How Should Bond Issue Costs Be Accounted for on the Books of the Issuing Corporation?
Businesses can raise money from investors in several ways, including the issuance of bonds. A bond is a form of debt in which the issuer borrows money from investors, pays interest on the loan periodically or all at the end, and repays the loan when the bond matures. Several different costs arise from issuing a bond, but you must spread the tax deductions for these costs over the life of the bond.
You can issue bonds through a private placement or public offering. In a private placement, you sell bonds directly to a single buyer, such as a pension fund, without registering the bond issue with the Securities and Exchange Commission. Private placement fees include the money you pay to lawyers and accountants to properly execute the sale. You’ll also encounter miscellaneous fees, such as printing costs. In a public offering, you sell your bonds to an investment syndicate for a guaranteed price. The syndicate then resells the bonds to the public at a higher price. The profit earned by the syndicate is a cost to you, called an underwriting fee. You must register a publicly offered bond with the SEC, which requires additional fees.
Under U.S. generally accepted accounting principles, the total costs of a bond issue must be “capitalized.” This means that you carry the costs on your books as a non-current asset or an “other” asset. To record the costs, you debit an account called “debt issue costs” and credit "cash." When you capitalize a cost, you cannot deduct it as an expense all at once. Instead, you must amortize it over the life of the bond. Normally, you use straight-line amortization, in which you divide the total costs by the number of years until the bond matures. Each year, you debit “debt issue expense” and credit "debt issue costs" for the annual amortization amount. Many companies split the annual amortization into semi-annual or monthly transactions.
Suppose you publicly issue 30-year bonds with a $700,000 face value; you must repay this amount when the bonds mature. If the bonds are paying an interest rate higher than the prevailing rate, you’ll raise more than the face value. The extra amount is the bond premium. In this example, the bonds sell for $735,000, but you receive only $710,000 in cash because the syndicate takes a $25,000 underwriting fee, and additional costs of $5,000 raise the total issue cost to $30,000. You record the sale with a debit to "cash" of $705,000, a debit to "debt issue costs" of $30,000, a credit to "bonds payable" for $700,000, and a credit to "premium on bonds payable" of $35,000. You amortize the bond premium and the issue costs every six months. The semiannual transaction to amortize the issue costs is a debit to "debt issue expense" and a credit to "debt issue costs" of $500, which is $30,000 divided by 60 periods.
International financial reporting standards handle bond issue costs in a different way. Instead of capitalizing the cost as a separate item to be amortized over the life of the bond, the standards call for you to set "bonds payable" equal to the net cash you receive after subtracting issue costs. The example would change as follows: debit "cash" and credit "bonds payable" for $705,000. Under this method, the bond premium of $5,000 is added to the face value of the bond, which is the treatment preferred by the international standards. The method is consistent with the U.S. method for equity issue costs.
Companies can also raise money by issuing common and preferred stock, which represent the ownership, or equity, of the company. Unlike bonds, stocks are not debt and you don’t have to repay them. Preferred stocks always pay a dividend, but this is optional for common stocks. You can deduct interest payments on bonds from your taxable income, but dividends are not deductible. Bonds and preferred stock do not participate in the growth of the company, because they offer fixed returns. Common stocks give shareholders a right to benefit from earnings through dividends or higher stock prices.