Sometimes it’s those smaller new standards that fly under the radar and jump out to surprise us. While focus lately has been on ASC 326 and adopting a new credit loss model, there has been another financial instrument-related ASU that may also have a significant impact on your reporting for investments. In our recent Essential U.S. GAAP Update course, we cover a relatively narrow amendment that has resulted in more than its fair share of questions and looks of concern. ASU 2017-08, Premium Amortization on Purchased Callable Debt Securities, is effective for private issuers for the first time in fiscal year 2021 and clarifies how certain premiums on purchased debt securities must be amortized. The overall point for this ASU is to ensure that, when practical to do so, a prepayment of the debt will not result in a “surprise” loss upon settlement for the investor.
To illustrate, let’s look at an example:
Let’s assume Bernie Corp. acquires a $1 million / 7% / 5-year corporate bond from Funky Mittens Inc. that is callable by Funky Mittens at the end of Year 1 at par value. Now let’s consider two different scenarios:
- Bernie acquired the bond at a discount (e.g., $960,000) as market rates were higher than the stated rate at the time of purchase.
- Bernie acquired the bond at a premium (e.g., $1,050,000) as market rates were lower than the stated rate at the time of purchase.
Under both scenarios, the amortized cost basis of the debt investment will be amortized over the life of the bond, such that at the end of five years, the amortized cost basis will be equal to the face amount ($1 million), so that when the bond is paid off, cash of $1 million is received and the $1 million investment is removed from the balance sheet.
However, what happens if the bond is actually prepaid at the end of year one, as is allowed under the terms of the instrument?
- In Scenario 1, the discount will not have been amortized fully, resulting in receipt of $1 million to prepay the bond and removal of the partially amortized investment (say, $970,000). The difference between the face amount and the amortized cost basis at the prepayment date (i.e., unamortized interest income) represents a “gain” on settlement of the bond ($30,000).
- In Scenario 2, the premium will not have been amortized fully, resulting in receipt of $1 million to prepay the bond and removal of a partially amortized investment (say, 1,035,000). The difference between the face amount and the amortized cost basis at the prepayment day (i.e., unamortized reduction to interest income) represents a “loss” on settlement of the bond ($35,000).
While the FASB doesn’t mind “surprise gains”, “surprise losses” that could have been foreseen are NOT considered “good GAAP”… and that’s where this ASU comes in. For certain purchased, callable debt, the ASU aims to eliminate the possibility of “surprise losses” upon prepayment by requiring the investor to accelerate its amortization (if necessary) to the earliest call date, such that the amortized cost basis is equal to (or below) the call price.
The basic concept of this ASU may seem pretty straight-forward, but once we start to dig a bit deeper, we see there are a number of issues that may present significant challenges to first-time adopters.
As we saw in the basic examples, “surprise losses” only arise from investments in debt securities acquired at a premium. Therefore, the scope of this ASU only covers these scenarios. It further narrows the scope to only those instruments acquired at a premium, where the prepayment feature can only be exercised at a present date and at a price that is known at inception. Therefore, instruments that are prepayable immediately (no preset date) upon issue, or the price of which is not known in advance, would not be subject this this amendment.
There is an additional scope exception for investment in securitized debt securities (e.g., mortgage-backed securities) that are backed by underlying prepayable debt securities, as well as debt securities for which the entity is already amortizing the premium after considering “estimated prepayments” which is more common for banks and financial institutions.
While the concept may seem simple, actually applying this amendment to a significant portfolio of debt securities may prove to be a significant challenge. While a portfolio may include debt investments acquired at a premium and others at a discount, only those individual securities acquired at a premium, with present prepayment terms, are going to have a manipulated amortization schedule. It may become evident that your current accounting software does not have the ability to capture the necessary data needed, nor the capability to separately amortize the speed of some investments and not others. Careful attention needs to be applied to how this amendment will become operational once adopted.
Funky prepayable debt:
Our example above is quite simple, but some debt instruments may have multiple prepayment dates at different prepayment prices. How does this impact amortization of a premium? The amendment, along with subsequent statements by the FASB, have provided guidance on this issue. However, it will require constant monitoring of the instrument and adjustment of the speed of amortization based on the next possible prepayment date. If that date passes without prepayment, the amortization is potentially adjusted again for the next prepayment date, creating even further operational complications.
The FASB chose to have this amendment applied using a modified retrospective transition approach (i.e., cumulative effect adjustment to retained earnings upon adoption). However, it is not exactly clear how this will impact certain instruments, such as those with multiple prepayment dates that had not been applying the amendment but would have been impacted by it if they had. Therefore, careful consideration must be given to transition and accounting policy choices may need to be made. Our Essential U.S. GAAP for the Investment Management Industry covers some interpretations by the AICPA Expert Panel that addressed this issue.
In our live courses in 2019 and webinars in 2020, ASU 2017-08 was a hotly debated topic, showcasing how some of the narrow and less-substantial amendments sometimes have some of the most significant impacts from a practical sense. If you want a rundown of all of these issues and more, consider taking our U.S. GAAP Update eLearning. That way you can avoid your own surprises and keep up to date on ALL the new U.S. GAAP developments, because you never know which ones are going to be your big ones!
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