The Financial Accounting Standards Board (FASB) recently made targeted changes to the rules governing accounting for amortization of premiums for purchased callable debt securities. The changes are reflected in Accounting Standards Update (ASU) 2017-08—Receivables—Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. This article examines what these changes mean.
A premium debt security is a security that trades above its par value in the secondary market. Such a security will trade at a premium when it extends a coupon (interest) rate that is higher than the current prevailing interest rates offered for newly issued securities. This type of investment gives investors a higher yield, and thus they will pay more for it.
Under current Generally Accepted Accounting Principles (GAAP), a premium is typically amortized to the security’s maturity date, even if the holder is certain the call will be exercised. Therefore, when a call is exercised on a callable debt security held at a premium, the unamortized premium is recorded as a loss in earnings. The new standard revised under ASU 2017-08 shortens the amortization period for the premium to the earliest call date. If the call option is not exercised at the earliest call date, then the effective yield of the security should be reset using the payment terms of the debt security.
The amendment does not require an accounting change for securities held at a discount. Such securities will continue to be amortized to maturity.
Financial statement users noted that prior GAAP resulted in the recognition of excessive interest income before the security was called, which was then followed by the recording of a loss on the call date for the unamortized premium. They also informed the FASB about diversity in practice regarding the amortization period for premiums of callable debt securities, as well as how the potential for the exercise of a call is factored into current impairment assessments. In most cases, investors price securities 1) to the call date that produces the worst yield when the coupon is above current market rates, and 2) to maturity when the coupon is below market rates in anticipation that the borrower will act in its economic best interest. Therefore, in the FASB’s opinion, the amendment to the amortization period will provide more decision-useful information to all financial statement users.
The standard takes effect for public business entities for fiscal years and interim periods within those fiscal years, beginning after December 15, 2018. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020.
Early adoption is permitted, including adoption in an interim period. If an entity early adopts in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. In the period of implementation, an entity should record a cumulative-effect adjustment directly to net assets, or retained earnings, as of the beginning of the period of adoption to account for the change in methodology (also known as the modified retrospective basis).
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