Accounting for Debt Issuance Costs

Before we look at the debt issuance costs, we need to define what we are reviewing and a little history in where current recognition, measurement and disclosure is with generally accepted accounting principles.

When a firm undertakes a process of issuing debt to investors, it incurs a range of costs. These fees include will generally fall into three broad categories being:

• accounting: how the debt issuance transactions are going to brought to account, ensuring all external financial reporting requirements are complied with;
• legal: the structuring of the debt instruments establish certain legal rights and responsibilities upon different parties and these need to be documents clearly in internal and external paperwork. These teams will also be involved in ensuring external reporting requirements are met;
• underwriting: in the issuing of debt instruments the ability to manage the risks involved in establishing price (the coupon and effective rates) and up-take of the issuance is often underwritten by third party firms: this activity incurs fees that the issuer must cover.

Changes in Financial Reporting

The development in the accounting for debt issuance costs for external financial reporting is an excellent example of the benefits conceptual frameworks in accounting have brought about. Establishing the essential elements of the financial statements and consistency in disclosing them ensures a much fairer reporting of firm activities to stakeholders.

In the case of debt issuance, previously, we would recognise the fees the issuance was incurring as an asset on the balance sheet. The reporting entity would then amortise this asset over the life of the debt issuance. This amortisation would then bring these costs into the statement of financial performance over time.

However, conceptual accounting frameworks’ development questioned how we could recognise these costs as assets with no future economic benefits. So, if the costs had no future economic benefits, what were they? And if they were not intangible, we could amortise them.

Harmonized Accounting Standards of Debt Issuance Costs

As reporting jurisdictions further harmonised accounting practice, the need to establish a more consistent treatment of these costs was required.

In and around 2015/16 changes were brought in that meant a shift in how these costs were recognised and disclosed. Instead of being recognised as an asset, we would now treat issuance costs as a contra-liability.

And the annual expense component is to be measured using the effective interest method and disclosed as an interest expense in the statement of financial performance. We will have a separate article on this method of calculating the interest expense but suffice to this method aids in better reporting as it better reflects the fair cost of borrowing for the lender.

The Effective Interest Method Measurement

So far, we have defined issuance costs and how changes in conceptual accounting frameworks have driven changes in how these costs are recognised and disclosed.

Next, we move onto how they are measured and the calculations involved in using the effective interest method. We will start setting out the example here and then carry that over into the next section for the debits and credits.

In a previous article titled Accounting for Convertible Debt, we looked at how the accounting entries for a $3,000,000 debt issue for our trusty business ABC Ltd. In carrying on the example, we are not going to worry about any convertibility issues. Instead, we’ll modify the example a little and say ABC issued 1,000 notes priced at $3,000 each, maturity in five years – with no discount or premium. We’ll look at these issues in another article.

Calculations – Debt Repayment Table

The first calculation we’ll need to look at is the annual payment, split into interest and principal. And we need to know what the aggregate balance of the loan balances was over the term. As Table 1 below shows, this figure is $9,432,944 – but not to worry, we’ll come back to this figure. In the meantime, we can see that a $3,000,000 loan with an interest rate of 7.5%, maturity in five years, has the following repayment table.

Using the same table, we now need to know how to apportion the debt issuance costs. ABC Ltd paid out in accounting, legal and underwriting costs of $65,000. Under the new approach to accounting for these costs, we now have to bring these to account as an expense, and the effective interest method helps nicely.

Calculation – Effective Interest Table

Coming back to that total of $9,432,944. What Table 2 does below takes the closing balance for each year and divide this into the $9,432,944 total. So let’s see, for year 1, this was a calculation of:

£2,483,506 / $9,432,944 = 26.33%.

This figure is then multiplied by the issuance costs. So we would have:

26.33% x $65,000 = $20,672

This calculation is carried on for each year the debt is on issue, with us coming to the end of year five and the last of the issuance costs are brought to account, a figure of $4,753.

Debt Issuance Accounting Example

Journal 1 – Debt Issuance

Now we are ready to get the debits and credits done for our ABC example. At the time of issue, we would make the following entries in Journal 1:

We know that the debit to the Bank will be $3,000,000, but at this stage, we don’t know what the credits will be for the liability and equity entries:

Journal 2 – Debt Issuance Costs

We know there are $65,000 in issuance costs, assuming these are paid when issuing the debt. The newly created “Debt Issuance Costs” is a contra-liability account and will have a natural debit balance, disclosed in the liability section of the statement of financial position.

Journal 3 – Interest and Debt Payments

Moving along in time, we are now 12 months down the road, one year into the life of the $3,000,000 in notes that ABC has issued. We now need to account for the year of interest expenses. You could, of course, combine these two. I notice many people like to do this, but I like to separate them, and it is much clearer what is going on. Journal Entry 3 below, we are recording the annual interest and principal repayment:

Journal 4 – Debt Issuance Cost Apportionment

And then, in Journal Entry 4, we can consider the interest expense of the debt issuance costs we need to apportion to year 1.

ABC would then make these entries each year to reflect interest costs and debt liability it incurs and carries in its financial statements, respectively.

Conclusion

That brings us to the end of this tutorial on debt issuance costs and their associated accounting entries. We will be writing a few more around this topic, particularly how to account for premiums and discounts and cover equity fundraising.

If you have read this far, thank you, please drop us a comment below (be kind, I’ve been out of accounting for over a decade, and so it’s quite the climb getting back to this). Or get in touch through our ask a question series or use the Contact us link.