American Accounting Association 2006 Midwest Region Meeting March 30 – April 1 Chicago, Illinois

Saturday, April 1, 11:00 a.m. to 12:50 p.m.
Concurrent session 6D - Accounting History and Corporate Governance (History, Government and Nonprofit)

Title: Debt–Related Derivatives, US State Governments, and Evolving Financial Reporting Standards

Louis J. Stewart Kean University

ABSTRACT: This paper examines the nature and extent of debt – related derivative activities among US state governments. The general downward trends of interest rates over the past decade has presented many credit worthy municipal debt issuers with exceptional opportunities to reduce their debt service costs by refunding outstanding debt and financing new projects at historically low interest rates. In this environment, many states government are utilizing interest rate swaps and other derivative financial instruments to synthetically change the cash flow and risk characteristics of the interest payment associated with their long term debt. My paper presents the first descriptive study of those activities among US state governments. This paper also summarizes the available authoritative and professional guidance for appropriate footnote disclosure standards for debt related derivative transactions as well as sample language from the Comprehensive Annual Financial Reports (CAFR) of various states. There are currently 23 state governments and the District of Columbia that have engaged in such transactions with an aggregate notional value approaching $23 billion. These transactions were highly concentrated with over 80% of debt – related derivative notional value being concentrated among the District of Columbia and eight states – California, New Jersey, Massachusetts, New York, Texas, Minnesota, Alabama, and Pennsylvania. The most popular debt – related derivative financial instrument among US state governments is the floating to fixed swap. The objective of the floating to fixed payer swap is to hedge a state government’s exposure to the risk of rising bond market interest rates from their floating rate long term debt and to synthetically lock in contemporary low market fixed interest rate for their outstanding bond obligations. GASB Technical Bulletin 2003 – 1 as well as guidance from the Government Financial Officers Association (GFOA) and the National Federation of Municipal Analysts (NFMA) provide public sector derivative users with guidance on appropriate disclosure practices. I found that GASB’s new disclosure standards have improved the transparency of state governments’ financial statements with respect to their derivative activities.

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