In a time of volatile energy prices and economic uncertainty, the Governmental Accounting Standards Board has issued a standard that should allow state and local governments to more easily use derivative financial instruments to hedge against changes in prices and interest rates.

GASB Statement 53, Accounting and Financial Reporting for Derivative Instruments, establishes rules for long-needed consistency in reporting on derivatives. It requires governments to report most derivatives at fair value in financial statements prepared on an accrual basis and using the economic resources measurement focus.

GASB project manager Randy Finden said that the board wrote a statement that clarified the treatment of derivatives that governments use most often.

"We spent a lot of time studying the kinds of derivatives that governments enter into," Finden said. "They are chiefly associated with borrowing -- their debt -- and commonly trying to set a fixed-rate interest rate. There's also a lot of activity in commodities for transportation and utility entities that are buying and selling energy. We tailored the document to those kinds of transactions."

The use of derivatives as hedging devices has become more common as governments take measures to reduce the risk of unpredictably high fuel prices. These prices not only affect transportation and heating, but also fuel for government-owned energy utilities. Work on the project, however, began well before the current spike in energy prices.

Anne Ross, senior vice president at municipal bond specialist Roosevelt & Cross, praised the statement, saying that it would improve disclosures and thus facilitate analysis of government financial statements. "Heretofore, disclosures on derivatives have been inconsistent, which is why, as an analyst, I appreciate a standard that now provides some guidance on not only what needs to be disclosed but how it needs to be disclosed," she said.

Under the new statement, changes in fair values of hedging derivatives will be reported as deferred inflows and outflows on the statement of net assets. Investment derivatives, including ineffective hedges, will be reported as income or loss in current-year investment revenue. The statement provides specific guidance on determining whether a derivative will result in an effective hedge.

WHAT IT DOESN'T SAY

In a significant change from an exposure draft issued in 2007, the final statement does not address how governmental funds report derivatives. The board opted to remain silent on the issue, Finden said, while it works on a measurement attribute project. That project, part of the board's work on a conceptual framework, is expected to be completed in 2010, after which it may begin work on a new statement or an amendment to Statement 53.

After reviewing comments received on the exposure draft, the board also decided not to include financial guarantee contracts, loan commitments and insurance contracts within the scope of the standard. It also elaborated on what "on or about" means in the repricing dates of a hedging interest rate.

Michael Marz, vice chairman of financial advisory and investment banking concern First Southwest Co. and a member of the GASB task force that helped research the standard, said that the board had originally intended to improve reporting on derivatives simply by improving disclosures.

Research, however, revealed that the market wanted more.

"GASB, looking at what the Financial Accounting Standards Board had done [on accounting for derivatives], established similar procedures, though I believe the GASB procedures are better and more flexible for municipal issuers in terms of showing effectiveness of a hedge," he said. "They were leading-edge with that regard."

That flexibility, Marz explained, is more conducive to municipal finance, which, unlike corporate finance, tends to use derivatives as hedges on liabilities, rather than assets.

The statement reflects the common government need to ensure that a current year's resources are sufficient to cover the current year's costs. By allowing changes in fair value to be deferred until a future period, the statement avoids distortions in current-year assessments of inter-period equity.

The statement is effective for reporting periods beginning after June 15, 2009, with earlier application encouraged. The board is now working on implementation guidance to help governments and the users of financial statements understand the changes in accounting principles.

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