Issues Analysis: Financial Instruments and Foreign Currency Translation: Financial Statement Presentation Prepared by Staff of the Public Sector Accounting Board November 2010 TABLE OF CONTENTS Paragraph Introduction....01-.05 Measurement....06-.21 On initial recognition....06-.07 Derivatives....08-.17 Non-derivative financial instruments....18-.21 Embedded derivatives identification and recognition....22-.23 The fair value option....24-.26 Hedge accounting....27-.35 Reporting on interest revenue and expense....36-.39 Derecognition of financial liabilities....40-.46 Financial statement and risk disclosures....47-.50 Reporting of remeasurement gains and losses....51-.62 Other matters....63-.64 Amendments to FOREIGN CURRENCY TRANSLATION, Section PS 2600....65-.72 Transitional provisions....73-.76 Introduction.01 This issues analysis is a supporting document to the Public Sector Accounting Board (PSAB) Exposure Draft, Financial Instruments and Foreign Currency Translation: Financial Statement Presentation, (the ED). It provides information on how significant matters arising from comments received on the 2009 Exposure Drafts, Financial Instruments and Foreign Currency Translation (the 2009 Exposure Drafts) have been dealt with. This analysis has not been reviewed by PSAB and the views expressed are not a position of the Board. Prior to establishing a position, PSAB will review and deliberate responses submitted to the ED. Financial Statement Presentation Issues Analysis, November 2010 Page 1 of 18
.02 The project objective is to issue a detailed standard that will improve financial reporting of derivative and non-derivative financial instruments in financial statements prepared in accordance with the CICA Public Sector Accounting (PSA) Handbook. The proposed standard on financial instruments seeks to do this by requiring the recognition of derivatives, consistent reporting of their influence on financial position and changes in it, and by improving disclosures associated with financial instruments and financial risks..03 Among the issues raised in responses to the 2009 Exposure Drafts were concerns as to the presentation of gains and losses that have yet to be realized arising from fair value measurement and translation of items denominated in foreign currencies. The 2009 Exposure Drafts proposed that these remeasurement gains and losses would be presented separately in the statement of operations. Some respondents asserted that although this approach would support comparison of budget-to-actual results, dividing the statement of operations into two components could lead to conflicting assertions as to financial performance..04 Following discussion of responses to the 2009 Exposure Drafts, PSAB asked its task force to identify other presentation options. The presentation approach excludes the market-based adjustments associated with the requirements being proposed from the statement of operations. This is to ensure the information reported is complete and current. Use of these measures reflects the inherent variability associated with these items and is not meant to be predictive of a final settlement value. Accordingly, PSAB concluded changes in these values should be reported in a separate financial statement..05 Although responses indicate that recognizing the fair value of derivatives is unpopular in some quarters, PSAB was not persuaded that principles underlying the proposals are fundamentally flawed. Development of a recognition standard is consistent with the general requirement that notes should not be used as a substitute for proper accounting treatment. Within this issues analysis, points commonly made in responses will be examined. Measurement On initial recognition.06 The financial instruments ED does not explicitly state the measurement basis to be applied at initial recognition. Generally, measurement at initial recognition will be grounded on a market transaction. However, it is not unknown for the initial measurement of public sector transactions to be affected by its terms. For example, this can be the case when a portfolio investment or a loan receivable has concessionary terms..07 The financial instruments ED requires the use of trade date accounting when recognizing publicly traded securities. Although standards for profit-oriented entities permit the use of settlement date accounting, it is not relevant to public sector reporting as governments are not subject to income tax. Recent changes to Financial Statement Presentation Issues Analysis, November 2010 Page 2 of 18
the Introduction to Public Sector Accounting Standards are expected to significantly diminish the number of entities applying profit-oriented standards that a government will consolidate on a line-by-line basis. For these reasons, the benefits of conforming to one approach were viewed as outweighing the added complexity associated with the alternatives. This complexity arises for users who may need to understand the affect of an alternative treatment and when preparing consolidated financial statements as principles require that a single policy be consistently applied. Derivatives.08 The measurement proposals are supported by the constituent groups that responded to the financial instruments ED except the sovereign finance community..09 Several respondents questioned whether fair value measurement violates provisions in the conceptual framework. A clause in FINANCIAL STATEMENT CONCEPTS, paragraph PS 1000.60, is cited government financial statements are, however, prepared primarily using the historical cost basis of measurement It has been concluded that the reference given is a narrow interpretation of the somewhat limited measurement guidance that appears in Section PS 1000. Paragraphs PS 1000.60-.61 identify market value and valuation techniques as among measurement approaches that may be relevant. Measurement at fair value or market value is required by other standards in the PSA Handbook..10 Providing users with relevant financial information may require that amounts be updated to reflect current information. Assets measured at historical cost are subject to valuation provisions and write-downs. Liabilities such as employee benefit obligations and contingencies are remeasured applying current information. When items are susceptible to variability, current information enhances its relevance. Fair value measurement is not a violation of the conceptual framework..11 Several respondents from the sovereign finance community asserted that financial reporting standards for governments should follow a path independent from international standards. Many aspects of the financial instruments proposals vary from international standards in order to simplify their application or to respond to national circumstances. The classification approach is different from that in either IAS 39 or IFRS 9. 1 This approach received broad support in responses to the 2007 Statement of Principles. It was felt that in reducing the number of categories to two, the effort to initially designate items would be reduced without compromising the objectives of financial reporting..12 These proposals are distinct from international standards in other ways. PSAB is not proposing to amend its impairment requirements or provide for hedge 1 IAS 39 and IFRS 9 are the standards of the International Accounting Standards Board that address the reporting of financial instruments. Financial Statement Presentation Issues Analysis, November 2010 Page 3 of 18
accounting. PSAB has independently concluded that derivatives are assets and liabilities and the most relevant basis of measurement for derivatives is fair value. This conclusion was communicated in earlier due process documents. A majority of responses received from a broad cross-section of constituents supported adoption of this principle..13 Some respondents argued that derivatives should not be measured at fair value based on the assertion that governments use derivatives exclusively or primarily as a risk management enabler. As such, it is argued that the recognition, measurement and presentation of derivatives in summary financial statements should be determined by their intended application. This argument is justified on grounds that readers of financial statements would be presented with a straightforward representation of the expected outcome of the underlying transactions. The proposals do not generally allow financial assets and financial liabilities to be offset and do not provide for hedge accounting in any form..14 PSAB did not identify any new arguments that caused it to reconsider the conclusion it reached at the time it reviewed responses to earlier due process documents that addressed the measurement of derivatives. It concluded that fair value is the only relevant measure for derivative financial instruments. Derivatives generally have little or no value when acquired. Consequently, when reported at cost they are invisible. However, the contractual rights or obligations associated with a derivative may give rise to a significant liability or asset. A government need not hold a derivative to maturity as in a subsequent period it can either settle or realize its fair value by entering into an offsetting contract. In this case, gains and losses are reported only when the derivative is settled or offset, rather than in the period in which the change in fair value occurred. PSAB believes reporting the value of derivatives and gains and losses associated with changes in those values is essential to understanding the nature of the risk exposures associated with derivative financial instruments..15 The proposals limit the offsetting of a financial asset and a financial liability to situations where there is a legal right of offset and the government intends to settle on a net basis, or realize the asset and settle the liability simultaneously. Many derivatives have rights and obligations independent of other financial instruments controlled by a government. In the absence of the right to settle multiple contracts on a net basis, faithful representation requires the assets and liabilities associated with individual contracts not be offset..16 The offsetting principle proposed is stringent. Some assert that it would be reasonable to allow offsetting when the characteristics of the hedging instrument offset the variability in changes in the cash flows or fair value of the hedged risk and all settlement dates are the same. Based on responses to earlier proposals as well as Board and task force deliberations, straightforward principles that limit the need for judgment are favoured over a set of detailed rules that would be required to define situations where offsetting might be permitted. Financial Statement Presentation Issues Analysis, November 2010 Page 4 of 18
.17 Some respondents asked that PSAB include guidance equivalent to that contained in EIC-173, Credit Risk and the Fair Value of Financial Assets and Financial Liabilities. EIC-173 was issued by the Emerging Issues Committee of the Accounting Standards Board. EIC-173 provides an interpretation of the application of provisions in FINANCIAL INSTRUMENTS RECOGNITION AND MEASUREMENT, Section 3855. 2 Although some provisions that EIC-173 comments on are equivalent to those in its proposed standard, PSAB has no plans to expand the level of detail in its guidance or to establish an emerging issues committee. Non-derivative financial instruments.18 A few respondents asserted that there should be broader application of fair value measurement. Some suggested that PSAB s proposals were out of step with International Financial Reporting Standards and International Public Sector Accounting Standards, which require greater application of fair value based measures. Some did not support the narrowing of the fair value category relative to its definition in an earlier due process document, asserting that PSAB has not made a convincing case for excluding non-equity financial instruments from fair value measurement. These positions were justified by the view that reliable and readily obtainable measurement information can be obtained, even in the case of non-traded instruments. It was asserted that broader adoption of fair value measurement would ensure that like items are measured in like ways..19 Only a few of the respondents critical of the use of fair value measurement directly commented on the requirement to include equity instruments that are portfolio investments traded in an active market in the fair value category. Generally, those who addressed the measurement of these items agreed that fair value could apply when it is expected a gain or loss will be realized, based on the view that the proposal represents a reasonable compromise. Some offered that many governments probably do not have large portfolios of publicly listed equities..20 Cost is not indicative of a future value or the future cash flows associated with an equity instrument. A bond can be held to maturity but an equity instrument has no fixed date of maturity. Fair value provides users with better information about the resource that the equity instrument represents and the risk associated with holding it. For these reasons, fair value provides an objective, consistent and comparable basis for measurement. By not requiring all equity instruments held as portfolio investments to be part of the fair value category, PSAB balanced the additional information provided against the time and trouble associated with valuing unquoted equity holdings. 2 The Emerging Issues Committee was disbanded by the Accounting Standards Board (AcSB) earlier this year. The current body of EIC pronouncements will effectively be superseded when publicly accountable enterprises that apply the standards issued by the AcSB implement IFRSs. Interpretations of IFRSs are issued by the IASB s IFRS Interpretations Committee. Financial Statement Presentation Issues Analysis, November 2010 Page 5 of 18
.21 The ED introduces a statement of remeasurement gains and losses to report unrealized gains associated with equity instruments in the fair value category. Consequently, gains and losses would not factor into the statement of operations until realized. When a portfolio of securities is managed for growth, the fair value option can be designated to ensure that all securities in that portfolio are reported on a consistent measurement basis. As responses to earlier due process documents broadly supported this classification model, PSAB did not want to create additional intent-based categories that would make the standard more complex to apply and understand. Embedded derivatives identification and recognition.22 Some respondents expressed concerns as to the requirements that determine when embedded derivatives need to be recognized separately. While complex in their application, these provisions are viewed to be important in maintaining the integrity of reporting requirements specific to derivatives..23 The transitional provisions provide for flexibility upon implementation. Governments establish an accounting policy that applies to the identification of embedded derivatives. The transition provisions do not establish a specific cutoff date or require retroactive application to historic contracts. The intent is to ensure that when an atypical variability exists in contract rights and obligations, and the terms meet the conditions of a derivative, that this is identified and reported on. The approach provides governments with the opportunity to align their contract management and financial reporting functions on a go-forward basis. The fair value option.24 Many who agreed with the measurement proposals, supported the fair value option. Some concerns were expressed specific to the potential for a loss of comparability between governments. Ensuring comparability among governments that will inevitably vary in their approaches to managing financial instruments, was not a key objective. In application, there is a trade-off between the enhanced relevance gained when a government manages financial instruments on a fair value basis and the diminished comparability. On balance, it is felt that the benefits of the option exceed the potential for diminished comparability..25 The fair value option is not intended as an item-by-item designation. The provisions governing its application are tied to groups of financial assets, financial liabilities, or both, that are managed on a fair value basis according to a risk management or investment strategy. Avoiding an item by item designation upon initial recognition reflects the desire that this standard be easier to apply than standards that require those applying the standard to actively designate items upon initial recognition. Financial Statement Presentation Issues Analysis, November 2010 Page 6 of 18
.26 The proposal now provides that the fair value option may be applied to unquoted equity instruments that are portfolio investments. This position reflects the view that governments should be able to report all portfolio investments at fair value when that is the measurement basis that is used to manage them. Hedge accounting.27 Within the current proposals, the fair value option is not intended to serve as a substitute for hedge accounting. It was felt that by distinguishing certain gains and losses that are yet to be realized, hedge accounting would not be necessary. The measure of a period s surplus/deficit excludes unrealized gains and losses whether owing to fair value measurement or currency translation. The ED places these amounts in a separate statement, the statement of remeasurement gains and losses..28 By avoiding hedge accounting, the complexity is diminished and those preparing and auditing financial statements are not required to judge whether the transaction at hand qualifies for hedge accounting and is or is not fully effective. When this must be done, judgment is needed as the provisions guiding the application of hedge accounting cannot be sufficiently detailed to handle all possible situations. Extensive literature to support the application of hedge accounting by profitoriented entities is still considered by many to be inadequate. Some feel that hedge accounting artificially constrains appropriate strategies. For these reasons, some profit-oriented entities prefer to use fair value accounting and simply reflect the variability associated with their financial instruments..29 Respondents were mixed on the proposal to withdraw hedge accounting. Some who supported this position stated that the risk of failing to report ineffectiveness will be avoided and the flexibility to record any hedged asset or liability at fair value will generally allow a government to achieve financial reporting similar to the existing model..30 PSAB recognizes that the present hedge accounting standard is inadequate as it does not address the scope of hedging activity being undertaken by governments. Derivatives are commonly used to manage many risks in addition to currency risk. As cited in one response, governments are actively managing interest expense on future debt issues. Anticipating that interest rates may increase from historic lows, a government may choose to trade financial instruments in a manner that would generate gains should interest rates increase. There are a variety of strategies to accomplish this objective. When a government declares specific trading activity to be for hedging purposes, it effectively seeks to attribute the gains and losses from these transactions to the interest cost accounted for over the life of the future debt issue..31 PSAB recognizes that hedge accounting can rectify perceived mismatches associated with the timing of recognition of gains and losses between the hedging instrument and the hedged item. In absence of hedge accounting, strategies that Financial Statement Presentation Issues Analysis, November 2010 Page 7 of 18
set out to hedge risks associated with anticipated transactions such as future debt issues may result in gains or losses being realized and reported in operations prior to the revenues or expenses associated with the anticipated transaction. Some assert that this is the way it should be as it is a transparent portrayal of the transactions. Others assert that hedge accounting is warranted to properly represent the outcome of the strategy. For the latter to be enabled, rules rather than principles are needed to guide in assessing the performance of the strategy selected by management and to establish when the usual rules that apply to the reporting of revenues and expenses are overridden..32 A second risk management strategy affected by distinguishing gains and losses based on the period they are realized or settled was identified in another response. A government may use a series of short-term hedging instruments to hedge a long-term risk. Applying the proposed requirements, it would find that gains and losses on the hedging instruments would be realized (and reported in operations) prior to the period the gain or loss associated with the long-term risk is reported on in operations. However, developing a broad principle that would remediate this problem may diminish accountability. This is because there is an inherent risk of ineffectiveness when the hedging instruments selected are shorter in their duration to maturity than the risk being managed. 3 For this reason, many hedge accounting standards, including those that apply to profit-oriented entities in Canada, require an entity engaging in this strategy to measure and report on ineffectiveness during the term of the hedge. To do otherwise diminishes accountability..33 To enable adoption of a new hedge accounting standard, PSAB would need to achieve a consensus on application requirements. The debate about offsetting in presentation would also need to be resolved. To remedy mismatches in the timing of recognition or the basis of measurement, PSAB would need to choose between: (a) justifying deferrals, which add complexity to understanding financial position as amounts are reported that are neither assets nor liabilities; (b) modifying the carrying amount of hedged items with the consequence that the measurement of hedged items is neither amortized cost nor fair value; (c) excluding gains and losses from the statement of operations, reporting the deferred amounts in another statement; or (d) continuing the practice of off-balance sheet and synthetic instrument accounting that lacks transparency and diminishes accountability when ineffectiveness in hedging relationships is not adequately considered. Given these choices, PSAB preferred an approach that is straightforward in its application. Gains and losses are reported in operations in the period they are realized or settled. Thus, the need to apply judgment is avoided, something hedge accounting inevitably requires. 3 Being that any gain or loss arising on the hedging instrument will not fully offset the hedged risk. Financial Statement Presentation Issues Analysis, November 2010 Page 8 of 18
.34 PSAB is monitoring the research of the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) as these standard setters work to reduce the complexity of financial instruments standards that apply to profit-oriented entities. Hedge accounting is cited as among the areas of focus..35 To date, PSAB has not been persuaded that hedge accounting would overcome the concerns of those who are opposed to the fair value measurement of derivatives. Consequently, it has concluded the superior approach is to report unrealized gains and losses associated with derivatives and the translation of foreign denominated balances in a statement of remeasurement gains and losses. Reporting on interest revenue and expense.36 Interest is recognized using the effective interest method. Some respondents suggested that the standard should allow governments the flexibility to apply other methods when accounting for interest. The effective interest method has been favoured as it exactly discounts the estimated future cash payments or receipts throughout the life of a financial instrument..37 While all requirements are subject to a materiality evaluation, the straight-line method can significantly overstate yield in the initial reporting period of a multiperiod investment. This is illustrated in the example below. Illustration: A government invests in a strip Canada bond that pays $5,000,000 upon maturity in five years. 4 Its purchase price is $3,917,500, which provides an effective yield to maturity of 5 percent. Year Strip Bond Effective Yield Straight- Yield Over(under) Over(under) Interest Method Line Statement Yield 0 3,917,500 1 4,113,512 196,012 5.00% 216,500 5.53% 20,488 0.53% 2 4,319,188 205,676 5.00% 216,500 5.26% 10,824 0.26% 3 4,535,147 215,959 5.00% 216,500 5.01% 541 0.01% 4 4,761,905 226,758 5.00% 216,500 4.77% (10,258) (0.23%) 5 5,000,000 238,095 5.00% 216,500 4.55% (21,595) (0.45%) Total 1,082,500 1,082,500.38 When interest revenue and expense is reported based on a consistent methodology that aligns with how interest yielding instruments are evaluated and managed, representational faithfulness is enhanced. It is acknowledged that provisions in existing standards will need to be conformed. To ease transition, carrying values and past results would not be restated when the effective interest method is adopted. 4 An investor in this type of security receives only the face value of the bond on maturity. An investment dealer has sold the stream of interest payments originally associated with the bond to other investors. As such, a strip bond trades at a discount to maturity based on its effective yield. Financial Statement Presentation Issues Analysis, November 2010 Page 9 of 18
.39 One respondent noted that the proposed standard does not contain text addressing situations where there has been a change in the estimated future cash flows, other than due to impairment. 5 Such guidance principally serves to address instruments requiring ongoing assessments of estimates of payments and receipts such as asset securitizations. Text in the appendix to the financial instruments ED addresses situations generally encountered in the public sector such as assets purchased at a discount, the treatment of floating rate instruments and the effects of write downs due to impairment. Securitization arrangements are not viewed to be sufficiently common in the public sector for the standard to include provisions addressing their accounting. Derecognition of financial liabilities.40 The provisions governing derecognition of liabilities received considerable support in responses. Those who disagreed with the adoption of these provisions cited issues associated with securities held by sinking funds and for debt management purposes..41 Sinking funds may acquire an issuer s own debt securities for investment purposes. When sinking funds are established pursuant to an issuer s own legislation or policies, those funds are not externally restricted. 6 Some respondents indicated they disagreed with the liability derecognition requirements because the purchase of a government s own securities by its sinking fund would need to be accounted for as an extinguishment. The implication is that a gain or loss would need to be recognized and the gross obligations of the issuer reduced..42 In this respect, these proposals are not establishing new requirements as the elimination of interfund amounts is required by existing standards. BASIC PRINCIPLES OF CONSOLIDATION, paragraph PS 2500.06, states: Government financial statements should consolidate governmental units 7 line-by-line basis on a uniform basis of accounting after eliminating inter-governmental unit transactions and balances..43 It may be that LONG-TERM DEBT, paragraph PS 3230.22, has created a misunderstanding. The paragraph includes the requirement that a government disclose the amount of a government s own securities purchased but not cancelled. However, it is not reasonable to interpret this disclosure requirement as overriding the general consolidation requirements. The requirement to disclose 5 6 7 FINANCIAL INSTRUMENTS RECOGNITION AND MEASUREMENT, CICA Handbook Accounting paragraph 3855.A26, was cited. Paragraph PS 3100.04 defines the term external restrictions as stipulations imposed by an agreement with an external party, or through legislation of another government, that specify the purpose or purposes for which resources are to be used. A governmental unit is a government organization that is not a government business enterprise. Governmental units would include: government not-for-profit organizations and other government organizations such as government departments, funds, agencies, service organizations and boards. Financial Statement Presentation Issues Analysis, November 2010 Page 10 of 18
such holdings is not, in itself, contradictory with the line-by-line consolidation requirements..44 As is generally the case, governments are at liberty to enhance the disclosures they provide to explain the origin and purpose of their sinking funds. When they believe it to be relevant, they may include notes that reconcile their security holdings with amounts reported on the statement of financial position and clarify that in presenting a consolidated position, some debt instruments held in the sinking fund have been derecognized..45 It was noted that certain government securities are traded in secondary markets as strip bonds. When this is the case, an investor receives only the principal repayment upon the instrument s maturity. Alternatively, an investor may acquire only the interest coupons. A government issuer that reacquires either instrument would derecognize the discounted value of the obligation extinguished..46 Respondents raised other issues specific to debt management activities. It was concluded that the respondents did not identify new arguments that necessitated reconsideration of conclusions previously reached. Financial statement and risk disclosures.47 There was overall support for the financial statement and risk disclosures. Individual respondents raised specific points and the wording of some provisions has been clarified. Overall, none of the changes warrant a detailed review..48 Some suggested that the location of the risk disclosures be limited to the notes to the financial statements. Generally, the risk disclosures focus on descriptive and analytical information as opposed to breaking down balances reported on in the financial statements. Providing flexibility as to the location of the risk disclosures aligns with concepts communicated in FINANCIAL STATEMENT DISCUSSION & ANALYSIS, SORP-1. It is expected that users will look to the FSD&A for this information as they do when reviewing the financial statements of profit-oriented entities. For these reasons, the option to locate the risk disclosures in the FSD&A has been maintained..49 PSAB was asked to consider the applicability of the requirements to smaller local governments. It should be noted that the proposals do not require the disclosure of fair values when cost or amortized cost is the basis of measurement. Local governments who do not hold derivatives or equity instruments as portfolio investments will not have items to report at fair value. The risk disclosures are intended to provide those who use financial statements with a better understanding of the significant areas of risk and its possible affects on future financial performance. Understanding risk exposures is a concern of financial statement users for both large and small entities. Given the classification model proposed, many aspects of the overall model are inherently scalable and do not place onerous requirements on smaller governments. Financial Statement Presentation Issues Analysis, November 2010 Page 11 of 18
.50 Some concerns were raised that aspects of the requirements are too complex. An example cited is the requirement to apply a hierarchy that informs users as to the source of fair value measures. These requirements are limited to items that are reported at fair value. Application of the hierarchy provides disclosures that are straightforward to understand as they disclose the total values in the category being reported on that are based on quoted prices and the portion that has been measured based on two levels of less objective inputs. As responses contained no specific suggestions to improve the approach, no change has been made. Reporting of remeasurement gains and losses.51 Views expressed on the proposal to distinguish remeasurement gains and losses in the statement of operations were mixed..52 A strength commonly cited by those who supported this approach is that it facilitates budget-to-actual comparisons while providing a measure of outcomes associated with risk management and investment strategies. The need to support budget-to-actual accountability is viewed as a distinguishing characteristic of public sector financial reporting..53 Those opposed to the inclusion of remeasurement gains and losses as a component in the statement of operations cited various reasons. Some took the position that remeasurement gains and losses should not be segregated or that governments should be given the option of doing this. However, the most commonly expressed criticism was that two components could confuse readers or lead to conflicting assertions as to financial performance..54 PSAB discussed a broad range of possible alternatives, including delaying the project pending conclusions of research being undertaken by the IASB and the FASB. PSAB also discussed limiting new requirements to disclosures..55 Delaying the project until the IASB and the FASB issue their proposals was not favoured. PSAB is not convinced that either of these proposals will address the concerns of those constituents opposed to fair value measurement. Both the IASB and the FASB have confirmed that fair value measurement of derivatives remains a cornerstone principle and, in each case, the proposed classification models require broader application of fair value measurement than PSAB is proposing. PSAB is not convinced that increased acceptance of its proposals lies in broader application of fair value measurement..56 Present indications are that the IASB and the FASB may not issue proposals that reflect a consensus position on all points being debated. Although a consensus would be desirable in many respects, whether it is achieved is of limited consequence to PSAB. PSAB has not adopted a strategy of implementing international standards domestically although it remains committed to assessing the research and conclusions of other standard setters. This will be done in relation to the needs of the users of public sector financial reports in Canada. In Financial Statement Presentation Issues Analysis, November 2010 Page 12 of 18
line with this view, PSAB determined that a domestic financial instruments standard needs to be adopted..57 Reverting to a disclosure standard is not an acceptable conclusion as it would be of limited benefit to users. Information about assets and liabilities held would continue to be excluded when reporting on established measures of financial position and performance. The first due process document established that derivatives are assets and liabilities. 8 While not predictive of a final settlement, fair value enhances the information provided to users as it is indicative of economic changes associated with the rights and obligations arising from those assets and liabilities..58 Adoption of a disclosure standard would not resolve the need to review hedge accounting. Respondents to the first due process document strongly supported the need to develop a hedge accounting standard broader in scope than is presently in place. Respondents to the second due process document suggested that achieving consensus on specific hedge accounting provisions will be difficult. Discussions suggested that the path to consensus on requirements to assess and recognize ineffectiveness would be paved with controversy. Unless a meaningful basis for evaluating effectiveness can be agreed upon, a new standard would do little to improve reporting on the performance of risk management strategies..59 Although some stakeholders maintain that Canadian standards need not be influenced by international decisions, PSAB believes the credibility of financial reports issued by governments is influenced by the perceived quality of the standards they are based upon. When fundamental reporting differences are perpetuated for reasons that cannot be clearly enunciated, it can reflect negatively on the standards and consequently on reporting based on those standards..60 Given the significant drawbacks associated with a disclosure standard, PSAB asked staff to identify recognition-based options that would support budget-toactual accountability. Three viable options were identified and assessed: (a) Issuing a final standard based on the 2009 Exposure Drafts. (b) Adding hedge accounting provisions to the financial instruments principles that were exposed. Gains and losses from financial instruments would be 8 As stated in paragraph 25 of the March 2006 Statement of Principles, Recognition and Measurement of Derivatives, derivatives qualify as assets and liabilities for the following reasons: (a) The ability to settle a derivative in a gain position by receiving cash, another financial asset or a non-financial asset is evidence of a future economic benefit and is compelling evidence that the instrument is an asset. (b) Similarly, the requirement to pay cash, transfer a financial asset, or a non-financial asset in settlement of a derivative in a loss position is evidence of a duty to sacrifice assets in the future and indicates that the instrument is a liability. (c) The transaction or event giving rise to the government s control of the benefit, or conversely obligating the government, occurs upon execution of the contract to acquire the derivative financial instrument. Financial Statement Presentation Issues Analysis, November 2010 Page 13 of 18
reported in the statement of operations unless hedge accounting permitted reporting of those gains and losses outside of the statement of operations. (c) Proposing new presentation requirements that provide for a statement of remeasurement gains and losses..61 PSAB determined that the alternative (c) should be exposed for comment. The key provisions to enable this alternative are the amendments to FINANCIAL STATEMENT PRESENTATION, Section PS 1200, that are contained in the ED. PSAB favoured this alternative because it achieves the benefits of a recognition standard and provides clear budget-to-actual accountability..62 The approach taken is easy to understand. Market-based adjustments associated with financial instruments and currency translation that have yet to be realized are excluded from the statement of operations. These gains and losses are presented in the statement of remeasurement gains and losses. Although other adjustments to items carried at historical cost occur, they will continue to be reported in the statement of operations as generally they are an estimate of a final settlement. Examples are: valuation allowances, asset write-downs and various liabilities including contingencies. In this regard, this approach is arguably superior to other comprehensive income. Many view the concept of other comprehensive income as arbitrary in its application and not well suited to public sector financial reporting. Other matters.63 The project scope does not establish a principle that would determine when financial assets are derecognized. When the primary sources of generally accepted accounting principles (GAAP) do not deal with the accounting and reporting in financial statements of transactions or events encountered by the public sector reporting entity, other sources of GAAP may need to be consulted. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES, Section PS 1150, guides those who may need to do this..64 Accounting requirements that determine when financial assets are derecognized are the subject of ongoing research efforts by other standard setters. This issue does not arise frequently in the public sector but may arise when a government enters into a sale and repurchase agreement ( repos ) in respect of traded securities it holds. Until PSAB addresses asset derecognition, governments may wish to consider the recently released International Public Sector Accounting Standards IPSAS 29 Recognition and Measurement of Financial Instruments in establishing an accounting policy. Financial Statement Presentation Issues Analysis, November 2010 Page 14 of 18
Amendments to FOREIGN CURRENCY TRANSLATION, Section PS 2600.65 In October 2009, PSAB issued an Exposure Draft proposing amendments to FOREIGN CURRENCY TRANSLATION, Section PS 2600. Key aspects of these proposals were as follows: (a) eliminate the deferral of gains and losses arising on the translation of longterm monetary assets and liabilities; and (b) require gains and losses originating from the translation of foreign denominated balances that have yet to be settled to be reported as remeasurement gains and losses. Given the nature of the amendments proposed, the comment periods for this Exposure Draft overlapped with the financial instruments Exposure Draft. PSAB evaluated responses to the two Exposure Drafts concurrently..66 A majority of the respondents supported amending the provisions that applied to the translation of balances at dates subsequent to their initial recognition. This support is based on achieving consistent measurement of currency risk and the associated economic effects of changes in exchange rates. Others cited the benefit of a transparent representation of the performance of the risk management strategy..67 Those opposed to the changes expressed concern that their adoption would cause erratic swings in reported results that do not reflect the underlying economic substance of what is a long-term arrangement. A view was expressed that deferring and amortizing foreign currency gains and losses reduces the variability on annual surplus/deficit..68 Others who were critical of the proposals expressed the view that foreign denominated balances should be measured at the rate of exchange agreed to in a hedge as this reflects the government s legal obligation and cash flow requirements..69 When a government enters into a derivative, generally its counterparty is not the same as the counterparty to the hedged risk. For example, in the case of a debt obligation denominated in a foreign currency, a government is legally required to make interest and principal payments to the bondholders. It may choose to hedge that currency risk using a derivative and, when it does, it has legal obligations beyond those associated with the debt obligation. Netting the two contracts is a short cut that denies users information as to underlying obligations..70 A government that chooses to issue a foreign denominated security rather than one with a Canadian dollar repayment obligation has taken on currency risk. This is a management decision that should be evident to financial statement users. The Financial Statement Presentation Issues Analysis, November 2010 Page 15 of 18
government may choose to mitigate this risk or it may determine it will not do this. There should be accountability for this decision. A government that chooses to manage the currency risk may choose from many alternative strategies. Similarly, financial statements should include information that allows readers to assess the extent to which the strategy selected has successfully mitigated the risk..71 Some assert that it is unfair to use current rates of exchange to measure what is a long-term liability. Exchange rates can fluctuate dramatically and may not be predictive of the final settlement amount. Deferral is preferred on grounds that it allocates the financial impact of currency risk over the future periods that will be affected. However, unlike amortization of a capital asset where a known amount is allocated to the future periods during which the asset will provide service, the financial effect of currency exposure is unknown. When the deferral model is applied to currency risk, it is simply that a deferral of accountability for a risk the government has knowingly assumed..72 The deferral method can fail miserably in diminishing volatility. An illustration provided in one response demonstrated this. It is reproduced below. It illustrates that the deferral method simply defers volatility until the period of repayment. The largest value reported in the statement of operations, being $28,484,489, is associated with deferral accounting. This is because in the period of repayment, the denominator reverts to one and no further deferral of accountability associated with a decision not to hedge a currency risk is possible. The entire gain or loss must be reported. Financial Statement Presentation Issues Analysis, November 2010 Page 16 of 18
Date US Funds FX Rate Translated Value Yr of Issue $150,000,000 1.3808 $207,119,250 Gain (Loss) Reported in Statement of Remeasurement Gains and Losses [ED] Accumulated Remeasurement Balance [ED] Statement of Operations Current Amortization Method 31-Mar-96 $150,000,000 1.3632 $204,480,000 $2,639,250 $2,639,250 $219,938 31-Mar-97 $150,000,000 1.3843 $207,645,000 ($3,165,000) ($525,750) ($81,348) 31-Mar-98 $150,000,000 1.4166 $212,490,000 ($4,845,000) ($5,370,750) ($674,613) 31-Mar-99 $150,000,000 1.5092 $226,380,000 ($13,890,000) ($19,260,750) ($2,612,753) 31-Mar-00 $150,000,000 1.4535 $218,025,000 $8,355,000 ($10,905,750) ($1,257,888) 31-Mar-01 $150,000,000 1.5774 $236,610,000 ($18,585,000) ($29,490,750) ($4,854,984) 31-Mar-02 $150,000,000 1.5935 $239,025,000 ($2,415,000) ($31,905,750) ($5,434,584) 31-Mar-03 $150,000,000 1.4693 $220,395,000 $18,630,000 ($13,275,750) $448,573 31-Mar-04 $150,000,000 1.3105 $196,575,000 $23,820,000 $10,544,250 $11,442,420 31-Mar-05 $150,000,000 1.2096 $181,440,000 $15,135,000 $25,679,250 $28,484,489 $25,679,250 $25,679,250 At March 31, 2005 the debt issue is repaid and a gain of $25,679,250 is realized. Application of the deferral method would require that a gain of $28,484,489 be reported in 2005. Under the proposed approach, an increase in net assets of $15,135,000 would be reported in 2005, with the $25,679,250 realized gain reported in the statement of operations. Financial Statement Presentation Issues Analysis, October 2010 Page 17 of 18
Transitional provisions.73 Generally, those who did not support the transitional provisions explained that they could not support transition to the proposed standard and the associated amendments. Some who supported the proposals indicated that restatement of prior year comparative information should be required. Some respondents sought additional time to implement..74 Unless transitional provisions specify otherwise, ACCOUNTING CHANGES, paragraph PS 2120.13, allows governments adopting new or revised PSA Handbook standards to apply them retroactively or prospectively. When a new accounting standard contains provisions that permit a choice, permitting retroactive application can allow the benefit of hindsight. As the fair value option could be applied with hindsight, a decision was made that the financial statements of prior periods should not be restated. While retroactive restatement could have been required for other provisions, PSAB was mindful that these standards may involve some significant changes and it chose not to impose additional resource requirements that might delay implementation..75 Following receipt of comments on the proposal to amend the financial statement presentation requirements, PSAB will redeliberate the timeframe for transition to the financial instruments standard and amendments that affect other standards, such as foreign currency translation..76 PSAB recognizes that some government organizations transitioning to the PSA Handbook may seek to apply these standards in advance of the required implementation date. This is because organizations that have previously reported based on the CICA Handbook Accounting face the prospect of restating their accounts twice in a matter of just a few years for items that fall within the scope of these proposals. PSAB hopes to facilitate this process by indicating a decision on the finalization of these proposals in March 2011. Financial Statement Presentation Issues Analysis, October 2010 Page 18 of 18