Running head: EFFECTIVE EVALUATION METHODS FOR DERIVATIVES 1

Effective Evaluation Methods for Derivatives

Under GASB Statement No. 53

Michael Witt

University of Maryland University College

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Effective Evaluation Methods for Derivatives

Under GASB Statement No. 53

In June 2009, the Governmental Accounting Standards Board (“GASB”) issued GASB Statement No. 53 on

Accounting and Financial Reporting for Derivative Instruments. It was intended to improve transparency

for derivative instrument reporting for state and local government entities’ financial reporting (Metzger,

2009a, p.53). It requires fair value measurement for most derivative instruments and offers new

guidance on hedge accounting requirements. Ackerman (2007) defines “fair value” as the value of the

instrument’s future cash flows in present-day dollars or its fair market value (p. 1).

A derivative is a financial instrument based on the value of an underlying reference instrument (Dodd,

2010, p. 33). The derivative allows its holder to mitigate its risk without actually entering into the

principal transaction, e.g. hold commodities, foreign currency, securities (Government Accounting

Standards Board, 2008). These instruments are often complex contractual arrangements as investments

or risk management tools. As evidence of their complexity, it is possible that hedge derivatives could be

used to mitigate identified risks for an investment derivative (Anonymous, 2008, p. 1).

According to Gauthier (2008), to be a derivative, a financial instrument must provide leverage, have an

ascertainable reference rate, and contain settlement terms (p. 71). Leverage allows the contracting

parties to achieve their desired economic effect with an investment only a fraction of that otherwise

required. A reference rate must be a verifiable price, rate, or index, e.g. prime, LIBOR, federal funds. The

reference rate can be conditioned on the occurrence or non-occurrence of a subsequent event and is

applied to the notional amount to determine the payment amount. The settlement terms must involve a

notional amount or payment provision, and have an objectively determinable price contracted by the
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parties. When the payment amount is based on a predetermined valuation, it satisfies one of the

contracted payment provisions. Some derivatives can be settled for a cash amount substantially less that

the notional amount (Gauthier, 2008, p. 71).

Government entities typically use two types of investment derivatives – rate swaps and contracts.

Interest-rate swaps are effective to lower the cost of debt without having to refinance or maintain the

cash flows that are required to do so (Metzger, 2009b, p. 25). Commodities contracts are risk

management tools to smooth cash flow for those services that governments may provide.

Gauthier (2008) contends that unlike conventional investments, derivates provide leverage (p. 71).

Some financial instruments that may otherwise qualify as hedge derivatives are excluded from GASB No.

53, including sale and purchase agreements, insurance contracts, financial guarantees, and loan

commitments. The Statement also excludes certain derivative contracts based on underlying

instruments that are not traded on an exchange, e.g. climate contracts, liquidated damages (White and

Towne, 2010, p. 9).

Generally Accepted Accounting Principles (“GAAP”) apply to both private-sector companies and

government entities. Financial Accounting Standard (“FAS”) 133 addresses the treatment of derivatives

for private sector financial statement preparation. GASB Statement No. 53 covers recognition,

measurement, and disclosure of derivatives for public sector accounting, primarily state and local

governments.

The Statement only applies to the government-wide, proprietary fund, and fiduciary fund financial

statements (Gauthier, 2008). These financial statements are prepared using the economic resources

measurement focus and full-accrual accounting (Gauthier, 2008, p.71). GASB 53 is not applicable to
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financial statements that use the financial resources measurement and modified accrual accounting

(Anonymous, p. 126). That method is traditionally only used at the fund statement level.

Both FAS 133 and GASB 53 require that derivatives are reported at fair value, and that the gains and

losses for most derivatives are reported as part of investment income for the period in which it occurs.

Under both statements, the underlying item is also reported at fair value so that any change in value is

offset between the two items. Each accounting period’s statements should reflect the actual intent of

the derivative instrument as any gain or loss in one hypothetically should be balanced by the other

(Metzger, 2009a, p. 48).

Derivatives that can be associated with underlying items that are hedgeable are hedging derivative

instruments (GASB, 2008). For derivatives not used as hedging instruments, each accounting period’s

earnings will reflect the gain or loss (FASB, 1998). For hedging derivatives, GASB No. 53 requires

recognition each period of the gain or loss on a derivative used as a hedge and the corresponding

change in value of the associate risk item. Fair value changes for some hedge derivatives are deferred

and reported as a change in the position value (Gauthier, 2008, p. 71).

Hedge derivatives mitigate risks in cash flow or fluctuations in the underlying item’s fair value. Assets,

liabilities, and expected transactions are common financial statement items to hedge (Anonymous,

2008, p. 126). Since, the derivative value and the fair value of the underlying item move inversely, any

change in value of one should be effectively offset by the fair value change in the other (Gauthier, 2008,

p. 71).

Items recorded on the statement of position are deferred, but the governmental entity must prove the

derivative is effective as a hedging instrument using the Consistent Critical Terms Method (“CCTM”) or a

quantitative method (Gauthier, 2008, p. 72). The CCTM is a simple comparison of the material terms of
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the hedge instrument and the underlying item. To satisfy this test, the critical terms must be the same

or substantially similar (Ruppel, 2010, p. 265).

The CCTM is a qualitative test of the hedge derivative and the underlying item. It evaluates the

effectiveness of a hedge by its contractual terms to verify whether changes in cash flow or fair value of

the underlying item will be substantially offset by the changes in cash flow or fair value of the hedging

instrument (Metzger, 2009b, p. 27). GASB 53 outlines specific guidelines for evaluating various types of

potential hedging derivatives.

Commodity swaps can hedge either cash flow or fair value. To be effective as a derivative instrument,

the CCTM requires that a cash flow hedge derivative be for the same quantity, time and delivery. It must

have no fair value of its own, and its reference rate must be consistent with the underlying item’s.

Lastly, the hedging instrument cannot have a price floor or cap unless its associated hedgeable item has

a similar restriction on its price fluctuation (Ruppel, 2010, p. 265).

Governments usually determine the fair value of commodity swap contracts from the investment

bankers who typically broker the transactions in the first place. The derivative fair value is based on net

present value calculations (Metzger, 2009b, p. 28). Under GASB 53, these hedges require the same

critical terms as cash flow hedges and three additional criteria.

The fair value derivative for commodity swap contracts must have the same or similar maturity date,

reset their reference rate at least every 90 days, and cannot be prepayable. The maturity date of both

the derivative instrument and the underlying items must be close enough in time to limit market risk.

The reference rate must reset to align the variable payment with the market rate. GASB 53 excludes call-

options that have mirrored derivatives (Ruppel, 2010, p. 265).

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Under the CCTM, forward contracts are effective as hedges under the same terms as cash flow hedges

for commodity swaps. The discount or premium is not part of the effectiveness evaluation. It is included

in investment income as a gain based on the forward price of the underlying item (Ruppel, 2010, p. 266).

Quantitative methods include the Synthetic Instrument and Dollar-Offset Methods (“DOM”), and

regression analysis. These techniques use historical data points like rates, prices, and payments and new

market conditions to evaluate effectiveness. Changes in supply and demand cause asymmetrical

changes that become the new market conditions that must be considered to determine fair value

(Ruppel, 2010, p. 265). GASB No. 53 allows other methods not specifically identified above if they have

the same fundamental characteristics (Gauthier, 2008, p. 72).

When the derivative does not pass the CCTM, the Synthetic Instrument Method (“SIM”) can be used to

measure the difference between the derivative and its underlying item. The SIM combines the hedge

and its associated originating item to compare its actual and intended performances (Gauthier, 2008, p.

72). If the variable cash flows substantially offset one another, the “synthetic” rate is fixed. The

difference cannot be more than 10% for the derivative to be effective as a hedge (White, 2010, p. 12).

Results over 111% or under 90% are outside the acceptable range to be a derivative. If the synthetic rate

is within the 10% margin, the actual result approximates the desired expected result and the derivative

is effective as a hedging instrument.

The Dollar-Offset Methods (“DOM”) is a direct contrast of the expected cash flows and fair-value

changes of the positional hedging derivative and the expected cash flows and fair-value changes of the

underlying item (Metzger, 2009a, p. 49). This method can be applied using the changes for the current

accounting period or since inception of the derivative instrument. If the changes of either instrument
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are divided by the changes of the other, and the result is between 80 and 125 percent, the derivative is

qualifiable as a hedge (Gauthier, 2008, p. 72).

Regression analysis is a statistical measure that considers the relationship of the cash flows and fair

values of the potentially hedgeable derivative and its underlying item. Under GASB 53, the changes for

the two instruments substantially offset each other if the R-squared value is at least .80, the F-statistic

demonstrates significance at a 95% confidence interval, and the regression coefficient is between -1.25

and .80 (Gauthier, 08, p2). This last requirement shows the comparison of the DOM and regression

analysis as evaluation methods, but more detailed analysis of this statistical method requires inferences

beyond financial analysis (Ruppel, 2010, p. 263).

When the underlying item is sold, retired, or expired, it is no longer a financial instrument. If that occurs

before the maturity date of the hedging instrument, that derivative is no longer effective as a hedge, but

is still recognized as an investment (Gauthier, 2008, p. 72). Any remaining value or deferred credits or

charges from previous periods are closed to investment income in the current reporting period (GASB,

2008).

While derivatives used to only be used by Wall Street and sophisticated bankers and traders. Today’s

governmental entities must embrace these financial instruments to mitigate investment, market and

exchange rate risk. GASB Statement No. 53 improves governmental financial reporting by requiring

governments to recognize and disclose their derivative instruments. These new reporting requirements

align government-wide financial statements with their FAS 133 private-sector counterparts to provide

transparency in the measurement and effectiveness of derivative instruments.

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References

Ackerman, A. (2007, July 3). GASB Updates Proposed Guidance on Derivatives. Bond Buyer, p. 1. 

Anonymous. Official Releases. (2008). Journal of Accountancy, 206(3), 126-133,136-141. 

Dodd, R. (2010, June). Municipal Bombs. Finance & Development, 47(2), 33-35. 

Financial Accounting Standards Board. (1998). Statement No. 133 – Accounting for Derivative
Instruments and Hedging Activities. Norwalk Connecticut: FASB.

Gauthier, S. (2008, December). Final GASB Guidance on Derivatives. Government Finance

Review, 24(6), 71-72.

Government Accounting Standards Board. (2008). Summary of Statement No. 53 – Accounting and
Financial Reporting for Derivative Instruments. Norwalk, Connecticut: GASB.

Metzger, L. (2009a). Measuring Hedging Effectiveness for Derivatives. The Journal of Government

Financial Management, 58(4), 48-53. 

Metzger, L. (2009b). Derivative Measurement and Reporting for Governments. The CPA

Journal, 79(11), 24-29. 

Ruppel, W. (2010). Wiley GAAP for Governments 2010: Interpretation and Application of Generally
Accepted Accounting Principles for State and Local Governments. Hoboken, New Jersey: John Wiley
& Sons, Inc.

White, M. & Towne, J. GASB No. 53 – Accounting for Derivative Instruments [PPT document]. Retrieved
from the Florida Government Finance Officers Association online web site:
www.fgfoa.org/files/White%20GASB%20No53MAW-final.ppt.