Issued in 1995, Section 3860 of the CICA Handbook - Accounting remains Canada's standard for the presentation and disclosure of financial instruments. Also in 1995, the International Accounting Standards Committee (IASC) released its equivalent standard, IAS 32, and, since then, a number of other standard-setters have followed suit. But if Canada was once in the vanguard where financial instruments were concerned, it has since been surpassed by the IASC and the US Financial Accounting Standards Board (FASB), both of which have developed accounting standards addressing the recognition and measurement of many financial instruments. In the United States, the FASB has introduced several standards in this area - most recently FASB Statement 133, "Accounting for derivative instruments and hedging activities." Internationally, the IASC has issued IAS 39, "Financial instruments: Recognition and measurement," and similar standards have been adopted in several jurisdictions that follow IASC standards. Canada, however, remains withoutrecognition and measurement standards in this important area.

This summer, the international Financial Instruments Joint Working Group of Standard Setters (JWG) plans to publish, for comment, its proposals for accounting for financial assets and financial liabili-ties. The JWG includes representatives of the CICA Accounting Standards Board (AcSB), the FASB, the IASC and national standard-setters in Australia, France, Germany, Japan, New Zealand, the Nordic countries and the United Kingdom. The proposed draft standard is based on the principles outlined in the March 1997 CICA / IASC discussion paper, "Accounting for financial assets and financial liabilities," and it proposes a full fair-value model. It also explains the rationale behind the JWG's conclusions, and provides additional guidance and illustrative examples.

In preparing the proposal, the JWG has taken into account the responses the discussion paper received (see "World-class derivatives," CAmagazine, June/July 1998, p. 36) and subsequent work by national standard-setters and others. The AcSB is optimistic that international consensus will develop as a result of the JWG's efforts and that it can pattern a standard on this consensus. However, the penalty for this stance has been an ongoing lack of standards in this area within Canada - a position that cannot be allowed to continue for much longer. As a result, the AcSB has a keen interest in comments on the JWG's draft standard and will be seeking to implement recognition and measurement standards for financial instruments in Canada as soon as possible.

The JWG is likely to propose that the future for accounting for financial instruments lies in a model that recognizes all financial instruments in the basic financial statements at their fair value, both on initial recognition and subsequently. The FASB, the IASC and other leading standard-setters have already concluded that fair value is the only relevant measurement for derivative financial instruments and is the most relevant measure for other financial instruments. It stands to reason that a Canadian standard will not be able to take a significantly different direction. The JWG draft proposes a model that avoids the complexities of mixing historical cost and fair-value measurements, and illustrates how a fair-value model can provide greater benefit to the users of financial statements.

The JWG's draft contains three fundamental proposals:

· All financial assets and financial liabilities should be recognized on the balance sheet and measured at fair value.

· All gains and losses resulting from changes in fair value of financial assets and financial liabilities should be recognized in the income statement in the reporting period in which they occur, disaggregated by the main underlying financial risks.

· The financial statements should contain comprehensive financial risk disclosures that explain the enterprise's policies for managing financial risks (including hedg-ing strategies), its financial risk positions at the reporting date, and the results of its financial risk management during the reporting period.

Fair-value measurement

A previous CAmagazine article (see "Financial instruments: Old price or new?" January / February 1999, p. 47) outlined the benefits of fair-value measurement of financial assets and liabilities versus measures based on historical cost.

Some who accept the merits of fair value for balance-sheet measurement of financial instruments have greater difficulty in accepting the performance- reporting effects. To appreciate those effects, consider an example involving a Canadian corporate bond held as part of an RRSP investment portfolio. Investors are now used to such instruments being reported at their fair value in their RRSP statements and do not question that this is relevant information about the bond at the reporting date. The amount originally paid for the bond becomes less important over time. An investor analysing how well an RRSP account has performed over the past year would probably look at the fair value of the bond at the beginning of the year and compare this with the fair value of the bond at the end of the year to see what percentage return has been earned during the period. The investor's measure of performance is the change in fair value of the bond during the year, including interest.

The investor is also likely to be interested in the components of the bond's change in value. Typically, an investor assesses the risks that he, or she, is prepared to accept in exchange for a particular return. For example, the investor might have been prepared to accept the greater credit risk associated with a Canadian corporate bond - rather than a Canadian government security - in exchange for the former's higher level of interest. Armed with information about the separate credit and interest rate risks under-lying the change in fair value during the reporting period, the investor can assess whether the superior interest return on the corporate bond offered suitable compensation for changes in the corporation's credit quality. The information about the fair value at the reporting date, the changes in that value and the components of that change all provide the investor with valuable information for his or her decision-making.

The JWG's draft standard requires the same kind of information. The fair value of any financial asset or financial liability embodies the market's expectation of future income return from that instrument, taking into account the current market rate of return for commensurate risk. As a result, if an investor knows the fair value of a financial instrument and has information about its terms and risks, he or she has the basics for evaluating the market's expectations.

Issuers of financial instruments, such as mutual fund units, commonly warn investors that past performance does not assure similar future returns. Nonetheless, information about what the performance has been, and how it has varied relative to other market indicators, is of value to the user. With this information, the investor can make adjustments for different expectations about future performance.

In contrast, reliable forecasts of the future income effects of a financial instrument are unlikely to be possible from the simple extrapolation of past gains and losses based on historical cost. The fact that a certain return has been accrued on a particular instrument, or a particular interest or dividend flow has arisen in the past period, does not tell the whole story. Reflecting the effects of changes in economic conditions and events - when they occur - is essential to informed analysis.

Hedge accounting

The conceptual merit of accounting adjustments to reflect hedging strategies is highly questionable; moreover, maintaining some consistency in financial reporting demands hedge-accounting rules of extreme complexity. The JWG reasons that greater understandability can be achieved by other means, and proposes that an enterprise should explain its hedging strategies in the notes to the financial statements, together with the financial effects of such strategies. That way, a user of the financial statements can understand the enterprise's financial position at the reporting date. He or she will also gain the information needed to understand the extent to which an enterprise has adopted certain strategies that have affected its past performance and will affect its financial position in future reporting-periods. The effects of all past transactions, conditions and events are reported in the basic financial statements, while those that relate to future reporting-periods are disclosed in a manner that allows users to consider them in projecting future cash flows.

Other aspects

The draft standard also addresses transfers of financial assets, including securitisation transactions. The proposed approach is based on accounting for the individual components of financial assets - those retained and those transferred. This is similar to the general concepts underlying FASB Statement 125, "Accounting for transfers and servicing of financial assets and extinguishments of liabilities," and a proposed AcSB Accounting Guideline on the subject of securitisation transactions. (There are, however, a number of differences in the detailed application of those principles.)

A variety of tricky implementation issues have been addressed in the JWG's proposals. Respondents to the March 1997 discussion paper expressed concerns as to: whether it is consistent to measure debt liabilities at fair value when they are considered to be financing nonfinancial assets that are measured on historical cost bases; the effects of taking into account changes in an enterprise's own credit-worthiness in measuring the fair value of its financial liabilities; the reliability of fair-value measures; and whether fair-value measures are relevant for accounting for banking book financial assets and financial liabilities. The "basis for conclusions" section in the draft standard addresses these issues.

The AcSB believes that the best prospects for developing a Canadian standard on this subject - one that would be consistent with standards in other international jurisdictions - is to develop it after receiving input on the JWG's proposals. The AcSB will carefully consider comments on the draft standard and will exchange comments with other participating standard-setters. Every effort will be made to achieve the same accounting for financial instruments in all jurisdictions. It seems clear that Canadian standards must develop at least to the level of existing US and international standards. The current lack of standards and mixed historical cost / fair-value practices is no longer acceptable. Your comments will help to shape the nature of that change - both in Canada andin the international arena.