Accounting for Debt Issuance Costs
Debit issuance costs are the costs that a company spends to issue new bonds or debt to the market. These are the necessary costs that the company cannot avoid, otherwise, the issuance of debt will not succeed.
When a company takes out a loan, they agree to repay the amount borrowed, plus interest, over a period of time. Debt financing can be a good option for companies because it allows them to access the funds they need without giving up equity in the company. However, it is important to remember that debt must be repaid regardless of whether or not a company is successful. This means that companies need to carefully consider whether or not they will be able to make the required payments before taking out a loan or debt.
A company can raise funds through debt by issuing bonds. bonds are a type of debt instrument in which an investor loans money to a borrower, typically for a period of time. The issuer agrees to pay the investor periodic interest payments, as well as repay the principal amount of the bond at maturity. Bonds are often used by companies to finance long-term capital expenditures, such as the purchase of new equipment or the construction of new facilities. Because bonds are a form of debt, they must be repaid even if a company is making a profit or not. As such, they represent a higher risk for investors than equity investments. However, bonds typically offer lower interest rates than other types of loans, making them an attractive option for companies in need of capital.
Issuing bonds or other debts always involves some costs. For example, there are the costs of marketing the bonds to potential investors, as well as the costs of interest on the bonds over time. In addition, there may be administrative costs associated with setting up and managing the bond program. However, these costs are generally outweighed by the benefits of issuing debt.
By borrowing money through the sale of bonds, businesses can raise the funds needed to finance important projects without having to increase taxes. As a result, issuing bonds can be a very effective way to raise money without putting undue strain on taxes.
List of Debt Issuance Costs
Debt issuance costs are the fees associated with issuing new debt. These costs can include underwriting fees, legal fees, and other miscellaneous costs that the company spends to issue debt.
While debt issuance costs may seem like a minor expense, they can add up quickly, especially for large companies. As a result, it is important for companies to carefully consider all of their options before issuing new debt. One way to minimize debt issuance costs is to work with a reputable and experienced financial advisor.
A good advisor can help to negotiate better terms with underwriters and lenders, which can save the company money in the long run. Furthermore, a financial advisor can help the company to choose the right type of debt for their needs, which can also help to reduce costs. When it is time to issue new debt, working with a trusted financial advisor can help to minimize costs and maximize savings.
Journal Entry for Debt Issuing Cost (GAAP: Amortizing Assets)
The debt issuing cost will be recorded as the assets and amortized over the bonds life. The company will require to capitalize the debit issuing cost as the assets on the balance sheet when the company issue debt and paid for the fees.
The journal entry is debiting Debt issuing cost and credit cash paid.
| Account | Debit | Credit |
|---|---|---|
| Debt Issue Cost | 000 | |
| Cash/Accounts Payable | 000 |
The issue cost will be present on the balance sheet as assets. It will be a long-term asset as the bonds are highly likely to have a multiple-year lifespan. But the issue cost is not qualified as the fixed assets, we can record it under the other assets and amortize based on the bond terms.
At the end of each year, the debt issue cost will be reclassed from the assets to expenses on the income statement.
The amortization will base on the initial cost divided by the bond terms.
Debt issue expense = Debit Issue cost / Bonds term.
The journal entry will debit debt issue expense and credit debt issue cost.
| Account | Debit | Credit |
|---|---|---|
| Debt issue expense | 000 | |
| Debt issue cost | 000 |
The company has to amortize the debt issue cost base on the bond lifetime. It will keep decreasing until reaching zero balance when the bonds retire.
Change in Debt Issuance Cost (GAAP: Contra-Liability)
In 2015, the FASB has modified the accounting treatment over the debt issuance cost. It is no longer present as the assets on the balance sheet. The company has to record it as the contra accounts of debt/bonds on the balance sheet, which is the same as the bond discount.
It means that debt issuance cost will be classified as the contra account of bonds/debt which will decrease the debt on the balance sheet. There is no recognition of assets account.
At the end of the year, the company will make the adjusting entry to amortize the contra-liability account. So it will automatically increase the debt/loan balance.
The new update only changes the classification of debt issuance cost from assets to contra liability. The issuance cost will be present in only one line on the balance sheet with the bonds payable. It prevents the users from confusion and makes it easy to read.
The amortization method remains the same. The contra-liability will be amortized over the lifetime of the debt or bond.
Debt Issuance Cost (IFRS: Effective Interest Method)
Under IFRS, the debt issuance cost is also classified as the contra-liability account which will reduce the face value of the debt or bonds balance.
However, it is not allowed to amortize the debt issuance cost over the bond’s lifetime over the straight-line method.
IFRS suggests that the company must recalculate the interest rate using the effective interest method. The issuance cost is part of the finance cost that company spends to obtain the debt/bonds. So it should be recorded as part of the interest expense.
The effective interest rate must be higher than the stated interest rate as the company spends an additional amount (issuance cost) to obtain the debt.
Debt Issuance Cost Example
Company ABC has issued bonds of 10 million to the capital market to borrow from investors. The bonds have a lifetime of 5 years and 5% interest rate. During the issuance of bonds, the company has paid for the following fee such as:
- Underwriting fee: $ 250,000
- legal fee: $ 250,000
- Other costs: $ 100,000
Please prepare a journal entry for the debt issue cost.
GAAP: Amortized Assets
The company spends an issuance cost $ 600,000 ( $250,000 + $ 250,000 + $ 100,000) to issue the bonds to the capital market.
The issuance cost has to be recorded as the assets and amortized over the period of 5 years.
On the issued date, the company has to record the balance of the asset on the balance sheet.
The journal entry is debiting debt issuance cost $ 600,000 and credit cash paid $ 600,000.
| Account | Debit | Credit |
|---|---|---|
| Debt Issue Cost | 600,000 | |
| Cash | 600,000 |
Debt issue cost is recorded as long-term assets on the balance sheet.
At the end of the first year, ABC will amortize the debt issue cost base over the period of 5 years.
Amortization expense = $ 600,000 /5 years = $ 120,000 per year.
The journal entry is debiting debt issue expense $ 120,000 and credit debt issuance cost $ 120,000.
| Account | Debit | Credit |
|---|---|---|
| Debt issue Expense | 120,000 | |
| Debt issue cost | 120,000 |
It will decrease the debt issue cost (assets from the
Presentation on the Balance sheet
| Account | Amount |
|---|---|
| Cash | 000 |
| Inventory | 000 |
| Debt Issuance Cost | 480,000 |
| Fixed Assets | 000 |
| Total Assets | |
| Accounts Payable | 000 |
| Bonds Payable | 10,000,000 |
| Total Liability |
GAAP: Contra-Liability
Under this new method, the company is required to record the debt issuance cost as the contra account of bonds payable. The issuance cost will reduce the bonds payable balance from $ 10 million on the initial recording.
The company still required to amortize the issuance cost over the term of the bond.
It basically changes the classification of debt issuance cost only.
Presentation on Balance Sheet
| Account | Amount |
|---|---|
| Liabilities: | |
| Accounts Payable | 000 |
| Bonds Payable ( $ 10,000,000 – $ 480,000) | 9,520,000 |
Effective Interest Rate (IFRS)
Under IFRS, the company is required to recalculate the effective interest rate base on the actual cash flow.
First, ABC needs to calculate the effective interest rate which must be higher than 5% as the company paid additional issuance cost $ 5,000,000. It is the finance cost that company has to spend. We need to use the total finance cost to recalculate the effective interest rate.
The easy way to calculate the effective interest rate is by using the Excel formula (IRR). Please refer to the following formula:
The amount company received at the beginning of the year is only $ 9.4 million ($ 10 million – $ 0.6 million). The negative balance of $ 500,000 represents the annual interest paid to investors. The amount in 5th year includes the payback of the bond principle.
After getting the effective interest rate, we have to recalculate the interest expense and compare it with the interest paid. The variance will be adjusted. Please refer to the following table:
| Year | Amount | Carry Amount | Interest Paid | Interest Expense | Variance |
|---|---|---|---|---|---|
| 0 | 9,400,000 | ||||
| 1 | (500,000.00) | 9,505,504 | 500,000 | 605,503.78 | 105,503.78 |
| 2 | (500,000.00) | 9,617,804 | 500,000 | 612,299.84 | 112,299.84 |
| 3 | (500,000.00) | 9,737,337 | 500,000 | 619,533.67 | 119,533.67 |
| 4 | (500,000.00) | 9,864,571 | 500,000 | 627,233.46 | 127,233.46 |
| 5 | (10,500,000.00) | 10,000,000 | 500,000 | 635,429.25 | 135,429.25 |
| 6.44% | 2,500,000.00 | 3,100,000.00 | 600,000.00 | ||
| 0 |
You can refer to the Excel File for the detailed formula.
When the company issue bonds to the market, it records only the net amount of $ 9.4 million ($ 10 million – $ 0.6 million). It nets off with the issuance cost.
Similar to GAAP, The balance on the balance sheet is only $ 9.4 million, not 10 million.
Year 1:
- ABC pays interest $ 500,000 to a creditor as stated on the bonds ($ 10 million x 5%).
- Interest Expense is $ 605,503.78 based on the effective interest rate (6.44%).
- The company has to record an increase in bonds payable. The journal entry is debiting interest expense $ 605,503.78 and credit cash paid $ 500,000, Bonds Payable $ 105,503.78.
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | 605,503.78 | |
| Cash | 500,000 | |
| Bonds Payable | 105,503.78 |
This adjustment needs to record every year based on the table above.
At the end of year 5, the bonds payable will reach the $ 10 million amount (check Carry Amount Column), and it will reverse to zero when the company paid off the bonds.
The total interest expense is $ 3.1 million (check Interest Expenses Column) which is equal to the total interest paid of $ 2.5 million plus the issuance cost of $ 0.6 million.
Debt issuance cost if the company retires the bonds early
As we have explained above, the debt issue cost will be allocated based on the bonds/debt lifetime. And it is expected to reach zero when on the bonds/debt maturity date.
However, it will be a problem when the issuer retires the bonds before the maturity date. It means the company buyback the bonds from the market. It pays back the principal and interest to the investors.
At that time, the balance of debt issuance cost still exists on the balance sheet as the assets, but the bonds already retired. The company has to write off debt issuance costs (amortized assets or contra-liability) from the balance sheet.