When we use the effective interest method How does the amortization of a discount or premium change?

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.

ASC 310-20-35-26

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.

ASC 310-20-35-29

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

Bank Corp originates a loan with the following terms.

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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.

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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.

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%.

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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.

ASC 310-20-35-27

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.

ASC 310-20-35-30

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?

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?

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.

ASC 310-20-35-28

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?

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

Bank Corp originates 1,000 loans with the following terms:

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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.

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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.

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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.

ASC 310-20-35-33

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?

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

Bank Corp purchases a noncontingent callable debt security on 1/1/20X1 with the following terms.

The issuer has the right to call the debt security as outlined in the call schedule below.

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%.

Ending amortized cost basis

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.

Ending amortized cost basis

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.

Ending amortized cost basis

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