Accounting for Debt Issuance Costs

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

When I 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 how debt issuance costs are accounted for in external financial reporting is a great example of the benefits conceptual frameworks in accounting have brought about. By having establishing clearly what the basic elements of the financial statements are made up and consistency in how they disclosed ensures a much fairer reporting of firm activities to stakeholders.

In the case of debt issuance the case use to be that the fees incurred were recognised as an asset and disclosed in the statement of financial position. This asset was then amortized over the life of the debt issuance; thereby bringing those costs into the statement of financial performance.

However with the development of accounting conceptual frameworks this brought into question of how these costs were being recognized as an asset and yet they held no future economic benefits. And therefore connected to this if these costs were not an asset what were they? If they were not an intangible asset they could therefore not be amortized.

Harmonized Accounting Standards of Debt Issuance Costs

As reporting jurisdictions further harmonized 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 change to how these costs were to recognized and disclosed. Instead of being recognized as an asset issuance costs would be brought to account 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 worked through defining what issuance costs are and how changes in accounting conceptual frameworks have driven changes in how these costs are recognized 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 in to the next section for the debits and credits.

In a previous article that reviewed how convertible debt should be accounted for, “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 rather 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 to be concerned with. We’ll look at these issues in another article.

The first calculations we’ll need to look at is the annual payment, split into both interest and principle. And we are needing to know what the aggregate balance of the loan balances were 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 mean time 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.

Table 1

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 how we account for these costs we now have to bring these to account as an expense and the effective interest method helps nicely.

Coming back to that total of $9,432,944. What Table 2 does below is take the closing balance for each year and divide this into the $9,432,944 total. So lets 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 end of year 5 and the last of the issuance costs is brought to account, a figure of $4,753.

Table 2

Debt Issuance Accounting Example

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 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:

DateAccount NameDebitCredit
10 MayBank$3,000,000
Debt$3,000,000
Journal Entry 1

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

DateAccount NameDebitCredit
10 MayDebt Issuance Costs$65,000
Bank$65,000
Journal Entry 2

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 a lot of people like to do this, but I like to separate them out and it is much clearer what is going on. Journal Entry 3 below we are recording the annual interest and principle repayment:

DateAccount NameDebitCredit
10 MayInterest Expense$225,000
Debt$516,494
Bank$741,494
Journal Entry 3

And then in Journal Entry 4 we can bring to account the interest expense of the debt issuance costs being apportioned to year 1.

DateAccount NameDebitCredit
10 MayInterest Expense$20,672
Debt Issuance Costs$20,672
Journal Entry 4

These entries would then of course be made each year, reflecting in ABC’s financial statements to interest costs and debt liability it is incurring and carrying respectively.

Conclusion

That brings us to the end of this tutorial on debt issuance costs and its associated accounting entries. We will be writing a few more around this topic, in particular how to account for premiums and discounts and also covering off equity fund raising.

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.

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