Accounting for Derivatives

What is a derivative?
A derivative is an arrangement to receive or make payments based on prices related to a transaction without actually entering into that transaction. Examples are interest rate swaps and futures contracts.

Why are they used?
Governments enter into derivatives for four main reasons.

As hedges for a specific financial risk.
To lower borrowing costs.
To generate income.
To manage cash flows.

The most common derivative seen for our clients are interest rate swaps to lower borrowing costs. By entering into a pay fixed, receive variable swap, the government may end up with a lower rate than initially issuing fixed rated bonds due to the demand from large money market funds for variable rate instruments compared to fixed rate instruments.

How does a pay fixed, receive variable swap work?
These are used when a government issues variable-rate debt (bonds with an interest rate that rises and falls as market rates change). The government pays a counter party a fixed rate. They receive a payment based on the variable rate from the counter party. The government then makes a payment based on the variable rate to the bond holders. If the index used to calculate the two variable rate payments is the same, the amount received and amount paid are the same. Then the ultimate effect of the swap is to fix the interest at the fixed rate paid to the counter party.

Risks Posed by Derivatives

Credit risk - risk that the counter party will not make good on its promise to pay the government.
Interest rate risk – the longer a derivative lasts, the greater the risk that changes in interest rates will affect the value of the transaction.
Termination risk – risk that the derivative will end earlier than expected and deprive a government of the protection and potentially requiring a large termination payment.
Basis risk – if the rate for the payment from the counter party is based on a different index than the rate for the payment to the bond holders, the amounts will not be the same.
Rollover risk – if the term of the derivative is not equal to the debt.
Market access risk – risk that a government will not be able to issue debt on a timely basis or at a reasonable cost.

Accounting for interest rate swaps
These are typically hedging instruments. If such an instrument is effective, the fair value of the derivative is reported in the full accrual balance sheets with any changes in fair value reported as deferred inflow/outflow in that same statement. If such an instrument is ineffective, the fair value of the derivative is reported in the full accrual balance sheets with any changes in fair value reported as a component of investment income in the operating statement.

If a derivative remains an effective hedge for the complete term of the debt, the fair value and offsetting deferred inflow/outflow will eventually be reduced to zero with no impact on the operating statement. If it becomes ineffective at some point, the remaining deferred inflow/outflow will be moved from the balance sheet to the operating statement.
There are also additional disclosures required that summarize the various derivatives by type and show amounts and where they are recorded in the financial statements.

How do you tell if a hedge is effective?
First apply the consistent critical terms method since it is the easiest to use. If that doesn’t work, one of the other methods may be used. If that second method doesn’t work, then you may try another method but are not required to do so. The method used can change from year to year.

Consistent critical terms method – the terms such as notional amount, variable interest rate, and ending date are the same for both debt and derivative.
Synthetic instruments method – effective if the synthetic rate divided by the target rate falls within a range of 90 to 111 %.
Dollar-offset method - effective if the dollar amount of change in the hedging item divided by the dollar amount of change in the hedged item falls within a range of 80 to 125%.
Regression analysis – results must meet specific parameters to be effective.
Please refer to the sources listed for more complete details related to derivatives.

Sources:

Governmental Accounting Standards BoardStatement No. 53 Accounting and Financial Reporting for Derivative Instruments
Derivative Instruments: A Plain-Language Summary of GASB Statement No. 53 by GASB staff
Understanding Accounting for Derivatives by Stephen Gauthier in GAAFR Review may 2010

Duane B. Schlereth - Duane has over 37 years experience in several areas of public accountancy. He spent six years in the audit department of Price, Waterhouse in Edmonton, Canada, passing the Canadian Chartered Accountants' examination in 1976.

His background includes significant experience with City and County governments from auditing services to consulting services. Duane has been in charge of our performance audits related to SPLOST for schools since that law became effective. Duane was the winner of the Georgia Society of CPA's Gold Key for the highest marks on the 1984 CPA Exam and the winner of the Elijah Watt Sells Award for one of the top 120 marks in the nation out of 70,000 on the 1984 CPA Exam.

Duane is a member of the Governmental Accounting Committee of the Georgia Society of CPA's and is past president of the Northeast Georgia Chapter of the Georgia Society of CPA's. He has his certification in the Governmental and Non-Profit Certificate of Educational Achievement program. He is a member of the Government Finance Officers Association, serving on the Certificate of Achievement for Excellence in Financial Reporting Special Review Committee and the Distinguished Budget Presentation Awards program review committee. He is also a member of the Georgia Government Finance Officers Association. Duane has written and taught numerous seminars on "How to Prevent Fraud". He is past treasurer of the local Red Cross chapter, and past Vice-President of Elachee Nature Science Center. He is a past president of the Lake Lanier Rowing Club as well as a member of their race team.

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