The amortization reduces the net earnings from each year from $50,000 to $45,000. (The $5,000 is treated as a return of capital each year.)

This amortized value methodology served two functions. In an actively traded portfolio or trading situation the sale decision could be made dependent upon the unrealized gain/losses on the security. A gain on the security would produc e a capital gain to the portfolio. In a buy and hold portfolio in which the governmental entity had bought the security to match a defined cash flow requirement, the amortized cost method provides an accurate measure of the invested principal as the prin cipal moves toward maturity.

(Mortgaged backed securities do not fit this rigid standard because the paydowns on the security as mortgage payments are made may fluctuate throughout the life of the bond. ---------------------)

Market Background

Over the past decade governmental entities have realized the value of their invested assets. They began to see the investment portfolios as an important source of incremental income. As a result, portfolios started to take advanta ge of extended maturities and lower marginally credit risks to increase yield. Since the markets only pay investors for risk taken this means that they were absorbing more risk for additional income. Unrealized gains and losses could act as a caution fl ag that too much risk was being taken by the portfolio in extended maturities or lower credit ratings.

When interest rates changed dramatically in 1994, many governmental investors were forced to sell securities which had unrealized losses thus incurring realized losses. If the entity did not report the portfolio based on amortiz ed cost methodology and consistently compare their book value to the market value (pricing) the governing boards were faced unexpectedly with true losses of principal. Governing boards and state legislatures suddenly demanded a reporting which clearly id entified risks through a comparison of book and market values.

[Losses had also been incurred in the private sector and the Financial Accounting Standards Board issued FASB 115, which required that investments be identified as buy and hold or trading securities. A buy and hold securi ty could be reported on an amortized value but those in the trading category had to be marked to market (compared to the market value) to identify risks. FASB 124 which applies to non-profit organizations, such as universities and foundations, required m ore stringent market value reporting on all investments because of the nature of the funds involved.]

The GASB 31 process is seen as an investment performance - or risk - indicator as much as an investment accounting methodology. It is similar to the performance measurements used by longer bond fund and private investment managers to d etermine the success in their choice of securities and their management of those securities on an ongoing basis. A significant unrealized loss or gain also indicates something about how much risk is present. However, it must be remembered that these man aged longer portfolios are, by their nature, usually more actively managed and not necessarily used for matching cash flow but rather long-term investment income and performance. (This difference between the two is also exemplified in the use of yield ve rsus rate of return because the inflows and outflows of cash interfere with the accurate calculation of rate of return.)

New Investment Definitions

Investment Income

As seen in the example above, investment earnings under the amortized cost method represent the true interest received minus the pro rated amortization or accretion. Under the fair value GASB standard however there are two p arts to the income. (1) The investment income is defined as the accrued interest from the coupon in the reporting period (2) plus or minus the change in the fair value from the beginning of the period. This means that the change in fair value fro m the beginning to end of the period will be shown as income and reported in the financial operating statements. These two components can be combined or reported separately. Given the unrealized nature of this change in value it would serve every government to report these two components separately so that unrealized (i.e. non-existent) income is not interpreted incorrectly and spent when it does not exist!

For example,

The 5% bond from the example above has a beginning fair value on year #1 of 101.00 or $1,010,000. It earns interest during the year of $50,000. At the end of year #1 its market value has fallen to 99.00 or $990,000. The interest for the year is:

This component of the unrealized change in value is now captured as investment earnings and reported in the financial statements. This is very different from the amortized cost valuation methodology because under that met hodology no loss would be recognized unless the security was sold before maturity.

The differences between these two methodologies becomes even clearer if we compare the two using the example above at each year-end.

Over the life of the bond the net change in fair value has resulted in a loss in interest earnings of $20,000 on the financial statements even though the security matured and there was no actual loss in interest earnings at all.

Realized Gains and Losses

One of the most important changes under the GASB Statement has to do with the realized gains and losses. Under the amortized cost method, realized gains and losses are added to the investment income for the reporting period. Un der GASB 31, the reporting of gains and losses is optional. If they are reported it is only in the footnotes of the financial statements!

For example, if a $100,000 par bond was carried at fair value at $120,000 and it was sold for $110,000 under the amortized cost method it would result in a $10,000 gain. However, the change in the fair value ($120,000-110,000) would re sult in a loss of $10,000. The -$10,000 is the total contribution of the sale to the investment income for the year. The realized gain of $10,000 can only appear in the notes. When a capital gain/loss transaction occurs (investment sale, call or mat urity), only the change in fair value of the current period is included in investment income. MENTION TWO SETS OF BOOKS HERE For this reason it is important for you to calculate and monitor realized gains/losses on an amortized cost basis also t o assure that real losses do not go undetected.

Fair Value

GASB 31 requires that any security in an internal investment pool purchased with maturity greater than one year be reported at fair value in the financial statements. Fair value is defined as the market value (bid) if the security is traded on a recognized exchange or the value of the investment in a current transaction with a qualified buyer not under the condition of a forced sale. GASB did not take a position as to whether the bid or asked price should be used. H owever, the Board does expect that if a security is bought at an asked price and prices do not change then the ask should be used for consistency. This does not recognize the realities of the market where prices are constantly changing. If accuracy is r equired the bid price should be used since that is the price at which the security could be sold on the open market.

Money market investment with maturity of one year or less at the time of purchase may be carried at amortized cost. Money market securities are defined as short term, liquid securities including US Treasury Bills and Notes, commercial paper, banker's acceptances, and agency discount notes and notes. The funds invested with investment pools that operate like a money market fund ("2a-7 like pools") such as LOGIC are also reported at cost. Your investment in LOGIC wo uld always be carried at par (100). A "2a-7 like pool" is a reference to the SEC's rule 2a-7 in the Investment Company Act of 1940 that allows money market funds to use amortized cost rather than market value. This is because of the short- term nature of the securities (no longer than 13 months) and the little inherent volatility of such securities and because they maintain a $1 (not $2) net asset value.

In either of these cases, the securities that have a maturity longer than one year when purchased (which we will call GASB specific securities) must always be reported at fair value even when they have less than a year remaining to maturity. They will continue at fair value until matured or liquidated.

All asset-backed securities (ABS), derivatives (floating notes, step-ups, ???????????? DID THEY EXCEPT CALLABLES????? callables, etc.) and structured notes are to be reported at fair value regardless of the time to maturity. Investmen t in open end mutual fund or pools with fluctuating net asset value (such as Lone Star Liquidity Plus or the Government Fund) must be reported at fair value based on the published share price and number of shares held because of the increased risk these p ools and funds represent to the investor. GASB has new reporting standards for government sponsored external pools that are not "2a-7 like".

Exceptions to Fair Value Reporting

GASB intended that most investments be reported at fair value. However, because of the relative short-term nature of most governmental portfolios there are certain exceptions noted in the statement.

(1) Money market investments purchased with less than one year to maturity may be carried at amortized cost. These securities such as Treasury Bills and Notes, commercial paper, banker's acceptances and agency discount notes and notes are short term and not very volatile. The spread (or difference) between the bid and asked prices is very narrow which indicates little volatility and a better ability for the investor to liquidate near his/her cost if necessary. For that reason GASB al lowed that these could be carried at amortized cost.

(2) Non-negotiable certificates of deposit are also carried at amortized cost (which will always be 100). The statement specifies that "nonparticipating contracts" are to be so carried. "Nonparticipating" includes those securities whose value is not affected by changes in the market or interest rates. These are non-negotiable and non-transferable. In addition, the statement adds that the fair value can not be impaired by the credit of the issuer. Section 8 appe ars to provide for CDs up to $100,000 to be carried at original cost, but does not limit the maturity to one year.

Investment Reporting

To illustrate how the GASB reporting methodology is to work we will use the example of fair value securities from the GASB 31 Statement, Appendix C. The Appendix traces five securities over a two-year period. Three securities are held at the beginning of the period, two additional bonds are purchased and finally three of the securities are sold during the two-year period. (The amortized value is not shown in these examples.)

Year One Beginning Positions (July 1, 1997)

Purchases and Sales During 1st Fiscal Year

During the first year the following sale and purchase took place:

Bond #3 had a fair value at the beginning of the period of $240,000 and is sold for $250,000 generating a $10,000 increase in fair value. The change in fair value at year end will be the net increase or decrease of sale proceed s less beginning fair value ($250,000-240,000 or $10,000)

Bond #4 is purchased for $330,000 which is its fair value for the period until it is marked to market at the end of the period. The beginning fair value for securities purchased throughout the year is its original purchase cost regardl ess of how the market has moved.