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Monetary & Financial Statistics: June 2000
Calculating the accrual of interest on debt securities
By C B Wright Tel: 020 7601 4624 E-Mail: chris.wright@bankofengland.co.uk
This article reports a current methodological debate which could affect the way in which interest flows
are recorded in a variety of macro-economic statistics. When new international statistical standards
were published in 1993, one of the major changes to the recommended presentation of the National
Accounts was the adoption of accruals reporting. However, as countries have begun to implement
these standards, questions have been raised about their exact interpretation. The International
Monetary Fund (IMF) is currently undertaking a wide-ranging consultation amongst central banks and
statistical agencies before attempting to clarify the standards. This article is intended to alert UK
users of financial statistics to the issues involved and to invite their comments.
Background
One of the more important changes made to the United The boundary between interest income and
Kingdom’s macro-economic statistics in recent years has capital gains
been the adoption of accruals recording for income and
expenditure. Prior to the UK’s implementation, in 1998,
The recording of interest accruals raises a number of
of the 1995 European System of Accounts (ESA95) – the
complex methodological issues. At their heart is the
European standard paralleling the international System of
recognition that interest receipts, like other forms of
National Accounts (SNA93) – income flows were
income, represent the value of a “service” provided – in
recorded on a “due for payment” basis ie at the point
this instance the service derived from the provision of
where cash payments were scheduled to occur. For many
funds.
economic transactions, this practice meant that the
statistical recording of events through the flow of
For funds intermediated through the banking system,
income, did not map well to the timing of the economic
principally deposits and loans, the concept of interest is
events or processes generating these flows. Thus
generally clear. The actual flows, as recorded under the
economic activity taking place in a given period would
old standards, represent the contractually agreed rates –
frequently not be recorded in the statistics until some
fixed or variable – applied to the outstanding balances
later period.
and settled at the due date. The application of the
accruals standards in these cases is generally
For many transactions, these timing discrepancies were
straightforward: the income accounts record the flow of
small. However, for some activities, the due date for
interest continuously throughout the period(s) that funds
settlement could be as much as a year after the economic
are provided; the balance sheet simultaneously records
activity which the National Accounts were seeking to
the interest as accruing within the asset/liability position
record. This was particularly true for interest income
of the lender/borrower of the capital sum; and the actual
where the practice of annual or semi-annual interest
settlement of the interest receivable/payable at the due
crediting has been widespread.
date is recorded not as interest income, but as a financial
transaction which, in the case of a cash payment, may be
The new international and European standards make
viewed as extinguishing the accumulated accruals within
specific reference to the treatment of interest when
the balance sheet.
guiding on the implementation of the accruals principle.
However, the standards are not wholly consistent in
The concept of interest is generally less clear for funds
describing their preferred methodology and this has
raised through the capital markets. Where debt securities
inevitably led to differences of interpretation amongst
are tradable in secondary markets, their current realisable
statisticians. These differences focus on the
value is free to vary so that, at any given moment, the
interpretation of the return on tradable securities:
yield to redemption is made up of elements comprising
specifically, on where to draw the boundary between
any contractual or coupon payments, and the effects of
interest and capital gains/losses on debt instruments
unwinding any discount/premium from the final
where the total return is made up of both elements.
redemption value. Many securities use this latter element
Because the analytical framework of the National
as their principal or sole means of delivering a return – ie
Accounts and the Balance of Payments (BoP) requires
they are issued at a discount and pay low or no coupons
that only the interest element should be classified as
to the holder. Under such circumstances, the capital
income, ambiguities over the position of the boundary
uplift is generally recognised as interest: under the old
have potentially wide-ranging implications for key
accounting standards, this was only recorded at
macro-economic statistics including the BoP current
redemption; but the new standards count the amortised
account and sectoral surpluses/deficits.
uplift as accruing continuously over the life of the
instrument.
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Monetary & Financial Statistics: June 2000
Under historic cost accounting rules, this latter as a once and for all change which establishes a
interpretation is meaningful to both the issuers and completely new future income stream. Such differences
holders of debt securities. For example, a five year zero pose no particular difficulties when they arise in the
coupon bond, issued for £747 but with a redemption separate accounts of the individual parties. However, the
value of £1000, has a yield to maturity of 6% and would System of National Accounts requires that the two parties
be shown by both the issuer and acquirer as generating an record an identical flow.
accrual of interest of £45 during the first year of its life.
If there were no change in market conditions, then a new The application of “fair value” accounting principles
acquirer, purchasing this security in the secondary market introduces a further potential blurring of the boundary
at the end of the first year, would pay £792 and would between income and capital gains. Both the issuer and
amortise this smaller discount over the remaining four the holder of tradable securities will now record the
years to maturity. Under this scenario, both the issuer revalued price of the instrument following any change in
and the new acquirer of the security would record an market conditions – in the example this means a reported
accrual of interest of £48 in the bond’s second year. This value of £823 at the end of year 1. The question for the
result satisfies the requirements of the National Accounts issuer is then how to record the subsequent flow of
that flows of income should be reported symmetrically accruing interest. If he continues to record his original
by counterparties, and, if the accrual of interest is treated estimate of the flow in the second year of the bond - £48
as a re-investment within the parent instrument,1 can also – then the implied effective interest cost is 5.8% as
mean that the respective liability and asset positions of against 6% at the time of issue. Put another way, the
the two parties are reported identically. internal coherence between the reported stocks and flows
in the accounts is impaired. The position for the holder
In practice, the above example is not realistic. Market of the security has also become less clear. If, for
conditions would normally change over the life of such a example, market conditions were to change for a second
bond so that a new acquirer, purchasing in the secondary time, then the projected accruing interest stream of the
market, will typically view the return differently from the new acquirer in our example would also cease to be
issuer. If, in our example, market conditions had consistent with the new market value of the bond. The
changed at the end of the first year of the bond, issue for both parties is therefore whether to record the
immediately prior to the new acquirer’s purchase, so that interest stream derived under the historic cost accounting
the new acquisition price was £823, rather than £792 rules or whether to recalculate the future accrual of
previously, then the new acquirer will face a flat yield to interest whenever a change in market conditions leads to
maturity of 5% and will amortise the new discount to a change in the market or fair value of the security.
redemption over the four years to maturity. This gives
an accrual of interest of just £41 in the second year of the Interest Accruals within the National
bond as against the £48 which will still be reported by the Accounts
issuer. Both estimates of accruing interest are
meaningful but they now fail to satisfy the National
It should be clear from these examples that the use of the
Accounts requirement for symmetry. The amortised
standard historic cost calculations for accruing interest
present value calculations and associated accruing
fail to satisfy one of the most basic principles of the
interest estimates by the two parties are set out in the
National Accounts – the symmetrical recording of flows
table below.
by counterparties. Two alternative solutions have been
proposed: imposing symmetry by the overlaying of the
Table 1 flows, as viewed by one counterparty (typically the
issuer), onto the accounts of both parties; and the
Original Issuer New Acquirer
recalculation of interest flows subsequent to any change
Year End year Interest End year Interest
npv accrual npv accrual in market conditions. These alternatives form the
£ £ £ £ subject of the current IMF consultation and the
0 747 - - - associated methodological debate.
1 792 45 823 -
2 840 48 864 41
3 890 50 907 43
The current SNA/ESA guidance is generally understood
4 943 53 952 45 to recommend the first of these approaches. Under this
5 1000 57 1000 48 treatment, the future flow of interest is determined at the
point of issue – ie it is not affected by any subsequent
From this example, it will be seen that the interpretation changes in market conditions. Supporters of the
of the interest accruing on tradable debt securities may approach argue that it best represents the cost of capital
change subsequent to a change in market interest rates. associated with the security and that this cost remains the
This occurs not through any change in the terms and most relevant flow for financial analysis, even though it
conditions of the security, but because the revaluation of may not be recognised by a purchaser in the secondary
the security associated with the change in market interest market, who may be unaware of the original issue price.
rates is perceived differently by the two parties: the issuer This treatment is widely referred to as the “debtor
views the revaluation as a purely temporary disturbance approach” because it records the accrual of interest from
which must be reversed over the remaining life of the the perspective of the issuer.
security; while the new acquirer accepts the revaluation
Many National Accountants and Government Finance
statisticians favour the “debtor approach” on practical
1
The position in which the accrual of interest is recorded within the data collection grounds. The quality and availability of
balance sheet is of analytical interest but it is not the main point at issue data from issuers of securities has tended to be higher
in the present methodological debate.
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Monetary & Financial Statistics: June 2000
than from holders so that practical considerations have The perceived advantages of the “creditor approach” are
commonly made it acceptable to impose the data essentially the reverse of those features for which the
provided by issuers. “debtor approach” was criticised: it is fully consistent
with the market value framework of the System of
The arguments ranged against the “debtor approach” National Accounts; and it satisfies the wider SNA
typically focus on the conceptual rather than the definition of interest. The equivalent flows for the last
practical. A key concern is that, while the accounting example are set out for comparison below.
requirement for symmetry is met (by constraining the
flows of the holder), the historic cost flows fail to Table 3
reconcile the changes in the market value of the security
subsequent to a change in market conditions. This is Year Opening Interest Coupon Re- Closing
best illustrated through a further example. value Accrual payment valuation Value
£ £ £ £ £
Consider a five year bond with a face value of £1000 and 1 1000 50 -50 - 1000
2 1000 50 -50 - 1000
paying an annual coupon of £50. The bond is issued at 3 1000 50 -50 -36 964
£1000 and so delivers a yield of 5% with the issuer 4 964 67 -50 - 981
recording an annual accruing interest liability of £50 5 981 69 -50 - 1000
which is exactly extinguished at the year end by the
annual coupon. At the end of the third year, market The major criticism of the “creditor approach” is that it is
conditions change and the value of the bond drops to difficult to measure. Market conditions change
£964 ie a yield to maturity of 7%. During the fourth continuously so that, in principle, the “creditor approach”
year of the bond, the accounts will continue to record an requires the use of high frequency data on security values
annual interest accrual of £50 but the bond has now to generate the appropriate flows. This criticism may
appreciated in value to £981. In the final year the bond overstate the difficulties to an extent, since it will
returns to its face value of £1000 immediately prior to normally be possible to estimate the flows based on an
being redeemed. The reconciliation between opening outstanding balance sheet value and an estimate of the
and closing balance sheet positions is set out in the table. average market interest rate over the period. Such
techniques are either used or proposed by the principal
Table 2 supporters of the method.
Year Opening Interest Coupon Re- Closing The Issues
value accrual payment valuation value
£ £ £ £ £
1 1000 50 -50 - 1000
Choosing between these two different approaches raises
2 1000 50 -50 - 1000 some fundamental questions for official statisticians.
3 1000 50 -50 -36 964 Firstly, should the international statistical standards be
4 964 50 -50 17 981 based upon questions of conceptual adherence to the
5 981 50 -50 19 1000 wider system of the economic accounts or guided more
by practical questions of data collection and
The main point to note here is that, following the “debtor measurement? Secondly, where specific user needs in a
approach”, requires the addition of revaluation particular area of statistics conflict with a standard agreed
adjustments in each period after the initial change in in the wider context of the System of National Accounts,
market conditions in order to reconcile movements how should statisticians respond; and, in the specific
between the opening and closing balance sheet positions. context of the current debate, are there perspectives on
Put another way, the receipt of the annual coupon is not these alternative treatments which users can offer which
sufficient to prevent the value of the outstanding steer towards a particular approach either because of the
principal from increasing. Critics of the “debtor specific use to be made of interest flow data or because
approach” argue that only the first revaluation adjustment of the impact of these alternatives on wider statistical
– a fall of 36 in year three – is analytically meaningful, aggregates such as the bop Current Account or the
being linked to a change in market conditions; and that, General Government Surplus/Deficit?
in the fourth and fifth years, the recorded accrual of
interest is inconsistent with the wider SNA definition, The boundary between income flows and capital
which classifies as interest those funds which can be gains/losses is a particularly sensitive one for the System
withdrawn from the security without reducing the of National Accounts because of the system’s
outstanding principal. presumption that capital gains and losses are wealth re-
distributing rather than wealth creating events.
The main alternative to the “debtor approach” is to Nevertheless, this distinction is under challenge in a
recalculate the accruing interest flows for both number of areas.
counterparties following each change in market
conditions. This method, widely referred to as the A more comprehensive account of the conceptual and
“creditor approach”, has thus far received less practical arguments in the present methodological debate
widespread support but is being promoted by European may be found on the IMF’s Website at
Balance of Payments statisticians and has been www.imf.org/external/np/sta/na/interest/index.htm. The
implemented in all macro-economic statistics in views of users on the specific issues raised here are
Australia. invited either to the present author or direct to the IMF
through the Website.
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