Financial Instruments

Transcription

1 Financial Instruments Navigating new waters OCTOBER 1, You probably have a strategic plan in place that goes beyond this date. You probably also have a financial plan to help you implement that strategic plan. But have you planned for the mandatory implementation of the new financial instruments accounting standards recently released by the Canadian Accounting Standards Board (AcSB)? The new financial instruments standards will impact virtually every business entity in Canada, large and small. If your company actively uses the capital markets for financing or investing purposes, or if you actively hedge financial risks, you need to assess the impact these standards will have on your business. And you need to start that assessment as soon as possible. These standards are a culmination of many years of consultation with Canadian constituents and with international standard setters. Having explored several approaches to accounting for financial instruments, the AcSB has produced standards that will enhance the understandability of financial statements, are practical and are harmonized with those of international partners. The AcSB presently has standards in place for disclosures about an entity s use of financial instruments and for presentation of financial instruments when included in 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. Even though the new standards are lengthy, their impact will be modest for many entities. However, in some cases the new standards will give rise to significant accounting changes. This document outlines features of the new standards and highlights steps you should take to prepare for their implementation. The new standards comprise three new Handbook Sections: Financial Instruments Recognition and Measurement, Section This Section will probably affect all entities to some degree. It prescribes when you recognize a financial instrument on the balance sheet and at what amount sometimes using fair value; other times using costbased measures. It also specifies how to present financial instrument gains and losses. (See page 3.) Hedges, Section Application of this Section is optional. It provides alternative treatments to Section 3855 when you choose to designate qualifying transactions as hedges for accounting purposes. It expands on Accounting Guideline AcG-13, Hedging Relationships, and replaces the hedge accounting requirements in Section 1650, Foreign Currency Translation, by specifying how to apply hedge accounting and what disclosures are necessary when it is applied. (See page 6.) Comprehensive Income, Section This Section introduces new requirements for situations when you must temporarily present certain gains and losses outside net income. There are also a number of significant consequential amendments to other Handbook Sections. In many cases, there will be little change from current accounting. If you have no financial instruments other than cash, accounts receivable, accounts payable and arms length debt, you will find little, if any, difference in accounting for these instruments. However, if you have investments in common shares, use derivatives, trade other types of financial instruments, or want to apply hedge accounting, you will probably be significantly affected. Financial Instruments [ 1 ]

2 Background In Good Company The AcSB developed the new standards based on existing US Financial Accounting Standards Board (FASB) standards and International Financial Reporting Standards (IFRS), taking into account the latest improvements that have been made to those pronouncements. The AcSB has tried to avoid any conflicts with US GAAP, to address unique Canadian circumstances and to address interaction with other aspects of Canadian GAAP. Like FASB standards and IFRS, the Canadian proposals are based on several key principles: 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. Prior to the introduction of financial instrument standards, off-balance sheet treatment of derivatives was commonplace. Transparency demands that all financial rights and obligations be reflected in financial statements. Accordingly, you must now recognize all derivatives on the balance sheet, regardless of whether they are part of hedging relationships. Fair value is the most relevant measure for financial instruments and the only relevant measure for derivative financial instruments. Fair value helps financial statement users assess the impact of current economic events on liquidity and solvency and provides greater transparency in reporting the performance of portfolios of instruments you might liquidate prior to maturity. Derivatives are invisible unless they are measured at fair value and gains and losses sometimes disproportionate to changes in market conditions are not reported. This information is essential for users of financial statements to understand the nature of the rights and obligations inherent in derivatives. Only items that are assets or liabilities should be reported as such in financial statements. Gains and losses are not liabilities or assets and should not be reported as such in the balance sheet. The new standards create other comprehensive income which facilitates matching of gains and losses in the income statement in certain specified circumstances, while avoiding their reporting as if they were assets or liabilities on the balance sheet. Also, the new standards will require you to remove a financial liability from the balance sheet when, and only when, the obligation specified in the contract is discharged, cancelled or expires. The new standards do not change present accounting for derecognition of a financial asset. 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. The new standards contain the option to apply special hedge accounting in specified circumstances. This special accounting is 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. EFFECTIVE DATE You must implement these standards no later than for annual and interim periods in fiscal years beginning on or after October 1, (In many cases this will mean application to calendar years beginning on January 1, 2007.) You may apply them as of the beginning of an earlier fiscal year. While the mandatory effective date might seem some way off, and you are not required to restate comparative figures, significant implementation planning may be necessary if you use financial instruments extensively. We encourage you to review the new standards as soon as possible to consider their impact on your organization. [ 2 ] Financial Instruments

3 Financial Instruments Recognition and Measurement Out of the Fog IDENTIFY ALL FINANCIAL INSTRUMENTS The first step in applying the standards is to identify the financial instruments. You will almost certainly need to involve individuals from all areas of your organization to ensure the terms and conditions of both financial and nonfinancial contracts are understood. A financial instrument is a contract that creates a financial asset for one party and a financial liability or equity instrument for the other party. Financial means the contract will settle for cash (or an equity instrument if it is an asset) either directly or indirectly. Therefore, a contractual right to exchange financial instruments under favourable conditions is a financial asset and a contractual obligation to exchange financial instruments under unfavourable conditions is a financial liability. Financial instruments include cash, trade receivables and payables, loans and notes receivable and payable, investments in equities and debt instruments (including investments in common shares, guaranteed investment certificates and term deposits), as well as derivative contracts such as forward contracts, swaps and options. A derivative is a contract whose value changes in response to changes in some specified rate, price, index, etc., which requires nominal or no initial investment and which is settled in the future. certain guarantees; and loan commitments. The standards apply to contracts to buy or sell non-financial items such as commodities if: the contract can be settled net in cash (or by another financial instrument); and the contract is not for the entity s expected purchase, sale or usage requirements, unless the price is based on a variable that is not closely related to the underlying item. Even entities with no direct derivative contracts might have a derivative embedded in another type of instrument. An embedded derivative appears as a feature in a conventional contract that changes key elements of the contract in response to changes in a specified rate, price, index, or other underlying variable. Since the general requirement for derivatives is to measure them at fair value with gains and losses recognized immediately in net income, you may need to separate derivatives embedded in any financial or non-financial contracts accounted for in Is the hybrid contract carried at fair value? YES NO Does the embedded derivative meet the derivative definition? NO YES Do not separate the derivative of a commodity, equity or currency other than that in which the debt or loan is denominated; and terms and conditions in purchase orders or sales contracts linking the price to changes in variables such as foreign currency rates or commodity prices. You may elect to identify embedded derivatives only in contracts entered into after the beginning of a fiscal year ending no later than March 31, You also need to take account of the requirements for embedded derivatives as you negotiate new loans, leases, insurance and other contracts. Is it closely related to the host contract? YES NO Separate the derivative There are a number of financial instruments covered by other Handbook Sections or active AcSB projects that are excluded from the new Sections. Examples include: interests in subsidiaries, joint ventures, and significant influence investees; employee benefits; insurance contracts; leases; stock-based payments; a different manner if the characteristics of the derivative are not closely related to the non-derivative host contract. The standard provides significant guidance to help you make this determination. Examples include: loans or investments in convertible debt where the interest payments or possibly the final principal amount are linked to changes in the price CLASSIFY ALL FINANCIAL INSTRUMENTS All financial instruments must be classified into one of the categories described below. Characteristics of the instrument and your use of it determine whether you have a choice of category. Classification determines how each instrument is measured and where gains and losses are recognized. Financial Instruments [ 3 ]

4 Reclassification is rarely possible so it is important to understand the implications where choice is available. Financial assets and financial liabilities held for trading almost all derivatives are in this category, as are any instruments you buy and sell for the purpose of profit-taking. In addition, you may choose to designate any financial instrument into this category when first recognized. This may help ensure that all financial instruments managed as a portfolio are accounted for on the same basis. Held-to-maturity investments this category is for fixed maturity financial assets with fixed or determinable payments that you have the positive intention and ability to hold to maturity i.e., only debt instruments. This category may only be used if you are virtually certain you will hold the item to its maturity. If there are significant sales of assets within this category before maturity, you must reclassify all financial assets in the portfolio to the availablefor-sale category unless the reason for the sales is outside your control. Therefore, you need to take care in allocating financial instruments to this category. Loans and receivables this category includes all loans and receivables except debt securities. Debt securities are normally quoted in an active market and include investments in government debt, corporate bonds, convertible debt, commercial paper, securitized debt instruments such as collateralized mortgage obligations and real estate mortgage investment conduits, and interest-only and principal-only strips. Alternatively, you may designate loans and receivables as held for trading or available for sale. Available-for-sale financial assets this category captures all financial assets that are not classified as held for trading, held to maturity, or loans and receivables. Note that investments in equity instruments may be classified only as held for trading or available for sale. The category might also include debt instruments that you do not wish to classify as held to maturity. Other financial liabilities financial liabilities that are not classified as held for trading continue to be measured at amortized cost. The chart below summarizes the implications of classifying financial assets and financial liabilities into the five categories. RECOGNITION AND INITIAL MEASUREMENT You recognize all financial assets and liabilities when your organization becomes a party to the contract creating the item. Financial items acquired or assumed in arm s length transactions are initially measured at fair value, usually the value of the consideration given or received. Most of the time this will be the cash advanced or received. However, if the instrument is constructed in a way that confers an apparent benefit on one of the parties, (usually by incorporating off-market rates, such as in the case of an interest-free loan), you must determine fair value with reference to fair value prices for the risks involved. For instruments with a stated maturity date, this will require discounting future cash flows at a current fair market rate with the resultant premium or discount recognized in a manner consistent with the substance of the transaction (income gain or loss, contributed surplus, etc.) There are SUMMARY OF REQUIREMENTS FOR MEASUREMENT AND RECOGNIZING GAINS AND LOSSES Category Initial measurement Subsequent measurement Gains and losses ASSETS Loans and receivables Held-to-maturity investment Fair value Amortized cost using the effective interest method Recognized in net income when the asset is derecognized; impairment write-downs and foreign exchange translation adjustments recognized immediately in net income Available-for-sale financial assets Fair value Fair value* Recognized in other comprehensive income; transferred to net income when the asset is derecognized; impairment write-downs recognized immediately in net income Held for trading Fair value Fair value Recognized immediately in net income LIABILITIES Other Fair Value Amortized cost using the effective interest method Recognized in net income when the liability is derecognized; foreign exchange translation adjustments recognized immediately *Equity instruments that do not have a quoted market price in an active market are measured at cost. [ 4 ] Financial Instruments

5 special requirements for related party transactions; in particular inter-company loans. MEASURE FINANCIAL INSTRUMENT IN SUBSEQUENT PERIODS Ongoing measurement of a financial instrument depends on the manner in which it was classified in step 2 unless the instrument is designated as part of a hedging relationship (see Hedges, on page 6). Held-for-trading financial assets and financial liabilities, and available-forsale financial assets are measured at fair value. Investments in equity instruments classified as available for sale that do not have a quoted market price in an active market and derivatives based on equity instruments which cannot be reliably measured at fair value are measured at cost. Held-to-maturity investments, loans and receivables are measured at amortized cost. All other financial liabilities are measured at amortized cost. The new standard includes guidance on determining fair values. For many financial instruments, calculation of fair value will require locating a reliable current price or rate. When a current price in an active market is not available, future cash flows are discounted using appropriate discount rates for the term of each cash flow. For more complex derivatives and other financial instruments it may be necessary to use more complex instrumentspecific models. Development of a consistent approach is necessary for all. Revaluation of options can be complicated if option pricing models are used, but for many purposes the valuation can be simplified by amortizing the premium paid and recognizing the change in the difference between the current fair value of the underlying item and the strike price in the contract in current period net income. (This is called the intrinsic value method.) Consistency in approach and, ideally, price sources is necessary for all revaluations. You must use the effective interest method for instruments measured at amortized cost. This might differ from your current practice. RECOGNIZE GAINS AND LOSSES Like the measurement requirements, the method of recognizing gains and losses in net income depends on the classification of the financial instrument. Section 1530 defines comprehensive income as a change in the value of net assets that is not due to owner activities (investments or distributions). The standard introduces the term other comprehensive income to capture the revenues, expenses, gains and losses that are reported outside net income. Foreign currency translation gains and losses on self-sustaining foreign operations are an example of items that would be included in other comprehensive income. Temporarily record gains and losses here Sales Cost of sales Other expenses Net income Other comprehensive income Comprehensive income Held-to-maturity investments, loans and receivables, other financial liabilities amortization of premiums or discounts and losses due to impairment are included in current period interest income or expense. Foreign exchange gains and losses, where relevant, are also recognized in current period net income in accordance with Section 1651 (formerly Section 1650). Other gains and losses are recognized only when the instrument is removed from the balance sheet. Held-for-trading, including almost all derivative instruments all gains and losses are included in net income in the period in which they arise. Available for sale revaluation gains and losses are included in other comprehensive income until the asset is removed from the balance sheet; the premium or discount recognized on acquisition of a fixed income investment is amortized as interest income or expense using the effective interest method. Losses due to impairment are also included in net income. Gains and losses on financial instruments classified as financial liabilities are recognized in net income, whereas those classified as equity are recognized in equity. PROVIDE DISCLOSURES Once you have determined how to account for your financial instruments, you need to consider how to provide information about instruments in the financial statements in a manner that will enable a user to understand their use. Required disclosures include information about the financial x Recycle gains and losses to net income later instruments themselves, how fair values have been determined, and the manner in which your organization uses financial instruments in financial risk management. You may need to develop systems to gather the information necessary to provide the required disclosures. Financial Instruments [ 5 ]

6 Hedges Special Relationships Section 3865 replaces the guidance formerly in Section 1650, Foreign Currency Translation, and Accounting Guideline AcG-13, Hedging Relationships by prescribing the actual accounting treatment for qualifying hedge relationships. Accounting practices for hedging relationships have varied. In many cases, gains and losses on hedging instruments were deferred on the balance sheet or were kept off-balance-sheet until such time as it was considered appropriate to include them in net income. Also, the results of ineffective hedges were often not reflected in net income immediately. These practices will no longer be permitted. In addition, if you previously applied Accounting Guideline AcG-13, Hedging Relationships, you will need to re-consider those relationships to ensure they qualify under the new standard. All financial instruments are packages of risks and expected rewards. Examples of risks include interest rate, credit risk, foreign currency risk, systemic (market) and diversifiable (specific) risks and other price risks. Exposure to a risk creates potential variations in future cash flows and, consequently, income. Hedging involves entering into one or more contracts designed to offset exposure to one or more risks. Since risks may be viewed from different perspectives, a hedge relationship does not reduce an identified risk exposure it offsets it to qualify for hedge accounting. Hedge accounting changes the measurement and/or timing of income recognition of the financial instruments in a hedging relationship so that gains and losses are recognized in net income in the same accounting period. Because it alters the measurement and/or timing of at least one of the hedged item or the hedging item, special rules apply to ensure hedge accounting is applied in a consistent manner to appropriate items. It is important to remember that hedge accounting is always optional. Hedge accounting is not necessary for offsetting items when both the hedged item and the hedging item are measured in the same way such as when both instruments are classified as held-for-trading. You need to evaluate your risk exposures and how those risks are managed, then consider whether hedge accounting is necessary to reflect the effects of your risk management program in net income. In some cases, designating a financial instrument as held for trading when it is initially recognized may achieve comparable results to designating the item as a component of a hedging relationship. You should also consider whether hedge accounting best communicates your stewardship efforts to investors in some circumstances, the costs to comply with the requirements of Section 3865 may exceed the perceived benefits to investors. INCEPTION OF THE HEDGING RELATIONSHIP Because hedge accounting is optional, you must designate and document a hedging relationship before applying hedge accounting. The hedged and hedging items must be specifically identified. This is especially important when the hedged item is an anticipated transaction because you must be able to identify it definitively when the transaction occurs. Documentation includes the risk management objective and strategy for the relationship as well as the method for assessing the effectiveness of the hedge (the correlation of changes in fair values or cash flows of the hedged and hedging items) on an ongoing basis. The designation and documentation requirements of the new standard are similar to those of AcG-13. Section 3865 defines two types of hedges, a fair value hedge and a cash flow hedge, and prescribes the accounting treatment for each. Accordingly, the accounting treatment is no longer part of the required documentation. FAIR VALUE HEDGES A fair value hedge is a hedge of the exposure to changes in fair value of all or a portion of a recognized asset or liability or previously unrecognized firm commitment attributable to a specified risk. You might use a fair value hedge when you want to participate in market fluctuations in a price or rate but hold or have issued or are committed to acquire or issue a fixed rate or fixed price instrument. An example might be a fixed rate debt issue which you hedge with an interest rate swap that has the effect of converting fixed coupon payments to floating rate payments. Generally, the debt issue would be classified as an other financial liability and accounted for at amortized cost using the effective interest rate method. As a derivative, the interest rate swap would be accounted for at fair value. [ 6 ] Financial Instruments

7 Without hedge accounting, your reported net income would reflect the volatility of any variances between the fixed rate on the debt and the current value of the fixed rate leg of the swap. In a fair value hedge, both the hedged item and the hedging item are measured at fair value with gains and losses due to fluctuations in fair value recognized immediately in net income. You must expect the relationship to be effective both at its inception and throughout its term. The relationship must also meet that expectation of effectiveness on an ongoing basis. Effectiveness of a fair value hedge means that changes in the fair value of the hedged item must offset changes in the fair value of the hedging item. Because there may be factors which affect the fair value of the hedged item that you decide not to hedge (either due to risk perception or inability to offset with a hedging instrument), it is important to identify the specific risks that are being hedged or to document that the relationship covers all risks. Changes in fair value are only recognized for the documented risks. This distinction could be very important to avoid ineffectiveness caused by the effects of basis or other risks. In addition to circumstances under which either the hedged or hedging item cease to exist, you must discontinue hedge accounting if the hedge relationship ceases to be effective. CASH FLOW HEDGES A cash flow hedge is a hedge of the exposure to variability in cash flows of a recognized asset or liability or a forecasted transaction attributable to a specified risk or variability in cash flows of a firm commitment attributable to foreign currency risk. You might use a cash flow hedge when you want to achieve the effect of locking in a future variable cash flow. Common examples are hedges of the foreign currency risk in future purchases or sales but a cash flow hedge can also be used when a floating rate recognized asset or liability is effectively converted to a fixed rate stream of future cash flows through the use of a derivative. An example of this application could be a floating rate debt that you hedge with an interest rate swap to lock in a stream of fixed cash flows. In a cash flow hedge, there is no change to the measurement of or gain or loss recognition on the hedged item. However, the portion of the gain or loss on the hedging item determined to be effective is recognized in other comprehensive income and released into net income in the same period as the hedged item affects net income. Any ineffective portion is recognized immediately in net income. When a hedged anticipated transaction materializes, you have the option of including the amounts accumulated in other comprehensive income during the hedge in the carrying amount of the asset acquired or liability incurred to simplify accounting for the transfer to net income. Hedges of net investments in a self-sustaining foreign operation are treated in a similar manner. DISCONTINUE HEDGE ACCOUNTING Hedge accounting stops when a hedging relationship becomes ineffective or is otherwise terminated. Termination could result from the hedged or hedging item ceasing to exist or from your choice to no longer apply hedge accounting to that relationship. You stop hedge accounting on a prospective basis, so that the accounting up to the date of discontinuance does not change. After that date, you account for the hedging instrument and the hedged item in accordance with the normal requirements for those items, and unwind the effects of the previous hedge accounting in the manner originally intended. The discontinuance requirements of the new standards are similar to those in AcG-13. However, they do provide some additional flexibility regarding the time at which an anticipated transaction actually occurs, versus the originally forecasted occurrence. DISCLOSURE Because hedge accounting is an optional treatment, you must disclose your objectives and the strategies you employ as well as sufficient information to understand the effects achieved. Section 3865 provides specific guidance on minimum disclosure standards. Financial Instruments [ 7 ]

8 Transition The new standards must be applied no later than as of the first day of the fiscal year beginning on or after October 1, You may elect to apply them earlier but must do so as of the first day of a fiscal year. You are permitted a fresh start on applying the new standards for classification of financial assets and liabilities. Any adjustments to carrying amounts are recognized as adjustments to opening retained earnings or, in the case of assets classified as available-forsale or amounts previously deferred in respect of cash flow hedges which will be redesignated as new cash flow hedges, to other comprehensive income. You do not restate your financial statements for periods prior to implementation of the standards. The new standards require you to assess all of your existing contracts to determine whether any derivatives that might be embedded in them must be accounted for separate from their hosts. You may elect to include in this review only contracts entered into on or after the first day of any fiscal year ending no later than March 31, Further information about the new standards, and related implementation guidance, is available on the Financial Instruments project page of the AcSB website at: w w w. a c s b c a n a d a. o r g The AcSB has established a Financial Instruments Working Group, which is charged with assisting in the development of Implementation Guidance to help apply the standards. Questions for consideration by the Working Group may be sent to: Kate Ward, Principal, Accounting Standards kate.ward@cica.ca Phone: Questions about the sections may also be sent to: Ian Hague, Principal, Accounting Standards ian.hague@cica.ca Phone: Financial Instruments Navigating new waters [ 8 ] Financial Instruments