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By Ian Hague
Illustration: Jason Schnieder
* This article was updated in January 2005. For the update, click here.
 NEW PROPOSALS FOR FINANCIAL INSTRUMENTS WILL BRING CANADIAN STANDARDS IN LINE WITH BEST INTERNATIONAL PRACTICE
The Accounting Standards Board (AcSB) has issued another proposal for recognition and measurement of financial instruments. This follows an exposure draft in 1991 and one in 1994; a discussion paper in 1997; and proposals developed in 2000 by a joint working group comprised of international representatives and members of accounting standard-setters or professional organizations. What is the prospect of these latest proposals ending up as accounting standards? Why are they more acceptable than those issued previously and will the latest proposals affect financial reporting if adopted?
In June 1998, the Financial Accounting Standards Board (FASB) in the US issued FASB Statement 133, Accounting for Derivative Instruments and hedging Activities. Later that year the International Accounting Standards Committee (succeeded by the International Accounting Standards Board) issued IAS 39, Financial Instruments: Recognition and measurement, a standard based on FASB Statement 133 and other US pronouncements addressing accounting for financial instruments existing at that time. This placed the AcSB in a position where it had a significant hole in its body of accounting standards compared with those other two organizations.
Both US standards and International Financial Reporting Standards (IFRS) for financial instruments are complex because of the nature of many financial instruments. Much of this complexity also results from the mixed-measurement model adopted in those standards. The AcSB was reluctant to adopt pronouncements based on those complex standards while hope remained that international consensus would be arrived at regarding the comprehensive fair-value model being developed by the joint working group. However, it has become clear that much work is still needed before a comprehensive fair-value accounting model could be introduced.
No longer can Canada afford to be without accounting standards for recognition and measurement of financial instruments. The AcSB is determined to fill the gap in GAAP and develop Canadian standards that reflect best international requirements (FASB Statement 133, related US pronouncements and IAS 39) for recognition and measurement of financial instruments. Those standards may then be used as a springboard for further improvements based on a starting point common to the AcSB's partners.
The latest AcSB proposals have been developed based on the existing FASB standards and IFRS, taking into account the latest improvements that have been made to those pronouncements. As with those standards, the Canadian proposals are based on several key principles:
1. Fair value is the most relevant measure for financial instruments and the only relevant measure for derivatives. The proposals would require that all financial assets be measured at fair value with the exception of loans, receivables and investments that are intended to be held to maturity (which should be measured at amortized cost) and investments in equity instruments that do not have a quoted market price in an active market, which should be measured at cost.
Similarly, the proposals would require that all financial liabilities be measured at fair value when they are held for trading or are derivatives. Other financial liabilities would be measured at amortized cost.
The proposals would permit an entity to designate any financial instrument, on initial recognition, as one that it will measure at fair value with gains and losses recognized in net income in the period in which they arise. Special accounting would be permitted for certain items designated as hedged (see principle 4). But this would not affect the basic principle that all derivatives should be measured at fair value.
2. Only items that are assets or liabilities should be reported as such in financial statements. Gains and losses do not represent liabilities or assets. Therefore, the proposals would require that gains and losses on financial instruments measured at fair value be recognized in the income statement in the periods in which they arise, with the exception of financial assets available for sale, for which gains and losses are recognized in other comprehensive income until the financial asset is removed from the balance sheet or becomes impaired (an accompanying exposure draft proposes to introduce a requirement to present comprehensive income and its components as well as net income); and certain financial instruments that are part of a designated hedging relationship, which qualify for special accounting (see principle 4). The AcSB proposals would not permit gains or losses to be deferred on the balance sheet as if they were assets or liabilities.
3. Financial instruments and nonfinancial derivatives represent rights or obligations that meet the definitions of assets or liabilities and should be reported in financial statements. The proposals would require that all financial assets and financial liabilities, including derivatives, be recognized in financial statements. This is not affected by special accounting for hedges. The proposals would also require an entity to remove a financial liability from its balance sheet only when the obligation specified in the contract is discharged, cancelled or expires. They do not address derecognition of a financial asset.
4. Special accounting for items designated as being part of a hedging relationship should be provided only for qualifying items. Because financial instruments and other assets, liabilities or anticipated transactions may be used together but measured on different bases or recognized at different times, there is a demand for modifications to the basic method of accounting to adjust for these differences. The proposals contain the option to apply special hedge accounting in such circumstances.
However, the proposals specify the circumstances when a hedge may qualify for special accounting. That special accounting would be constrained by the need to ensure that gains and losses resulting from any ineffectiveness in a hedging relationship can be identified, measured and recognized immediately in net income.
The proposals have been developed starting with proposed improved IFRS, which are based on existing US GAAP. The style of IFRS is more consistent with that of Canadian standards, and having been developed more recently than some of the FASB standards, the way they are presented is more user-friendly. The AcSB has modified those standards only to alleviate any conflicts with US GAAP, to address unique Canadian circumstances or to address interaction with any other aspects of Canadian GAAP. The resultant AcSB proposals are similar to those considered in 1991 and 1994 in that they propose a mixed measurement model combined with requirements for hedge accounting, but they are more advanced.
Similar to the 1997 and 2000 proposals, an underlying principle is the relevance of fair-value measurement. However, the proposals contain significant exceptions to that principle, particularly in those areas where respondents to previous proposals had most difficulty with fair-value measurement.
In many straightforward situations, the proposals will not result in a significant change to existing accounting. For example, existing accounting for trade receivables, trade payables, long-term debt, loans and deposits will largely remain unchanged. However, there will be more significant changes in accounting for derivatives as well as for equity investments.
Without measuring derivatives at fair value they are invisible, and gains and losses (at times disproportionate to changes in market conditions) would not be reported. This information is essential for users of financial statements in order to understand the nature of the rights and obligations inherent in derivatives. Accordingly, all derivatives would now be recognized and measured at fair value. Equity investments also would be required to be recognized and measured at fair value.
Some aspects of the proposals will be in place sooner rather than later, as a result of requirements to implement criteria for hedge accounting by July 1, 2003 to comply with Accounting Guideline, AcG-13, Hedging Relationships, and EIC requirements to measure freestanding derivatives at fair value. In addition, most entities have been required to disclose fair-value information about financial instruments for several years, so that information should be readily available. Consequently, the change on applying the proposals may not be extensive for some enterprises.
These proposals will bring Canadian standards in line with best international practice. They might not be the most straightforward, but they will fill the existing gap in Canadian GAAP and would significantly enhance the information being conveyed to financial statement users about the effects of financial instruments on an entity's financial position.
The proposals are available at AcSB's website, www.acsbcanada.org, for comment by July 31. The AcSB plans to implement resulting standards for fiscal periods commencing on or after October 1, 2004.
Ian Hague is a principal with the Accounting Standards Board, responsible for the financial instrument project
Technical Editor: Robert T. Rutherford, FCA, VP, Standards, CICA | 
