Final GASB guidance on derivatives: a number of arrangements that might otherwise qualify as derivatives have been excluded from the scope of GASB Statement No. 53.(The Accounting Angle)(Governmental Accounting Standards Board)

This past June, the Governmental Accounting Standards Board (GASB) released Statement No. 53, Accounting and Financial Reporting for Derivative Instruments. The provisions of this new standard become mandatory for the fiscal year ending June 30, 2010.

Background. In essence, a derivative is an arrangement to receive or make payments based on market prices without actually entering into the related financial or commodity transactions. Sometimes a derivative will function economically as an investment. At other times, derivatives are used to offset potential volatility in cash flows or fair value, or as a means of lowering the cost of borrowing. Technically speaking, an arrangement must possess three characteristics to qualify as a derivative:

* Settlement features. A derivative always involves an objectively verifiable reference rate. This reference rate may be a specific price, a specific rate, or an index of prices or rates. It could also be the occurrence or nonoccurrence of an event. In addition, a derivative will always involve either a notional amount, a payment provision, or both. A notional amount is the value to which the reference rate is applied to determine the amount of the payment. A payment provision specifies the amount of the resulting payment should a reference rate behave in a predetermined fashion.

* Leverage. Another characteristic of a derivative is that the contracting parties are able to achieve a given economic effect at only a fraction of the investment of resources normally required to do so. In an interestrate swap, for example, a government is able to achieve a result equivalent to refinancing its debt without generating anything near the cash flows that would normally be required to do so.

* Net settlement. A third characteristic of a derivative is that it can be settled for cash at substantially less than the notional amount.

Common examples of derivatives found in the public sector include interest-rate swaps, basis swaps, "swaptions," and commodities contracts.

A number of arrangements that might otherwise qualify as derivatives have been excluded from the scope of GASB Statement No. 53: normal purchase and sales contracts; insurance contracts; financial guarantee contracts contingent upon default; certain contracts that are not exchange-traded; and loan commitments.