Treatment of Interest on

Two papers:
Instruments indexed to foreign currency:
Separate discussion; option to treat it as “denominated” in that currency.
Instruments indexed to something else (e.g., CPI, share prices, oil price):
Issues are how the indexation amounts are:
• classified as interest or revaluation; and
• allocated over the life of the instrument.
2

Index-linked securities in the SNA
7.104. Index linked securities are financial instruments for which the amounts of the coupon payments (interest) and/or the principal outstanding are linked to a general price index, a specific price index or an exchange rate index.
When the coupon payments are index linked , the full amounts of such payments are treated as interest receivable or payable, in the same way as the interest receivable and payable on any other security paying a contractually agreed variable income.
When the value of the principal is index linked , the difference between the eventual redemption price and the issue price is treated as interest accruing over the life of the asset in the same way as for a security whose redemption price is fixed in advance. In practice, the change in the value of the principal outstanding between the beginning and end of a particular accounting period due to the movement in the relevant index may be treated as interest accruing in that period, in addition to any interest due for payment in that period. ...
3

Issues
Redemption value is not known
– Implication: value of interest before redemption is unclear.
It is argued that some indexation (such as to stock prices, oil prices, gold prices) combines motives for both interest income and holding gains.
Interest is the return for putting financial resources at disposal of another entity.
Holding gains/losses effect of index value fluctuations.
4

Are negative values of interest payable/receivable acceptable or meaningful, when general interest rates are positive?
Or are such fluctuations an indication that the value is driven by revaluation factors rather than being a return for supplying financial resources?
Business accounting does not have the interest/holding gain distinction.
5

Keeping the 1993 SNA unchanged for the concept of interest and not
allowing revisions of interest accruals (when the coupons are indexlinked, the full amounts paid as coupons, after indexation, are accrued as interest; and when the value of the principal is index-linked the difference between the actual redemption value and the issue price is treated as interest accruing over the life of the instrument (paragraph
7.104)). For determining interest accruing in an accounting period, the movement in the relevant index during the period is used to determine interest accruing in that period, without revising them later.
6

Year
1
2
3
4
5
Total
Opening balance
1000
1058
1101
1319
1519
Interest
70
60
160
190
-77
403
58
10
-39
0
Revaluation Closing balance
-12 1058
-17 1101
1319
1519
1403
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Comments:
Interest is volatile due to movements in index.
Revaluations are due to changes in market expectations about future path of the index. It could arise also from market interest rate changes or credit ratings (in this example, these were assumed unchanged).
Revaluations cancel out over life of instrument.
8

Keeping the 1993 SNA unchanged for the concept of
interest, and accepting revisions of interest accruals that will be determined in each accounting period either
(a) by using the movement in the relevant index in each
accounting period and revising interest when actual redemption value is known, or
(b) by using the most recent observation of the relevant
index and revising interest continuously.
9

1
4
5
2
3
Total
Year
Opening balance
Interest
Initial Final
1000 70 70
1058
1101
1319
1519
60
160
190
-77
75
80
86
92
403 403
-17
58
10
-39
Revaluation
Initial Final
-12 -12
0
-32
138
114
-208
0
Closing balance
1058
1101
1319
1519
1403
10

1
4
5
2
3
Total
Year
1058
1101
1319
1519
Opening balance
Interest (estimates made in the year)
1 2 3 4
1000 70 63 89 103
67 96
105
114
125
138
70
75
80
86
92
403
5
11

Comments:
The total interest accrued over the life of the instrument is the same with that in the 1993 SNA approach.
The allocation over the life is different.
Revaluations cancel out over the life of the instrument.
The issue is whether it is desirable to revise interest accruals:
(a) when actual cash flows are know at the redemption.
(b) on a regular basis using the latest information (on the index).
12

Clarifying or changing the 1993 SNA for defining interest on index-linked instruments by fixing the rate of
interest at the time of issue, and treating any deviation of the index from the expected path as holding gains/losses.
AEG discussion in December 2004 was helpful; this option had previously been ruled out of consideration.
13

Year
1
2
3
4
5
Total
Opening balance
1000
1058
1101
1319
1519
Interest
100
109
469
80
86
94
Revaluation Closing balance
-22 1058
-43
124
1101
1319
100
-225
-66
1519
1403
14

Comments
Interest accruals are calculated using the expected yield-tomaturity (YTM) at issue.
Interest for the life of instrument may not be equal to the difference between issue price and redemption value.
Revaluations may not cancel out over the life of the instrument (equal to the difference between expected and actual redemption value).
15

Clarifying or changing the 1993 SNA for defining interest by regarding indexed-linked instruments as
effectively including derivative contracts. This is similar to previous approach. However, interest is imputed based on a similar instrument that is not indexed and the value of the embedded derivative reflects the deviation (of the imputed interest) from actual movements in the relevant index.
16

4
5
2
3
Total
1
Year
Embedded derivative approach
Standard bond component
Interest Opening balance
1000 80
Revaluation Closing balance
0 1080
1058
1101
1319
1519
86
94
100
109
469
0
0
0
0
1166
1260
1360
1469
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4
5
2
3
Total
1
Year
Embedded derivative approach
Derivative component
Interest Opening balance
0 0
Revaluation Closing balance
-22 -22
-22
-65
59
159
0
0
0
0
-43
124
100
-225
-66
-65
59
159
-66
18

Comments
Interest accruals are imputed based on similar instruments that are not indexed. Effectively, for the debtor approach, this means using the expected YTM at issue.
Derivative reflects the deviation of imputed interest from actual movements of the relevant index.
The standard bond component may also have revaluation if market interest rate changes. Then, it becomes difficult how to disentangle revaluations due to change in index or due to market interest rates.
19

Which alternative, among the four presented in the Executive Summary, do the members prefer?
(a) 1993 SNA approach as it is?
(b) 1993 SNA with revisions:
• when actual redemption value is known?
• using the most recent observation?
(c) Modified debtor approach?
(d) Embedded derivative approach?
20

BOPCOM discussion:
Evenly divided between (a) and (c).
Conclusion to keep the status quo – i.e., option (a) - in the absence of a consensus for change.
21

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