Standard & Poor's is urging the Governmental Accounting Standards Board to significantly expand the amount of information that state and local governments must disclose about their derivatives transactions in the notes to their financial statements.
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The credit rating agency made the request in a five-page letter sent late last month commenting on GASB's preliminary views document that proposed accounting and financial reporting standards for governments' derivatives transactions, saying such disclosures are needed to put into context the numbers in the financial statements.
The rating agency's comments run counter to those of some industry groups that have told GASB it should abandon the note disclosures if it insists on moving forward with accounting and reporting standards for governments' derivatives transactions. Typically, GASB starts with required note disclosures and then, when it adopts accounting and financial reporting guidance, drops that requirement. In its preliminary views document, which it issued last April, GASB proposed keeping the note disclosure requirements as well as the proposed accounting and financial reporting guidance.
Standard & Poor's also told GASB that governments should be allowed to elect whether or not to use hedge accounting for their derivatives -- an election called for by The Bond Market Association. In addition, the rating agency said that GASB should permit governments to count derivatives that are partial or net hedges as hedges.
"Essentially, the message we're trying to get across is that while the accounting treatment is nice and it will be helpful, the most helpful thing would be qualitative disclosure," because audited financial statements can become stale and the disclosures can help put the numbers in context, Peter Block, a director at Standard & Poor's who co-authored the letter with Neri Bukspan, the firm's managing director and chief accountant, said yesterday.
"For example, if we know what the volatility, the sensitivity to interest rates, is in terms of the valuation of the issuer's portfolio, that's a lot more helpful than to know the actual value as of June 30, 2005," Block said. "If we know the portfolio is highly sensitive to interest rate changes and the numbers are 10 months old, there's a good chance that the numbers are not going to be accurate" when they are released six to nine to 10 months after the government's fiscal year ends if interest rates have changed.
In its letter, Standard & Poor's asked GASB to require governments to disclose:
* Early termination options afforded to the parties and any related costs.
* Triggers in derivative contracts, such as the value points or other events that would require the posting or receipt of collateral, as well as the amount of collateral posted or received.
* Derivative settlement insurance obtained and the terms for termination of that insurance.
* Amounts and line items where derivatives and related gains and losses are reported on the balance sheet and the statement of changes, including the amount by which the derivative activities increased or decreased a specific cost or revenue line item.
* Sensitivity analysis for derivatives and related hedged items -- for example, the dollar value of a specified percentage point movement in interest rates -- provided by specific contract or at some minimal level of aggregation.
* Material derivative positions entered into and closed during the same reporting period.
* Whether derivative obligations are senior to, on parity with, or subordinate to other debt.
Standard & Poor's said it agrees with GASB that governments should disclose their amount of hedging ineffectiveness. "Ineffectiveness disclosures are important to our analysis, given that many derivative contracts are not entirely effective but, nonetheless, are reported accounting hedges," the agency said. "The amount of the ineffectiveness provides an indication to analysts of how well the derivative mitigates the intended risks."
The rating agency said that it agrees with GASB's main accounting proposal -- that governments should recognize the change in fair value of their derivatives in their statement of activities or change statement, unless the derivative is a hedge, in which case it would defer related derivative gains and losses on the balance sheet.
However, the agency said that GASB should make hedge accounting optional for governments because this "would allow hedging without the accounting headaches of effectiveness testing."
"Nevertheless, governments should disclose the purpose for entering into derivative transactions and the accounting choices of using or not using hedge accounting as well as the other applicable disclosures," Standard & Poor's said.
GASB issued its preliminary views document in April. The proposals would require governments to report the fair value of their derivatives transactions as assets or liabilities in their financial statements. The government would have to report the annual changes in the fair value of a derivative in its financial statement as increases or decreases in investment income.
However, if a derivative is being used as a hedge, and is effectively reducing the risk that it was created to address, then, under GASB's proposals, the annual charges would be deferred and would be accumulated in the statement of net assets or balance sheet as deferred credits or deferred charges. A government would have to annually "test" its derivatives to see if they are effective hedges. (c) 2006 The Bond Buyer and SourceMedia, Inc. All rights reserved. http://www.bondbuyer.com http://www.sourcemedia.com
