Definition
The term debt issue costs refers to the expenses associated with issuing bonds or notes. These expenses can include underwriting charges, printing costs, and legal and registration fees. Accounting rules require companies to amortize these costs over the term of the associated debt.
Explanation
Issuing long-term bonds represents an important source of financing for many companies. The process of issuing bonds to the public takes a considerable amount of time. Approval is needed from the Securities and Exchange Commission, a prospectus must be written, and underwriting of the securities might be arranged.
When a company issues debt, it can do so in one of two ways:
Underwriter Placement: the entire debt issue is sold to an investment bank, who subsequently resells to both the public as well as security dealers. The underwriter will purchase the bonds at a specific price, thereby assuming the risks associated with this debt.
Private Placement: the company can also choose to sell the debt issue directly to the public; oftentimes a pension fund or another large institutional investor such as an insurance company. This is a less costly option since it does not require the use of an underwriter or approval of the Securities and Exchange Commission.
With either of the above two options, the company incurs costs such as legal fees, printing expenses, and possibly underwriting and registration fees. Generally Accepted Accounting Principles require companies to create an asset account known as bond issue costs or debt issue costs, and move these costs over the term of the security to the income statement using a corresponding expense account.
Example
Company A issued $10,000,000 in bonds with a coupon rate of 3.5% and a term of twenty years. The Federal Reserve decreased interest rates slightly as Company A prepared the public offering of these securities. For this reason, the bonds were sold at 102, which is 102% of par value. Company A also incurred $40,000 in fees and other charges associated with issuing this debt.
The journal entry to record the issuing of the bonds at a premium would be:
Debit | Credit | |
Cash ($10,000,000 x 1.02), Less Costs | $10,160,000 | |
Debt Issue Costs | $40,000 | |
Premium on Bonds Payable | $200,000 | |
Bonds Payable | $10,000,000 |
Note: Cash is recorded as the difference between the amount paid for the securities ($10,200,000) minus the debt issue costs of $40,000.
Using the straight line method, Company A would amortize the premium over a period of twenty years. The journal entry for this transaction is as follows:
Debit | Credit | |
Premium on Bonds Payable ($200,000 / 20 years) | $10,000 | |
Interest Expense | $10,000 |
As noted in the above journal entry, selling the bond at a premium effectively decreases the interest expense of the issuing company. Using the straight line method, Company A would amortize the debt issue costs over a period of twenty years. The journal entry for this transaction is as follows:
Debit | Credit | |
Debt Issue Expense ($40,000 / 20 years) | $2,000 | |
Debt Issue Costs | $2,000 |
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The term bonds issued at a premium refers to newly issued debt that is sold at a price in excess of its par value. When a bond is issued at a premium, the company will typically choose to amortize the premium paid over the term of the bond using a straight-line method.
Hristina NikolovskaJanuary 9th, 2024
The term bonds issued at a discount refers to newly issued debt that is sold at a price that is less than its par value. When a bond is issued at a discount, the company will typically choose to amortize the discount over the term of the bond using a straight-line method.Hristina NikolovskaJanuary 9th, 2024
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