The User's Perspective
Derivatives: Significant Changes in Disclosure Proposals
As reported in the May 2006 issue of The User’s Perspective, the GASB issued a Preliminary Views document, Accounting and Financial Reporting for Derivatives, which proposed bringing the fair value of derivatives onto the financial statements of state and local governments. The key aspects of the proposal were:
- Report the fair value of derivatives in the balance sheets.
- For a derivative that is an effective hedge against the loss of fair value or cash flows, the changes in fair value would not be reported immediately as investment income but would be reported in the balance sheets as deferrals until the derivative ends or becomes ineffective; at that point, any remaining deferrals would be reported as investment income in the change statements.
- For a derivative that is either ineffective or associated with an investment carried at fair value, the changes in the fair value of the derivative would be reported as investment income.
The Preliminary Views described the procedures for assessing whether a derivative is an effective hedge. It also proposed a variety of disclosures regarding a government’s derivatives and the risks those derivatives expose the government to.
One year later, after considerable public input and extensive deliberation, the GASB has decided to proceed with the basic approach outlined above. However, numerous changes have been made to address concerns expressed during the public comment period, which will be evident when the GASB issues an Exposure Draft of a proposed Statement in June. In particular, significant changes were made to the note disclosures, which are the subject of this article.
Quick Review: What Are Derivatives Again?
Governments are increasingly entering into derivatives, a type of financial instrument, either as an investment vehicle or in an effort to minimize financial risks. Derivatives are unique in that their values or cash flows are determined by the performance of a separate instrument, agreement, or transaction. Perhaps the most common type of derivative employed by governments is the interest-rate swap.
Some governments have found that entering an interest rate swap and issuing variable-rate debt results in lower borrowing costs than if they had issued debt with a fixed interest rate without a derivative. In a pay-fixed, receive-variable swap, a government pays a fixed interest rate to a financial firm, usually larger than the rate it pays on the variable-rate debt, and in return, the firm pays the government a variable rate equal to that of the debt. This kind of swap hedges against rising interest rates—in other words, it protects the government from having to pay higher debt service.
Some derivatives are structured to provide an up-front cash payment to the government from the other party. The payment arrangements or terms of the derivative agreement provide for the repayment of the up-front cash. The cash payment is essentially a loan to the government and would therefore be reported as a liability, apart from the related derivative.
The risks associated with derivatives
Although many derivatives are hedges intended to lower the risk of losing cash flows or asset value, derivatives also expose governments to certain risks. For example, the possibility that the firm will not make its payments to the government is called credit risk. The chance that a derivative may end earlier than expected and re-expose the government to the risks it was trying to avoid is known as termination risk. The existence of these risks is an important rationale for standards that require governments to report their derivatives to the public. Risks aside, derivatives may have an impact on a government’s overall financial well-being—some are assets that a government may be able to draw on, while others are liabilities for which a government may be on the hook. Considered together, a government’s derivatives may represent very significant resources or obligations.
Proposals for Note Disclosures
The Exposure Draft to be issued in June is expected to propose that governments present a note to the financial statements that begins with a summary of their portfolio of derivatives. This new proposal recognizes the difficulties that financial statement users have had trying to sort out the lengthy narrative notes presented by some governments with many derivatives. The summary would be organized as follows:
- Derivatives first would be divided among those associated with a government’s governmental activities, business-type activities, and fiduciary activities.
- Within each of those three groups, individual derivatives would be aggregated by type—fair value hedges, cash flow hedges, and investments.
The summary would include the following information about the derivatives:
- Notional amount (that is, the amount—stated in dollars, shares, gallons, and so on—on which payments depend)
- Fair value and the locations in the financial statements where it is reported (this disclosure will be helpful because the amounts disclosed in the notes are included within larger numbers in the financial statements)
- Changes in fair value during the year and the locations in the financial statements where they are reported
- The fair value of derivatives that were reclassified from a hedge to an investment
- The amount removed from the deferred inflows and outflows in the balance sheets and reported as investment income (for instance, because a derivative ended or was no longer effective).
For derivatives that are hedges, governments also would disclose:
- The objectives for entering into the derivative
- Significant terms, such as notional amount, rates or indexes the derivative is based upon, options, starting and ending dates, and the amount of cash that changed hands when the derivative was initiated
- The net cash flows of the hedging derivative if the item being hedged is debt
- The risks to which the derivative exposes the government.
One significant change from the proposals in the Preliminary Views is that governments would disclose when their investment derivatives expose them to credit risk, but otherwise investment derivatives would be disclosed like other investments (according to GASB Statement No. 40, Deposit and Investment Risk Disclosures). The GASB received comments that the Preliminary Views requirements were duplicative for investment derivatives and therefore the resulting disclosures could be particularly extensive and costly for pension funds and other governmental entities with a large number of derivatives in their investment portfolios.
Another new disclosure proposed in the Exposure Draft relates to contingent liabilities included in derivatives. An example of such a contingent liability is a requirement that a government post collateral if its credit rating declines. A government with a derivative containing a contingent liability would describe the contingency and the circumstances that would trigger it and disclose the total fair value of all derivatives containing contingent liabilities, the total amount it would have to post as collateral if the triggering circumstances occurred, and any amounts it posted as collateral during the year.
Other disclosure changes
The Preliminary Views proposed disclosures related to the process of evaluating the effectiveness of hedging derivatives. The Exposure Draft does not include the Preliminary View’s disclosures of the method used to evaluate effectiveness and the results of the evaluation. Governments also would not have to calculate and disclose the amount of ineffectiveness in hedging derivatives that are determined to be effective, as the Preliminary Views had proposed. Very few of the financial statement users that commented on the Preliminary Views stated that these disclosures would be useful to them. In light of comments the GASB received stating that implementing the ineffectiveness disclosure could be costly, the benefits of these disclosures did not seem sufficient.
Other Changes in the Exposure Draft
In addition to changes in the required disclosures, the GASB made a number of other revisions in response to public comments. Perhaps most significantly, the Exposure Draft would allow governments to employ methods of evaluating whether hedging derivatives are effective other than those identified in the standards, as long as those methods meet qualifying criteria.
For a derivative to be considered a hedge in the first place, the Preliminary Views would have required that the government’s stated objective for entering into the derivative be to hedge an identifiable risk. However, because of potential difficulties documenting that objective, the GASB dropped the criterion, though governments would still disclose the objectives of their derivatives in the notes.
One type of derivative—synthetic guaranteed investment contracts (SGICs)—would be reported at contract value, rather than fair value. This is consistent with the fact that annual gains and losses on SGICs are not immediately reported in the financial statements but are spread over the remaining life of the investments that underlie them.
How You Can Help Shape the Derivatives Standards
The Exposure Draft is expected to be posted to the GASB website, www.gasb.org, at the end of June. To assist financial statement users, the GASB again is preparing a plain-language supplement that is much shorter and uses much less technical jargon. The supplement also will be offered on the GASB website. An Internet-based form will be available for sharing your views with the GASB regarding the proposed standards. The feedback of financial statement users is essential to ensuring that the proposals meet their needs for information about derivatives.
- Derivatives project page on the GASB website (includes the project work plan, minutes of Board discussions, and other information).