A derivative instrument is a financial instrument or other contract containing all of the following characteristics:

• Settlement factors – It has:
  • One or more reference rates (or underlyings)
    –AND–

  • One or more notional amounts or payment provisions (or both)

    These terms determine the amount of the settlement(s) and, in some cases, whether or not a settlement is required.

• Leverage – It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
  –AND–
• Net settlement – Its terms require or permit net settlement, it can readily be settled net by a means outside the contract or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

For example, assume that Sample Agency issued $100 million variable-rate demand bonds. The bonds pay the SIFMA swap index plus 10 basis points. At the same time, Sample Agency enters into a pay-fixed, receive-variable interest rate swap with the notional amount of $100 million. Assume that the variable rate is the SIFMA swap index and the fixed rate is 3.704 percent.

In this example, the potential hedgeable items are the variable-rate bonds. The reference rate is the SIFMA swap index. No payments are required for Sample Agency at the inception of the derivative contract. The contract fulfills the net settlement requirements because either party to the contract will pay or receive the notional amount times the difference between the 3.704 percent fixed rate and the variable SIFMA swap index.

The diagram below depicts the payment terms of the swap and the variable-rate demand bonds from the example above:

The following derivative instruments are excluded from the scope of GASB 53:

• Normal purchases and normal sales contracts
• Certain financial guarantee contracts
• Certain contracts that are not exchange-traded
• Loan commitments and insurance contracts accounted for under GASB 10
• Derivative instruments that do not have leverage as of the trade date

Normal Purchases and Sales Contracts

Normal purchases and sales contracts generally involve the purchase or sale of a commodity in the normal course of the agency’s operations. These contracts provide protection from price changes in commodities the state acquires to use or sell in the future. If a normal purchase or sales contract represents a significant commitment, disclose the nature and amount of that commitment within Note 15. Conduct an evaluation at least annually to determine if a contract meets the normal purchases and normal sales scope exception.

If delivery of the commodity is not taken under a normal purchase and normal sales contract, and the commodity contemplated in the purchase contract is acquired through another contract, the scope exception does not apply. Evaluate the contract to determine if the contract is an effective hedging derivative instrument.

If the contract:

• Is an effective hedge — the fair value increase or decrease is included as an adjustment to the cost of the commodity.
• Is not an effective hedge — the fair value increase or decrease is reported within the investment revenue classification.

Certain Financial Guarantee Contracts

The financial guarantee contracts included in the scope of GASB 53 are limited to the financial guarantee contracts considered to be investment derivative instruments entered into primarily for the purpose of obtaining income or profit. This amended scope was made in GASB 59. An example is a credit default swap that an agency enters into to take a position for gain or income in response to changes in a reference rate (such as a contract that provides for payments to be made if the credit rating of a debtor falls below a particular level).

A financial guarantee contract that meets the definition of a derivative instrument and is not entered into as an investment derivative instrument primarily for the purpose of obtaining income or profit is outside the scope of GASB 53. An example is a bond insurance for which the agency pays the premium. The bond insurance is associated with the agency’s debt, and the debt holder is the beneficiary.

Impact of Trade Date Accounting

Transactions of derivative instruments — either exchange-traded (such as a commodity futures contract) or non-exchange-traded (such as a forward contract) — are accounted for based on the trade date. The trade date is the date when the transaction occurred (such as the date the agency acquires or sells ownership of the derivative instrument). Make GASB 53 disclosures and recognize changes in fair value starting on the trade date. It is not correct for agencies following GASB to account for derivative instrument activity based upon the settlement date (such as the date on which the securities are delivered or received in exchange for the cash payment).

To determine if a contract is a derivative instrument, consider if there is leverage or not. Contracts to purchase “when announced” or “to-be announced” securities do not meet the GASB 53 definition of a derivative instrument. The securities are reported at their full amount as an investment with a corresponding payable to purchase the security on the trade date. Since the contract was already reported as an investment, no leverage exists.

Apply similar logic to foreign currency exchange “spot” contracts. These are contracts of a very short-term nature that are used for the management of transactions that will be settled in foreign currencies. Because these contracts are outside the scope of GASB 53, do not include them in any GASB 53 disclosures and do not use USAS general ledger (GL) accounts 0059 or 0105.

Governmental Funds

GASB 53 does not address the issue of reporting derivative instruments at fair value in the governmental fund statements. Derivative instruments measured at fair value are only reported in the proprietary, fiduciary and government-wide statements.