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Trading and Capital-Markets Activities Manual

Trading Activities: Accounting
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

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 requirements 
  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 

ACCOUNTING STANDARDS

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 objectives.

 ACCOUNTING FOR SECURITIES PORTFOLIOS 

Treatment Under FASB Statement No. 115 

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 in price. 
  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 securities 
  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 financial statements. 

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 prepayment risk, 
  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 immediately. 
  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 shareholders' equity. 
  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 equal payments).

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, 
  fails, 
  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 and 
  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 LOCOM. 

SECURITIZATIONS 

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 as sales. 

Continue to ACCOUNTING FOR DERIVATIVE INSTRUMENTS 

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