Understanding Financing Fees: Key Changes and Implications : Arizona State based
Introduction to Financing Fees
When a company borrows money, it incurs third-party financing fees, known as debt issuance costs. These fees are paid to bankers, lawyers, and other parties involved in arranging the financing. These costs are crucial for understanding the financial implications of borrowing and how they impact the company's balance sheet and financial statements.
Pre-2015 Treatment of Financing Fees
Before April 2015, financing fees were treated as a long-term asset and amortized over the loan's term using either the straight-line or interest method. These were known as deferred financing fees.
ASU 2015-03: A Significant Accounting Update
In April 2015, the Financial Accounting Standards Board (FASB) issued ASU 2015-03, which changed how debt issuance costs are accounted for. Effective December 15, 2015, the update requires that financing fees be deducted directly from the debt liability as a contra-liability, rather than creating an asset.
Key Changes Introduced by ASU 2015-03
The amendments mandate that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability. This aligns with the treatment of debt discounts and simplifies the presentation of debt issuance costs.
Example of Updated Treatment
Companies now report debt figures on their balance sheet net of debt issuance costs. For instance, if Sealed Air Corp incurred such costs, they would be deducted from the debt liability directly, rather than being shown as a separate asset.
Impact on Amortization Expense
The classification or presentation of the related amortization expense does not change. Over the term of borrowing, the amortization of debt issuance costs continues to be classified as interest expense on the income statement.
Implications for Private and Public Companies
The update affects both private and public companies and applies to term loans, bonds, and any borrowing with a defined payment schedule. Below is an example of debt issuance costs treatment pre- and post-ASU 2015-03.
Example Calculation
Suppose a company borrows $100 million in a 5-year term loan and incurs $5 million in financing fees. At the borrowing date, these fees would be deducted directly from the debt liability:
Journal Entries:
- Debit: Debt Liability $100 million
- Credit: Cash $95 million
- Credit: Financing Fees (Contra-liability) $5 million
- Treatment of Revolver Commitment Fees
The changes under ASU 2015-03 do not apply to commitment fees paid to revolving credit lenders. These fees are still treated as a capital asset because they represent the benefit of being able to tap the revolver in the future. Therefore, commitment fees continue to be capitalized and amortized.
Purpose of the Accounting Rule Change
The primary aim of the update is to simplify accounting rules. The new rules now align with FASB's treatment of debt discounts and premiums and the International Financial Reporting Standards (IFRS) treatment of debt issuance costs. Previously, debt issuance costs were treated as an asset, conflicting with the definition of an asset as they provide no future economic benefit.
Feedback and Consistency
Feedback indicated that different balance sheet presentation requirements for debt issuance costs and debt discounts and premiums created unnecessary complexity. By changing the treatment of debt issuance costs, FASB aimed to reduce this complexity and align US GAAP with IFRS.
Impact on M&A and LBO Models
For those involved in modeling mergers and acquisitions (M&A) and leveraged buyouts (LBO), it's essential to note the changes in fee treatment:
- Financing fees (term loans and bonds): Directly lower the carrying value of the debt.
- Financing fees (revolvers): Capitalized and amortized.
- Transaction fees: Expensed as incurred.
Despite the intention to simplify accounting, these changes introduce nuances that financial modelers must consider.
Conclusion
Effective December 15, 2015, FASB changed the accounting for debt issuance costs. Instead of capitalizing fees as an asset, the fees now directly reduce the loan's carrying value. Over the loan's term, the fees continue to be amortized and classified as interest expense. The new rules do not apply to commitment fees on revolvers, impacting financial models, especially M&A and LBO models, where financing is a significant component of the purchase price.
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