Premiums and Discounts - A Refresher

Although there have not been any new accounting developments in accounting for premiums and discounts on investments and loans, the steady volume of questions on this topic shows that a review of the basics should be a useful exercise.

A premium arises when a security or loan is purchased for an amount greater than its par value. Conversely, a discount arises when a security or loan is purchased for less than its par value. In most cases, this difference is driven by the current market rates of interest being higher or lower than the stated rate on the security/loan. Additionally, some investments such as US Treasury Bills do not have a coupon rate of interest and are always sold at a discount.

After acquisition, the premium or discount represents an adjustment to the yield over the life of the subject asset. Premiums are amortized and discounts are accreted into interest income from the acquisition date to the maturity date. This all seems straightforward, until you get into the exceptions.

It is not uncommon for securities to have call dates which occur prior to the security’s maturity date. Many bankers are tempted to amortize a security’s premium to the call date, thereby avoiding a possible loss if the security is called while there is still unamortized premium on the books. While this practice could be characterized as conservative, it is not permitted under generally accepted accounting principles (GAAP), or regulatory guidance. The call date, even if considered likely, does not define the life of the asset. The premium must be amortized to the maturity date.

GAAP does allow expected maturity dates to be used only for holdings of similar debt securities where prepayments are probable and the timing of those prepayments are reasonably estimated. The most common examples of this are mortgage-backed securities and collateralized mortgage obligations.

Regulatory guidance provides another exception when defining the life of a loan. Emphasizing substance over form, the OCC states that the amortization /accretion period should be the normal loan period for that type of loan. Example: If a loan has a balloon repayment date that in reality represents a re-pricing date, the loan should be considered a floating rate loan that re-prices periodically. Alternatively, if at maturity the loan is expected to be re-underwritten with new loan documentation and a new credit review, the original contractual due date controls, because after that due date, the lender has made a new loan.

Finally, if a loan (or security) is placed on non-accrual status, amortization/accretion stops. If the loan is ultimately charged-off, the net investment in the loan (principal plus or minus premium/discount) is charged to the allowance for loan losses.

For more information on premium and discount accounting, please contact your FBLG advisor or Joseph Press at or 303-296-6033.