Financial Instruments – filling the gap in GAAP*

By Ian P. Hague

*This is an updated version of an article by Ian P.N. Hague in CAmagazine, June/July 2003. Click here for the original version.

On January 27, 2005, the AcSB issued new standards on financial instruments that will impact virtually every business entity in Canada, small and large. These standards are a culmination of many years of consultation, with the standard setters having explored several approaches to recognition and measurement, closely monitoring related international developments, and putting out several exposure drafts for comment to produce standards that will enhance the understandability of financial statements, are practical and are harmonized with those of international partners.

The Accounting Standards Board (AcSB) presently has in place standards for disclosures about an entity’s use of financial instruments and how financial instruments should be presented when included on the balance sheet. However, until now it has not had standards that comprehensively address when an entity should recognize a financial instrument on its balance sheet, or how it should measure the financial instrument once recognized. The new standards will fill that gap in GAAP.

Elsewhere on the international front, FASB in the United States and the International Accounting Standards Board (IASB) have issued similar standards covering recognition and measurement of financial instruments, which were initially met with resistance and in some areas, despite subsequent modifications, still continue to do so. The new Canadian standards will bring Canadian GAAP in line with that of the United States and the IASB.

The need for accounting standards
In June 1998 the Financial Accounting Standards Board (FASB) in the US issued FASB Statement 133, Accounting for Derivative Instruments and Hedging Activities. Later thatt 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 complex nature of financial instruments. However, 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 develop about the comprehensive fair-value model being developed by the JWG. However, it has become clear that significant further work is necessary before a comprehensive fair-value accounting model could be introduced.

Canada cannot afford to be without accounting standards for recognition and measurement of financial instruments any longer. The AcSB is now filling the gap in GAAP having developed Canadian standards that reflect best international requirements (FASB Statement 133, related US pronouncements and IAS 39) for recognition and measurement of financial instruments.

The new standards
The new standards have been developed based on existing FASB standards and IFRS, taking into account the latest in improvements that have been made to those pronouncements. Like 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 derivative financial instruments. The new standards will require that all financial assets be measured at fair value with the exception of loans, receivables and investments 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 new standards will require that all financial liabilities be measured at fair value when they are held for trading or are derivatives. Other financial liabilities will be measured at amortized cost.

The new standards will 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 will be permitted for certain items designated as being hedged (see principle 4). However, this will 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 new standards will 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 standard will 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).

Accordingly, the new standards will not permit gains or losses to be deferred on the balance sheet as if they were assets or liabilities.

3. Financial instruments and non-financial derivatives represent rights or obligations that meet the definitions of assets or liabilities and should be reported in financial statements. The new standards will require that all financial assets and financial liabilities, including all derivatives, be recognized in the financial statements. This is not affected by special accounting for hedges. The new standards will also require that an entity remove a financial liability from its balance sheet when, and only when, the obligation specified in the contract is discharged, cancelled or expires. The new standards 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. Accordingly, the new standards contain the option to apply special hedge accounting in such circumstances. However, they specify the circumstances when a hedge may qualify for special accounting. That special accounting will 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 new standards have been developed starting with improved IFRS, which are based on existing US GAAP. The style of IFRS is more consistent with Canadian standards, and having been developed more recently than some of the FASB standards, the manner in which 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 other aspects of Canadian GAAP.

In many straightforward situations, the new standards 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 and for equity investments. Without measuring derivatives at fair value they are invisible, and gains and losses — sometimes disproportionate to changes in market conditions — would not be reported. This information is essential for users of financial statements to understand the nature of the rights and obligations inherent in derivatives. Accordingly, all derivatives will now be recognized and measured at fair value. Equity investments also will be required to be recognized and measured at fair value.

Canadian entities have already implemented criteria for hedge accounting since July 1, 2003 to comply with Accounting Guideline, AcG-13, Hedging Relationships, and the Emerging Issues Committee has required that freestanding derivatives be measured 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. Accordingly, the change on applying the proposals may not be extensive for some enterprises.

These new standards will bring Canadian standards in line with best international practice. They may not be the most straightforward, but at least they will fill the existing gap in Canadian GAAP and will significantly enhance the information conveyed to financial statement users about the effects of financial instruments on an entity’s financial position.

The new standards will become mandatory for annual and interim periods in years commencing on or after October 1, 2006, although earlier adoption is permitted and some are already taking advantage of that ability. 

Ian Hague is a Principal with the Accounting Standards Board, responsible for the  financial instruments project.