Project Pages

Derivatives and Hedging—Project Plan

Project Description: The objective of this project is to consider whether derivatives should be displayed at fair value on the statement of net assets and whether current derivative note disclosures are appropriate. If derivatives are displayed in the financial statements, consideration of hedge accounting will be necessary. Disclosures, such as derivative objectives, terms, and risks, will also be included within the scope of deliberations. Because of the state of existing standards for state and local governments, a Statement is expected to be followed by an Implementation Guide.

Background: This project is needed to establish additional financial reporting or disclosure requirements for derivatives and hedging accounting that will assist financial statement readers in making decisions and assessing accountability. When the Board issued Statement No. 31, Accounting and Financial Reporting for Certain Investments and for External Investment Pools, in 1997, a number of financial instrument issues were not addressed. For example, derivatives, hedge accounting, and fair values of liabilities were not included in the scope of the Statement. Statement 31’s background information indicates that it was the first phase of the Board’s Financial Instruments project, thereby establishing an expectation that the Board would address the remaining issues in a follow-up project(s).¹

Current accounting requirements call for extensive derivative disclosures. There is no specific requirement to present a derivative’s fair value on the face of the financial statements (except for pension and OPEB plans). Likewise, the Board has not addressed hedge accounting in this area. This is a significant issue because fair value gains and losses can relate to another asset, liability, or anticipated transaction.

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¹Statement 31, paragraphs 26 and 41.

Accounting and Reporting Issues

The following major issues have been identified. The list provides a basic outline of how the project is scheduled progress.

1. Should the GASB develop a new definition for derivatives? If so, how? The definition in Technical Bulletin No. 2003-1, Disclosure Requirements for Derivatives Not Presented at Fair Value on the Statement of Net Assets, is consistent with the definition in FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities.

2. Are there derivatives that should not be included in the scope of the standard, such as derivatives associated with normal purchases and sales? Firm commitments? Anticipated transactions? Insurance contracts? How should embedded derivatives be treated?

3. Should the fair value of derivatives be disclosed in the notes or displayed in the financial statements? In other words, are derivatives commitments that should be disclosed? Or are they assets and liabilities that should be displayed on the statement of net assets?

4. If derivatives are displayed, should hedge accounting be permitted? Is the hedged item also displayed at fair value? Or should the hedge and the hedged item be reported using some other method?

5. What are the parameters of hedge accounting (if permitted)? Should there be a hedge effectiveness test to qualify for hedge accounting? If so, what is the frequency of such tests?

6. If hedge accounting is used, should there be a “shortcut” method? That is, a method in limited circumstances that avoids hedge effectiveness tests and documentation requirements.

7. Should future contracts be included in the scope of the project? FASB Statement No. 80, Accounting for Futures Contracts, provides the current GAAP for government. Should the requirements for derivatives parallel the requirements for future contracts?

8. Should matched-book financings be permitted hedge accounting?

9. What derivative and hedging information should be disclosed? Should the requirements of TB 2003-1 be updated and incorporated into a Statement?

Project History:

Technical Bulletin No. 2003-1, Disclosure Requirements for Derivatives Not Presented at Fair Value on the Statement of Net Assets, was issued June 2003. The Bulletin provides interim guidance pending the completion of the Derivatives and Hedging project.

A meeting of the Derivatives and Hedging task force was held in April 2003. Scope and accounting issues were discussed. At its July 2003 meeting, the Board discussed whether derivatives should be reported at fair value on the statement of net assets. Cash flow hedge accounting methods were the focus of discussions for 2003 Board meetings.

At the December 2003 and January 2004 meetings, the Board participated in educational sessions with selected members of the Derivatives and Hedging task force. The Board began considering a context-based method of measuring derivatives as a potential alternative to other forms of fair value reporting. The context-based method would measure a derivative based on the measurement attribute used for a clearly and closely related asset or liability.

At the March 2004 meeting, the Board tentatively concluded that derivatives represent assets and liabilities, and should be reported as such on the balance sheet. At the April 2004 meeting, discussion centered on swaptions and the application of the context-based method. The Board tentatively decided that under the context-based approach, the intrinsic value of the issued option represents a borrowing. If the option expires worthless, the Board tentatively decided that a gain should be recognized at expiration.

At the May 2004 meeting, discussion of swaptions and the context-based method continued. The following tentative decisions were reached relative to the potential use of a context-based method. In governmental funds, swaption payments for intrinsic value generally should be reported as a long-term liability. A governmental fund should measure an option for time value using fair value. Within the context-based method and during the option period, the swaption should be measured using fair value. The Board also discussed derivatives used in the purchases and sales of commodities—futures contracts, forward contracts, and commodity swaps—in the development of the context-based approach. The Board tentatively concluded that forward contracts and commodity swaps for normal purchases and sales should be excluded from this project. Within the context-based method, commodity derivatives (those not tentatively excluded) associated with anticipated transactions and firm commitments should be measured at fair value with increases and decreases reported as gains and losses.

At the July 2004 meeting, the Board considered how the context-based method should treat the possibility of a derivative’s early termination. The Board tentatively specified that certain “indicators” suggest that the derivative should be reported at fair value immediately, whereas other indicators suggest that the derivative needs to be reassessed to determine the likelihood of early termination.

At the August 2004 meeting, the Board considered but did not make a decision regarding a hedge accounting method. Three alternatives were considered: mark-to-market, deferral, and basis adjustment. The Board discussed, but agreed not to pursue macro hedging. The Board deferred a decision on recognizing hedge ineffectiveness.

At the October 2004 meeting, Peter Shapiro from the Swap Financial Group led a discussion on (1) how derivative fair values are estimated, (2) current developments in the municipal swap market, and (3) hedge effectiveness. No decisions were made.

At the November 2004 meeting, the Board tentatively agreed to recognize hedge ineffectiveness as gain or loss and to use the deferral hedge accounting method.

Current Developments:

At the January 2005 meeting, the Board discussed a comprehensive hedge accounting illustration. This illustration included the process of constructing and analyzing a three-year swap. Issues of ineffectiveness, over- and underhedging, and recapture were also discussed. No decisions were made at this meeting.

At the February 2005 meeting, the staff briefed the Board on the results of their interviews with a limited number of financial statement users regarding reporting ineffectiveness as gains and losses, and potential hedge criteria. The Board then discussed the two papers presented by the staff. The first paper followed up the January meeting discussion of reporting ineffectiveness by providing additional reporting examples, including recapture. The second paper presented a first draft of a staff proposal for identifying derivatives that would qualify for either the context-based approach or hedge accounting. The Board’s discussion focused more on the objective of the project than on the qualifying conditions and criteria presented in the paper; therefore, no decisions were reached on the staff proposal.. The Board then discussed the general direction of the project. For the April meeting, the project team presented a review of the scope of the project, tentative decisions already made, the issues identified to date with regard to the two basic alternatives under consideration (context-based method and hedge accounting), and a detailed project plan for addressing remaining issues.

Work Plan:

The following work plan, which should lead to a Statement, has been developed in conjunction with and has been affected by the work done for the TB.

Derivatives and Hedging—Recent Developments

Minutes of Meeting, August 9-11, 2005

Scott Krantz from the Southern Nevada Water Authority (SNWA) led an educational discussion on commodity swaps. Mr. Krantz described the objective of SNWA’s hedging program and outlined the various methods for assessing its effectiveness. He detailed the differences between cash settlement of a commodity hedge compared to physical delivery. Mr. Krantz also described the various layers of swaps his authority uses to hedge price risk. No decisions were called for.

Minutes of Meeting, June 21-23, 2005

Before discussion of the staff papers, staff described their approach to consideration of FASB and IASB literature. The Board indicated that staff’s approach is consistent with the strategic plan and the rules of procedure. Staff also updated the Board on the implications of the “normal purchase/normal sales” exception. Using the FASB definition of derivatives, forward contracts for the purchase of sales of commodities that cannot be cash-settled are not derivatives and are not within the scope of the project. There was a discussion of commodity contracts that can be cash-settled. Staff indicated that a better understanding of business practices is necessary and that a Board educational session at the next meeting would be appropriate. The Board agreed with this recommendation.

The Board focused its formal discussion on two topics. The first was a discussion of what is hedgeable. During this discussion, the Board tentatively decided that firm commitments and forecasted transactions are items that may be hedged, provided they meet the criteria (to be developed) for hedge accounting. The Board also tentatively decided that transactions solely within a government—interfund transactions—may not be hedged. However, transactions between a primary government and a discretely presented component unit would be hedgeable. Risks associated with only a portion of cash flows or fair values of a financial asset or liability (or potential financial asset or liability) would be hedgeable, provided that effectiveness could be measured. On the other hand, staff will do further research on comparable treatment of risks associated with nonfinancial assets and liabilities. Groups of similar assets, liabilities, firm commitments, and forecasted transactions would be hedgeable. The Board agreed that staff needs to do further research on whether or not to allow hedge accounting to be applied to hedges of a net position and foreign currency risk.

The second paper focused on the termination of hedge accounting in circumstances other than when the expected payments have been made or a derivative’s term has expired. The Board tentatively decided that in all cases, the balance in the deferral account would immediately be recognized as gain or loss on the change statement. This would occur as soon as the hedge accounting relationship is dissolved. The Board also indicated that the format of the illustration was satisfactory.

As noted above, the August meeting is expected to be an educational session that will prepare the Board for establishing the criteria that must be met to qualify for hedge accounting.

Minutes of Meeting, May 17–19, 2005

The Board continued its discussion of derivatives and hedging. After considering the effects of measuring derivatives at fair value on the statement of net assets, the Board tentatively decided that there needs to be some form of “special accounting” for derivatives. The special accounting treatments considered by the Board include methods that mitigate the effects of fair value gains and losses on the change statement, either by measuring a derivative at its historical price in certain instances (the context-based method) or by reporting hedging gains and losses as deferrals on the statement of net assets (the fair value with hedge accounting method). The Board then tentatively decided that the fair value with hedge accounting method (1) is the most desirable special accounting method and (2) should also be used for reporting derivatives in governmental funds. These tentative decisions will be further refined as the Board considers additional topics set forth in the project work plan, including calibrating the criteria for applying hedge accounting.

At the next meeting, the Board will discuss firm commitments and forecasted transactions. Additional topics may be presented for the Board’s consideration.

Minutes of Meeting, April 5–7, 2005

The Board continued its discussion of the Derivatives and Hedging project. The Board tentatively decided that historical price is not a viable method of accounting for derivatives; that method will no longer be considered as a potential method in future deliberations. The Board tentatively agreed to remove the matched-book issue from the project because of the unique issues that need to be addressed for that subject would further delay the project. On the other hand, the Board tentatively reconfirmed that the scope of the project includes derivative disclosures.

A detailed project plan was presented. It was tentatively decided at this time that a Preliminary Views document would be included in the project’s technical plan. For the May meeting, the Board will discuss the remaining three methods: context-based, hedge accounting, and fair value without modification.

Minutes of Meeting, February 22–24, 2005

Staff briefed the Board on the results of their interviews regarding reporting ineffectiveness as gains and losses, and potential hedge criteria. The Board then discussed the two papers presented by the staff. The first paper followed up the January meeting discussion of reporting ineffectiveness by providing additional reporting examples, including recapture. The second paper presented a first draft of a staff proposal for indentifying derivatives that would qualify for either the context-based approach or hedge accounting. The Board discussion focused more on the objective of the project than on the qualifying conditions and criteria presented in the paper; therefore, no decisions were reached on the staff proposal.. The Board then discussed the general direction of the project. For the April meeting, the project team will present a review of the scope of the project, tentative decisions already made, the issues identified to date with regard to the two basic alternatives under consideration (context-based method and hedge accounting), and a detailed project plan for addressing remaining issues.

Minutes of Meeting, January 11–13, 2005

The Board discussed a comprehensive hedge accounting illustration. This illustration included the process of constructing and analyzing a three-year swap. Issues of ineffectiveness, over- and underhedging, and recapture were also discussed. No decisions were made at this meeting. At the February meeting, the Board will resume discussions of the context-based method.

Derivatives and Hedging—Major Tentative Decisions to Date

September 30 through October 2, 2003

A majority of the Board tentatively reached a consensus that an entity-wide risk assessment should not be a criterion for hedge accounting.

March 9–11, 2004

The Board tentatively decided that derivatives are assets and liabilities.

April 20—22, 2004

Swaptions: The Board tentatively decided that under the context-based approach, the intrinsic value of the issued option represents a borrowing. If the option expires worthless, the Board tentatively decided that a gain should be recognized at expiration. Tentative agreement was also reached to move the issuance of the Exposure Draft from November to December of this year.

June 1–3, 2004

The following tentative decisions were reached regarding swaptions as the context-based approach continues to be developed for further consideration:

• In governmental funds, swaption payments for intrinsic value generally should be reported as a long-term liability.

• A governmental fund should measure an option for time value using fair value.

• Within the context-based method and during the option, the swaption should be measured using fair value.

The Board also discussed derivatives used in the purchases and sales of commodities—futures contracts, forward contracts, and commodity swaps in the development of the context-based approach. The following tentative decisions were reached:

• Forward contracts and commodity swaps for normal purchases and sales should be excluded from this project.

• Within the context-based method, commodity derivatives (those not tentatively excluded) associated with anticipated transactions and firm commitments should be measured at fair value with increases and decreases reported as gains and losses.

July 14 and 15, 2004

The staff recommendation regarding probable terminations was tentatively accepted with edits to clarify the proposal. The Board specified that certain “indicators” suggest that the derivative should be reported at fair value immediately, whereas other indicators suggest that the derivative needs to be reassessed to determine the likelihood of early termination.

August 24—26, 2004

The Board was unanimous in its tentative decision to continue to explore a hedge accounting alternative.

The tentative conclusion not to pursue a macro hedging requirement was based on a six-to-one vote.

Given their uncertainty of ineffectiveness, the Board was unable to decide on a preferred method of hedge accounting, but tentatively indicated a preference toward deferral. The mark-to-market method also received some support. No interest was expressed in pursuing the basis adjustment alternative at this time.

Two members tentatively voted for ineffectiveness to be reported in the performance section, whereas five members tentatively voted for ineffectiveness to appear below the performance indicator. The two members who tentatively favored the mark-to-market approach disagreed on where the ineffectiveness should be reported.

November 17–19, 2004

The Board tentatively agreed to recognize hedge ineffectiveness.

The Board tentatively supported the deferral method of hedge accounting.

April 2005

The Board tentatively decided that historical price is not a viable method of accounting for derivatives; that method will no longer be one of the potential methods. The Board agreed to remove the matched-book issue from the Derivatives and Hedging project as it no longer fits within the scope of that project. On the other hand, the Board tentatively agreed that the scope of the project includes derivative disclosures. It was tentatively decided that firm commitments and anticipated transactions be redeliberated and that a Preliminary Views document would be the most appropriate due process document for the project.

June 2005

The Board tentatively decided that firm commitments and forecasted transactions are items that may be hedged, provided they meet the criteria (to be developed) for hedge accounting. The Board also tentatively decided that transactions solely within a government—interfund transactions—may not be hedged. However, transactions between a primary government and a discretely presented component unit would be hedgeable. Risks associated with only a portion of cash flows or fair values of a financial asset or liability (or potential financial asset or liability) would be hedgeable, provided that effectives could be measured. On the other hand, staff will do further research on comparable treatment of risks associated with nonfinancial assets and liabilities. Groups of similar assets, liabilities, firm commitments and forecasted transactions would be hedgeable. The Board agreed that staff needs to do further research on whether or not to allow hedges of a net position of assets and liabilities, and foreign currency risk.

The second paper focused on the termination of hedge accounting in circumstances other than when the expected payments have been made or a derivative’s term has expired. The Board tentatively decided that in all cases, the balance in the deferral account would be immediately eliminated by recognition as gain or loss on the change statement. This would occur as soon as the hedging relationship is dissolved. The Board indicated that the format of the illustration was satisfactory.

Derivatives and Hedging—Relevant Links