WASHINGTON - The Governmental Accounting Standards Board released final accounting and financial reporting standards last week that will require state and local governments to report more information about their derivatives instruments in their financial statements for fiscal years beginning after June 15, 2009.
The standards will not be binding, but governments will have to meet them to receive so-called clean or non-qualified audit opinions on their financial statements.
GASB officials are strongly urging governments to begin applying the standards before the effective date and plan to provide more guidance to budget officials through training seminars and an implementation guide that is due to be released during the first quarter of 2009.
The final standards differ from the proposed ones primarily in that they will exempt governments from having to report derivative instruments at fair value as assets or liabilities in the government fund financial statement - which includes general debt service and capital project funds.
However, governments will have to account for derivatives at fair value in their proprietary fund financial statements, which cover electric or water and sewer utilities, their fiduciary fund financial statements, which cover pension plans, and the accrual-based government-wide financial statement, the summary of all fund categories.
Additionally, GASB determined that the standards will not apply to financial guarantee contracts, loan commitments, or insurance contracts.
GASB officials said they decided to defer consideration of fair value reporting of derivatives in governmental fund financial statements for another project on recognition and attributes. Proprietary and fiduciary fund statements employ corporate or nongovernmental accounting, they said.
"The issue is, should we have fair value transactions in the governmental fund," said Randal Finden, GASB's manager on the derivative standards project. "Here you have the possibility of whipsawing practice, and that is Year one, we're not going to do anything with fair value. Year two, uh oh, the derivatives statement requires them to be on the balance sheet at fair value. Year three, never mind, we aren't going to report them any more at fair value."
Rather than forcing governments to keep changing practices, GASB decided to wait to make the decision in the other project, he said.
The standards define fair value as either the value of a derivative's future cash flow in today's dollars or the price it would fetch if it were sold on an open market. Annual changes in the fair value of the derivatives would be reported in the financial statements as investment gains or losses.
However, derivatives used as hedges would be treated differently. When a derivative acts as a hedge - effectively reducing risk that it was created to address - its fair value would be deferred, like outstanding bonds, until the contract ends. This will give budget officers more freedom to strip hedge derivatives from the flow of resources statements, GASB officials said.
Without the distinction between an effective and ineffective hedge, municipalities might be responsible for million-dollar fluctuations, in a 20-year interest rate swap for example, over the life of a long-term contract.
"This year's gains become tomorrow's losses," Finden said.
The new rules offer three quantitative options for determining if a hedge is effective or not. A fourth option leaves open the door for a new quantitative method to be used.
"That was a big win," said Michael Marz, vice chair at First Southwest Co. and a member of an advisory task force for the new standards since 2001. For-profit companies are required to list their derivatives as gains or losses in accord with the Financial Accounting Standards Board Statement 133.
The GASB standards provide more flexibility for governments, Marz said, adding: "I think it was the single biggest plus the rules make."
Municipal bond participants responded favorably to the final proposal and said GASB improved upon its July 2007 exposure draft.
"The first [draft] was broad and sweeping," said Brian Mayhew, chief financial officer of the Bay Area Toll Authority in Oakland. The final proposal is "much more refined and more focused."
The adjustments in the final proposal were necessary, he said, because GASB realized "how much damage they could do" with the first draft.
Mayhew said the Bay Area Toll Authority has about $3 billion worth of hedged derivatives. After running some tests with the new rules, all of the derivatives would qualify as hedges so that gains and losses could be deferred, he said. None of the derivative contracts would be considered ineffective hedges and recorded as a loss, he said.
"I'm not sure [GASB] achieved everything they set out to do, but it was the right way to go," Mayhew said.
Other market participants said most derivatives can be counted as effective hedges under the new standards, which will cut costs for governments. About 99 percent of the derivatives used by governments are plain vanilla interest rate swaps, said Robert Lamb, president of Lamont Financial Services Corporation in Wayne, N.J., which specializes in public finance.
He and other issuer advisors said the four effective hedge options will reduce expenses on financial statements. Issuers that were once unsure whether to list derivatives as gains or losses now have more clarity for defining a deferrable hedge. But there will still be "growing pains," Lamb said, as governments determine how much outsourced accounting help is needed.
The new standards also help bond buyers, underwriters and analysts dissect the financial health of a government. Robert Fuller, founder of Capital Markets Management LLC, a swap advisory firm in Hopewell, N.J., said the interest rate swaps held by Jefferson County, Ala., "would clearly show up differently [under the new standards] than they do today."
GASB, he said, "is trying to prevent other Jefferson Counties from happening."