Borrowing entities pay commissions to investment banks, accounting, legal, and documentation costs to issue debt instruments like corporate bonds and notes.
These costs along with debt discounts and premiums should be recorded as a reduction to the long-term financial facility on the balance sheet of the borrowing entity.
These costs are then amortized to reflect the expense on the income statement periodically.
Let us discuss what are debt issuance costs and what is their accounting treatment.
What is Debt Issuance?
Debt issuance is the practice of borrowing money through bonds or other debt instruments.
Governments, corporations, and large entities use bonds to issue debt and raise funds from the market. In return, investors receive interest plus their principal amount returned.
The debt issue is different from bank loans as the investors in these instruments vary from financial institutions, corporate entities, and even individuals.
Also, there are no restrictions on the use of borrowed money through debt issues in contrast to bank loans.
These debt instruments are marketable securities and are traded in the market by investors. For that purpose, borrowers often issue debt instruments at discounts to attract more investors.
Short-term debt instruments like notes and certificates mature in one to five years. Long-term debt instruments like bonds mature usually after fifteen to twenty years.
What are the Debt Issuance Costs?
Debt issuance costs or fees refer to the expenses incurred to issue debts. These costs may include legal, accounting, and management costs related to debts.
For accounting purposes, costs linked to issuing debts should be included as a relevant expense.
Some debt issuance costs include:
- Registration and listing fees
- Documentation, preparation, and processing fees
- Underwriting fees, commissions, and other fees.
- Accounting, consultation, and legal fees.
- Other incremental fees associated with debt issuance.
Any other incremental cost that can be linked to the debt arrangement can be accounted for as the issuance cost as well.
Some costs that cannot be included in the issuance fees include commissions paid to employees, employee stock performance options, bonuses, and premiums paid to directors.
Any advance costs or fees paid for debt issuance arrangements where the arrangements do not materialize cannot be accounted for as debt issuance costs.
Accounting for Debt Issuance Costs
The US Generally Accepted Accounting Rules (GAAP) provide guidelines on the accounting treatment and recognition of debt issuance fees.
Debt issuance costs should be reported as a deduction from the face value of the debt on the balance sheet of the issuer.
Debt issuance costs are recorded on the balance sheet first and then amortized periodically to transfer the expense to the income statement.
The journal entry to record the issuance fees will be:
DR Debit Issuance Cost Account
CR Accounts Payable Account/Cash
Both the GAAP and IAS rules now classify the debt issuance costs as a reduction to the face value of the debt rather than the asset on the balance sheet.
Therefore, the journal entry under the new accounting rules will be:
DR Long-Term Debt (Net of Issuance costs)
CR Cash (Net of Issuance Costs)
Any discounts and costs associated with the debt instruments should be adjusted as a reduction in the face value of the financial liability rather than creating an asset on the balance.
The reduction amount will then be amortized over a specified accounting period like the interest costs. The amortization period is usually the same as the debt maturity for short or medium-term debts and can be shorter for long-term debts.
Accounting for Revolving Debt Issuance Costs
A revolving line of credit or debt facility is a flexible borrowing option for borrowers that can be used for a specified period as and when needed.
A borrower would pay upfront costs to acquire the revolving line of credit but may not draw the debt immediately.
In such situations, the borrower may account for the initial debt issuance costs as short-term assets on its balance sheet.
If the facility is for more than one year, the entity should record the entire asset amount as a non-current asset.
The total cost or fees will then be amortized to the income statement to reflect the expense periodically.
The GAAP rules do not classify the accounting treatment for debt issuance costs for revolving lines of credit.
If an entity immediately withdraws all the available financing amount and intends to repay the debt at maturity, it is similar to a term loan.
In such situations, the borrowing entity should report the issuance costs in accordance with the GAAP rules for term loans and record a reduction to the face value of the loan.
Example
Suppose an entity ABC issues a bond with a face value of $1 million. The total issuance fees, including the accounting, legal, and investment bank’s fee are $70,000.
Under the GAAP rules, the journal entry will be:
Account Name | Debit | Credit |
Cash | $930,000 | |
Long Term Debt – Bond | $930,000 |
The issuance cost will be amortized over 10 years.
Therefore, the amortization cost per year will be $7,000.
The journal entry to record the transaction will be:
Account Name | Debit | Credit |
Debt Issue Expense Account | $7,000 | |
Debit Issue Cost | $7,000 |
Amortization of Debt Issuance Costs, Premiums, and Discounts
If the face value and present values of a debt instrument (bond) are different, then there is a premium or discount amount.
A bond premium or discount amount should first be adjusted to the face value of the debt instrument when recording the entry to the balance sheet.
These amounts will then be amortized over the period of debt maturity to transfer the expense to the income statement.
Similarly, the debt issuance cost will be first recorded on the balance sheet as a reduction to the financial liability and then amortized.
Debt issuance costs, premium, and discount amounts should be amortized over the same period. The GAAP rules do not specify the amortization period but it’s wise to use the maturity period of the debt.
Also, an entity can use any appropriate amortization method including the straight-line amortization method to record the expense on the income statement. When an entity records a financial liability at fair market value at the beginning, it should immediately expense the debt issuance costs rather than amortizing them.