Proposed Accounting
for Derivatives
Why Is It So Hard?
Different instruments & countless products
Discounting, present value, yield curve, implied
forward rate,
volatility, option pricing, gamma, theta
Jargon
Hedging: offsets versus outcomes
Accounting model
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Mixed attribute model
Expected transactions are not recognized in
the accounting model
Examples of Jargon
Caps, Collars, Floors
Spark spread
Crack spread
GASB Environment—
Derivative Users
Pensions and endowments: foreign
exchange derivatives
Utilities and transit agencies: energy
derivatives
Governments active in debt market:
interest rate swaps
No investment banks
Some History
Technical Bulletin 94-1, Disclosures about
Derivatives and Similar Debt and Investment
Transactions
Statement No. 31, Accounting and Financial
Reporting for Certain Investments and for
External Investment Pools
Technical Bulletin 2003-1, Disclosure
Requirements for Derivatives Not Reported at
Fair Value on the Statement of Net Assets
GASB Documents
GASB’s Preliminary Views document,
Accounting and Financial Reporting for
Derivatives
Plain Language Supplement, Accounting
and Financial Reporting for Derivatives
Both issued March 31, 2006 and available at
www.gasb.org
What is a Derivative for Financial
Reporting Purposes?
A derivative has:
1. One or more reference rates (underlyings)
and one or more notional amounts
2. Leverage
3. Net settlement
Examples of Derivatives
Interest rate swap
 Variable-rate to fixed-rate
 Fixed-rate to variable-rate
Basis swap
 Exchange payments based on the changes of two
variable rates
Swaption
 Gives the purchaser of the option the right, but not the
obligation, to enter into an interest rate swap
Commodity swap
 Reduce exposure to a commodity’s price risk
Hybrid Instruments
Hybrid instruments consist of a companion
instrument (not measured at fair value) and a
derivative (measured at fair value)
This is a substance over form issue: A derivative
should be treated as a derivative regardless of
whether it is a stand-alone instrument or
included in another instrument, such as a bond,
insurance contract, or a purchase or sale
contract
Example: off-market swap. That is, a swap that
presents a government with an up-front
payment.
Excluded Instruments
Normal purchases & normal sales
contracts

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Commodity (e.g., gas or electricity)
Govt. intends to and has practice of taking
delivery or selling commodity
Quantity is consistent with volume used
Traditional insurance contracts
Traditional financial guarantee contracts
Non exchange-traded climate contracts,
liquidated damages, etc.
Fair Value
Based on either:
Market-observed prices or
Models, such as from a Bloomberg
terminal
Proposed Accounting
Fair value with hedge accounting
Derivatives would be measured on the balance
sheet at fair value
Fair value changes would be reported on the
“change statement” as investment income
Exception: Effective HEDGES!
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Changes in fair value of derivative would be reported
on the balance sheet as deferrals—either deferred
charges or deferred credits
Swap asset, deferred credit
Swap liability, deferred charge
Hedge Financial
Statement Presentation
Statement of net assets
Cash
Deferred outflow
Swap liability
Change statement
Interest expenditure/expense
Year 1
Year 2
$5,000
$5,000
($6,000)
$0
$0
$0
$6,000
Drivers of the
Proposed Accounting
Derivatives should be measured at fair value
If it is an effective hedge,
hedge accounting should be applied
Effective hedge is found using one acceptable
method of evaluating hedges
If method subsequently renders hedge
ineffective, “may” use another method
Up-front payments to a government may
represent borrowings
Fair Value with Hedge
Accounting
Pros

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Fair value recognize the economic reality of the
transactions
Deferrals recognize the effects of a mixed-attribute
model and that fair value gains and losses relate to
future periods
Reduces volatility in the change statements
Cons

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Suspend normal accounting conventions—change
statement does not reflect the economic substance of
the transaction
Deferrals would not meet the traditional definitions of
assets and liabilities
Complexity—need to develop qualifying criteria
What is a Hedge?
Hedging instrument is a derivative
Derivative is associated with a hedgeable
item
The hedge is effective
No need to document Management’s
intent

Facts & circumstances
Hedgeable Items
Single asset or liability
Groups of similar assets or liabilities—
same risk exposure
Expected transaction—occurrence is
probable
Intra-entity transactions do not qualify for
hedge accounting
Is a Hedge Effective?
Methods of Evaluating Hedges
Consistent critical terms
Synthetic instrument
Quantitative techniques

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Linear regression
Dollar offset
Others?
Consistent Critical Terms
Method
Notional and principal amounts the same
Fair value of derivative is zero at date of
inception
No modifications to net settlements
Benchmark rates based on the same
index—BMA to BMA
Additional terms based on


Fair value
Cash flow
Consistent Critical
Terms Method
Little or no ineffectiveness is expected
Retained—The PV addressed interest rate
hedges (based on FAS 133’s shortcut
method)
Added—hedges that employ options
(caps, floors, and collars), forwards, and
futures. (Text tentatively based on FAS
133, paragraph 65—Easy Pass)
Consistent Critical
Terms Method
An example:
Hedged
Principal/notional
Term
Payments
Variable payment
Debt
$1,000
10 years
Every 6 months
BMA
Hedging
Derivative
$1,000
10 years
Every 6 months
BMA
Synthetic Instruments Method
Based on notion that the combined cash
flows of a swap and hedged debt create a
third instrument—a synthetic instrument


Synthetic fixed-rate bond
Synthetic variable-rate bond
Comes from Consistent Critical Terms
Approach, but used when benchmark
rates are not the same—% of LIBOR swap
Synthetic Instruments Method
Uses the fixed-leg of the swap as the fixed
leg. As long as actual payments travel
within a range of 90% to 111% of the fixed
leg, the hedge would be considered to be
effective.

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Swap-based hedge should use the fixed
payment of the swap
Commodity hedges would use the fixed rate
established by the hedge
Quantitative Techniques
Methods
Dollar offset
Regression analysis
Dollar Offset
Changes of the hedged item are offset by
changes of the hedging derivative

Change in fair values or cash flows of the
hedging derivative divided by the same
changes of the hedged item should be within
the range of 80 to 125 percent
Evaluation may be done on either a
periodic or cumulative basis
Dollar Offset Example
Hedged debt
Interest rate swap
Fair Value
Change
$1,000
(1,150)
($1,000/$1,150)
86.96%
Regression
Evaluation of the hedge should indicate that
the hedged item and the hedging derivative
regress such that:
R-squared statistic must be 0.80 or higher
F-statistic 95 percent confidence interval
Slope coefficient between –1.25 and –0.80
Disclosures
Similar derivatives may be aggregated
Summary of derivative activity by:
1)
2)
3)
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Govt. activities, business-type activities, and
fiduciary activities
Then fair value hedges, cash flow hedges, and
investment derivatives
Then type
Notional amount
Fair values & changes and where reported
Fair values & amounts reclassified from hedge to
investment
Disclosures
Disclosures for HEDGING derivatives
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Application of TB-2003 disclosures
Significant terms
Risks: Credit, Interest Rate, Basis,
Termination, Rollover, Market-access, Foreign
Currency
No disclosure of hedge ineffectiveness
Disclosures for INVESTMENT derivatives

Risks: Credit, Interest Rate, Foreign Currency
Disclosures
Contingencies (e.g., collateral posts)
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Fair value of derivatives with feature
Amount of all potential settlements
Amounts posted
Hedged debt
Synthetic guaranteed investment contracts
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Description and nature
Fair values
Wrapper
Underlying investments
Summary
Derivatives would be reported on the balance
sheet and measured according to their fair
values. Fair value changes would be reported on
the change statement, provided a derivative is
not a hedging derivative.
If a derivative is a hedging derivative, its fair
value changes would be deferred on the balance
sheet until the hedged transaction occurs.
Test hedge effectiveness
Disclose
Looking Forward
Exposure Draft second quarter of 2007
Final standard second quarter of 2008
Proposed Standard would be effective for
reporting periods beginning after June 15,
2009
Retroactive
Questions?
Randal Finden—203.956.5240
rjfinden@gasb.org
Web site—www.gasb.org
The views expressed in this presentation are those of the
GASB’s staff. Official positions of the GASB are determined
only after extensive due process and deliberation