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The matching concept in accounting requires companies to match expenses to the revenues to which they relate. Therefore, companies may spread costs over several years to ensure that. A typical example of the matching principle affecting accounting is depreciation. Companies spread the cost of their assets over several years to reflect the revenues they help generate.
Another area where the matching concept applies is deferred financing costs. As the name suggests, these costs get delayed for later periods. Before discussing the accounting treatment of deferred financing costs, it is crucial to know what these costs are.
What are Deferred Financing Costs?
Deferred financing costs are expenses a company incurs when obtaining financing, such as a loan or bond issuance. Usually, these costs occur upfront but get spread over the financing term. Some examples include fees paid to banks or other financial institutions for underwriting or arranging financing, legal and accounting fees, and other professional fees. These costs may also include preparing and filing documents with regulatory bodies.
When a company incurs deferred financing costs, it will record them as an asset on its balance sheet. These costs get amortized over the term of the financing, usually on a straight-line basis. Simply, it means the total amount is spread evenly over the financing period. The amortization of deferred financing costs is an increase in interest expense in the income statement.
What is the accounting treatment of Deferred Financing Costs?
The accounting for deferred financing costs involves various steps. As mentioned above, the primary treatment for these costs is to recognize an asset. At this stage, the amount will be the same as the company incurs for the related expense. For example, if a company spends $10,000 to acquire a loan, this amount will get recognized as an asset.
The second stage of the accounting for deferred financing involves amortizing the asset recognized before. As mentioned above, this process occurs on a straight-line basis. Essentially, this accounting treatment converts the asset to an expense in the income statement. The remaining deferred financing cost stays on the balance sheet until the final year of its life.
What is the journal entry for Deferred Financing Cost?
As stated above, there are two stages to accounting for deferred financing costs. The first involves recognizing an asset for the amount of the costs incurred. At this stage, the journal entry will be as below.
| Dr | Deferred financing cost |
| Cr | Cash or bank or account payable |
Over the years, the amount gets amortized and converted into an expense. This process occurs from the end of each period until the final year. At this stage, the journal entry will be as follows.
| Dr | Interest expense |
| Cr | Deferred financing cost |
Example
Red Co. incurs fees of $50,000 to obtain a $10 million loan. The company recognizes this amount as a deferred financing cost. Similarly, the company spreads this cost over ten years. In the first stage, Red Co. recognizes the whole amount as a deferred financing cost using the following journal entry.
| Dr | Deferred financing cost | $50,000 |
| Cr | Bank | $50,000 |
Over the years, Red Co. amortizes the deferred financing cost. The amortized amount equals $5,000 annually ($50,000 / 10 years). Red Co. records this amortization as follows.
| Dr | Interest expense | $5,000 |
| Cr | Deferred financing cost | $5,000 |
Conclusion
Deferred financing cost is expense companies recognize as an asset and spread over several years. This requirement comes from the matching concept in accounting. However, the accounting for deferred financing costs occurs over several years. Companies record these costs as an asset and later keep amortizing them on a straight-line basis.
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