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Fixed Income Securities – FVPL

• Fixed income security refers to any type of investment that yields a regular or fixed return. It is an investment that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity. In a variable income security, payments change based on some underlying benchmark measure such as short-term interest rates. However, in this and subsequent chapters, by fixed income securities we mean debt securities that yield a regular return in the form of interest. The terms “debt securities” and “fixed income securities” are used here interchangeably.
• A debt security is defined as “any security representing a creditor relationship with an enterprise.”
• The term “debt security” includes, among other items, U.S. Treasury securities, U.S. government agency securities, municipal securities, corporate bonds, convertible debt, commercial paper, all securitized debt instruments, such as collateralized mortgage obligations (CMOs) and real estate mortgage investment conduits (REMICs), and interest-only and principal-only strips.
• A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Investments in equity shares are a form of financial asset.
• Investments in debt securities are classified as either fair value through profit and loss or as available-for-sale securities or held-to-maturity investments.
• IFRS 9 is the first part of Phase 1 of the IASB’s project to replace IAS 39. Financial Instruments: Classification and Measurement, which is Phase 1, was published in July 2009 and contained proposals for both assets and liabilities within the scope of IAS 39. An entity shall apply IFRS 9 for annual periods beginning on or after 1 January 2013.
• An entity shall classify financial assets as subsequently measured at either amortized cost or fair value on the basis of both:
• The entity’s business model for managing the financial assets; and
• The contractual cash flow characteristics of the financial asset. (IFRS 9 Para 4.1)
• As per US GAAP, an entity shall classify debt securities into “trading” if it is acquired with the intent of selling it within hours or days. However, at acquisition an entity is not precluded from classifying as “trading” a security it plans to hold for a longer period. Classification of a security as trading shall not be precluded simply because the entity does not intend to sell it in the near term. Investments that are classified as “trading” securities are classified under “fair value through profit or loss” category.
• Bonds are either subscribed at the initial off er through the primary market route or purchased through the secondary market. In a secondary market the buy order is placed through a broker known as a counter party. Most corporate bonds are traded over-the-counter.
• Interest on bonds is payable by the issuer on the coupon date. Investors should account for the interest on the coupon date. However, the interest accrues on the bond on a daily basis even though it is paid periodically as per the terms of the bond, usually on a semi-annual basis.
• Corporate action is, as the name implies, an action taken by the issuer of the bonds that impact the investments or earnings from such investments. Typical examples of corporate actions include interest payment by the company, calls or the issuance of new debt by the issuer that result in change of the name, or number of bonds held by the investor, and so on.
• One of the key activities during the trade life cycle of fixed income securities is the corporate action in the form of interest as stated on the face of the bond. The accounting event for coupon accrual is recorded on the date on which the interest becomes payable by the company.
• The accrued interest purchased on the date of purchase of the bond is reversed on the first date on which interest is payable by the company. This effectively reduces the interest income during the first period during which the bond is held by the investor.
• The bonds should be carried in the books at fair market value for bonds that are held as trading securities. However, interest should be accounted for as though the bond is required to be shown on the basis of amortized cost. The premium paid or discount realized on purchase of the bond should be amortized over the remaining life of the bond on a yield-to-maturity basis. Such an amortized premium or discount is added with the interest on the one hand and held separately in a mark-to-market account on the other.
• The effective interest is calculated based on an iterative process in such a way that the carrying cost is increased to the extent of the effective interest for the period the bond is held. The carrying cost at the end of the tenure of the bond should be equal to the face value of the bond.
• Since interest accrues on a day-to-day basis, the interest on bonds held by the investor from the date of the previous coupon date until the valuation date should be recorded in the books of accounts as “Interest Income” for the period.
• At the end of every valuation date the fair value of the bond is ascertained and the bonds are mark-to-market. This process is known as “portfolio valuation.” The market rate at the end of the period is determined from the primary stock exchange where the bonds are traded. If there is an increase in the market rate over and above the purchase rate then such an increase is recognized as an unrealized gain and the corresponding amount is shown in the MTM—Bonds—FVPL (Asset/Liability) account.
• Interest accrues on the bond on a daily basis even though it is paid periodically, as per the terms of the bond usually on a semiannual basis. Hence, when the bond is sold, the investor actually should get not merely the value of the bond but also the interest element from the previous coupon date until the date of settlement of the trade.
• The profit or loss on liquidation of the bonds is ascertained by deducting the cost of sales from the net sale consideration. Cost of sales is arrived at by following FIFO, LIFO or the weighted average method.
• Certain debt instruments have a call provision which grants the issuer an option to retire all or part of the issue prior to the maturity date as mentioned in the document, even though most of the new bond issues usually have some restrictions against certain types of early redemption.
• Functional is the currency of the primary economic environment in which the entity operates. All other currencies other than the functional currency are known as foreign currencies for the entity. Presentation currency is the currency in which the financial statements are presented to the investors. The entity is free to choose any currency as its presentation currency.
• A foreign currency transaction is a transaction that is denominated in a currency other than the entity’s functional currency or requires settlement in a foreign currency. “Denominated” means that the balance is fixed in terms of the number of units of a foreign currency regardless of changes in the exchange rate.
• An entity must convert foreign currency items into its functional currency for recording in its book of accounts. On initial recognition foreign currency transactions are recorded in the functional currency by applying to the foreign currency amount the spot exchange rate between the functional currency and the foreign currency at the date of the transaction.
• Under the relevant accounting standards foreign currency monetary items are treated differently from foreign currency non-monetary items during subsequent recognition of those items on any valuation date. The essential feature of a monetary item is the right to receive or an obligation to deliver a fixed or determinable amount of units of currency.
• When an asset is non-monetary and is measured in a foreign currency, the carrying amount is determined by comparing the cost or carrying amount, as appropriate, translated at the exchange rate at the date when that amount was determined (i.e., the rate at the date of the transaction for an item measured in terms of historical cost); and the net realizable value or recoverable amount, as appropriate, translated at the exchange rate at the date when that value was determined (e.g., the closing rate at the end of the valuation date). The effect of this comparison may be that an impairment loss is recognized in the foreign currency but would not be recognized in the functional currency, or vice versa.
• Exchange differences arise from the settlement of monetary items at a subsequent date to initial recognition, and re-measuring an entity’s monetary items at rates different from those at which they were initially recorded (either during the valuation date or at the previous valuation dates). Such exchange differences must be recognized as income or expenses in the period in which they arise.
• When a gain or loss on a non-monetary item is recognized in profit or loss, any exchange component of that gain or loss is also recognized in profit or loss. When a gain or loss on a non-monetary item is recognized directly in other comprehensive income, any exchange component of that gain or loss is recognized directly in other comprehensive income.
• For every transaction denominated and recorded in a foreign currency, a corresponding journal entry is recorded and accounted for in its functional currency, based on the foreign exchange rate on the date on which such a transaction is recognized. This process is known as FX revaluation.
• FX translation is required to be performed by the investor to adjust the FX rate differential between the transaction date and the valuation date in respect of all assets and liabilities, which can either be monetary items or non-monetary items.
• When an entity trades in foreign currency (i.e., where the trade currency is different from the functional currency), then the total unrealized gain or loss consists of two components—capital gain and currency gain.

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{ 2 comments… add one }

  • Ca Yagnesh Desai August 18, 2015, 3:17 am

    Wonderful and Great Job…

  • George Matalavea May 17, 2016, 6:27 pm

    Good summary!

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