Accounting for bonds and funds

Investing in government and corporate bonds is rising up the local authority treasury management agenda again, but I’ve recently heard several people cite “difficult accounting” as a drawback.  I know that being an accountant myself I might think it’s easier than others do, but I’d like to show you that the rules are not at all difficult and shouldn’t be a barrier to local authorities investing in this asset class.

After all, with five year gilts paying 1.50% but base rate likely to be 0.50% for most of that time, if not all, they appear to offer rather good value for a credit risk free investment.  For minimal extra risk over the same five year period you can get 2.00% from the European Investment Bank.  Authorities without the financial or human resources to hold and manage bonds directly can still gain the benefits of this asset class by using pooled bond funds.

Local authorities are required to prepare theirs accounts using International Financial Reporting Standards, as adapted by the CIPFA/LASAAC Code of Practice on Local Authority Accounting in the UK.  The investment accounting rules in the 2013/14 edition of the Code are based on International Accounting Standard 39, which classes bonds and pooled funds as “available for sale” (AFS) financial assets.  The significance of this classification is that while most of the gains and losses are taken to the income & expenditure (I&E) account, gains and losses arising from fluctuations in market value are shown in the AFS reserve instead.

Let’s take a real example and see how it works.  You can buy £1,000,000 of the five year UK government bond, the 2018 1.25% gilt, for just £988,000 today.  Assuming your purchase costs are negligible, you would show this as a £988,000 investment just like a fixed term deposit of the same amount.  Interest is credited to the I&E account at the bond’s effective interest rate (EIR) of 1.51% – this rate takes account of both the £12,500 annual interest and the £12,000 capital gain that you are going to receive in 2018.  You can calculate this EIR very accurately and very easily in a spreadsheet using the “rate” function, but you can do it roughly in your head too.  The £12,000 capital gain spread over 5 years is £2,400 a year; adding that to the £12,500 annual interest gives £14,900 a year of income; dividing that by the initial investment of £988,000 gives 1.51%.  If you go to enough significant digits there’s a slight difference in the two answers due to the effects of compound interest, but at these interest rates it’s quite immaterial.

So if the investment income is £14,900 a year, then by 31^st March 2014 you will have earned roughly half of this sum, £7,450, but in cash terms you will only have received £6,250 (being half of £1 million x 1.25% – as gilts pay interest every six months).  So at year end, just like for other investments, you will need to accrue the income you haven’t received in cash yet, £1,200, crediting I&E and debiting (increasing) the investment on the balance sheet to £989,200.

However, it’s likely that market interest rate expectations and investor appetite for gilts will be a bit different at the end of March than they are today.  So for example, the market price of your bond might have fallen to £98.62 per £100 face value, leaving you with a £3,000 unrealised loss.  The key point here is that this is a paper loss and not a revenue cost; you will reflect this by debiting the AFS reserve and crediting the investment balance, taking it to £986,200.  In fact, the £3,000 will never hit the revenue account, because you are guaranteed to receive the £12,500 annual interest and the £1,000,000 principal back on maturity, irrespective of how the market value changes in the meantime.

Accounting for pooled bond funds is even easier.  Funds are also AFS, but they do not have an EIR and so your investment income is simply equal to the amount distributed to you by the fund.  The only accrual you would need to make is if a dividend is declared before 31^st March but paid to you afterwards.  Any changes in the price of the fund’s units representing capital gains or losses are taken to the AFS reserve as they are with bonds held directly.

This can cause a problem if you have an accumulating share class where all the income is rolled-up in the fund, so you never receive any dividends.  This means you would never account for any investment income until you sold your units.  IAS 39 allows investors to get round this by designating these as “fair value through profit and loss” (FVTPL).  However, the CIPFA/LASAAC Code does not permit local authorities to take advantage of this entirely sensible option, leaving them either ignoring the Code or withdrawing all their investments every year end.

Now, IAS 39 is due to be withdrawn and replaced with IFRS 9 soon, with adoption of the new standard currently scheduled for 2015/16, having already been put back two years.  Some aspects of IFRS 9 are still out for consultation though, so it is possible that implementation will be delayed again.  The main change proposed in the accounting for bonds is a simplification – if bonds are expected to be held to maturity then they will not be measured at market value, and so you will no longer show unrealised gains and losses in the AFS reserve.  Fair values will still need to be calculated and disclosed in the notes to the accounts, but just like fixed term deposits and long-term borrowing, they will not affect the I&E account or the balance sheet.

The proposed accounting for pooled funds in IFRS 9 is the opposite of IAS 39 – the default position is that they will be FVTPL, with all gains and losses going straight to I&E, but with an option to irrevocably designate them as “fair value through other comprehensive income”, which is effectively the same as the AFS category.  We will be lobbying CIPFA/LASAAC to allow local authorities to make use of this designation when the time comes.  It would be rather odd if a new accounting standard that allows you to account the same way as before is used by CIPFA to enforce a change that adds volatility to the revenue account.

So hopefully you’ll agree with me that bond accounting isn’t too difficult, even if there is a bit more involved than accounting for fixed term deposits.  I certainly wouldn’t want the need for a simple spreadsheet calculation and the posting of one or two extra journals a year to stop you making sound treasury management decisions.

David Green is Client Director at Arlingclose Limited. This is the writer’s personal opinion and does not constitute investment advice.