The National Association of Bond Lawyers has warned the Governmental Accounting Standards Board that its proposed accounting standards for derivatives could cause some state and local issuers to run afoul of bond covenant and disclosure requirements — and, in extreme cases, possibly even trigger default proceedings on certain bonds. NABL issued the warnings in a five-page comment letter sent to GASB Wednesday. GASB is expected to finalize the standards in June. But NABL told the board in its comment letter that it “is concerned the [proposed] accounting and financial reporting requirements ... may significantly impact, either positively or negatively, a state or local government’s compliance with outstanding revenue bond covenants and possibly result in misleading disclosure to investors.” “NABL does not believe this result is the intended consequence” of the proposed standards, the association added. The proposed standards generally would require state and local governments to report the fair value of their derivative transactions as assets or liabilities in their financial statements, depending on whether the derivatives represent resources or claims on resources. Fair value would be defined as either the value of the derivative’s future cash flows in today’s dollars or the price it would fetch if it could be sold on an open market. Annual changes in the fair value of the derivative would be reported in the financial statement as increases or decreases in investment income. However, if a derivative is being used as a hedge, effectively reducing risk that it was created to address, and is associated with something that is not reported in the financial statements at fair value, such as outstanding bonds, then the annual change would be deferred and accumulated in the statement of net assets or balance sheet. Increases in fair value would appear as deferred inflows and decreases in fair value would appear as deferred outflows. The deferrals of credits or charges would continue until the derivative ceased to be an effective hedge, at which time any remaining deferred credits or charges would be reported as investment income. Governments would have to continue to disclose information about their derivatives in the notes to their financial statements as well as in a summary of their derivatives activity that would indicate where in the financial statement information about each derivative transaction is reported. As a result of the proposed standard, if an issuer has a derivative instrument that is no longer an effective hedge, then the issuer is required to recognize in its current fiscal year, as either a gain or a loss, the present value of the derivative instrument’s cash flows over the entire remaining life of the contract. In its letter, NABL warned that if the proposed standards are implemented, state and local governments with derivatives that have underlying revenue bonds issued pursuant to indentures that contain certain covenants “will experience 'paper’ income and losses that do not accurately reflect the operating results of the public enterprises for purposes of compliance with bond covenants that are based on operating results.” NABL primarily is concerned about issuers that have bond documents containing “rate” or “additional bonds test” covenants that use generally accepted accounting principles “in effect from time to time” to calculate net revenues. This is in contrast to bond covenants that use GAAP “in effect when the bonds are issued.” A rate covenant generally requires the establishment of rates and collection of revenues to pay for annual operating expenses and debt service. The covenant, for example, may call on the issuer to establish rates that would allow it to obtain revenues equal to 1.2 times annual debt service. An “additional bonds test” covenant generally allows for the issuance of additional parity or senior revenue bonds when adequate annual net revenues are projected or realized. If the GASB proposals are finalized and an issuer has a derivative instrument that is no longer an effective hedge, then the issuer will be required to recognize in its current fiscal year as either a gain or loss the present value of the derivative instrument’s cash flows over the entire remaining life of the contract. If the derivative is tied to revenue bonds with covenants based on GAAP as “in effect from time to time,” then that gain or loss will have to be taken into account in calculating net revenues of the public enterprise for purposes of meeting the covenants. A recognition of a such a loss could be significant enough to decrease the public enterprise’s net revenues such that the creditworthiness of its bonds drops or it fails to comply with its rate covenant, possibly triggering default proceedings. Decreased revenues also could force the issuer to fail to meet its additional bond test covenant so that it could no longer issue additional parity lien bonds. To mitigate these potentially adverse impacts, NABL recommends that GASB exempt all existing derivative instruments from the final accounting and financial statement disclosure standards. Absent such an exemption, GASB should permit a government to clarify which of its derivative instruments are “investments” and which are “hedges” at any time prior to the issuance of its first financial statement that reflects the proposed accounting changes for derivatives, NABL said. GASB also should also permit the treatment of hedging state and local derivative instruments as “effective” until the associated debt is retired or the derivative is terminated. Further, GASB should permit the treatment of “qualified hedges” under Treasury rules as effective hedges under GASB’s standards until termination, according to NABL.

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