New Accounting Standards for Financial Instruments

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1 ATTENTION: Ultimate Designated Persons Chief Financial Officers Panel Auditors Please distribute internally to: Internal Audit Regulatory Accounting Senior Management Contact: Louis P. Piergeti Vice-President, Financial Compliance (416) MR0431 November 3, 2006 New Accounting Standards for Financial Instruments This notice will provide guidance to Members concerning the application of new Accounting Standards for Financial Instruments. The new accounting standards will require that every Member firm identify all financial instruments in its organization to ensure the terms and conditions of both financial and non-financial contracts are understood and properly classified and documented into one of five categories in its internal accounting policies. This includes the method of measurement and income recognition. Background These standards are a culmination of consultation by the Accounting Standards Board ( AcSB ) with Canadian constituents and with international standard setters. Having explored several approaches to accounting for financial instruments, the AcSB has produced standards that are intended to enhance the clarity and practicality of financial statements, and harmonize them with international standards. The AcSB 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 comprise three new Handbook Sections: Financial Instruments - Recognition and Measurement, new Handbook Section This section prescribes when a financial instrument is to be recognized on the balance sheet and at what amount sometimes using fair value; other times using cost-based measures. It also specifies how financial instrument gains and losses are to be presented. Hedges, new Handbook Section Application of this Section is optional. It provides alternative treatments to Section 3855 for entities which choose to designate qualifying transactions as hedges for accounting purposes. It builds on existing Accounting Guideline AcG-13, Hedging Relationships, and Section 1650, Foreign Currency Translation, by specifying how hedge accounting is applied and what disclosures are necessary when it is applied.

2 Comprehensive Income, new Handbook Section This Section introduces a new requirement to temporarily present certain gains and losses outside net income. Definitions 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. Financial instruments include cash, 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. There are a number of financial instruments covered by other Handbook Sections or active AcSB projects that are excluded from the new Sections. These are referred to as scope exceptions to Handbook Section Examples include: interests in subsidiaries and joint ventures; employee benefits; deferred charges; leases; stock-based payments; and future tax liability. For items that are considered scope exceptions, member firms are still required to search for embedded derivatives (e.g. in lease agreements) as they may have an effect on those items not held for trading. There are five categories in which financial instruments must now be categorized under the new standards. They include: 1. Financial assets and financial liabilities held for trading - all derivatives not designated in a hedge relationship are in this category, as are any instruments a securities dealer buys and sells for the purpose of profit-taking in the near term. In addition, there is an alternative to designate any financial instrument into this category when first recognized. Regulatory Requirement: This alternative should be designated as the prescribed regulatory accounting method for all financial instruments of a securities dealer to ensure they are accounted for on the same basis. 2. 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. In almost all cases, securities dealers do not have the intention to hold to maturity. Regulatory Requirement: The alternative to classify such investments as held for trading should be the prescribed regulatory accounting method for securities dealers and is consistent with the current industry accounting. 3. Loans and receivables - this category includes all loans and receivables such as financing balances (for example repurchase and reverse repurchase balances) 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 mortgage backed securities, collateralized mortgage obligations and real estate mortgage investment conduits, and interest-only and principal-only strips. In a securities dealer, debt securities are generally bought and sold for the purposes of profit taking and should therefore be classified as held for trading. This prescribed regulatory accounting method is consistent with current industry accounting. Regulatory Requirement: In respect to loans and receivables (such as repos and securities loaned), Member firms should designate them as held for trading and measure at fair value (and not the alternative option of measuring at amortized cost). 4. Available-for-sale financial assets - this category captures all financial assets that are not

3 classified as held for trading, held to maturity, or loans and receivables. Regulatory Requirement: This category is not recommended for securities dealers where there is an alternative to classify the asset as held for trading so that any unrealized gains or losses are included in the regular income statement of the firm and not separately tracked as other comprehensive income until such gains or losses are in fact realized. 5. Other financial liabilities - financial liabilities that are not classified as held for trading continue to be measured at amortized cost. Comprehensive Income In the securities industry, all financial assets and liabilities are recognized when the securities dealer becomes a party to the contract creating the item. Financial items acquired or assumed in arm s length transactions must be measured at fair value, usually the value of the consideration given or received. The hierarchy used to determine fair value is based on 1) quoted market prices in an active market (for example refer to IDA Form 1 general instructions for definition of market value ); 2) valuation techniques (if no market exists) such as discounted cash flow analysis or option pricing models; and 3) most common technique used by market participants. New Handbook section 1530 now introduces the requirement for income measurement affecting all financial and non-financial instruments and to present unrealized gains and losses relating to financial assets available for sale or non-financial assets available for sale in a new statement of income referred as Other Comprehensive Income also referred to as OCI. The total of the OCI gains or losses may be presented as follows: 1) Immediately below net income on the income statement; 2) In a separate statement that begins with net income; or 3) In a statement of changes in equity. The following chart below (an extract of the AcSB brochure) summarizes the implications of classifying financial assets and financial liabilities into the five categories.

4 The following chart below (an extract of the AcSB brochure) summarizes the implications of classifying financial assets and financial liabilities into the five categories. SUMMARY OF REQUIREMENTS FOR MEASUREMENT AND RECOGNIZING GAINS AND LOSSES Category Initial Measurement Subsequent Measurement Gains and Losses ASSET Loans and receivables Held-tomaturity investment 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-forsale financial assets * 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 Recognized immediately in net income LIABILITIES Other 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. Effective Date The CICA mandatory effective date is for annual and interim periods in fiscal years beginning on or after October 1, In order to plan for these changes, the IDA has prepared the attached worksheet (See Appendix A) in consultation with the Panel Auditors Broker Committee to assist Member firms in meeting documentation requirement as to the identification and classification of financial instruments before the effective date of application. Once the classification of instruments is documented and the fiscal year commences - changes are not permitted. Financial statement accounting policies followed in periods prior to the effective date are not reversed, therefore comparative figures are not restated. Further information is provided in the attached Accounting Standards Board ( AcSB ) brochure entitled Financial Instruments Navigating New Waters dated October 1, 2006 or visit the AcSB website at

5 Regulatory Guidance on Documentation Requirements The IDA has determined after detailed and careful analysis of the new accounting standards that current regulatory accounting requirements are materially in compliance with the alternatives available for securities dealers under the new accounting standards. This includes the fair market value reporting of financial instruments on the balance sheet (Statement A) and measurement of realized and unrealized gains or losses as currently reported on the income statement (Statement E). Material compliance with the new accounting standards requires that all Members identify, classify and document the method of income measurement for all financial instruments in their internal accounting policies and procedures. To assist Member firms in complying with the documentation requirements set out in the new accounting standard, in consultation with the panel auditors committee, we have prepared the attached Appendix A (Form 1 - Statement A and E) worksheet as regulatory guidance to assist in documenting firms internal accounting policies. Regulatory Position on Comprehensive Income Reporting The effect of following the prescribed regulatory accounting options means that existing Form 1 Statement E will not be supplemented at this time to include a new Statement of Other Comprehensive Income ( OCI ). As a result, any item that would otherwise be reported as OCI should be included on Form 1, Statement E, line 30 (with details). This regulatory financial reporting standard is considered a departure from GAAP and would therefore be disclosed in the notes to the financial statements, similar to the non-preparation of Statement of Cash Flow. The regulatory accounting policy would also be reported as the basis of accounting in Note 2 to Form 1 - Statement A. Given that the only identifiable income measurement item to be reported on the OCI is the unrealized exchange gain or losses arising from the translation of financial statements of a selfsustaining foreign operation (currently reported by Member firms on Form 1 - Statement E, line 30), current regulatory financial reporting disclosure is materially unaffected by the new Comprehensive Income reporting standard. This Member Regulation Notice is intended to be used as regulatory guidance to assist in the implementation of the requirements set out for the new accounting standards for Financial Instruments. The Notice is not intended to be exhaustive and deal with all matters set out in the new accounting standards such as accounting treatment for securities with embedded options and non-financial instruments with embedded options. Member firms should seek professional accounting advice from their panel auditors.