Preface – Accounting for Investments – Volume 2: Fixed Income Securities & Interest Rate Derivatives

Accounting for Investments – Fixed Income Securities & Interest Rate Derivatives is the second volume of the Accounting for Investments series. This volume covers the financial instruments of fixed income securities and interest rate derivatives viz. interest rate swaps, caps, floors, collars, reverse collars and cross currency swaps. As in the first volume, this book provides an exhaustive treatment of accounting, presentation and disclosure aspects of any entity dealing with such financial instruments.
Since the break out of a severe financial crisis starting in the year 2008 that virtually crippled the world economy, the regulatory authorities including the accounting standard setters have been on their toes and, thanks to their tireless efforts, a substantial addition to the knowledge of accounting has been made along with a thorough overhaul of the accounting standards relating to financial instruments. The good news is that the seat of accounting standard setting authorities on both sides of the Atlantic are now speaking in a singular voice despite some lag in the implementation timeline. This means that very soon there will be a “convergence” in spirit of the world’s top two standards , although it may take a little longer before we see a single converged standard in letter.

Never in the past have we seen such rapid succession of accounting standards issued on financial instruments continuously revised and fine-tuned, based on feedback received from the accounting fraternity and other users of financial statements across the globe. While these measures are an attempt to bring about a better accounting model by plugging the inherent gaps and inconsistencies in today’s complex economic environment, no one can say for sure whether these changes would prevent such occurrence of financial crises in the future. Nevertheless, it is a good development and this book captures the changes that have already been announced irrespective of the actual date of implementation, and other key proposals in the exposure draft stage are also considered at the appropriate places.

This book assumes that the reader already has basic accounting knowledge. Those who are entirely new to the field of accounting should refer to some basic accounting books before attempting to this one. It might be useful to have some basic orientation on accounting for investments, especially plain derivatives on equity instruments like equity futures and equity options to understand better the concepts given in this volume. However, it is not a must and the readers can easily grasp the essentials as this volume is meant to be self-sufficient in dealing with basic accounting concepts in so far as it relates to the particular financial instrument under review.

The entire trade life cycle of each financial instrument is covered in detail from the accounting perspective. For each illustration, the accounting journal entries, general ledger accounts, trail balances, income statements and balance sheets are presented to give a complete understanding of the accounting treatment. Also for all calculated numbers the details of such calculations are given. The presentation and disclosure requirements for these financial instruments are given separately in an exclusive chapter and are not given as part of each illustration and solution to the worked out problems in this book.

While an overview of the trade life cycle for each financial instrument is given, the readers are advised to refer other resources for a detailed treatment on the trade life cycle from the front office and middle office perspective. The trade life cycle in so far as it relates to the back office viz. the accounting aspects are covered in detail with appropriate reference to the GAAP or IFRS requirements. For each financial instrument, the relevant accounting standards that are applicable are given and wherever necessary a comparison showing the similarities and differences between the US GAAP and IFRS is also provided.

Chapter Arrangement:

Chapter 1: Fixed Income Securities – Theory – This chapter gives some basics of fixed income securities, basics of bond markets, types of issues and special characteristics, bond coupons, bond maturity, bond pricing, yield measures, duration and certain types of bonds like municipal bonds, corporate bonds, risks of investment in bonds and so on.

Chapter 2: Fixed Income Securities – Fair value through profit or loss – This chapter covers the accounting for fixed income securities held for trading purposes. After explaining the meaning and definition of fixed income securities, an overview of the categories of financial instruments is given along with the recent changes contemplated by the accounting standard IFRS 9. The explanation of fair value through profit or loss is given with the circumstances in which the designation at fair value through profit or loss on initial recognition is allowed. Fair value concepts and the measurement hierarchy of fair value as per the accounting standard are explained here. The trade life cycle for fixed income securities held as trading securities is given with the accounting entries to be passed at various stages. Illustrations cover fixed income securities in the functional currency of USD held for trading purposes.
Distinctions between FX revaluation and FX translation are given in great detail along with the explanation of functional currency, foreign currency and presentation currency and the requirements of accounting standards in this regard. Another illustration covers bonds in AUD with the functional currency of USD explaining the FX revaluation and FX translation processes.

Chapter 3: Fixed Income Securities – Available-for-sale – This chapter covers the accounting for bonds that are held as available for sale. Amendments made through IFRS 9 that impacts this category is explained. FX translation on available-for-sale securities calls for some special treatment, which is explained in this chapter. The trade life cycle for bonds classified as available for sale securities is given with the accounting entries to be passed at various stages. One illustration covers equity shares in the functional currency of USD held as available for sale; one more illustration is given in a foreign currency with FX translation into the functional currency of USD.

Chapter 4: Fixed Income Securities – Held-to-maturity – This chapter covers the accounting for bonds that are classified as held-to-maturity. Meaning of securities classified as held-to-maturity is discussed. Tainting rules along with exceptions are given. However, tainting rules are dispensed with in light of the recent changes made to this category. Similar changes are also proposed by the FASB. The concept of effective interest rates is then explained. Impairment provisions relating to amortized cost category is covered in this chapter. The trade life cycle for bonds classified as held-to-maturity securities is given with the accounting entries to be passed at various stages. Onet illustration covers equity shares in the functional currency of USD held as available for sale. FX revaluation and FX translation on held-to-maturity securities is explained with the help of one more illustration, which is given in foreign currency with FX translation and accounting entries in the functional currency.

Chapter 5: Presentation, Disclosure and Reclassification – This chapter covers the current accounting standards for the presentation of financial instruments in the financial reporting system, the mandatory disclosures required for these financial instruments, as well as the requirements when an entity reclassifies the financial instruments. The presentation and disclosure requirements are very important as these give quantitative and qualitative information about the financial position of the entity and provide adequate information for the reader of the financial statements to understand the nature and extent of risks undertaken by the entity. These presentation and disclosure requirements are mandatory and ought to have been provided in the illustrations and solutions to problems throughout this book. However, for the sake of convenience the requirements are all bunched and presented in this chapter only. Readers should understand that these requirements should be taken to be an inclusive component of the illustrations and solutions to the problems throughout the book.

Chapter 6: Interest Rate Derivatives – Theory – This chapter covers the theoretical aspects of interest rate derivatives. First an explanation of what is meant by derivatives in a financial instrument is explained, followed by a definition of derivatives as per US GAAP as well as IFRS accounting standards. Then the nuances of over-the-counter derivates are elaborated on comparing the same with exchange-traded derivative contracts. The benefits of interest rate derivatives are spelled out. The following common types of interest rate derivatives are briefly explained viz. forward rate agreements, interest rate swaps, caps, floors, interest rate collars, reverse collars, swaption, and cross currency swaps. The status of various financial instruments for hedging purposes is covered in this chapter.

Chapter 7: Interest Rate Swaps – Receive fixed and pay floating – This chapter covers the accounting aspects of interest rate swaps – receive fixed and pay floating. Meaning of interest rate swap – receive fixed and pay floating is explained with an illustration. The definition of a derivative as per US GAAP and as per IFRS is then given. The trade life cycle for an interest rate swap contract is given with the accounting entries to be passed at the various stages. The trade life cycle for an interest rate swap contract viz. recording the trade; accounting for the upfront fee in the form of premium on the trade; resetting the interest rate on the floating leg; accrual of interest on the pay leg as well as the receive leg on the valuation date; accounting for the interest payable on the pay leg as well as the receive leg on the coupon date; payment or receipt of net interest; valuation entries on valuation date; and the termination of the trade and accounting for termination fee are all covered. Ane illustration covers the accounting aspects of an interest rate swap contract in the functional currency of USD.

Chapter 8: Interest Rate Swaps – Pay fixed and receive floating – This chapter covers the accounting aspects of interest rate swaps –pay fixed and receive floating. The meaning of an interest rate swap – pay fixed and receive floating is explained with an illustration. The trade life cycle for an interest rate swap contract is given with the accounting entries to be passed at the various stages. The trade life cycle for an interest rate swap contract viz. recording the trade; accounting for the upfront fee in the form of premium on the trade; resetting the interest rate on the floating leg; accrual of interest on the pay leg as well as receive leg on the valuation date; accounting for the interest payable on the pay leg as well as the receive leg on the coupon date; payment or receipt of net interest; valuation entries on valuation date; and termination of the trade and accounting for termination fee are all covered. An illustration covers the accounting aspects of an interest rate swap contract in the functional currency of USD.

Chapter 9: Interest Rate Caps – This chapter covers the accounting aspects of interest rate caps. The meaning of interest rate caps is explained with an illustration, before covering the benefits of interest rate caps and the risk associated with it.
The trade life cycle for an interest rate cap contract is given with the accounting entries to be passed at the various stages. The trade life cycle for an interest rate cap contract viz. recording the trade; accounting for the upfront fee in the form of premium on the trade; receive or pay the interest on the coupon date depending upon the actual interest rate; valuation entries on valuation date; and termination of the trade and accounting for termination fee are all covered. An illustration gives the accounting aspects of an interest rate cap contract in the functional currency. One problem as a holder of the cap instrument and another problem as a writer of the cap instrument are also given here.

Chapter 10: Interest Rate Floors – This chapter covers the accounting aspects of interest rate floors. The meaning of interest rate floors is explained with an illustration before covering the benefits of interest rate floors and the risk associated with it.
The trade life cycle for an interest rate floor contract is given with the accounting entries to be passed at various stages. The trade life cycle for an interest rate floor contract viz. recording the trade; accounting for the upfront fee in the form of premium on the trade; receiving or paying the interest on the coupon date depending upon the actual interest rate; valuation entries on valuation date; and termination of the trade and accounting for termination fee are all covered. An illustration gives the accounting aspects of an interest rate floors contract in the functional currency. One problem as a holder of the floor instrument and another problem as a writer of the floor instrument are also provided.

Chapter 11: Interest Rate Collars and Reverse Collars – This chapter covers the accounting aspects of interest rate collars and reverse collars. The meaning of an interest rate collar is explained with an illustration, before covering the benefits of an interest rate collar and the risk associated with it. An interest rate collar is an instrument that gives protection against rising rates by guaranteeing that the holder will never pay above a pre-agreed rate but at the same time sets a downside rate below the floor rate, which the holder will benefit from if interest rates do fall below the floor rate. The trade life cycle for an interest rate collar contract is given with the accounting entries to be passed at the various stages. The trade life cycle for an interest rate collar contract viz. recording the trade, accounting for the upfront fee in the form of premium on the trade, receiving or paying the interest on the coupon date depending upon the actual interest rate, valuation entries on valuation date, termination of the trade and accounting for termination fee are all covered. An illustration gives the accounting aspects of an interest rate collar contract in the functional currency. Similarly, the accounting and trade life cycle of a reverse collar are also given with suitable illustrations.

Chapter 12: Cross Currency Swaps – This chapter covers the accounting aspects of cross currency swaps – receive floating and pay floating in different currencies. Meaning of a cross currency swap is explained with an illustration. The trade life cycle for a cross currency swap contract is given with the accounting entries to be passed at various stages. The trade life cycle for a cross currency swap contract viz. recording the trade, accounting for the upfront fee in the form of premium on the trade, resetting the interest rate on the floating leg, accrual of interest on the pay leg as well as receive leg on the valuation date, accounting for the interest payable on the pay leg as well as the receive leg on the coupon date, payment or receipt of net interest, valuation entries on valuation date, termination of the trade and accounting for termination fee are all covered. FX revaluation and FX translation for a cross currency swap contract is explained with the help of an illustration.

Appendix A: Time Value of Money – This appendix gives an overview of the mathematics involved in fixed-income securities transactions.

Appendix B: Recent Proposals in Accounting Standards – This appendix gives an overview of the recent proposals by the accounting standard setting authorities viz., IASB and FASB. The proposals are in the exposure draft stage and are yet to be promulgated as authoritative standards. The reason for covering this material in the appendix is that some of the changes contemplated have far-reaching implications on the accounting followed for the financial instruments covered in this volume.

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