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Accounting for Callable Debt Securities for State and Local Governments

by Khaled Abdel Ghany, PhD, CPA | Jan 04, 2018
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In March 2017, the Financial Accounting Standards Board (FASB) issued the Accounting Standards Update No. 2017-08 “Premium Amortization on Purchased Callable Debt Securities.” The requirement of this update is to shorten the amortization period for certain callable debt securities held at a premium. Specifically, the Update required the premium to be amortized to the earliest call date. FASB did not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity.

The Governmental Accounting Standards Board (GASB) requires the state and local governments to amortize premium or discount on long-term debt over the life of the debt to the maturity date. GASB also requires the recognition of deferred outflow of resources or deferred inflows of resources in both cases of current and advance refundings, and the recognition of gain or loss when a government uses its own existing resources to extinguish a debt. These deferred inflows and outflows of resources, gains, and losses amounts represent the difference between the reacquisition price and the net carrying amount of the old debt.

This article presents analysis and discussion of the FASB new accounting update and how it could be applicable to state and local governments’ debt refunding or debt extinguishment transactions. I concluded that shortening the amortization period for callable long-term debt issued at a premium should provide better and more valid measure of the deferred inflows of resources and deferred outflows of resources, gains, and losses. Consequently, the quality of financial reporting for state and local governments would be significantly improved by reflecting the real economic results of debt refunding or debt extinguishment transactions.

FASB New Accounting Standards Update

Under the current Generally Accepted Accounting Principles (GAAP), premiums and discounts on callable debt securities are generally amortized to the maturity date. An entity that holds a long-term callable debt security at a premium may not amortize that premium to the earliest call date. If that callable debt security is subsequently called, the entity records a loss equal to the unamortized premium balance.

FASB stated that the amendments in the Update 2017-08 more closely align the amortization period of premiums and discounts to expectations incorporated in market pricing on the underlying securities. In most cases, market participants price securities to the call date that produces the worst yield when the coupon is above current market rates (that is, the security is trading at a premium) and price securities to maturity when the coupon is below market rates (that is, the security is trading at a discount) in anticipation that the borrower will act in their economic best interest. As a result, the amendments more closely align interest income recorded on bonds held at a premium or a discount with the economics of the underlying instrument.

IFRS No. 9

The International Financial Reporting Standard (IFRS) No. 9 “Financial Instruments” allows, in special circumstances, the use of a shorter period of time when applying the effective interest method to amortize premium or discount. This will be the case when the variable to which the premiums or discounts relate is repriced to market rates before the expected maturity of the financial instrument.

In such a case, the appropriate amortization period is the period to the next such repricing date. For example, if a premium or discount on a floating-rate financial instrument reflects the interest that has accrued on that financial instrument since the interest was last paid, or changes in the market rates since the floating interest rate was reset to the market rates, it will be amortized to the next date when the floating interest is reset to market rates. This is due to the fact that the premium or discount relates to the period to the next interest reset date because, at that date, the variable to which the premium or discount relates (i.e., interest rates) is reset to the market rates.

However, IFRS No. 9 stated that if the premium or discount results from a change in the credit spread over the floating rate specified in the financial instrument, or other variables that are not reset to the market rates, it is amortized over the expected life of the financial instrument.

Government Debt Refundings

Refundings involve the issuance of new debt whose proceeds are used to repay previously issued (“old”) debt. The new debt proceeds may be used to repay the old debt immediately (a current refunding); or the new debt proceeds may be placed with an escrow agent and invested until they are used to pay principal and interest on the old debt at a future time (an advance refunding).

GASB Statement No. 7 “Advance Refundings Resulting in Defeasance of Debt” stated that a debt is considered defeased in substance for accounting and financial reporting purposes if the debtor irrevocably places cash or other assets with an escrow agent in a trust to be used solely for satisfying scheduled payments of both interest and principal of the defeased debt, and the possibility that the debtor will be required to make future payments on that debt is remote. The trust is restricted to owning only monetary assets that are essentially risk-free as to the amount, timing, and collection of interest and principal. The monetary assets should be denominated in the currency in which the debt is payable. For debt denominated in U.S. dollars, essentially risk-free monetary assets are limited to:

  1. Direct obligations of the United States government
  2. Obligations guaranteed by the U.S. government
  3. Securities backed by U.S. government obligations as collateral and for which interest and principal pay

GASB Statement No. 65 “Items Previously Reported as Assets and Liabilities” stated that for current refundings and advance refundings resulting in defeasance of debt reported by governmental activities, business-type activities, and proprietary funds, the difference between the reacquisition price and the net carrying amount of the old debt should be reported as a deferred outflow of resources or a deferred inflow of resources, and recognized as a component of interest expense in a systematic and rational manner over the remaining life of the old debt or the life of the new debt, whichever is shorter.

The reacquisition price is the amount required to repay previously issued debt in a refunding transaction. In a current refunding, this amount includes principal of the old debt and any call premium. In an advance refunding, it is the amount placed in escrow that, together with interest earnings, is necessary to pay interest and principal on the old debt and any call premium. A premium or discount pertaining to the new debt is not considered part of the reacquisition price but, instead, is a separate item related to and amortized over the life of the new debt.

On the other hand, the net carrying amount is the amount due at maturity, adjusted for any unamortized premium or discount related to the old debt, as well as any deferred outflows of resources or deferred inflows of resources associated with a derivative instrument that is an effective hedge of the old debt.

In May 2017, GASB issued the Statement No. 86 “Certain Debt Extinguishment Issues”. This standard required a government that places cash and other monetary assets acquired with only existing resources in an irrevocable trust to extinguish the debt, to recognize gain or loss, in the period of the in-substance defeasance. The gain or loss is the difference between the requisition price and the net carrying amount of the debt.

Amortization Period: Governmental Accounting

GASB Statement No. 62 “Codification of Accounting and Financial Reporting Guidance Contained in Pre-November 30, 1989 FASB and AICPA Pronouncements” requires the difference between the present value of a note and its face amount to be treated as discount or premium and amortized as interest expense or revenue over the life of the note in such a way as to result in a constant rate of interest when applied to the amount outstanding at the beginning of any given period.

The premium or discount amortization is calculated by the interest method. Under this method, the periodic interest cost (including amortization) is representing the effective interest expense calculated at the effective interest rate on the sum of the face amount of the debt and (plus or minus) the unamortized premium or discount at the beginning of each period. The difference between the periodic interest cost and the nominal interest on the outstanding amount of the debt is the amount of periodic amortization.

GASB Statement No. 62 also stated that the discount or premium resulting from the determination of present value in cash or noncash transactions is not an asset or liability separable from the note that gives rise to it. Therefore, the discount or premium should be reported in the Statement of Net Position as a direct deduction from or addition to the face amount of the note. It should not be classified as a deferred charge or deferred credit. The description of the note should include the effective interest rate; the face amount also should be disclosed in the notes to the financial statements.

Discussion and Conclusion

The FASB new accounting rule acknowledged that in the case of long-term callable debt issued at a premium, the issuer most likely will call and repay that debt on the first call date. Therefore, instead of recognizing losses equal to the amount of unamortized premium on the first call date, the FASB new Accounting Standard Update requires the amortization of the premium over a shorter period of time up to the first call date. On the other hand, in the case of long-term callable debt issued at discount, the issuer normally pays less interest than the average market interest rate. Therefore, there are small probabilities that the issuer will repay that debt on the first call date. Consequently, FASB did not change the amortization period for the discount which is the period to the debt maturity date.

For state and local governments, GASB requires the recognition of deferred inflows of resources and deferred outflows of resources for both current and advance refundings. The recent governmental accounting standard requires the recognition of gain or loss when a government uses its own existing resources to extinguish a debt before maturity. GASB requires the amortization of premium or discount on a period equals to the debt life to maturity.

I suggest that GASB should consider the new shorter amortization period for premium on long-term callable debt introduced by FASB, which is also supported, to some extent, by the IFRS No. 9. The amounts recognized as deferred inflows of resources or deferred outflows of resources (in case of current and advance refunding), and the amounts recognized as gain or loss (in case of debt extinguishment using a government’s existing resources) will be more valid and representative of the transaction substance if the premium amortization period is shortened to the first call date.

Generally, a government that pays higher interest rate on a long-term callable debt will probably repay that debt at the first call date. Therefore, it is more reasonable to amortize the premium to the first call date and not to the maturity date. Consequently, at the first call date, the premium is completely amortized, and the amount of deferred inflows of resources or deferred outflows of resources, and the amounts of gains or losses will reflect the real economic results of debt refunding or debt extinguishment transactions.

Khaled Abdel Ghany headshotKhaled Abdel Ghany, PhD, CPA is Executive Accounting Advisor, Office of the Chief Financial Officer, D.C. Government. You can contact him at drabdelghany@yahoo.com.

This article appeared in the winter 2018 issue of the WashingtonCPA Magazine. Read more here.

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