The International Accounting Standards require companies and business entities to report their financial information in their financial statements. The balance sheet is the health statement of a business entity that reflects the financial obligations, assets, and shareholder’s equity. Different standards under IAS dictate measurement, recognition, and disclosure of varying assets and liabilities of the balance sheet.
On the liability side of the balance sheet, liabilities and shareholder’s equity are the two broader categories. As we narrow down, the liabilities are further sub-divided into the business entity’s short-term and long-term obligations.
This article will talk about the borrowings of a business entity and subsequent recognition & measurement for recording it and how they are present in the balance sheet of an entity.
A firm’s capital structure tells about the sources of funding for different capital and operating expenses. The two broader sources of capital funding are owner’s equity and debt financing. The owner’s equity is the amount funded by company owners, and it can be common stock for corporations. The debt financing is further segregated into bank loans, bonds, debentures, etc.
The purpose of financing can be to purchase equipment or machinery for business, expand the plant or office, introduce new products, etc. The nature of debt financing is liabilities, and equity financing is shareholder’s equity.
The capital funding of a business entity is recorded in the balance sheet under the category of non-current liabilities. Non-current liabilities include leases, loans, debt securities, or any other long-term financial obligations. In the coming sections, we will talk about borrowings & debts and their financial treatment.
What Is Borrowing & Debt?
Borrowing and debt is the line item in the company’s financial statement corresponding to the long-term debt of a business entity. More formally, we can define borrowing and debt as,
The long-term liabilities of the company that are due in more than 12 months are called borrowings. More specifically, borrowing and debts are the financial obligations that need to be repaid. The debt and borrowing are raised as a financial obligation when a company borrows money from financial institutions or the general public to fund its capital requirements.
According to FASB’s Accounting Standards Codification,
The company’s debt is payable, representing a contractual obligation to pay money on demand to the creditor on the agreed-upon dates.
The business entity borrowing the money has to pay the principal amount in installments. A certain amount of interest is also paid on the principal amount.
What Is Included In Borrowing & Debt?
Borrowing and debt are often represented as one line item in the balance sheet, but it often constitutes different long-term debt items. Let’s see at different items that come under borrowing and debt.
Loans From Bank & Financial Institutions
Loans are the long-term financial obligations of a business entity arising from financing from financial institutions like a bank. The loans are paid back over time. Bank loans are secured loans as they are often taken by pledging an asset of the business. The amortization of loans is done by paying a sum of principal and interest for every period.
Debentures are also long-term debt securities having a fixed rate of interest. The business entity takes a public loan by issuing debentures and pays a fixed interest over the life of debentures. More commonly, debentures are issued for more than 10 years.
There are different types of debenture, including secured, unsecured, convertible, etc. more commonly, debentures are unsecured loans issued based on the creditworthiness of issuers.
Bonds are long-term debt securities issued by business corporations and the government to raise capital from the public. Bonds are tradable securities that can be traded in the open market like shares.
Due to the nature of bonds, their value can be changed due to demand and supply factors. Fixed interest is also paid by the issuer periodically.
Classification In Balance Sheet
According to the (IAS)International Accounting Standards and IFRS, a business entity is responsible for properly disclosing and recording all financial statements. The balance sheet classification of a business entity’s debt and borrowing is non-current liabilities in the liabilities section of the company’s balance sheet.
It is an important concern when to recognize an item as a liability or asset. According to the FASB’s Accounting Standards Codifications, the initial recognition of the loans, debentures, and securities must be done in all the concerned financial statements.
The principal amount of the issued debentures, loans, or bonds is recorded as the long-term liability.
If the bonds have been issued at a premium, the premium on bonds is recorded as the reserve in accounts.
Any interest due on the loans, debentures, or bonds periodically must be recognized as an expense in the income statement. If the interest is not paid but due, the amount will be shown as a part of current liabilities.
Current Part Of Borrowings
If the company uses amortization, the amount of loan payable in the current period is shown as a current liability in the balance sheets.
According to US GAAP, the business entity must make the following disclosures regarding the long-term debt and borrowings:
- The company must disclose the amount of any long-term debt and borrowing that is due in more than 12 months from the date of issuance. The disclosure also includes stating the interest rates, conversion features, restrictions on assets, debt covenants, and other matters related to the long-term debt. The disclosure condition is applied on debenture, bonds, term loans, and other contractual obligations
- Initial recognition of the long-term debt, the discount or premium on bonds, and debentures.
- It should make a disclosure about the current part of long-term debt
- A proper disclosure about the schedule of long-term debt instruments. It includes term features of loans, collateral requirements, fair representation, normal operating cycle, etc.
- If a debt instrument like bond or debentures is subject to redemption, a proper disclosure about the debt redemption features, percentage price for debt redemption, starting, and debt maturity is required.
- For the repayment of debt and borrowing, a proper disclosure is required regarding sinking fund requirements, the timing of repayment for the redeemable securities and loans.
- Fair value disclosure of debt requires disclosing any amount as a part of a balance sheet or notes to financial statements. If required, the fair value disclosure is required in the balance sheet and notes as well.
- Proper disclosure of debt issuance costs net and gross is required. The gross debt issuance cost is the amount before accumulated amortization and includes legal, printing, registration costs, and underwriting costs. The net debt issuance costs are the costs after accumulated amortization and include legal, printing, registration, and underwriting costs.
- Accumulated amortization must be disclosed as debt issuance costs.
Modification And Restructuring Of Debt
There might be several reasons why the company and creditor decide to modify the loan terms or undergo restructuring of debt. Modification and restructuring are more common for the term loans issued by financial institutions and banks.
A business entity must account for and recognize any modification or restructuring of debt and borrowing. The recognition includes:
- Adjustment in the carrying amount of the loan as a result of the modification in loan terms
- Change in the amount of interest expense due to the modification must be recognized in the income statement of the business entity. Any unpaid interest will be recorded in liabilities.
- If the interest rate change is applicable to prior periods, the business entity should record gain or loss of interest in the income statement.
- Any expenses incurred to execute the modifications in changes are recorded in the income statement.
Capitalization Of Borrowing Cost
Under the IAS 23, the business entity must capitalize the borrowing costs on the debts and liabilities. The definition of borrowing costs as under IAS 23.6 is:
- Interest expense on the debt, financial leases, and loans is calculated and capitalized
- Any financial charges w.r.t to the leases
- Any exchange differences due to foreign currency borrowings are adjusted in the interest costs.
Debt Retirement And Amortization
When the business retires or redeems any debt security, it requires to record the entry for the retirement of the debt. For instance, if a company had issued bonds with the face value of $500,000 at a discount of 10%.
The entry for the redemption of bonds with the face value of $200,000 will be made in books as,
The treatment for the discount on the debt will be amortized along with interest periodically. It can be monthly, bi-annually, quarterly, or annually.
Most business entities use debt financing as an immediate way to finance capital requirements. For startups and new companies, debt financing is often used for the initial costs of startups. Many mature business organizations opt for the borrowing option when they are expanding business operations.
In this article, the borrowing costs, recognition, debt retirement, and amortization have been discussed to help you understand the disclosures required to record long-term debt and borrowing in the company’s balance sheet. We also discussed the recognition of part of the loan as expenses and remaining as a liability.