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Capital-Markets Activities Manual
Source: Federal Reserve System
(The complete Activities
Manual (pdf format) can be downloaded from the Federal Reserve's web
The securities and financial contracts that
make up an institution's trading portfolio are generally marked to market,
and gains or losses on the positions are recognized in the current period's
income. A single class of financial instrument that can meet trading,
investment, or hedging objectives may have a different accounting treatment
applied to it depending on management's purpose for holding it. Therefore,
an examiner reviewing trading activities should be familiar with the different
accounting methods to ensure that the particular accounting treatment
being used is appropriate for the purpose of holding a financial instrument
and the economic substance of the related transaction.
The accounting principles that apply to securities portfolios, including
trading accounts and derivative instruments are complex; their authoritative
standards and related banking practices have evolved over time. This section
summarizes the major aspects of the accounting principles for trading
and derivative activities for both financial and regulatory reporting
purposes. Accordingly, this section does not set forth new accounting
policies or list or explain the detailed line items of financial reports
that must be reported for securities portfolios or derivative instruments
in financial reports. Examiners should consult the sources of generally
accepted accounting principles (GAAP) and regulatory reporting requirements
that are referred to in this section for more detailed guidance.
Examiners should be aware that accounting practices in foreign countries
may differ from those followed in the United States. Nevertheless, foreign
institutions are required to submit regulatory reports prepared in accordance
with regulatory reporting instructions for U.S. banking agencies, which
are generally consistent with GAAP. This section will focus on reporting
requirements of the United States.
The major topics covered in this section are listed below. The discussion
of specific types of balance-sheet instruments (such as securities) and
derivative instruments (for example, swaps, futures, forwards, and options)
is interwoven with these discussions.
• sources of GAAP accounting standards and regulatory reporting
• the broad framework for accounting for securities portfolios,
including the general framework for trading activities
• general framework for derivative instruments, including hedges
• specific accounting principles for derivative instruments, including
domestic futures; foreign-currency instruments; forward contracts (domestic),
including forward rate agreements; interest-rate swaps; and options
The Federal Reserve has long viewed
accounting standards as a necessary step to efficient market discipline
and bank supervision. Accounting standards provide the foundation for
credible and comparable financial statements and other financial reports.
Accurate information, reported in a timely manner, provides a basis for
the decisions of market participants. The effectiveness of market discipline,
to a very considerable degree, rests on the quality and timeliness of
reported financial information.
Financial statements and regulatory financial reports perform a critical
role for depository institution supervisors. Supervisory agencies have
monitoring systems in place which enable them to follow, off-site, the
financial developments at depository institutions. When reported financial
information indicates that an institution's financial condition has deteriorated,
these systems can signal the need for on-site examinations and any other
appropriate actions. In short, the better the quality of reported financial
information from institutions, the greater the ability of agencies to
monitor and supervise effectively.
Accounting Principles for Financial Reporting
Financial statements provide information needed to evaluate an institution's
financial condition and performance. GAAP must be followed for financial-reporting
purposes-that is, for annual and quarterly published financial statements.
The standards in GAAP for trading activities and derivative instruments
are based on pronouncements issued by the Financial Accounting Standards
Board (FASB); the American Institute of Certified Public Accountants (AICPA);
and, for publicly traded companies, the Securities and Exchange Commission
(SEC). GAAP pronouncements usually take the forms described in table 1.
The SEC requires publicly traded banking organizations and other public
companies to follow GAAP in preparing their form 10-Ks, annual reports,
and other SEC financial reports. These public companies must also follow
special reporting requirements mandated by the SEC, such as the guidance
listed above, when preparing their financial reports.
Accounting Principles for Regulatory Reporting
Currently, state member banks are subject to two main regulatory requirements
to file financial statements with the Federal Reserve. One requirement
involves financial statements and other reports that are filed with the
Board by state member banks that are subject to the reporting requirements
of the SEC.1 The other requirement
involves the regulatory financial statements for state member banks, other
federally insured commercial banks, and federally insured savings banks-the
Reports of Condition and Income, commonly referred to as call reports.
The call reports, the form and content of which are developed by the Federal
Financial Institutions Examination Council (FFIEC), are currently required
to be filed in a manner generally consistent with GAAP.2
For purposes of preparing the call reports, the
guidance in the instructions (including related glossary items) to the
Reports of Condition and Income should be followed. U.S. banking agencies
require foreign banking organizations operating in the United States to
file regulatory financial reports prepared in accordance with relevant
regulatory reporting instructions.
Various Y-series reports submitted to the Federal Reserve by bank holding
companies have long been prepared in accordance with GAAP. Section 112
of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA)
mandates that state member banks with total consolidated assets of $500
million or more have to submit to the Federal Reserve annual reports containing
audited financial statements prepared in accordance with GAAP. Alternatively,
the financial-statement requirement can be satisfied by filing consolidated
financial statements of the bank holding company. Thus, the summary of
GAAP that follows will be relevant for purposes of (1) financial statements
of state member banks and bank holding companies, (2) call reports of
banks, (3) Y-series reports of bank holding companies, and (4) the section
112 annual reports of state member banks and bank holding companies.
1. Generally, pursuant to section 12(b) or 12(g) of the
Securities Exchange Act of 1934, state member banks whose securities are
subject to registration are required to file with the Federal Reserve
Board annual reports, quarterly financial statements, and other financial
reports that conform with SEC reporting requirements.
2. The importance of accounting standards for regulatory reports is recognized
by section 121 of the Federal Deposit Insurance Corporation Act of 1991.
Section 121 requires that accounting principles applicable to regulatory
financial reports filed by federally insured banks and thrifts with their
federal banking agency must be consistent with generally accepted accounting
principles (GAAP). However, under section 121, a federal banking agency
may require institutions to use accounting principles ''no less stringent
than GAAP'' when the agency determines that GAAP does not meet supervisory
ACCOUNTING FOR SECURITIES PORTFOLIOS
Treatment Under FASB Statement
Statement of Financial Accounting Standards (SFAS) No. 115, ''Accounting
for Certain Investments in Debt and Equity Securities,'' as amended by
SFAS 140, ''Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities,'' is the authoritative guidance for
accounting for equity securities that have readily determinable fair values
and for all debt securities.3
(SFAS 140 replaces SFAS 125, which had the same
title.) Investments subject to SFAS 115 are to be classified in three
categories and accounted for as follows:
• Held-to-maturity account. Debt securities that the institution
has the positive intent and ability to hold to maturity are classified
as held-to-maturity securities and reported at amortized cost. SFAS 140
amended SFAS 115 to require that securities that can contractually be
prepaid or otherwise settled in such a way that the holder of the security
would not recover substantially all of its recorded investment must be
recorded as either available-forsale or trading. Reclassifications of
held-tomaturity securities as a result of the initial application of SFAS
140 would not call into question an entity's intent to hold other securities
to maturity in the future.
• Trading account. Debt and equity securities that are bought and
held principally for the purpose of selling them in the near term are
classified as trading securities and reported at fair value, with unrealized
gains and losses included in earnings. Trading generally reflects active
and frequent buying and selling, and trading securities are generally
used with the objective of generating profits on short-term differences
• Available-for-sale account. Debt and equity securities not classified
as either held-tomaturity securities or trading securities are classified
as available-for-sale securities and reported at fair value, with unrealized
gains and losses excluded from earnings and reported as a net amount in
a separate component of shareholders' equity.
Under SFAS 115, mortgage-backed securities that are held for sale in conjunction
with mortgage banking activities should be reported at fair value in the
trading account. SFAS 115 does not apply to loans, including mortgage
loans, that have not been securitized.
Upon the acquisition of a debt or equity security, an institution must
place the security into one of the above three categories. At each reporting
date, the institution must reassess whether the balance-sheet classification
4 continues to be appropriate.
Proper classification of securities is a key examination issue. As stated
above, instruments that are intended to be held principally for the purpose
of selling them in the near term should be classified as trading assets.
Reporting securities held for trading purposes as available-for sale or
held-to-maturity would result in the improper deferral of unrealized gains
and losses from earnings and regulatory capital. Accordingly, examiners
should scrutinize institutions that exhibit a pattern or practice of selling
securities from the available-for-sale or held-to-maturity accounts after
a short-term holding period, particularly if significant amounts of losses
on securities in these accounts have not been recognized.
SFAS 115 recognizes that certain changes in circumstances may cause the
institution to change its intent to hold a certain security to maturity
without calling into question its intent to hold other debt securities
to maturity in the future. Thus, the sale or transfer of a held-to-maturity
security due to one of the following changes in circumstances will not
be viewed as inconsistent with its original balance-sheet classification:
• evidence of a significant deterioration in the issuer's creditworthiness
• a change in tax law that eliminates or reduces the tax-exempt
status of interest on the debt security (but not a change in tax law that
revises the marginal tax rates applicable to interest income)
• a major business combination or major disposition (such as the
sale of a segment) that necessitates the sale or transfer of held-to-maturity
securities to maintain the institution's existing interest-rate risk position
or credit-risk policy
• a change in statutory or regulatory requirements significantly
modifying either what constitutes a permissible investment or the maximum
level of investments in certain kinds of securities, thereby causing an
institution to dispose of a held-to-maturity security
• a significant increase by the regulator in the industry's capital
requirements that causes the institution to downsize by selling held-to-maturity
• a significant increase in the risk weights of debt securities
used for regulatory risk-based capital purposes.
Furthermore, SFAS 115 recognizes other events that are isolated, nonrecurring,
and unusual for the reporting institution and that could not have been
reasonably anticipated may cause the institution to sell or transfer a
held-to-maturity security without necessarily calling into question its
intent to hold other debt securities to maturity. EITF 96-10, as amended
by SFAS 140, provides that transactions that are not accounted for as
sales under SFAS 140 would not contradict the entity's intent to hold
that security, or any other securities, to maturity. (See paragraph nine
of SFAS 140 for additional guidance on criteria which would require such
transactions to be accounted for as sales.) However, all sales and transfers
of held-to-maturity securities must be disclosed in the footnotes to the
An institution must not classify a debt security as held-to-maturity if
the institution intends to hold the security for only an indefinite period.5
Consequently, a debt security should
not, for example, be classified as held-to-maturity if the banking organization
or other company anticipates that the security would be available to be
sold in response to-
• changes in market interest rates and related changes in the security's
• needs for liquidity (for example, due to the withdrawal of deposits,
increased demand for loans, surrender of insurance policies, or payment
of insurance claims),
• changes in the availability of and the yield on alternative investments,
• changes in funding sources and terms, and
• changes in foreign-currency risk.
According to SFAS 115, an institution's asset-liability management may
consider the maturity and re-pricing characteristics of all investments
in debt securities, including those held to maturity or available for
sale, without tainting or casting doubt on the standard's criterion that
there be a ''positive intent to hold until maturity.'' However, to demonstrate
its ongoing intent and ability to hold the securities to maturity, management
should designate the held-to-maturity securities as not available for
sale for purposes of the ongoing adjustments that are a necessary part
of its asset-liability management. Further, liquidity can be derived from
the held-to-maturity category by the use of repurchase agreements that
are classified as financings, but not sales.
Transfers of a security between investment categories should be accounted
for at fair value. SFAS 115 requires that, at the date of transfer, the
security's unrealized holding gain or loss must be accounted for as follows:
• For a security transferred from the trading category, the unrealized
holding gain or loss at the date of transfer will already have been recognized
in earnings and should not be reversed.
• For a security transferred into the trading category, the unrealized
holding gain or loss at the date of transfer should be recognized in earnings
• For a debt security transferred into the available-for-sale category
from the held-to-maturity category, the unrealized holding gain or loss
at the date of transfer should be recognized in a separate component of
• For a debt security transferred into the held-to-maturity category
from the available-for-sale category, the unrealized holding gain or loss
at the date of transfer should continue to be reported in a separate component
of shareholders' equity, but should be amortized over the remaining life
of the security as an adjustment of its yield in a manner consistent with
the amortization of any premium or discount.
Transfers from the held-to-maturity category should be rare, except for
transfers due to the changes in circumstances that were discussed above.
According to the standard, transfers into or from the trading category
should also be rare.
SFAS 115 requires that institutions determine whether a decline in fair
value below the amortized cost for individual securities in the available-for-sale
or held-to-maturity accounts is ''other than temporary'' (that is, whether
this decline results from permanent impairment). For example, if it is
probable that the investor will be unable to collect all amounts due according
to the contractual terms of a debt security that was not impaired at acquisition,
an other-than-temporary impairment should be considered to have occurred.
If the decline in fair value is judged to be other than temporary, the
cost basis of the individual security should be written down to its fair
value, and the write-down should be accounted in earnings as a realized
loss. This new cost basis should not be written up if there are any subsequent
recoveries in fair value.
3. SFAS 115 does not apply to investments in equity securities
accounted for under the equity method nor to investments in consolidated
subsidiaries. This statement does not apply to institutions whose specialized
accounting practices include accounting for substantially all investments
in debt and equity securities at market value or fair value, with changes
in value recognized in earnings (income) or in the change in net assets.
Examples of those institutions are brokers and dealers in securities,
defined benefit pension plans, and investment companies. SFAS 115 states
that the fair value of an equity security is readily determinable if sales
prices or bid-and-asked quotations are currently available on a securities
exchange registered with the SEC or in the over-the-counter market, provided
that those prices or quotations for the over-the-counter market are publicly
reported by the National Association of Securities Dealers' automated
quotation systems or by the National Quotation Bureau. Restricted stock
does not meet that definition. The fair value of an equity security traded
only in a foreign market is readily determinable if that foreign market
is of a breadth and scope comparable to one of the U.S. markets referred
to above. The fair value of an investment in a mutual fund is readily
determinable if the fair value per share (unit) is determined and published
and is the basis for current transactions.
4. In this context, ''classification'' refers to the security's balance-sheet
category, not the credit quality of the asset.
5. In summary, under SFAS 115, sales of debt securities that meet either
of the following two conditions may be considered as ''maturities'' for
purposes of the balance-sheet classification of securities: (1) The sale
of a security occurs near enough to its maturity date (or call date if
exercise of the call is probable)-for example, within three months-that
interest-rate risk has been substantially eliminated as a pricing factor.
(2) The sale of a security occurs after the institution has already collected
at least 85 percent of the principal outstanding at acquisition from either
prepayments or scheduled payments on a debt security payable in equal
instalments over its term (variable-rate securities do not need to have
Other Sources of Regulatory Reporting Guidance
As mentioned above, SFAS 115 has been adopted for regulatory reporting
purposes. Call report instructions are another source of guidance, particularly,
the glossary entries on-
• coupon stripping, Treasury receipts, and STRIPS,
• foreign debt exchange transactions,
• market value of securities,
• non-accrual status,
• premiums and discounts,
• short positions,
• transfers of financial assets,
• trading accounts,
• trade-date and settlement-date accounting,6
• when-issued securities transactions.
6. As described in this glossary entry, for call report
purposes, the preferred method for reporting securities transactions is
recognition on the trade date.
Traditional Model Under GAAP
The traditional model was used to account for investment and equity securities
before SFAS 115. However, the traditional model still applies to assets
that are not within the scope of SFAS 115 (for example, equity securities
that do not have readily determinable fair values).
Under the traditional accounting model for securities portfolios and certain
other assets, debt securities are placed into the following three categories
based on the institution's intent and ability to hold them:
• Investment account. Investment assets are carried at amortized
cost. A bank must have the intent and ability to hold these securities
for long-term investment purposes. The market value of the investment
account is fully disclosed in the footnotes to the financial statements.
• Trading account. Trading assets are marked to market. Unrealized
gains and losses are recognized in income. Trading is characterized by
a high volume of purchase and sale activity.
• Held-for-sale account. Assets so classified are carried at the
lower of cost or market value (LOCOM). Unrealized losses on these securities
are recognized in income. This account is characterized by intermittent
sales of securities.
Under GAAP, the traditional model has been generally followed for other
assets as well. Thus, loans that are held for trading purposes would be
marked to market, and loans that are held for sale would be carried at
SFAS 140, superseding SFAS 125, covers
the accounting treatment for the securitization of receivables. The statement
addresses (1) when a transaction qualifies as a sale for accounting purposes
and (2) the treatment of the various financial components (identifiable
assets and liabilities) that are created in the securitization process.
To identify whether a transfer of assets
qualifies as a sale for accounting purposes, SFAS 140 focuses on control
of the assets while taking a ''financial components approach.'' The standard
requires that an entity surrender control to ''derecognize'' the assets,
or take the assets off its balance sheet. Under SFAS 140, control is considered
to be surrendered and, therefore, a transfer is considered a sale if all
of the following conditions are met:
• The transferred assets have been
put beyond the reach of the transferor, even in bankruptcy.
• Either (1) the transferee has the right to pledge or exchange
the transferred assets or (2) the transferee is a qualifying special-purpose
entity, and the holder of beneficial interests in that entity has the
right to pledge or exchange the transferred assets.
• The transferor does not maintain control over the transferred
assets through (1) an agreement that entitles and obligates the transferor
to repurchase or redeem them before their maturity or (2) an agreement
that entitles the transferor to repurchase or redeem transferred assets
that are not readily obtainable.
The financial components approach recognizes
that complex transactions, such as securitizations, often involve the
use of valuation techniques and estimates to determine the value of each
component and any gain or loss on the transaction. SFAS 140 requires that
entities recognize newly created (acquired) assets and liabilities, including
derivatives, at fair value. It also requires all assets sold and the portion
of any assets retained to be valued by allocating the previous carrying
value of the assets based on their relative fair value.
Financial assets that can be prepaid contractually
or that can otherwise be settled in such a way that the holder would not
recover substantially all of its recorded investments should be measured
in the same way as investments in debt securities as either available-for-sale
or trading under SFAS 115. Examples include some interest-only strips,
retained interests in securitizations, loans, other receivables, or other
financial assets. However, financial instruments covered under the scope
of SFAS 133 should follow that guidance.
ACCOUNTING FOR REPURCHASE AGREEMENTS
In addition to securitizations, SFAS 140
determines the accounting for repurchase agreements. A repurchase agreement
is either accounted for as a secured borrowing or as a sale and subsequent
repurchase. The treatment depends on whether the seller has surrendered
control of the securities as described in the ''Securitizations'' subsection.
If control is maintained, the transaction should be accounted for as a
secured borrowing. If control is surrendered, the transaction should be
accounted for as a sale and subsequent repurchase. Control is generally
considered to be maintained if the security being repurchased is identical
to the security being sold.
In a dollar-roll transaction, an institution
agrees to sell a security and repurchase a similar, but not identical,
security. If the security being repurchased is considered to be ''substantially
the same'' as the security sold, the transaction should be reported as
a borrowing. Otherwise, the transaction should be reported as a sale and
subsequent repurchase. The AICPA Audit and Accounting Guide for Banks
and Savings Institutions establishes criteria that must be met for a security
to be considered ''substantially the same,'' including having the same
obligor, maturity, form, and interest rate.
Generally, a bank surrenders control if
the repurchase agreement does not require the repurchase of the same or
substantially the same security. In such cases, the bank accounts for
the transaction as a sale (with gain or loss) and a forward contract to
repurchase the securities. When a repurchase agreement is not a sale (for
example, requires the repurchase of the same or substantially the same
security), the transaction is accounted for as a borrowing. However, repurchase
agreements that extend to the security's maturity date, and repurchase
agreements in which the seller has not obtained sufficient collateral
to cover the replacement cost of the security, should be accounted for
Continue to ACCOUNTING
FOR DERIVATIVE INSTRUMENTS
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