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6.5 Interest method
Publication date: 31 May 2022
us Loans & investments guide
The ASC Master Glossary provides the following definition of the interest method.
Definition from the ASC Master Glossary
Interest method: The method used to arrive at a periodic interest cost (including amortization) that will represent a level effective rate on the sum of the face amount of the debt and (plus or minus) the unamortized premium or discount and expense at the beginning of each period.
While the definition in the ASC Master Glossary focuses on debt, the concept is also applicable to loans, receivables, and debt securities.
For loans, receivables, and debt securities that are not prepayable by the issuer, the interest method is generally applied over the contractual life of the asset for purposes of recognizing accretion and amortization associated with premiums, discounts, and deferred origination fees and costs.
Example LI 6-1 illustrates the basic application of the interest method.
EXAMPLE LI 6-1
Application of the interest method
Application of the interest method
Investor Corp pays $4,650,000 for a bond with the following terms.
Par amount |
$5,000,000 |
Coupon rate |
6% paid annually |
Years to maturity |
10 years |
Since Investor Corp pays $4,650,000 for a bond with a par amount of $5,000,000, it acquires the bond at a discount of $350,000.
What is the effective interest rate of the bond? How should Investor Corp record interest income on its investment?
Analysis
The effective interest rate is determined by solving for the rate needed for the present value of the bond’s future cash flows to equal the initial amortized cost basis of the bond.
The schedule of cash flows is shown below. There is a cash outflow at the date the bond is purchased equal to the purchase price. The annual cash inflow relates to the 6% coupon payments on the par amount of the bond (6% × $5,000,000 = $300,000). The bond is repaid at maturity.
Period |
Cash inflow (outflow) amount |
Purchase date |
($4,650,000) |
Year 1 |
300,000 |
Year 2 |
300,000 |
Year 3 |
300,000 |
Year 4 |
300,000 |
Year 5 |
300,000 |
Year 6 |
300,000 |
Year 7 |
300,000 |
Year 8 |
300,000 |
Year 9 |
300,000 |
Year 10 |
5,300,000 |
The interest rate needed for the present value of these cash flows to equal the initial amortized cost basis of $4,650,000 is approximately 6.996%.
Investor Corp would record interest income each period by applying the effective interest rate of 6.996% to the carrying value of the bond (for example, in period 2, 6.996% × $4,675,336 = $327,109) as shown in the following table. This table also illustrates the impact of using the effective interest rate (rather than the coupon rate) to determine the periodic interest income.
Period |
Cash inflow (outflow) |
Coupon payment |
Accretion of discount |
Interest income |
Unamortized discount |
Ending carrying amount |
0 |
($4,650,000) |
— |
— |
— |
$350,000 |
$4,650,000 |
1 |
300,000 |
$300,000 |
$25,336 |
$325,336 |
324,664 |
4,675,336 |
2 |
300,000 |
300,000 |
27,109 |
327,109 |
297,555 |
4,702,445 |
3 |
300,000 |
300,000 |
29,006 |
329,006 |
268,549 |
4,731,451 |
4 |
300,000 |
300,000 |
31,035 |
331,035 |
237,514 |
4,762,486 |
5 |
300,000 |
300,000 |
33,206 |
333,206 |
204,308 |
4,795,692 |
6 |
300,000 |
300,000 |
35,530 |
335,530 |
168,778 |
4,831,222 |
7 |
300,000 |
300,000 |
38,016 |
338,016 |
130,672 |
4,869,238 |
8 |
300,000 |
300,000 |
40,675 |
340,675 |
90,087 |
4,909,913 |
9 |
300,000 |
300,000 |
43,521 |
343,521 |
46,566 |
4,953,434 |
10 |
5,300,000 |
300,000 |
46,566 |
346,566 |
— |
— |
6.5.1 Applying the interest method when cash flows change
The application of the interest method may be relatively straightforward for a financial asset that has static terms and involves cash flows that are fixed in terms of their timing and amount. However, there can be significant complexity in applying the interest method when the timing or amounts of cash flows are not fixed. These instruments include:
- Instruments that allow the borrower to prepay the principal of the loan/security
- Investments in asset backed securities when prepayments from assets underlying the investments are passed through to investors, which are treated as prepayments on the securities
- Variable-rate instruments
Over time, different approaches to address the complexity have been developed. In many cases, the use of a specific method is required by the accounting literature. In other cases, a policy election among the alternatives is permitted. The three main approaches are prospective, catch-up, and retrospective.
Figure LI 6-2 discusses each of the approaches, which are designed to address situations in which the timing or amount of cash flows is different than the amount anticipated when the initial effective interest rate was calculated.
Figure LI 6-2
Interest method approaches to changes in estimates
Interest method approaches to changes in estimates
Method |
Description |
Prospective approach |
A new effective interest rate is computed based on the current cost basis of the instrument and remaining cash flows. Changes in cash flows from previous estimates are included in future interest income on a prospective basis. |
Catch-up approach |
The cost basis is adjusted to the present value of the revised estimated cash flows discounted at the original effective interest rate. Using this approach, the impact of the change in cash flows is recorded in the current period. |
Retrospective approach |
A new effective interest rate is computed based on the original cost basis, actual cash flows to date, and the revised estimate of remaining cash flows. The new effective interest rate is then used to adjust the cost basis to the present value of the revised estimated cash flows, discounted at the new effective interest rate. Using this approach, the impact of the change in cash flows is recorded in the current period. |
While a current period adjustment is recorded under both the catch-up and retrospective approaches, the key distinction relates to the effective interest rate. In a catch-up approach, cash flows are updated to reflect current estimates, but the rate used to discount those cash flows remains the original effective interest rate. Under the retrospective approach, the effective interest rate is changed to reflect the actual cash flows received to date and the revised estimate of future cash flows.
6.5.1.1 Applying the interest method to changing rates
ASC 310 provides guidance on accounting for a loan in which the stated interest rate changes over time based on a defined schedule.
If the loan's stated interest rate increases during the term of the loan (so that interest accrued under the interest method in early periods would exceed interest at the stated rate), interest income shall not be recognized to the extent that the net investment in the loan would increase to an amount greater than the amount at which the borrower could settle the obligation. Prepayment penalties shall be considered in determining the amount at which the borrower could settle the obligation only to the extent that such penalties are imposed throughout the loan term (See Section 310-20-55). Accordingly, a limit is imposed on the amount of periodic amortization that can be recognized. However, that limitation does not apply to the capitalization of costs incurred (such as direct loan origination costs and purchase premiums) that cause the investment in the loan to be in excess of the amount at which the borrower could settle the obligation. The capitalization of costs incurred is different from increasing the net investment in a loan through accrual of interest income that is only contingently receivable.
If the loan's stated interest rate decreases during the term of the loan, the stated periodic interest received early in the term of the loan would exceed the periodic interest income that is calculated under the interest method. In that circumstance, the excess shall be deferred and recognized in those future periods when the constant effective yield under the interest method exceeds the stated interest rate (See Section 310-20-55).
For an interest rate that contractually increases over the life of an asset, the stated interest may be lower than the effective interest income recognized. As discussed in ASC 310-20-35-18(a), a reporting entity is precluded from accruing interest at an effective rate that results in a net investment in the asset greater than the amount at which the borrower could settle its obligation. When this occurs, the reporting entity is limited in the amount of interest income that can be recorded.
Conversely, for an interest rate that contractually declines over time, the stated interest will be greater than the effective interest. In this circumstance, the interest method should be applied. Cash-based interest received as interest payments in excess of interest recognized should be deferred as an adjustment to the amortized cost basis of the instrument.
Example LI 6-2 illustrates the recognition of interest on an instrument that has an interest rate that increases.
EXAMPLE LI 6-2
Interest recognition on an instrument with an increasing interest rate
Interest recognition on an instrument with an increasing interest rate
Finance Co pays $950,000 for a bond with a par value of $1,000,000. Other than the purchase discount of $50,000, there are no items that impact the amortized cost basis of the bond. As a result, Finance Co records the bond at $950,000.
The bond's annual interest rate increases over its life as shown in the following table. The bond has a five-year term, but can be prepaid at face value at the issuer's option at par plus accrued interest.
Period |
Interest rate |
||
Year 1 |
2% |
||
Year 2 |
3% |
||
Year 3 |
4% |
||
Year 4 |
5% |
||
Year 5 |
6% |
What is the effective interest rate of the bond? How should Finance Co record interest income on its investment?
Analysis
The effective interest rate needed for the present value of the bond's cash flows to equal the initial carrying amount of $950,000 is approximately 5.058%. However, using this effective interest rate would result in the bond's carrying amount exceeding the amount that could be prepaid by the borrower during the third year:
Period |
Cash in / (out) flow |
Coupon payment |
Accretion of discount |
Interest income |
Unamortized discount |
Ending carrying amount |
0 |
(950,000) |
— |
— |
— |
50,000 |
950,000 |
1 |
20,000 |
(20,000) |
28,052 |
48,052 |
21,948 |
978,052 |
2 |
30,000 |
(30,000) |
19,471 |
49,471 |
2,476 |
997,524 |
3 |
40,000 |
(40,000) |
10,456 |
50,456 |
(7,980) |
1,007,980 |
As a result, the amortization schedule is updated in period 3 to only amortize the remaining unamortized discount ($2,476) as opposed to the full amount of amortization that otherwise would have been recorded based on the effective interest rate of approximately 5.058%. Once the discount is fully amortized, the effective interest rate becomes the stated rate. This is shown in the following table.
Period |
Cash inflow (outflow) |
Coupon payment |
Accretion of discount |
Interest income |
Unamortized discount |
Ending carrying amount |
0 |
($950,000) |
— |
— |
— |
$50,000 |
$950,000 |
1 |
20,000 |
$20,000 |
$28,052 |
$48,052 |
21,948 |
978,052 |
2 |
30,000 |
30,000 |
19,471 |
49,471 |
2,476 |
997,524 |
3 |
40,000 |
40,000 |
2,476 |
42,476 |
— |
1,000,000 |
4 |
50,000 |
50,000 |
— |
50,000 |
— |
1,000,000 |
5 |
1,060,000 |
60,000 |
— |
60,000 |
— |
— |
Note that the $50,000 discount has been fully recognized by the end of the third year. As a result of the limitation in ASC 310-20-35-18(a), interest income in years 3 through 5 are different than what they would have otherwise been.
6.5.1.2 Applying the interest method to variable rate instruments
ASC 310-20-35 provides guidance on calculating the effective interest rate on a variable rate instrument. For the purposes of amortizing premiums or discounts, the determination of whether to use the variable rate at inception or as it changes over the life of the instrument is an accounting policy election. If a reporting entity chooses to use the variable rate as it changes over the life of the instrument, subsequent changes should be accounted for using a prospective approach.
If the loan's stated interest rate varies based on future changes in an independent factor, such as an index or rate (for example, the prime rate, the London Interbank Offered Rate [LIBOR], or the U.S. Treasury bill weekly average rate), the calculation of the constant effective yield necessary to recognize fees and costs shall be based either on the factor (the index or rate) that is in effect at the inception of the loan or on the factor as it changes over the life of the loan. (See Section 310-20-55.) A variable rate loan whose initial rate differs from the rate its base factor would produce is also subject to the provisions of (a) and (b).
The preceding paragraph provides that when a loan's stated interest rate varies based on future changes in an independent factor, the lender shall calculate a constant effective yield by using the independent factor in effect at the inception of the loan or the factor as it changes over the life of the loan. In applying the guidance in (c) in the preceding paragraph, the lender may not change from one alternative to the other during the life of the loan. The lender must select one of the two alternatives and apply the method consistently throughout the life of the loan.
In a period in which the independent factor on a variable rate loan changes, the constant effective yield is recalculated not from the inception of the loan but from the time of the change. See Example 9 (paragraph 310-20-55-43) for an illustration.
Financial assets with provisions that can cause the timing or amount of cash flows to change should be evaluated to determine whether the provisions are derivatives that should be separately accounted for under the guidance in ASC 815. See DH 4 for information on the evaluation of embedded derivatives.
Example LI 6-3 and Example LI 6-4 demonstrate the application of the interest method to an instrument with an interest rate that varies based on an interest rate index.
EXAMPLE LI 6-3
Interest recognition on an instrument with a variable rate – policy of using rate in effect at inception
Interest recognition on an instrument with a variable rate – policy of using rate in effect at inception
Finance Co pays $950,000 for a bond with a par value of $1,000,000. Other than the purchase discount of $50,000 there are no items that impact the amortized cost basis of the bond; therefore, Finance Co records the bond at $950,000.
The bond's annual interest rate is based on an interest rate index plus a 2% fixed spread. The bond has a five-year term. Interest is paid annually and full payment of principal is due at maturity.
Finance Co has elected a policy of using the rate in effect at inception of a financial asset for purposes of determining the asset's effective interest rate.
Through the life of the bond, the interest rate index and total coupon amount resets as shown in the following table.
Period |
Interest rate index |
Coupon |
||
Year 1 |
2% |
4% |
||
Year 2 |
1.5% |
3.5% |
||
Year 3 |
3% |
5% |
||
Year 4 |
4% |
6% |
||
Year 5 |
4% |
6% |
How should Finance Co amortize the discount over the life of the bond?
Analysis
Since Finance Co has chosen an accounting policy to determine the effective rate using the interest rate in effect at inception of the bond, amortization of the discount should be determined assuming a 4% coupon rate (i.e., it should be assumed the rate will not change over the life of the bond). The effective interest rate needed for the present value of the bond's cash flows (based on the 4% coupon in effect at inception) to equal the initial carrying amount of $950,000 is approximately 5.16%.
The following table shows how the discount should be amortized using this accounting policy.
Period |
Assumed cash in/(out) flow (1) |
Interest income (2) |
Unamortized discount |
Ending carrying amount |
0 |
(950,000) |
— |
50,000 |
950,000 |
1 |
40,000 |
49,020 |
40,980 |
959,020 |
2 |
40,000 |
49,485 |
31,495 |
968,505 |
3 |
40,000 |
49,975 |
21,520 |
978,480 |
4 |
40,000 |
50,489 |
11,031 |
988,969 |
5 |
1,040,000 |
51,031 |
— |
— |
(1) The Assumed cash in/(out)flow column represents the cash flows used for the purposes of calculating the accretion of the discount and are based on the variable index at inception/acquisition plus the fixed spread (i.e., 4% assumed coupon payments each year and payment of par at maturity).
(2) The Interest income column represents the interest that would have been recorded in each period if the variable index never changed from inception/acquisition. Actual interest income will be different as rates change each period.
|
||||
The discount amortization would not change in subsequent periods when the coupon on the instrument changes, however the total interest income would change with changes in the variable interest rate. For example, in the second year, interest income would be $44,485 ($5,000 less than $49,485) since interest rates declined by 0.5% (from 4% to 3.5%).
EXAMPLE LI 6-4
Interest recognition on an instrument with a variable rate – policy of updating the rate
Interest recognition on an instrument with a variable rate – policy of updating the rate
Assume the same facts as Example LI 6-3 except that Finance Co elects an accounting policy to change its effective interest rate calculation when the variable rate changes.
How should Finance Co amortize the discount over the life of the bond?
Analysis
In the first year, the calculation of the effective interest rate, and in turn the amortization of the discount, would be based on the 4% rate in effect at the inception of the bond as shown in Example LI 6-3.
In subsequent years, Finance Co would update its effective interest rate on a prospective basis, using the updated coupon on the bond. For example, in year 2, Finance Co would calculate the effective interest rate needed for the present value of the bond's cash flows (based on the 3.5% coupon in effect in year 2) to equal the then-carrying amount of $959,020 (the carrying amount at the end of year 1/beginning of year 2); that rate is approximately 4.65%.
This revised effective interest rate would be applied to the carrying amount of the bond at the end of year 1/beginning of year 2 ($959,020) resulting in interest income of $44,558 ($35,000 coupon + $9,558 amortization of discount) for year 2.
6.5.1.3 Applying interest method to borrower prepayment options
In most cases, the effective interest rate on an instrument should be calculated using the contractual life of an asset. In some cases (e.g., beneficial interests accounted for under ASC 325-40 and certain callable debt securities acquired at a premium), the guidance requires that the effective interest rate not be calculated using the contractual life of the instrument.
When the contractual life is used to amortize premiums and discounts, prepayments impact unamortized amounts as they occur. However, ASC 310-20-35 permits the use of an estimated life when certain criteria are met.
Except as stated in the following sentence, the calculation of the constant effective yield necessary to apply the interest method shall use the payment terms required by the loan contract, and prepayments of principal shall not be anticipated to shorten the loan term. If the entity holds a large number of similar loans for which prepayments are probable and the timing and amount of prepayments can be reasonably estimated, the entity may consider estimates of future principal prepayments in the calculation of the constant effective yield necessary to apply the interest method. If the entity anticipates prepayments in applying the interest method and a difference arises between the prepayments anticipated and actual prepayments received, the entity shall recalculate the effective yield to reflect actual payments to date and anticipated future payments. The net investment in the loans shall be adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the loans. The investment in the loans shall be adjusted to the new balance with a corresponding charge or credit to interest income.
If loan-by-loan accounting is used, net fees and costs shall be amortized over the contract life and adjusted based on actual prepayments.
The use of the contractual term results in a reporting entity amortizing premiums or discounts over the contractual life of the financial asset. To maintain the effective interest rate, an adjustment needs to be made as prepayments occur. In the period a prepayment occurs, in accordance with ASC 310-20-35-16, the carrying amount of the financial asset should be adjusted such that the new carrying amount equals the present value of the updated cash flows (subsequent to the prepayment) discounted at the original effective interest rate. This will result in accelerated recognition of a portion of the unamortized premium or discount in interest income.
Example LI 6-5 illustrates the accounting for interest on a prepayable instrument under the contractual method.
EXAMPLE LI 6-5
Interest recognition on a prepayable instrument – prepayments are accounted for when they occur
Interest recognition on a prepayable instrument – prepayments are accounted for when they occur
Bank Corp originates a loan with the following terms.
Principal amount (due in full at maturity) |
$100,000 |
Origination fees paid by the borrower |
$3,000 |
Origination costs incurred by Bank Corp |
$1,000 |
Coupon rate |
5% paid annually |
Term |
5 years |
Prepayment feature |
The borrower can prepay the loan at any time without penalty. |
Assume that the loan origination fees and costs meet the requirements in ASC 310-20 to be deferred as part of the carrying amount of the loan; therefore, the carrying amount of the loan is $98,000 ($100,000 principal - $3,000 loan origination fees + $1,000 loan origination costs).
Bank Corp calculates the effective interest rate on the loan by determining the present value of the loan's cash flows (assuming the loan remains outstanding for its entire contractual term) to equal the initial carrying amount of $98,000; this rate is approximately 5.47%.
Bank Corp calculates the following interest income and amortization using this effective interest rate.
Period |
Cash inflow (outflow) |
Accretion of discount |
Interest income |
Unamortized discount |
Ending carrying amount |
0 |
($98,000) |
— |
— |
$2,000 |
$98,000 |
1 |
5,000 |
359 |
5,359 |
1,641 |
98,359 |
2 |
5,000 |
378 |
5,378 |
1,263 |
98,737 |
3 |
5,000 |
399 |
5,399 |
864 |
99,136 |
4 |
5,000 |
421 |
5,421 |
444 |
99,556 |
5 |
$105,000 |
$444 |
$5,444 |
— |
— |
At the end of the period 2, the borrower prepays $20,000 of principal.
How should Bank Corp account for the principal repayment?
Analysis
Bank Corp should first determine the new carrying amount of the loan by calculating the present value of the new contractual payments using the initial effective rate of 5.47%. The new contractual payments are $4,000 of interest payments (5% × $80,000 remaining loan balance) and an $80,000 principal payment at maturity. Using this calculation, the new carrying amount of the loan is $78,990.
After Bank Corp recognizes the prepayment, the carrying amount of the loan absent an adjustment would be $78,737 ($98,737 loan carrying amount at the end of period 2 - $20,000 prepayment). Bank Corp should record an adjustment to the carrying amount of the loan of $253 to adjust the loan value to $78,990 ($78,990 - $78,737 = $253).
Bank Corp would record the following journal entries.
Dr. Cash |
$20,000 |
|
Cr. Loan asset balance |
$20,000 |
|
To record the prepayment made by the borrower |
||
Dr. Loan asset balance |
$253 |
|
Cr. Interest income |
$253 |
|
To adjust the loan balance to the present value of the remaining contractual cash flows |
||
Bank Corp would also recompute its amortization schedule prospectively (i.e., it would not adjust the interest income and accretion amounts recorded in prior periods). Due to adjusting the loan balance to reflect the present value of the remaining contractual cash flows, the effective interest rate would remain 5.47%.
Period |
Cash inflow (outflow) |
Accretion of discount |
Interest income |
Unamortized discount |
Ending carrying amount |
0 |
($98,000) |
— |
— |
$2,000 |
$98,000 |
1 |
5,000 |
359 |
5,359 |
1,641 |
98,359 |
2 |
25,0001 |
631 |
5,6312 |
1,010 |
78,990 |
3 |
4,0003 |
319 |
4,3194 |
691 |
79,309 |
4 |
4,000 |
337 |
4,337 |
355 |
79,645 |
5 |
$84,000 |
$355 |
$4,355 |
— |
— |
1 $20,000 prepayment + $5,000 interest payment
2 Interest income of $5,378 originally recognized in year 2 plus $253 adjustment.
3 New loan asset balance of $80,000 ($100,000 - $20,000 prepayment) x 5% coupon rate.
4 Product of the carrying amount of $78,990 and the original effective interest rate of 5.47%.
|
|||||
Estimating prepayments when determining the effective interest rate
As discussed in ASC 310-20-35-26, when a reporting entity holds a large number of similar loans, investments in debt securities, or other receivables for which prepayments are probable, and the timing and amount of prepayments can be reasonably estimated, the reporting entity may elect to consider estimates of future principal prepayments in the calculation of the effective interest rate.
For certain callable debt securities purchased at a premium, if the entity does not elect to apply the guidance in ASC 310-20-35-26, it must amortize the premium to the next call date. Refer to the Premium amortization on purchased callable debt securities section below for further discussion.
ASC 310-20 provides implementation guidance to assist in determining whether instruments are similar for the purposes of meeting the requirements to aggregate the assets and estimate prepayments when determining the effective interest rate.
Loans grouped together shall have sufficiently similar characteristics that prepayment experience of the loans can be expected to be similar in a variety of interest rate environments. Loans that are grouped together for purposes of applying the preceding paragraph shall have sufficiently similar levels of net fees or costs so that, in the event that an individual loan is sold, recalculation of that loan's carrying amount will be practicable.
There are a number of characteristics to be considered in determining whether the lender holds a large number of similar loans for purposes of estimating prepayments in accordance with paragraph 310-20-35-26. The objective is to evaluate all characteristics that would affect the ability of the lender to estimate the behavior of a group of loans. The following are examples of some characteristics that shall be considered when aggregating loans:
a. Loan type
b. Loan size
c. Nature and location of collateral
d. Coupon interest rate
e. Maturity
f. Period of origination
g. Prepayment history of the loans (if seasoned)
h. Level of net fees or costs
i. Prepayment penalties
j. Interest rate type (fixed or variable)
k. Expected prepayment performance in varying interest rate scenarios
When calculating the effective interest rate considering estimated prepayments, the pool of instruments becomes the unit of account, but only for the purposes of calculating interest income. For purposes of applying other measurement guidance, such as the calculation of fair value or the measurement of impairment, the unit of account will likely be different. For example, when calculating impairment under the current expected credit loss (CECL) impairment model, the guidance requires instruments to be aggregated if they are based on similar credit risk characteristics. As a result, aggregation of instruments for purposes of calculating estimated credit losses under the CECL impairment model is likely to be based on different criteria than those used to aggregate loans when determining interest income.
Question LI 6-3 discusses the potential application of ASC 310-20-35-26 to callable corporate bonds.
Question LI 6-3
Investor Corp invests in callable corporate bonds. Can Investor Corp estimate prepayments for purposes of applying the interest method?
Investor Corp invests in callable corporate bonds. Can Investor Corp estimate prepayments for purposes of applying the interest method?
PwC response
It depends. If Investor Corp can demonstrate the following then estimating prepayments may be permissible.
- Its corporate bonds can be grouped into homogenous pools
- It is probable that the bonds will experience prepayments (the issuers will exercise their call options)
- The prepayments can be reasonably estimated
See below for further discussion of callable debt securities purchased at a premium.
Question LI 6-4 addresses whether an entity is required to apply the guidance in 310-20-35-26.
Question LI 6-4
If a reporting entity meets the requirements in ASC 310-20-35-26 to consider estimates of future principal prepayments in the calculation of the effective interest rate, is it required to do so?
If a reporting entity meets the requirements in ASC 310-20-35-26 to consider estimates of future principal prepayments in the calculation of the effective interest rate, is it required to do so?
PwC response
No. As discussed in ASC 310-20-35-28, whether to consider future prepayments is an election available to a reporting entity for portfolios that meet the stated criteria. It is not required. However, the election is a policy decision and should be applied consistently. See below for further discussion of callable debt securities purchased at a premium.
For loans that do qualify under paragraph 310-20-35-26, a lender may use either method for different loans and select the most appropriate method for a group of loans based on the characteristics of those loans. (For example, homogeneous mortgage loans might be aggregated while construction loans are accounted for separately.) However, once a lender has selected the appropriate method of accounting for a loan or a group of loans, a lender must continue to use the method throughout the life of the loan or group of loans.
Question LI 6-5 addresses whether the criteria used to create a pool can be changed when applying ASC 310-20-35-26.
Question LI 6-5
Once a loan pool has been established for a group of similar loans for purposes of applying the guidance in ASC 310-20-35-26 to estimate prepayments when determining the effective interest rate, may the characteristics that were used to identify the pool be changed?
Once a loan pool has been established for a group of similar loans for purposes of applying the guidance in ASC 310-20-35-26 to estimate prepayments when determining the effective interest rate, may the characteristics that were used to identify the pool be changed?
PwC response
No. Once a pool of loans has been established, the characteristics used to identify that pool may not be changed (for the purposes of calculating interesting income). Therefore, the loan pool becomes the unit of account going forward for the purposes of determining interest income, and as a result, the characteristics considered in aggregating similar loans into a pool may not be changed. However, future loan pools may be aggregated using a different set of characteristics.
As discussed in ASC 310-20-35-26, a reporting entity should periodically reevaluate its estimation of prepayments including when actual cash flows differ from estimated cash flows and estimates of future prepayments might change.
Excerpt from ASC 310-20-35-26
If the entity anticipates prepayments in applying the interest method and a difference arises between the prepayments anticipated and actual prepayments received, the entity shall recalculate the effective yield to reflect actual payments to date and anticipated future payments. The net investment in the loans shall be adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the loans. The investment in the loans shall be adjusted to the new balance with a corresponding charge or credit to interest income.
Example LI 6-6 illustrates the accounting for interest on a prepayable instrument if prepayments are estimated in accordance with ASC 310-20-35-26.
EXAMPLE LI 6-6
Interest recognition on prepayable instruments – prepayments are estimated
Interest recognition on prepayable instruments – prepayments are estimated
The content in this example is from Example 4 in ASC 310-20-55-26 through ASC 310-20-55-32 and includes the calculations from that example.
Bank Corp originates 1,000 loans with the following terms:
Loan principal amount |
Each loan has a principal amount of $10,000, resulting in principal of the loan pool of $10,000,000 |
Contractual payment terms |
Equal annual payments |
Aggregate origination fees paid by the borrowers on loan pool |
$300,000 |
Aggregate origination costs incurred by Bank Corp on loan pool |
$100,000 |
Coupon rate |
10% paid annually |
Term |
10 years |
Prepayment feature |
The borrower can prepay the loan at any time without penalty. When prepayments occur, the amortization schedule of the loan resets. |
Assume the loan origination fees and costs meet the requirements in ASC 310-20 to be deferred as part of the carrying amount of the loan; therefore, the carrying amount of the loan pool is $9,800,000 ($10,000,000 principal - $300,000 loan origination fees + $100,000 loan origination costs).
Bank Corp concludes that the loans have similar characteristics, prepayments are probable, and it can reasonably estimate payment timing. Based on Bank Corp's estimates, it is expected that the loans will prepay at a constant annual rate of 6%.
Bank Corp calculates the effective interest rate on the loan pool by determining the present value of the cash flows (assuming a prepayment rate of 6%) to equal the initial carrying amount of $9,800,000; this rate is approximately 10.5627%. Bank Corp calculates the following interest income and amortization schedule using this effective interest rate.
Period |
Cash inflow (outflow) |
Stated Interest |
Accretion of discount |
Interest income |
Unamortized net fees |
Ending carrying amount |
0 |
($9,800,000) |
— |
— |
— |
$200,000 |
$9,800,000 |
1 |
2,227,454 |
1,000,000 |
35,141 |
1,035,141 |
164,859 |
8,607,687 |
2 |
2,049,623 |
877,255 |
31,946 |
909,201 |
132,913 |
7,467,265 |
3 |
1,880,619 |
760,018 |
28,724 |
788,742 |
104,189 |
6,375,388 |
4 |
1,719,716 |
647,958 |
25,453 |
673,411 |
78,736 |
5,329,083 |
5 |
1,566,144 |
540,782 |
22,111 |
562,893 |
56,625 |
4,325,832 |
6 |
1,419,028 |
438,246 |
18,677 |
456,923 |
37,948 |
3,363,727 |
7 |
1,277,230 |
340,168 |
15,131 |
355,299 |
22,817 |
2,441,796 |
8 |
1,138,934 |
246,461 |
11,458 |
257,919 |
11,359 |
1,560,781 |
9 |
1,000,180 |
157,214 |
7,646 |
164,860 |
3,713 |
725,461 |
10 |
802,091 |
72,917 |
3,713 |
76,630 |
— |
— |
At the end of period 3, Bank Corp has experienced 6% prepayments in periods 1 and 2, and 20% in period 3. In addition, based on new information at the end of period 3, Bank Corp revises its estimate of prepayments to 10% beginning in period 4 and 6% in the remaining years.
How should Bank Corp account for the change in estimated principal repayments?
Analysis
Bank Corp should recalculate the effective interest rate on the loan pool by determining the rate needed for the present value of the loan pool cash flows (from inception of the loans (period 0) using the actual prepayments in periods 1 – 3 and the revised prepayments estimate in periods 4 – 10) to equal the original carrying amount of the loan pool ($9,800,000). This rate is approximately 10.6083%.
Pursuant to ASC 310-20-35-26, a reporting entity that elects to anticipate prepayments would be required to recalculate the effective yield to reflect the actual prepayments to date and to anticipate future payments (i.e., it is required to use the retrospective method). Therefore, Bank Corp would recognize an adjustment to the carrying amount of the loans of $8,876, which represents the cumulative effect applicable to periods 1 and 2 of the revised effective interest rate of 10.6083% as compared to the original effective interest rate of 10.5627%. Bank Corp would use the revised effective interest rate of 10.6083% beginning in period 3.
Period |
Cash inflow (outflow) |
Stated interest |
Amortization |
Interest income |
Unamortized net fees |
Ending carrying amount |
0 |
($9,800,000) |
— |
— |
— |
$200,000 |
$9,800,000 |
1 |
2,227,454 |
1,000,000 |
35,141 |
1,035,141 |
164,859 |
8,607,687 |
2 |
2,049,623 |
877,255 |
31,946 |
909,201 |
132,913 |
7,467,265 |
3 |
2,944,644 |
760,018 |
41,9511 |
801,969 |
90,962 |
5,324,590 |
4 |
1,653,939 |
541,555 |
23,294 |
564,849 |
67,668 |
4,235,500 |
5 |
1,246,229 |
430,317 |
18,998 |
449,315 |
48,670 |
3,438,586 |
6 |
1,129,164 |
348,726 |
16,050 |
364,776 |
32,620 |
2,674,198 |
7 |
1,016,331 |
270,682 |
13,005 |
283,687 |
19,615 |
1,941,554 |
8 |
906,285 |
196,117 |
9,849 |
205,966 |
9,766 |
1,241,235 |
9 |
795,875 |
125,100 |
6,574 |
131,674 |
3,192 |
577,034 |
10 |
$638,249 |
$58,023 |
$3,192 |
$61,215 |
— |
— |
1 Amortization of $33,074 using the revised effective interest rate of 10.6083% + adjustment to the carrying amount of $8,876 relating to the difference in amortization for years 1 and 2 between the original and revised effective interest rates.
|
||||||
Premium amortization on purchased callable debt securities
Premiums and discounts on loans, investments in debt securities, and receivables are generally amortized to maturity date. If the entity holds a large number of similar loans for which prepayments are probable and the timing and amount of prepayments can be reasonably estimated, the entity may elect to consider estimates of future principal prepayments in the calculation of the constant effective yield necessary to apply the interest method.
One exception relates to callable debt securities purchased at a premium with explicit, noncontingent call features that are callable at fixed prices on preset dates. This guidance only relates to debt securities. Refer to LI 3.2.2 for the definition of debt securities.
Callable debt securities whose coupon rate exceeds market yields often trade at a premium in the market. Similar to other types of receivables, an entity may elect to consider expected prepayments on debt securities in its calculation of the effective interest rate if it holds a large number of similar loans for which prepayments are probable and their timing and amount can be reasonably estimated. However, if this election is not made, ASC 310-20-35-33 requires premiums on certain individual callable debt securities (i.e., the amount of the amortized cost basis that exceeds the amount payable by the issuer at the next call date) to be amortized to the next call date. Conversely, discounts on individual callable debt securities are amortized to the maturity date unless the election in ASC 310-20-35-26 is made on a portfolio of debt securities.
The remainder of this section assumes an entity has adopted ASU 2020-08, Codification Improvements to Subtopic 310-20, Receivables – Nonrefundable Fees and Other Costs. For public business entities, this guidance became effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Public business entities cannot early adopt this guidance. For all other entities, this guidance is effective for fiscal years beginning after December 15, 2021 and interim periods within fiscal years beginning after December 15, 2022. Early adoption for entities that are not public business entities is permitted for fiscal periods beginning after December 15, 2020, including interim periods within those fiscal years. This guidance should be adopted prospectively by resetting the effective yield to the extent that the amortized cost basis of an existing individual callable debt security within its scope exceeds the amount repayable by the issuer at the next earliest call date, unless the guidance in ASC 310-20-35-26 is applied to consider estimated prepayments.
For each reporting period, to the extent that the amortized cost basis of an individual callable debt security exceeds the amount repayable by the issuer at the next call date, the excess (that is, the premium) shall be amortized to the next call date, unless the guidance in paragraph 310-20-35-26 is applied to consider estimated prepayments. For purposes of this guidance, the next call date is the first date when a call option at a specified price becomes exercisable. Once that date has passed, the next call date is when the next call option at a specified price becomes exercisable, if applicable. If there is no remaining premium or if there are no further call dates, the entity shall reset the effective yield using the payment terms of the debt security. Securities within the scope of this paragraph are those that have explicit, noncontingent call options that are callable at fixed prices and on preset dates at prices less than the amortized cost basis of the security. Whether a security is subject to this paragraph may change depending on the amortized cost basis of the security and the terms of the next call option.
The term “next call date” is important in evaluating whether a debt security with explicit, noncontingent call features that is callable at fixed prices on preset dates is subject to the guidance in ASC 310-20-35-33 and in order to apply this guidance. Debt securities may have call features that are only exercisable on certain dates. However, call features in debt securities are often exercisable over a period of time as opposed to a single date. For the purposes of this guidance, the “next call date” is the first date when a call feature at a specified price that is not currently exercisable becomes exercisable. For example, if evaluating the next call date on 1/1/20X1 of a debt security callable at a price of $102 from 7/1/20X1 through 12/31/20X1, the next call date would be 7/1/20X1. Once 7/1/20X1 has passed, the next call date would be based on a different call option within the debt security that is exercisable at a different price subsequent to the 7/1/20X1 through 12/31/20X1 call period (if applicable).
Certain debt securities may fall outside the scope of this guidance, even if the debt security is purchased at a premium. For example, certain asset backed securities may not have explicit, noncontingent call features that are only exercisable on certain dates. Another example is a debt security for which the price at the next call date is greater than the amortized cost basis of the debt security. As a result, it would not be subject to ASC 310-20-35-33. Some debt securities that have multiple call features may not initially be subject to this guidance but may subsequently become subject if the call feature associated with the then next call date is at a price less than the amortized cost basis of the debt security. Example LI 6-8 illustrates a debt security that becomes subject to the guidance at a later date.
Assuming a debt security is subject to the guidance in ASC 310-20-35-33, the security’s effective yield should be adjusted prospectively if a call feature is not exercised. Question LI 6-6 addresses a situation when an issuer does not exercise its call option on a callable debt security purchased at a premium.
Question LI 6-6
For debt securities subject to ASC 310-20-35-33, how should an entity calculate the effective yield on a callable debt security purchased at a premium if the issuer does not exercise the call option at the next call date?
For debt securities subject to ASC 310-20-35-33, how should an entity calculate the effective yield on a callable debt security purchased at a premium if the issuer does not exercise the call option at the next call date?
PwC response
If a callable debt security purchased at a premium is not called at its next call date, the holder should reset the effective yield using the amortized cost basis and the remaining payment terms of the security as of that date, which may require consideration of the debt security’s next call date. If the entity has fully amortized the premium of the debt security as a result of applying this guidance, the amortized cost basis would equal par value. Going forward, the effective yield of the security would equal its coupon rate.
Conversely, if the entity has been amortizing the premium on a debt security to an amount greater than par value (which would occur if, for example, a security was purchased at a $5 premium and the original next call was at a $3 premium), the amortized cost basis would be higher than par value at that date. In this scenario, the entity would reset the effective yield using the amortized cost basis at that date and the remaining payment terms (including any future call options). For example, if the security was callable at par two years later, the remaining premium would be amortized over the next two years.
Example LI 6-7 illustrates the amortization of a premium on a debt security within the scope of ASC 310-20-35-33 with multiple call features.
EXAMPLE LI 6-7
Amortization of a callable debt security’s premium
Amortization of a callable debt security’s premium
Bank Corp purchases a noncontingent callable debt security on 1/1/20X1 with the following terms.
Principal amount: |
$100,000 |
Annual coupon rate: |
15% |
Maturity: |
12/31/20X5 |
Purchase price: |
$110,000 |
The issuer has the right to call the debt security as outlined in the call schedule below.
Call date/period |
Call price (per thousand dollar debt security) |
1/1 – 12/31/20X1 |
N/A |
1/1 – 12/31/20X2 |
105 |
1/1 – 12/31/20X3 |
103 |
1/1 – 12/31/20X4 |
102 |
1/1 – 12/31/20X5 |
100 |
How would Bank Corp amortize the debt security’s premium assuming the issuer never exercises the call option and the debt security remains outstanding through maturity?
Analysis
On 1/1/20X1, the date of purchase, Bank Corp determines that the debt security’s amortized cost basis of $110,000 exceeds the price ($105,000) of the call feature on the next call date (1/1/20X2). Bank Corp begins amortizing the premium such that the debt security will have an amortized cost basis of $105,000 on 12/31/20X1. This results in an effective interest rate of 9.09%.
Period
|
Cash inflow / (outflow)
|
Unamortized premium
|
Interest income
|
Ending amortized cost basis
|
|---|---|---|---|---|
1/1/20X1 |
$(110,000) |
$10,000 |
N/A |
$110,000 |
12/31/20X1 |
$15,000 |
$5,000 |
$10,000 |
$105,000 |
On 1/1/20X2, the next call date is 1/1/20X3 when the debt security is callable at $103,000. Bank Corp resets the bond’s effective yield to 12.38% such that the debt security will have an amortized cost basis of $103,000 on 1/1/20X3.
Period
|
Cash inflow / (outflow)
|
Unamortized premium
|
Interest income
|
Ending amortized cost basis
|
|---|---|---|---|---|
12/31/20X2 |
$15,000 |
$3,000 |
$13,000 |
$103,000 |
On 1/1/20X3, the debt security’s amortized cost basis of $103,000 exceeds the call price of $102,000 on the next call date of 1/1/20X4. Bank Corp resets the bond’s effective yield to 13.59% such that the debt security will have an amortized cost basis of $102,000 as of 1/1/20X4.
On 1/1/20X4, the debt security’s amortized cost basis of $102,000 exceeds the call price of $100,000 on the next call date of 1/1/20X5. Bank Corp again resets the debt security’s effective yield to 12.75% such that the debt security will have an amortized cost basis of $100,000 as of 1/1/20X5. On 12/31/20X4, the debt security’s premium has been fully amortized.
The calculations of interest income and the debt security’s amortized cost basis from years 20X3 through 20X5 are illustrated as follows.
Period
|
Cash inflow / (outflow)
|
Unamortized premium
|
Interest income
|
Ending amortized cost basis
|
|---|---|---|---|---|
12/31/20X3 |
$15,000 |
$2,000 |
$14,000 |
$102,000 |
12/31/20X4 |
$15,000 |
0 |
$13,000 |
$100,000 |
12/31/20X5 |
$115,000 |
0 |
$15,000 |
0 |
Example LI 6-8 illustrates the amortization of a premium on a debt security with multiple call features, but the debt security is not initially subject to the guidance in ASC 310-20-35-33 because its amortized cost basis is less than the amount the call can be exercised for at the next call date.
EXAMPLE LI 6-8
Amortization of a callable debt security’s premium
Amortization of a callable debt security’s premium
Bank Corp purchases a noncontingent callable debt security on 1/1/20X1 with the following terms.
Principal amount: |
$100,000 |
Annual coupon rate: |
15% |
Maturity: |
12/31/20X5 |
Purchase price: |
$106,000 |
The issuer has the right to call the debt security on any date beginning with the first call date outlined in the call schedule below.
Call date/period
|
Call price (per thousand dollar debt security)
|
1/1 - 12/31/20X1 |
N/A |
1/1 – 12/31/20X2 |
110 |
1/1 – 12/31/20X5 |
102 |
How would Bank Corp amortize the debt security’s premium assuming the issuer never exercises the call option and the debt security remains outstanding through maturity?
Analysis
On 1/1/20X1, the date of purchase, Bank Corp determines that the debt security’s amortized cost basis of $106,000 is less than the call price of $110,000 of the call feature on the next call date (1/1/20X2). As such, the debt security is not subject to ASC 310-20-35-33 and Bank Corp begins amortizing the premium over the contractual maturity using the debt security’s effective interest rate of 13.28%.
Period
|
Cash inflow/(outflow)
|
Unamortized premium
|
Interest income
|
Ending amortized cost basis
|
|---|---|---|---|---|
1/1/20X1 |
$(106,000) |
$6,000 |
N/A |
$106,000 |
12/31/20X1 |
$15,000 |
$5,079 |
$14,079 |
$105,079 |
On 1/1/20X2, the debt security’s amortized cost basis of $105,079 exceeds the call price of $102,000 on the next call date (1/1/20X3). The debt security is now subject to ASC 310-20-35-33, Bank Corp resets the debt security’s effective yield to 11.34% such that the debt security will have an amortized cost basis of $102,000 on 1/1/20X3.
Period
|
Cash inflow/(outflow)
|
Unamortized premium
|
Interest income
|
Ending amortized cost basis
|
|---|---|---|---|---|
12/31/20X2 |
$15,000 |
$2,000 |
$11,921 |
$102,000 |
On 1/1/20X3, the debt security’s amortized cost basis is $102,000 and there are no additional call features at a different price. As a result, the debt security is no longer subject to ASC 310-20-35-33. Bank Corp resets the debt security’s effective yield to 14.14% and begins amortizing the remaining premium to contractual maturity.
The calculations of interest income and the debt security’s amortized cost basis for years 20X3 through 20X5 are illustrated as follows.
Period
|
Cash inflow/(outflow)
|
Unamortized premium
|
Interest income
|
Ending amortized cost basis
|
|---|---|---|---|---|
12/31/20X3 |
$15,000 |
$1,419 |
$14,419 |
$101,419 |
12/31/20X4 |
$15,000 |
$756 |
$14,337 |
$100,756 |
12/31/20X5 |
$115,000 |
0 |
$14,244 |
0 |
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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