What is a Derivative?
The new accounting standard, CICA Handbook Section 3855, applies to all entities that enter into contracts – not simply derivative contracts. The new definition of a derivative scopes in more contracts than just traditional swaps, forwards, futures and options.
All derivatives are required to be reported on the balance sheet at fair value and remeasured at fair value at each reporting date. Changes in fair values of derivatives must be recorded in net income. The balance sheet assets and liabilities will increase for those entities with derivatives not currently fair valued, and net income may potentially be more volatile.
A derivative is a financial instrument or other contract with all 3 characteristics:
- Value changes with underlying variable – Contract contains a price or rate
- Requires little or no initial net investment – No upfront payment is made or payment is small relative to the notional amount at the trade/signing date of the contract
- Settled at future date – Any financial instrument that can be settled at a future date.
A derivative must be recorded at fair value at each reporting date on the balance sheet. The changes in fair value are recorded through net income.
All existing derivatives must be re-measured at fair value on adoption date and recorded on the balance sheet with an offset to opening retained earnings or accumulated other comprehensive income on the date of adoption.
All new derivatives scoped in as a result of the new standard must be measured at fair value on adoption date and recorded on the balance sheet.
- How will you know whether or not you have identified all derivatives without reviewing all of your contracts?
- What if contracts are written and filed in remote office locations?
- Are there enough trained personnel to search for derivatives throughout the organization?
- Does your enterprise have appropriate systems to obtain the necessary data for derivative fair values, especially for non-traditional derivatives?
- How will you ensure ongoing compliance with the requirements of Section 3855 for head office as well as for offices across Canada and entities throughout the world?
- How will management communicate the increase in balance sheet assets and liabilities, as well as potential earnings volatility to shareholders, analysts, audit committees, etc.?