Bankers shifting their investments to the HTM category have to provide for the amortisation expenses on these securities. Typically, treasury heads while shifting government securities to HTM category prefer the lots carrying lower premium to securities with higher premium, to save on the amoritisation cost. The other securities are placed in the available for sale (AFS) category.
The securities in the AFS category are valued scrip-wise at quarterly intervals and the depreciation/appreciation is aggregated. Coupon income received and accrued during a fiscal is accounted as income from the security during the year. Net depreciation on the security at the end of the fiscal is also accounted for during the year. But, the redemption gain/loss is not accounted every year. It is accounted only during the fiscal in which the security is redeemed.
When the interest rates increase, the net income (coupon income minus depreciation) from the bonds falls below the yield prevailing at the time of purchase and adversely affects the profit. Though the depreciation is provided for, present accounting procedure does not allow book value to undergo any change. Carrying the premium security at purchase price will result into booking heavy redemption loss at the time of maturity. The redemption loss is directly proportional to the excess of current yield booked in the earlier years over the YTM pegged at the time of purchase. The redemption loss may be a burden to the future balance sheets.
Addressing the issue, Fixed Income Money Markets and Derivatives Association (FIMMDA) plans to propose Reserve Bank of India (RBI) to address the above loopholes and thereby bridge the gap between the US GAAP and Indian GAAP and put in place the right accounting practices and thereby protect against the huge burden of the redemption loss that banks may have to face at the maturity of the instrument.
US GAAP recommends that the periodic interest income on the securities under the AFS category must be computed by the effective yield calculated by amortising the discount or premium to the interest expense.