When entering into a new long-term financing arrangement, or even renegotiating an existing one, there are often fees associated with the origination. The overarching accounting theory when accounting for these debt issuance costs is the utilization of the matching principle. This means that to properly match these costs with the new loan, the costs should be capitalized and amortized over the term of the loan. Under the old guidance, these costs would be classified in the Other Assets section of a Company’s balance sheet. Accounting Standards Update (ASU) 2015-03 Interest – Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs now requires these costs to be presented as a direct deduction to the carrying amount of the related debt. The FASB’s rationale for this change in presentation is that loan fees cannot be an asset because they provide no future economic benefit.
There are various types of potential costs that relate to financing arrangements, some of which are:
- Fees charged to the Borrower in connection with the process of originating, refinancing, or restructuring a loan, such as application and underwriting fees.
- Fees charged to the Borrower that relate directly to making the loan (for example, fees that are paid to the lender as compensation for granting a complex loan or agreeing to lend quickly).
- Fees charged by the Borrower’s legal counsel to review the agreements.
The loan fees are amortized through Interest expense in a Company’s income statement over the period of the related debt agreement.
Illustration: A Borrower enters into a new term note with its bank. The agreement requires a loan origination fee of $15,000, which is paid by the Borrower to the Lender at the date of the loan’s closing. The Borrower also incurs legal costs of $5,000. The term note is valid for five years.
The loan fees should be recorded as a contra liability account on the Company’s balance sheet and amortized over the five-year term. Here is the initial journal entry:
DR: Current Contra Debt Account – Loan Fees $4,000
DR: Non-Current Contra Debt Account – Loan Fees $16,000
CR: Cash $20,000
For our illustration and for simplicity purposes, each year, amortize 1/5th of the fee and group the amortization with interest expense on the Company’s income statement.
DR: Interest Expense $4,000
CR: Current Contra Debt Account – Loan Fees $4,000
There are also certain disclosures relating to capitalized loan fees which are required to be made in a Company’s footnotes. These requirements include a description of the Company’s accounting policy related to the capitalization of these types of costs, the original amount of debt issuance costs capitalized, accumulated amortization of loan fees, the periodic expense amount, projected expense amounts for the next five years and the effective interest rate of the debt after taking into account the amortization of loan fees.
As always, materiality plays a role in a Company’s decision to capitalize or expense the debt issuance costs and to what extent the policy and particulars are disclosed in the Company’s footnotes.
See our blog post, "Audit Materiality: It’s in the Eye of the Beholder" for further discussion of the concept of materiality or speak with a Meaden & Moore expert today to learn more.