Sometimes the business has to bear significant expenses in the process to raise the finance. The expenses may include the appraisal fees, registration charges, accounting fees, regulator charges, loan marketing expenses, regulator fees, and all other related expenses.
If the fees for obtaining the loan are not material, the business may charge in the current period. However, if the amount is material, it must be amortized over the life of the loan to comply with the matching principle of accounting.
Detailed concept
When the business enters into the loan agreement or opts to restructure an existing loan, fees are associated with the process. These fees need to be recorded in the financial statement. However, the question arises if related fees should be charged in a single (current) accounting period or spread over the life of the loan.
The concept of amortization arises because a loan is usually long-term and does not relate to a single (current) accounting period. Hence, as per the matching concept, the loan should be amortized over the life of the loan. The amortization of the fees helps to ensure that cost is allocated to the periods in which benefit is obtained from the loan. Hence, it seems to be a fair approach.
However, it’s important to note that amortization requires the business to handle extensive records. So, it’s a wise decision only to amortize the cost when the loan fees are material for the company.
There are several potential costs for the financing arrangement that includes the following,
- The fee is charged in the process of initiating, restructure, and refinancing the loans. For instance, underwriting and application fees, etc.
- Cost of drafting and review of the financing/refinancing agreement.
- The lender charges other fees. For instance, in the case of a complex loan, certain compensation is paid for agreeing to lend the funds quickly.
The initial accounting treatment of raising finance requires the business to record net proceeds; it refers to the net amount of the cash received after deduction is made for issuance cost.
So, if the business raises finance via loan amounting to $10 million and the issuance cost amounts to $100,000. The accounting standard requires the business to record the cash receipt amounting to $9.9 million and the same amount in the liability.
Further, immediately taking $100,000 in the income statement may not be logical because the loan is obtained for an extended period. So, this amount needs to be amortized over the life of the loan or financial instrument.
The amortization is done by using the effective rate of interest. It’s important to note that the effective interest rate incorporates up to three elements as following.
- Annual interest payable.
- Premium repayable on redemption.
- Issuance cost of the loan.
Let’s understand accounting and other details for the loan cost with the help of an example.
Suppose Amber plc issues $10 million 5% loan notes on January 1, 2021; the cost issuance amounts to $200,000. These loan notes are repayable on December 21, 2023, with a premium amounting to $1million. The effective rate of interest on the loan amounts to 8.85%. The loan is redeemable at a premium of $1 million after three years.
It’s important to understand that 5% is a coupon rate, and the annual payment needs to be made annually. The coupon payment for the 5% amounts to $500,000 ($10m*5%). So, this amount will be paid each year to the lender.
An easy way to do the accounting in the preparation of the amortization schedule is as below,
| Year | Opening balance $000 | Effective interest @ 8.85% | The payment as per coupon rate $000 | Closing balance $000 |
| Year-1 | 9,800 | 867 | (500) | 10,167 |
| Year-2 | 10,167 | 900 | (500) | 10,567 |
| Year-3 | 10,567 | 933 | (500) | 11,000 |
It’s important to note that the face amount of the loan is $10 million, and we have recorded $9.8 million as the opening balance. That’s because the cost of issuance amounting to $200,000 has been deducted from the loan’s face value.
Entries in the year-1
Journal entry for initial recording liability is as follow,
| Particulars | Debit | Credit |
| Cash | $9.8 million | |
| Note payable (liability) | $9.8 million |
The debit impact of the transaction is receipt of the cash (net off with the cost of issuance). Similarly, the credit impact is the creation of liability due to acceptance of an obligation to pay.
Journal entry for recording accrued expense is as follow,
(Entry is passed at the end of an accounting year)
| Particulars | Debit | Credit |
| Finance expense | $867,000 | |
| Accrued liability | $867,000 |
The debit impact of the transaction is a recording of the expense in the income statement, and it’s adjusted against profit before interest and tax. In comparison, the credit impact of the journal entry is the creation of accrual in line with the matching concept.
Journal entry for paying coupon interest is as follow,
| Particulars | Debit | Credit |
| Accrued liability | $500,000 | |
| Cash | $500,000 |
The debit impact of the transaction is a reduction in the liability as a pre-agreed portion of the liability has been repaid. On the other hand, the credit impact is an outflow of economic benefits from the business.
The entries for the effective interest, coup-on, and liability are posted in the books at the time of books closure. At the end of year-3, closing liability reaches $11 million. That’s due to an effective rate of interest which was calculated to incorporate and amortize issuance cost of $200,000 and premium of the $1 million.
At the end of year-3, the following entry will be recorded to remove an original principal of $10 million and the premium of $1 million from the business books.
| Particulars | Debit | Credit |
| Note payable | $11 million | |
| Cash | $11 million |
Hence, the cost of issuance, interest, and premium has been amortized over the life of the note payable, which was three years.
The journal entries for the interest and reduction of liability need to be posted in line with the scheduled movement. Accurate posting of the journal entries ensures liability in the books is the same as the amount for the redemption.
Conclusion
The loan fees are deducted from the total of the loan raised. The deducted amount is amortized over the complete life of the loan. In other words, the loan fees are allocated to different accounting periods with the help of an effective rate of interest.
The amortization of the finance cost is done in line with the matching concept of accounting which states that expense should be charged in a period where economic benefit is obtained. So, if the business deducts the complete cost of loan issuance in the first year, it can be allocated over the life of the loan by incorporating the issuance cost in the effective rate of interest.
The effective rate of interest includes the cost of interest, the cost of loan issuance, and the cost of premium redemption if applicable which is charged in the income statement from period to period.
Frequently asked questions
How long should the loan cost be amortized?
The cost of the loan should be amortized to the complete life of the loan. It helps to ensure fees of the loan issuance are amortized to the period of loan usage.
What’s amortization in accounting?
Amortization is the accounting concept that helps to lower the book value of the loan periodically. As soon as the borrower keeps paying, the fund’s liability keeps decreasing. The same concept of amortization is applicable on the intangibles assets where value keeps decreasing in line with the usage.
What’s the journal entry for paying the loan installment?
The cash payment should be credited in full, and interest expense should be debited in priority; the remaining amount should be adjusted against the loan. If the loan’s monthly installment is higher, greater liability is expected to be debited after deduction of expenses.
What is the coupon rate of the loan note?
The coupon rate is the rate of paying interest, and this rate is not charged in the income statement but is used for calculating the amount of payment.
What are the four types of amortization?
The four types of amortization include,
- Straight line (the principal repayment is constant/similar over the life of the loan).
- Declining balance (the interest payment declines and the principal repayment increases).
- Annuity (Series of payments is made at equal interval)
- Bullet (Periodic payments only cover the cost of interest, a large amount is paid at the end of the term)
- Balloon (Repayment for the entire principal is made at maturity).
- Negative period (Periodic amount is lower for the period in comparison with the cost of interest)
Sometimes the business has to bear significant expenses in the process to raise the finance. The expenses may include the appraisal fees, registration charges, accounting fees, regulator charges, loan marketing expenses, regulator fees, and all other related expenses.
If the fees for obtaining the loan are not material, the business may charge in the current period. However, if the amount is material, it must be amortized over the life of the loan to comply with the matching principle of accounting.
Detailed concept
When the business enters into the loan agreement or opts to restructure an existing loan, fees are associated with the process. These fees need to be recorded in the financial statement. However, the question arises if related fees should be charged in a single (current) accounting period or spread over the life of the loan.
The concept of amortization arises because a loan is usually long-term and does not relate to a single (current) accounting period. Hence, as per the matching concept, the loan should be amortized over the life of the loan. The amortization of the fees helps to ensure that cost is allocated to the periods in which benefit is obtained from the loan. Hence, it seems to be a fair approach.
However, it’s important to note that amortization requires the business to handle extensive records. So, it’s a wise decision only to amortize the cost when the loan fees are material for the company.
There are several potential costs for the financing arrangement that includes the following,
- The fee is charged in the process of initiating, restructure, and refinancing the loans. For instance, underwriting and application fees, etc.
- Cost of drafting and review of the financing/refinancing agreement.
- The lender charges other fees. For instance, in the case of a complex loan, certain compensation is paid for agreeing to lend the funds quickly.
The initial accounting treatment of raising finance requires the business to record net proceeds; it refers to the net amount of the cash received after deduction is made for issuance cost.
So, if the business raises finance via loan amounting to $10 million and the issuance cost amounts to $100,000. The accounting standard requires the business to record the cash receipt amounting to $9.9 million and the same amount in the liability. Further, immediately taking $100,000 in the income statement may not be logical because the loan is obtained for an extended period. So, this amount needs to be amortized over the life of the loan or financial instrument.
The amortization is done by using the effective rate of interest. It’s important to note that the effective interest rate incorporates up to three elements as following.
- Annual interest payable.
- Premium repayable on redemption.
- Issuance cost of the loan.
Let’s understand accounting and other details for the loan cost with the help of an example.
Suppose Amber plc issues $10 million 5% loan notes on January 1, 2021; the cost issuance amounts to $200,000. These loan notes are repayable on December 21, 2023, with a premium amounting to $1million. The effective rate of interest on the loan amounts to 8.85%. The loan is redeemable at a premium of $1 million after three years.
It’s important to understand that 5% is a coupon rate, and the annual payment needs to be made annually. The coupon payment for the 5% amounts to $500,000 ($10m*5%). So, this amount will be paid each year to the lender.
An easy way to do the accounting in the preparation of the amortization schedule is as below,
| Year | Opening balance $000 | Effective interest @ 8.85% | The payment as per coupon rate $000 | Closing balance $000 |
| Year-1 | 9,800 | 867 | (500) | 10,167 |
| Year-2 | 10,167 | 900 | (500) | 10,567 |
| Year-3 | 10,567 | 933 | (500) | 11,000 |
It’s important to note that the face amount of the loan is $10 million, and we have recorded $9.8 million as the opening balance. That’s because the cost of issuance amounting to $200,000 has been deducted from the loan’s face value.
Entries in the year-1
Journal entry for initial recording liability is as follow,
| Particulars | Debit | Credit |
| Cash | $9.8 million | |
| Note payable (liability) | $9.8 million |
The debit impact of the transaction is receipt of the cash (net off with the cost of issuance). Similarly, the credit impact is the creation of liability due to acceptance of an obligation to pay.
Journal entry for recording accrued expense is as follow,
(Entry is passed at the end of an accounting year)
| Particulars | Debit | Credit |
| Finance expense | $867,000 | |
| Accrued liability | $867,000 |
The debit impact of the transaction is a recording of the expense in the income statement, and it’s adjusted against profit before interest and tax. In comparison, the credit impact of the journal entry is the creation of accrual in line with the matching concept.
Journal entry for paying coupon interest is as follow,
| Particulars | Debit | Credit |
| Accrued liability | $500,000 | |
| Cash | $500,000 |
The debit impact of the transaction is a reduction in the liability as a pre-agreed portion of the liability has been repaid. On the other hand, the credit impact is an outflow of economic benefits from the business.
The entries for the effective interest, coup-on, and liability are posted in the books at the time of books closure. At the end of year-3, closing liability reaches $11 million. That’s due to an effective rate of interest which was calculated to incorporate and amortize issuance cost of $200,000 and premium of the $1 million.
At the end of year-3, the following entry will be recorded to remove an original principal of $10 million and the premium of $1 million from the business books.
| Particulars | Debit | Credit |
| Note payable | $11 million | |
| Cash | $11 million |
Hence, the cost of issuance, interest, and premium has been amortized over the life of the note payable, which was three years.
The journal entries for the interest and reduction of liability need to be posted in line with the scheduled movement. Accurate posting of the journal entries ensures liability in the books is the same as the amount for the redemption.
Conclusion
The loan fees are deducted from the total of the loan raised. The deducted amount is amortized over the complete life of the loan. In other words, the loan fees are allocated to different accounting periods with the help of an effective rate of interest. The amortization of the finance cost is done in line with the matching concept of accounting which states that expense should be charged in a period where economic benefit is obtained.
So, if the business deducts the complete cost of loan issuance in the first year, it can be allocated over the life of the loan by incorporating the issuance cost in the effective rate of interest.
The effective rate of interest includes the cost of interest, the cost of loan issuance, and the cost of premium redemption if applicable which is charged in the income statement from period to period.
Frequently asked questions
How long should the loan cost be amortized?
The cost of the loan should be amortized to the complete life of the loan. It helps to ensure fees of the loan issuance are amortized to the period of loan usage.
What’s amortization in accounting?
Amortization is the accounting concept that helps to lower the book value of the loan periodically. As soon as the borrower keeps paying, the fund’s liability keeps decreasing. The same concept of amortization is applicable on the intangibles assets where value keeps decreasing in line with the usage.
What’s the journal entry for paying the loan installment?
The cash payment should be credited in full, and interest expense should be debited in priority; the remaining amount should be adjusted against the loan. If the loan’s monthly installment is higher, greater liability is expected to be debited after deduction of expenses.
What is the coupon rate of the loan note?
The coupon rate is the rate of paying interest, and this rate is not charged in the income statement but is used for calculating the amount of payment.
What are the four types of amortization?
The four types of amortization include,
- Straight line (the principal repayment is constant/similar over the life of the loan).
- Declining balance (the interest payment declines and the principal repayment increases).
- Annuity (Series of payments is made at equal interval)
- Bullet (Periodic payments only cover the cost of interest, a large amount is paid at the end of the term)
- Balloon (Repayment for the entire principal is made at maturity).
- Negative period (Periodic amount is lower for the period in comparison with the cost of interest)
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