Accounting's role in capital markets
Accounting systems with a micro-user orientation play a significant role in the effective operation of capital markets. This role is derived from the many frauds and collapses experienced in the early to mid 1900s. Because of these events, regulators saw fair and accurate reporting as a key factor in sustaining and enhancing confidence in capital markets (Craig and Diga, 1996, p.5). The literature goes further and has identified two criteria as a means of assessing the significance of accounting information in capital markets :

• Value relevance in capital markets (criterion No. 1).
• Ability to reflect the economic impact of transactions (criterion No. 2).

Value relevance
Value relevance is measured by the ability of accounting information to have a significant impact on share prices (Barth, 1994) and can be used as a means of assessing how capital market participants view accounting information. Empirical research examined the value relevance of fair value accounting disclosures and supported the hypothesis that fair value disclosures provide incremental explanatory power over historical cost accounting (Nelson, 1996; Venkatachalam, 1996 and Schrand, 1997. In particular, Venkatachalam (1996) specifically examined the value relevance of fair value estimates for derivatives and found fair value derivatives disclosures have incremental explanatory power.)

These findings support the use of fair value accounting on the grounds that the method is relevant in explaining changes in the value of securities traded in capital markets.

Economic impact
Derivative transactions can be used for speculative or hedging purposes. These purposes have different effects on share prices and firm valuations. Derivatives used for speculation increase earnings variability as they increase a firm's exposure to market movements. Alternatively, derivatives used for hedging purposes are generally designed to reduce earnings variability by minimizing the impact of market changes.

The valuation of security prices is dependent on the present value of future cash flows, which in turn is dependent on the expected value of earnings (Elton and Gruber, 1991). Therefore, capital market prices are influenced by the economic impact of a firm's activities on the expected level of future earnings and cash flows.

In a micro-user orientation, it is particularly important for accounting information to accurately reflect the economic impact of derivative transactions. If an accounting treatment does not reflect the economic implications of derivative transactions, the value relevance of that information is reduced.

Therefore, the degree to which a particular accounting treatment reflects the real economic impact of derivative transactions affects accounting's role in capital markets and can be used as a criterion to assess a derivatives accounting standard.

Accounting's role in taxation
The significance of accounting's role in taxation depends on the particular orientation of the accounting system. Accounting systems with a macro-user orientation require that accounting and tax rules be similar, in order to ensure the alignment of accounting with macroeconomic objectives.

However, accounting systems with a micro-user orientation generally do not require accounting practices to correspond directly with tax rules (Doupnik and Salter, 1993; Craig and Diga, 1996). This allows market participants to choose separate accounting and taxation practices, improving in theory their corporate image for the capital market, and minimizing their tax expense.

One criterion to assess derivatives accounting practices could then be their similarity with taxation rules (criterion No. 3). However, the significance of this criterion depends on the orientation of the accounting system.

Canada, and many capitalist economies such as the United States and Australia, are characterized as having a micro-user orientation (Doupnik and Salter, 1993; Craig and Diga, 1996). This assertion is reinforced by Canada's conceptual framework, which mentions that "it is not practicable to expect financial statements to satisfy the many and varied information needs of all external users of information about an entity. Consequently, the objective of financial statements for profit oriented enterprises focuses primarily on information needs of investors and creditors..." (CICA Handbook, Section 1000, para. 11).

Countries with micro-user orientations such as Canada have no standardized chart of accounts like the "Plan comptable" in France. Therefore, the symmetry between taxation and accounting rules is considered to be less important in Canada.

Agency theory
Jensen and Meckling (1976) examined the relationship between principal and agent within the theory of the firm. Agency theory has identified the existence of two agency relationships. First, in the manager-shareholder relationship, the manager acts as an agent for the shareholders who are considered to be the owners. Shareholders are not in control of the company, since the managers make all pertinent decisions. Second, in the shareholder-debtholder relationship, the manager is assumed to act on behalf of the shareholders. Therefore, the debtholder is the principal and, as the manager acts on behalf of shareholders, the shareholders become the agent (Godfrey et al., 1992).

In both of these relationships, the interests of the agent and principal are separated, imposing agency costs (Jensen and Meckling, 1976). In attempting to align the differing interests, monitoring and bonding costs are incurred. Monitoring costs are associated with overseeing the agent's behaviour (e.g., mandatory audit costs) and while initially borne by the principal, are transferred to the agent through contracting.

In the manager-shareholder relationship, monitoring costs are transferred by adjusting the agent's remuneration package (or bonus plan) according to the perceived level of monitoring required (Godfrey et al., 1992). In the shareholder-debtholder relationship, monitoring costs are transferred via debt covenants, placing restrictions on the investment, dividend and financing activities of a firm.

Since agents bear monitoring costs, they are likely to establish mechanisms designed to align the interests of the agent and principal. The costs associated with these mechanisms are called bonding costs (e.g., the cost of preparing financial statements). These costs are also borne by the agent.

Jensen and Meckling (1976) acknowledge that it is too costly to align the interests of shareholders and management perfectly. The costs incurred after monitoring and bonding are characterized as the residual loss. This "loss" is borne by the principal and is caused by the agent acting in his/her own interest at the expense of the principal.

Accounting's role in contracting
Accounting plays an important role in the reduction of agency costs (Jensen and Meckling, 1976). Both of the contracts discussed above "are often defined, or written in terms of financial accounting variables" (Whittred et al., 1996, p. 46). Agents can reduce agency costs by voluntarily producing financial statements and having their accuracy attested by an independent external auditor.

Watts (1979) examined the presence of financial statements in an unregulated environment during the 19th century and noted that agency contracts existed at that time and were linked to the existence of financial reporting. These findings lend support to the argument that one of the objectives of financial reporting is to reduce agency costs. The literature has identified two areas to assess the degree to which accounting treatments and/or regulation can reduce agency costs: minimizing management manipulation, and transparency.

Minimizing management manipulation
Empirical evidence from agency theory found that management manipulates accounting numbers to benefit from the contracting process (refer Holthausen et al., 1995). In instances where management can manipulate accounting numbers to transfer wealth, accounting standards can assist in reducing agency costs by minimizing the scope for such manipulation.

There are three types of accounting treatment, which have differing implications on the measurement of derivatives: historical cost accounting, fair value accounting and hedge accounting. Additionally, the estimation of fair value requires a certain amount of subjectivity and a certain number of assumptions, especially when there is not an observable and active market.

Therefore, a derivatives accounting standard could be assessed by two criteria related to the amount that management manipulation is minimized:
1. The possibility to choose between diverse accounting methods, particularly when hedge accounting is permitted (criterion No. 4).
2. The degree of subjectivity and estimation inherent in the application of fair value accounting (criterion No. 5).

Note that Blanchette and Hague (2000) also used management's intention as a criterion to categorize issues regarding accounting for derivatives.

Transparency in reporting
The off-balance-sheet nature of derivatives has implications for the debtholder-shareholder relationship. If debt covenants do not specifically require the reporting of derivatives positions, entities can keep these positions unreported. Consequently, debtholders are kept unaware of potentially material positions. The lack of transparency in derivatives reporting also increases monitoring costs.

Following this argument, a derivatives accounting standard could be assessed by the level of transparency created as costs associated with debtholder-shareholder contracting could be reduced (criterion No. 6). Transparency in reporting can occur in two forms: disclosing information in the body of financial statements or in the notes.

A regulated future
The six criteria we have introduced can be used for assessing current and proposed accounting standards and practices. They were established considering two areas of accounting literature: micro- vs macro-user orientations and agency theory.

Three of the criteria refer to factual components of financial analysis for derivatives: value relevance in capital markets, the ability to reflect the economic impact of transactions and transparency in reporting. Two criteria flow from the degree of management manipulation: the possibility to choose between diverse accounting methods (e.g. hedge accounting) and a requirement for estimation (e.g. fair value). The remaining criterion (similarity with taxation rules) has greater significance for international accounting systems with a macro-user orientation.

It is clear that these criteria should be weighted prior to their application. Obviously, the relative weight may differ depending on the importance of each criterion to users. For example, criterion No. 3 regarding taxation is probably more important in France (macro-user orientation) than Canada or the United States. In this article, we have not attempted to attach weights to the suggested criteria.

However, we can clearly observe that the recent developments in the area of accounting for derivatives tend to favour certain criteria. In the 1990s, regulators attempted to address criterion No. 6 (transparency in reporting) by increasing the level of mandatory disclosures regarding off-balance-sheet derivative instruments (e.g., CICA Handbook, Section 3860). More recently, regulators have attempted to address the recognition and measurement issues associated with derivatives (e.g., FAS 133), which refer to criteria No. 1, No. 2, No. 4 and No. 5 (value relevance, economic impact, degree of management manipulation and requirement for estimation).

The most recent work in progress includes a comprehensive draft standard issued by representatives of nine countries, including Canada and the US, and the International Accounting Standards Committee (JWG, 2000). This draft appears to be consistent with some of the criteria noted here, since it recommends fair value accounting within a minimum degree of involvement of management manipulation.

The future of derivatives accounting will certainly involve extensive regulation regarding the recognition and measurement of derivatives. We have proposed a set of criteria to assess these regulations. One question will then arise: does the evolution of accounting help users to understand what's going on with derivatives? It would be helpful to have accounting rules that uncover the hidden face of derivatives in a way that doesn't make them look more complex than they already are.


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