Peeling away financial reporting issues one layer at a time

ASU 2015-03: The Latest Simplification to GAAP That’s Not

Relative to the big changes that are supposed to be coming from the FASB (leases, revenue recognition, loan impairment), ASU No. 2015-03 on debt issuance costs is very small potatoes.  But, if you are looking for an exemplar of the verbal gymnastics the FASB is wont to fob off as its “basis for conclusions” one would be hard pressed to find lower hanging fruit.

ASU 2015-03 made two changes to GAAP:

  • Deferred debt issuance costs would, instead of being reported as an asset, be deducted from the gross carrying amount of the debt to which it relates.
  • Amortization of debt issuance costs would be reported as interest expense.

Question #1: Will the amendments, as claimed by the FASB, simplify GAAP? 

No.  Moving an item from the left side of the balance sheet to the right side as a so-called “valuation account” (which it is not) and reclassifying an operating expense as interest expense (which it is not) is more like re-arranging the deck chairs on a ship that deserves to sink.

Question #2: Will the amendments maintain or improve the usefulness of the information provided to users of financial statements?

No again. “Representational faithfulness” is lost if debt issue costs are reported as interest expense.  And deferred issuance costs do not reduce amounts owed.

The FASB’s forefathers understood that debt issuance costs are not the same thing as interest expense. For one thing, debt issuance costs are paid to investment bankers, and interest is paid to creditors.  And as predictors of future cash outflows, they are very different animals.  In recognition of these fundamental differences, APB 21 (issued in 1971) rightly separates debt issuance cost from premiums and discounts on the debt itself.

As a practical matter, conflating past costs with current interest expense screws up a key measure of risk, interest coverage, while artificially inflating operating income.

Question #3: Is Simplification the Real Reason for this Update? 

I doubt it.  One (admittedly cynical) explanation for this ASU is that issuers are behind the cosmetic changes to operating income and interest expense I described in the previous paragraph.  Especially with interest rates low, as they are today, issuers are willing to take the hit to their interest coverage ratios in exchange for higher operating earnings.

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Of course, none of my questions were actually discussed by the FASB in its basis for conclusions, for if they were, there is not way that this ASU could have seen the light of day.  Given these omissions, it should come as no surprise that the official rationales are highly specious.

Rationale #1: Deferred debt issuance costs are not assets.  IFRS presents them as a reduction of the debt.

While technically true statements, these are not logically sufficient justifications for presenting debt issuance costs as a reduction to liabilities.   Debt issuance costs paid to other parties in no way reduces the amount owed, so how could they be a “valuation account”?  That’s why the Accounting Principles Board could not bring itself to do what the FASB will now happily do four decades later, apparently to provide issuers with even more window dressing opportunities.

It also should go without saying that just because the IASB does it, that doesn’t make it right. And if it’s not right, who cares whether it brings U.S. GAAP closer to IFRS?

Rationale #2: Debt issues costs are similar to debt discounts.

Unsurprisingly, the FASB didn’t actually state why debt issuance costs were similar to a debt discount.  That’s because nothing about debt issuance costs is similar to debt discounts — except that they are both the result of contrived calculations that have no meaning to users of financial statements.  The unamortized debt discount is a convoluted function of expected future cash outflows remaining to fully service a debt, while the unamortized portion of debt issuance costs is an incorrigible allocation of past cash flows that never had anything to do with debt service.

But wait, I forgot one thing they do have in common: they both have debit balances. (Wow.)

Rationale #3: Treating debt issuance cost as a valuation account instead of an expense is consistent with the treatment of equity issuance costs set forth in ASU 340-10-S99-1.

At the present time, ASU 340-10-S99-1 is from Topic 5A of the SEC’s Codification of Staff Accounting Bulletins.  Tracking back further takes you to SAB No. 1, issued in 1975, which bootstrapped the Codification, and probably back even further than that to some obscure publication issued years before the FASB, or maybe even the APB came into existence.

“The devil can cite Scripture for his purpose.
An evil soul producing holy witness
Is like a villain with a smiling cheek,
A goodly apple rotten at the heart.
O, what a goodly outside falsehood hath!”

      Shakespeare — The Merchant of Venice

OK, before everyone gets too bent out of shape, my point is not that the FASB is the devil incarnate.  Yet, the convolutions in its basis for conclusions brought the above quotation to mind.  Out of one side of its mouth the FASB summarily rejects a provision in APB 21 promulgated by its forefathers in due process — without trying to explain the reason why it was written into U.S. GAAP in the first place.  Out of the other side, it “cites” for its ultimate “purpose” a questionable analogy to a contrary ancient staff position — again without explaining the line of reasoning for historically different treatments of debt and equity issuance costs.

Although I can’t say exactly when the SEC staff position was published, it was definitely a long time before private standard setters settled on the conceptual definitions for assets, liabilities, revenues, expenses, gains and losses that are supposedly a cornerstone of today’s financial reporting deliberations.  I very much doubt that the SEC staff’s reason for allowing equity issuance cost to permanently bypass the income statement was based on anything other than a pragmatic reluctance to burden fragile post-IPO earnings with the high costs of investment bankers’ fees.  Notwithstanding, the FASB certainly did find it to be a convenient hook on which to hang their collective hats.

* * * * *

As specious as the basis for conclusion is in ASU 2015-03, the FASB unanimously approved its issuance.

Perhaps it couldn’t have been any other way, for even one half-hearted dissent would have risked revealing for whom the FASB really toils.

9 Comments

  1. Reply Brian E April 17, 2015

    What do you mean by the cosmetic change from operating income to interest expense? Debt issue costs are currently amortized to interest expense via the interest method. This ASU only changes the balance sheet location. While maybe not perfect, contra-liability presentation seems more sound than asset classification for issue costs.

    • Reply Tom Selling April 17, 2015

      Hi, Brian:

      The ASU amended ASC 835-30-45-3 to specifically state for the first time in authoritative GAAP that amortization of deferred issuance cost is interest expense. If companies amortized deferred issuance costs to interest expense in the past, it must have been on the basis of non-authoritative GAAP. Therefore, practice likely varied in this area. Now, everybody has to take it to interest expense — even though, as I described in the post, I strongly believe it is inappropriate to do so.

      By the way, I received an email from a former FASB member who agreed with my analysis of the ASU. He wrote, “An honest basis [for conclusions] would have to include the word smoothing.”

      Best,
      Tom

  2. Reply Paul April 18, 2015

    How much does the FASB think that the company borrows in the transaction? Does it borrow the purchase price, the amount paid by investors seeking the return yield (effective rate) listed in the SEC FWP form? Or is the amount borrowed the net proceeds the company receives after paying the fees, to spend as it likes? Why is the effective interest cost for the borrower then different than the effective return for the investor? I would guess that the FASB is appealing to its notion that all costs of borrowing are interest, and regardless of when the cash flows occur or to whom they are paid, interest costs should be accrued over the time period of the borrowing transaction.

    • Reply Tom Selling April 18, 2015

      Hi, Paul:
      Excellent question: what precisely is interest? I imagine that its origin was as a contracting convention for determining total debt service. For example, if an amount is loaned for a variable time, what is the contractual payment to settle the debt at point in time x?

      This is not the same question an accountant asks, and I’m not sure that drawing a relationship between return on investment with contracted-for interest is the appropriate way to measure the cost of borrowing money. I might have more to say on this in a later post.

  3. Reply Greg April 20, 2015

    Debt issue costs have always been treated as interest expense. The master glossary of the codification defines interest cost as “with respect to obligations having explicit interest rates, interest cost includes amounts resulting from periodic amortization of discount or premium and issue costs on debt”.

    • Reply Tom Selling April 20, 2015

      Greg,
      The definition of interest costs that you cite has its origins in FAS 34, on the capitalization of interest. These debt issuance costs would not be reflected as interest expense, but would be part of the depreciation on the self-constructed asset for which interest costs were capitalized. So, that example actually proves my point. It is also why the Board had to amend ASC 835-30 to make specifically require that debt issuance costs within the scope of that topic had to be amended.

      When viewing a glossary term in the ASC, I suggest you display as “printer friendly with sources.”
      Best,
      Tom

      • Reply Greg April 21, 2015

        While I disagree that existing GAAP does not require debt issue costs to be treated as interest expense, I will grant you that I think the FASB has some conflicting guidance around interest. I think a good example of this is the cash flow treatment of debt issue costs versus the cash flow treatment of interest.

        I’ve always found it odd that debt issue costs were treated as financing activities in the statement of cash flows yet were amortized to interest expense, which is an operating activity in the statement of cash flows. Even if you argue that I’m wrong and that GAAP never required debt issue costs be treated as interest expense, it does now with this new pronouncement, yet debt issue costs will still be considered financing activities.

        If debt issue costs truly are an interest expense, they should have similar treatment in the statement of cash flows.

  4. Reply Greg April 21, 2015

    Regardless of its origins of the definition, interest cost is defined as “…issue costs on debt” so you can argue all you want that the new standard is some big change to income statement presentation, but it’s not. Current GAAP requires amortization of debt issue costs be classified as treated as interest expense so there is no change. Not only does the definition in the codification specifically state that issue costs are a component of interest cost, as someone else stated, interest expense is required to be reflected in the financial statements using the effective interest method, which includes debt issue costs.

    You may think that there was no specific requirement before to put debt issue costs in interest expense, and for arguments sake, let’s say there wasn’t, but I’d wager the vast majority of companies already put them there for no other reason than they recognize interest under the effective interest method, which is required by GAAP. I know that over my career, I’ve never once seen a company not amortize debt issue costs to interest expense. Well I take that back, I had one, and we called it an error.

  5. Reply Robert February 21, 2017

    The FASB and AICPA have nothing better to do with themselves so they dream up more changes that are meaningless, but give us more work to do.

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