination Provisions an amendment of GASB Statement No. 53 June 2011 CONTENTS Paragraph Numbers Introduction Standards of Governmental Accounting and Financial Reporting Scope and Applicability of This Statement... 3 Amendments to Termination of Hedge Accounting... 4 Amendments to Glossary... 5 Effective Date and Transition... 6 Appendix A: Background Appendix B: Basis for Conclusions Appendix C: Codification Instructions v

8 Statement No. 64 of the Governmental Accounting Standards Board Derivative Instruments: Application of Hedge Accounting Termination Provisions an amendment of GASB Statement No. 53 June 2011 INTRODUCTION 1. As a result of a swap counterparty, or a swap counterparty s credit support provider, committing or experiencing either acts of default or termination events, some governments have replaced their swap counterparty and credit support providers. When these swap agreements have been hedging derivative instruments, questions have arisen regarding the application of the termination of hedge accounting provisions in Statement No. 53, Accounting and Financial Reporting for Derivative Instruments. Those provisions require a government to cease hedge accounting upon the termination of a hedging derivative instrument, resulting in the immediate recognition of the deferred outflows of resources or deferred inflows of resources as a component of investment income. 2. The objective of this Statement is to improve financial reporting for state and local governments by clarifying whether an effective hedging relationship continues after the replacement of a swap counterparty or a swap counterparty s credit support provider. 1

9 STANDARDS OF GOVERNMENTAL ACCOUNTING AND FINANCIAL REPORTING Scope and Applicability of This Statement 3. This Statement clarifies the existing requirements for the termination of hedge accounting. This Statement applies to all state and local governments and amends Statement 53, paragraphs 22d and 82. Amendments to Termination of Hedge Accounting 4. Paragraph 22d of Statement 53 is amended as follows to clarify when the application of hedge accounting should continue upon the replacement of a swap counterparty or a swap counterparty s credit support provider. d. The hedging derivative instrument is terminated unless an effective hedging relationship continues as provided in this subparagraph. An effective hedging relationship continues when all of the following criteria are met: (1) Collectability of swap payments is considered to be probable. 9a (2) The swap counterparty of the interest rate swap or commodity swap, or the swap counterparty s credit support provider, is replaced with an assignment or in-substance assignment. (3) The government enters into the assignment or in-substance assignment in response to the swap counterparty, or the swap counterparty s credit support provider, either committing or experiencing an act of default or a termination event as both are described in the swap agreement. 9a When collectability of payments is not probable, such as when a swap counterparty, or a swap counterparty s credit support provider, has entered into bankruptcy and the swap is not collateralized or does not remain insured, an effective hedging relationship does not continue. Amendments to Glossary 5. The Glossary of Statement 53, paragraph 82, is amended to include the terms assignment and in-substance assignment. 2

10 Assignment An assignment occurs when a swap agreement is amended to replace an original 14 swap counterparty, or the swap counterparty s credit support provider, but all of the other terms of the swap agreement remain unchanged. In-substance assignment An in-substance assignment occurs when all of the following criteria are met: The original 15 swap counterparty, or the swap counterparty s credit support provider, is replaced. The original swap agreement 16 is ended, and the replacement swap agreement is entered into on the same date. The terms that affect changes in fair values and cash flows in the original and replacement swap agreements are identical. These terms include, but are not limited to, notional amounts; terms to maturity; variable payment terms; reference rates; time intervals; fixed-rate payments; frequencies of rate resets; payment dates; and options, such as floors and caps. Any difference between the original swap agreement s exit price and the replacement swap s entry price is attributable to the original swap agreement s exit price being based on a computation specifically permitted under the original swap agreement. Exit price represents the payment made or received as a result of terminating the original swap. Entry price represents the payment made or received as a result of entering into a replacement swap. 14 A swap counterparty replaced in the current reporting period may have previously replaced another swap counterparty in the past. Accordingly, as used in this Statement, the term original as it applies to the swap counterparty or the swap counterparty s credit support provider may include a swap counterparty that has replaced the original swap counterparty, or a credit support provider that has replaced the swap counterparty s original credit support provider. 15 See footnote A swap agreement replaced in the current reporting period may have previously replaced another swap agreement in the past. Accordingly, as used in this Statement, the term original swap agreement may include a replacement swap agreement. EFFECTIVE DATE AND TRANSITION 6. The provisions of this Statement are effective for financial statements for periods beginning after June 15, Earlier application is encouraged. In the first period that this Statement is applied, changes made to comply with this Statement should be treated 3

11 as an adjustment of prior periods, and financial statements presented for the periods affected should be restated. If restatement of the financial statements for prior periods is not practical, the cumulative effect of applying this Statement should be reported as a restatement of beginning net assets for the earliest period restated. In the period that this Statement is first applied, the financial statements should disclose the nature of the restatement and its effect. Also, the reason for not restating prior periods should be explained. The provisions of this Statement need not be applied to immaterial items. This Statement was issued by unanimous vote of the seven members of the Governmental Accounting Standards Board. Robert H. Attmore, Chairman Michael D. Belsky Michael H. Granof David E. Sundstrom Jan I. Sylvis Marcia L. Taylor James M. Williams 4

12 Appendix A BACKGROUND 7. Questions regarding the application of the termination of hedge accounting provisions in Statement 53 have been raised in practice when swap counterparties have been replaced in swap agreements. These questions first focused on whether the provisions to terminate hedge accounting apply to situations in which the swap counterparty enters bankruptcy an event of default in most swap agreements. The accounting provisions of Statement 53 require a government to cease the application of hedge accounting upon the termination of a hedging derivative instrument. That termination results in the immediate recognition of the related deferred outflows of resources or deferred inflows of resources as a component of investment income. 8. To address the counterparty bankruptcy question, a project was added to the GASB technical agenda in August During the Board s research, additional questions were raised regarding other acts of default and termination events that are described in most swap agreements. To address the application of the termination provisions to these other acts and events, the Board expanded the scope of the project in December A government may replace a swap counterparty by amending an existing swap agreement to insert a new counterparty in lieu of the original swap counterparty. A payment may be made between the new swap counterparty and the original swap counterparty (or its bankruptcy estate) because, from the perspective of the new swap counterparty, the terms of the amended swap agreement are now based on off-market interest rates. A government also may replace a swap counterparty s original credit 5

13 support provider with another credit support provider by amending an existing swap agreement. 10. A government may replace a swap counterparty by entering into a new swap agreement with a new swap counterparty. If the terms of a replacement swap agreement that affect fair values and cash flows are identical to the terms of the original swap agreement, the replacement swap agreement likely will have an off-market interest rate. In some cases, due to different methods of calculation, the original swap agreement s exit price may not be the same as the replacement swap agreement s entry price. The difference between an exit price and an entry price may result in a net payment being made or received by the government. A government also may replace a swap counterparty s original credit support provider with another credit support provider by entering into a new swap agreement with the original counterparty. 11. To address the issues raised regarding the application of the hedge accounting termination provisions, the GASB studied standard swap terms, especially those included in standard agreements issued by the International Swaps and Derivatives Association, Inc., and consulted with experts in the industry. 12. In February 2011, the Board issued an Exposure Draft, Derivative Instruments: Application of Hedge Accounting Termination Provisions. Twenty-eight organizations and individuals responded to the Exposure Draft by submitting comment letters. Those responses contributed to the Board s deliberations in finalizing the requirements of this Statement. 6

14 Appendix B BASIS FOR CONCLUSIONS 13. This appendix discusses factors considered significant by Board members in reaching the conclusions in this Statement. It includes discussion of the alternatives considered and the Board s reasons for accepting some and rejecting others. Individual Board members may have given greater weight to some factors than to others. 14. Initially, the project was added to the Board s technical agenda to clarify whether the termination provisions in paragraph 22d of Statement 53 should apply to hedging swap agreements when a swap counterparty enters into bankruptcy and that swap counterparty is replaced. In the Board s view, a clarification is necessary because the termination event was not initiated by any action of the government. As a result of additional questions raised and issues identified during the GASB s research, the Board considered expanding the clarifying guidance to other termination events and acts of default that are described in swap agreements. The Board decided to expand the guidance to address other termination events and acts of default that share the same characteristic as a counterparty bankruptcy because an action of the government does not initiate the default or termination event. To avoid a standard that may not be responsive to changing terms of swap agreements, the Board concluded that the Statement should not include a detailed listing of specific acts of default or termination events. 15. A hedging derivative instrument exists when the fair value or cash flow changes of the hedgeable item and the derivative instrument substantially offset and the additional criteria of paragraph 27 of Statement 53 are met, thereby establishing an effective hedging relationship. The Board believes that when there is a replacement of a swap counterparty, 7

15 or a swap counterparty s credit support provider, the continuation of hedge accounting should be limited to those circumstances in which an existing effective hedging relationship continues. That belief is based on the view that the replacement does not change a government s financial position when the criteria set forth in the Statement are met. Collection of Payments Is Probable 16. The Exposure Draft proposed to limit the application of the provisions of this Statement to swaps that are liabilities to a government. That proposal was based on the view that a bankrupt counterparty would not be in a position to make payments to a government; therefore, making the hedge no longer effective. Changes in fair value of swaps that are not effective hedging derivative instruments cannot be reported as deferred outflows of resources or deferred inflows of resources. The Board received comments on the Exposure Draft indicating that collectability of payments from a defaulting counterparty may nevertheless still be probable. This could be the case when a swap is collateralized or remains insured. After considering these comments, the Board concluded that a swap should not be required to be a liability to a government before the provisions of this Statement should be applied. Replacement by Assignment or In-Substance Assignment 17. A swap counterparty may be replaced by way of an assignment. An assignment occurs when the terms of a swap agreement remain unchanged, except that the swap counterparty has been replaced through an amendment to the agreement. A government also may replace a swap counterparty s credit support provider with another credit support provider by amending an existing swap agreement. As noted above, the Board believes 8

16 that an effective hedging relationship continues because the hedging relationship has not changed. The application of the hedge accounting provisions of Statement 53 should continue under these circumstances. 18. The Board also considered circumstances that would be equivalent to an assignment. Paragraph 3 of Statement No. 7, Advance Refundings Resulting in Defeasance of Debt, establishes the concept of an in-substance transaction. For accounting and financial reporting purposes, defeasance of debt can be either legal or in-substance. When certain criteria are met (paragraph 4 of Statement 7), an in-substance defeasance occurs even though a legal defeasance has not. No gain or loss is recognized immediately. Likewise, even though a hedging swap agreement is replaced by a new hedging swap agreement, the Board believes that the effective hedging relationship has not changed when an insubstance assignment has occurred, and no gain or loss should be recognized immediately. In practice, some contract documents refer to these changes as a novation in lieu of what this Statement refers to as an assignment or in-substance assignment. 19. To ensure equivalence between an in-substance assignment and an assignment, this Statement provides criteria for an in-substance assignment that directly affect fair value and cash flow changes. First, the terms of the original swap and the replacement swap agreements are identical, except for the change of the swap counterparty or swap counterparty s credit support provider. Second, because financial markets are constantly changing, the original swap agreement ends and the replacement swap agreement is entered into on the same date. The Board believes that any time lapse between when the original swap agreement ends and the replacement swap agreement is entered into beyond that date represents a modification of a hedging relationship. Notwithstanding these 9

17 criteria, when a swap counterparty, or a swap counterparty s credit support provider, commits or experiences either an act of default or a termination event under the swap agreement, the price to exit a swap agreement may be less than an up-front payment to enter into a replacement swap. The exit price could be less because the original swap agreement s exit price may be based on an average of multiple quotations or another computation specifically permitted under the original swap agreement. The Board concluded that such a net payment does not adversely affect the underlying hedging relationship and, therefore, in these circumstances, a net payment should not result in the termination of hedge accounting. When a swap counterparty, or a swap counterparty s credit support provider, has been replaced, some respondents to the Exposure Draft expressed concern that the term original implies that the provisions of this Statement can only be applied once to such a replacement. The Board s intent, however, was to allow serial application of this Statement whenever a swap agreement, a swap counterparty, or a swap counterparty s credit support provider, is replaced. Based on the respondent comments, the Board added explanatory footnotes to the standard to clarify this intent. 20. The Board considered whether a replacement swap agreement that has terms different from the original swap agreement also should continue hedge accounting. When a government enters into a replacement swap with different terms, the Board s view is that the government has indicated the intent to end the current hedging derivative instrument by replacing it with a new hedging derivative instrument designed to manage identified risks in a different manner. The Board concluded that this new derivative instrument may not continue to substantially offset the effects of changes in fair values or changes in cash 10

18 flows in the same manner as the original hedging derivative instrument and, therefore, should result in the termination of the application of hedge accounting. Failure to Comply with a Swap Agreement 21. The criteria in this Statement are limited to when a swap counterparty, or a swap counterparty s credit support provider, commits or experiences either an act of default or a termination event. In the development of the Exposure Draft, the Board considered extending the continued application of hedge accounting to when a government s actions lead to a termination of a hedging derivative instrument. The Board concluded, however, that a government s termination of a hedging derivative instrument without a counterparty s default demonstrates the intent to end the current hedging relationship. That government s action should result in the termination of the application of hedge accounting. Recent events indicate that credit downgrades of a swap counterparty s credit support provider have precipitated amendment or replacement of some swap agreements. The Board s research indicates that in these circumstances, inclusion of a swap counterparty s credit support provider in a swap agreement is intended to diminish a government s credit risk to a swap counterparty. Because the replacement of a swap counterparty s credit support provider in the case of a default or a termination event does not change the hedging relationship, this event is specifically identified in the criteria developed for this Statement. 22. Some respondents to the Exposure Draft believed that a government may delay replacement of a swap counterparty until the counterparty defaults so that the government could continue to apply hedge accounting. These respondents believed that this delay could create additional financial risk to the government. The Board s research indicates 11

19 that terminations of hedging swap agreements are not uncommon. These terminations may occur for a variety of reasons, such as a revised view on future interest rates or the potential for more favorable financing terms, such as employing a different reference rate. A hedging swap agreement may be terminated because there have been changes to the hedged item, such as a refunding of debt, or the likelihood that the hedged expected transaction is no longer probable, such as the cancellation of the expected issuance of debt. None of these terminations involve the default of a swap counterparty, or a swap counterparty s credit support provider. All occur by the choice of a government. The Board views these terminations as changing a government s financial position and do not suggest to the Board that there is a continuation of an effective hedging relationship. After considering the issues raised by these respondents, the Board concluded that in these situations, an effective hedging relationship has been terminated for financial reporting purposes and a potential new hedging relationship has been established. Effective Date and Transition 23. This Statement is effective for financial statements for periods beginning after June 15, Given the limited scope of this Statement, the Board believes that the effective date allows sufficient time for implementation. Some governments may wish to implement earlier than that date. Accordingly, this Statement encourages early application. 12

20 Appendix C CODIFICATION INSTRUCTIONS 24. The section that follows updates the June 30, 2010, Codification of Governmental Accounting and Financial Reporting Standards, for the effects of this Statement. * * * DERIVATIVE INSTRUMENTS SECTION D40 Sources: [Add the following:] GASB Statement [Revise subparagraph d as follows; renumber subsequent footnotes:] d. The hedging derivative instrument is terminated unless an effective hedging relationship continues as provided in this subparagraph. An effective hedging relationship continues when all of the following criteria are met: (1) Collectability of swap payments is considered to be probable. 10 (2) The swap counterparty of the interest rate swap or commodity swap, or the swap counterparty s credit support provider, is replaced with an assignment or in-substance assignment. (3) The government enters into the assignment or in-substance assignment in response to the swap counterparty, or the swap counterparty s credit support provider, either committing or experiencing an act of default or a termination event as both are described in the swap agreement. [GASBS 53, 22; GASBS 64, 4] 10 When collectability of payments is not probable, such as when a swap counterparty, or a swap counterparty s credit support provider, has entered into bankruptcy and the swap is not collateralized or does not remain insured, an effective hedging relationship does not continue. [GASB 64, 4] 13

21 [Insert new paragraph.504, including footnote, as follows; renumber subsequent paragraphs:].504 Assignment. An assignment occurs when a swap agreement is amended to replace an original 15 swap counterparty, or the swap counterparty s credit support provider, but all of the other terms of the swap agreement remain unchanged. [GASBS 64, 5] 15 A swap counterparty replaced in the current reporting period may have previously replaced another swap counterparty in the past. Accordingly, as used in this section, the term original as it applies to the swap counterparty, or the swap counterparty s credit support provider, may include a swap counterparty that has replaced the original swap counterparty or a credit support provider that has replaced the swap counterparty s original credit support provider. [GASBS 64, 5] [Insert new paragraph.528, including footnotes, as follows; renumber subsequent paragraphs and footnotes:].528 In-substance assignment. An in-substance assignment occurs when all of the following criteria are met: The original 16 swap counterparty, or the swap counterparty s credit support provider, is replaced. The original swap agreement 17 is ended, and the replacement swap agreement is entered into on the same date. The terms that affect changes in fair values and cash flows in the original and replacement swap agreements are identical. These terms include, but are not limited to, notional amounts; terms to maturity; variable payment terms; reference rates; time intervals; fixed-rate payments; frequencies of rate resets; payment dates; and options, such as floors and caps. 16 See footnote 14. [GASBS 64, 5] 17 A swap agreement replaced in the current reporting period may have previously replaced another swap agreement in the past. Accordingly, as used in this section, the term original swap agreement may include a replacement swap agreement. [GASBS 64, 5] 14

22 Any difference between the original swap agreement s exit price and the replacement swap s entry price is attributable to the original swap agreement s exit price that is based on a computation specifically permitted under the original swap agreement. Exit price represents the payment made or received as a result of terminating the original swap. Entry price represents the payment made or received as a result of entering into a replacement swap. [GASBS 64, 5] 15