Canada: Implications For Investment Funds Of New Standards For Canadian GAAP

The Accounting Standards Board of the Canadian Institute of Chartered Accountants has issued a new set of financial reporting standards that address accounting and disclosure for financial instruments. The changes, which are of particular relevance to investment funds, are intended to be one step in a 5-year transitional process to replace Canadian GAAP with International Financial Reporting Standards (IFRS), although some key components will take effect early in the transitional cycle. In particular, new standards relating to the determination of the fair value of financial instruments as contemplated in CICA Handbook section 3855: Financial Instruments – Recognition and Management (s. 3855) will apply to interim and annual financial statements for financial years that commenced as early as October 1, 2006.

S. 3855 establishes a framework for recognizing and measuring financial assets, financial liabilities and non-financial derivatives. It is premised on the basis that financial instruments and non-financial derivatives qualify as assets or liabilities which should be reported as such in financial statements, and that not only is fair value the most relevant measure for financial instruments, it is the only relevant measure for derivative financial instruments. S. 3855 applies to all types of financial instruments except certain particular interests, including interests in subsidiaries, entities subject to significant influence, and joint ventures that are otherwise accounted for as subsidiaries, interests in joint ventures and interests in variable interest entities.

By introducing several new definitions and requirements for determining the fair value of a financial instrument, s. 3855 will have an impact on a number of internal valuation processes and systems as well as disclosure for investment funds. For instance, certain of these requirements change the manner in which the fair value of a financial instrument is calculated, thereby impacting upon the calculation of net asset value (NAV), which is required to be measured in accordance with Canadian GAAP pursuant to National Instrument 81-106 - Investment Fund Continuous Disclosure (NI 81-106).

Some of the key components of the new standard include the following:

• S. 3855 distinguishes between "active" markets (for which quotations are regularly and readily available) and "inactive" markets (for which quotations are not so available). For publicly traded securities (i.e. investments in "active" markets), the fair value of a long position is the bid price, and, for a short position, asking price. This is a different basis for calculation than the basis currently used by most investment funds in calculating NAV. Last trade or closing prices will no longer be acceptable as a measure of fair value for investments in active markets, although mid-market prices can be used to determine fair value where long and short positions are offset in the same investment. Investments in equity instruments that do not have a quoted market price (i.e. investments in "inactive" markets) are to be measured at cost, provided they are not classified as held for trading;

• S.3855 requires that all non-derivative financial assets (with the exception of loans and receivables and held-to-maturity investments) be measured at fair value. Loans and receivables and held-to-maturity investments, on the other hand, are to be measured at amortized cost;

• Certain specific valuation techniques must be used for non-publicly traded investments including the use of recent arm’s length market transactions between knowledgeable, willing parties, reference to current fair value of similar instruments, as well as all factors that the market considers in pricing an investment;

• The amortized cost is no longer permitted to be used for money-market funds or investments in debt securities if quoted prices are available; and

• All transaction costs must now be itemised as an expense in the statement of operations, and fair value must specifically exclude transaction costs. Transaction costs are defined as "incremental costs that are directly attributable to the acquisition" and include fees and commissions paid to brokers, levies by regulatory agencies and securities exchanges, as well as transfer taxes and duties. Transaction costs do not include debt premiums or discounts, financing cost or internal administration and holding costs.

The key issues raised by s. 3855 include the effect that these requirements will have on the calculation of NAV by investment funds that are reporting issuers. NI 81-106 requires investment funds to calculate NAV in accordance with Canadian GAAP, so investment funds would be required to calculate NAV in accordance with s. 3855.

Currently, most securities are valued by investment funds at the last trade or closing price. S. 3855 would require public securities to be priced at the bid price (or the asking price, for securities sold short). There are concerns that pricing securities at the bid would understate values, especially in less liquid markets such as small cap securities or emerging markets securities. As NAV is used to determine issue and redemption prices, s. 3855 could lead to arbitrage opportunities or inequities amongst investment fund securityholders. There are also concerns that bid prices may be more difficult to obtain or may be less reliable than last trade pricing.

Other issues that s. 3855 raises include (i) issues for money market funds, as short term debt securities may be required to be valued at bid prices, as opposed to at amortized cost; and (ii) issues as to whether brokerage commissions and similar transactional costs can be capitalized.

As mentioned above, s. 3855 was introduced primarily to establish harmonized standards for recognizing and measuring financial assets, financial liabilities and non-financial derivatives, with little forethought as to the impact it would have on investment funds, disclosure, and NAV calculation. In anticipation of the negative implications of s. 3855 for investment funds, the Canadian Securities Administrators (CSA) have granted blanket relief from the requirement to calculate NAV in accordance with Canadian GAAP to investment funds subject to NI 81-106¹. This relief extends to all NAV calculations, other than for financial statements. The exemptive relief is effective until the earlier of (i) September 30, 2007; and (ii) the effective date of amendments to NI 81-106 to address the issue.

This exemptive relief (subject to the investment fund’s material contracts, as discussed below) permits investment funds to disregard s. 3855 for the purposes of calculating NAV for any purpose (including for issuances and redemptions of securities and for disclosure obligations), thereby avoiding potential arbitrage and dilution risks. Investment funds are, however, still required to follow Canadian GAAP (and therefore s. 3855) for the purposes of calculating the NAV reported in their financial statements. The exemptive relief also requires that the notes to the financial statements include a reconciliation of the NAV calculated in accordance with Canadian GAAP to the NAV calculated without giving effect to s. 3855.

Although the exemptive relief granted by the CSA permits the calculation of NAV other than in accordance with Canadian GAAP, investment funds will still need to review their material contracts to determine how to calculate NAV. The constating documents of most investment funds stipulate a methodology for calculating NAV (for issuances, redemptions, the calculation of management fees, etc.) and if the methodology incorporates Canadian GAAP, the fund may need to follow s. 3855. In addition, investment funds will need to review arrangements with service providers (such as pricing services) to ensure that NAV is being calculated appropriately and to ensure that information is available to permit compliance with s. 3855 for financial statement reporting purposes.

The s.3855 standards apply to interim or annual financial statements relating to fiscal years beginning on or after October 1, 2006. As mentioned above, however, investment funds have been given a temporary reprieve from having to comply with s. 3855 (other than for financial statements) until the earlier of September 30, 2007 or the effective date of amendments to NI 81-106 addressing the issue.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.