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1993 SNA Update Information - The definition of interest

Clarification description
The ISWGNA with the approval of the Statistical Commission has decided that the accrual accounting of interest is based on the debtor approach. According to this method, the amount and time path of interest accrual are determined at the time the debt securities are created. The AEG has decided not to reopen the question of the accrual of interest on debt securities. The current definition of interest, however, is not necessarily consistent with that decision. Therefore the definition of interest needs to be clarified. Interest is defined now as the amount that “under the terms of the financial instrument agreed between them…the debtor becomes liable to pay to the creditor over a given period of time without reducing the amount of principal outstanding.” [paragraph 7.93] The principal outstanding of a traded security is its current market value. [paragraph 10.14] Thus, interest cannot be determined at the inception of the instrument because it depends on a value of the principal outstanding that can be known only in the future. It would be better to define nominal value as the value of a debt security that would prevail if the current market interest rate were the same as it was at the inception of the security, and then define interest in terms of nominal value. Any definition must, however, take account of the fact that interest accrued on some debt securities, such as index-linked securities, cannot be determined at their inception. In addition to revising the definition of interest, the following applications of that definition need clarifying:
(a) Changes in the Market Value of a Traded Debt Security When the Current Market Interest Rate Differs from the Rate at the Inception of the Security
The market value of traded debt securities is equal to the sum of discounted future payments by the debtor, with the discount rate equal to the current market interest rate applicable to the security. It is well established that a change in the value of a security resulting from a change in the market interest rate is a price change and treated as a revaluation. Once such a change in price and value has occurred and the current market interest rate no longer equals the rate at the inception of the security, and if there are no further changes in interest rates and no changes in the volume resulting from transactions or other economic flows, then the market value of the security will change gradually in the opposite direction until the security reaches its maturity date. Although the original change in the value of a security resulted from a price change, the succeeding changes in value do not result from a price change. This type of change in value is not covered by the current SNA descriptions of transactions, non-transaction changes in the volume of assets, or revaluations. The treatment of this type of value change needs to be decided and the text needs to be revised to state and justify the decision.
(b) The Time Path of Interest Accrual
Even if the total amount of interest to be accrued over the life of a security can be determined at the inception of the security, the time path of interest accrual may not be determinable. A zero-coupon bond with a maturity greater than one year is an example. The most common assumption is that the average annual interest rate over the entire maturity expected at the inception of the security is constant in each accounting period. Markets, however, often provide evidence that the interest rate is expected to change during the life of the security. The text of the SNA could usefully acknowledge that the time path of interest accrual often must be determined by assumption and that a constant interest rate is the best assumption unless there is strong evidence to the contrary. Paragraph 7.103 describes the calculation of interest on deep-discounted bonds. That description does not produce a constant interest rate. It should be revised to state that the initial discount should be amortized in a manner that produces a constant interest rate.
(c) The Use of “Interest Payments” and “Principal Repayments.”
Interest is a continuous flow. Between payments by a debtor, interest accrues continuously and increases the total liability of the debtor. One can speak of the amount of interest accrued during an accounting period, but not of an interest payment. Any monetary payment by a debtor to a creditor must be a repayment of principal. It may be useful analytically to describe the principal repaid either as part of the original amount borrowed or as the interest that has accrued, but both types of payment are a repayment of principal. The text of the SNA should be revised to clarify this concept. It may be useful then to describe the term “interest payment” as a convenient shorthand reference to a particular type of principal repayment. The term “coupon payment” is undefined but used as one type of “interest payment.” The current text of the SNA suggests that coupon payments should always be treated as payments of accrued interest, which is not necessarily true. Coupon payment should be defined clearly. One possibility is that they refer only to financial instruments for which a series of periodic payments are required of the debtor. If the security was not issued at a premium or a discount, then each coupon payment is equal to the amount of interest accrued since the previous payment.
(d) Valuation of an interest-bearing asset/liability
In various places of the SNA, the terms face value, par value, redemption value, redemption price, and nominal value are used to describe an aspect of an interest-bearing asset/liability. None of these terms are adequately defined, but they all appear to be used as interchangeable references to the value of a security on its maturity date. If they are interchangeable, then one should be selected for consistent use and the others should be noted as equivalent terms sometimes used by economists. If they are not interchangeable, then each term and the differences between them should be defined clearly. In either case, nominal value should not refer to the maturity value. It should be the value of a security when the discount rate is the current market interest rate at the inception of the security. Redemption price should not be used as a reference to a value.
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