principles of investment accounting - ohio apt of duties principles of investment accounting -...

Principles of Investment Accounting

Presented By

United American Capital Corporation

Ohio APT 41st Annual Conference - October 2014

Investment Accounting System

๏ Ensures full disclosure and accountability.

๏ Accurately describes all investments.

๏ Investment Reports are public records and promote “clean” audits.

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Principles of Investment Accounting - Presented by United American Capital Corporation

Separation of Duties


Investing Authority

Maintains official investment records

Balances with custodian and Investment Manager

State Auditor examines internal records

Registered Investment Advisor

Submits monthly/quarterly reports to Public Entity

Sends transaction advices to Public Entity

Custodian Bank

Issues monthly custody statements

Pays for purchases/delivers sold bonds on settlement date DVP

Brokers/Dealers

Sends trade confirmations to Public Entity and Investment Manager

Affirms trades with custodian

Delivers/Receives bonds vs. Payment (DVP)

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Investment Reports

๏ Portfolio Inventory

๏ Transaction Activity • Purchases

• Sales

• Maturities

• Called Bonds

๏ Investment Income • Interest Received

• Realized Capital Gains/Losses

Principles of Investment Accounting - Presented by United American Capital Corporation 4

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Components of the Inventory

๏ CUSIP: Letter and number combinations assigned to identify publicly traded securities. Each number is unique to the issue.

๏ Issuer: Entity issuing the bonds.

• Fannie Mae (FNMA), Freddie Mac (FHLMC), Federal Home Loan Bank (FHLB), Federal Farm Credit Bank (FFCB), and Farmer Mac (FAMCA), U.S. Treasury (UST), Municipalities, Corporations

๏ Investment Type: Callable bonds (fixed rate and step-ups), Non callable bonds (or bullets), Discount notes



๏ Par Value: The value of a bond at maturity; its future value.

๏ Market Value: The liquidation value of each security as of a specific date; may be greater (or less) than your purchase cost due to changing interest rates.

๏ Book Value (Cost): The amount disbursed to purchase a security, including any accrued interest due to the seller on the settlement date.



๏ Settlement Date: The date in which the securities are delivered versus payment. The legislation requires "delivery vs. payment" (DVP) and the use of a qualified safekeeping agent.

๏ Maturity Date: The future date in which the par amount is paid to the investor. The par value will be paid at maturity, regardless of original purchase cost.



๏ Coupon (or Rate): The annual percentage amount paid to an investor, based upon the par value of the bond; the rate may be fixed or variable.

๏ Yield to Maturity: The rate of return anticipated on a bond if it is held to maturity. • If coupon < YTM, the bond was purchased at a

discount.

• If coupon > YTM, the bond was purchased at a premium.

• If coupon = YTM, the bond was purchased at par (100).


Portfolio Inventory Example


CUSIP Investment # Issuer Par Value Stated Rate

Maturity Date Purchase Date Days to Maturity

YTM Market Value Accrued Interest

Principal Book Value

Agency (NC)

31398A3G5 11-0005 FNMA 450,000.00 1.500 09/08/2014 09/08/2010 160 1.500 452,780.55

450,000.00 450,000.00

3135G0FY4 12-0005 FNMA 500,000.00 0.750 12/19/2014 11/23/2011 262 0.778 502,228.00 Received 499,575.00 499,575.00

3133EAHP6 12-0010 FFCB 250,000.00 0.520 03/16/2015 03/16/2012 349 0.540 250,868.50 249,850.00 249,850.00

3133EANJ3 12-0011 FFCB 250,000.00 0.500 05/01/2015 05/01/2012 395 0.554 250,829.25 249,600.00 249,600.00

3134G4RA8 14-0001 FHLMC 500,000.00 0.350 03/30/2016 12/20/2013 729 0.440 499,024.00 498,980.00 498,980.00

3130A0C65 14-0002 FHLB 650,000.00 0.625 12/28/2016 12/26/2013 1 0.756 646,489.35 Received 647,471.50 647,471.50

3135G0RT2 14-0005 FNMA 500,000.00 0.875 12/20/2017 03/07/2014 1 1.121 491,624.50 935.76 495,450.00 496,385.76

Agency (Call)

3136G1F87 13-0006 FNMA 500,000.00 0.500 03/04/2016 03/04/2013 703 0.503 500,192.50 499,950.00 499,950.00

3134G46W3 14-0004 FHLMC 500,000.00 0.570 06/20/2016 01/28/2014 811 0.587 499,241.00 300.83 499,800.00 500,100.83

3136G1YS2 14-0003 FNMA 500,000.00 0.850 12/30/2016 12/30/2013 1 0.850 499,727.00 500,000.00 500,000.00

Treasury

912828TQ3 13-0002 USNOTE 250,000.00 0.250 09/30/2014 10/17/2012 182 0.266 250,205.00 Received 249,921.88 249,921.88

Totals

4,850,000.00 4,843,209.65

1,236.59 4,840,598.38 4,841,834.97

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The Concept of Asset Conversion

๏ An investment transaction is a conversion process.

• Cash and investments are both assets of your public entity.

• Adjustments are made between cash and investments when bond purchases, sales, maturities, and calls take place.


CASH INVESTMENT

INVESTMENT CASH

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The Concept of Asset Conversion

๏ The total asset value of the public entity increases when the investment pays interest (or when capital gains are realized).


Cash Increases Income is credited.

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Cash Basis Portfolio Accounting

๏ Purchase cost is reduced by the amount of purchased accrued interest at the next interest payment date.

• The buyer will receive the entire coupon payment at the next interest payment date.

Book Value = Principal + Accrued Interest

(Principal Cost= Par Value * Purchase Price)

• After the next interest payment is received, the accrued interest is amortized from the book value and the book value will equal the principal cost.


Cash Basis Portfolio Accounting

๏ Purchase cost remains level to the maturity or sale date.

๏ Premiums are not amortized; discounts are not accreted.

๏ Income is reported when received (realized).

๏ Realized income is shown as proceeds minus cost.


Net Effect Between “Total Cash” & “Total Investments”

๏ A bond with an original issue date of 5/12/13, purchased in the secondary market for a settlement date of 4/11/14, at a price of 99.56 with a coupon of 0.55% and maturing on 11/21/2016, will affect the total cash account as follows:

995,600.00 $1,000,000 par minus a discount of $4,400 (which will be a realized gain at maturity).

+ 2,138.89 Accrued interest paid at purchase = Initial Purchase Cost

= 997,738.89 Reduction in total cash offset by an increase in total investments



๏ At the following interest payment date (05/21/2014), cash and investments are affected as follows:

Gross interest payment received minus accrued interest paid at purchase = net interest income (the “pay-in” amount):

$ 2,750.00 Interest received (credited by the custodian bank)

- 2,138.89 Accrued interest paid at settlement date (4/11/2014)

$ 611.11 Net interest income (Increase in cash offset by a decrease in investment cost)



๏ Another method is to increase cash by the full amount of the next interest payment received, previously offset by a negative addition to income at the original settlement date.

๏ In the example shown, the amount of accrued interest paid at purchase, $2,138.89, is treated as a negative to total cash on the purchase date.



๏ A straight interest payment (after the amortization has taken place) is paid-in totally, as an increase in the cash account.

• This amount is recognized even if the amount of interest paid has been totally credited to the money market sweep account within the custody account.

• From an accounting perspective, cash is debited and interest income is credited.


Accrual Portfolio Accounting

๏ Purchase cost is adjusted daily (“adjusted book value”).

๏ Premiums are amortized over the life of the security.

๏ Discounts accrete over the life of the security.

๏ Interest accrues daily.

๏ Capital gains/losses are based upon adjusted book value.


Reconciliation Process

๏ Components of the Reconciliation Process:

• Internal Records (the official books subject to audit)

• Custodian Bank – safekeeping of investment assets, purchase cost, income, trade activity

• Investment Advisor (if used) – inventory of assets and individual purchase cost, income, list of transactions

• Additional Records – broker/dealer trade confirms



๏ A “pay-in” is made by the Public Entity evidencing a receipt of funds.

๏ A pay-in will occur when interest is received and/or capital gains are realized.

๏ It is recommended that a pay-in occurs when a receipt of funds occurs (credited) at the custodian bank. • Periodic pay-ins during the month are acceptable

provided that such transactions are reconciled prior to the pay-in to ensure that the Public Entity’s records balance with the custodian.



๏ On cash basis accounting, a negative pay-in may occur at maturity if the purchase premium of a bond exceeds the final interest payment amount.

๏ Additionally, in the case of callable securities where a premium has been paid, a lower yield will be realized if the bond is called prior to maturity.


Common Reconciliation Errors


Using market value rather than book value (c0st)

Failing to account for purchased accrued interest

Not recognizing a discount at maturity

Not amortizing a premium paid

Not maintaining supporting documentation

Not recognizing income when received

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Questions


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