Definition of Loan Costs
Loan costs may include legal and accounting fees, registration fees, appraisal fees, processing fees, etc. that were necessary costs in order to obtain a loan.
If the loan costs are significant, they must be amortized to interest expense over the life of the loan because of the matching principle.
Example of Amortizing Loan Costs
Assume that a company incurs loan costs 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. In addition to the one-time loan costs of $120,000 the company will also have the cost of the borrowed money which is $360,000 ($4 million X 9%) of interest each year for five years.
It would be misleading to report the entire $120,000 of loan costs as an expense for the month of February. 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 loan costs as interest expense 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 monthly amortization of $2,000 and the monthly interest expense of $30,000 results in total monthly interest expense of $32,000 for each of the 60 months beginning on March 1.
When the note is issued and the loan costs are incurred, the company will debit a liability account such as Deferred Debt Issuance Costs for $120,000. This account balance is presented along with the $4,000,000 credit balance in Notes Payable. The result will be an initial net long-term liability of $3,880,00 and a net cash increase of $3,880,000. Each month the company will amortize the debt issue costs by crediting Deferred Debt Issue Costs for $2,000 and debiting Interest Expense for $2,000.
