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FASB Revisits Accounting for Premiums on Callable Debt Securities

April 28, 2017

Premiums associated with most callable debt securities will have a shorter amortization period under guidance recently released from the Financial Accounting Standards Board (FASB). In its Accounting Standards Update (ASU) 2017-08, Receivables—Nonrefundable Fees and Other Costs (ASU 2017-08), the FASB revised the amortization period for debt securities with noncontingent call features, which are also callable at a fixed price and predetermined date, to the earliest call date.

ASU 2017-08 modifies current U.S. generally accepted accounting principles (GAAP), which requires that reporting entities amortize the premium as an adjustment of the yield on the debt security over the contractual life of the instrument (i.e. to the maturity date). A premium represents the amount of the security's amortized cost basis in excess of the contractual payments required by the issuer. When determining the amount of the premium to be amortized to the earliest call date, the premium represents the amortized costs basis in excess of the fixed call amount. In many instances bonds are acquired at a premium and with the expectation that the bond will be called by the issuer at a date prior to maturity due to terms which provide the issuer with preset call dates and amounts. Under current GAAP, should the issuer exercise the call option, the bond holder would record a loss in earnings as a result of the recognition of the remaining unamortized premium on the bond. The result is a higher yield recognized prior to the call date, with a loss (or significantly lower yield) in the period in which the call was exercised.

Changing the amortization period to the earliest call date will address these concerns. In electing to change the amortization model, the FASB considered the market pricing for callable bonds, which is often described as a "yield-to-worst" pricing model. Callable debt securities are typically priced to the call date that produces the worst yield for securities that are trading at a premium. In the FASB's opinion, the change in recognition of the premium from the contractual maturity date to the earliest call date more aligns the yield on the security with the market pricing for such instruments.

Terms of the call feature must include a preset date and call amount in order to be within the scope of ASU 2017-08. Prepayable instruments in which the prepayment date and amount are not established are not within the scope of these amendments, including asset-backed securities such as mortgage-backed securities. However, existing GAAP does allow for estimates to be made for certain prepayable instruments, including many mortgage-backed securities.

Contingently callable debt securities are also not within the scope of ASU 2017-08 until the contingency has been resolved. Once resolved, the amortization of any existing premium would be in accordance with these amendments, and therefore, amortized to the earliest call date. If a debt security has multiple call features, the amortization of the premium should be to the earliest call date that is also at a fixed amount. If, at the earliest call date, the option is not exercised, any remaining premium should be amortized to the next earliest call date.

As an example, a callable debt security is acquired by a reporting entity for $106, including a $6 premium as compared to par value. The security is callable by the issuer in 12 months for $103 and in 24 months for $101. In this instance, the initial premium would be divided into different components. The $3 premium as compared to the initial call date would be amortized to that initial call date. If the security is not called by the issuer on that date, the premium of $2 would be amortized from that date to the next call date and amount of $101. Finally, if the security was not called on the second call date the remaining $1 premium would be amortized over the remaining contractual term of the security (i.e. to the maturity date). If the security only included the initial call date and amount of $103, and the issuer did not call the security on that date, the remaining $3 premium would be amortized over the remaining contractual term of the security.

Debt securities with coupons below market rates (trading at a discount) are priced to maturity, and the discount is amortized to maturity. ASU 2017-08 will not affect accounting for debt securities held at a discount.

When Does ASU 2017-08 Take Effect?

The amendments required by the ASU will take effect for public business entities for fiscal years and interim periods within those fiscal years beginning after Dec. 15, 2018. All other entities must adopt the amendments for fiscal years beginning after Dec. 15, 2019, and interim periods beginning after Dec. 15, 2020. Adoption will follow a modified retrospective approach, where a cumulative-effect adjustment will be made directly to retained earnings as of the beginning of the adoption period.

Early adoption is permitted. If adopted during an interim period, entities will need to ensure any adjustments are reflected as of the beginning of the fiscal year that includes that interim period.

For More Information

If you have any comments, questions or concerns about ASU 2017-08, please contact Mike Loritz of MHM's Professional Standards Group. Mike can be reached at mloritz@cbiz.com or 816.945.5611.

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