Step 2 - Classification

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INTRODUCTION: The second step in applying Section 3855 involves classification of the contracts
identified in the first step as being within the scope of the standard into the categories defined in the
standard. Note that hedge accounting, described in Step 6, may modify the effects of the classification
made in this second step.


All contracts must be classified into one of the categories described below.                   Financial assets
                                                                                               3855.65; Financial
Characteristics of the instrument and your use of it determine whether you have a choice       liabilities 3855.70;
                                                                                               Chart illustrating
of category. Classification determines how each instrument is measured and when and            classification
where gains and losses are recognized. Reclassification is rarely possible, so it is           alternatives3855.A28
                                                                                               Basis 3855.77, .78
important to understand the implications where choice is available.

                                                                                               Basis 3855.79-.96
Financial assets and financial liabilities — held for trading

If you have a history of buying and selling financial assets and financial liabilities for     3855.19(f)(i),
short-term profit taking, they must be classified as held for trading. Financial liabilities
classified as held for trading include obligations to deliver securities borrowed to cover
short sales.

You must also classify a hybrid instrument as held for trading if it contains an embedded
derivative that must be separated and you are unable to measure the fair value of the
derivative separately. This classification might apply either at initial recognition of the
hybrid or at a subsequent date and, as such, represents the only exception to the
requirement to irrevocably designate a financial asset or financial liability as held for
trading on initial recognition. (See also Embedded Derivatives Chart.)

Any financial asset or financial liability may be designated as held for trading on initial
recognition provided you can reliably measure its fair value and provided it is not
acquired in a related party transaction from an entity that did not classify it as held for
trading. Since fair value hedge accounting requires fair value measurement for some or
all of both the hedged and hedging items, the use of the option to designate a financial
instrument as held for trading may be beneficial as a replacement for hedge accounting
in certain circumstances. For example, if you intend to hedge an item with a derivative,
use of the fair value option can achieve the same reporting result as fair value hedge
accounting without the ongoing work to maintain eligibility for hedge accounting.
There are also restrictions on the ability to designate a non-derivative instrument as a
hedging item, so the held-for-trading category may be useful to achieve concurrent and
offsetting gains and losses between non-derivative instruments that form economic

Financial Instruments Working Group                                                                      Page 1 of 4
                                                                                                Basis 3855.217
US GAAP difference — FAS 115 only applies to debt and equity securities with
readily determinable fair values. It requires classification of assets into held-for-trading
on the basis of “near-term” buying and selling activity but does not permit entities to
classify investments or liabilities other than derivatives as held for trading on a
discretionary basis. A new standard providing this ability is in the exposure phase.

IFRS GAAP difference — IAS 39 allows the discretionary designation of any financial
asset or financial liability as held for trading, however, it imposes conditions on use of
the option.

The word “trading” does not need to be used in the financial statements — you may               3855.35

want to describe these items as “financial assets and financial liabilities at fair value
through net income” or something similar.
Derivatives must always be classified either as held for trading or as a hedging
instrument in a qualifying hedging relationship. For practical purposes, there is no
difference in measurement — derivatives are always measured at fair value, although
there could be differences in the timing of recognition of gains and losses in net income.
(See also Derivatives Flowchart.)

                                                                                                Basis 3855.97-.100
Held-to-maturity investments

This category is for fixed maturity financial assets with fixed or determinable payments        3855.19(g), .23, .24,
that you have the positive intention and ability to hold to maturity, – i.e., only debt         3855.22, .30, .31

instruments. This category should only be used if you are virtually certain you will hold
the item to its maturity. You must reassess your intention for holding each asset to
maturity at each reporting date. If there are significant sales of assets within this
                                                                                                3855.26, .27, .28,
category before maturity, you must reclassify all financial assets in the category as           .29, .32

available-for- sale unless the reason for the sales is outside your control. Once the
category has been “tainted” in this manner, you are not permitted to use the category
until the beginning of the third fiscal year following the tainting. Therefore, you need to
take care in allocating financial instruments to this category. Held-to-maturity
investments are measured at amortized cost.
                                                                                                Basis 3855.217
US GAAP difference — Section 3855 allows you to resume using the held-to-maturity
category after tainting after the passage of two complete fiscal years. FAS 115 is silent
on whether tainting can be cured with the passage of time; accordingly, it is assumed
that it is not possible to resume use of the category after tainting. FAS 115 also does not
refer to “an insignificant amount” of sales.

IFRS GAAP difference — An instrument with a put option may be classified as held to
maturity under both Canadian and US GAAP provided the holder has the intention and
ability to hold the instrument to maturity. This classification is specifically prohibited in
IAS 39.

Step 2 – Classification                                                                                   Page 2 of 4
                                                                                                Basis 3855.101-.104
Loans and receivables
This category includes all loans and receivables 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 collateralized mortgage obligations and real estate mortgage investment conduits, and
interest-only and principal-only strips. Debt securities must be classified as held for
trading, held-to-maturity investments or available-for-sale financial assets as
appropriate. Alternatively, you may designate loans and receivables as held for trading
or available for sale. This category is the second of the two asset categories where
amortized cost measurement is possible. You should note that the treatment of impaired
assets in this category follows Sections 3025 and 3020, respectively, rather than the
treatment set out for other assets in Section 3855.
                                                                                                Basis 3855.218
IAS GAAP difference — IAS 39 requires loans that are quoted in an active market to
be classified as held for trading. Section 3855 does not contain this requirement because
it would conflict with US GAAP — Statement of Financial Accounting Standards FAS
65, Accounting for Certain Mortgage Banking Activities, requires mortgage loans to be
accounted for at the lower of cost or market.

                                                                                                Basis 3855.105
Available-for-sale financial assets

This category captures all financial assets that are not classified as held for trading, held   3855.19(i)

to maturity, or loans and receivables. Note that investments in equity instruments may
be classified only as held for trading or available for sale. The category might also
include debt instruments that you do not wish to classify as held to maturity.

Other financial liabilities

Financial liabilities that are not classified as held for trading continue to be measured at    3855.70, .71

amortized cost. These include accounts payable, bank loans, long-term debt, etc.

US GAAP difference — The classifications in Section 3855 (and IAS 39) are based on those in FAS
115, however, FAS 115 only applies to certain investments in debt and equity securities. The
international and Canadian standards apply to a much broader range of financial instruments.


Reclassification is rarely possible. Held-to-maturity securities may be reclassified as         3855.80-.83
                                                                                                Basis 3855.164-.166
available-for-sale due to a change in intention or ability to hold the investment to
maturity. However, reclassifications or sales of more than an insignificant amount of
held-to-maturity investments bring into question your intent for the entire category and
will cause it to become tainted. A tainted category is reclassified to available-for-sale
and the category may not be used for the next two fiscal years. Reclassification into or

Step 2 – Classification                                                                                Page 3 of 4
out of the held-for-trading category is only possible when a hybrid instrument contains
an embedded derivative that cannot be separately measured at fair value.

There are no restrictions on reclassifications between the loans and receivables category
and available-for-sale, and vice-versa. It is also possible to reclassify an asset from
available-for-sale to held-to-maturity. These reclassifications must be made
prospectively — you do not adjust your prior accounting for the instrument.

Designation of an instrument in a hedging relationship nominally changes its
classification — if the hedging relationship is discontinued for any reason, the
instrument may revert to its original classification. Designation into or out of hedge
accounting is done on a prospective basis — you do not reverse the effects of hedge
accounting on de-designation. (See Step 6 — Hedge Accounting.)

US GAAP difference — FAS 115 allows reclassifications between categories but states that transfers
from the held-to-maturity category and into or out of the trading category should be “rare”. Section 3855
prohibits reclassifications involving the trading category. For practical purposes, FAS 115, IAS 39 and
Section 3855 are consistent in this regard.

The chart below summarizes the implications of classifying financial assets and financial liabilities into
the five categories.

                                             AND LOSSES

                                         Initial          Subsequent
                     Category                                                             Gains and losses
                                      measurement         measurement

                 Loans and
                                      Fair value          Amortized cost       Recognized in net income when the asset is
                                                          using the            derecognized; impairment write-downs and
                                                          effective interest   foreign exchange translation adjustments
                 Held-to-maturity                         method               recognized immediately in net income
                                      Fair value
                                                                               Recognized in other comprehensive income;
                 Available-for-sale                                            transferred to net income when the asset is
                                      Fair value          Fair value*          derecognized; impairment write-downs
                 financial assets
                                                                               recognized immediately in net income

                 Held for trading     Fair value          Fair value           Recognized immediately in net income

                                                          Amortized cost
LIABILITIES                                               using the
                                                                               Recognized in net income when the liability
                 Other                Fair value                               is derecognized; foreign exchange translation
                                                          effective interest   adjustments recognized immediately

*Equity instruments that do not have a quoted market price in an active market are measured at cost.

Step 2 – Classification                                                                                                     Page 4 of 4

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