Amortization period is shortened for premiums paid for some callable debt

Investors, banks and insurance companies holding municipal bonds and some classes of corporate debt will be able to avoid recording losses in earnings when the issuer calls the bonds before they mature, under an amendment to U.S. GAAP the FASB published on March 30, 2017.

The amendments in Accounting Standards Update (ASU) No. 2017-08, Receivables—Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities, shorten the amortization period for the premium paid on callable debt securities to the earliest date on which the debt can be called instead of when the instrument matures. The update largely covers municipal bonds but also could affect the accounting treatment of some callable corporate debt.

The change avoids the overstatement of interest income in the earlier periods after the purchase of the debt, followed by a loss during the period when the issuer calls the debt in. Proponents believe the update will better portray the way callable debt securities are priced and traded in the markets.

“For our client base, this is a welcome change,” said Matthew Schell, a partner in the national office at Crowe Horwath LLP. “A lot of financial institutions and insurance companies want this ability to amortize it earlier, particularly since that’s what the market’s belief is. It’s priced so that the security is going to be called away.”

When interest rates dip, municipalities with outstanding debt can cut their interest payments by calling it in before it matures. FASB ASC 310-20-35-33, Receivables — Nonrefundable Fees and Other Costs — Subsequent Measurement — Estimating Principal Prepayments, formerly SFAS No. 91, however, prohibits bondholders from amortizing the premium to the earliest call date. The amendments in ASU No. 2017-08 override that prohibition.

“People wanted that ability to amortize that premium — to take that expense and adjust their yield downward faster because they knew it would get called,” Schell said. “If they don’t amortize it, and it gets called way, they would essentially take a loss.”

Under current GAAP, when a bond is called early, the unamortized premium is recorded as a loss in earnings, the FASB said.

“Really, if you’re not amortizing to that first call date, you're overaccruing income,” said Gregory Smith, senior director at the Investment Company Institute. “So I think this better aligns the accounting with the realities of the economics.”

The update does not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity.

Public businesses must comply with the revision to U.S. GAAP for fiscal years and quarterly periods beginning after Dec. 15, 2018. Private companies will have an extra year. They must comply with the quarterly requirements within fiscal years beginning after Dec. 15, 2020. Companies may adopt the amendments early.

Six of the FASB’s seven members approved the update for publication, with Marc Siegel dissenting.

Siegel, a former securities analyst, did not disagree with the premise of the update, but he said the board could have broadened the amendments’ scope. The project was originally undertaken to improve the disclosures about interest income on purchased debt securities and loans, but the FASB ended up dropping these changes as it worked on the project.

This was a “squandered” opportunity, Siegel wrote in his dissent.

The FASB added the project to its agenda in March 2015 after investors and analysts told the board about the difficulty they have understanding the amount of interest income that appears in financial statements. They said they wanted information about the amount of interest income that is attributed to cash paid by borrowers versus how much is attributed to the subsequent accounting of the premiums or discounts related to prior purchases.

The FASB cut the interest income disclosure requirements from the project by the time it released the draft version of the amendments in Proposed ASU No. 2016-340, Receivables—Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities, in September 2016.

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