When a company decides to issue debt securities such as bonds or debentures to raise capital, there are several costs it must bear. Debt issuance costs encompass all the expenses associated with the issuance and sale of these debt instruments. These expenses can impact both the net yield obtained from the debt issue and the effective interest rate.
Common debt issuance expenses include, among others:
- Legal fees: Legal fees for drafting, reviewing, and validating the debt issue’s requisite legal documentation are included here;
- Accounting costs: The costs of hiring accountants to check the issue for compliance with financial reporting standards are included;
- Underwriting fees: The underwriters of a debt securities issue receive these payments in exchange for their agreement to purchase any unsold shares;
- Printing expenses: The printing expenses for the prospectuses and associated materials are paid for by them;
- Regulatory costs: They include fees paid to regulatory authorities for debt security issuance approval;
- Other direct costs: Credit rating agency fees, listing fees, and other similar expenses are examples of direct expenditures.
Accounting Treatment for Debt Issuance Cost
Historical Approach
In the past, a company’s balance sheet would display deferred charges representing the costs incurred during the issuance of debt. These charges were accounted for separately and gradually written off over the duration of the corresponding obligation. Amortization expenses associated with these costs were typically included in the interest section of the income statement and calculated using either the straight-line or effective interest methods.
Current Approach
The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2015-03 in April 2015. This update mandated that businesses present debt issuance costs as a direct deduction from the carrying amount of the corresponding debt liability.
Following the adoption of ASU 2015-03, the amortization of debt issuance costs throughout the duration of the associated debt will persist, but it will be recognized as a reduction of the debt rather than an asset. Typically, the effective interest method is employed to determine the amortization amount for each reporting period.
Impact on Financial Statements
Balance Sheet
Under the latest accounting standard, debt issuance costs are directly deducted from the liability on the balance sheet. As a result, the total amount of debt issued is reduced from the reported net liability. This approach differs from the previous method, where these expenses were recorded as separate assets.
Income Statement
The revised format of the balance sheet does not impact the effect on operating cash flow. The interest expense still incorporates the amortization of debt issuance costs, which has an impact on the net income.
Cash Flow Statement
The impact of debt issuance costs is reflected in the cash flow statement through two categories: financing activities and operating activities. The initial payment of these costs is recorded as an outflow in the cash flow from financing operations and occurs at the time of debt issuance. Since the amortization of these expenses is a non-cash expenditure, it is presented in subsequent periods’ net income within the cash flow from operating activities section.
Debt Issuance Costs and the Effective Interest Rate
When considering all the fees and charges related to a loan, including those associated with debt issuance, the effective interest rate represents the true expense of the loan. Due to the debt issuance costs, the face value of the debt is lower than the net proceeds received by the corporation. Consequently, the corporation obtains less capital than what is recognized as liabilities.
In other words, the actual interest rate paid by the corporation on the borrowed funds is higher than the nominal rate. This factor is taken into account in the calculation of the effective interest rate. When debt issuance costs are involved, the effective interest rate will always exceed the nominal interest rate.
Conclusion
Debt issuance costs significantly impact the actual cost of debt for a company and play a crucial role in shaping the borrowing landscape. All relevant fees and charges, such as legal fees, accounting fees, underwriting fees, printing expenses, and regulatory costs, must be deducted from the carrying amount of debt. This presentation enhances the accessibility of information and facilitates meaningful comparisons across different companies.
These charges not only decrease the net proceeds from debt issuance but also elevate the effective interest rate, providing a more accurate reflection of the true cost of borrowing. Investors, regulators, and other stakeholders can better evaluate a company’s financial well-being and cost of capital when they have a comprehensive understanding of these details.
FAQ
Having a clear comprehension of debt issuance expenses is crucial as they impact multiple aspects, including the net capital received from a debt issue, the effective interest rate, and the presentation of various financial statements.
Previously, loan issuance costs were recognized as an asset on the balance sheet. However, with changes in accounting standards like ASU 2015-03, these costs are now deducted from the loan liability. This adjustment enhances transparency and enables businesses to be more easily compared to one another.
The effective interest rate increases as a result of debt issuance costs, which reduce the net cash received by a company from a debt issuance. This occurs because, despite receiving less cash, the corporation is still obligated to pay the same nominal interest rate.
The cash flow from financing operations displays an outflow representing the debt issuance charges incurred during the specific period. These expenses are non-cash in nature and are amortized back into the operating cash flow and net income over subsequent periods following the year of issuance.
On the income statement, the amortization of debt issuance expenses is accounted for as interest expenditure, which reduces the net income.