A new accounting rule that changes the calculation of bond premium amortization on certain callable debt securities could create tracking headaches due to the book-to-tax differences that might result.
The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2017-08, “Receivables – Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities,” in March 2017. While the rule changes the amortization period under U.S. generally accepted accounting principles (GAAP), it is important for financial services companies that hold securities to recognize that, depending on a bond’s facts and circumstances, the new GAAP approach might not be permissible for tax purposes.
The New Amortization Period for Book Purposes
ASU 2017-08 applies to the amortization of premium on debt securities with explicit noncontingent call features that are callable at fixed prices on preset dates. Under current GAAP, bondholders generally amortize the premium as an adjustment of yield over the contractual life of the instrument. Upon exercise of a call on a callable debt security held at a premium, the unamortized premium is recorded as a loss to earnings.
As a response to comments received from stakeholders, the FASB agreed, this approach of amortizing through to maturity does not reflect the underlying economics of a bond. The update, therefore, “more closely aligns the amortization period of premiums and discounts to expectations incorporated in market pricing” by reducing the amortization period to the earliest date a bond could be called.
The ASU applies only to securities held at a premium. Securities held at a discount will continue to be amortized to maturity. It also applies only to bonds that are callable based on an explicit decision by the issuer, not due to prepayment features, contingent call options, or call options where the timing or amount to be paid is not fixed.
The ASU is effective for public business entities for fiscal years beginning after Dec. 15, 2018. For all other entities, it is effective for fiscal years beginning after Dec. 15, 2019. Early adoption is permitted, and some banks are pursuing this option due to market and regulatory pressures.
Tax Amortization Methods
Even though the GAAP accounting method is changing, bondholders will be required to maintain their historic tax methods of accounting for premium amortization if the new GAAP method is not an acceptable method for federal income tax purposes.
Under IRS rules for a taxable bond, the holder must assume the scenario that gives it a higher yield. Unless a taxable bond has a significant call premium, this approach generally requires amortizing to maturity, rather than the earliest call date. For example, consider a $100,000 bond with a $10,000 acquisition premium and $5,000 call premium. If the acquisition premium is amortized to its seven-year maturity, the yield is 8.074 percent; if amortized to the two-year call date, with the $5,000 call premium paid, the yield is only 6.894 percent. But if the call premium were $8,000, the yield would be 8.218 percent when amortized to the call date.
In the absence of a significant call premium that boosts the call date yield to greater than the maturity yield, the ASU approach will not correspond with the proper tax treatment for a taxable bond. For tax purposes, the bondholder can’t rely on the ASU yield but must amortize to maturity. In other words, the holder will need to keep separate premium amortization schedules for book and tax purposes.
For tax-exempt bonds, on the other hand, under IRS rules the holder must assume the lower yield scenario, which generally means amortizing to the earliest call date, rather than maturity. In that case, the ASU approach also will be correct for tax purposes. If, however, the holder has been applying the current GAAP approach and amortizing to maturity for tax purposes, it is currently using an incorrect tax method and should consider changing it to follow the ASU.
Recording Adoption of the New Method
Bondholders will apply the ASU to their books retrospectively through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. For available for sale (AFS) securities, any catch-up of amortization also affects the unrealized gain or loss. Banks should consider and record the appropriate tax effects with these entries as well.
The Road Ahead
ASU 2017-08 shortened the amortization period of callable debt securities for GAAP purposes to the earliest call date. The tax rules for amortization did not change, though, so banks should expect to compute new book-to-tax adjustments after adoption of the ASU.
