BC13. In concluding on the amortization period, the Board considered the cost and complexity of a management expectation model similar to the International Financial Reporting Standards (IFRS) guidance under IFRS 9, Financial Instruments. IFRS differs from GAAP in that, under IFRS, prepayment options are factored into the calculation of the effective interest rate in most cases for financial instruments measured at amortized cost. Under IFRS 9, measuring the amortized cost of a financial instrument with prepayment options is based on the notion of the instrument’s expected life. Therefore, IFRS 9 requires an entity to estimate cash flows considering all contractual terms of the financial instrument (for example, prepayment, call, and similar options). However, the Board determined that the increased cost and complexity of this model may not justify the benefits when applied only to callable debt securities.
BC14. Additionally, at the request of certain respondents to the amendments in the proposed Update, the Board considered the cost and complexity of requiring a yield-to-worst amortization methodology rather than a yield-to-earliest call amortization methodology. Those respondents pointed out that some callable bonds have multiple call dates with differing prices (that is, call tables). The yield-to-worst pricing methodology assumes that the issuer will call on the call date that produces the worst yield, which is not necessarily the earliest call date. For example, if there are different call premiums associated with different call dates, the earliest call date might not produce the worst yield.
BC15. Certain Board members preferred a yield-to-worst amortization methodology because it is more consistent with market pricing and results in a more precise reflection of the economics of the debt security. Also, it presents an opportunity to align GAAP reporting with regulatory reporting requirements for preparers in the insurance industry.
BC16. However, consistent with the view of the majority of respondents to the proposed Update, the Board decided that amortizing to the earliest call date substantially achieves the stated objective of better aligning the accounting with expectations incorporated in market pricing while reducing the cost and effort necessary to analyze and conclude on a likely call date broadly across all industries to which the amendments in this Update apply. The cost of considering all call dates within a particular callable security may be higher for companies without access to sophisticated pricing systems or those companies that have an active investment portfolio of callable securities. In addition, the Board learned that in a majority of purchases the yield would be the same under either approach but to perform a yield-to-worst calculation for each purchase would create unnecessary internal controls and financial reporting costs.
BC17. Furthermore, the effective rate as determined under a yield-to-worst pricing methodology can change from period to period when interest rates change. Therefore, to be consistent with a yield-to-worst pricing methodology, a yield-to-worst amortization methodology also would require companies to periodically reassess their effective rate. Such an approach also might have required the Board to develop guidance to determine how to report a changing effective rate from period to period, and companies would have potentially needed to implement systems to account for the effect of such a change in circumstances. Alternatively, the Board could have required a modified yield-to-worst amortization methodology in which the effective rate is set upon purchase and not updated periodically, which more closely follows insurance regulatory requirements. However, that approach would still contain the potential operational complexities and cost-benefit considerations described in paragraph BC16.
BC18. Lastly, only those bonds that have varying call prices on varying call dates or those that have other features such as increasing interest rates (that is, step-up bonds) may have a “worst yield” that is determined by amortizing the premium to a call date other than the first call date. However, those types of securities are a relatively small portion of all callable bonds. In summary, the Board determined that a yield-to-worst amortization methodology provides further precision to a small minority of callable debt securities but that the yield-to-worst amortization methodology does not provide greater benefits or a reduction in costs to the greater population of callable debt securities.
BC19. After considering the costs and complexities associated with a yield-to-worst approach, the Board concluded that a yield-to-earliest call approach was a more cost-effective way to better align interest income recorded on bonds at a premium with the economics of the underlying instrument than current GAAP. Therefore, the Board affirmed its decision to require a yield-to-earliest call amortization methodology rather than a more precise yield-to-worst amortization methodology.
BC20. The Board considered whether amortizing premiums to the earliest call date would be appropriate in circumstances in which a security was not called as expected on the earliest call date. In that situation, if the call price is at par, as it is in most circumstances, the interest income would be lower in the periods before the earliest call date, because of the amortization of the premium, and higher after the earliest call date, because of interest income being reset to the coupon rate. If the security was not called at the earliest call date, it would likely be because of market interest rates rising above the security’s coupon rate. Therefore, resetting the interest rate to the coupon rate after the earliest call would reflect the rise in market interest rates. The Board determined that this approach is appropriate because this outcome is consistent with the market economics of the security. Additionally, for these same reasons, the Board concluded that this accounting change is appropriate regardless of the interest rate environment (that is, in a period of rising, falling, or stagnated interest rates) and because it is an improvement to GAAP because it better reflects the economics at the point in time of the purchase of the security and in subsequent periods.
BC21. In situations in which an entity amortizes a premium to a call price greater than par and the debt security is not called on the earliest call date, an entity would reset the yield using the payment terms of the debt security. If the security contained additional future call dates, the entity would consider whether the amortized cost basis exceeded the amount repayable by the issuer at the next call date. If so, the excess would be amortized to the next call date.
BC22. In summary, the Board determined that amortizing the premium (that is, the excess of amortized cost basis over the amount repayable at the earliest call date) to the earliest call date improves the usefulness of the information provided to financial statement users by more closely aligning accounting with market economics while reducing cost and complexity.