Bond Issue Costs Made Easy: Journal Entries & Amortization

Welcome to this session. This is professor Farhead in which we will discuss debt issue cost. What is the big idea here? The big idea is very simple. When you want to borrow money, there's a cost for borrowing the money. Well, of course there is a cost. It's the interest rate. Yes, that's one cost to borrow the money. Another cost to borrow the money are additional expenditure that you incur for one reason or another. Now when you want to borrow money from the bank on a personal level they charge you with pulling your credit charging you with an application loan so on and so forth. For large companies there are additional cost for borrowing money and we call those debt issue cost. Now what are these costs? So it's very important to understand them. One is credit rating fees. What's a credit rating fees? If you want to borrow money what's going to happen is this. You are going to ask a credit agency such as Moody's or S&P to rate your debt. Is it AAA a triple BB B so on and so forth because borrowers they want to know what's the credit risk and they are not going to spend money evaluate your risk. If you want to sell your debt to the public you have to pay a credit rating agency. You might have to pay legal and attorney fees. Why? Well, you want to make sure you have the bond indenture, the agreement, registration document, the offering material, the contract, all legal, covering all your basis. So, you need legal fees, legal and accounting fees. You might have to conduct an audit. Well, that's additional cost. You might have printing cost. Now, you might be saying, who spends money on printing cost? Legally, you have to print the the offering. It could be hundreds of pages and you have to send it to everyone who's interested. Well, that's an additional cost. You might have to pay what's called registration and and underwriting fees. When you sell your debt, you might need someone to help you like an investment bank. Rather than you selling it because you're not in the business of raising money, you ask an investment banker. They assist you with pricing, marketing, distributing, and selling those bonds. So notice all these are additional cost in addition to what? In addition to the interest rate that you have to pay. So what's going to happen is this. Right from the get-go, from day one, you would receive less of the proceeds. Why? Because you have to pay for these additional cost than what you are signing up for. Now keep in mind, just because you received less, it doesn't mean your liability goes down. you are still responsible for the full face amount of the bond. So remember we talked about the bonds they have a face value you are still responsible for the face value. Now we want to make a minor distinction here whether the offering whether you are raising money you are borrowing money through a public offering or a private offering because the we need to understand that not all offering are the same in terms of expenses. What do you mean by public offering? What do you mean by private placement? Here's what happens. Sometime a company wants to borrow $10 billion. If they go to a bank, the bank would say, I'm not willing to lend you $10 billion for one customer. They would say, well, why? Why not? Because it's a lot of risk to lend this money. So, what happened is the company what they would do rather than going to few borrowers, one, two, or three banks, they would go and sell it to the public. In other words, they want to sell Durban. They want to borrow money from the public at large, anyone that's interested. So that's why investing the public at large. So this $10 billion will be spread among maybe 100, 200, you know, several investors. But here's what's going to happen. Once you sell to the public, you might need an investment banker. Why? Because you need someone to help you with that. Then once you sell to the public, you are under the SEC regulation. And then you have to pay uh there's a regulatory burden, a substantial filing requirement, an audit, so on and so forth. And what happened is you have higher expenses because you have to market this at public follow the SEC requirement and the overt issue cost is substantial. But what happened is you were able to raise the $10 billion. So there's a cost. If you want to borrow $10 billion and not one individual or one bank or one institution is willing to lend you, you want to go to the public, but there's a cost to do that versus a private placement. In a private placement, you go directly to few investors like pension fund, banks, insurance and you would sell them, you would raise your money, you would sell them the bond directly. So there are minimum requirement because this is a private placement. The assumption is insurance companies, pension, pensions and banks, they are financially savvy. They don't need any protection from the public. Therefore, they will need to do their own due diligence rather than the government asking you for additional filing requirement. So, generally your marketing cost is lower and your overall debt cost is lower. The point I'm trying to make here, if a two companies wants to raise $10 billion, the one that's going through a public offering, they might receive for the sake of simplicity 9.5, the private company 9.75. So they saved they saved 0.25 on the offering. But this is exactly what we need to discuss here. This additional cost that they incur, how do we account for it? And this is the cracks. This is the point of this lecture. Let's go ahead and get started. So, how is that issue cost accounted for? Well, let's assume we want to borrow half a million, but we received $472,218. Here's what we have to do. We have to report this issue cost as a direct deduction from the debt liability. So, the issue cost does not provide any future benefit. So, we cannot treat this as an asset. >> [snorts] >> Well, we cannot sell any previous legal fees. It it it doesn't provide any future benefit. If we pay underwriting fees, there is nothing we can do with that. Um registration costs, we cannot say this is an asset. So all these are not assets. So what are they initially? We are going to record them as a deduction from the liability. They're going to be considered contra liability. Now before I proceed, I know what you are thinking and I hope you know what they are exactly. So, if I borrowed half a million and I received immediately $472,218, okay, the difference is approximately $18,000. What is that $18,000? Come on, you guys know that. How are we going to account for it at the end of the day? This is an interest expense. But we cannot count it as an expense immediately. Why? because interest expense is spread out amortized through time. So these costs are directly associated with borrowing the debt. Borrowing money when you borrow money there's any any time you spend money on borrowing the money I don't care how it's packaged at the end of the see it's interest cost so initially it's included in the initial carrying amount of the bond but eventually it's interest cost. So how do we show the obligation on the initial on the initial recording? So the debt issue doesn't reduce the amount borrowed. So if you borrowed half a million and you you walked away with 472,218, it doesn't mean that's the only thing you are responsible for. You are responsible for the half a million. So let's assume you borrowed a million, you received 950,000 because you have a $50,000 in issuance cost. Well, the company would would would still show the face value minus the 50,000 and we call the difference is the carrying value 950,000. So the carrying value of the bond is really what what you are carrying but you are still responsible for paying back 1 million. So this illustrate the difference between the face amount which is the amount due at maturity a million dollar and the carrying amount and the carrying amount is a very important concept in bonds. The amount at which the debt is reported after considering any unamvertised discount premium and debt issue. Now we already talked about discount and premium but now we are going to be adding the debt. The debt issue is part of the carrying cost. Simply put, it's going to reduce initially the face value because the carrying cost goes down from that debt cost. So over over the life of the debt, the carrying value adjusts till it's equal to the face value. And you will we will see that soon when we look at an example. But here's what I want you to see to make things simple. How do we calculate the initial liability? Assuming we issued a bond at par means we wanted to borrow a million. We got a million, but we incurred $50,000 of of issuing cost. Therefore, the initial carrying value is 950. Now, if the bond was issued at a discount, let's assume we issued the bond and we issued it at a discount of 30,000. So, if the bond is 1 million, the discount is 30 and the issue cost is 50. Now it's going to be 1 million -30 - 50. The carrying amount will start at 920. Then eventually you know the the carrying cost always go back to the face amount as we advertise this 80,000. Same thing when we amortize the 50 and if the bond is issued at a premium. So let's assume the face amount is a million and issued at a premium of 10,000. So we add the premium. Hopefully you remember this premium is a is an adjunct liability not contra liability. Then we subtract the 50,000. We end up with a carrying amount of 960. Again, this 960 will eventually go back to a million. Now, the best way to illustrate this is to actually look at an example with figures. Let's assume we want to borrow half a million. It's a 5-year term semiannual payment. The stated annual rate is 8%. So, the stated means we have to pay 8% per year. Semianually 4%. Now when we issued this bond, the market rate was 9. The market rate is higher than the stated rate. We cannot meet the market rate. What's going to happen? The bond is issued at 480,218. Now, if you don't know how we came up with the price of this bond, go back and figure out how to issue the price of the bond. How to find the price of the bond. But you know the bond will be issued at a discount because the market rate is greater than the coupon rate. In other words, we are not as competitive. We only we are offering 8% and everybody else in the market similar to us is offering 9. Therefore, we're going to get discounted. We're going to we are going to receive less than what we want to get. 480,218. You should be able to count to account for this to the penny, but it's given because we have to move on. Now, during this process, we incurred an additional $8,000 in debt issue cost. So, right from the get-go, we lost approximately uh $20,000, $19,000 something, approximately $20,000 in discount because our offering was not competitive. Then we have to pay an additional $8,000 in cost in in debt issue cost. What are cost? attorneys, printing fees, uh SEC filing requirements, so on and so forth. Now, keep in mind how we compute the cash payment. The cash payment does not change for this bond. The cash payment per period is the face value times the stated rate times the time period for 6 month,000. This amount, this $20,000 is fixed because this is according to the contract. If you bought this bond, you paid 480,218, you would receive 20,000 every 6 months. No if and buts about it. This is based on the stated rate. Now, you paid less. Now, obviously, you know, as an investor, you're earning more and as an issuer, your cost is more than 8%. And we're going to see it. We already know it's discounted at 9. And we know it's going to be more than 9 because when we discounted at 9, we came up we came to 480,8. We know our inter our effective rate will be more than nine because we we lost an additional 8,000. So although we we we are paying 8% on the face amount we lost money issuing the bond the 20,000 issuing the bond at a discount. Then we incur an additional 8,000. So all in all how much money did we walk away with? We walk we walk away with approximately 470,000 but we are paying interest for as if we borrowed half a million. Therefore, our effective rate will be higher. So, I just want you to know this up front. From a logical perspective, I want you to see this. Now, what does that mean? It means right from the get-go, we issued face value is half a million. Uh we issued it at 480. So, right from the get- go, we h we obtained 19,000, not we obtained, we received 19,782 less than what we're supposed to because we only received 480,28. Then from this amount, $480,18, we they took an additional $8,000 from us. Again, additional $8,000 from us. Now, we end up with $472,218. But we are still paying 8% 8% on on half a million. But we did not receive the half a million. We received 472. We know our interest rate will be higher. Now the discount amount is 19,782. I hope you know how to do this. Now we are adding this issue cost. Therefore we received less at 27,782 less than the face amount. So when we combine them, we take half a million minus 472 218. This is the amount that we received less than the face amount. So what do we do with this amount? You know what we do with the discount from the prior session? We advertise this discount to interest expense. And and guess what? We are going to advertise the 8,000 to interest expense using the effective rate. The only thing difference different in this session is we have to compute the effective rate. The effective rate is the new interest rate that we will computing because in the prior session we would use the market rate then if it's semiannually we we multiply it by 1/2 so it's 4.5 we know it's going to be more than 9%. We know the rate will be more than 9%. Now let's look at the initial journal entry and you should know this. The initial journal entry is this. We have a bond payable of half a million. We are responsible for paying back. We received cash472,218 and we have a discount of 27,782 that we are going to advertise. On the balance sheet we will show the face amount minus any unamortis discount. So our starting carrying amount is 472,28. Now the first thing we want to know is what is that effective rate? How do we compute the effective rate? We know before I show you is it's going to be more than 9% annually. It's going to be more than 9%. If we received if we received 480,28 it will be exactly 9% semiannually 4.5. We did not receive 480 480,28. We received 4728. Therefore, it's going to be more than 9. So, how do you compute this? Well, if we receive $472, we still have to pay $20,000 in cash every 6 months and we have to pay half a million at maturity. So, the semiannual effective rate is the rate that equate the present value of those present value of those future value payment. Basically, we're looking for what's R in this formula. What's R? We have to solve for R. So, what's the present value? So basically what's the present value of this inuity on some rate and what's the present value of the principal amount for some rate which is we don't know but we know once all what we're looking for is the rate and we know the answer should be 47218. Now if we solve for this now in an intermediate accounting course you're not expected to solve for this using a uh use manually. You could plug everything in a calculator, but basically you are looking at the present value of 20,000 annuity at some unknown interest rate. The present value of the principal amount at some unknown interest rate for 10 period. And if you solve, you will find out semiannually because this is semiannual, you're counting 10 period, you will find out that the rate is 4.70 9456%, if we multiply it by two, the effective annual rate is 9.4189. Therefore, the annual rate is is the 9.4189. And I told you before we did this computation, it's going to be greater than 9%. We already know this. So, if you get some other number, you know that you're you did something wrong in the in your computation. So, it's 1 - 1 + r raised to the -10. Same thing raised to the -10. 1 plus r raised to the -10. So, this is the semiannual rate. Now, let me show you this picture again so you can see what's going on here. We received 472,18. Every six months, we have to pay 20,000 and after 5 years, we have to pay the full amount. The original market rate is 9%. The effective rate for this deal, we're even paying more than 9. We're paying 94189. So, this additional 41 is for that $8,000. So the semiannual is 4.70945. So when we go to amvertise this debt, we are going to be using the semianual effective rate. I just want you to see this. So the low lower net proceeds plus the unchanged future amount will give us a higher effective borrowing rate because we received less money and we got charged a fee and we have to pay the same amount 20,000. It gave us a higher rate and I showed you how to do this computation. Now what are we going to do overall? Ammer amortize the carrying value using the effective rate. The effective rate that we just computed. The economic reality is this. We are starting with 472,28. We're going to multiply this amount by the effective rate to come up with our interest expense. Our first interest expense. I hope you know the how how we compute the interest expense. The interest expense is the carrying amount the book value of for the beginning of the period times the effective rate. The effective rate here semi annually 4.70945. So this is the interest expense. So this is the debit to interest expense. Now you know I'm not paying that much. I'm only paying half a million times 8% time semiannually I'm only paying in cash 20,000. The difference between my expense and my cash is the amount I am going to amortise. And obviously, you know, in a in a discounted bond, the interest expense is higher than the cash. And this is the amount that I I would amortize that increase the 2,300 part of the combined discount and the debt issue cost increasing the carrying amount. Now, period after period, my carrying amount goes up. And now we'll go back we'll go back to the amortization schedule that we are comfortable and familiar with. We are starting with 472,28. Our first interest expense is 22,239 commu computed right here. It's the beginning of the period carrying value times the effective rate. Then the cash interest is 20,000. The difference between those two equal to the amvertised amount. The amortized amount is added to the beginning carrying value to come up with the ending carrying value. The ending carrying value becomes the beginning carrying value times 4.70 945 will give us interest expense of 22,334. So notice interest expense went up because the carrying value went up. The cash payment will stay the same 20,000. The difference between them is 2344. Then this amount is added to the to the beginning to come up with the ending 4766 476801. This amount again times the semiannual effective will give us a new interest expense that's higher than the previous one because our carrying value going up. Remember our carrying value will keep going up until it reaches you guessed it half a million. Now all the columns in here are I I showed you here how to compute each one. how to compute the interest expense, how to compute the cash amount which is the same and the amortization amount and the ending carrying value. So if you're not sure how to read this, you should be able to read an amortization schedule from the prior session. The only thing difference here is the effective rate is a little bit higher happened to be for this example. Now we also want to be familiar with the journal entry. So I'm going to show you the journal entry for payment two and payment three. If you know these journal entries, you know uh the journal entries for everything. So the journal entry for payment 2, we debit interest expense 22,344. Cash is always the same 20,000 and we debit discount and debt issue cost we are advertising of that 2344. Then for the third payment, the cash will be the same. The interest expense 22,455. The difference is credit the discount on the amortization. Well, what's going to happen to the discount eventually the amortization discount? It's going to add up to the initial amount which is which was how much was it? Um I don't remember the amount of the uh was it uh the overall was how much the overall amount was 27,782. So if you add all these amount that we advertised, it's going to add up to that amount because the the at the end it's going to be half a million minus 0 equal to half a million. So remember a discounted bond here we go 27,782. So we advertise this amount and as we advertise it the bond carrying value goes up to the face value of half a million. And notice the bond interest expense period 1 was 22,239. Period 5 was 226.91. It's higher because the carrying value is going up. In period 10, the interest expense is even higher. Now, in a premium bond, that's the opposite because the premium bond, the carrying value goes down. The amortization, the same thing. Amortization, first 2239, then 26 uh 91, then 338. Again, when we add up all the amortization, they will add up to 27781. And eventually by period 10 I showed you the balance is half a million. And once the balance is half a million what do we do? We write that last check for half a million. Debit bonds payable credit cash. So what happened overall? Let me show you this entry. This is the last entry where we just kind of send this bond to the grave. But this is the first entry. The first entry was what was the first entry? This was the first entry. The first the first entry we establish this bond half a million and it's going to stay until 5 years with us in this 27782 we were chipping we were crediting this amount period after period we were crediting this amount until it went down to zero at the end what's left is the bond. So this is when we were chipping we were chipping this 27,000 um 782. What's left is the bonds. We pay back the bond half a million. All said and done there is no gain or loss as recognized. Now obviously if we retire this bond earlier you should know how to do this. We compare the proceeds to the particular carrying value date and we have a gain or a loss but we looked at this in another recording. So this session specifically focuses on what? focuses on the debt issue cost that additional 8,000. How do we deal with it? It gets added to the discount and it's advertised. But when once it's added to the discount, what's going to do? It's going to increase your effective interest rate. So when you increase your effective interest rate, your interest expense, if it's especially if it's a discount, it's even higher. And if it's a premium bond, usually your premium bond, your interest expense goes down because it's a premium bond. It will push it a little bit back up because again, it's an additional cost you have to incur. Now, regardless, what do you have to do now? Well, go to far hat lectures, look at lectures, multiple choice exercises, interactive exercises, how to do this, uh, true false, simulations, um, all sorts of resources to help you. Whether you are an accounting student, CPA exam candidate, CMA exam candidate, the best investment you can make is invest in yourself. And God bless.