Tax-Exempt Bonds - Accounting and Auditing Considerations in the …

    Tax-Exempt Bonds - Accounting and Auditing Considerations in the
                            Current Environment


May 2008



INTRODUCTION AND BACKGROUND

The current credit environment has impacted the market for debt
securities. While all debt securities may be affected, this article focuses on
tax-exempt debt issued 1 by not-for-profit organizations and municipalities,
states, cities and other governments such as redevelopment agencies,
school districts, public universities, airports and seaports. This article has
a particular focus on debt that is referred to as (1) auction rate securities
(ARSs) and (2) variable rate demand obligations (VRDOs). While the
current environment presents accounting and auditing issues for investors
in that tax-exempt debt, this article focuses on issues facing the issuers of
that debt.

Traditional ARSs are long-term debt securities with legal maturities
typically of at least 20 years, with interest rates that are reset periodically
(typically every week or month but in some cases every 35, 49, 60, or 90
days) in blind auctions held by investment banks. Because the interest
rates are reset on a relatively short time frame, traditional ARSs were
designed to be traded as liquid, short-term debt securities.

Most ARSs are guaranteed by a third party, typically known as a bond
insurer, and the bond insurer's rating typically affects the rating of the
bond. Recently, some bond insurers have experienced credit downgrades,
while others have struggled to maintain their credit rating due in part to
their exposure to subprime mortgages. As some investors became
concerned that the troubled bond insurers may no longer be able to meet
their obligations in the event of default, those investors have avoided
ARSs.

In addition, many investors, such as investment banks, have experienced
significant losses associated with their investments related to subprime

1
  For purposes of this article, the discussion of tax-exempt debt and
entities that issue such debt includes conduit debt and organizations that
are obligors under conduit debt.

                                      1
mortgage securities, reducing the available capital for ARSs. As a result,
many investment banks serving as auction agents, who previously may
have purchased securities at auction to prevent failed auctions, 2 began to
allow auctions to fail. Every major investment bank has experienced failed
auctions, and no entity that has issued ARS's is insulated from these
market conditions.

Interest rates on ARSs with failed auctions typically default to the
maximum rate defined in the related agreements. Some organizations
have experienced interest rate increases from the low single digits to as
high as twenty percent as a result of auction failures. Also, it is not
uncommon to have an auction fail one week and be successful the
following week, though perhaps with significantly higher interest rates.
This has resulted in significant interest rate volatility and, in some cases,
higher overall interest costs for entities issuing that debt.

Due to the significant increase in interest costs associated with ARSs due
to the above factors and founded or unfounded fears in the credit markets,
many issuers of ARSs are restructuring their ARSs in various ways
depending on their specific facts and circumstances. Some are issuing
new bonds (including VRDOs, which are discussed in more detail below),
others changing the interest rate mode as provided for under existing
agreements, some buying back their own bonds, and some pursuing a
variety of other options.

VRDOs are short-term obligations that are characterized by a "put" or
demand feature that gives the bondholder the ability to "put" the bonds
back to a remarketing agent (or in some circumstances, to the issuer of the
VRDO). If the "put" bonds cannot be remarketed to another investor, a
liquidity facility issued by a financial institution [for example, a standby
bond purchase agreement (SBPA), letter of credit (LOC), or line of credit]
typically provides the agent or issuer of the VRDO funding to cover the put.

In addition, organizations may have interest rate swaps associated with
tax-exempt debt. Based on the terms of these swap agreements, credit
downgrades to the parties to the swap may trigger an automatic
termination of the swap or a requirement to post collateral. In addition,
changes in bond interest rates may result in the swap no longer effectively
hedging the interest-rate risk associated with the debt.


2
  A failed auction occurs in circumstances in which not enough orders exist
to purchase all the securities being sold at the auction.

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This nonauthoritative article provides issuers of tax-exempt debt and their
auditors an overview of the accounting and auditing considerations that
may be relevant in light of these recent market events and entity
transactions. The purpose of this article is to raise awareness about
potential accounting and auditing issues that may be relevant to issuers of
tax-exempt debt and their auditors (in connection with that tax-exempt
debt), and to point readers toward accounting and auditing guidance that
may be relevant to those issues. Each situation is different and should be
evaluated based on its specific facts and circumstances. Some of those
issues, as well as the accounting and auditing guidance that may
be applicable, are highlighted below.


DISCUSSION OF ACCOUNTING AND AUDITING ISSUES


Bond restructuring

Not-for-profit organizations and governments wishing to restructure their
ARSs have several options available, including but not limited to
reacquiring the ARSs, refinancing the ARSs, or changing the security's
interest rate mode (e.g., from an auction rate to a fixed or variable rate).
Certain of these actions may result in the ARSs being considered
extinguished for accounting purposes. (In addition, such actions may
affect the balance sheet classification of the liabilities, which is discussed
later in this article.)


Applicable guidance

Nongovernmental issuers of tax-exempt debt

Paragraph 16 of FASB Statement No. 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities, provides
guidance for determining circumstances in which a liability is considered
extinguished.

Paragraph 16(a) of Statement No. 140 provides that a liability should be
considered extinguished (and derecognized) if "the debtor pays the
creditor and is relieved of its obligation for the liability." This explicitly
includes situations where the debtor reacquires its outstanding debt
securities, regardless of whether the reacquired securities are held by the
debtor (as "treasury bonds") or cancelled.


                                      3
Paragraph 16(b) of Statement No. 140 provides that a liability should be
considered extinguished (and derecognized) if "[t]he debtor is legally
released [FN omitted] from being the primary obligor under the liability,
either judicially or by the creditor." If an ARS is restructured through an
advance refunding transaction, 3 because the debtor has not paid the
creditors (i.e., the holders of the ARSs), the debtor may need a legal
opinion in order to conclude that it has been legally released as the
primary obligor of the ARSs. While there is no direct auditing guidance as
to the form and content of a typical legal letter governing a legal
defeasance, the principles outlined in AU Section 9336, The Use of Legal
Interpretations As Evidential Matter to Support Management's Assertion
That a Transfer of Financial Assets Has Met the Isolation Criterion in
Paragraph 9(a) of Financial Accounting Standards Board Statement No.
140, may be helpful in determining whether the letter obtained by the
debtor is adequate audit evidence that the debtor has been legally
released as the primary obligor of the ARSs.

Statement No. 140 also provides guidance on accounting for assets that
may be transferred to an escrow to advance refund the ARSs. Specifically,
such assets should meet the isolation criterion of paragraph 9(a) of
Statement No. 140 in order for the assets placed into the escrow trust to
be derecognized from the debtor's balance sheet. A legal opinion may be
needed as audit evidence to support the assertion that the assets
transferred to the trust have met the isolation criterion.

EITF Issue No. 96-19, Debtor's Accounting for a Modification or Exchange
of Debt Instruments, provides guidance for evaluating whether a
replacement of one debt instrument with another is, in essence, a
refinancing of the debt with the same creditors (that is, a modification of
the original debt terms), rather than an extinguishment of the old debt.
EITF Issue No. 96-19 also provides guidance for reporting costs incurred
by the debtor in connection with an exchange or modification,
and addresses the consideration of the role played by an intermediary
such as an investment bank in a modification/extinguishment as either an
agent or a principal.

3 In an advance refunding, the proceeds from the sale of the refunding
bonds are used to purchase governmental securities, which are deposited
into an escrow account. The escrow account is structured such that the
principal and related earnings on the governmental securities are sufficient
to pay all principal, interest, and any call premium on the ARSs up to the
date at which they may be called.

                                     4
If the debtor's action with respect to its debt results in an extinguishment, it
should account for that extinguishment pursuant to APB Opinion No. 26,
Early Extinguishment of Debt, as amended.


Governmental issuers of tax-exempt debt

If the action results in or is an advance refunding that results in a
defeasance, paragraphs 8 to 12 of GASB Statement No. 7, Advance
Refundings Resulting in Defeasance of Debt, provide guidance. GASB
Statement No. 23, Accounting and Financial Reporting for Refundings of
Debt Reported by Proprietary Activities, (which includes guidance about
the presentation that would occur in the Statement of Net Assets and
Statement of Activities), provides guidance for all refundings (current as
well as advance refundings). On the balance sheet of the proprietary fund
activity, or the statement of net assets of the government, any gain or loss
resulting from the refunding should be deferred and reported as a
deduction from or an addition to the new debt liability. The amortization
period is the shorter of the term of the original debt or the new debt.


Derivatives

Entities with interest rate swaps may find that those swaps are no longer
effective in economically hedging the risk of interest rate increases.
Additionally, credit downgrades of insurers and entities issuing tax-exempt
debt are resulting in increased exposure to the risk of needing to post
collateral or, in some cases, involuntary termination of some swaps.
Finally, debt restructuring may result in discontinuation of hedge
accounting for related interest rate swaps.


Applicable guidance

Nongovernmental and certain governmental proprietary issuers of tax-
exempt debt 4



4
 As used in this article, "certain governmental proprietary issuers" refers to
governmental proprietary activities that apply paragraph 7 of GASB
Statement No. 20.

                                       5
An issuer of ARS may have hedged the variability of the future cash flows
(variable interest payments) using a hedge characterized as a cash flow
hedge under FASB Statement No. 133, Accounting for Derivative
Instruments and Hedging Activities. 5

Paragraphs 28 through 34 and 500 to 501 of Statement No. 133 provide
guidance on accounting for cash flow hedges, including accounting for
hedge termination.


Governmental issuers of tax-exempt debt

GASB has not issued standards addressing                 the   recognition   or
measurement of debt-related interest rate swaps. 6

Proprietary funds/activities that apply paragraph 7 of GASB Statement No.
20 are required to apply the provisions of FASB 133 (to the extent that they
do not contradict or conflict with the provisions of existing GASB
statements). They do not, however, apply FAS 133's cash flow hedge
accounting provisions, because the accounting required conflicts with the
GASB's financial reporting model. (See GASB Q&A, item 7.72.1). 7

Unless an entity or fund applies paragraph 7 of GASB Statement No. 20,
GASB Technical Bulletin 2003-1, Disclosure Requirements for Derivatives
Not Reported at Fair Value on the Statement of Net Assets, paragraphs
10(d)1-3, requires that if a derivative exposes a government to termination

5 Issuers and their auditors should note that subsequent to the effective
date (the first day of the first fiscal quarter beginning after January 8, 2007)
of FASB Statement No. 133 Implementation Issue G26, Cash Flow
Hedges: Hedging Interest Cash Flows on Variable-Rate Assets and
Liabilities That Are Not Based on a Benchmark Interest Rate, for a hedge
to qualify as a cash flow hedge under Statement No. 133, issuers have
had to hedge the entire change in the variable rate and not just the
benchmark component.
6
   Appendix A to this article discusses a June 2007, GASB exposure draft
of a proposed standard, Accounting and Reporting for Derivative Financial
Instrument."
7
  Once GASB's proposed derivatives standard is issued and effective,
FASB Statement No. 133 likely will no longer be applicable to governments
that apply paragraph 7 of GASB Statement No. 20

                                       6
risk, the government should disclose that exposure as termination risk and
also the following:
(1)     Any termination events that have occurred.
(2)     Dates that a derivative may be terminated.
(3)     Out-of-the-ordinary termination events contained in contractual
documents, such as "additional termination events" contained in the
Schedule to the International Swap Dealers Association Master
Agreement.


Debt Covenants

A downgrade of the credit rating of the bond insurer insuring the debt, as
well as other events, may trigger technical defaults under the debt
agreements. If a default occurs, issuers of tax-exempt debt should
consider whether that default triggers classification of the liability as current
or cross defaults in other arrangements.

Replacement of ARSs classified as long-term liabilities with VRDOs
classified as current liabilities (discussed further below) could trigger
violations of liquidity covenants in other debt agreements.

Ratings downgrades of surety providers (for example, sureties provided to
satisfy debt service reserve requirements) may trigger defaults.


Applicable guidance


Nongovernmental and certain governmental proprietary issuers of tax-
exempt debt

Accounting Research Bulletin No. 43, Chapter 3A, Current Assets and
Current Liabilities, defines current assets and current liabilities for balance
sheet classification purposes. FASB Statement No. 78, Classification of
Obligations That Are Callable by the Creditor, clarifies how the debtor
should present obligations that are callable by the creditor in a balance
sheet in which liabilities are classified as current or noncurrent.


Governmental issuers of tax-exempt debt




                                       7
GASB Statement No. 38, Certain Financial Disclosures, requires that
violations of finance related or legal covenants be disclosed in notes to the
financial statements.

Failure to file a document required under a Rule 15c2-12 continuing
disclosure covenant (such as a material event notice) may be considered a
debt covenant violation that requires disclosure under Statement No. 38.


Events Occurring Subsequent to the Balance Sheet Date

Events occurring subsequent to the balance sheet date but prior to the
issuance of the financial statements, such as actions pertaining to
extinguishing or modifying an ARS arrangement, may need to be reflected
in the financial statements. For example, bond restructuring transactions
occurring after the balance sheet date may have an effect on the debtor's
current/noncurrent balance sheet classifications as of that balance sheet
date. Also, other events occurring after the balance sheet date, such as
failed auctions, potential or actual cancellation of a liquidity facility, or a
mandatory tender of bonds may need to be disclosed in the financial
statements as subsequent events.


Applicable guidance


Nongovernmental and governmental issuers of tax-exempt debt

Paragraphs 5 and 6 of AU Section 560, Subsequent Events, provide
guidance pertaining to subsequent events. Paragraph 6 notes the sale of a
bond subsequent to the balance sheet date as an example of an event that
requires disclosure in the notes to the financial statements.

Accounting Research Bulletin No. 43, and FASB Statement No. 6,
Classification of Short-Term Obligations Expected to Be Refinanced, (and
for governmental entities, NCGA Interpretation No. 9. Certain Fund
Classifications and Balance Sheet Accounts) provide guidance for the
classification of short-term obligations that are expected to be refinanced
on a long-term basis.




                                      8
EITF Issue No. 86-30, Classification of Obligations When a Violation is
Waived by the Creditor, 8 addresses the classification of obligations at the
balance sheet date that are not callable at the balance sheet date but that
become callable by violation of a debt agreement provision after the
balance sheet date but before the financial statements are issued.


Balance Sheet Classification (Issues not Discussed Elsewhere)

Issuers of VRDOs typically execute a standby bond purchase agreement,
a letter of credit, or a similar liquidity facility with a bank to provide funding
in the event that debt holders "put" the bonds to the debtor and the bonds
are not remarketed. The terms of the liquidity facility and other relevant
factors (such as any subjective acceleration clauses, material adverse
event clauses, repayment terms/installment payment schedules associated
with liquidity facilities or take out agreements, and the debtor's ability and
intent to refinance the debt) may affect the balance sheet classification of
VRDOs. Typically, debt that contains a put option to the debtor should be
classified as a current liability. In certain circumstances, however, the
terms of the liquidity facility or other factors may lead to the conclusion that
the debt should be classified as long-term.


Nongovernmental issuers of tax-exempt debt

Accounting Research Bulletin No. 43, Chapter 3A, Current Assets and
Current Liabilities, defines current assets and current liabilities for balance
sheet classification purposes. FASB Statement No. 78, Classification of
Obligations That Are Callable by the Creditor, clarifies how obligations that
are callable by the creditor should be presented in a balance sheet in
which liabilities are classified as current or noncurrent.

EITF Topic No. D-23, Subjective Acceleration Clauses and Debt
Classification, FASB Technical Bulletin 79-3, Subjective Acceleration
Clauses in Long Term Debt Agreements, and FASB Statement No. 6
provide guidance pertaining to balance sheet classification in
circumstances in which debt agreements include subjective acceleration
clauses.


8
  Consensus Opinions of the EITF represent "other accounting literature"
for governmental entities other than proprietary entities or funds that apply
paragraph 7 of GASB Statement No. 20, under current GAAP.

                                        9
EITF Topic No. D-61, Classification by the Issuer of Redeemable
Instruments That Are Subject to Remarketing Agreements, discusses the
appropriate balance sheet classification of debt in the circumstances in
which (1) the debt has a long-term maturity (for example, 30 to 40 years),
(2) the debt holder may redeem or put the bond on short notice (7 to 30
days), (3) the debtor has a remarketing agreement that states that the
agent will make its best effort to remarket the bond when redeemed, and
(4) the debt is secured by a short-term letter of credit that provides
protection to the debt holder in the event that the redeemed debt cannot be
remarketed.


Governmental issuers of tax-exempt debt

NCGA Statement 1, Governmental Accounting and Financial Reporting
Principles, as amended, provides that bonds and similar long-term
liabilities of proprietary funds/activities should be reported by those
funds/activities as current or noncurrent liabilities, as appropriate, in
conformity with ARB Opinion No. 43, FASB Statement No. 6, and FASB
Statement No. 78. All other unmatured indebtedness should be reported
as general long-term debt. Unmatured principal of general long-term debt
is not a specific fund liability of governmental funds. Matured principal of
general long-term debt should be reported as a liability of the fund in which
the proceeds were deposited or in a debt service reserve fund.

For demand bonds such as VRDOs, GASB Interpretation No. 1, Demand
Bonds Issued by State and Local Governmental Activities, provides
guidance that is similar (but not identical) to that of EITF Topic No. D-61.
Generally, demand bonds are reported as general long-term debt of
proprietary funds (or for proprietary funds/activities, excluded from current
liabilities) if the following conditions are met.

a.    There is an arm's-length financing (take out) agreement to convert
bonds "put" but not resold into some other form of long-term obligation.
b.    The take out agreement does not expire within one year from the
date of the debtor's statement of net assets.
c.    The take out agreement is not cancelable by the lender or the
prospective lender during that year, and obligations incurred under the
take out agreement are not callable by the lender during that year.
(discussed further below)
d.    The lender or the prospective lender or investor is expected to be
financially capable of honoring the take out agreement.



                                     10
If these conditions are not met, demand bonds should be reported as fund
liabilities of governmental funds or as current liabilities of proprietary
funds/activities.

In evaluating condition (c), if the take out agreement is cancelable or
callable because of violations that can be objectively determined by both
parties but no violations have occurred prior to issuance of the financial
statements, the demand bonds should be classified as long-term debt.
Otherwise, the demand bonds should be classified as a fund liability of
governmental funds or as a current liability of proprietary funds/activities. If
the take out agreement is cancelable or callable because of violations that
cannot be objectively determined by both parties (for example, due to the
existence of subjective acceleration clauses or material adverse change
clauses whereby the lender has the unilateral ability, based on subjective
information, to deem that a violation has occurred), then the agreement
does not provide sufficient assurance of long-term financing capabilities to
classify the bonds as long-term debt.

If a take out agreement has been exercised converting the bonds to an
installment loan, the installment loan should be reported as general long-
term debt and the payment schedule under the installment loan should be
included as part of the schedule of debt service requirements to maturity.


Going Concern Considerations

Several events (some interrelated) could call into question the entity's
ability to continue as a going concern. For example:

   · As discussed earlier, a downgrade of the bond insurer or other
     events may trigger technical defaults of the debt agreements
   · Failed auctions for ARSs may indicate that future issuances of ARS
     may no longer be an available source of funds, or that the higher
     failed-auction penalty interest rate may have a significant impact on
     liquidity
   · A downgrade of VRDOs could result in termination of a liquidity
     facility, a mandatory tender of the bonds, and/or an acceleration of
     the debt
   · Ineffective derivative arrangements, potential termination of
     derivatives, and/or collateral posting requirements can pose
     significant challenges to an issuer's liquidity




                                      11
   · Overall market conditions may indicate that a debtor's access to the
     debt and derivative markets is constrained, which may lead to
     liquidity problems
   · Entities seeking to convert ARSs to VRDOs may find that the market
     for liquidity facilities is limited and, as a result, either (1) enter into
     facilities on less favorable terms than would otherwise be the case,
     or (2) be unable to obtain a liquidity facility (self-liquidity can expose
     the entity to significant liquidity strains)

The auditor should consider such events and circumstances in evaluating
a debtor's ability to continue as a going concern.

Applicable guidance


Nongovernmental and governmental issuers of tax-exempt debt

AU Section 341, The Auditor's Consideration of an Entity's Ability to
Continue as a Going Concern, provides guidance with respect to
evaluating whether there is substantial doubt about the debtor's ability to
continue as a going concern, as well as the impact on the auditors' report.


SUMMARY

As noted earlier, each entity's situation with respect its tax-exempt debt is
different and should be evaluated based on its specific facts and
circumstances Therefore, it is important that the entity and its auditors
carefully evaluate the facts and circumstances of each situation to
determine the appropriate financial reporting and auditing procedures. In
addition, applicable authoritative guidance in addition to that listed above
should be consulted when necessary.


Article Authors: Ad Hoc group of AICPA Members




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APPENDIX A ­ GASB's Proposed Guidance for Derivatives

At the time this article was written, no GASB standard required recognition
of derivatives in the statement of net assets. In June 2007, GASB issued
an exposure draft of a proposed standard, Accounting and Reporting for
Derivative Financial Instruments, which would require that the fair value of
all derivatives be reported in the government-wide statement of net assets.
The proposed GASB standard would mandate evaluation of all derivatives
as potential hedging derivatives. The GASB model for hedge accounting
differs from the FASB model in many respects, most notably in that the
GASB model provides that gains/losses associated with effective hedges
would be reported in deferral accounts on the statement of net assets.

If a termination of a swap that was a hedging derivative occurs, hedge
accounting would be discontinued. Termination events would include the
disassociation of a hedge with a hedgeable item; the lack of hedge
effectiveness using any one of GASB's proposed methods (consistent
critical terms, creation of a synthetic instrument, dollar offset, regression
analysis, etc.); the likelihood that a hedged expected transaction will occur
is no longer considered probable; the retirement or sale of a bond; or the
termination of the hedging instrument.9

The impact of termination, modification or extinguishment of a hedging
derivative would be reflected in the statement of activities (or, for
proprietary funds/activities, in the statement of revenues, expenses, and
changes in net assets). Any associated deferral balance would be
eliminated and reported as an element of investment income (loss).

Issuance of a final standard is expected in June 2008, and would be
effective for fiscal years beginning after June 15, 2009.




9
  GASB. Exposure Draft: Proposed Statement of the Governmental
Accounting Standards Board ­ Accounting and Financial Reporting for
Derivative Instruments. Paragraphs 18, 21-53.

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