New standards on accounting for financial instruments:  a primer

New rules for financial instruments have introduced drastic changes to GAAP, creating scepticism among managers, investors and even accountants, who believe that they will be more complex than ever. However, beyond their apparent complexity, the new rules can be demystified by considering a few fundamental changes

By Michel Blanchette, CMA, FCMA

Even the best specialists are sometimes overwhelmed with the quantity and complexity of accounting methods and notes to financial statements. In their drive to turn generally accepted accounting principles (GAAP) into an economic validation tool, for instance, standard setters have added more accounting rules and technical details. All that this has managed to do in some cases is hide economic reality behind complicated and disconcerting rules. Financial statements have become a veritable muddle of information that can be difficult for even a company’s management to follow.

Canadian accounting standards were substantially updated recently. New standards, issued in April 2005 and dealing with financial instruments, comprehensive income and hedging, will apply to fiscal years beginning on or after October 1, 2006 (October 1, 2007, for non-publicly accountable enterprises). Although designed for greater transparency and relevance in accounting practices, these new standards are currently being criticized because they include a plethora of complex details and guidelines, in addition to introducing a new class of accounting information — comprehensive income. However, using the right approach, it’s not difficult to understand the purpose and basic logic of the new standards.

Operations covered

Transactions involving financial instruments are many and varied. One can purchase financial assets by paying cash for them or by transferring other assets or benefits in exchange. Conversely, one can assume or incur a financial liability or equity instrument in exchange for a sum of money, or for certain assets or benefits. Moreover, some “derivative” financial instruments don’t involve a physical exchange when executed, but require an exchange of assets at a later date.

Basically, financial instruments cover just about everything that appears on a balance sheet, except for inventory, capital expenditures and a few other items. They include cash or a commitment to exchange cash, monetary items (such as accounts receivable, accounts payable, investments in bonds and loans), equity instruments and derivatives.

Equity instruments include common shares, preferred shares and any securities that could eventually enable their holders to obtain shares or a residual right to an entity’s profits or net assets. According to accounting standards, they are deemed to be financial instruments on both sides of the balance sheet, either as financial assets (when held as investments), or as equity (when they provide a residual right to an entity’s net assets).

Accounting issues

A simple way to look at accounting for financial instruments is to classify a firm’s operations in two categories: those directly related to the usual course of business and those that are incidental or speculative. Transactions in the usual course of business are ongoing; they primarily involve non-monetary assets used to develop or produce services or goods for sale. Such transactions are mainly measured at cost, with expenses designed to match this cost with income (often by amortization) and income accounted for under the revenue recognition principle. The latter principle is a major constraint in measuring accounting profitability, since it’s generally forbidden to recognize income or gains before a transaction with third parties has been realized.

Incidental or speculative transactions accompany those in the usual course of business, but require different management competencies. They include cash flow management (including speculative investments based on seasonal cash variations and derivative-based hedging strategies), as well as transactions in support of the usual course of business (such as managing accounts receivable and accounts payable and the full range of debt funding aimed at supporting short-and long-term infrastructure). For instance, it’s quite possible to manage accounts receivable independently from current operations, although they are closely related to sales processes, by going through a financial institution that can handle all collection and follow-up operations with customers.

Historically, GAAP have been based on the principles of cost, revenue recognition and matching. These basics still apply for the usual course of business transactions. But the cost principle has created problems in at least two situations. First, there is an entire range of speculative transactions for which historical cost measurement is totally inappropriate. The only measurement that can be relevant in this case is one based on fair value. Second, so-called “off-balance sheet” derivative transactions are invisible to readers of financial statements when measured at historical cost because this cost is nil (or almost nil) as defined by GAAP. To analyze off-balance sheet transactions involving derivatives, one must be able to weigh the risks that they involve and measure them against a value that takes such risks into account — fair value.

For all these reasons, accounting standard setters have been forced to use fair value as a preferred solution in response to the many criticisms levelled at the cost principle. It’s true that the cost principle has lent credibility and reliability to accounting data in the past. Reliability, moreover, is a crucial value for GAAP and has managed to push the cost principle to the forefront until now. Thus, it will hardly come as a surprise that today’s GAAP quickly reverts to the cost principle in situations where fair value is unavailable or based on too much subjectivity. Things have changed, however, and the time has come to adopt fair value for some incidental and speculative transactions.

We are therefore left with three main issues:

• Recognition and presentation of information as part of the balance sheet vs. off-balance sheet;
• Measurement at cost vs. fair value; and
• The resulting presentation (after measurement at fair value) of unrealized gains and losses in the income statement vs. outside the income statement.

Recognition and presentation of financial instruments

Section 3861 of the CICA Handbook outlines how financial instruments should be presented on the balance sheet and what additional information should be disclosed in the notes to financial statements. As far as presentation in the body of the balance sheet is concerned, the gist of the rules is in line with the usual characteristics of balance sheet items, i.e.:

• For an asset to be recognized, it must provide future benefits that the entity controls and for which a transaction has  occured.
• For a liability to be recognized, it must represent an obligation to transfer value to a third party and there must be no way for the entity to circumvent its obligation.
• Equity represents ownership of the entity’s assets, net of liabilities; it is the residual interest in net assets.

Accordingly, all financial instruments must be recognized on the balance sheet, for they all have the characteristics of an asset, a liability or an equity instrument. This also applies to derivatives, which are presented with assets where the entity is in a favourable position and with liabilities when it is in an unfavourable position. Some so-called “hybrid” financial instruments must also be given special treatment and be broken down so that their various components can be adequately presented on the balance sheet. For instance, convertible bonds are shown as follows: a portion with the issuer’s liabilities (equal to the present value of future payments that the entity cannot circumvent) and the other portion in equity (equal to the additional value that the conversion privilege has made it possible to obtain at the issuance of bonds).

The requirements of note disclosure are designed to compensate for any shortcomings associated with the cost principle, with the invisibility of off-balance sheet items and with the impossibility of disclosing the uncertainty and risk within the framework of a single balance sheet. These requirements include a description of the features of the instruments, a description of the risk management policies, an estimate of fair values (if they aren’t already available in the body of the balance sheet) and additional information about risk (amounts of exposure to interest rates, credit risk, by maturity date, by currency).

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Measuring financial instruments

The issue of measuring financial instruments flows from a well-known GAAP — the cost principle. Accounting practices used until recently to measure financial instruments were generally restricted to the cost method or amortized cost. Under these methods, the book value of a financial instrument remains unchanged as long as the instrument is held by the entity, except to recognize the amortization of any applicable premiums or discounts, or to reflect impairment.

The publication of Section 3855 of the CICA Handbook has shaken the foundations of financial instrument measurement in Canada. Table 1 summarizes these rules by breaking them down according to balance sheet items and by specifying how to treat unrealized gains and losses on changes in fair value, when applicable. The table shows that the accounting treatment for financial instruments is not as complicated as the wording of Section 3855 makes it look. In fact, all financial instruments are measured at fair value when they are initially recognized, and this amount becomes their historical cost. Subsequently, items appearing in equity continue to be valued at cost on the balance sheet, along with financial assets held to maturity, and most liabilities. However, the cost approach has been replaced by a fair value measurement in two situations.

The first situation is one where financial assets and liabilities are deemed to be “speculative.” In this case, gains and losses on changes in fair value are immediately recognized in income so that they can be factored into net earnings. This immediate recognition is important if the accounting rate of return shown in the income statement is to reflect the economic reality of speculative transactions. The traditional argument that a company could be unduly penalized if unrealized gains and losses were recognized in its income no longer holds true where speculation is involved. The income statement would be misleading if it didn’t include unrealized gains and losses on speculative transactions. In spite of this, entities aren’t required to qualify their financial instruments as speculative for accounting purposes, except in the case of derivatives. Thus, any firm that feels disadvantaged by such an accounting treatment could simply designate all of its financial instruments (except derivatives) as held to maturity or available for sale. However, it’s important to point out that, under GAAP, a firm is forbidden from changing the initial classification of a financial instrument where such a reclassification would affect the “speculative” category (whether into or out of). In addition, a number of exceptions are provided for hedging strategies.

The second situation in which financial assets are measured at fair value is when they are deemed to be “available for sale.” In this case, accounting standard setters have had to be creative in finding room for unrealized gains and losses on such instruments in the financial statements, as there was much lobbying to avoid their immediate recognition in income. Furthermore, since they could also not be presented with assets or liabilities (as deferred losses or deferred gains, as had been done in the past) because they didn’t share the theoretical characteristics of such items, a new class was created in owners’ equity called “other comprehensive income.” This new class makes it possible to account for unrealized gains and losses without recognizing them immediately in income. Thus, available for sale instruments can be shown at fair value on the balance sheet, without affecting income until gains and losses are realized. Such gains and losses are then transferred from other comprehensive income to income upon realization.

Other comprehensive income is shown under a new item in owners’ equity, as are contributed surplus and retained earnings. This item will also be used to recognize a number of gains and losses that are not realized under hedge accounting. Moreover, other comprehensive income is also reported as part of a new disclosure required by GAAP, i.e. comprehensive income. The latter is a new measure of profitability that incorporates net income (loss) as well as gains and losses for the period that are recognized in other comprehensive income.

The new standards on financial instruments are impressive. The CICA Handbook’s new Section 3855 alone has 88 paragraphs, not including the appendices. Most financial statement users, including many analysts and even public accountants, may feel lost when confronted with this maze of new rules. Still, it’s possible to make sense of them by looking away from the technical details to focus on the logic of different accounting treatments and at how financial statements are primarily affected. Over and above the apparent complexity of these new standards, it’s possible to get one’s bearings by identifying the real conceptual changes — the fair value measurement of some instruments (those that are speculative, available for sale, and derivatives) and the introduction of a new class of accounting disclosure (comprehensive income).

Michel Blanchette, CMA, FCMA, CA (michel.blanchette@uqo.ca) is professor at Université du Québec en Outaouais.

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