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Welcome. In this lesson,

Â we're going to continue with a very similar example.

Â Last time we talked about accounting for a premium,

Â now we're going to account for discount

Â just to make sure you fully understand how each of these work.

Â And we're going to add another complicating factor and that will be issuance costs.

Â So, the mathematics for bond discount as we said, is identical.

Â The interest rate will be higher than

Â the stated interest and the interest expense will be greater than cash paid.

Â Now, we're going to use the same effective rate,

Â the rate of return implicit in the loan,

Â the contractual interest rate adjusted for any net deferred loan fees or costs,

Â premium, or discount existing at the origination

Â and acquisition of the loan, the FASB definition.

Â So, we're going to adjust the interest rate.

Â Let's add another complicating factor and let's talk about

Â debt issuance costs. So, what are those?

Â Well, debt issuance costs are costs,

Â other than those that are paid to the lender,

Â you don't count those,

Â but they are costs that are attributable to issuing the debt.

Â So, what could that be?

Â Well, it could be legal costs.

Â Attorneys always have to get their pound of flesh.

Â Accountants are right behind them in getting the costs that are

Â involved in reviewing financial statements and providing them to the lenders upfront.

Â There can be a number of different payments to different parties,

Â there might be a broker that was involved in arranging the deal.

Â Any of these payments are called debt issuance costs and you

Â can capitalize them as it will by accounting for them

Â as part of the discount on

Â the debt and therefore increasing the effective yield on the debt.

Â So, it's going to adjust the interest rate, just like discount.

Â Debt issuance costs, they can be viewed as a decrease in a premium, if that occurs,

Â like in our previous example,

Â or an increase in the discount,

Â and we'll now illustrate this in our discussion of the accounting for a discount.

Â So, we're going to go back to the same example we used before,

Â for Padre Pizza issuing $10 million of bonds on 1 /1/ 2016 that mature in eight years.

Â But now, it still has a stated interest of 8 percent,

Â but we're going to sell them to yield eight and a quarter percent.

Â So the bonds pay interest semiannually and

Â Padre Pizza also incurred a $100,000 in debt issuance costs.

Â So, when we account for the discount,

Â again, were the bonds sold at a discount or premium?

Â Well the amount paid,

Â we'll calculate that in just a minute,

Â but you expect it to be

Â a discount when the yield is higher than the stated interest rate.

Â What is the price paid for the bond?

Â Let's calculate it now.

Â So this again is a net present value problem.

Â You can take the present value of an annuity for 16 periods at

Â eight and a quarter percent adjusted for the fact that the payments are semiannual,

Â and the present value of $10 million,

Â it's paid in eight years,

Â at eight and a quarter percent again adjusted, so it's semiannual,

Â and the result is $9,855,680.

Â What about the issuance costs?

Â Well, the bonds are sold at a discount under the stated value of $144,320.

Â Where did we get that?

Â The $10 million face amount minus the 9,855,680

Â that was actually received for the bonds when they were sold at a discount.

Â So, what do we do with those issuance costs?

Â Well they're added to the discount.

Â So we had $100,000 of

Â issuance costs that are going to be added to the discount of $144,000

Â and we'll have a total discount now of $244,320.

Â So when I issue the bonds,

Â I will make the following journal entry.

Â The cash is for the amount that we actually received.

Â We calculated that before.

Â The bonds payable is for the face amount of the bonds of $10 million.

Â The cash at the issuance costs,

Â there was cash and payables of $100,000 various amounts.

Â And then the discount on the bonds is going to be

Â the total of the difference between the cash received

Â and the bonds payable and the initial direct costs of issuing the bonds,

Â It gets added into the discount.

Â We have a total discount of the $244,320.

Â So, if the bonds had been sold at a premium,

Â the $100,000 of that issuance costs would have reduced the premium on the bonds.

Â They could actually change the premium to a discount net.

Â But they will reduce the premium or increase a discount.

Â Now, by changing the amount of the discount,

Â those issuance costs will change the rate.

Â So, when we consider issuance cost,

Â the effective interest rate is going to again be

Â different from the market rate that the bonds were sold at.

Â If I put an additional $100.000 of discount in there,

Â it's going to increase the discount and therefore increase the effective interest rate.

Â Let's go to Excel and I'll show you how using goal seek,

Â you can calculate that the effective interest rate is now 8.43%.

Â Now, we're going to introduce another complicating factor and this is discount.

Â As you saw in our lesson,

Â the FASB decided just recently, actually,

Â that issuance costs are going to be added to

Â discount or subtracted from a premium when determining the effective rate.

Â So, this is going to make it a little bit more

Â complicated in each and every instance because you have to take into

Â account issuance costs and not just the yield

Â which the bonds were sold in every instance.

Â So, let's go back to our example here of Padre Pizza.

Â $10 million of bonds, 1/16,

Â matures in eight years, pays interest annually,

Â They were sold to yield 8.25%.

Â They're 8$ bonds, but they were sold to yield 8.25%.

Â That means that the stated rate of the bonds is below the market rate,

Â they're issued at a discount.

Â We've calculated the discount previously and we've taken that into account here,

Â but we can see right away something's wrong in our amortization table.

Â So I have a discount of $144,320 and I have issuance costs of $100,000.

Â The $100,000 has put off our effective rate.

Â I can tell that because this number is not $10 million at the bottom.

Â How do I fix that?

Â I'm going to adjust the effective rate using goal

Â seek to now take into account not just the yield at which the bonds were sold,

Â but the issuance costs.

Â So I can do that by adjusting this rate here and I want this number to be $10 million.

Â So, we'll do a goal seek.

Â We go back over to data,

Â the what if analysis, the goal seek.

Â Now we want this number down here to be $10 million.

Â And we want that to happen by changing our effective rate,

Â and we just did it.

Â And the rate comes out to be 8.43 percent.

Â This is adjusting.

Â Let me go back to start inking.

Â Even though they were sold to yield 8.25 percent,

Â the fact that there were issuance costs of a $100,000 changes the effective rate.

Â And it's not just slightly,

Â it's 18 basis points.

Â So you can see that the issuance cost had a significant impact here,

Â it was 18 basis points on the effective yield.

Â Now, issuance costs can be significant,

Â you've got to pay the accountants, you've got to pay them lawyers,

Â there's usually fees and commissions, and replacement.

Â So, it's not uncommon at all to have this type of adjustment to the yield,

Â based simply on the issuance costs.

Â So again, we know we've got it right because our bottom lines are matching.

Â Here's our entries, again,

Â the interest is calculated using the effective yield including

Â consideration of the issuance costs times the carrying amount.

Â That carries over here.

Â Here's our interest cost.

Â Here's our amortization of discount.

Â The amortization of discount includes amortization of the issuance cost.

Â Again, FASB decided that this would all

Â be displayed together on one side of the balance sheet.

Â Previously, people would put these issuance quest as an asset,

Â on the asset side and amortize them, usually straight line.

Â So this is relatively new,

Â it just came out within the last year or two.

Â This is how you're going to have to do this now in the real world.

Â Again, the spreadsheet is flexible enough that you can come in and make that kind of

Â adjustment and get great answer and have your journaling entries correct.

Â Okay, so let's record the entries of what we've calculated.

Â Our interest expense at June 30,

Â we're paying cash of 400,000,

Â we've calculated the interest expense using

Â the effective interest rate we just calculated of 8.43 percent.

Â We've got interest expense of $411,005,

Â and the balance is a amortization of the discount on the bonds of $11,005.

Â Now, this will continue as we showed on

Â the Excel spreadsheet throughout the life of the bonds until at the end.

Â The total discount including the initial issuance costs will be zero.

Â So the interest and the carrying value,

Â again, are increasing at an increasing rate.

Â And the carrying value is equal to that face amount when we get to the end.

Â So again, here's your interest real curve.

Â Notice, it's just the opposite of what we had with the premium that was sloping down,

Â this is sloping up.

Â So the interest expense is increasing over time.

Â Can we do this straight line?

Â Again, if it's not a material difference.

Â We possibly could.

Â Now, we're going to take the whole 244,320 and amortize over that period.

Â So if you have a significant discount and a significant issuance cost,

Â you probably won't be able to use a straight line method.

Â But in this case, assuming that it's immaterial,

Â and the difference I get 244,320 divided by 16 periods is 15,270 per period.

Â So my interest per period will be 415,270,

Â and that would be the same amount each period until the bonds are redeemed.

Â That's the accounting for a discount.

Â It's a mirror image of accounting for a premium.

Â The only factor that we added in there that's a little bit different is we added

Â in issuance costs and the accounting for issuance costs.

Â Now, the issuance costs may be a little different than some of you may have

Â seen in earlier coursework and that's because the gap actually changed.

Â The FASB updated the presentation for issuance costs in 2015,

Â with accounting standards update ASU 2015-03 issued in April of 2015.

Â What were they doing? They wanted to simplify the presentation of that issuance cost.

Â Prior to this, a lot of people had shown debt issuance cost as

Â a separate asset on the asset side of the balance sheet,

Â capitalized those costs, and they accounted for those

Â separately from discount or premium.

Â The FASB decided to simplify that accounting by requiring that

Â the issuance costs be a direct deduction from the carrying amount of the debt liability,

Â consistent with debt discounts.

Â Really, what they're doing is the FASB does not like to capitalize deferred costs.

Â So what this does is it avoids having an amount on

Â the balance sheet that technically doesn't meet the definition of an asset.

Â A deferred cost that's capitalized on the balance sheet,

Â it's not an asset that you can realize cash by

Â selling it or in some sort of market transaction.

Â So consequently, they preferred to remove those amounts from

Â the balance sheet and put them as a deduction from the carrying amount of

Â the debt liability and that's the way I accounted for this in this course.

Â Now, that was not without controversy.

Â In fact, during the exposure process,

Â a majority of the private company council members

Â and certain other respondents that focused on private companies,

Â stated they disagreed with the guidance and this ASU.

Â They didn't think it was

Â the right information to provide to the users of their financial statements.

Â It was a matter of relevance and their amount.

Â Their users wanted to see the face amount of the borrowings and

Â that's the most relevant amount for the users of private company financial statements.

Â And they thought that netting

Â the issuance costs against the face amount could be misleading.

Â It might imply if there was a significant discount

Â that they owed less than they actually did, for example.

Â So they proposed two alternatives.

Â The first alternative was to retain current GAAP,

Â just report the debt issuance costs as a separate deferred cost asset.

Â The second, would have been just to require those debt issuance costs to be expensed,

Â don't defer them at all.

Â The costs have been incurred, we've paid the layers,

Â we've paid the broker,

Â let's just expense those costs.

Â Well the FASB thought about it and didn't do either of those things.

Â They did put it out that the debt issuance costs would continue to be

Â deferred but now they would be the deduction from the carrying value of the debt.

Â So the lesson here though,

Â is that GAAP is always evolving and you will need to keep up.

Â This is not something you can think that you can study this in 2017 and in 2020,

Â it will be the same.

Â You need to keep track of what's changing in GAAP.

Â Now also, another lesson is that opinions vary in regard to what is

Â relevant accounting information and the answer is not always intuitive,

Â and it's not always a free choice either.

Â You need to follow the rules as they've been promulgated.

Â Now, a helpful place to go and look and see

Â why the FASB has done something is the basis for conclusions.

Â Now, these are included in the text of an accounting standards update, the ASU,

Â but they're are not included in the codification, the ASC.

Â So when a new standard is issued,

Â it's usually useful to go and take a look at that ASU,

Â especially as the basis for conclusions,

Â and get a better understanding maybe,

Â of why the fairs we did,

Â what they did, and that will help you in your application of that standard.

Â So that wraps up our discussion on discount and issuance cost.

Â Now, we'll move on in the next lesson to add further complications.

Â