- What is this new standard? What does it do and for whom is it most critical?
- Highlights of the new standards:
- All financial instruments, including derivatives, are to be included on a company’s balance sheet and measured, either at their fair values or, in limited circumstances when fair value may not be considered most relevant, at cost or amortized cost. The standards also specify when gains and losses as a result of changes in fair values are to be recognized in the income statement. These requirements will probably affect all entities to some degree.
- Existing requirements for hedge accounting are extended. To date the AcSB has requirements in place that specify the circumstances under which hedge accounting is permissible, but do not comprehensively specify how hedge accounting should be performed – i.e. what are the debits and credits that should be recorded, and where. This standard remedies that shortfall.
- A new location for recognizing certain gains and losses - other comprehensive income – has been introduced. This provides an ability for certain gains and losses arising from changes in fair value to be temporarily recorded outside the income statement, but in a transparent manner.
- Together, these standards will enhance the transparency of financial instruments on financial statements. More financial instruments will be visible on the balance sheet, the gains and losses arising on those instruments will be visible, and relationships among items having offsetting risk exposures for accounting purposes will be more clearly portrayed.
- The standards will be most critical for those who use a lot of financial instruments – particularly financial institutions. However, they will also affect other companies that use financial instruments, whether to manage risks, in investment portfolios, or otherwise. They will also affect those who actively manage commodity risks.
- Why did the Accounting Standards Board choose to issue new standards at this time?
- The new standards are designed to close a gap in GAAP. At the moment, there is no comprehensive accounting for financial instruments in Canada. These standards will bring Canadian standards in line with best international practice.
- Why do we need this standard?
- Presently financial statements include disclosures about financial instruments, but do little to reveal the financial effects of using such instruments. For example, a company’s balance sheet today may include investments at the price for which they had been originally purchased – perhaps many years ago. Unless there has been a permanent decline in value of those investments, the financial statements will not reflect the fact that those investments may be worth much more, or much less than the amount at which they are recorded on the balance sheet. Consider, for example, an RRSP statement that provides you only with the cost at which you acquired your investments, but not their value today. How informative would that be? One thing that these standards would do is to make more transparent the values of, and gains and losses on, all types of financial instruments. In the case of derivatives, what was once an asset may have become a liability as a result of changes in value.
- Consider another example, two Canadian companies with sales in Canadian dollars and purchases in US dollars. One company chooses to manage the mis-match between the currencies by entering into derivatives to “fix” the price at which it can convert Canadian dollars into US dollars to pay for its purchases, but the other company does not. Those two entities may now be in very different positions, because one is exposed to changes in the Canadian/US dollar exchange rate, but the other is not. These standards would ensure that those differences are transparent from the balance sheet and income statement and that the financial effects of these different currency risk management strategies are clear to users of financial statements.
- Whether a company is in financial trouble or not can’t be changed by accounting standards, but these new requirements will make it more obvious, and warn at an earlier date, when a company may be in difficulty. These standards bring greater transparency to the financial effects of financial instruments and reveal exposures that would otherwise be invisible from financial statements.
- Similar standards on financial instruments issued in the U.S. and internationally have resulted in criticism from some quarters. How are the Canadian standards different
?
- The AcSB has carefully monitored the criticisms that have been raised in the US and internationally. The standards are lengthy and, in places, complex. This, in many cases, reflects the nature of financial instruments. One of the important aspects of these standards is that they harmonize Canadian standards with those in the US and internationally. We have proceeded cautiously and taken advantage of the learning and experience gained by our American, European, U.K., Australian and Japanese counterparts, to produce a hybrid of US GAAP and international standards that are adapted for Canadian needs. The new standards close a lot of the gaps in Canadian GAAP without sacrificing the basic objective of having most financial instruments measured at fair value. The AcSB will continue to monitor and participate in international discussions on accounting for financial instruments. With the same starting point as our international colleagues, the AcSB will be better positioned to be influential in any further international deliberations.
- How does the AcSB standard compare to the FASB and IASB standard, in qualitative terms?
- The AcSB has sought to avoid all conflicts with equivalent FASB standards. Thus, a Canadian company would not be precluded by the Canadian standards from applying an aspect of the US standards. However, that does not mean that all aspects of the US standards have been included in the Canadian standards. Some of the detailed guidance in the US standards has not been incorporated into the Canadian standards because the AcSB does not believe that all of the guidance is necessary. However, it has established a Working Group that will consider the need for ongoing implementation guidance in Canada if issues do arise on which there may be significant divergence in practice.
- There are few instances where the Canadian standards would differ from those in the US. Most notably is the ability to designate any financial instrument on initial recognition as one that will be measured at fair value with gains and losses recognized in net income. This is an option that can greatly simplify the accounting in some cases and is one that has also been adopted by the IASB. The FASB is also studying the possibility of introducing a similar option in the US. Some are critical that this option might be used to measure some financial instruments at fair value when fair value is not reliably determinable. The AcSB specifies that such practice is not permitted and provides guidance as to how reliable fair values can be determined. The AcSB will continue to monitor best international practice in determining fair values with a view to enhancing this guidance if necessary.
- The Canadian proposals are somewhat broader in scope than the US standards.
- Certain aspects of the IASB standards are already addressed in Canadian standards – for example, how to account for impairment of a loan, or when to remove a financial asset from the balance sheet under a transaction such as a sale of receivables. These aspects are not, therefore, part of the current standards. Otherwise the Canadian standards would be broadly consistent with those internationally.
- Will this standard have the effect of discouraging the use of derivatives/hedges?
- It is not the role of the AcSB to encourage or discourage particular business practices or transactions. The standards do not say anything about whether derivatives or hedges are a good or bad thing. Their intent is to make transparent the financial effects of a company’s use of derivatives/hedges.
- What sort of effort has the AcSB made to ensure that the new standards accurately reflect how businesses actually manage an entity?
- Several features of the new standards capture that reality. For example, financial assets held to maturity, loans and receivables and most financial liabilities would continue to be measured at amortized cost, reflecting a view that such instruments are managed in that way. The standards that permit certain gains and losses to be recorded outside income (in other comprehensive income) also reflect management’s view that those items are not income or losses of the current period.
- Companies employ various strategies to manage risks. An example is hedge accounting. Hedge accounting in effect overrides the normal accounting and can span several accounting periods in order to match offsetting risk exposures. It is essential that there be a high level of confidence that the hedge strategy will be truly effective. This is why so-called macro-hedging strategies involving large groups of dissimilar items won’t qualify for special accounting treatment.
- When does the standard come into effect?
- The mandatory effective date for the standards to be adopted is for annual and interim periods beginning on or after October 1, 2006. (In many cases this will mean application to calendar years beginning on January 1, 2007.) However, early adoption is permitted, as soon as for years ending on Decemebr 31, 2004.
- What companies will have to adopt the new standard?
- The standards would apply to all entities that use financial instruments. They focus on the nature of the instrument, rather than the nature of the entity. Thus, any entity that uses, say, derivatives, would apply the standard to account for those derivatives. Although, it should be noted, that the standard applies not only to derivatives, but also to financial instruments such as accounts receivable, accounts payable, loans, deposits, investments and long-term debt.
- This new standard is long and complex. Why?
- Our aim is improved financial reporting. By bringing these instruments onto the income statement, users, analysts etc. will have much transparent, comprehensive information at their fingertips, as opposed to having to wade through detailed financial statement notes to find where these instruments are measured and recorded, as is the case today.
- We have sought to make the standard as easy to read as possible. We have had the benefit of being able to step back from the US and international material and adapted it in a manner that we believe would be more user-friendly for Canadian businesses. However, the fact remains that complex financial instruments require complex accounting to reveal the financial effects of those instruments on a companies activities.
- Some of the complexity arises as a result of exceptions from the basic principles necessary to reflect the manner in which certain financial instruments are used and to ensure international harmonization.
- The AcSB’s Financial Instruments Working Group is developing material to assist entities that are not affected by some of the more complex aspects of the requirements, (because they do not have the instruments or situations to which those requirements apply). It will help them find their way to the relevant parts of the standards that will affect them.
- What is the AcSB doing to ensure that small businesses or small practitioners can implement this standard?
- In the most straightforward cases, the standard will have little effect on the basic accounting. For example, little accounting change is required for trade receivables, trade payables or long-term debt. However, it is true that if small businesses enter into complex transactions, then the accounting may be complex.
- In the meantime, the AcSB’s Financial Instruments Working Group, in conjunction with the AcSB’s Differential Reporting and Not-for-Profit Organizations Advisory Committees, is developing implementation guidance to assist small businesses and their advisors in dealing with the more straightforward situations.
- A series of articles have also been printed in the November and December 2004 issues of CAmagazine, explaining how one might go about preparing to adopt the new standards.
- What is the reasoning for recording derivatives/financial instruments on the balance sheet at fair value? Isn’t disclosure of fair values sufficient?
- Derivatives/financial instruments are assets or liabilities of an entity. They can be extremely valuable, or result in large obligations to an entity. Without reflecting these assets or liabilities on the balance sheet, a significant part of an entity’s assets or liabilities is not evident to users of financial statements.
- The cost of many derivatives may be very small, but the exposures can be great. For example, one may enter into a forward contract to purchase US dollars for Canadian dollars in three months time. At the time of the purchase, there is little cost to this transaction and the forward exchange rate agreed to does not create a significant exposure. However, if the relative Canadian/US dollar exchange rate were to move significantly, then the resultant forward contract could be very valuable or onerous. That value is what is reflected on the balance sheet under these proposals.
- Disclosure is not a substitute for proper recognition and measurement. By recording derivatives/financial instruments on the balance sheet at fair value, the effects of their exposure are clearly evident to users of financial statements in assessing the financial position and results of an entity.
- Won't this standard result in increased income statement volatility
?
- This standard may result in increased volatility in the income statement. Some of that volatility is shielded by the use of other comprehensive income, but to the extent that gains and losses are recognized directly in the income statement, volatility that reflects the volatility of the markets will be recognized in the income statement.
- Financial statements are intended to portray the financial position and changes in financial position of an entity. When the changes in financial position are volatile, investors are better served if the financial statements reflect that volatility.
- Investors need to understand volatility. Masking it will not aid such understanding. Typically, investors consider their tolerance for potential volatility before investing. By clearly displaying that volatility, an investor has full information on which to make an investment decision.
- How can I obtain a copy of the proposals?
- The standards can be obtained from the AcSB web site at www.acsbcanada.org. At the beginning of April 2005, they will be included in the CICA Handbook — Accounting. For those without Internet access, the standards can be obtained by writing to: Information Services Officer, Standards Group, The Canadian Institute of Chartered Accountants, 277 Wellington Street West, Toronto, Ontario, Canada M5V 3H2. Fax: (416) 204-3412.
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