VI. Income (2024)

Income from Direct Investment

392. Income from direct investment is income that accrues to a direct investor from ownership of direct investment capital. A direct investor is an investor who makes a long-term investment in an enterprise with the intention of having an effective voice in the management of that enterprise. Accoding to the BPM, ownership of 10 percent or more of the shares of an enterprise is considered a

direct investment. Direct investment capital is primarily comprised of:

the share of the direct investor in the equity capital of an enterprise;

the share of the direct investor in accumulated profits not remitted by the enterprise;

other net claims of the direct investor on the direct investment enterprise.

Direct investment enterprises can be incorporated enterprises (privately or publicly owned), branches, unincorporated enterprises, or notional enterprises delineated in accordance with the principles of residence presented in the BPM.

393. The BPM divides income from direct investment into (1) income on equity (which includes dividends, distributed branch profits, and reinvested earnings) and (2) income on debt (interest). The following example illustrates this classification scheme. Enterprise X in Clintonstan holds 50 percent of the equity of enterprise Y in Bushland. These transactions take place in the reporting period. The profits of Y are 200 units, of which 100 units are paid in dividends to shareholders and 100 units are reinvested in the enterprise. Enterprise X extends a long-term loan of 500 units to enterprise Y, and the interest rate on this loan is 10 percent. Concurrently, enterprise Y has a claim of 100 units on enterprise X in the form of a short-term trade credit on which the interest rate is 15 percent. Enterprise X issues bonds at an interest rate of 8 percent, and enterprise Y acquires 100 of these bonds.

The balance of payments of Clintonstan should reflect these entries:

The credit entries under direct investment income-income on equity reflect the share of enterprise X in distributed and undistributed earnings of enterprise Y. The entry for direct investment income-income on debt reflects the interest (50 units) received on the loan extended to enterprise Y minus the interest (15+8=23 units) payable by X to Y. The interest payable by X to Y is recorded, in accordance with recommendations contained in the BPM, as negative direct investment income. Any income derived by enterprise X from investments in enterprise Y is netted against income paid by X to Y. If enterprise Y held a small number of shares in enterprise X, this investment would represent negative direct investment rather than portfolio investment. Dividends payable by enterprise X to enterprise Y on such shares would be netted against dividends payable by direct investment enterprise Y to direct investor X.¹⁵ The rationale for these negative direct investment flows is explained in paragraph 529 of chapter 9.

Income from Portfolio Investment and Other Investment

394. Income from portfolio investment and from other investment is income accruing to an investor from investment (other than direct investment) in financial assets. The most typical forms of income from portfolio investment are interest earned on debt securities and dividends earned on equity securities (shares) issued by companies in which the investor has no effective voice in the management. Payments made under interest rate swaps and similar arrangements also represent income from portfolio investment. The BPM shows that income from portfolio investment is divided into two categories: (1) income on equity and (2) income on debt. Income on debt is further divided into (1) income earned from bonds and notes and (2) income earned from money market instruments and financial derivatives (such as interest rate swaps).

395. The most common forms of income from other investment are interest earned from deposits, loans, and trade credits. Lease fees from financial lease arrangements represent, in part, interest on loans construed to be extended in connection with imputed changes of ownership for the goods. This interest also constitutes income from other investment.

396. The following example illustrates the classification scheme for investment income. In a specific period, residents of Urangastan derive certain income from their financial investments abroad.

Central Bank of Urangastan

(1) Interest of 70 units on bank deposits

(2) Interest of 80 units on securities issued by a foreign public enterprise

(3) Interest of 30 units on a loan extended to a foreign central bank

Government of Urangastan

(4) Dividends of 40 units on a 50 percent share in the equity of enterprise X located in Central Paradiso

(5) Share of 50 units in the undistributed earnings of enterprise X located in Central Paradiso

(6) Dividends of 20 units on a 5 percent share in enterprise Y located in Central Paradiso

National Airline of Urangastan

(7) Interest of 10 units from bank deposits abroad

(8) The airline receives a charter fee of 25 units for an aircraft chartered for two years to Central Paradiso for operations in Central Paradiso. The aircraft is separately accounted for by the airline and is recognized by the authorities of Central Paradiso as part of that country’s capital stock. The charter fee includes depreciation costs of 10 units and the remainder of the fee (15 units) represents direct investment income.

(9) The airline receives a lease fee of 35 units for equipment (other than mobile equipment), which is leased for six years to Jaymaranda. As the cumulative lease payments will cover 80 percent of the value of the equipment and the carrying charges, the lease is a financial one. The compilers estimate that the lease fee covers depreciation costs of 20 units and interest payments of 15 units.

Car Manufacturer in Urangastan

(10) Interest of 15 units on debt securities issued by a foreign government

(11) Interest of 55 units on trade credits extended to a dealer in Central Paradiso

(12) Net receipts of 12 units from an interest swap contract with a bank in Central Paradiso

(For simplicity, it is assumed that all foreign currency receipts were sold to the central bank for local currency.)

In the BOP statement of Urangastan, these transactions should be classified thus:

Interest

399. The following examples illustrate time of recording for interest income. According to the binding agreement between the creditor and the debtor, interest due on a long-term loan extended by the government of Clintonstan to the government of Bushland amounts to 100 units at the end of 1990 and 120 units at the end of 1991. Bushland compiles BOP statistics on an annual basis. As the frequency with which interest payments are due is the same as the periodicity of Bushland’s BOP statements, the statement should reflect interest payments due in each year—whether or not the interest is actually paid. If the debtor is not able to pay the interest on the loan at the end of 1990 but makes up for the payment in the following year, these entries would be shown:

Thus interest is recorded for 1990 although it was not actually paid. The contra entry to this debit is shown as an increase in short-term liabilities. In 1991, when the interest due in 1990 is paid, the BOP statement shows a decrease in short-term liabilities.

400. The next example illustrates the recording of interest income when interest payments are due less frequently than BOP statistics are prepared. Madornia issues a 20-year, zero coupon bond with a face value of 10,000 units to a resident of Pokolbin. (A zero coupon bond is one that has no discrete interest payments. Instead, at the time of redemption, the holder of the bond receives the interest in the form of the difference between the bond’s redemption, or face, value and issue or acquisition price. Zero coupon bonds are issued at discounts that reflect underlying interest rates; otherwise no investor would purchase such bonds.) The interest rate is 10 percent when the bond is issued. Therefore, the value of the zero coupon bond at the time it is issued can be determined by discounting 10,000 units by 10 percent each year for 20 years. This value is 1,486 units.

401. One year after issue, the accrued interest on the bond is 10 percent of 1,486 units (149 units). At this time, if there are no changes in interest rates, the bond is valued at issue value plus accrued interest (1,635 units). In the second year, the accrued interest on the bond is 10 percent of the bond’s value at the end of the first year (164 units). The value of the bond at the end of the second year, if there are no changes in interest rates, is equal to its value at the end of the first year plus the interest accrued in the second year (1,799 units). This process continues for 18 years until the bond matures. At maturity, the value of the bond is 10,000 units, and the sum of accrued interest for all periods equals the difference between the redemption value and issue price (8,514 units). The accrual of interest is therefore reflected in “reinvestment” of the interest in the bond. Madornia’s BOP statement reflects, for years 1, 2, and 20, the following entries in respect of the zero coupon bond:

In this example, it was assumed that interest rates remained unaltered during the life of the bond. In many instances, this would be an unrealistic assumption. How should the accrual of interest on securities be calculated when interest rates change during the life of the security?

402. A possible approach would be to ignore changes in interest rates and calculate the accrual of interest for all periods by using the interest rate prevailing at the time the security was issued. Such a method of recording would probably be consistent with the way the issuing enterprise accrues interest in its accounts. However, there are two disadvantages with this method. The first is that, if the security is traded, the new holder of the security is unlikely to know, or care, what the interest rate was at the time the security was issued. The purchaser’s concerns will relate to the prevailing interest rate and the effect of that rate on the return that he or she will receive on his or her investment. The second disadvantage with using the interest rate prevailing at time of issue to accrue interest over the life of the security is that this method does not reconcile well with the use of market values for measuring levels of investment. The change in the market value of a security in a particular period reflects (among other things) the prevailing rate of interest and not the rate of interest prevailing when the security was issued. If the latter rate were used in the calculation of accrued interest, there would be distortions between levels of investment and financial transactions and in the apparent rates of return on the securities.

403. To overcome these difficulties, the BPM recommendation is that, if securities are traded, prevailing rates should be used to determine accrued interest. This method will not always be consistent with those used by issuers of securities to accrue interest. However, unless there are significant movements in interest rates over time, any differences are unlikely to be significant.

404. The next example illustrates the calculation of interest accrued but not paid on securities that are issued at discounts and that have coupon payments of interest as well. In these cases, interest accrued but not paid is equal to interest that would be accrued if the security were a zero coupon security minus the coupon interest. For example, if the market value of a security at the beginning of a period is 90 units, the prevailing interest rate is 10 percent, and the coupon return is 7 units, the interest accrued but not paid would be [(0.1 ˘ 90) – 7] or 2 units. In this example, the security must be trading at a discount from face value as the prevailing interest rate is higher than the rate implied by the coupon payment (7/90 or 7.77 percent). If the security were trading at a premium, the calculated interest accrued but not paid would be negative. In this case, there would be a downward adjustment to the coupon payment to calculate the overall interest to be recorded on the security.

405. The treatment of interest on index-linked securities, the principal amounts of which are based on indexes derived from—for example—commodity prices or exchange rates, also warrants attention. Like securities issued at discounts, the value of an index-linked security at maturity generally differs from the value of the security at the time of issue. The difference represents investment income accrued during the life of the security. The accrued interest in each period is calculated by applying the percentage movement in the index underlying the security to the market value of the security. For example, a resident of Dromesia issues a security, the principal of which is based on the consumer price index (CPI) of Dromesia. The security is purchased by a nonresident for 50 units of domestic currency. Dromesia’s CPI is 100 at the time of purchase. At the end of the first period, Dromesia’s CPI has increased by 10 percent to 110. The accrued interest income is therefore 10 percent of 50 units or 5 units. In parallel with the increase in the underlying index, the value of the security has increased to 55 units at the end of the period.

These entries would be shown in Dromesia’s balance of payments in the first period:

Income on Equity

406. It is suggested in the BPM that remitted earnings of branches and other unincorporated enterprises be recorded at times of remittance. This treatment is recommended because these payments are the result of discretionary decisions that can occur at any time and because no agreement between legally independent partners is involved in determining when the investment income is paid. The BPM recommendation for reinvested earnings is that such earnings be recorded in the periods in which the underlying profits are earned. Dividends should be recorded in the periods in which the dividends are declared payable.

407. This example illustrates principles for the time of recording of equity income from direct investment. A legally independent, wholly owned subsidiary of an enterprise resident in Longa is operating in Urangastan and earns profits of 1,000 units in 1989. The direct investment enterprise in Urangastan pays 600 units to shareholders and retains 400 units to strengthen reserves. The decision about distribution of dividends is made in 1990 after the usual accounting and auditing procedures have been completed. The dividends are actually paid in January 1991.

The following entries would be shown:

Thus, total earnings attributable to the direct investor are recorded as reinvested earnings in the statement for 1989. Dividends declared in 1990 are recorded in that year. This entry is offset by an increase in direct investment-other capital; the increase reflects Longa’s claim on Urangastan for the amount outstanding. Actual remittance of the dividends in 1991 reduces this short-term claim; the reduction is recorded in the financial account under direct investment-other capital. In the case of portfolio investments, dividends declared but not paid in a period are recorded as an increase in other investment-other assets/liabilities.