Derivatives challenges with GASB 53

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1 Derivatives challenges with GASB 53 P2F2 Financial Forum 28 October 2014

2 Disclaimer The views expressed by presenter(s) are not necessarily those of Ernst & Young LLP. These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice. Page 1

3 Objectives Identify the characteristics of a derivative instrument Understand the methods of evaluating hedge effectiveness Understand the events that lead to the termination of hedge accounting Identify the financial reporting requirements for derivative instruments Page 2

4 Background Page 3

5 Why governments hedge Page 4

Characteristics of a derivative instrument Governmental Accounting Standards Board (GASB) 53, Accounting and Financial Reporting for Derivative Instruments, became effective for financial statements

6 Characteristics of a derivative instrument Governmental Accounting Standards Board (GASB) 53, Accounting and Financial Reporting for Derivative Instruments, became effective for financial statements for periods beginning after 15 June It was first implemented for governments with 30 June 2010 year-ends. It s been more than four years since first implemented. What are governments still struggling with? Page 5

7 Characteristics of a derivative instrument Page 6

8 Characteristics of a derivative instrument Settlement factors Derivative instrument Net settlement Leverage Page 7

9 Scope of standard What s in? Swaps Futures Forwards Options (cap, floor, collar) Swaption (option to enter into a swap) Page 8

10 Scope of standard What s out? Normal purchases, normal sales contracts Insurance contracts accounted for under GASB 10 Certain financial guarantee contracts Certain contracts that are not exchange traded Loan commitments For derivative instruments reported in financial statements prepared using the current financial resources measurement focus, GASB 53 should not be applied Page 9

11 Evaluating hedge effectiveness Page 10

12 Evaluating hedge effectiveness Two types of hedges: Cash flow Fair value Page 11

13 Evaluating hedge effectiveness Cash flow hedge: Fair value hedge: Address risks that arise due to variable prices or rates Manage risks by eliminating variable or market fluctuations to which the cash flows of the associated item are subject: Most hedges undertaken by governments are cash flow hedges. Pay-fixed, receive-variable interest rate swap Address risks of changes in fair values of items that have prices or rates that are fixed or known Manage risks by unlocking fixed prices and rates, thereby allowing item to be valued as if it had current market rate/price Pay-variable, receivefixed interest rate swap Page 12

14 Evaluating hedge effectiveness Four methods to evaluate effectiveness: Consistent critical terms Synthetic instrument Dollar-offset Regression Page 13

15 Evaluating hedge effectiveness 1. Consistent critical terms: Evaluates effectiveness with qualitative considerations Same characteristics: Notional amount/quantity Zero fair value Net settlement Reference rate/benchmark rate Payments occurring over same period of time No floor or cap Time interval reference rate Rate reset days Payment dates Delivery location Page 14

16 Evaluating hedge effectiveness 2. Synthetic instrument: Combining the hedgeable item and the potential hedging derivative instrument to simulate a third synthetic instrument Limited to cash flow hedges in which the hedgeable items are interest bearing and carry a variable rate Effective if the actual synthetic rate is substantially fixed (90% to 111%) Page 15

17 Evaluating hedge effectiveness Synthetic instrument example Pay fixed 5% Government Counterparty Pay variable auction rate Receive variable 50% LIBOR + 80 bp Bondholders Page 16

18 Evaluating hedge effectiveness Synthetic instrument example (continued) Government Pay fixed 5% Counterparty Fixed rate 5.00% (Receive variable rate) -4.55% Net payment 0.45% Pay variable auction rate Receive variable 50% LIBOR + 80 bp Pay variable on bonds 4.30% Synthetic rate 4.75% Bondholders Synthetic rate/fixed rate 4.75%/5.00% 95.00% Effective Page 17

19 Evaluating hedge effectiveness 3. Dollar-offset: Compares the changes in expected cash flows or fair values of the potential hedging derivative instrument with the changes in expected cash flows or fair values of the hedgeable item Effective if within a range of 80% to 125% Page 18

Evaluating hedge effectiveness Dollar-offset example: In March 2014, the government enters into a supply contract for the purchase of natural gas of 100,000 MMBTUs in December 2014 at the Chicago

20 Evaluating hedge effectiveness Dollar-offset example: In March 2014, the government enters into a supply contract for the purchase of natural gas of 100,000 MMBTUs in December 2014 at the Chicago Citygate spot price. Government enters into forward purchase contract for natural gas of 100,000 MMBTUs in December Government will pay fixed price of $10.00 per MMBTU and receive the spot rate at Henry Hub. Page 19

21 Evaluating hedge effectiveness Dollar-offset example (continued) March June 2014 Chicago Citygate December forward price $ $ Henry Hub December forward price March June 2014 Change Expected cash flow Chicago Citygate $ (5,000) $ (57,000) $ (52,000) Expected cash flow Harry Hub (46,000) (46,000) $ (52,000) $ (46,000) = 113% Effective Page 20

22 Evaluating hedge effectiveness 4. Regression: Consider the statistical relationship between the cash flows or fair values of the potential hedging derivative instrument and the hedgeable item. The changes in cash flows or fair values of the potential hedging derivative instrument substantially offset the changes in cash flows or fair values of the hedgeable item if all of the following criteria are met: The R-squared of the regression analysis is at least The F-statistic calculated for the regression model demonstrates that the model is significant using a 95% confidence interval. The regression coefficient for the slope is between and Page 21

23 What are the pros and cons? Method Pros Cons Consistent critical terms Easy to implement Little flexibility Synthetic instruments Relatively easy to implement In differing rate environments, could fall out of range Dollar offset Regression analysis Conceptually easy to implement (hypothetical perfect trade) Favorite among Accounting Standards Codification (ASC) 815 Unpredictable and subjective if hedging and hedged rates do not move in tandem Relatively harder to implement; needs statistical knowledge and proper number of data points Page 22

24 Evaluating hedge effectiveness Hybrid instruments Derivative instrument + Companion Instrument (debt, lease, insurance contract) Embedded derivative instrument: Call option in a bond Cap or floor in a sale or purchase contract Interest rate swap in a debt instrument Page 23

25 Termination of hedge accounting Page 24

26 Termination of hedge accounting Hedge accounting should cease to be applied if: The hedging derivative instrument is no longer effective. The likelihood that a hedged expected transaction will occur is no longer probable. The hedged asset or liability, such as a hedged bond, is sold or retired but not reported as a current refunding or advanced refunding resulting in a defeasance of debt. The hedging derivative instrument is terminated (exception, GASB 64). A current refunding or advanced refunding resulting in the defeasance of the hedged debt is executed. The hedged expected transaction occurs, such as the purchase of an energy commodity or the sale of bonds. Renegotiating or amending a critical term of a hedging derivative instrument terminates hedge accounting. Page 25

27 Termination of hedge accounting Financial reporting at termination: The balance in the deferral account should be reported on the flow of resources statement within the investment revenue classification. If reported separately within investment revenue, the removal of the balance in the deferral account should be captioned increase (decrease) upon hedge termination. Reapply hedge accounting? Hedge accounting should not be reapplied to that hedging relationship. A derivative instrument from a terminated hedge, however, may be employed as a hedging derivative instrument in a new hedge. Page 26

28 Financial reporting and disclosures Page 27

29 Financial reporting requirements for derivative instruments Financial reporting recognition and measurement Investment derivative Recorded at fair value with changes in fair value reported within the investment revenue classification on the flow of resources statement Hedging derivative Recorded at fair value with changes in fair values reported as either deferred inflows or deferred outflows in the statement of net assets Economic resource method Economic resource method Page 28

30 Disclosures for derivative instruments Summary disclosures Organized by governmental activities, business-type activities and fiduciary funds Information should then be divided into the following categories: Hedging derivative instruments (distinguishing between fair value hedges and cash flow hedges) Investment derivative instruments Within each category, derivative instruments should be aggregated by type (examples include receive-fixed swaps, pay-fixed swaps, swaptions, rate caps, basis swaps or futures contracts). Information to be presented: Notional amount Fair value and changes in fair value during the reporting period and where those changes in fair value are reported Fair value based on other than quoted market prices, with the methods and significant assumptions used to estimate those fair values disclosed Fair values and deferral amount of derivative instruments reclassified from a hedging derivative instrument to an investment derivative instrument Page 29

31 Financial reporting requirements for derivative instruments Hedging derivative instrument disclosures: Objectives Terms: Notional amount Reference rate Embedded options, caps, floors or collars Date entered into and date scheduled to terminate Amount of cash paid or received when entered into Page 30

32 Financial reporting requirements for derivative instruments Hedging derivative instrument disclosures (continued): Risks: Credit Interest rate Basis risk Termination risk Rollover risk Market-access risk Page 31

33 Financial reporting requirements for derivative instruments Investment derivative instrument disclosures: Risks: Credit risk Interest rate risk Foreign currency risk Page 32

34 Financial reporting requirements for derivative instruments Other disclosures: Contingent features: Existence and nature of contingent features and the circumstances in which the features could be triggered Fair value of derivative instruments that contain those features Fair value of assets required to be posted as collateral Amount of collateral posted Hybrid instruments: Disclosures of the companion instrument should be consistent with disclosures required of similar transactions, for example, disclosures for debt instruments. Synthetic guaranteed investment contracts (SGIC): For SGIC that is fully benefit-responsive: Description Fair value Page 33

35 Appendix A Characteristics of a derivative instrument Page 34

36 Characteristics of a derivative instrument Definition of a derivative instrument: Settlement factors: One or more reference rates One or more notional amounts, payment provisions, or both Leverage: Requires no initial net investment 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 Net settlement: Its terms require or permit net settlement. Page 35

Settlement factors Reference rates The price or index of a security or commodity An interest rate or interest rate index A foreign exchange rate or index A measure of

37 Settlement factors Reference rates The price or index of a security or commodity An interest rate or interest rate index A foreign exchange rate or index A measure of creditworthiness (e.g., Moody s rating) An insurance index or catastrophe loss index: A climatic or geological condition (temperature, earthquake severity, or rainfall) Page 36

38 Settlement factors Notional amount A number of: Currency units Shares Bushels Pounds Other units (Applied to the underlying to determine settlement price X no. of shares) Page 37

39 No initial net investment (or a small value) A derivative requires either: No initial net investment An initial net investment (after adjustment for the time value of money) that is less, by more than a nominal amount, than the initial net investment that would be commensurate with the amount that would be exchanged to acquire the asset (or incur the obligation) related to the underlying Some derivative instruments require an initial net investment as compensation for the time value of an option or for terms that are more or less favorable than market conditions. It does not require initial net investment of the notional amount. Page 38

40 Net settlement three ways to meet requirement 1. Net settlement by terms of the contract itself (cash or other assets) 2. Net settlement by market mechanism 3. Delivery of a derivative or an asset that is readily convertible to cash (such as actively traded/liquid securities, commodities and foreign currencies) Page 39

41 Appendix B Regression approaches Page 40

42 Evaluating hedge effectiveness Three potential regression approaches 1. Settlement: Settlement date remains the same for all data points. Tenor (duration) changes (one-month forward price, two-month forward price) P r i c e Date Page 41

43 Evaluating hedge effectiveness Three potential regression approaches 2. Declining maturity: Gradually removes the time value factor just as we would expect to happen as the derivative approaches maturity P r i c e Date Page 42

44 Evaluating hedge effectiveness Three potential regression approaches 3. Constant maturity: The current terms of the hedge are treated as static. Forward curve tenor remains the same always 12-month forward spot price. P r i c e Date Page 43

45 Appendix C Hybrid instruments Page 44

46 Evaluating hedge effectiveness Hybrid instruments: The companion instrument is not measured at fair value. A separate instrument with the same terms would meet the definition of a derivative instrument. The economic characteristics and risks of the derivative instrument are not closely related to the economic characteristics and risks of the companion instrument: Up-front payment with off-market terms Written option that is in the money Inconsistent reference rate Potential negative yield Leverage yield Page 45

47 Evaluating hedge effectiveness Accounting for hybrid instruments Embedded derivative instrument + Companion instrument GASB 53 Standard applicable to companion instrument (debt, lease, insurance) Page 46

48 Evaluating hedge effectiveness Up-front payment with off-market terms (valuation): Fixed swap rate is the break-even rate that sets the present value of the fixed payments equal to the present value of the expected floating rate, e.g., London Interbank Offered Rate (LIBOR) payments: Price or value of a swap = present value of fixed leg present value of floating leg Price of an at-the-market swap = 0 An off-market swap has value to one party and requires an up-front cash payment to compensate for the off-market rate Page 47

49 Evaluating hedge effectiveness Up-front payment with off-market terms (interest rate swap): Embedded derivative instrument is measured first. Remaining balance is affiliated to the value of the debt. Embedded derivative instrument + Companion instrument At-the-market swap Above-market portion treated as debt Page 48

50 Termination of hedge accounting Challenge association with new hedgeable item Issue: The swap is now off-market and the fair value (FV) of the derivative does not equal the balance in the deferral account (previous changes were recorded in investment revenue). Two approaches: Hybrid instrument approach Straight-line amortization over the life of the swap At-the-market swap treated as the potential hedging derivative instrument Above-market portion treated as a borrowing Amortized over life of the swap Compute a reconciling difference so that the FV of the swap ending balance and the deferral ending balance align correctly See GASB Q&A Illustrations 5.2 Other Illustrations: Off-Market Swap Page 49

51 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US Ernst & Young LLP. All Rights Reserved. CSG no. ED None

Statement No. 53 of the. Governmental Accounting Standards Board. Accounting and Financial Reporting for Derivative Instruments

Statement No. 53 of the. Governmental Accounting Standards Board. Accounting and Financial Reporting for Derivative Instruments NO. 279-B JUNE 2008 Governmental Accounting Standards Series Statement No. 53 of the Governmental Accounting Standards Board Accounting and Financial Reporting for Derivative Instruments Governmental Accounting