The Governmental Accounting Standards Board (GASB) voted unanimously this week to issue a Preliminary Views document that is intended to improve the accounting and financial reporting of derivatives by state and local governments. The New York Times reports that derivatives are increasing in popularity among local governments as a means of reducing their cost of borrowing. The governments enter into derivatives contracts at the same time they issue bonds, in what is known as interest rate swaps. When these swaps perform as intended, they do reduce the costs of borrowing, however, things don’t always perform as planned.
The Board believes the public needs access to better and more information about the risks and impact derivatives transactions could have on government financial positions in light of substantial increases in both the number and dollar amounts of governmental derivative contracts.
“To evaluate the inherent risks that derivatives potentially pose to the financial health of governments, the public needs to better understand the nature of these transactions, including how their value and cash flows change over time,” Robert Attmore, chairman of the GASB, explained in a prepared statement. “We intend to make the reporting of derivatives and disclosure of the related risks more transparent.”
The proposal would require that the fair value of derivatives be reported in the financial statements, as well as the change in that fair value. If, however, a derivative is effectively hedging (reducing) the risk it was created to address, then the annual changes in the derivative’s fair value would be deferred and reported in a government’s balance sheet. Governments would also disclose additional information about their derivatives in the notes to the financial statements.
Interest rate swaps can be challenging to evaluate, Randal J. Finden, who is managing the GASB’s derivatives project, told the New York Times, because there can be periods when they look like losers but recover with a change of interest rates. According to the Times and Finden, the GASB isn’t trying to discourage the use of derivatives by government but, because failed swaps can result in large payments, governments party to such underperforming swaps would be required to report the amount necessary to buy out the contracts as liabilities on their balance sheets.
The Preliminary Views document will be available at the end of April for free download from the the GASB web site at www.gasb.org. The Preliminary View will be accompanied by a plain-language supplement that summarizes the proposed standards for financial statement users and others without an accounting background.