One of the major differences between financial statements of banks compared to non-financial companies is the amount of financial instruments that will be included within those financial statements.
If you're reading a set of financial statements for any bank, you'll regularly see the term used, so let's explain exactly what they are and the complexities around accounting for them.
A financial instrument is a contract that gives rise to a financial asset in one entity and a financial liability or equity instrument in another.
It's a contract, a piece of paper between two parties, typically an issuer and an investor.
A good example of a financial instrument will be a corporate bond for the investor holding those bonds.
They're recorded as a financial asset, a debt security investment shown on its balance sheet.
This would appear as a debt liability in the balance sheet of the company that issued the bond.
Another example of a financial instrument would be companies issuing shares, but an investor holding those shares.
They'd also record a financial asset, an equity security investment on its balance sheet, and it would appear as part of shareholder's equity for the issuer.
While we can look at this in simple terms at a high level, when we dive into the detail, the accounting becomes a lot more complex.
Let's think about how these financial instruments might be further classified under US gaap.
There are three distinct classifications which we'll discuss in turn held to maturity trading and available for sale held to UR is relevant for debt securities and redeemable preference shares.
It is a restrictive classification under US gap.
There must be no intention to sell the security for it to sit within this category, and this must be justified for each investment individually.
For example, securities that may be sold. For example, if there were a change in interest rates should not be classified as held to maturity debt securities classified as held to maturity.
I reported that amortized cost in the balance sheet, meaning that they're held at their original cost on the balance sheet.
The logic here is that the investor intends to hold their security in order to collect contractual cash flows rather than looking to sell it for a profit before maturity, meaning that the fair value of the security is not relevant to this investor, although there are no gains or losses from changes in the market value of the asset to worry about in the income statement, interest income will need to be recorded in the income statement on an effective interest basis.
If a security is acquired with the intention to sell within the near term, which could be hours, days, or at most a few weeks, the security must be recognized under US gap as trading.
Specifically, US GAAP tells us that there should be documented intent to trade frequently.
If the objective is to profit from price differences, then trading is the correct Category.
Financial instruments in this category are accounted for at fair value, which can also be referred to as mark to market for trading securities.
Any changes in the fair value of the assets shown on the balance sheet are recognized in net income directly.
Whether those gains or losses are realized or unrealized, the final category is available for sale.
This captures assets that would not be categorized as either health maturity or trading.
This would include securities that, for example, may be sold if economic conditions change.
Financial instruments in this category are again accounted for fair value, or they're marked to market.
However, unlike trading securities, any changes in the fair or market value are not shown in net income, but instead recognized in other comprehensive income, so do not impact retained earnings.
Reclassification between categorizations is allowed where it is justified by the circumstances of the accounting rules for the trading category.
Reclassification into or outta this category should be rare.
Here we have an example of financial instruments highlighted on a real bank's balance sheet reporting under US gap.
You'll notice that we have investments, which includes available for sale, which are shown at a fair value, meaning that they're marked to market at each balance sheet date and health maturity, which reflects the securities amortized cost.
We also have trading securities, which are the largest single category of assets for this bank and recorded at fair value.
The impact of these can also be seen in the income statement where the interest income from debt securities is included within interest income.
In addition, realized and unrealized gains and losses on trading securities are shown within the market making section of this bank's income statement, and the change in market value of available for sale securities is shown in the comprehensive income statement.
