To make informed decisions, financial statement users need to understand the nature of the items on a company’s income statement, particularly whether they are persistent or transient, in order to properly evaluate their current performance implications and future cash flow consequences. Historically, accounting standards have given income statement gains and losses careful attention when there are concerns that these components are nonrecurring and may be misunderstood if not clearly described. Formerly, debt extinguishment transactions required prominent reporting as separate line items, but this is no longer the case. In the interest of full transparency, the authors believe that FASB should reestablish separate line item reporting to ensure users can fully comprehend their impact.
History of Debt Extinguishment Reporting
Authoritative accounting principles for debt extinguishment gains and losses can be traced to the Committee on Accounting Procedure’s 1953 Accounting Research Bulletin 43. Gains and losses on the early extinguishment of debt were prescribed differing treatment depending on whether it was replaced by other debt (i.e., refunded). Nonrefunding debt gains and losses were reported currently in income, but refunding gains and losses were allowed to be either recognized currently or amortized over the original unfulfilled term of the refunded debt (or any period of time in between).
In 1972, shortly before it was replaced by FASB, the Accounting Principles Board (APB) issued Opinion 26, which stated “all extinguishments of debt before scheduled maturities are fundamentally alike. The accounting for such transactions should be the same regardless of the means used to achieve the extinguishment” (para. 19). The new treatment called for all extinguishment gains and losses to be recognized in income and identified as a separate item.
Three years later, FASB issued SFAS 4, which required that debt extinguishment gains and losses be reported as extraordinary items to ensure that their nature was clearly described to users. FASB freely admitted that the criteria used to define extraordinary items in APB Opinion 30 would seldom apply to debt extinguishments.
Under pressure from the SEC, which viewed disclosures as inadequate, FASB defended its decision to mandate extraordinary item treatment of debt extinguishment gains and losses on the basis that this treatment was “a practical and reasonable solution” (SFAS 4, para. 15). Given the circumstances, FASB believed it worthwhile to make a practical exception to its conceptual approach in order to make sure that these discretionary, and potentially opportunistic, income-affecting transactions were transparently reported.
Nearly 30 years later, in 2002, FASB issued SFAS 145, reversing its earlier decision on mandatory treatment of these gains and losses as extraordinary items, effectively leaving the question up to the judgment of managers and auditors. More recently, in 2015, FASB did away with reporting extraordinary items altogether through Accounting Standards Update (ASU) 2015-01. The result is that financial statement users cannot count on the past prominent reporting of these gains and losses to identify their presence and impact on reported income.
Since interest rates have fallen and remained at historically low levels since the 2008 credit crisis, there has been little chance that extinguishment transactions, including those of an opportunistic nature, would result in gains that could be misinterpreted by financial statement users. Recent improvements in the U.S economy, however, led the Federal Reserve to impose a modest 0.25% rate increase in December 2015, followed by another 0.25% increase in December 2016. The Federal Reserve has raised interest rates twice (in 0.25% increments) so far in 2017 and has indicated that it plans one more rate hike before year-end. These rate increases create opportunities for managers to recognize gains by refinancing existing low-interest-rate debt, which opportunities will only grow as rates continue increasing toward historical levels. These gains, which would have previously received distinctive treatment as extraordinary items, will now be presented higher up on the income statement and possibly without clear language documenting either their existence or their nature. The authors’ concerns about the transparency of the reporting of these gains are heightened by the results of a recent study wherein the authors found that “line item position on the income statement has important valuation implications” (Eli Bartov and Partha Mohanram, “Does Income Statement Placement Matter to Investors? The Case of Gains/Losses from Early Debt Extinguishment,” Accounting Review, November 2014, http://bit.ly/2fOztYy).
Research on Debt Extinguishments
Two contemporary research studies shed light on the likely impact of FASB’s decision to undo the extraordinary treatment of debt extinguishment gains and losses, and related managerial reactions. First, Marcos Massoud, Cecily Raiborn, and Joseph Humphrey found that the number of early debt extinguishments reported as extraordinary items dropped from 40 in 2002, the last year when all debt extinguishments were required to be reported as extraordinary items, to just four in 2003 (“Extraordinary Items: Time to Eliminate the Classification,” CPA Journal, February 2007, http://bit.ly/2g8hN7c). Their findings suggest that managers and auditors viewed relatively few of these transactions as actually meeting APB Opinion 30’s criteria of “unusual in nature” and “infrequent in occurrence” for determining extraordinary items.
Financial statement users cannot count on the past prominent reporting of these gains and losses to identify their presence and impact on reported income.
Second, looking at data from after SFAS 145 was issued, Abhijit Barua found that “companies have an unusually high propensity to report gains from the early retirement of debt during periods of economic recession, as well as in the fourth quarter of a fiscal year” (“Early Extinguishment of Debt: Rational Debt Management or Earnings Management?” CPA Journal, May 2013, http://bit.ly/2xQ4ane). He also noted that most companies either did not report these gains as separate line items or did not describe them as gains from extinguishment of debt. This suggests at least some opportunistic behavior is in play, unsurprisingly accompanied by a lack of transparency in how they are reported.
Going forward, managers (and their auditors) will continue to interpret concepts first described in APB Opinion 30 when deciding whether a particular transaction requires separate line item reporting. Those provisions stipulate that gains and losses that are either unusual in nature or infrequent in occurrence be reported as separate line items within income from continuing operations. For managers making these judgments, FASB’s own words in SFAS 145 provide justification for a conclusion that debt extinguishment transactions are neither unusual nor infrequent:
Since the issuance of Statement 4, the use of debt extinguishment has become part of the risk management strategy of many companies, particularly those operating in the secondary lending market. (Summary)
Elsewhere, SFAS 145 states:
The Board concluded that the rescission of Statement 4 would improve financial reporting by eliminating a requirement to classify a normal and important part of many entities’ ongoing activities to manage interest rate risk as an extraordinary item. (para. A5)
Clearly, the evolution of debt extinguishments toward what can be described as routine financial management provides ample support to make a case that separate line item reporting under Accounting Standards Codification (ASC) 225-20-45-16 is not warranted. This leads to the authors’ concern that an uptick in debt extinguishment transactions in coming years, expected in reaction to rising interest rates, will result in increased reported net income without an explicit obligation for the reporting companies to provide users with definitive documentation of its source or nature.
FASB’s Project Activity
FASB has three projects on its agenda that eventually should improve the reporting for gains and losses in general and debt extinguishments in particular. At the same time, all of these projects are broad in nature and relatively early in their due process, making it unlikely that new detailed guidance will be provided anytime soon.
The first is a conceptual project, “Conceptual Framework—Presentation.” Like all of FASB’s conceptual projects, this one is directed at producing a Statement of Financial Accounting Concepts, which is not authoritative in its own right, but is intended to guide FASB in its future deliberations of technical issues. In August 2016, FASB issued an exposure draft, and 17 comment letters were received. FASB has reported on its analysis of the comments received, but has not yet outlined its next steps. A review of the proposed statement reveals nothing suggesting a near-term release of accounting guidance that would add clarity and specificity to the income statement reporting of debt extinguishment transactions. Rather, the draft discusses the role of hetero- and homogeneity in determining what is reported as line items, subtotals, and totals in financial reporting; and how 1) the underlying cause of events or transactions, 2) the nature of an activity, and 3) its frequency are all factors that should play a role in making those decisions. Notably, the draft admits that “distinguishing revenues from gains and expenses from losses is difficult given their present element definitions. Those element definitions are expected to be addressed in a subsequent phase of the conceptual framework project.”
The second project, “Financial Performance Reporting—Structure of the Performance Statement,” is classified as a research project that was added to FASB’s agenda in January 2014. According to FASB, “The primary objective of this research project is to: “evaluate ways to improve the relevance of information presented in the performance statement. The project will explore and evaluate improvements to the performance statement that would increase its understandability by presenting certain items that may affect the amount, timing, and uncertainty of an entity’s cash flows.” The still-preliminary nature of this project is indicated by the summary provided of FASB’s Sept. 20, 2017 board meeting, where it was discussed:
The Board decided to add a project to its agenda to focus on the disaggregation of performance information. The project would consider disaggregation either through presentation in the income statement or through disclosure in the notes.
FASB’s staff is now developing a project plan for this new third project. The research project is retained and now includes a goal of “developing an operating performance measure,” but no progress toward that goal was reported.
The authors encourage FASB to continue pursuing its projects on financial reporting with all possible haste; however, they harbor no illusions that these projects can be completed in time to ensure that users will have what they need to confidently decipher the effects of any uptick in debt extinguishment gains reported on income statements in the years ahead. They also, in the name of improving financial reporting, encourage FASB to explicitly consider requiring greater transparency for the entire class of transactions where opportunistic managerial behavior is a possibility.
In the meantime, the authors believe it would be prudent for FASB to fast-track an Accounting Standards Update that would restore reporting requirements to those that existed before FASB first required and then rescinded the extraordinary item treatment for debt extinguishments. Specifically, APB Opinion 26 required debt extinguishment gains and losses to be reported as a separate line item on the income statement regardless of any judgments about whether the transaction itself was unusual in nature or infrequent in occurrence. If reestablished, this treatment would ensure that statement users are not misled by line items that aggregate extinguishment gains with income components from other sources.
The authors cannot help but note that the reporting problem described above is largely an artifact of the traditional, transactions-based reporting model; these gains and losses occur largely because of interest rate changes that then change the market value of the underlying debt, which changes go unrecognized until they are realized in a debt extinguishment transaction. Marking financial liabilities (and assets) to market and recognizing the related gains and losses currently in income, as proposed by the CFA Institute in A Comprehensive Business Reporting Model, Financial Reporting for Investors(2007, http://cfa.is/2xcIySu), would go a long way toward eliminating opportunistic managerial behavior in reporting debt extinguishment gains and losses.