Years of transition

By Andrée Lavigne & Nadi Chala

As financial disclosure in Canada increases, it remains to be seen whether transparency has improved

In recent years, accounting standard-setters have adopted rules aimed at improving the level of transparency and disclosure in financial reports. In parallel, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have initiated projects to harmonize their respective generally accepted accounting principles (GAAP) requirements in order to respond to the desire of investors to compare performance across geographies. In Canada, the Accounting Standards Board (AcSB) indicated its decision to adopt the International Financial Reporting Standards (IFRS) by converting Canadian GAAP to IFRS over a five-year transition period. In 2011, Canadian GAAP will cease to exist and Canadian public companies will move to IFRS. No transparency of financial reporting can be achieved without adequate narratives. Today notes to the financial statements and management analysis are essential ingredients of transparency and comprehensibility of financial reports. This is particularly true given the current direction of accounting standards where relevance of information is emphasized over the precision of calculation. For example, the recent adoption of fair value as the principal measurement attribute of financial instruments will necessitate new disclosures in financial statements.

Though there are many facets of narrative disclosures, the notes to the audited financial statements continue to be the most relevant information of financial reports. Knowledgeable investors sift through the notes in search of unconventional accounting methods, off-balance-sheet items and related-party transactions.

A useful publication on financial statements disclosures
For more than 30 years the CICA has published Financial Reporting in Canada, which analyzes financial statement disclosures for a sample of Canadian firms and gives examples of such disclosures. Currently, this publication is particularly relevant as Canadian firms seek guidance in the years of transition to IFRS.

The 31st edition of the publication adopts essentially the same approach as the previous editions by surveying disclosures and presentation practices of 200 Canadian public companies and by providing useful examples of GAAP application. The sample corporations were selected on the basis that they were listed on the S&P/TSX composite index during 2005, they used Canadian GAAP and were corporations (as opposed to income trust entities that are now included in the index). The 200 companies surveyed cover all 10 industry sectors covered by the S&P/TSX index. Revenue reported by these companies ranged from less than $1 million to more than $31 billion, while total assets ranged from $36 million to more than $469 billion.

Some new features were introduced this year, including references to the primary sources of Canadian GAAP and IFRS with an examination of the differences between these two sources of GAAP. (Only significant similarities and differences between Canadian GAAP and IFRS are presented. Even if standards are converged, there can be differences in the detailed application, which could have a material impact on the financial statements.) Key Canadian requirements related to financial instruments but not yet implemented by companies in 2005 are also examined. Illustration of the requirements, which are harmonized with IFRS and US GAAP, are presented by referencing to extracts of financial statements published by European and US companies.

Although the survey questions used in this edition are comparable to the ones in the previous years, a different perspective was used on some issues such as financial instruments and consolidation. Consequently, key disclosures data were collected, including terminology used, amount of detail given, classification and grouping of items in the statements, and nature and extent of management estimates and hypothesis. These data were collected without a concern as to whether it is subject to a particular CICA Handbook requirement. This perspective might be more revealing to the reader as it moves the observations beyond a compliance framework by allowing a better identification of pertinent voluntary disclosures data and examples.

The survey reported that companies expanded their disclosures in 2005 financial statements with more than one-third of the 200 sampled corporations presenting more than 30 pages of notes. Notes are increasing in length and complexity, likely for two reasons. First, in recent years there has been a proliferation of new, complex requirements that are becoming effective. Second, given the expansion of governance rules and responsibilities, companies’ management is putting more effort to ensure that comprehensible and transparent information is presented.

Proposal for an analysis of disclosures
In this article, we examine some of the disclosures related to two current financial reporting issues: consolidation of variable interest entities and derivatives and hedge activities. For that purpose, we suggest a classification of the notes into two categories. The first category (D1) deals with disclosures aimed at helping investors assess management estimates and judgement. The second category (D2) deals with disclosures on amounts reflected in the primary financial statements such as the composition of main categories of assets, liabilities, equity, revenues and expenses.

Consolidation of variable interest entities
Traditionally GAAP require that the owner of a controlling financial interest in an entity consolidate that entity. Recently the AcSB published Accounting Guideline No. 15, Consolidation of Variable Interest Entities (AcG-15), that introduces a new interpretation of control in the context of Variable Interest Entity (VIE). The term “VIE” refers to an entity in which the allocation of voting interests does not adequately reflect who actually controls and stands to benefit or suffer loss from the entity’s assets and liabilities. To implement AcG-15, management has to determine whether the company has a significant relationship with entities considered to be VIE and, if so, whether for each relationship the company is the primary beneficiary. These questions are addressed at inception of relationship and sometimes subsequently when, for example, changes occur to the governing documents or the contractual arrangements among the parties involved.

Effective date of AcG-15 was November 1, 2004. Consequently, all companies in the current edition of Financial Reporting in Canada sample had to consider the application of this guideline for fiscal periods ended in 2005. This context is very different from the observations reported for fiscal periods ending in 2004 where only 12 companies provided a reference to the guideline.

Disclosures related to consolidation according to AcG-15 reported in the 200 firms for fiscal years ending 2005 were as follows:

• 83 companies made no reference to AcG-15;
• 16 companies referred to AcG-15, but mentioned it was not applicable to their operations;
• 57 companies referred to AcG-15, but mentioned its recommendations did not have a material effect on financial statements;
• 35 companies indicated that AcG-15 did have an impact and that the company was the primary beneficiary;
• nine companies indicated that AcG-15 had an impact, but the company wasn’t the primary beneficiary (seven of nine said they deconsolidated entities subsequent to AcG-15 adoption).

Given the above survey results, we can observe that the large majority of companies are not impacted, or not significantly, by AcG-15. The notes to the financial statements do not provide any insights on management examination. Generally no type D1 note was provided. Readers of financial statements are given management conclusions without having the details on how that conclusion was reached. The lack of disclosure is not unusual, as there are no specific GAAP requirements for such explanation.

The 35 companies that consolidated VIE presented type D2 note as required by AcG-15, which details the elements of consolidated entities. The types of VIE included tax shelters, partnerships, joint ventures, production and distribution agreements, investments, securitizations vehicles, franchises, trusts, guarantees and leasing. Some firms referred to more than one type of VIE. (Table 1 at www.camagazine.com/loblaw is an example of D2 disclosures.

Derivatives and hedge activities
Derivatives and hedge activities represent an area of concern for companies both in terms of economic risk and the complexity of GAAP requirements. Many companies use derivatives to manage economic risks inherent in a company’s operations.

In April, 2005, the AcSB completed its financial instruments project by issuing the following new CICA Handbook — Accounting sections:

• Section 1530, “Comprehensive Income”
• Section 3855, “Financial Instruments — Recognition and Measurement”
• Section 3861, “Financial Instruments — Disclosure and Presentation”
• Section 3865, “Hedges”

These sections, essentially converged with both US GAAP and IFRS, are applicable to fiscal years starting October 1, 2006. Meanwhile, all companies applying hedge accounting have to refer to Accounting Guideline No. 13 “Hedging Relationships” (AcG-13), which was originally issued to harmonize the documentation standards for hedge accounting with US GAAP. Implementation of the new sections on financial instruments will require companies to identify and fair value all derivatives; document hedge relationships; and account all hedges using one of the two prescribed methods either as cash-flow or fair-value hedges.

The new sections’ requirements on financial instruments, hedges and comprehensive income had limited impact on the surveyed companies as they merely only described the new rules. None of the companies adopted, as allowed, the new requirements in 2005.

All companies surveyed had to conform to AcG-13. Accordingly, not all economic hedges qualified for hedge accounting. Rather, hedge accounting was used as permitted only for certain hedging instruments and hedged items; when certain documentation and hedge effectiveness criteria were met; and prospectively from the date a hedging relationship was formally documented.

The majority of companies surveyed have hedged for many years some of their economic risks. For example, more than 65% of the companies indicated the presence of hedges of anticipated future transactions in all the years surveyed since 2002.

As in the case of the nonconsolidation of VIE (AcG-15), very few companies provided type D1 note related to the effectiveness test used and to the derivative fair-value measurement (AcG-13). The information in both cases can be very useful to the reader of financial statements. In the case of hedge effectiveness testing, companies could select a qualitative approach if they meet strict criteria set either by AcG-13 or by Section 3865 Hedges. A qualitative approach would allow a company to be exempt from ongoing effectiveness testing. If a hedging relationship does not meet the criteria for using the qualitative approach, companies will have to use a quantitative method to test effectiveness at inception and quarterly thereafter. Since various qualitative and quantitative methods could be used, it would be useful if companies provided detailed information about how they assessed hedge effectiveness.

Similarly, companies refer to different sources in order to measure the fair-value information of derivatives. Quoted market prices in active markets are the best evidence of fair value and should be used as the basis for the measurement, if available. If a quoted market price is not available, the estimate of fair value should be based on the best information available. Often companies did not provide sufficient explanations of the method for establishing the fair value of derivatives. (Generally, companies did not elaborate on the measurement of derivatives fair value. They indicated frequently that it was obtained from counterparties’ quotes without further explanations.) The note disclosure presented by Deutsche Telekom might provide a good example of such disclosure (see table on page 49).

The company does not hold or issue derivatives for speculative trading purposes. Like all financial instruments, derivatives are carried at their fair value upon initial recognition. The fair values are also relevant for subsequent measurement. The fair value of traded derivatives is equal to their market value, which can be positive or negative. If there is no market value available, the fair value must be calculated using standard financial valuation models.

The fair value of derivatives is the value that Deutsche Telekom would receive or have to pay if the financial instrument were discontinued at the reporting date. This is calculated on the basis of the contracting parties’ relevant exchange rates, interest rates, and credit ratings at the reporting date. Calculations are made using middle rates. Interest-bearing derivatives are recorded at the full fair values, including accrued interest.

With respect to type D2 notes, which provides disclosures on the significance of amounts related to the derivatives used by the company, the companies provided disclosures that varied in terms of their usefulness. Often, disclosures did not allow the reader to evaluate readily the types and extent of derivatives used, their significance on the balance sheet, the sensitivity to value changes of the underlying and their impact on earnings.

One interesting noteworthy disclosure is that adopted by Deutsche Telekom, which details the different categories of derivatives. The illustration provides a good example for companies to consider when adopting the new financial instruments standards.

Conclusion
A review of financial disclosures in the 2005 financial statements revealed that companies are disclosing more information than they did in the past. While disclosure is increasing, it remains to be seen whether transparency has improved.

Financial Reporting in Canada is devoted to the analysis of financial statements disclosures of Canadian companies. It will evolve in the coming years to provide more data on voluntary information as published in the notes to the financial statements. As Canadian accounting standards converge to international accounting standards, it will also offer more examples of IFRS application. Such a shift will provide the readers with useful information in the years of transition when the interaction between Canadian GAAP and IFRS becomes increasingly critical.

Nadi Chala, FCA, FCMA, is a professor at ESG UQAM and an academic partner at Raymond Chabot Grant Thornton.
Andrée Lavigne, CA, is a principal with the Research Studies department in the Knowledge Development Group at the CICA

Technical editor: Ron Salole, vice-president, Standards