CANADIAN STANDARDS GIVE LITTLE GUIDANCE ON HOW TO ACCOUNT FOR FINANCIAL INSTRUMENTS BUT STANDARD-SETTERS ARE WORKING ON IT

For almost 14 years, accounting standard-setters, including the Canadian Accounting Standards Board, have devoted considerable time and effort to developing accounting standards for recognition and measurement of financial instruments in financial statements. The Canadian Board has directed its resources toward the pursuit of a comprehensive model. This approach has been followed to avoid complications that arise when only some aspects of the issue are addressed, and to avoid the need for multiple, incremental changes to standards. However, there continues to be little sign of agreement on a generally accepted model that is capable of implementation in the short term.

Canadian accounting standards continue to contain very little guidance as to when financial instruments, such as equity investments, debt or derivatives should be recorded in financial statements or what amount should be attributed to those instruments if they are recorded. Meanwhile, a substantial body of literature has accumulated in the United States and internationally, at least partially, addressing these questions. It seems it is now time to take a different tack.

The most recent proposals issued by the AcSB were in the form of an Invitation to Comment, Financial Instruments & Similar Items, in December 2000 in conjunction with nine other standard-setting bodies, including the US Financial Accounting Standards Board and the International Accounting Standards Committee. Highlights of those proposals are summarized below (see also CAmagazine, May 2001).

• All financial instruments (with a limited exception) should be measured at fair value on company balance sheets.
• Gains and losses arising from changes in fair value of financial instruments should be recognized in the income statement in the periods in which they arise.
• The effects of a company's hedge relationships should be disclosed in notes to the financial statements rather than by modifying the above method of accounting for financial instruments.
  Internationally, more than 280 comments were received in response to the proposals, with more than 40 from Canada. More than two-thirds of the responses came from preparers of financial statements, with 40% of those from financial institutions and their representatives. These mostly opposed the proposals. Responses from other constituent groups -- accounting firms and the accounting profession, regulators, actuaries -- were more mixed in their views. Financial analysts, responding through the Association for Investment Management and Research, strongly supported the proposals.

While much of the attention focused on specific aspects of the proposals, a number of key themes are evident from the responses.

Basis for financial accounting
Many respondents" arguments regarding the purposes and conceptual bases for financial accounting are inconsistent with the conceptual frameworks under which accounting standards in Canada are developed. Many of these arguments have implications that go beyond accounting for financial instruments.

The role of management intent
Many strongly believe balance sheet measurement and income recognition should reflect management's intentions. For example, many believe a debt security that management intends to sell in the short term should be measured at fair value. This same group also believes that perhaps identical, debt security -- but that management intends to hold to realize its value through interest flows and maturity in the long term -- should be measured on a different basis. Similarly, many believe that definitions of assets and liabilities, or income recognition principles, should be modified in certain circumstances so gains or losses arising in the current period on financial instruments intended to manage risks associated with transactions in future periods can be matched with expected losses and gains arising in the future periods.

Consistency with internal practices
It's a common belief that the role of external financial reporting is to portray an enterprise as if seen through the eyes of management -- that is, financial reporting should be consistent with internal management practices. For example, many banks and their representatives believe that instruments for which the focus is on managing contractual cash flows (loans, deposits, etc., in the banking book) should be measured using a basis of accounting different from that used in the trading book, where the focus is on managing value changes. It is, obviously, desirable that there be as much compatibility as possible between management practices and external financial reporting. However, it is difficult to see how accounting that is driven by the manner in which management chooses to manage its financial instruments and risks can provide information that is consistent and comparable between enterprises.

Realization
Many believe fair value is relevant only for financial instruments -- capable of immediate realization or settlement. For other instruments, they argue fair value is irrelevant if it cannot be immediately realized. However, those who support a fair value objective for all financial instruments believe that, while liquidity factors would be taken into account in measuring the fair value of a financial instrument, realization is not a fundamental attribute that should affect the relevance of fair value for measuring a financial instrument. For many financial instruments, even if they are not immediately realizable, the value is capable of realization by entering into related positions using derivatives or similar financial instruments.

The role of earnings
Many believe a fundamental purpose of financial statements is to determine dividends, taxation, etc. Therefore, they are concerned about the use of a reported net income number that includes changes in fair value, for these purposes. Projects underway internationally on reporting financial performance, which the Canadian Board has recently added to its agenda, might be the place to resolve these issues.

Merits of the proposed model
Other arguments are more specific to the proposals themselves. In many cases they reflect strongly held differences of opinion. Often the evidence available to those holding the opposing views may not be sufficient to enable resolution of the conflict. Thus, it is not clear whether to refute or confirm one or the other view, or if a trade-off is necessary to reach a solution.

Fair value information
There is a fundamental inconsistency between the views of many financial statement preparers -- that financial statement users do not want and would not understand fair value-based information -- and the responses of financial statement users who say they want and use this information. Further work seems needed to better understand the difference of views.

Basis for prediction
Many are comfortable with historic cost/ realization accounting on the grounds that it is familiar and provides a more stable basis than fair values for prediction of future accounting income. They argue fair value-based earnings cannot be predicted in the same way because of the effects of uncertain future events and see this as a significant drawback to preparing budgets, forecasts, etc., and to managing analysts" expectations. Further work seems necessary to demonstrate how fair value information can be used and to assess its merits in relation to information available today.

Practical concerns
Numerous practical concerns are cited -- particularly about volatility, measurement reliability, cost/benefits and adverse economic effects. Many of these are difficult to evaluate without more practical experience and on some, conflicting views arise. For example, even though it is broadly argued there are significant circumstances in which fair value of financial instruments cannot be reliably determined, some significant respondents that use fair value information today believe reliable fair value is capable of being determined for all
financial instruments with appropriate commitment and investment. These concerns might best be further evaluated by field-testing. Some strongly encourage further work to resolve these kinds of issues.

Two additional themes arise that do not fall within the categories above.

Financial instruments vs. other items
Many see a fundamental inconsistency between measuring financial instruments at fair value and nonfinancial items largely on historic cost bases. Standard-setters recognize that whenever a boundary is drawn between financial statement items with different measurement attributes, inconsistencies and complexities often result. Some aspects of this issue are practical, in that only a certain number of issues can be addressed at any one time. In addition, there is presently no intention on the part of any standard-setters to introduce a fundamental new measurement basis to the entire financial statements. The proposals argue that there is economic logic in drawing a line between financial instruments and nonfinancial items, and more so than drawing a line including some financial instruments but not others.

Overwhelming size of the proposals
Finally, many commentators found the magnitude of the proposed changes and volume of the material too overwhelming to adequately address in detail. One of the questions this raises is whether it is better to implement fundamental change all at once, or to make several, incremental changes toward an overall goal.

The differences of view as to the basis for financial accounting need to be considered, not only in the context of financial instruments but also in the context of other areas of accounting where similar issues arise. These are fundamental issues that need to be taken into account by standard-setters in all areas of financial accounting. Without a consistent approach to these issues, there is a significant risk that a piecemeal, patchwork of standards will evolve with no common framework to hold it together.

The differences of opinion as to the merits of the proposal seem capable of resolution only with rigorous testing. In the past, many have claimed an inability to fully come to grips with, and consider the consequences of, a fair value model for financial instruments until a clear proposed standard implementing that concept has been set out. The proposals set out such a standard.

There is a need for more work that actively involves those beyond the standard-setting community. Many express strong desires for field-testing to be undertaken. Those who believe there is considerable merit in the proposals, such as the International Organization of Securities Commissions, urge that further work proceed as soon as practicable.

The first priority seems to be to work in close cooperation with users and preparers of financial statements to further consider the practicality of the proposals and to demonstrate or refute the relative merits of fair value and historic cost-based reporting of financial instruments for user analysis purposes. It is suggested that such work should involve rigorous testing to consider how fair value information would be used in decision models, as well as to simulate the preparation of fair value information to understand better the extent of many of the practical concerns.

Resolution of these matters will take time and involve approaches that may differ from those used by accounting standard-setters in the past. Therefore, the canandian Accounting Standards Board, while remaining committed to a global resolution of the issues associated with accounting for financial instruments, is embarking on projects to catch up, at least to some degree, with our international standard-setting partners. That way, the Canadian Board can fill the present gap in Canadian standards while continuing to participate with our international partners in exploring the larger issues associated with a comprehensive model.

The time for theoretical discussion of the proposals is, at least for now, over. The time has come to rigorously test the model and refine it. It is also time for Canada to fill the gap in its own standards and catch up with its international partners. In the long run, these strategies continue to be compatible with the goal of a single global set of accounting standards, comprehensively addressing all aspects of accounting for financial instruments.