Welcome. In this lesson,

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

Last time we talked about accounting for a premium,

now we're going to account for discount

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

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

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

The interest rate will be higher than

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

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

the rate of return implicit in the loan,

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

premium, or discount existing at the origination

and acquisition of the loan, the FASB definition.

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

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

debt issuance costs. So, what are those?

Well, debt issuance costs are costs,

other than those that are paid to the lender,

you don't count those,

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

So, what could that be?

Well, it could be legal costs.

Attorneys always have to get their pound of flesh.

Accountants are right behind them in getting the costs that are

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

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

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

Any of these payments are called debt issuance costs and you

can capitalize them as it will by accounting for them

as part of the discount on

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

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

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

like in our previous example,

or an increase in the discount,

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

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

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

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

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

So the bonds pay interest semiannually and

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

So, when we account for the discount,

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

Well the amount paid,

we'll calculate that in just a minute,

but you expect it to be

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

What is the price paid for the bond?

Let's calculate it now.

So this again is a net present value problem.

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

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

and the present value of $10 million,

it's paid in eight years,

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

and the result is $9,855,680.

What about the issuance costs?

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

Where did we get that?

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

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

So, what do we do with those issuance costs?

Well they're added to the discount.

So we had $100,000 of

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

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

So when I issue the bonds,

I will make the following journal entry.

The cash is for the amount that we actually received.

We calculated that before.

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

The cash at the issuance costs,

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

And then the discount on the bonds is going to be

the total of the difference between the cash received

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

It gets added into the discount.

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

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

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

They could actually change the premium to a discount net.

But they will reduce the premium or increase a discount.

Now, by changing the amount of the discount,

those issuance costs will change the rate.

So, when we consider issuance cost,

the effective interest rate is going to again be

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

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

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

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

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

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

As you saw in our lesson,

the FASB decided just recently, actually,

that issuance costs are going to be added to

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

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

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

account issuance costs and not just the yield

which the bonds were sold in every instance.

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

$10 million of bonds, 1/16,

matures in eight years, pays interest annually,

They were sold to yield 8.25%.

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

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

they're issued at a discount.

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

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

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

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

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

How do I fix that?

I'm going to adjust the effective rate using goal

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

but the issuance costs.

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

So, we'll do a goal seek.

We go back over to data,

the what if analysis, the goal seek.

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

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

and we just did it.

And the rate comes out to be 8.43 percent.

This is adjusting.

Let me go back to start inking.

Even though they were sold to yield 8.25 percent,

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

And it's not just slightly,

it's 18 basis points.

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

it was 18 basis points on the effective yield.

Now, issuance costs can be significant,

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

there's usually fees and commissions, and replacement.

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

based simply on the issuance costs.

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

Here's our entries, again,

the interest is calculated using the effective yield including

consideration of the issuance costs times the carrying amount.

That carries over here.

Here's our interest cost.

Here's our amortization of discount.

The amortization of discount includes amortization of the issuance cost.

Again, FASB decided that this would all

be displayed together on one side of the balance sheet.

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

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

So this is relatively new,

it just came out within the last year or two.

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

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

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

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

Our interest expense at June 30,

we're paying cash of 400,000,

we've calculated the interest expense using

the effective interest rate we just calculated of 8.43 percent.

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

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

Now, this will continue as we showed on

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

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

So the interest and the carrying value,

again, are increasing at an increasing rate.

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

So again, here's your interest real curve.

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

this is sloping up.

So the interest expense is increasing over time.

Can we do this straight line?

Again, if it's not a material difference.

We possibly could.

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

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

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

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

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

So my interest per period will be 415,270,

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

That's the accounting for a discount.

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

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

in issuance costs and the accounting for issuance costs.

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

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

The FASB updated the presentation for issuance costs in 2015,

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

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

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

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

capitalized those costs, and they accounted for those

separately from discount or premium.

The FASB decided to simplify that accounting by requiring that

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

consistent with debt discounts.

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

So what this does is it avoids having an amount on

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

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

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

selling it or in some sort of market transaction.

So consequently, they preferred to remove those amounts from

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

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

Now, that was not without controversy.

In fact, during the exposure process,

a majority of the private company council members

and certain other respondents that focused on private companies,

stated they disagreed with the guidance and this ASU.

They didn't think it was

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

It was a matter of relevance and their amount.

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

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

And they thought that netting

the issuance costs against the face amount could be misleading.

It might imply if there was a significant discount

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

So they proposed two alternatives.

The first alternative was to retain current GAAP,

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

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

don't defer them at all.

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

we've paid the broker,

let's just expense those costs.

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

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

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

So the lesson here though,

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

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

it will be the same.

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

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

relevant accounting information and the answer is not always intuitive,

and it's not always a free choice either.

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

Now, a helpful place to go and look and see

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

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

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

So when a new standard is issued,

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

especially as the basis for conclusions,

and get a better understanding maybe,

of why the fairs we did,

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

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

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