1. Precision Experience Assurance GASB No. 53 – Accounting For Derivative Instruments FMPA, AROC, October 26, 2010 Mark A. White, CPA, Partner, Purvis Gray & Company LLP 1

2. Precision Experience Assurance Statement 53 Accounting and Financial Reporting for Derivative Instruments 2

3. Precision Experience Assurance What Will We Talk About Today? There are many different types of derivatives that exist in the markets today Impossible to cover all possibilities today Will cover basics of the statement Will go into more detail on Interest Swaps and Gas Hedges since this is what FMPA employs 3

4. Precision Experience Assurance One Page Summary of No. 53 Derivatives generally fit into two general categories; – Hedging derivative if effectiveness test is met Record at FMV and defer the gain or loss – Investment derivative if effectiveness test is not met Record at FMV and recognize investment gain or loss – OUCH!! Thus most of the statement deals with meeting hedge effectiveness—the prize! Effectiveness = very close price correlation between Derivative and item being hedged (Interest rates, NG prices) 4

5. Precision Experience Assurance What is a Derivative Instrument for Financial Reporting Purposes? A financial instrument or contract that has all of the following characteristics: – One or more reference rates (underlying) and one or more notional amounts or payment provisions LIBOR, SIFMA Currency or other units specified in the derivative Currency units, shares, pounds, MMBTUs – Leverage Little or no initial cash investment – Net settlement Not required to take delivery of commodity Terms require or permit settlement net Can be settled with another derivative (swaption) 5

6. Precision Experience Assurance Excluded Instruments Normal purchases and normal sales contracts – Commodity—for example, gas or electricity used in an activity – Government intends to and has practice of taking delivery or selling the commodity – Quantity is consistent with volume used Traditional insurance contracts Non exchange-traded climate contracts, liquidated damages, etc. 6

7. Precision Experience Assurance Hedging Derivative Instruments The derivative instrument is associated with a hedgeable item – Consistency of notional amounts – Derivative instrument will be reported in same fund as hedgable item – Term or time period consistency The hedging derivative is effective in significantly reducing the identified financial risk using No. 53 methods 7

8. Precision Experience Assurance Common Derivative Instruments Interest Rate Swaps Futures contracts--NYMEX Options—exchange-traded and others Swaptions 8

9. Precision Experience Assurance Methods of Evaluating Effectiveness Consistent Critical Terms – Notional amount same as principal amount – Issued at FMV of zero – Formula for net settlements don’t change over the term of the instrument – Same reference rates – Both or neither can have cap or floor – Same time interval of reference rate – Same maturity dates 9

10. Precision Experience Assurance Methods of Evaluating Effectiveness Synthetic Instrument Method – Didn’t pass the CCT test, must now measure how much difference there is – Test of if the variable cash flows substantially offset, -- the synthetic fixed rate is substantially fixed – Does the difference in variable cash flows move the fixed rate more than 10%? No—Effective Yes– Ineffective 10

11. Precision Experience Assurance Methods of Evaluating Effectiveness Dollar Offset Method – Compares the changes in expected cash flows or fair values of the hedging derivative to the same for the hedgable item – Can be applied YTD or LTD – Has to fall within 80 to 125% in absolute terms 11

12. Precision Experience Assurance Methods of Evaluating Effectiveness Regression Analysis Other quantitative methods These methods are too detailed to go into today, they are in the statement and implementation guide and Jim Towne can answer any question you might have on them after the presentation 12

13. Precision Experience Assurance How To Implement Two ways to calculate effectiveness; – End of first year of adoption (FYE 9/30/10) – Life to date of derivative through end of first year of adoption (5/14/04 through 9/30/10) Must have information available from inception – Annual test, can use any of the approved methods If you test as of 9/30/10 and are deemed effective; employ hedge accounting – Record derivative at FMV and defer the gain loss at 9/30/10 values – Re-test annually 13

14. Precision Experience Assurance How To Implement If 9/30/10 effectiveness fails; – Test effectiveness as of 9/30/09, if effective; Record at FMV and defer gain/loss as of 9/30/09 Bring deferred gain/loss into Investment Income in 2010 – Test effectiveness as of 9/30/09, if ineffective; Record at FMV and restate equity as of 9/30/09 Current year change in FMV—investment gain/loss – What about retesting next year if ineffective this year? Too bad forever, unless terms of instrument substantially modified – Record at fund level or entity wide? 14

15. Precision Experience Assurance Practical Considerations For Members If Interest Rate Swap effectiveness fails; – DSC coverage problems in utility funds? Pledge of NET Revenues Resolution definitions Technical default Additional bonds test FAS 71 bail out? – Would not be a problem for governmental debt where gross revenues are pledged and Swap not recorded at fund level 15

16. Precision Experience Assurance Components of an Interest Swap Time: Beginning and end Reference rate Notional amount Payment frequency Receive variable and pay fixed to counterparty Receive fixed and pay variable to counterparty 16

17. Precision Experience Assurance Swap-Cash Flow Hedge 17 Swap counterparty State or local government Variable-rate bond holders Variable-rate coupon payments Variable payment received: 67% of 1- month LIBOR Fixed payment 5.0%

18. Precision Experience Assurance Consistent Critical Terms Method FailDue to Benchmark Interest Rate Contract Variable Rate Demand Bonds Swap Value at Inception0 Swap Fixed Leg Fixed for Life of Swap Notional Amount $ 10,000,000 Bond Principal $ 10,000,000 (no amortization) Termination Date12/1/2030 Maturity Date 12/1/2030 Variable Index 70% of 1 Month LIBOR Bechmark Interest RateSIFMA Frequency of ResetWeekly Frequency of ResetWekly Swap Payment Dates1st Bus. Day of ea. Mo. Bond Coupon Payment Dates1st Bus. Day of ea. Mo. 18

19. Precision Experience Assurance Consistent Critical Terms Method Pass Interest Rate Contract Variable Rate Demand Bonds Swap Value at Inception 0 Swap Fixed Leg Fixed for Life of Swap Notional Amount $ 10,000,000 Bond Principal $ 10,000,000 (no amortization) Termination Date 12/1/2030 Maturity Date 12/1/2030 Variable Index SIFMA Bechmark Interest Rate SIFMA Frequency of Reset Weekly Frequency of Reset Wekly Swap Payment Dates 1st Bus. Day of ea. Mo. Bond Coupon Payment Dates1st Bus. Day of ea. Mo. 19

20. Precision Experience Assurance Synthetic Instrument Method (Cash Flow Hedges Only-No Hybrids of Fair Value Hedges) Swap Notional Amount $ 10,000,000 Pay Fixed - Receive Variable From Counterparty Swap Fixed Rate 4% SWAP Index 70% 1 Mo. LIBOR Fixed Swap Variable Swap Net Variable Pmnt. To Receipt From Derivative Bond Total Synthetic FYE Counterparty (Pmnt) Receipt Interest Payments Rate 9/30/2010 $ (400,000) $ 100,000 $ (300,000) $ (95,000) $ (395,000) 3.95% Analysis of Synthetic Instrument Test Synthetic Rate 3.95% Swap Fixed Rate 4.00% Percentage Ratio 98.75% Is Ratio Between 90% and 111%?Pass 20

21. Precision Experience Assurance Synthetic Instrument Method (Cash Flow Hedges Only-No Hybrids of Fair Value Hedges) Swap Notional Amount $ 10,000,000 Pay Fixed - Receive Variable From Counterparty Swap Fixed Rate 4% SWAP Index 70% 1 Mo. LIBOR Fixed Swap Variable Swap Net Variable Pmnt. To Receipt From Derivative Bond Total Synthetic FYE Counterparty (Pmnt) Receipt Interest Payments Rate 9/30/2010 $ (400,000) $ 45,000 $ (355,000) $ (95,000) $ (450,000) 4.50% Analysis of Synthetic Instrument Test Synthetic Rate 4.50% Swap Fixed Rate 4.00% Percentage Ratio 112.50% Is Ratio Between 90% and 111%? Fail 21

22. Precision Experience Assurance Features of Futures Contracts Exchange-traded-NYMEX, etc. Standard terms—notional amount, reference rate/underlying, settlement dates At the market Entered into a no cost; however, accounts are adjusted daily Margin—collateral is required 22

23. Precision Experience Assurance FMPA Gas Hedges NYMEX Hedges (New Edge Account) Options – puts and calls (JP Morgan Account) FGU storage NYMEX Hedges (New Edge Sub Account) All of above are priced using Henry Hub prices Actual NG purchases are priced at FGT Zone 3 prices Test of effectiveness is essentially a comparison of the Henry Hub prices with the FGT Zone 3 prices Difference has been small so most should be effective 23

24. Precision Experience Assurance Disclosures Summary Information; – Segregate between Hedging and Investment Derivatives – Within each category, present by type – Notional amounts – FMV and change in FMV 24

25. Precision Experience Assurance Disclosures Hedging Derivatives; – Objectives – Terms-notional amounts, reference rates, maturities – Risks-credit risk, interest risk, basis risk, termination risk, rollover risk, market access risk, foreign currency risk, Investment Derivatives – Risks above 25

26. Precision Experience Assurance GASB No. 53 – Accounting For Derivative Instruments FMPA, AROC, October 26, 2010 Mark A. White, CPA, Partner Purvis Gray & Company LLP, 26