How will derivatives be accounted for under PSAB's new suite of financial instruments?
The big impetus to introduce a new set of standards for financial instruments was because the old standards simply did not account for derivatives. Given how much risk is associated with the use of derivatives, PSAB deemed this unacceptable.
In developing PS 3450, Financial Instruments, there is concrete guidance on the definition of derivatives, how to account for them, and related risk disclosures. The standard even includes guidance on embedded derivatives (financial instruments that may be embedded within existing contracts like lease agreements). Derivatives must be accounted for at their fair value each period, which will introduce volatility in the financial statements resulting from changes in fair value each period.
Typically, public sector entities use derivatives to hedge risks (i.e. interest rate risk, foreign currency risk, commodity risk). By hedging, derivatives usually have a relationship to one or more other financial instruments that the government is holding. For example, if a government issues a US Dollar bond, it might hedge FX risk by entering a US Dollar swap (derivative).
However, there is no explicit hedge accounting available in PSAB's new suite of standards. There are, however, certain elections that can be made within the standards to link the presentation of derivatives with the underlying risks that are being hedged. When applied effectively, these elections can minimize the volatility introduced into the financial statements.