In March, the Financial Accounting Standards Board (FASB) published an update to U.S. Generally Accepted Accounting Principles (GAAP) that will shorten the amortization period for premiums paid for callable debt securities, such as municipal bonds, to the earliest call date. The FASB believes the move will eliminate the unexpected losses that bondholders often record when the securities are called before they mature.
Here are the details of how the narrow-scope project is expected to affect investors, banks and insurance companies holding municipal bonds and some classes of corporate debt.
Municipalities with outstanding debt can cut their interest payments by calling the bonds in early, if the bonds accrue interest at higher rates than current market rates. Under existing GAAP, when a bond is called, any unamortized premium is recorded as a loss in earnings.
Existing GAAP (specifically, FASB Accounting Standards Codification Topic 310-20-35-33, Receivables — Nonrefundable Fees and Other Costs — Subsequent Measurement — Estimating Principal Prepayments) prohibits bondholders from amortizing the premium to the earliest call date. But many investors would prefer to shorten the amortization period — in other words, to take the expense and adjust their yield downward faster in case the debt gets called. Otherwise, under current practice, investors may overaccrue income.
The FASB added the callable debt project to its agenda in March 2015 to help align the accounting with financial realities. Investors and analysts told the FASB that they have difficulty understanding the amount of interest income that appears in financial statements. So, they asked the FASB to require information about the amount of interest income that’s attributed to cash paid by borrowers vs. the amount that’s attributed to the subsequent accounting of the premiums or discounts related to prior purchases.
A year later, in March 2016, the FASB published Accounting Standards Update (ASU) No. 2017-08, Receivables — Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. The standard shortens 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 it also could affect the accounting treatment of certain callable corporate debt.
Essentially, 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 more accurately reflect how callable debt securities are priced and traded in the markets.
The update doesn’t require an accounting change for securities held at a discount. Instead, the discount continues to be amortized to maturity.
When drafting the final version of the update, the FASB eliminated the interest income disclosure requirements from Proposed ASU No. 2016-340, Receivables — Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. This proposal was issued in September 2016.
Most financial institutions and insurance companies welcome the updated guidance. But one FASB member, former securities analyst Marc Siegel, dissented, calling the final version “a squandered opportunity.” Although he didn’t disagree with the premise of the update, Siegel would have preferred to broaden the amendments’ scope to include more disclosures.
Public companies must comply with ASU 2017-08 for fiscal years and quarterly periods beginning after December 15, 2018. Private businesses will have an extra year; they must comply with the quarterly requirements for fiscal years beginning after December 15, 2020. Companies also may adopt the amendments early.