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.
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.
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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.