Standards
Three New Measures
The Accounting Standards Board has issued three exposure drafts on accounting for derivatives and equity instruments.
FROM: SEP-OCT 2003 ISSUE | BY STEPHEN SPECTOR
Fifteen years after it first began research on financial instruments, the Accounting Standards Board (AcSB) plans to bring the project to a close — at least for the next few years. On the heels of this decision came three new exposure drafts that will mean significant changes to accounting for derivatives and equity instruments.
The first stage of the project saw the introduction of Handbooksection 3860 dealing with disclosure issues in 1996. Although the initial plan had been to address disclosure and measurement issues, the measurement side of the project was put off until a consensus among world standard setters could be reached.
The AcSB now feels this consensus has been reached. On March 31, 2003, it released three exposure drafts that address the measurement of derivatives and equity investments. These proposals are part of the AcSB's process of harmonizing Canadian GAAP with U.S. GAAP; they also reflect the Board's awareness of developments at the international level. The recommended new standards are based on both the U.S. Financial Accounting Standards Board's Statement 133 and the International Accounting Standards Board's planned revisions to IAS 39. They are intended to mitigate potential conflicts with U.S. GAAP, but be robust enough to address any specific Canadian situations that may arise.
Key Principles
The exposure drafts contain the following key principles:
- All financial assets are to be measured at fair value with the exception of loans, receivables and investments intended to be held to maturity, which are to be measured at amortized cost. Investments in equity instruments that do not have a quoted market price in an active market would also be measured at cost. Likewise, all financial liabilities are to be measured at fair value when they are held for trading or are derivatives. Other financial liabilities would be measured at amortized cost.
- Any gains and losses on financial instruments measured at fair value are to be recognized in the income statement in the periods in which they arise, with the exception of financial assets available for sale. In this instance, any gains and losses are recognized in other comprehensive income until the financial asset is removed from the balance sheet or becomes impaired. Basically, gains or losses cannot be deferred on the balance sheet as if they were assets or liabilities.
- All financial assets and financial liabilities, including all derivatives, are to be recognized in the financial statements. This stricture is not affected by the special accounting contemplated for hedges. In addition, an entity is to remove a financial liability from its balance sheet when, and only when, the obligation specified in the contract is discharged, cancelled or expires.
- An entity may apply special hedge accounting in circumstances when the hedge qualifies for the special accounting. Although this option seems to be redundant, the ability to employ the special accounting would 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.
Recognition and Measurement
The new Handbook section 3855, Financial Instruments — Recognition and Measurement, is intended to apply to all entities and financial instruments, with the exception of financial instruments that are the subject of other accounting standards or standard-setting projects. It will also apply to contracts to buy or sell a non-financial item that can be settled net in cash or by some other financial instrument as if it were a financial instrument, with limited exceptions. In addition, section 3855 will apply to all derivatives, including derivatives embedded in other contracts.
As a consequence of section 3855, an entity's financial assets will be classified as either held for trading, held to maturity, loans and receivables, or available for sale. Derivatives, including embedded derivatives that are not closely related to the host contract, will be classified as held for trading, irrespective of any other characteristic.
Hedges
The new Handbook section 3865, Hedges, expands on the existing requirements of Accounting Guideline AcG-13, Hedging Relationships. Section 3865 will require that a hedge be designated as a fair value hedge, a cash flow hedge, or a hedge of the net investment in a self-sustaining foreign operation.
For a fair value hedge, the gain or loss on a derivative hedging item, or the gain or loss on a non-derivative hedging item attributable to the hedged risk, is recognized in net income in the period of change, together with the offsetting loss or gain on the hedged item attributable to the hedged risk. The carrying amount of the hedged item is adjusted for the hedged risk.
For a cash flow hedge, the effective portion of the hedging item's gain or loss is initially reported in other comprehensive income and subsequently reclassified to net income when the hedged item affects net income.
For a hedge of the net investment in a self-sustaining foreign operation, an entity is to account for the hedge in the same manner as a cash flow hedge.
Comprehensive Income
The new Handbook section 1530, Comprehensive Income, is the third of the three exposure drafts issued last March and is a direct consequence of the other two. Given that the proposed Canadian standards are largely based on the U.S. standards, it was necessary for the AcSB to ensure that all aspects of U.S. GAAP were considered. And, since an integral part of the FASB standards on recognition and measurement of financial instruments is the ability to present certain gains and losses outside net income in a statement of other comprehensive income, it was necessary for Canadian GAAP to provide for this with the implementation of Canadian standards on recognition and measurement of financial instruments.
Section 1530 requires that an enterprise display comprehensive income and its components in a financial statement as prominently as other financial statements, in both the annual and interim complete set of financial statements. Moreover, the statement must show net income for the period, as well as each component of revenue, expense, gain or loss that is required by primary sources of GAAP (as defined in section 1100) to be recognized in other comprehensive income, and a total.
With the creation of a statement of comprehensive income, the AcSB took advantage of the opportunity to "clean up" the balance sheet. For example, exchange gains and losses arising from the translation of the financial statements of a self-sustaining foreign operation, previously recognized in a separate component of shareholders' equity (as per section 1650), will now be recorded as a component of other comprehensive income.
Also, section 3250, currently titled "Surplus," will be renamed "Equity." The renamed section 3250 will require an enterprise to separately present changes in equity arising from different sources and the components of equity, including other comprehensive income.
Changes in 2004
The AcSB plans to issue the revisions to the Handbook by the second quarter of 2004, with the intention that they become effective for fiscal years beginning on or after October 1, 2004. Look for a future column to deal with final texts when they are released next year.
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Stephen Spector, MA, FCGA, owns Spector and Associates and teaches Financial and Managerial Accounting at Simon Fraser University. He also serves on CGA-BC’s board of governors. E-mail shspector@shaw.ca.