A company incurs costs like underwriter’s fee, legal, commissions, etc. when it issues a bond. Publicly sold debt is usually done through an underwriter, i.e., the company may sell the bond issue to an underwriter who will then sell it to investors. US GAAP and IFRS treat the issuance costs differently.
US GAAP: Issuance costs are shown as an asset which is amortized on a straight-line basis over the life of the bond. In other words, under US GAAP, issuance costs are capitalized.
IFRS: Issuance costs reduce the carrying value of the debt.
Cash outflows are shown as a financing cash flow under both US GAAP and IFRS.
Two Methods of Amortization
There are two methods of amortizing the premium/discount of bonds:
Amortization premium/discount = interest expense – interest payment
We have so far focused on reporting bonds at amortized historical costs. This method reflects the market rate at the time the bonds were issued. When market rates change, the bond’s fair value diverges from carrying value. When market rates decline, the fair value of a bond with a fixed coupon rate increases, and vice versa.
Companies have the option to report financial liabilities at fair value. A company selecting this option will report gains/losses when market rates increase/decrease. Fair value of a liability can also change due to changes in the credit quality of the issuing company. Hence, companies are required to separately report the portion of the change in the liability’s fair value resulting from changes in their own credit risk.
Once bonds are issued, a company may leave the bonds outstanding until maturity or redeem the bonds before maturity. If the bonds remain outstanding until maturity, the company pays bondholders the face value of the bonds at maturity. However, if a company decides to redeem (retire) bonds before maturity, a gain or loss is recognized which is calculated as:
Gain or loss = Redemption price – Book value of the bond liability at the reacquisition date
If the redemption price is higher than book value, a loss will be reported. For example, if redemption price = 1,020,000 and book value = 990,000, the loss will be 30,000. If the redemption price is lower than the book value, a gain will be reported. A gain or loss on the extinguishment of debt must be reported in the income statement as a separate line item, if the amount is significant. The cash used to retire the debt is classified under financing cash flow. Additional detail about the extinguished debt is provided in MD&A or notes to financial statements.
Treatment of Bond Issuance Costs
IFRS: No write-off because issuance cost is included in book value of bond liability.
US GAAP: Unamortized bond issuance costs must be written off and included in gain/loss calculations.
The terms of borrowing between investors and the company issuing the bond are defined in a document called the bond indenture. Indenture often contains restrictions called debt covenants. Covenants are restrictions imposed by the creditor (bondholder/lender) on the issuer (borrower) to protect the creditor’s interest. The benefit of including debt covenants is that they reduce the default risk for investors and lower the interest costs of borrowing for the borrower.
Affirmative covenants require the borrower to take certain actions. For example, making interest payments on time, maintaining a certain level of working capital, or that it will maintain minimum acceptable financial ratios.
Negative covenants restrict the borrowing company’s actions. For example, the borrowing company may not be allowed to take on additional debt, pay dividends, sell assets, or any action that may affect the company’s ability to pay interest and principal to its investors.
Technical default occurs when the borrower violates a debt covenant (affirmative or negative).
The total amount of a company’s long-term debt (debt that is due after one year) is combined into a single line item and shown under the non-current liabilities section of the balance sheet. The portion of the long-term debt that is due within one year is shown as a current liability. Additional information on a company’s debt is disclosed in the notes to financial statements. They include:
In addition to this, MD&A provides other details about a company’s capital resources, including debt financing and off-balance-sheet financing.