Accounting for deferred financing costs
2.2. Straight-line method for deferred financing cost amortization
Let’s look at the amortization of deferred financing costs using the straight-line method:
Straight-line Method |
||
Year |
Debt Issue |
Debt Issue |
1 |
7,500 |
0.8% |
2 |
7,500 |
0.8% |
3 |
7,500 |
0.9% |
4 |
7,500 |
1.0% |
5 |
7,500 |
1.1% |
6 |
7,500 |
1.3% |
7 |
7,500 |
1.6% |
8 |
7,500 |
2.1% |
9 |
7,500 |
3.1% |
10 |
7,500 |
6.1% |
Total |
75,000 |
|
Amortization calculations under the straight-line method are simpler. Each year 1/10th of the deferred financing cost balance is amortized: $7,500 = $75,000 ÷ 10 and this amount is amortized to expense each year. The deferred financing cost amortization as a percentage of debt balance increases over time because the debt balance decreases while the amortization charge remains the same ($7,500).
In our example, does it matter which method is used by the company? Let’s compare results of amortization under the two methods:
Year |
Effective Interest |
Straight-line |
Difference |
1 |
12,710 |
7,500 |
5,210 |
2 |
11,699 |
7,500 |
4,199 |
3 |
10,638 |
7,500 |
3,138 |
4 |
9,524 |
7,500 |
2,024 |
5 |
8,355 |
7,500 |
855 |
6 |
7,126 |
7,500 |
(374) |
7 |
5,837 |
7,500 |
(1,663) |
8 |
4,482 |
7,500 |
(3,018) |
9 |
3,061 |
7,500 |
(4,439) |
10 |
1,568 |
7,500 |
(5,932) |
Total |
75,000 |
75,000 |
0 |
The differences don’t appear significant; however, the company’s management needs to decide whether these differences are material and then choose either the straight-line method (i.e., allowed alternative method) or the effective interest rate method (i.e., default required method).
online accounting course:
