Accounting for deferred financing costs
2. Example of accounting for deferred financing costs
Let’s take a look at an example of accounting for deferred financing costs. A company needs additional capital to fund its growth. The company obtains a bank loan in the amount of $1,000,000 for 10 years. Annual payments of principal and interest are required. The interest rate is 5%. Based on this information, the annual payment (principal plus interest) is $129,505.
In obtaining this loan, the company incurred $75,000 in costs (e.g., attorney fees). According to the generally accepted accounting standards, this amount should be amortized over 10 years (i.e., the loan term) using the effective interest rate method, or if no material differences result, the straight-line method.
We will first show the loan amortization schedule:
Year |
Payment |
Interest (5%) |
Principle |
Balance |
0 |
1,000,000 |
|||
1 |
129,505 |
50,000 |
79,505 |
920,495 |
2 |
129,505 |
46,025 |
83,480 |
837,016 |
3 |
129,505 |
41,851 |
87,654 |
749,362 |
4 |
129,505 |
37,468 |
92,036 |
657,325 |
5 |
129,505 |
32,866 |
96,638 |
560,687 |
6 |
129,505 |
28,034 |
101,470 |
459,217 |
7 |
129,505 |
22,961 |
106,544 |
352,673 |
8 |
129,505 |
17,634 |
111,871 |
240,802 |
9 |
129,505 |
12,040 |
117,464 |
123,338 |
10 |
129,505 |
6,167 |
123,338 |
0 |
Total |
1,295,046 |
295,046 |
1,000,000 |
5,900,915* |
(*) The total of all debt balances does not have any meaning for the debt amortization schedule, but it will be used later in this article to calculate amortization of deferred financing costs under the effective interest method.
At the beginning of the loan term, the loan balance was $1,000,000. At the end of the first year, the first payment in the amount of $129,505 was made. This payment included $50,000 of interest and $79,505 of principal reduction. The $50,000 is the result of applying 5% to the $1,000,000 loan balance. The principal reduction is the difference between the payment amount and the interest: $129,505 - $50,000 = $79,505. The same logic of determining principal and interest components of payments applies to years 2-10.
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