May 21, 2019Los Angeles, California

Caught in the Middle: Accounting andFinancial Reporting for Conduit Debt Under

GASB's New Standard

May 19-22, 2019 • Los Angeles, California113th Annual Conference

Learn more by visiting us at gfoa.org • #GFOA2019

Bob Balducci (Moderator)Comptroller, New York City Municipal Water Finance Authority

Cindy HarrisChief Financial Officer, Iowa Finance Authority

Barry FickExecutive Director, Minnesota Higher Education Facilities Authority

Caught in the Middle: Accounting and Financial Reporting for Conduit Debt under GASB’s New Standard

Government Officers Finance Association 113th Annual ConferenceLos Angeles, CA

Presenters: Barry W. Fick, Executive DirectorMinnesota Higher Education Facilities Authority

&

Cindy Harris, Chief Financial OfficerIowa Finance Authority

Your Presenters for: Caught in the Middle

• Barry W. Fick, Executive Director, Minnesota Higher Education Facilities Authority

• BS Economics – University of Minnesota• Juris Doctorate – Mitchell | Hamline School of Law• Certified Public Accountant (Inactive)• Chair, City of Lakeville MN Finance Advisory Committee

• Cindy Harris, Chief Financial Officer, Iowa Finance Authority• MS Economics – Univ. North Carolina, Chapel Hill• BA Economics – Grinnell College

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What are we going to discuss today?

• Theme of the Session:

“Conduit debt is issued by government that may or may not be responsible for its repayment, repaid by obligors via lease-like agreements that don’t get accounted for as leases, and result in assets to which governments may or may not ever hold title. Come learn about GASB’s newest (anticipated) guidance and how it will affect government issuers of conduit debt.”

What could possibly go wrong with debt like that?

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Outline of Presentation

• History of Conduit Debt• Purpose & Structure of IDB/Conduit/Private Activity Debt• Examples• Prior Standard – Interpretation no. 2• GASB Proposal – History & Outline• Benefits & Challenges• Examples• Questions, Comments

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A Short History of Conduit Debt – When and Why

• Time to use the “Wayback Machine”• Conduit debt first used in 1936• Reasons conduit debt used

• Interest rate environment• Tax Rates

• Benefit of Conduit Debt• Challenges of Conduit Debt

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Origination of Conduit Financing

• Began as Industrial Development Bonds or “IDBs”• Purpose was to bring or keep industry in a community• Courts allowed tax-exempt financing as State has power to define a “public

purpose”

• Conduit financing technique has been in use since 1930’s• Mississippi industrial development program – first use of IDB issue

• IRS Formally acknowledged tax-exempt status of IDBs in 1954• Use expanded dramatically in 1970’s and early 1980’s

• From 1975 – 1985 tax-exempt private activity debt expanded by a factor of 13

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Uses and History of IDBs and Conduit Debt

• Projects funded by IDBs expanded dramatically• Definition of public purpose stretched nearly beyond recognition• IDB tax-exempt financing used for restaurants, linear centers

• Congress and Executive Branch concerns• Concern about misallocation of resources• Concern about overuse of tax-exempt financing

• Tax Reform Act of 1986• Substantially restricted use of IDB financing on a tax-exempt basis

• Why were they so popular?

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10-Yr US Treasury Rate History 1965 - 2019

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Muni Market Data AAA GO Rate History – 1993 to 2019

1.99%

2.47%

2.83%3.16%

3.43%3.65%

3.84%4.01% 4.13% 4.23% 4.32% 4.38% 4.42% 4.44% 4.46%

1.55% 1.59% 1.63% 1.68% 1.77%1.92% 2.06% 2.16% 2.24% 2.32% 2.39% 2.44% 2.47% 2.49% 2.51%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

MMD Maturity Years

January 3, 1993 through May 3, 2019

Average 5/3/2019 MMD AAA GO

Historical Maximum Yields

Historical Minimum Yields

Historical Average Yields

5/3/2019 MMD AAA GO

Data source: Thomson Reuters

Historical MMD AAA GO Yield Distribution

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Questions for Session Participants

• Does your jurisdiction serve as a conduit issuer?

• If so, what types of issues do you see?

• Have you observed an increase in conduit borrowing over time?

• Do you expect or plan to expand/encourage more conduit borrowing?

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Current status of IDB or Private Activity Financing• Tax Code restrictions have increased over time

• Designed to prevent abuses and are broadly defined and applied

• Private Activity limitations in Internal Revenue Code• Specific types of bonds favored and discouraged and prohibited

• Arbitrage Rebate • Designed to reduce lost revenue to US Treasury from tax-exemption

• Definition of “Private Activity”• Revised multiple time over the years

• State-wide Volume Cap limitations• Allocation to different types of financing

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Examples of Private Activity Bonds

• “Qualified Public Facilities”• Multifamily Housing• Publicly owned Airports, Docks, Wharves, Mass Commuting facilities

• Private Activity Bonds• Health Care & Senior Living Facilities• Higher Education• Student Loans• Mortgage Revenue Bonds• Tax-Exempt 501(c)(3) organizations• Single Family & Multifamily Housing

• Size limitation on “Small Issue IDB” Manufacturing facility financing

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Examples of Private Activity Bonds

• No tax-exempt financing for specific types of financing• “Sky boxes” in sports arenas• Airplanes• Health clubs• Gambling Facilities• Liquor stores

• Limitations on advance refunding• Bank Qualification – interest deduction• Private use and benefits test – can affect tax-exemption

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Benefits of Conduit Debt Financing

• Issuer Benefits• More community development (guided or non-guided)• Fees

• Borrower Benefits• Lower borrowing costs

• Community Benefits• More community development

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Challenges of Conduit Debt Financing

• Issuer Challenges• Reduction or Elimination of bank qualification capacity• Reputation risk

• Borrower Challenges• Covenants imposed by issuer, fees charged by issuer

• Community Challenges• Loss of local control – especially if out-of-state issuer

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Questions for Session Participants

• Does your community have a policy on issuing Conduit debt?

• Do you charge a borrower to issue through your entity?

• Other considerations your community uses related to issuing Conduit debt?

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History of Legislative Action Around Conduit Debt

• State Legislation• 1936 Mississippi – “Balance Agriculture with Industry” program

• Court Decisions• State Courts pre-1954

• Federal Legislation• 1954 Tax Code• Revenue and Expenditure Control Act of 1968

• Made IDB interest taxable, but established exceptions which continue today

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History of Legislative Action Around Conduit Debt

• Tax Reform Act of 1969• Introduced concept of Arbitrage and required calculation of Arbitrage Rebate

• Tax Equity and Fiscal Responsibility Act of 1982• Defined “Private Activity Bond“, introduced information reporting requirements

• Tax Reform Act of 1986• Introduced significant restrictions on IDBs and Private Activity Bonds• Reduced demand and lowered issuance substantially

• Tax Cuts and Jobs Act of 2017• Tightened restrictions on IDBs and Private Activity Bonds

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The New GASB Reporting Rule for Conduit Debt

• Will provide a single method of reporting Conduit Debt Obligations• Under the new Rule, in general, Conduit Debt Obligations will not be

recognized as a liability on Issuer Financial Statements• There are exceptions to the general rule

• Exceptions must be reviewed annually

• The new rule is effective for reporting periods beginning after December 15, 2020

• Earlier adoption is encouraged• Prior year restatement may not be “practicable”

• GASB notes that “inconvenient” is not the same as “practicable” regarding restatement

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Reporting Conduit Debt on Financial Statements

• Options• Recognize Conduit Debt as a balance sheet liability• Recognize capital asset associated with the Conduit Debt• Not recognize Conduit Debt as a balance sheet liability• Not recognize capital asset associated with Conduit Debt

• History• No consistent application by issuers• Creates confusion for citizens, bond investors, rating agencies• Inhibits comparison of otherwise similar entities

• State legislation is not consistent between various states

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GASB Actions related to Conduit Debt Financing

• Interpretation 2• Issued in 1995• Described Conduit Debt in part as:

“The term conduit debt obligations refers to certain limited-obligation revenue bonds, certificates of participation, or similar debt instruments issued by a state or local government entity for the express purpose of providing capital financing for a specific third party that is not a part of the issuer’s financial reporting entity.

• Despite this description, confusion continued to exists as opinions differed about whether a specific financing met the description from Interpretation 2

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Prior GASB Actions related to Conduit Debt Financing

• Interpretation 2 established the requirement that a government issuer include Financial Statement Disclosure about its conduit debt obligations

• It set out disclosure criteria including:• General description of conduit debt obligations• Aggregate amount of conduit debt obligations outstanding at FYE• Clear statement that issuer has no obligation to pay debt other than from

borrower payments pursuant to the lease or loan agreement

• If an issuer was reporting the conduit debt obligation as a liability (along with the related asset) it could continue that practice

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Prior GASB Actions related to Conduit Debt Financing

• Interpretation 2 – Applied inconsistently by issuers• Financial Statement Note Disclosure is considered inadequate by

many financial statement users• Financial Statement users demanded additional disclosure• Concepts Statement No. 3 addressed Financial Statement Note

Disclosure for Conduit Debt Obligations• Concepts Statement No. 4 addressed the Disclosure Criteria for

Conduit Debt Obligations• There has been no comparison of Interpretation 2 with Concepts 3

and 4 until the GASB 2018 Proposed Statement on Conduit Debt

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Current GASB Action related to Conduit Debt

• Government Accounting Standards Advisory Council (GASAC)• Identified practice issues related to applying existing standards• Ranked Conduit Debt Obligation issues as a high priority for clarification

• GASB added Conduit Debt Obligations clarification to the technical agenda in August 2017

• GASB deliberations began in September 2017• Exposure Draft on Conduit Debt Obligations published July 30, 2018• Final consideration scheduled for April / May 2019• Effective for reporting periods beginning after December 15, 2020

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Benefits of the GASB Statement related to Conduit Debt• Government Accounting Standards Board hopes for the following

Improvements to Flow from the New Statement on Conduit Debt• Elimination of the option for Issuers to report Conduit Debt as an

Issuer liability will end a significant diversity in practice• Clarified definition of Conduit Debt will resolve stakeholders’

uncertainty regarding conduit debt status – “is it or isn’t it conduit?”• Eliminating diversity would enhance comparability in reporting• Revised disclosure requirements provides better information

regarding commitments & assist in assessing issuers’ role in conduit debt

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Questions for Session Participants

• Have you read the GASB Exposure Draft on Conduit Debt Obligations?

• Does your organization anticipate changing its reporting and accounting for Conduit Debt Obligations pursuant to the GASB new rule?

• Do you anticipate challenges in adoption as required?

• What level of compliance costs do you expect will be associated with adoption?

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GASB Exposure Draft Objectives

• Provide a single method of reporting conduit debt by issuers• Eliminate diversity in practice regarding “additional commitments”• Clarify existing definition of a Conduit Debt Obligation• Establish liability of the third-party obligor for the Conduit Debt• Establish standards for accounting and financial reporting• Better define “additional commitments” by issuers• Improve financial statement Note Disclosure for Conduit Debt

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GASB Definition of Conduit Debt

• Conduit debt has all of these characteristics:• At least three parties involved

• Issuer• Third-party Obligor• Debt holder or Trustee

• Issuer and third-party are not within the same financial reporting entity• The debt obligation is not a parity bond nor is it cross-collateralized• Third-party obligor is final recipient of debt issuance proceeds• Third-party obligor is primarily obligated to make all debt payments• Issuer’s commitment related to debt service is limited

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GASB Conduit Debt Proposal

• In general, issuers limit their commitment to the resources provided by the third-party obligor

• Issuer can extend “Additional Commitments” of its own resources• Moral Obligation pledge• Appropriation pledge• Extending a guarantee• Pledge issuer property, revenue or other assets as security• Request appropriations w/o a moral obligation or appropriation pledge

• Additional Commitments may or may not result in liability recognition• Extent of commitment reviewed annually – “more likely than not” standard

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Recognition of Liability or No Recognition

• General rule: Issuer will NOT recognize a conduit debt obligation as a liability

• Issuer will recognize a related liability and expense in “recognition criteria” are met

• If you use “Economic Resources Measurement Focus” Issuer will recognize a related liability and expense if qualitative factors indicate it is “more likely than not” (> 50%) that issuer will support debt service payments based on eight qualitative factors

• If you use “Current Financial Resources Measurement Focus” Issuer will recognize fund liability based on specific analysis

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Economic Resources Measurement Focus Specifics

• Qualitative Factors include situations where the third-party obligor• Enters bankruptcy or financial reorganization• Breach of covenants (rate covenant, coverage, payment default or

delinquency)• Experience significant financial difficulty, draws on reserve funds, revenue

loss, large investment losses, initiation of intercept & diversion• Termination of project that would generate revenue to pay debt service• Litigation that negatively affects project• Issuer concern that third-party obligor default could impede issuer access to

capital markets• Issuer’s history of acting on additional commitments on other conduit debt,

voluntarily or not• Issuer’s ability or willingness to support debt service payments

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Current Financial Resources Measurement Focus Specifics

• Issuer recognizes fund liability and an expenditure in the case when• The Liability is expected to be liquidated with expendable available financial

resources, provided that the Qualitative factors indicate that• It is more likely than not that the Issuer will pay the debt service

• The Liability is expected to be liquidated with expendable available financial resources when payment for a conduit debt obligation is due and payable

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Lease Obligations as Conduit Debt

• Conduit Debt can be structured as a lease – include the following:• Capital asset financed with conduit debt obligation proceeds• Issuer retains title to the capital asset• Third-Party Obligor makes debt service payments to holder or trustee• Third-Party Obligor payments match debt service payment amt. and timing

• Issuers do not report this arrangement as a lease• There are three options to analyze to determine if the Lease is to be

recognized as a liability as a Conduit Debt Obligation or not be so recognized

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Lease Obligation Recognition as Conduit Debt Factors

• Issuer relinquishes Title at the End of the Lease Arrangement• Issuer does NOT recognize liability for Conduit Debt nor the asset nor a

receivable for payments related to the lease arrangement

• Issuer Retains Title and Third-Party Obligor has exclusive use of the entire Capital Asset

• At inception and during the term of the lease arrangement, no Conduit Debt or asset or receivable is recognized

• At end of arrangement, issuer takes asset onto books at Acquisition Value –calculated using Statement No. 72, para. 79

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Lease Obligation Recognition as Conduit Debt Factors

• Issuer Retains Title and Third-Party Obligor has exclusive use only of a portion of the Capital Asset

• At inception the issuer recognizes the entire value of the asset at acquisition value

• No recognition of a liability for Conduit Debt Obligation• No recognition of a receivable for the payments related to the arrangement

• Issuer recognizes a Deferred Inflow of resources for the amount of the Capital Asset value recognized (full value)

• Deferred inflow is reduced and revenue recognized over the term of the arrangement

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Notes to Financial Statements for Conduit Debt Financing

• The new Statement clarifies financial statement Note disclosure for Conduit Debt Obligations

• Disclosure where no liability is recognized should include• General description of Issuer’s Conduit Debt Obligations• General description of the Issuer’s Commitment(s)• Show the aggregate outstanding principal amount of all Conduit Debt

Obligations that share the same type of commitments at Issuer FYE• Consider listing by Commitment type

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Notes to Financial Statements for Conduit Debt Financing

• Disclosure where a liability is recognized should include• Brief description of the:

• timing of recognition• Measurement of liability• Information about changes in liability

• Beginning balance• Increases• Decreases• End-of-period balances

• Cumulative amount of payments made on the recognized liability• Amounts expected to be recovered from those payments (if any)

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Examples of Conduit Debt and Financial Statement Reporting

• Iowa Finance Authority

• Minnesota Higher Education Facilities Authority

• Other States/Cities/Counties/Special Districts/Other Local Government issuers

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Examples of Conduit Debt and Financial Statement Reporting

• Conduit Debt Obligation Analysis• Facts and Assumptions

• Outline facts and circumstances of the specific project(s) and financing structure• Determine if Issuer provided any “Additional Commitments”

• Analyze effect on repayment obligation from Additional Commitments• Analysis using new Conduit Debt Definition• Analysis using new Qualitive Factors• Review existing Note disclosure

• Determination

• Disclosures

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GASB Illustrations of Conduit Debt

• IDBs for manufacturing facility

• State housing multifamily housing bonds

• Additional Commitment • Higher Education• Student Loan

• Risk to Issuer - Limited Moral or Monetary Commitment

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Other Conduit Debt Items of Interest

• Considerations related to Benefits and Costs• GASB’s assessment of expected benefits and perceived costs of issuing new

standards is unavoidably more qualitative than quantitative because no reliable and objective method has been identified for quantifying the value of improved information in financial statements

• GASB gathered information on the expected benefits of improving the conduit debt standards through input from research, the GASAC and outreach with stakeholders

• GASB considered cost in two areas• Cost of applying the guidance similar to existing standards• Cost of applying the recognition, measurement and additional disclosure obligations

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Other Conduit Debt Items of Interest

• Considerations related to Costs - continued• GASB’s assessment of expected benefits and perceived costs of issuing new

standards is unavoidably more qualitative than quantitative because no reliable and objective method has been identified for quantifying the value of improved information in financial statements

• GSAB believes that based on research and comments from market analysts and other participants, the expected benefits and perceived costs can be balanced between maximizing benefits and minimizing costs

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Other Conduit Debt Items of Interest

• Transition and Restatement of prior periods• GASB believes the effective date is appropriate since most issuers of conduit

debt currently report or can readily determine the amount of conduit debt obligations and related information to be disclosed

• Some issuers, especially those with significant amount of conduit debt will have additional reporting requirements, but GASB concluded there is adequate time to prepare for the new standard

• GASB believes that many issuers do not have issuer-extended additional commitments, reducing the need to change reporting

• Many preparers of Financial Statements and Auditors are familiar with GASB standards relating to Note Disclosure based on Statement No. 70

• GASB believes this will mitigate the implementation and ongoing cost of compliance

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Other Conduit Debt Items of Interest

• GASB believes the Statement should be applied retroactively• GASB recognizes that there may be a lack of readily available information for

the restatement of prior periods and disclosure requirements• GASB recognized it may not be practicable to restate prior periods• GASB recognized it may not be practicable to restate prior periods

• The idea of practicable has been used in other GASB Standards• GASB believes that reasonable efforts should be employed before an entity determines

that restatement of all prior periods presented is not practicable• The Exposure Draft notes that: “Inconvenient” should not be considered equivalent to

“Not Practicable”

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Questions, Comments, Observations

• Participant Questions

• Participant Comments

• Participant Observations

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Thank You & Additional Information

• Thank you for attending this Session

• Additional information on Conduit Debt reporting and definitions may be found at the GASB website www.gasb.org

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