Distinction between gain and income gain

Satoru Hagino Bank of Japan 2-1-1, Hongoku-cho Nihonbashi, Chuo-ku Tokyo, 103-8660, Japan [email protected]

1. Revision of Flow of Funds Accounts

The Bank of Japan (BOJ) has been compiling Flow of Funds Accounts statistics (FOF) since 1958. In view of recent changes in financial structure, BOJ started a project in 1996 to review FOF and is about to publish the data on revised basis. The project has been also motivated by the revision of System of National Accounts (93SNA) and the compilation of Manual on Monetary and Financial Statistics (MMFS) by IMF. We have tried to adopt as much as possible the recommendations of 93SNA and MMFS.

In the process of the project, we have coordinated with the Economic Planning Agency (EPA) that compiles Japan’s National Accounts. The coordinated work was aimed at realizing consistent revision of FOF and National Accounts. However, the distinction between income gain and capital gain is left unclear. Here, I would like to discuss a few conceptual issues on which we have not reached clear conclusion.

2. Distinction between income gain and capital gain

Concerning the treatment of -related financial derivatives, modification of 93SNA recommendation is under discussion. The point is whether market of interest-related financial derivatives should be recognized on accrual basis and payments should be recorded not as but as realization of holding gains/losses. Proposed treatment means that volume changes of financial should be treated as revaluation if they are caused by the changes in present value of future . Taking account of this point, we must reconsider the treatment of reinvestment of .

Do interests really accrue from discounted bonds? If we recognize changes in market value of discounted bonds as revaluation, they do not bear interests. Since the market value is decided by present value of cash flow at the time of redemption, this treatment seems theoretically appropriate.

93SNA recommend the accumulation method. By this method, we can avoid a practical problem that bonds do not bear interests. However, the distinction between interest and revaluation is blur at any rate because reinvestment of interests can be estimated in various ways. In the case of interest-bearing bonds issued at a discount, it is much more difficult to distinguish reinvestment of interest from changes in market value.

Let us say that a of 100 yen was issued at 95 yen, and its maturity is 5 years. 1 yen is recorded as interest income and reinvestment each period until the redemption if we adopt simple interest method of accumulation method. The difference between changes in market value and estimated amount of reinvested interests is recorded as revaluation. By compound interest method,

1 estimated amount of reinvested interests increase period by period and the amount of revaluation, accordingly, does not equal to that by simple interest method.

100

97. book value on accumulation basis 96 market value 95 record as reconciliation between flow and record as reinvestment of interests

1st 2nd 3rd 4th 5th (period) *UDSK9DOXHRIGLVFRXQWHGERQGV

Accrual of is much more controversial. Reinvested earning was introduced in Balance of Payments Manual (BOPM) 5th edition. Its concept is to regard retaining earnings of a as payments of dividends to equity holders and reinvestment by equity holders to the company. In , however, retained earning can be measured as change in market value of equity. Measuring reinvested earnings and mark-to-market valuation are incompatible with each other.

Let us think of company A. Its equity is held by Company B. Introducing the concept of reinvested earnings, B records retained earning of A as dividends from A and reinvestment to A. This treatment may be appropriate unless the equity of A is traded on the market. If the equity of A is held by many including B and traded on the market, increase of retained earnings in A is appreciated by market participants. The equity of A would gain value. In this situation, B would record the value-up of the equity as holding gains.

How should we record if the situation is as follows? A is domestic company and its equity is traded in the market. B is nonresidents and holds 60% equity of Company A. 40% of the equity of Company A are held by residents. To be consistent with IMF BOP Manual, 60% of retained earnings of Company A is treated as reinvested earnings because they are recognised as cross-border transaction. At the same time, 40% of retained earnings are recorded as stock fluctuation because those earnings inflate the value of Company B and the value-up is recognized as holding gains in the side of resident equity holders.

(1st period) (2nd period) B/S of Company A B/S of Company B B/S of Company A B/S of Company B Assets Liabili- ties

Equity Equity Retained earnings devidents or revaluation? *UDSK9DOXHRIHTXLW\

3. Treatment in revised FOF, BOP and National Accounts

Faced with above-mentioned problems in the process to revise Japan’s FOF statistics, we adopted following treatments. They are different from treatments in National Accounts and BOP.

2 We have applied accumulation method only to discounted bank debentures. They are evaluated on market value basis and changes in are recorded either as revaluation in flow- stock reconciliation table or flow table as reinvestment of interests. Other discounted bonds and interest bearing bonds issued at a discount is evaluated at market value and changes in value are recorded in flow stock reconciliation table only.

Above-mention treatment of discounted bank debenture is related to FISIM. Since FISIN is calculated only by interests in National Accounts, we have to estimate reinvestment of interests as far as discounted bank debenture is concerned.

Accumulation method is applied to foreign issued deep discounted bonds in Japan’s BOP. In National Accounts, accumulation method is applied for discounted bonds of which interest accrual is estimated in FOF and BOP.

Concerning equities, we have not adopted the concept of reinvested earnings. Listed shares and OTC shares are evaluated at market value and changes in value including the changes in retaining earnings are recorded in flow-stock reconciliation table. Other equities are evaluated at book value of issuers and retained earnings are not recorded in any tables in FOF.

In contrast, reinvested earnings are recorded in BOP. National Accounts combine FOF approach and BOP approach. Concretely, changes in equity value are recorded as reinvestment of for cross-border equity holdings and as revaluation for domestic equity.

4. Future problem

Recent financial innovation has facilitated the conversion of many types of cash flow to capital. In Japan, a new type of bonds might be issued that are issued based on future interest income. If this type of bonds is issued, we might have to record normal interest payments as realization of holding gains/losses.

If financial market give “marketability” to formerly non-traded instruments, we can measure their market value or fair value. Market participants that hold the instruments would regard the changes as revaluation in the same way as traded financial instruments such as listed shares. In Japan, trading of unlisted shares are becoming active and securities firms that estimate their price are increasing.

Why capital gains are not included in income in SNA framework? In the circumstances that the distinction between transaction and revaluation become more and more blur, is it possible and meaningful to put capital gains out of production frontier of SNA framework? In this connection, is it appropriate to measure the production of financial intermediaries only by interest income despite the fact that many intermediaries allocate their resources to dealing activities?

5. Distinction between transfer and revaluation

Similar problem occurs in the evaluation of loan claims. The distinction between transfer and revaluation is blur in this case. According to 93SNA, volume changes in loan should be recorded as other changes in assets if creditors recognize that a financial claim can no longer be collected. On the other hand, cancellation of debt by mutual agreement between debtors and creditors should be

3 recorded as a capital transfer from the creditor to the debtor.

In recent year, many Japanese banks are faced with financial difficulties by the increase of bad loans. Many of bad loans are evaluated on discounted cash flow basis and assigned to third parties. Loans are now traded instruments. On the other hand, there are cases that cancellation of claims is notified on legal basis from creditors to debtor under corporate reorganization schemes. It is true that those cases have different character from mere accounting treatment of writing-off. But those cases also should not be treated as transfer but as revaluation because creditors trying to overcome financial difficulties would like to collect their claims as much as possible.

Forgiveness of debts as capital transfer, accordingly, would be executed only by public institutions. Some public institutions extend loans with contracts to forgive their debts under specified conditions. The conditions normally meet their policy purposes. In this case, however, what if public loans decrease their value due to debtor’s insolvency? Should we suppose that public loans with debt forgiveness contracts never decrease their value?

(1st period) (2nd period) B/S of Company A B/S of Company B B/S of Company A B/S of Company B Assts Liabili- ties

loan write off transfer or Equity revaluation? Equity

*UDSK9DOXHRIORDQFODLPV

In principle, changes in value of loans are recorded as revaluation in revised FOF. The changes include increase of provision for loans and removal of loans from the balance sheet. As an exceptional case, we treat the removal of student loans by a public institution as capital transfer.

6. Relationship between Flow-of-Funds and Balance of Payments

Flow-of-Funds and Balance of Payments should be more consistent with each other on conceptual basis. In accordance with the discussion of interest-related financial derivatives, the treatment of reinvested earnings, at least, should be reconsidered.

REFERENCE

System of National Accounts 1993 Balance of Payments Manual FIFTH EDITION, 1993

RÉSUMÉ

La Banque du Japon est en train de publier le compte financier basé sur 93SNA. Au cours de la révision, nous avons trouvé que la distinction entre le principal et les intérêts est tres diffiscile. Comme les produit derivés en relation avec d’intérêts, est-ce qu’on doit traiter les intérêts courus des obligations et les rendements retenus dans les entreprises comme les plus-values? Nous devons choisir l’évaluation au prix du marché ou l’estimation de reinvestissement d’intérêts et des dividendes. Dans le cas de l’evaluation du crédit, on voit le même problème. Concrètement, il est difficile de distinguer les transfèrts de capitaux et les changements de values.

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