Journal Entries

This recurring website feature highlights articles from The GASB Report, the GASB’s monthly newsletter. The current article appeared in the February 2011 issue.

GASB Issues Exposure Draft Addressing Application of Hedge Accounting Termination Provisions

In February, the GASB issued an Exposure Draft, Derivative Instruments: Application of Hedge Accounting Termination Provisions, an amendment of GASB Statement No. 53. The Exposure Draft clarifies the application of requirements in Statement No. 53, Accounting and Financial Reporting for Derivative Instruments, which address the termination of hedge accounting.

The proposal is designed to enhance the usefulness and comparability of information on derivative instruments reported by state and local governments by clarifying what constitutes a termination event for accounting and financial reporting purposes.

The need for additional clarity in this respect is necessary because questions have arisen regarding the application of the termination provisions in Statement 53 when a counterparty or a counterparty’s credit support provider of an interest rate swap or commodity swap is replaced because the original counterparty, or counterparty’s credit support provider, failed to comply with the specific terms of a swap agreement.

The scope of the project was originally limited to circumstances involving counterparty bankruptcies. During staff research, however, constituents raised issues involving additional circumstances in which a counterparty, or a counterparty’s credit support provider, is replaced due to other acts of default and termination events, as described in the swap agreement. The proposed clarifying guidance was expanded by the Board to cover those issues.

The proposed Statement is limited to the following circumstances:

• The interest rate swap or commodity swap is a hedging derivative instrument as defined in Statement 53.
   
• The swap represents a liability of the government.
   
• The counterparty, or the counterparty’s credit support provider, is replaced with an assignment or an in-substance assignment.
   
• The government enters into the assignment or in-substance assignment in response to the counterparty, or the counterparty’s credit support provider, either committing or experiencing an act of default or a termination event as both are described in the original swap agreement.

Under the proposal, when a government replaces a counterparty, or a counterparty’s credit support provider, it is required to be done as either an assignment or an in-substance assignment, meaning that only the counterparty, or the counterparty’s credit support provider, has changed and not the key terms of the swap agreement. For a replacement swap to be considered an in-substance assignment, the original swap and the replacement swap agreements are required to be entered into on the same day, and, if there is a difference between the original swap agreement’s exit price and the replacement swap’s price, that difference is attributable to the original swap agreement’s exit price being based upon an average of multiple quotes.

The swap terms enumerated above are included within the proposal because the Board believes they address circumstances in which a government’s counterparty, or a counterparty’s credit support provider, has committed an act of default or triggered a termination event identified in a swap agreement. Without the proposed guidance, a government would be required to cease hedge accounting. This would cause the government to recognize any accumulated deferred amount as an investment loss even if the original swap was an effective hedging derivative instrument and the amended swap or replacement swap has identical terms that continue the effective hedging relationship.

Proposed Effective Date

The provisions of the Exposure Draft would be effective for financial statement periods beginning after June 15, 2011. Earlier application is encouraged.

How to Obtain a Copy of the Exposure Draft

Copies of the Exposure Draft may be downloaded free of charge from www.gasb.org. Alternatively, a single photocopy of the Exposure Draft may be obtained by calling the GASB Order Department at (800) 748-0659. The comment deadline for the Exposure Draft is April 15, 2011.