Why are loan costs amortized?
To clarify this, let's assume that a company incurs legal, accounting, and registration fees of $120,000 during February in order to obtain a $4 million loan at an annual interest rate of 9%. The loan will begin on March 1 and the entire $4 million of principal will be due five years later. The company's cost of the borrowed money will be $360,000 ($4 million X 9%) of interest each year for five years plus the one-time loan costs of $120,000.
It would be misleading to report the entire $120,000 of loan costs as an expense of one month. Hence, the matching principle requires that each month during the life of the loan the company should report $2,000 ($120,000 divided by 60 months) of expense for the loan costs in addition to the interest expense of $30,000 per month ($4 million X 9% per year = $360,000 per year divided by 12 months per year). The combination of the amortization of the loan cost plus the interest expense will mean a total monthly expense of $32,000 for 60 months beginning on March 1.
Can I Amortize Debt Financing Costs?
The nature of the debt has a big impact on how to account for expenses related to loans.
Anyone who has ever borrowed money knows that there are almost always costs involved. Whether it's a cash-advance fee from a credit card, closing costs for a mortgage, or underwriting expenses for companies tapping the credit markets through a bond offering, borrowers usually can't deduct the costs of debt financing immediately. Instead, they have to amortize those costs over the life of the loan. As you'll see below, the details can vary greatly by type of debt.
Business vs. personal debt
The most important distinction when it comes to debt financing costs is whether the loan is for business or personal reasons. Typically, most personal debt isn't eligible for a tax deduction anyway, so the question of amortizing isn't particularly relevant for tax purposes.
The big exception is mortgage debt for a personal residence, and there, special rules apply. Most closing costs follow the same amortization rules as other types of debt. Yet for points paid on a mortgage for a new home purchase or for money to improve your current home, an immediate deduction is available if certain tests are met. The home must be your primary residence, and it must be common to pay no more than the charged number of points on mortgages in your area. In addition, you have to pay the points from your own funds, rather than having the lender loan additional money covering them.
Deferred financing cost
From Wikipedia, the free encyclopedia
Deferred financing costs or debt issuance costs is an accounting concept meaning costs associated with issuing debt (loans and bonds), such as various fees and commissions paid to investment banks, law firms, auditors, regulators, and so on. Since these payments do not generate future benefits, they are treated as a contra debt account. The costs are capitalized, reflected in the balance sheet as a contra long-term liability, and amortized using the imputed interest method or over the finite life of the underlying debt instrument, if below de minimius.[1] The unamortized amounts are included in the long-term debt, as a reduction of the total debt (hence contra debt) in the accompanying consolidated balance sheets.[2][3] Early debt repayment results in expensing these costs.
Under U.S. GAAP, when issuing securities without specific maturity, such as perpetual preferred stock, financing costs reduce the amount of paid in capital associated with that security.[4]
Tax Treatment For U.S. federal income tax purposes, DFC are generally amortized over the life of the debt using the straight-line method.
Amortizing costs
Apart from that exception, you'll typically have to amortize debt financing costs. That involves recognizing those costs over the lifetime of the loan using what's known as the effective interest method. This method is a bit more complicated than a straight-line method, but it results in faster recognition of deductions.
For instance, assume you take out a five-year loan and pay $5,000 in fees. A straight-line method would have you amortize $1,000 each year. However, the effective interest method requires that the amortized expense be a fixed percentage of the outstanding debt balance each year. Because early years have a larger outstanding debt balance, effective interest amortization results in deductions of more than $1,000 in early years, shrinking in later years below the $1,000 mark until the full $5,000 is recovered in the final year.
Being able to amortize debt-financing costs as quickly as possible results in getting faster tax benefits, which is generally a good thing. Exceptions that let you take those costs as current expenses are the best outcome for taxpayers, but amortizing is still better than having expenses disallowed entirely for tax purposes.
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