The User's Perspective

May 2006


Derivatives: GASB Proposes More Transparency

            From late 2004 through 2005, the Governmental Accounting Standards Board conducted well over 100 in-depth interviews with a variety of people who use governmental financial information as a part of their work. Toward the end of each interview, an open-ended question was posed, asking if there were any issues that the GASB should be examining more closely. Virtually every interviewee involved in the municipal bond market—nearly 150 people, including bond lawyers, underwriters, and analysts at rating agencies, bond insurance firms, and mutual funds—mentioned the same issue: derivatives.

            Interestingly, derivatives were almost never mentioned in the 50 interviews with legislators, legislative staff, oversight agencies, and citizen and taxpayer groups. Although the financial community is consumed with concern about the rapid growth in recent years of government involvement with derivatives, the issue has not yet popped up on the general public’s radar screen.

            As it happens, the GASB has been studying derivatives intensively throughout this decade. In 2003, the GASB issued a staff bulletin specifying the kinds of information that governments should be disclosing in the notes to their financial statements, including their value and the risks associated with them. The GASB has now proposed new standards that would put derivatives on the financial statements themselves and add more useful information to the notes.

About Derivatives

            Some derivatives help governments to lower their borrowing costs. Some are used to reduce the possibility that a government will lose cash flows or the value of their assets in the future. Part of the explanation for the recent surge in derivatives may be the financial difficulties many governments faced in the first several years of this decade: Some derivatives are essentially investments intended to generate additional income, and some derivatives even provide governments with cash up front. In short, derivatives are perceived by governments as a way to help solve cash flow problems, to close budget gaps, or at least to attempt to reduce government costs.

            Derivatives can be very complex arrangements, in part because they are based on an entirely separate transaction, agreement, or rate. Their cash flows or value derive from what happens in the separate transaction (hence their name). From the GASB’s perspective, they also are leveraged (they require little or no initial payment from a government) and can be settled early with a net cash payment or the transfer of an equivalent asset.

            One of the most common derivatives is called an “interest rate swap.” Swaps typically are related to variable-rate debt (bonds with an interest rate that rises and falls as market interest rates change). A government enters into a derivative (typically with a private financial firm) in which it agrees to pay a steady interest rate to the firm, usually larger than the interest it currently pays on the variable-rate debt. In return, the firm agrees to pay the government an amount that is expected to offset the government’s interest payments to the owners of the bonds—an amount that changes as market interest rates change. Many governments have found that issuing variable-rate debt and entering a swap results in lower borrowing costs than if they only had issued debt with a fixed interest rate. If the derivative performs as planned, the government should also be protected from rising interest rates—no matter how high they rise, the government should pay no more than the fixed rate it promised the firm.

            Consider a government that issues variable-rate debt based on an accepted market index, which was 4.00 percent at the time. It enters into a derivative, agreeing to pay a firm 4.50 percent in return for a variable payment based on the same index as the debt. The firm always pays the government an amount equal to the interest payments the government has to make to the buyers of the bonds. If market rates were to rise to 7.00 percent, the firm would pay the government the same 7.00 percent the government has to pay the bond holders. Because the firm’s payment covers the government’s interest payments on the bond, the government essentially has locked in its interest payments at 4.50 percent—the amount it pays the firm.

The Concerns That Derivatives Prompt

            Although a government may enter into a derivative with prudent intentions, the derivative itself potentially exposes a government to risks that it otherwise would not face. That means a derivative intended to lower spending or to reduce a government’s exposure to risk could end up costing a government more than expected. Understanding such risks could be important for a state legislator or city council member, for instance, who is trying to identify what resources will be available to fund programs. Likewise, a taxpayer association concerned that taxes would have to be raised or services reduced, or a municipal bond analyst evaluating a government’s ability to make its debt service payments when they come due, would want to know about potential losses.

            The public is largely unaware of derivatives. Until the GASB’s 2003 pronouncement, governments generally did not disclose any information about their derivatives. Even today, derivatives usually do not appear in the financial statements. The GASB has been working to fill that information gap.

GASB’s Proposals

            At the end of April the GASB published a Preliminary Views document, Accounting and Financial Reporting for Derivatives, that proposes to place the value of derivatives, and changes in that value from year to year, on the financial statements. In general, the fair value of a derivative would appear on the balance sheets (such as the statement of net asset) as an asset or liability, depending on whether the derivative represents a resource (positive value) or a claim on resources (negative value), respectively. In the case of derivatives, fair value generally is the price at which the derivative can be terminated. The annual change in that derivative’s fair value would be reported as an increase or decrease in investment income in the change statements (such as the statement of revenues, expenditures, and changes in fund balances) with an important exception.

            If a government enters into a derivative (such as the interest rate swap described above) with the intention of hedging (reducing) a specific potential risk of loss of value or cash flows, then the reporting may be different.

            If a derivative is intended to hedge a specific risk associated with an item that is not reported at fair value in the financial statements (such as debt, which is reported at historical or original cost) and the derivative is effectively hedging that risk, then the annual changes in the derivative’s value would be deferred. In other words, the value changes would appear in the balance sheets as deferred credits (accumulated increases in fair value) or deferred charges (accumulated decreases in fair value), rather than being reported as gains or losses in the change statements. When the derivative ends, is terminated, or stops being effective, any accumulated changes remaining would then generally run through the change statements.

            The GASB proposal lays out acceptable methods governments may use to determine if a derivative is effectively hedging risk. The GASB specifies the parameters within which a derivative is considered an effective hedge for financial reporting purposes and therefore eligible for deferring fair value changes.

New Note Disclosures

            The current note disclosure requirements apply only to derivatives that are not being reported at fair value in the financial statements—which, at present, is most derivatives. However, because the GASB would require the fair value of derivatives to be reported in the financial statements, it is proposing that those disclosure requirements be extended to derivatives in general.

            The GASB also is proposing new disclosures, including:

  • Which of the approved methods a government used to evaluate the effectiveness of its hedging derivative
  • The actual critical values that resulted from the government’s assessment of hedge effectiveness—in other words, the actual number that was calculated using one of the approved methods for assessing effectiveness
  • The amount of ineffectiveness, if any, in a derivative that is a hedge (even if a derivative falls within the parameters to be considered effective for financial reporting purposes, it still may not be perfectly effective)
  • Changes in the fair value of a government’s derivatives during the year—starting with the beginning value, adding new derivatives and removing those that ended, and adding the change in value during the year to reach the final value that is reported in the financial statements.

Learn More about the Proposals

            To help people who are not accountants understand its proposals, the GASB has prepared a plain-language supplement that summarizes them with a minimum of technical jargon and a focus on the information that governments would present to the public. The plain-language supplement can be downloaded free from the GASB Web site. (If you do not have Adobe Reader, you can get it free by clicking on this link.)

            The supplement should be read in conjunction with the Preliminary Views document, which explains the proposals and the reasoning behind them in greater detail. The document also contains illustrations of how derivatives would be reported in governmental financial reports. The supplement refers to several of the illustrations in the Preliminary Views document, which also can be downloaded free.

            The GASB staff will be making presentations about the proposals and answering questions at meetings of several organizations that represent users of governmental financial information, including:

See the GASB’s calendar of speaking engagements for a complete list.

Let the GASB Know What You Think

            Setting standards that result in governments giving the public the information it needs depends on the potential users of that information providing input about how useful it is to them. The GASB will be soliciting feedback on its proposals through the end of July and strongly encourages the users of governmental financial information to get involved.

            There are a variety of ways you can share your comments with the GASB:

  • Use the GASB’s Internet comment form—clicking on this link will take you to an on-line form for submitting your feedback.
  • Send feedback by email (director@gasb.org) or traditional mail (Director of Research and Technical Activities, Project No. 26–4P, Governmental Accounting Standards Board, 401 Merritt 7, P.O. Box 5116, Norwalk, CT 06856-5116).
  • Participate in a panel discussion on July 10 in New York City—panels will be composed of persons with different perspectives, such as a user of governmental financial information, a preparer of financial statements, an auditor, and someone from the derivatives community.
  • Take part in an open roundtable discussion, especially intended for users of governmental financial information, to be held on July 10 in New York City .
  • Testify at one of two public hearings—in San Diego on June 21 or in New York City on July 10.

Full details of how to submit feedback by any of these methods can be found in the plain-language supplement and the notice to recipients at the front of the Preliminary Views document.