Initial GASB position on derivatives: the GASB's recent proposal would extend the requirement for fair value reporting to all derivative transactions of the state and local governments.

• Author: Gauthier, Stephen J.
• Position: The Accounting Angle - Governmental Accounting Standards Board

This past spring, the Governmental Accounting Standards Board (GASB) published its initial position on the appropriate treatment of derivatives in the form of the preliminary views document (PV) Accounting and Financial Reporting for Derivatives. The board plans to proceed with the issuance of an exposure draft once it has had adequate time to consider responses to the PV. This article will briefly summarize the proposals set forth in the PV.

BACKGROUND

In simple terms, a derivative is a financial instrument or contract that involves both a variable factor (reference rate) and a potential payment that are associated in one of two ways:

* As a function of some other number (notional amount). For example, "the government agrees to make semiannual payments equal to the prevailing London Interbank Offered Rate (LIBOR) applied to the amount of $1,000,000" or

* As a trigger (payment provision). For example, "the government agrees to make a payment equal to $10,000 on the following date should the prevailing LIBOR on that date exceed 6 percent."

Two additional criteria must be met before a given financial instrument or contract qualifies as a derivative:

* Leverage. The initial net investment (if any) must be less than the notional amount (or the result of applying the reference rate to the notional amount) and

* Net settlement. The contract must not require actual delivery (i.e., a derivative must derive its value from something else).

A simple contract to purchase 10,000 bushels of wheat at the current market price of $10/bushel would not qualify as a derivative because: 1) the leverage requirement would not be met since the net investment (i.e., $10/bushel x 10,000 bushels = $100,000) would be equal to the notional amount (i.e., current fair value of 10,000 bushels of wheat) and 2) the net settlement requirement would not be met since actual delivery of the wheat would, in fact, be required. That is, the contract possesses its own inherent value rather than deriving its value from something else. Conversely, the purchase for $1,000 of a contract conveying the right to purchase 10,000 bushels of wheat six months from today at today's market price (i.e., $10/bushel) would qualify as a derivative because: 1) the leverage requirement would be met since the net investment of $1,000 is clearly less than the notional amount of $100,000 and 2) the net settlement requirement would be met since, as a practical matter, the contract could be settled in six...