Accounting for Debt

R. Doogar Accy 493 D UIUC Sp 2004 1of 9 Accounting for Debt Issuing Debt A. Borrower’s books Debt transactions are an exchange involving receipt by the borrower of cash today, in return for a stream of promised payments in the future. To reflect this, the borrower increases the amount of assets (cash) and the amount of liabilities (debt). As always, we have to start with the valuation aspect. By the no-free-lunch theorem, FMV of debt = Cash Received (before any issue costs, just to keep life simple) This identity may be called the fundamental identity from which one then derives the accounting identity: FMV of Debt = Face Value of Debt " Premium or Discount on Debt And of course the premium or discount depends on whether the coupon rate (rc) exceeds the discount rate (rm) or not. The following relationship is basic: If rc > rm, then the debt is issued at a premium (issuer gets more cash than face value). If rc < rm, then the debt is issued at a discount (issuer gets less cash than face value). All sensible accounting for debt is based on the effective interest method, i.e. on the idea that time value of money is crucial to adjust for. [If an entity does not use the effective interest method, their accounting theory is out of date (and wrong). No ifs, no buts.]