1

Insurance Accounting Overview

Policy Maintenance Systems and the General Ledger

Reserves

Claims

Investment

Reinsurance

Pooling

Risk Based Capital (RBC)

Statutory versus GAAP

The Annual Statement Overview

Pages, Exhibits, Schedules

Inputs to the Annual Statement

Importing Data

11

Attachments

11

Schedule P

12

Cash Flow

12

Validations

13

Filing and Submission

13

Signatures

13

State Filings

14

Premium Tax/ Municipal Tax

14

Basic Accounting

15

Financial Statements , Recording Transactions, Accrual versus Cash

Investment Accounting

20

Useful Formulas and Excel Techniques

32

Insurance Accounting

This book is intended to fill a gap between too much information and too
little. It is designed to give someone new to Insurance Accounting a
comprehensive overview of the entire insurance accounting and NAIC Filing
process. You can certainly get into more detail on specific insurance
accounting issues but having a comprehensive overview will help new
employees speed up their training and jumpstart their insurance accounting
careers.

Overview
Insurance Accounting is one of the most exciting and challenging professions
in accounting today. There are so many facets that work together to
produce a very comprehensive statement of financial position that is of
utmost importance to policyholders and regulators. Consider that an
insurance policy has a lot of data. Besides the basic contact and billing
information, a policy might have Premium, Dividend, Policy Loan, Agents
Commission, Valuation and Claims records. Each of these records will
interface with the general ledger over time. For instance, when a policy is
sold, a premium is received, a commission paid and a reserve for future
claims is setup.

Policy Maintenance Systems and the General Ledger

Every night and every month end, the computer systems at an insurance
company run their nightly and monthly cycles. The daily cycle might
summarize the premiums received or claims paid during the day and
transfer that information to other systems like the Agency system that will
accumulate then pay commissions on the premiums or the Valuation system
that will adjust the reserves for the policy. The transactions entered for the
day will be summarized and entered into the General Ledger. The updates
to the premium records on the policies will be reconciled back to the daily
entry to the general ledger. Keeping everything reconciled so that you can
run a report of all the Policy Loan balances on the policy records and tie that
out to the Policy Loan account balance on the General Ledger is necessary
and vital to the flow of information through the insurance companys
financial reporting system. There are many systems that need to be kept

reconciled to the general ledger. What if the 1099s produced at year end
for the agents commissions did not tie out to the commission expense in the
general ledger? Do you think someone would question the integrity of the
general ledger data?

Reserves
For life insurance, a reserve is set up using mortality tables and interest
rates to determine the present value of the future claims payments that will
be made. The reserves are set up on a mean reserve basis. This is kind of
an averaging method to value all the policies as of the middle of their policy
year no matter when they were issued. Because of this mean reserve
valuation method, the company also needs to record net deferred premium
and net uncollected premium assets to compensate for setting up the mean
reserve. These assets offset the extra reserve liability which is set up for
policies that have not yet paid their premium up to the mean reserve date.
Conversely, unearned premium liabilities are set up to reflect the companys
obligation to provide insurance in the future for premium income they have
received in advance.

Policy
The Policy systems will hold the detail to back up general ledger amounts
such as the policy loan balance or the policy dividends unpaid balance. The
Policy system has many tables to keep track of all the facets of a policy.

Claims
Claims reserves are maintained for claims that have been reported and
claims that may have occurred but have not yet been reported. The reserve
for claims that have been reported will be estimated as to the total cost that
the insurance company is likely to incur. Similarly, the Incurred But Not
Reported (IBNR) claims reserves are estimated based on past experience
and average claim costs. An insurance company can track when the event
causing the claim occurs and when the claim was actually reported to derive
the IBNR claims.

Investment
Investment reserves are unique to the insurance industry. Because of the
assumptions made when designing an insurance policy, the regulators want
to be sure the premium monies invested for a block of policies is kept
invested to fund future claims on those same policies. When interest rates
drop substantially, an insurance company can sell the older higher paying
bonds for a substantial gain. Then they could use that gain to increase their
surplus and as backing for new sales of other insurance policies. They could
that is if the NAIC did not require them to set aside those gains and keep
them as reserves specifically for the policies from which the initial premium
monies were received!
The NAIC has set up an Interest Maintenance Reserve (IMR) and the Asset
Valuation Reserve (AVR) and even a Risk Based Capital reserve (RBC) which
is its own statement type.
The IMR is designed to capture the realized capital gains and losses that
result from changes in the overall level of interest rates and amortize them
into income over the approximate remaining life of the investment sold.
Companies frequently maintain an Excel worksheet with the Gains and
Losses from each year separated into its own row and then they amortize
each row over 30 years for example. They add up the current year
amortization from all the rows and that becomes their annual IMR
Amortization that they are allowed to run through the income statement and
close to surplus.
The AVR is designed to address the credit-related risks of the bonds and
stocks by calculating a basic contribution, a reserve objective, and a
maximum reserve amount. This reserve attempts to smooth the recognition
of credit related gains and losses through surplus.
The Risk Based Capital (RBC) statement is a method of establishing the
minimum amount of capital appropriate for an insurance company to support
its overall business operations in consideration of its size and risk profile. It
provides an elastic means of setting the minimum capital requirement in
which the degree of risk taken by the insurer is the primary determinant.
A companys risk-based capital is calculated by applying factors to various
asset, premium and reserve items. The factor is higher for those items with
greater underlying risk and lower for less risky items. The adequacy of a

companys actual capital may then be measured by a comparison to its riskbased capital as determined by the formula.
Risk-based capital standards will be used by regulators to set in motion
appropriate regulatory actions relating to insurers that show indications of
weak or deteriorating conditions. It also provides an additional standard for
minimum capital requirements that companies should meet to avoid being
placed in conservatorship.

Reinsurance
Insurance companies are rated every year by AM Best for example for many
things, one of which is the adequacy of their reserves and surplus to fund
the future claims. When insurance companies sell a lot of new business,
they have to pay a lot of money up front for underwriting and first year
commissions for example. All the first year expenses create a drain on
surplus which can then cause their ratings to drop. So, insurance companies
deliberately and carefully plan which policies they will sell in which areas of
the country through which companies in order to generate the most revenue
without draining their surplus so that ratings decline.
To maximize revenues across the entire organization, an insurance company
might want to reinsure some of its costly new business from one of their
younger lower surplus companies to one of their older surplus rich
companies. That way they can maximize the use of their surplus across the
organization to fund new business selling the most profitable insurance
policies.
In addition to funding new policy sales on one company with the surplus
from another company, insurers frequently transfer the excess risk to other
companies to minimize their exposure to large claims. Many times a newer
company with lower surplus will reinsure all its business over a certain dollar
amount. For instance if a life insurance company sells a 300,000 dollar face
value policy and it is only retaining 100,000 of risk, it will reinsure 200,000
to other reinsurance companies. It will then give the reinsurer 2/3 of the
net premiums on the policy in return for their promise to pay 2/3 of all the
claims on that policy. There are many different types of reinsurance
agreements.
For instance, facultative reinsurance is a reinsurance policy that provides an
insurer with coverage for specific individual risks that are unusual or so large

that they aren't covered in the insurance company's reinsurance treaties.

This can include policies for jumbo jets or oil rigs for example. Reinsurers
have no obligation to take on facultative reinsurance, but can assess each
risk individually. By contrast, under treaty reinsurance, the reinsurer agrees
to assume a certain percentage of entire classes of business, such as various
kinds of auto, up to preset limits.
The premiums that are written on your company are called the Direct
premiums. To transfer risk to another insurance company is called Ceding
or Ceded. To assume the risk from another insurance company is called
Assuming or Assumed.
To derive the income statement amounts net of reinsurance you would take
your accrual basis direct premiums minus your ceded premiums plus your
assumed premiums.
The reinsurance contract premium and claim amounts with individual
reinsurers are detailed in Schedule F for PC and Schedule S for LAH. These
schedules give detail to back up the summary reinsurance amounts used in
other schedules.

Pooling
Pooling is a reinsurance arrangement among affiliated companies, where the
subject business written by the pool participants is ceded to the pool lead
then retro-ceded among pool participants according to a specified
percentage of the total.
The complexity in a pooling arrangement is to report the claims history on
schedule P accurately. If the pool percentages change, then the prior year
claims activity must be restated so that the claims history will be reported
properly.
Generally, the prior year statements and the current year claims activity roll
up into a Sum of Pool statement. The Schedule P information is taken from
the Sum of Pool using the current pooling percentages. Prior year links to
accumulate the Non-Schedule P data are then used to complete the
remainder of the statement and create the Filed NAIC Statement.

Risk Based Capital (RBC)

The RBC statement is a statement associated with a specific Annual
Statement for a specific company. The RBC judges the adequacy of the
surplus for the company. It looks at the quality of the investment, rate of
premium growth, claims history and assigns factors used to compute the
required capital. If a company grows too quickly for example, the Excess
Premium Growth schedule would assign a bigger factor and require more
surplus. If the investment portfolio had an inordinate amount of low quality
bonds, a larger factor would be assigned requiring more capital. The actual
surplus is compared to the RBC computed surplus and depending on how it
compares, might bring about greater scrutiny from the regulators.

Statutory versus GAAP

Statutory (STAT) insurance accounting can be thought of as more
conservative than Generally Accepted Accounting Principles (GAAP)
accounting. GAAP is more of a going concern approach whereas STAT is
more of a solvency approach. GAAP is probably a more realistic measure
of how profitable an insurance company is that STAT. For instance in GAAP
the costs of acquiring new business such as underwriting and first year
commissions are capitalized and amortized to expense over several years.
This represents more of a matching approach to revenue recognition. These
costs are called Deferred Acquisition Costs, (DAC). Also, bonds will be
valued at their fair value for GAAP rather than their amortized cost like STAT
usually does.
GAAP policy reserves will be computed differently from STAT reserves.
Companies can use their experience to assign interest rates and mortality
rates that can be different from those prescribed by STAT.
Policyholder dividends are recorded as liabilities in STAT when they are
declared by the Board of Directors. Under GAAP, dividends are assumed to
be payable based on experience and intent and are accrued even without a
declaration by the Board of Directors.
GAAP accounting will record Deferred Income Taxes to recognize timing
differences between the tax return and the ultimate tax liability. STAT does
not require recognition of Deferred Income Taxes although many companies

do have this on their STAT statements. Just know that there is a difference
in calculation between STAT and GAAP for Deferred Income Taxes.
GAAP does not Non-Admit assets like STAT accounting does.

The Annual Statement - Overview

The annual statement today looks similar to the annual statements from the
1920s except the numbers are not hand written anymore! Generally, an
annual statement is a uniform financial statement with many Exhibits and
Schedules to show the results of operations in great detail. The exhibits and
schedules show the results of operations by line of business and net of
reinsurance transactions.
The output from the Annual Statement is compiled into a .Zip file that
includes several .PDF files and a couple .txt files. The PDF files are
organized into a Key pages (PK), Investment pages (PI) and Other pages
(PO). There is one big .txt file that ends in _s.txt. It contains all the data
from all the pages in the standard NAIC Filing layout. It is a tab delimited
text file. There is also a validations file in the .Zip file. The .Zip file is
uploaded to the NAIC website.
Your General Ledger numbers for Assets, Liabilities, Retained Earnings and
Income Statement are all fully reported on the first three pages. Amounts
from the Income Statement are then further broken out by the Exhibits
which follow. For instance Losses Incurred on line 2 of the Statement of
Income on a PC statement is detailed on the Underwriting and Expense
Exhibit Part 2 Losses Paid and Incurred. Part 2 has about 30 different
lines of business and schedules out the Direct and Assumed and the
beginning and ending Unpaid amounts to derive the Incurred losses for the
current year.

Pages, Exhibits and Schedules

Amounts on the Assets and Liabilities pages are also more fully detailed on
different schedules then totaled and transferred to the balance sheet. On
the PC Liabilities page for example, many of the loss and reinsurance
liabilities come from the many schedule F parts. On the assets page many
of the bond and stock totals come from schedule D pages.

In the Exhibits and Schedules, you will see cash basis expenses converted to
accrual basis. Expenses incurred on an accrual basis equals the cash basis
expenses paid less the beginning of the year accruals plus the end of the
year accruals. Some of the cash basis expenses paid during the year pay off
the expenses incurred on an accrual basis last year so they are not current
year expenses.
Also you see the premiums and claims scheduled out net of reinsurance as
the direct business plus the assumed less the ceded equals the net
premiums or net claims.
Another thing you will see in the annual statement is the non-admitting of
assets. The exhibit of non-admitted assets decreases the amount that can
be recognized on the Assets page for certain assets due to a high probability
it is uncollectible or excess risk of default for example. An increase in the
non-admitted assets is an expense that is taken to the surplus section of the
income statement. This also has to be added back to the cash flow page as
discussed later.
One last thing you need to understand in an annual statement is the
recognition of unrealized gains and losses. The NAIC has a table in the
schedule D1 instructions that sets forth when a bond must be valued at the
lower of book or fair based on the NAIC Designation. If a bond is valued at
Fair then there will be an amount shown in the unrealized column. The
Unrealized column is only for the current year adjustment. It is not life to
date. When a bond that was valued at fair last year end is sold for a loss
this year, the schedules need to show a reversal of the unrealized loss from
prior years in order to recognize the full amount of the realized loss this
year. Many people think the reversal of the Unrealized should include the
current year change in unrealized also but, if you look at the formula for the
Verification Between Periods schedule you will see that is not correct.
Unrealized losses would also need to be added back to the cash flow page as
discussed later.

Inputs to the Annual Statement

The annual statement has many inputs. Certainly the adjusted trial balance
from the General Ledger is a main source. Many general ledgers have lines
of business codes inherent in their account numbering structure. Also, the
account numbers frequently have the assumed and ceded reinsurance codes

10

built into the account numbers. The first three pages could be loaded from
the trial balance except that many of the cells on those pages actually pull
from Exhibits and Schedules further down in the statement.
The Valuation system is another main source of input into the annual
statement. It is where all the policy reserve amounts and counts come
from. In the LAH statement the reserves are reported on Exhibit 5. In the
PC statement the Loss reserves show up on part 2A.
The Claims system also is used extensively to fill out annual statement
exhibits. Claims paid and unpaid are scheduled out on Exhibit 8 for LAH
statements and Exhibit 2 on PC statements.
Results of operations are also allocated to states and a separate state page
is created showing the results of operations by line of business within each
state.
Investment systems are responsible for importing much of the data
necessary for the investment schedules like all the Schedule D reports for
the bonds and stocks. The D reports show the year end carrying value of
the assets which may be either the amortized cost or the fair value based on
the company type and the NAIC designation. The D reports allocate and
report all the amortization and interest income by the par value outstanding
during the year. If a mortgage backed bond pays a redemption amount or if
a partial sale is recorded, the amortization and interest attributable to that
redemption or partial sale must be allocated to it based on the number of
days that par value was held for the year.
General expenses are detailed by type and also split to general lines of
business. The Analysis of Operations by Line of Business is basically a
statement of income for each line of business. The Analysis of Operations by
line of Business splits everything from premium and claims to investment
income and expenses and taxes across the different lines of business.
Sometimes an insurance company completes a Functional Cost Survey to
help them allocate fixed costs by line of business based on how much time
certain departments spend on certain tasks.
The NAIC has set up Validations and EagleTM has added their own
validations to help you balance out the statement. For instance, line 1 of the
Liabilities page is labeled Losses and it must tie to the bottom line of Exhibit
2A which breaks out the Losses liability by line of business showing

11

reinsurance activity also. If these two amounts do not equal a validation

rule will fail. If the difference is more than NAIC allows it to be off, the
validation is said to be Out Of Tolerance (OOT). If the difference is less than
the NAIC allows then it is Out Of Balance (OOB). All OOT must be either
cleared by correcting something or explained by entering an explanation.
EagleTM validations will never be OOT, if they fail they will show up as OOB.

Importing Data
Because the NAIC filing file is such a well-known and accepted format, many
systems are designed to create that format and annual statement programs
are designed to import files in that format. All the investment accounting
programs now create the files to be imported in the NAIC filing format,
sometimes called the Annual uniform layout.
There are many other methods to import data into the Annual Statement.
Methods ranging from specialized Excel worksheets to .XML files are used.
Typically, a company might cell reference their Excel Data into an accepted
format for importing if it can be done by simply copying blocks of formulas.
Then the properly formatted data is saved as a Text, Tab-Delimited file and
that is the file that is imported into the Annual Statement.
Blocks of data can usually be copied and pasted into the annual statement
pages also.

Attachments
There are many attachments like the Notes to Financials and the
Organization Chart where you need to submit both a printable image and
also the electronic data. The electronic data is usually typed into a page
whereas the printable image would be attached in a ready to print format.
Some attachments like the Audited Financial statement are submitted as
PDF files with no electronic data component. The NAIC uses a program to
read the PDF and look for sensitive data which they would not want to
publish. If you submit a protected PDF, their program cannot search within
the file and they will ask you to resubmit the file in an unprotected state.

12

Schedule P
Schedule P is a PC Claims schedule which is organized by Accident year. So
if a claim occurred in 2005 and payments were made on that claim in each
of the next three years, you would see how much was paid in each calendar
year for the claim arising in 2005. Generally, you only need to import or
enter the claims paid in the current year and you would spread them across
the accident years they originated in. The prior year claims data would
remain the same except for it would be shifted up one and over one to
match the new rows and columns on the current year statement. The prior
year data plus the current year data is combined to create the published
data. The published data for each line of business is then summarized for all
lines of business.
Most lines of business in Schedule P have 10 years history and there is also
a Prior line. The Prior line represents claim payments made in the current
year for accident years prior to the 10 year history.
Some of the lines of business are called Short Tail Lines which means that
they do not have all 10 years of history broken out into 10 rows. Some of
the accident years are combined to report a summary of many accident
years.

Cash Flow
The cash flow statement is usually one of the last pages to be completed
because it depends on many of the other pages. The cash flow is really
quite mechanical. Completing it is simply a matter of tying out all the
changes in all the Assets, Liabilities and then including the Net Income and
adding back any non-cash income/expense items such as Amortization and
Depreciation for example. The change in cash has to equal the cash basis
change in all the other Assets, Liabilities and Net income.
Sometimes you actually have to trace the difference in each line item on the
balance sheet to the cash flow work-paper in order to get the cash flow to
balance to the change in cash. You should use a sources and uses approach.
An increase in an asset is a use of cash, to buy a new machine for example.
A decrease in an asset is a source of cash, to sell a stock for example. An
increase in a liability is a source of cash, to take out a loan for example. A

13

decrease in a liability is a use of cash, to pay off a loan for example. A non
cash income item such as discount amortization on a bond is initially
recorded as income but needs to be added back because it is not a source of
cash. Similarly, the depreciation on a fixed asset is recorded as an expense
but must be added back because it did not require the outlay of cash.

Validations
Some validations check for totals between pages that should tie out if the
numbers flow through the statement correctly. Some validations check the
totals on the page to make sure they equal the detail. Some validations
check for the presence of data when a condition is met.
The General Interrogatories ask question such as will this schedule or that
one be filed? If you answer yes to one of those questions and that schedule
is not completed you would see a crosscheck warning of the inconsistency.
The cross checks that check for two numbers being equal to each other are
presented only once, usually on the page that is closer to the front of the
statement.

Filing and Submission

There are annual filing requirements for March 1st, that is the big one, and
smaller filing requirements for April 1 and June 1.
The March 1st filing includes most of the statement plus the Actuarial
Opinion, Reinsurance Attestation, etc. The April 1st filing includes the Policy
Experience Exhibits, the Management Discussion and Analysis and the
Supplemental Health Care exhibit. The June 1st filing includes the Audited
Financials and the Accountants Letter of Qualifications.

Signatures
Companies usually only provide a hard copy of the annual statement to their
state of domicile. A word to the wise about signatures.. Signing the Jurat
page is done on the completed statements after you get them back from
printing, usually right before the due date. However, the executives that
need to sign will most likely be out of the office on business at that time.
Therefore, many companies print out the signature section of the Jurat page
on a large sticker sheet and have the executives sign that before the books

14

come back from printing. Then they can simply affix the signatures sticker
to the printed Jurat page and be ready to file.

State Filings
Every state that a company does business in had their own two dozen forms
or so that are specific to that state. EagleTM maintains a library of all these
forms from every state. They drop form fields on the actual state forms so
that the forms will pre-populate with the data from the annual statement. It
is usually the balance sheet, company information, state pages and schedule
T that have the data which is used to auto-complete these forms. The
remainder of the fields can simply be entered manually and then all the
fields are saved to a database so you can re-open the form later and see all
the data.

Premium Tax
Insurance companies have to pay premium taxes to the states where they
write their business. EagleTM keeps a library of all the premium tax forms
for every state. The tax forms will prepopulate with annual statement data
automatically. The form data is saved into a database and the forms
automatically calculate the tax liability.

Municipal Tax
Within a state, municipalities will charge a tax on premiums written in their
geographical location. EagleTM has both a library of municipal tax forms and
a geocoding program to help insurance companies determine which
municipality the insured policy resides in.

15

Basic Accounting
This chapter is designed to give accountants and bookkeepers that are not
CPAs the background they need to fully understand and master their
accounting duties and qualify them for advancements and promotions. This
book will help you understand how to record (journalize) transactions and
then create financial statements.
Have you ever thought about the physical law which states that to every
action there is always an equal and opposite reaction? When you drop a
ball, some of the kinetic energy of the ball is transferred to the floor and also
used to flex the material in the ball. The remainder of the energy is retained
in the ball and it bounces back up but not quite as high. The difference
between the starting height and the ending height represents the energy
transferred to the floor and flexing motion.
The same is true with double entry bookkeeping. To every action there is
always an equal and opposite reaction so to speak. For instance, if I buy an
annual insurance policy, my Prepaid Insurance goes up and my Cash goes
down by the same amount. Every month we create an adjusting journal
entry to record the prepaid insurance going down by one months worth of
insurance and the insurance expense going up by the same amount.

The Basic Accounting Equation

Assets = Liabilities + Owners Equity + Income Expense
Practice writing this formula down several times in shorthand such as:
A = L + OE + Inc Exp
Because Income minus Expenses equals Net Income, we could also write the
formula like this:
Assets = Liabilities + Owners Equity + Net Income
Or in shorthand:
A = L + OE + NI

16

This is essentially what all financial statements are showing. The Balance
Sheet has an Assets page and a Liabilities page. The Liabilities page has a
Liabilities and Owners Equity or Retained Earning section (they both mean
the same thing). The Owners Equity section will always have the Net
Income added in to the beginning OE to come up with the ending OE. So
the Balance sheet is showing that the Assets equal the Liabilities plus the
Ending Owners Equity which includes the Net Income. The Net Income
comes from the Income Statement. The Income Statement has an Income
page and an Expenses page. The Expenses are subtracted from the Income
to come up with the Net Income. If the Net Income is negative, that means
the Expenses were greater than the Income so we have a Net Loss from
operations.
Let us look at a simple set of financial statements to illustrate this concept.
Assets
Cash

$75.00

Bonds

150.00

Prepaid Insurance
Equipment

80.00

Accumulated
Depreciation

-5.00

Total Assets

25.00

75.00
$325.00

Liabilities
Accounts Payable
Loans Payable
Total Liablilities

$80.00
70.00
$150.00

Owners Equity
Beginning OE

$140.00

Net Income

35.00

Ending OE

$175.00

Total Liablities and OE

$325.00

17

Income
Sales Revenue

$175.00

Interest Income

15.00

Total Income

$190.00

Total Expenses

155.00

Net Income (Loss)

$35.00

Expenses
Salaries
Auto Expense

$121.00
17.00

Insurance Expense

5.00

Interest Expense

4.00

Advertising
Depreciation
Expense

3.00

Total Expenses

5.00
$155.00

Why do Debits (Dr) always equal Credits (Cr)?

We can rearrange the Basic Accounting Equation by adding Expense to each
side to come up with:
Assets + Expense = Liabilities + Owners Equity + Income Expense +
Expense
Which is the same as:
Assets + Expense = Liabilities + Owners Equity + Income
Or
A + Exp = L + OE + Inc
Practice writing down these equations several times also because this is why
debits always equal credits!

18

Debits always equal Credits because

Debits increase this side of the formula Assets + Expenses, and
Credits increase this side of the formula Liabilities + Owners Equity +
Income.
More completely, Dr Increase and Cr Decrease this side of the formula A +
Exp
And, Cr Increase and Dr Decrease this side of the formula L + OE + Inc

You can write this formula on two lines like this:

Assets + Expenses

Dr +, Cr -

Liabilities + Owners Equity + Income

Cr +, Dr

So,

Dr Increase this side

and

And

Cr Decrease this side and

Cr Increase this side

Dr Decrease this side

Practice writing this two line equation several times.

How to Journalize Transactions

Using the formula discussed above:
Assets + Expenses
Dr +, Cr -

Liabilities + Owners Equity + Income

Cr +, Dr

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Let us run through some examples of different transactions

Debit

Credit

Asset
Prepaid Insurance (A+)

30.00

Cash in Bank (A-)

30.00

To record purchase of Annual Insurance Policy.

Equipment (A+)

80.00

Loan Payable (L+)

80.00

To record purchase of equipment with proceeds from Loan.

Depreciation Expense (Exp+)

5.00

Accumulated Depreciation (A-)

5.00

To record periodic depreciation.

Liability

Interest Expense (Exp+)

Loan Payable (L-)

4.00
10.00

Cash (A-)

14.00

To record monthly loan payment, part of which is interest.

Expense
Automobile Expense (Exp+)

17.00

20

Cash in Bank (A-)

17.00

To record cash paid to gas station.

Insurance Expense (Exp+)

5.00

Prepaid Insurance (A-)

5.00

To charge off prepaid insurance for time passed.

Income
Cash in Bank (A+)

175

Sales Revenue (Inc+)

175

To record Sale of Merchandise

Investment Accounting
Bonds
First, lets look at a general overview of bonds and then we can discuss how
to record typical transactions. Bonds are promises to pay a face value, the
par value, at a specified maturity date in the future. Typically a bond will
pay interest every six months at a stated rate of interest, also called the
coupon rate. The stated rate of interest is expressed as an annual rate. If a
bond pays 6% on a semiannual basis and the par value is 100,000 you will
receive 3,000 every 6 months which equals 100,000 * .06 / 2. So the 3,000
interest payment equals the Face Value of 100,000 times the annual interest
rate of 6% divided by the number of payments per year which is 2 for a
semiannual bond. If this was a monthly bond then the monthly interest
amount would equal
500 = 100,000 * .06 / 12 since there are 12 payments every year.

21

Bonds are not usually purchased at face value. In other words, if we are
buying a 100,000 bond we do not typically pay 100,000. The reason we do
not pay face value for a bond is that the interest rate it pays is not typically
the same as the market rate of interest at the purchase date.
Lets say the market rate of interest is actually 7%. So we could buy a 7%
bond at par. We would probably buy a 6% bond for less than par so that it
yields closer to the market rate. Buying a bond for less than par is said to
be buying a bond at a Discount. If the market rate was 5% then we would
pay more than the face value of a 6% bond which is said to be buying the
bond at a Premium.

The difference between our purchase price and the par value charged
off to the Income Statement over the life of the bond such that the Interest
plus or minus the Amortization will net to earnings being recognized for the
bond at approximately the market rate. Specifically, when we buy a bond at
a premium or discount, we can calculate the exact yield we will be earning
on the bond. That yield is called the Effective Rate.

If we bought the bond at a Premium then the Book Value (purchase

cost) will be greater than the Par Value. This excess debit sitting in the
Asset account needs to be charged off to the Income Statement periodically
as Amortization of Premium. Premium amortization is a Debit to the income
statement and represents an expense. Interest income is a credit to the
income statement. If we net the Premium amortization debit with the
Interest income credit we get actual earnings credit from the bond at less
than the interest rate.
If we bought the bond at a Discount then the Book Value (purchase
cost) will be less than the Par Value. This shortage needs to be charged off
to the Income Statement periodically as Amortization of Discount so that at
maturity the Book Value will be equal to the Par Value. Discount
amortization is a Credit to the income statement and represents income.
Interest income is a credit to the income statement. If we combine the

22

Discount amortization credit with the Interest income credit we get actual
earnings credit from the bond at greater than the interest rate.
This is how we amortize a bond

Notice the formulas for line 6 are detailed in line 2. Basically you take the
Par times the annual stated rate divided by the number of periods per year
in column C. This is the interest you will receive. Then you take the Book
Value times the annual effective rate divided by the periods per year in
column D. This is the actual earnings for the bond. The difference between
those two amounts is amortization and it is added to the beginning Book
Value to equal the ending Book Value then it starts all over again for the
next period. So the effective rate of 6.961% will amortize the bond
purchased 1/1/2010 for 99,000 up to 100,000 at the maturity date of Feb 1,
2011.
Solving for the effective rate is an iterative process. You will need to
try this two or three times before you find the exact effective rate so that
Book = Par at the maturity date. What you do is first take a guess at the
effective rate to get close and then see how much you are off at the

23

maturity date. For instance in the above example, if we first put in .067, the
ending book value will be 99,709.20 which is different from the par of
100,000 by 290.80. If we change the effective rate to .069 the book value
ends up at 99,931.97. So, if a .002 change in the effective rate moves the
book value at maturity date by 222.77 = 99,931.97 99,709.20 how much
of a change to the effective rate will move the book value by our difference,
290.80?

The way you solve this is by using a proration formula like this
.002 / 222.77 is proportional to X / 290.80
You read this like so: .002 is to 222.77 as X is to 290.80.
To solve a proportion, you cross multiply and solve for X.

.002

Proportional to

222.77

X
290.80

So,

222.77 * X = .002 * 290.80

Or,

222.77 * X = .5816

X = .5816 / 222.77 (divide both sides by 222.77 to get rid of it

on the left side)
X = 0.0026107644655923149436638685639898
Then we add this number to our original .067 to equal .0696107644656.
If we use that number as the effective rate in the amortization table the
book value ends up as 100,000.09 at the maturity date a difference of 9
cents. The reason it is not exact is because this is a geometric function, not
a straight line function. You would have to solve the formula again like this
to get an exact 100,000.00 book value at maturity date.
If a difference of .00061076446 moves the book value by 68.12 = 99931.97
100000.09 then how much change to the effective rate would move the
book value by 68.03?

24

Now that we know more about bonds and how to journalize basic
transactions, let us look at how we would record some typical bond
transactions.
Debit
Bond (A+)

Credit

95,000

Cash in Bank

95,000

Record purchase of bond.

Bond (A+)
Discount Amortization (Inc+)

50
50

Record periodic amortization of discount.

Cash in Bank (A+)

1,200

Discount Amortization (Inc+)

Bond (A net -)

50
50

Interest Income (Inc+)

1,000
200

To record monthly interest of 200, monthly amortization of 50

and mortgage paydown of 1,000. Notice the net credit to the income
statement is $250 although the bond only pays $200.

Bond

25

Interest Receivable
Discount Amortization
Interest Income

100
25
100

To record Accrued Interest and Amortization for the end of the

month to recognize half a months worth of interest and amortization since
the bond pays on the 15th every month.

25

Debit

Cash in Bank (A+)

Credit

100,200

Interest Income (Inc+)

200

Discount Amortization (Inc+)

Bond (A net -)

50
50

100,000

To record Maturity of Bond along with final interest payment and

final Amortization adjustment.

Cash in Bank (A+)

Realized Loss (Exp+)

94,000
225

Bond (A-)

94,100

Interest Income (Inc+)

125

To record Sale of Bond for $94,000 cash which includes $125 of

interest income.
The Sale transaction illustrates a formula you should memorize to record
bond sales.
Total Cash from Sale including interest is
Minus Interest of

94,000
125

Equals Consideration of

93,875

Less Book Value of

94,100

Equals Gain (Loss)

( 225)

26

Partial Sales and Calls

You should recognize interest income and amortization up to the settlement
date of the sale or call. This can be done by prorating between scheduled
payment dates on the amortization schedule. For instance if the settlement
date of the sale is 90 days from the last semiannual payment, you can take
90/180 of the next scheduled payment amounts for interest and
amortization times the par value sold ratio to determine the interest and
amortization to record on the sale transaction. By doing this, you will have
the correct Interest and Book Value to subtract from the Total Cash so that
the Realized gain or loss is correct. You will also need to adjust the
amortization schedule to show the partial sale/call inserted into the schedule
and the reduced amount of par value going forward in future periods. See
formula for calculating Gain (Loss) above.

Permanent Declines
If a bonds value has substantially declined because of credit risk and there is
little likelihood that the value will improve, a permanent decline will write
down the Book Value and the Cost Basis to the Market or Fair value. You
would not write down the Tax Basis though. This write down is recorded as
a debit to Realized Loss (Exp +) and a credit to Book Value (A-). The
realized loss is reported in the Other Than Temporary Impairments column
on D part 1.

Mortgage Backed Bonds

Mortgage backed bonds pay you some principal along with the interest each
month. When you make your mortgage payment on your home part of your
payment is interest and part is principal. It is the same with mortgage
backed bonds. The issuer passes along the return of principal to the bond
holder each month. When an underlying mortgage defaults, if the mortgage
is secured, then the bond holder can receive the foreclosed amount also
which effectively accelerates the return of principal. The rate of prepayment
is sometimes published as a PSA or CPR factor which can be used to project
a repayment stream on the amortization schedule. First, lets talk about a
mortgage backed bond without the PSA and CPR factors.

27

When you purchase a mortgage backed bond the amortization

schedule is computed using a specific effective interest rate. When the
paydowns come in, you need to recognize some additional amortization
equal to the present value of the future amortization you would have
recognized had you held that par value. Or, stated another way, if you knew
when you bought the bond that you were going to receive this par value,
how much additional amortization would you have already recognized to
record this par value being redeemed. Either way, recognizing additional
amortization so that you can hold the effective rate constant so that the
Book Value will still equal the Par Value at maturity date is called the
Retrospective Method. Alternatively, you could change the effective rate
on the amortization schedule which would spread the additional amortization
over the remaining life which is called the Prospective Method. Practically
though everyone uses the Retrospective Method. The Retrospective Method
is recommended by auditors.
Stepped Bonds
Stepped bonds will vary the rate of interest that they are going to pay you
over the life of the bond. This makes for an interesting amortization
schedule! If a bond pays a below market rate at the beginning, like 2% then
4% then an above market rate at the end like 6% then 8% for instance,
the effective interest rate might be 5% for the life of the bond. In this case,
the amortization schedule will show discount amortization in the beginning
and premium amortization at the end.
Treasury Inflation Protected Bonds (TIPS)
TIPS bonds vary the amount of Par they will be paying based on an inflation
index. If inflation goes up then the amount of par you own will go up as
well. When the par value goes up you will now be amortizing to this new par
value. The par can go down also! The NAIC wants you to report the Fair
Value of the bond in the Carrying Value column. So, TIPS bonds will
necessarily have an Unrealized amount reported on D1 and also an
amortization amount. The change in the Fair Value for the year net of the
amortization is what is shown in the Unrealized column. As if that was not
enough, the NAIC would also like you to report the Original Issued Par Value
for the bond in the Par Value column, not the par you currently own for TIPS
bonds.

28

Valuation of Bonds for the Annual Statement

There is a Carrying Value column on Schedule D part 1 of the annual
statement which is usually the Book Value, also known as the Amortized
Cost. However, depending on the NAIC Designation, the Carrying Value
might be the Lower of Book Value or Fair Value. These rules depend on the
type of insurance company. For Life companies, if a bond is classified with
an NAIC Designation of 6 then you must enter the lower of fair value or
amortized cost. For Property and Casualty and Health companies, if a bond
is classified with an NAIC Designation of 3, 4, 5 or 6 then you must enter the
lower of fair value or amortized cost. The Securities Valuation Office has
published a cross reference between the Moodys and S&P Ratings and the
NAIC Designations, see below.

29

When a bond is reporting the Fair Value amount in the Carrying Value
column on Schedule D part 1, there will typically be an unrealized gain or
loss amount reported as well. Some people mistakenly assume the
Unrealized column should report the life to date unrealized adjustment
recognized on the bond but this is not always the case. Keep in mind when
creating the Verification Between Periods (DVER) schedule you are
explaining the difference between the beginning of the year and the end of
the year carrying value amounts. The Unrealized column amounts are part
of that formula.

The DVER is replicated here to help you understand the situation, see
below. Notice the Unrealized coming in from Schedule D Part 1 on line 4.1.
Basically, the DVER proves the following (Simplified by intent) formula to be
true taking amounts from the Schedule D reports.
Beginning Book/Carrying Value plus Purchases plus Amortization plus
Unrealized minus Realized Loss from Permanent Declines minus Book Value
Sold equals Ending Book Value.
Actually, the DVER does not subtract the Book Value Sold, it grosses
that up by subtracting the Consideration on the Sale adding back the
Realized Gain on the Sale and subtracting out the Realized Loss on the Sale
which equals the Book Value Sold. Additionally, it does not just add the
amortization; it adds the discount amortization and subtracts the premium
amortization.

30

If the bond was valued at Fair Value for both the beginning and end of the
period then the unrealized columns will equal the current year Fair Value
minus the prior year fair value minus the current year amortization. In
other words because they also need to report the amortization, it must be
netted into the total fair value change.
If the bond was valued at Book Value for the beginning of the year and
Fair Value at the end of the year the unrealized column will equal the current
year fair value minus the current year amortized cost.
If the bond was valued at Fair Value for the beginning of the year and
Book Value at the end of the year the unrealized column will equal the prior
year amortized cost minus the prior year fair value.

31

Debit

Credit

Stocks
Stocks (A+)

75,000

Cash in Bank (A-)

75000

To record Stock Purchase

Cash in Bank (A+)

38

Dividend Income (Inc+)

38

To record dividend income received

Fair Value Increase (A+)

375

Unrealized Gain (OE+)

375

To record Fair Value Adjustment

Cash in Bank

25

Stocks

25

To record Liquidating Dividend as return of cost basis

Stock Split No adjustment necessary to dollar balances. Only

need to adjust the total number of shares and the per share amounts.

32

Useful Formulas and Excel Techniques for Accountants

Being able to sort a block of data by Account Number for instance and then
write a formula to automatically subtotal it can be useful if you have a large
set of data. The way you solve this problem is to break it up into a few
smaller formulas. First you need an indicator column to test for when the
account number changes. I like to put a 1 on the first new account number
row and 0 on all the other rows. The formula in C4 below says if A4 is the
same as the previous account number A3 then put a 0 otherwise put a 1. So
we get a 1 on the first row of each new account number set. The formula in
D4 says if C4 = 1 then we are starting a new account number set so add
just B4 otherwise add B4 plus D3 which would be the running total of this
account number set. The formula in E4 says if C5 = 1 then the next row is a
new account number set so report D4, the running total of this current
account number set otherwise enter a blank.

33

Solving a Proration Formula

As discussed in the Bond effective interest rate section, solving a proportion
is one of the most useful equations for accountants. Let us look at another

34

example. Consider two lots of the same bond, Bond A has 77,234 of par
and Bond B has 52,978 of par. If bond A received $573.25 of interest for
the month, how much interest did bond B receive assuming they both pay
the same interest rate?
The way you solve this is by using a proration formula like this
573.25 / 77,234 is proportional to X / 52,978
You read this like so: 573.25 is to 77,234 as X is to 52,978.
To solve a proportion, you cross multiply and solve for X.

573.25

Proportional to

77,234

X
52,978

So,

77,234 * X = 573.25 * 52,978

Or,

77,234 * X = 30,369,638.5

X = 30,369,638.5 / 77,234 (divide both sides by 77,234 to get

rid of it on the left)
X = 393.22
So the 52,978 par value bond should have received 393.22 of interest.