The issue of accounting for financial instruments by local development centres (LDC)

The recent changes to accounting frameworks and the latest accounting developments raise many questions and issues which local development centres (hereafter “LDCs”) and their auditors cannot avoid!

The application of the appropriate accounting framework and compliance with accounting standards depend on the facts and specific circumstances of each entity and on the professional judgment of practitioners, which makes it impossible to provide guidance applicable to all LDCs. However, given the marked similarities in operating, investing and financing activities, most LDCs are facing the same problems, especially as regards the initial recognition of loans to or investments¹  in enterprises and the note payable to the Ministère du Développement économique, de l'Innovation et de l'Exportation (hereafter the “MDEIE”)². 

Which accounting framework to apply?

For their fiscal year beginning on January 1, 2012, LDCs must determine whether they are controlled by a government or local government and whether, as a result, they are considered government not-for-profit organizations.  If not, LDCs will be considered private sector not-for-profit organizations³. This analysis is crucial since it enables LDCs to determine which accounting framework applies to them. 

Note that, based on Section PS 1300, Government Reporting Entity, and the indicators of control set out therein, virtually all Quebec LDCs are included in the reporting entity of a regional county municipality (hereafter an “RCM”) or an RCM-city. These LDCs, which are controlled by a local government, are therefore government NFPOs. However, some LDCs are excluded from the reporting entity of their RCM or RCM-city and are not considered to be controlled by a government or local government. These LDCs are therefore private sector NFPOs.

Depending on the circumstances, the applicable accounting framework for the fiscal year ended December 31, 2012 will be the following:

• Private sector NFPOs: Accounting Standards for Not-for-Profit Organizations in Part III of the CICA Handbook – Accounting (hereafter “Accounting Standards for NFPOs”)⁴;
• Government NFPOs: Canadian Public Sector Accounting Standards (hereafter “Public Sector Accounting Standards”) with or without the PS 4200 series, at the discretion of the LDC.

For information on the subject, LDCs can refer to the Guide sur les normes comptables pour les organismes sans but lucratif contrôlés par les organismes municipaux posted on the Ministère des Affaires municipales, des Régions et de l’Occupation du territoire Web site.

Accounting for loans to and investments in enterprises

Accounting Standards for NFPOs

Section 3856, Financial Instruments, in Part II of the CICA Handbook – Accounting (applicable to NFPOs that follow Part III of the CICA Handbook – Accounting), requires that financial instruments be initially measured at fair value.

An LDC applying Accounting Standards for NFPOs will have to consider whether the loans to enterprises or investments therein are transactions carried out at market terms, and whether their face amount corresponds to the initial fair value.

If there is a difference between the face value of an investment or loan and its initial fair value, for example because the loan was made at a below-market rate of interest (or interest free), this difference will have to be accounted for in accordance with Section 3856. For instance, the difference may have to be recognized as an expense for the period if it is in the nature of a grant.

In practice, many LDCs and their auditors agree that the auditor’s report will include a qualified opinion in this regard, since LDC management does not assess, when a loan is granted or an investment is made, whether its face value corresponds to its initial fair value.

Public Sector Accounting Standards

As at December 31, 2012, Public Sector Accounting Standards did not include any specific standards on financial instruments. A new section on the subject was recently published (Section PS 3450, Financial Instruments), but adoption is not yet mandatory to date⁵.  Earlier application is however permitted.

In addition, Public Sector Accounting Standards include two sections that apply to accounting for loans to or investments in enterprises, i.e., sections PS 3040, Portfolio Investments, and PS 3050, Loans Receivable, which contain similar requirements regarding the initial measurement of loans or portfolio investments. When these transactions contain significant concessionary terms whereby part or all of the transaction is in the nature of a grant, the “grant” portion of the transaction should be recognized separately when the loan is granted or the investment is made, as appropriate⁶.  It should be noted that these two sections were in effect as at December 31, 2012, whether or not the LDC had adopted new Section PS 3450⁷,  which provides guidance on the subsequent measurement of loans, specifying that the difference should be recognized using the effective interest rate method.

In practice, many LDCs and their auditors agree that the auditor’s report will include a qualified opinion in this regard, since LDC management does not assess, when a loan is granted or an investment is made, whether it contains significant concessionary terms.

Accounting for a note payable to the MDEIE

In order to fulfill their mission and make the investments described above, LDCs receive funding from the MDEIE. The resulting note payable is generally interest free.

Accounting Standards for NFPOs

The provisions in Section 3856 relating to the initial measurement of financial instruments at fair value mentioned above also apply to the initial recognition of a note payable.

In practice, many LDCs and their auditors agree that the auditor’s report will include a qualified opinion in this regard.

Public Sector Accounting Standards

Section PS 3050 on loans only applies to loans receivable. Loans that are financial liabilities are therefore not covered by this section. Section PS 3230, Long Term Debt, only sets out the presentation requirements for such debt and the related disclosures, and no other standard in the Public Sector Accounting Standards addresses the initial measurement of a financial liability, not even Section PS 3450, Financial Instruments.

Some guidance will help LDCs and auditors determine the appropriate initial measurement basis, for example Financial Statement Concepts, paragraph PS 1000.60, which states the following “[…] There are a number of bases on which an amount can be measured. Government financial statements are, however, prepared primarily using the historical cost basis of measurement, whereby transactions and events are recognized in financial statements at the amount of cash or cash equivalents paid or received or the fair value ascribed to them when they took place.” However, some may maintain that it is necessary to initially recognize a note payable at fair value in order to comply with the financial statement concept of representational fairness, according to which transactions are accounted for and presented in a manner that conveys their substance rather than necessarily their legal or other form⁸.

Conclusion

LDCs should first determine the accounting framework that applies to their situation, i.e., Accounting Standards for NFPOs or Public Sector Accounting Standards, so that they can refer to the appropriate accounting standards to account for their financial assets and financial liabilities. However, applying these standards appropriately requires the exercise of professional judgment and, in some cases, the determination of significant estimates that materially affect the financial statements or require the use of experts such as valuation specialists.

Stéphane Landry, CPA, CA
Raymond Chabot Grant Thornton S.E.N.C.R.L.