The interest cost of borrowing should be reflected in the form of interest expense that is recognized at a constant interest rate, aka constant effective yield, throughout the contractual term of the obligation. This use of a constant interest rate is known as the ‘interest method’ (also referred to as the “effective interest method”, although the FASB does not use that terminology in the Codification), and is applied to a discount or premium realized upon issuance, and to debt issuance costs incurred on the transaction.
Accounting for discounts and premiums is mentioned in several places of the Codification. The most basic form of discount or premium arises when the face amount of the note differs from the present value of the futures cash flows. Present value is a discounted cash flow calculation, so the logical conclusion is that the discount rate used to compute the present value differs from the stated rate. Obviously, but this starts to encroach on the imputed interest discussion which will be addressed in a separate post. Discount also comes up as the result of allocating issuance proceeds when multiple instruments (e.g., detachable stock purchase warrants) are issued along with the note.
The accounting treatment of debt issuance costs are mentioned in the Codification in ASC 835-30-45-3. The title of this subtopic is “Other Presentation Matters” and is an odd place to stash the accounting treatment of debt issuance costs. Regardless, debt issuance costs should be recorded as a deferred charge and amortized over the term of the debt using the interest method. You will also find a discussion of debt costs in the debt modification section, ASC 470-50-40-17 to 19. There is also a somewhat beefy discussion of debt issuance costs and discount/premium in that non-authoritative FASB publication called Statement of Accounting Concepts No.6, Elements of Financial Statements, a replacement of FASB Concepts Statement No. 3 (incorporating an amendment of FASB Concepts Statement No. 2) (“FAC No. 6”). Paragraphs 235 – 239 of FAC No. 6 go into accounting for discounts, premiums and debt issuance costs on a conceptual basis. Interestingly, FAC No. 6 offers up the alternative of expensing debt issuance costs as a period cost. Personally, I think this flies in the face of reflecting issuance costs as additional borrowing costs in the form of interest. And, of course, it’s not authoritative anyway.
Let’s look at some simple calculations to illustrate how the interest method works (here’s the Excel spreadsheet file for all schedules shown for download; and an explanation of the calculations, too).
Amount borrowed: $100,000 (cash)
Note face amount: $100,000
Stated interest rate: 6%
Term: 5 years
Issuance date: 4/1/2013
Maturity date: 4/1/2018
Principal repayment schedule: 20 equal quarterly principal payments beginning on 7/1/2013
Interest payments: 20 quarterly payments beginning on 7/1/2013 computed in arrears on the outstanding balance
Debt issuance costs incurred: $5,000
Here’s the payment and interest cost schedule. I used the Goal Seek function in Excel to calculate the debt issuance cost amortization amounts. Note that the effective yield is 7.9% throughout and is the stated rate of 6% plus the periodic amortization effective rate of 1.9%
Let’s assume the debt was issued at a 10% discount to face ($90,000). Here’s the schedule. Amortization of the discount is computed using the same interest method as amortization of debt issuance cost resulting in an effective yield that does not change throughout the life of the note.
Same note but issued at a 10% premium to face. In other words the borrower received $110,000 but repays $100,000.
Just for giggles, let’s look at a modification of the note. Our borrower missed a payment and negotiated a modification of the note terms as follows (assume this is a modification for accounting purposes and not an extinguishment):
Outstanding principal on modification date: $75,000
Accrued interest: $2,289
New stated interest rate: 8.5%
New maturity date: 1/1/2019
Revised repayment schedule: 15 equal quarterly principal payments beginning on 10/1/2018, final lump sum payment on 1/15/2019
Revised interest payment schedule: 16 quarterly payments beginning on 1/1/2019 computed in arrears on the outstanding balance
Cash consideration paid to lender to induce the modification: 5% of outstanding principal and interest ($3,863)
A couple of things to note here:
1. Effective yield must remain 11.7% prior to the modification, so the previously computed discount and debt issuance cost amortization amounts for 1/1/2015 ($667 and $333, respectively) have changed ($725 and $362, respectively).
2. Unamortized discount is carried over and amortized over the modified life of the debt so the effective interest rate changes.
3. Unamortized debt issuance costs are added to the loan modification costs paid to the lender (expense as incurred if paid to a third party) and the balance is amortized over the modified term of the debt.
The result is a modified schedule that reflects a new effective yield for the modified note.