Andy Richards

Identifying Derivative Instruments

The Statement provides accounting and financial reporting guidance for nearly all varieties of derivative instruments, whether they are used to hedge risks or for investment purposes. The most common types of derivative instruments used by governments include interest rate and commodity swaps, interest rate locks, options (caps, floors and collars), forward contracts and futures contracts. However, derivative instruments are also structured in many different forms including hybrid instruments that contain companion instruments, such as a lease or debt instrument, in addition to an embedded derivative instrument, such as a call option or interest rate swap. Governments must carefully evaluate the details of any contractual arrangement to ensure all derivative instruments are identified, accounted for and appropriately reported in the financial statements. Identifying which arrangements contain derivative instruments will likely be the biggest challenge for many financial statement preparers while implementing the new Statement.

Preparers should focus on the characteristics of an arrangement, i.e., its substantive nature, rather than its given name to determine whether it is a derivative instrument. The Statement defines a derivative instrument as a financial instrument or other contract having all of the following characteristics:

• Settlement factors. It has one or more reference rates and one or more notional amounts or payment provisions or both.
• Leverage. It requires no initial net investment or an initial net investment 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; it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

The Statement, however, should not be applied to certain financial instruments that are normal purchases or sales contracts, traditional insurance and financial guarantee contracts, certain contracts that are not exchange-traded or loan commitments, as described in the Statement.

Measurement & Recognition

Once preparers have identified a derivative instrument, applying the measurement and recognition guidance in the Statement becomes relatively less complex. Derivative instruments—with the exception of synthetic guaranteed investment contracts that are fully benefit-responsive—are always measured on the statement of net assets at fair value either as an asset or a liability. The changes in fair value should be reported as part of investment income during the period of the change, except when a derivative qualifies as a hedging derivative instrument. The changes in fair value of hedging derivative instruments should be reported on the statement of net assets as either deferred charges or credits for as long as the hedge remains effective.

Hedging Derivative Instruments

A derivative qualifies as a hedging derivative instrument, and must be accounted for as such, if it is associated with a hedgeable item and is effective in providing changes in cash flows or fair values that substantially offset the cash or fair value changes of the hedgeable item. Hedgeable items include:

• A single asset or liability
• Groups of similar assets or liabilities that share the same risk exposure
• An expected transaction for which occurrence should be probable
• Specific risks of financial instruments, such as interest rate and credit risks

The Statement describes one qualitative method (the consistent critical terms method) as well as three quantitative methods (the synthetic instrument, linear regression and dollar offset methods) for evaluating whether a derivative instrument is an effective hedge. Specific guidance on the choice of method, the frequency at which evaluations of hedge effectiveness should be performed and accounting for terminations of hedging derivative instruments is included in the Statement. Unlike the guidance for nongovernmental entities, accounting for a derivative instrument as a qualifying effective hedge when it meets the criteria is required by the Statement, rather than optional. Also unlike the requirements for nongovernmental entities, the Statement does not contain a requirement that the hedging relationship be formally documented to qualify as an effective hedge.

Disclosure Requirements

The disclosures required by GASB Technical Bulletin No. 2003-1, Disclosure Requirements for Derivatives Not Reported at Fair Value on the Statement of Net Assets, have been incorporated into the Statement. In addition, the Statement requires that disclosures include a summary of derivative instrument activity that indicates the location of fair value amounts reported on the financial statements. Also, certain disclosures are required by the Statement for investment derivative instruments, which are similar to the disclosure requirements for other investments. Finally, for hedging derivative instruments, the hedge objectives, terms and risks should be disclosed.

Transition

The Statement is effective for financial statements for periods beginning after June 15, 2009. Earlier application is encouraged. Specific transitional guidance is provided in the Statement for potential hedging derivative instruments existing prior to the implementation of the Statement.

Additional Guidance

In February 2009, GASB also issued the Implementation Guide to Statement 53 on Accounting and Financial Reporting for Derivative Instruments. The guide is intended to assist financial statement preparers and attestors in the implementation and application of the Statement. The content from that guide also can be found in the June 30, 2009, edition of GASB’s Comprehensive Implementation Guide.