More Advanced Accounting Topics: Book Value vs.

Face Value of Debt

Hello, and welcome to the first lesson in this module on More Advanced Accounting. As you can
see, we're going to cover a wide range of topics here including Debt, Convertible Bonds, Equity
Investments, Noncontrolling Interests, Pensions, and More. As always, you can read this entire
module in written form in the quick reference guide accompanying these lessons. It matches up
pretty closely. We don't always make it one lesson per key rule. But you can usually figure out
what's going on by looking at the names of the key roles versus the names of the lessons here.
So, overall, it still matches up pretty closely. The usual difference is that we focus on the
explanations in the written guides, and we go into the calculations and formulas a bit more in
the Excel-based videos.

Now, we're going to get into the Excel part of this video in a little bit, and you'll learn about
Book Value versus the Face Value of Debt and Debt Issuance Fees. But I want to start by
covering something very important, which is should you complete these lessons in the first
place? The short answer is that the topics in all the lessons in this module are extremely
unlikely to come up in interviews, for the most part.

[01:00]

So, if you're taking this course for interview prep, no, you should skip this module and maybe
come back when you have extra time or when you need to look up something and use it in a
different case study later on or one of your own case studies or something like that.

We do cover some topics here that will appear in other case studies in the course, especially
the first few points and lessons here related to debt. So, you don't need to complete these
lessons, but they do give you some helpful background information once you get to the later,
more advanced case studies in the course.

The topics here are roughly in the order of most useful to least useful. And so what that
means is that, in terms of the most useful topics, the first lesson here, this one on Book Value
versus Face Value of Debt, and then the summary lesson in all these debt lessons about Book
Value versus Face Value versus Market Value, are most helpful, overall. The ones on Equity
Investments and Noncontrolling Interests are also useful because those concepts will come
up throughout the course as well in other case studies.

[01:59]

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If you don't have time to watch the videos, just look at the Excel files. And if you know your way
around the financial statements, you'll be able to figure out a lot of it just from those.

The other lessons are really here for your reference; the chances of getting interview questions
about different security types and how unrealized gains are recorded differently, or about LIFO
versus FIFO for inventory are close to 0%. So, for interviews, these are pretty much pointless to
learn and go over.

Also, remember that we do expand on many of these topics in later lessons in case studies,
such as the ones on Atlassian and Netflix. So, don't feel pressured to finish everything right
now. A lot of this is here for your reference if you want to come back later and look at these
topics before you start one of the more advanced case studies.

With that said, let's now go to Excel and discuss the first topic here, the Book Value versus Face
Value of Debt. The idea here is that when a company issues Debt, it also has to pay a financing
fee or issuance fee to the banks and lenders that arranged the issuance.

[03:02]

Now, these fees are usually very small, 1% to 3% of the issuance, but you have to account for
them somewhere because they represent an actual cash outflow. The way it works is that the
fees are paid in cash upfront when the debt is first issued, then they amortize over time until
the debt matures – in other words, until the company is required to repay the full debt principal
at the end of the term.

A long time ago, you used to record these financing or issuance fees as an asset called
Capitalized Financing Fees on the assets side on the Balance Sheet and then amortize them
over time. So, you'd reduce the asset each year. But then in 2015, the treatment changed to
synchronize the accounting under U.S. GAAP and IFRS. And now you deduct the financing fees
directly from the debt on the balance sheet, in other words its Book Value, and the annual
amortization increases that book value each year.

[03:51]

Let's see how this works with a quick example. So, we have here some simplified financial
statements based on the model that we developed for Target in Module 2, but I've simplified it
even more because I don't want you to think about extraneous points. I just want you to worry
about what matters with these debt-related concepts.

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If a company wants to issue $100 or $100 million, really, of debt, and it's going to pay a 3%
fee on it, here's how this would be recorded. We have one concept here called the Face
Value, which represents the actual $100 million that the company pays interest on. And so,
this is just equal to the $100 right here. But then the Book Value of the Debt is equal to the
$100 times (1 minus the debt issuance fee of 3%). So, we get $3 million in these debt issuance
fees. And we can calculate that just by subtracting these. And so, this number, the $97
million, is what will initially appear on the Balance Sheet even though the company is paying
interest on this $100 million, this Face Value of the Debt.

[04:56]

So, as I just said, the Face Value is what the company initially issues and pays interest on. This
one is only affected by issuances, principal repayments, and something called paid-in-kind
interest or PIK interest that we'll get to in an upcoming lesson.

The Book Value is what's shown on the company's balance sheet. And that's affected by
unamortized Financing Fees, Debt Discounts, and Premiums, which are covered in an
upcoming lesson, and then everything above as well: issuances, repayments, and paid-in-kind
interest. So, the Book Value is more of an accounting term, but the Face Value is really what
the company cares about because that's what they're paying interest on and what they
ultimately have to repay.

If you're wondering why we ignored all these points in the coverage of debt in Module 2, the
short answer is that the Financing Fees are very small; a 1% or 3% difference over 5 years or 10
years is barely going to make a difference. It's not going to change a company's valuation, and
it's not going to make you decide to invest or not invest in a company. So, these points are good
to know because you'll see them in the financial statements, but they're not essential to
company analysis.

[05:59]

Let's go into the first scenario here with the initial issuance and repayment upon maturity, then
we'll look at what happens with an early repayment of debt. And then we'll say a few words on
Deferred Taxes with these items at the end.

So, the idea here is that we are going to track what happens with all these items on the
statements. We're going to start out here with our debt schedule and assumptions. And then
once we do that, I'll show you how to reflect these items on the Income Statement, the Balance
Sheet, and the Cash Flow Statement.

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We already have our Face Value and Book Value. And for the Face Value, this is pretty simple.
We're going to say that the beginning Face Value equals the ending Face Value each year and
just copy this across. And then we're going to say the ending Face Value is just equal to the
beginning Face Value, and then we'll sum up the Debt Principal Repayments & Maturities that
year. So, we have that.

Now, for the Debt Principal Repayments & Maturities, we need to figure out what the year of
the debt repayment here is. And we're saying it's a 5-year maturity right now. We have the year
numbers up at the top, from 0 and then 1 through 5.

[07:00]

So, here, I'm just going to say 0 now, for the year number, for the full debt repayment. And so,
in this line, we can simply say, if our year number is equal to the Debt Maturity right here, we
will make this the negative of the Face Value at the start of this year. Otherwise, we'll say 0.
And so that's how our Face Value changes. And it's pretty simple.

The Book Value gets a little more complicated. With the Book Value, we're going to link the
beginning number in our first projected year to the ending number in the historical year. We
can copy this across. And then for the ending Book Value of Debt, we can just sum up
everything here and then copy this across. So, we have that out.

Now for the Amortization of Debt Issuance Fees. Here is where we're going to increase the
Book Value each year this happens. So, we're going to take those Initial Debt Issuance Fees, I'll
anchor that, and then we'll divide by the Debt Maturity of five years. We have that and now we
can see what happens here.

[08:02]

So, as the debt approaches maturity, the Book Value keeps approaching the Face Value. And
when it matures, the Book Value should be exactly equal to the Face Value, which is exactly
what happens here. We should also link to the Debt Principal Repayments, which we have from
above. So, let's fill that in. And you can see how this works. As soon as we hit maturity, the
Book Value is $100, And we repay exactly $100. And that's what shows up on the Financial
Statements. I'll also fill out the rest of these Unamortized Debt Issuance Fees, take the old
number and then I'll subtract the Amortization over here. And so, we have that.

Now, in terms of the Interest Expense, this is pretty simple. It's always going to be based on the
beginning Face Value of Debt. And then we can multiply by the Coupon Rate. This debt has a

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fixed interest rate called the Coupon Rate. So, multiply by that and anchor that. And we get to
our Interest Expense each year here.

[08:53]

Now, in addition to this Interest Expense, when a company amortizes these financing fees or
issuance fees, we also have to include that amortization in the Interest Expense on the Income
Statement. So, I will link up to this amortization number. I'll sum up these and copy this across.
And so, we have those.

This is the basic structure of what it looks like. Let's now go down to the Income Statement and
see how to link these in and go to the other statements as well. For the Interest Expense, I'm
going to go up to what we have right here, the Total Interest Expense on the Income Statement.
I'm going to leave the Loss on Debt Extinguishment blank for now. We'll get to that in the next
part of this. So, I'll copy across the Interest Expense. I'll sum it up and copy across the Total
Other Income and Expense. And you can see our Pre-Tax Income is now lower as a result of this.

On the Cash Flow Statement, our Net Income is lower. But we have to add back the
Amortization of Debt Issuance Fees because this is a non-cash expense. So, let's go up and take
our amortization from our schedule up at the top. And we can go to right here at the
Amortization of Debt Issuance Fees. This is non-cash, so we have to add it back on the Cash
Flow Statement.

[10:00]

We'll leave Loss on Debt Extinguishment blank for now. And then moving down here for the
Debt Issuances, let's go up and link to what we had right here. I'll link to the initial Debt
Issuance right there, and then I'll zero it out for the rest because we don't have any Debt
Issuances after this.

And then for the Debt Issuance Fees, let's go up. This will be an actual cash outflow. So, I'm
going to take the ending Book Value of Debt and then subtract the ending Face Value of Debt.
So, this will just be negative $3 million, and I'll zero this out because we don't have any other
Debt Issuances here to worry about.

For the Debt Repayments, let's go up to where we had it in our schedule here, Debt Principal
Repayments & Maturities. So, we have that.

And now to link all this on the Balance Sheet, let's go up to the Total Debt line item right here.
And for this one, in the first year, we don't really have an initial balance from the year before

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this. So, I am just going to link in the relevant line items here. This would be the Amortization
Debt Issuance Fees, and then the Debt Issuances, the actual cash outflow for the Debt Issuance
Fee, and then the Debt Repayments down here.

[11:08]

Now, we can copy this formula over, but we have to be careful because in the second year, we
do want to link to that balance from the preceding year. And we'll copy this across. And now
you can see exactly how it works. This is what shows up on the Balance Sheet.

When we first issued this Debt, only $97 million shows up because we have a 3% issuance
fee. But then we get some Amortization. And so, the Book Value climbs, and it keeps going
up. And then when we finally get to Year 5, it goes up to $100 in this year, and then on
December 31st of this year, we completely repay the Debt. And so, the Book Value and the
Face Value, both go to 0. And so, this is how it works on all three statements. You can see
how the Balance Sheet here stays in balance as well.

That is the basic walkthrough for this. Whenever we go through this concept, the next question
that we get is, “Wait a minute, that's fine, but what if there's an early repayment of Debt? In
other words, what happens if the Debt is due in Year 5, but the company decides to repay it in
Year 2 or Year 3? What happens to the Issuance Fees and Amortization then?”

[12:10]

The answer is that in early repayment situations when the Book Value differs from the Face
Value, often because of these Issuance Fees, you have to record a Gain or Loss on the
Extinguishment of Debt on the Income Statement. Some companies might group this within
Interest Expense as well; fix that typo there.

In this case, since the Book Value is always going to be less than or equal to the Face Value,
we can only record a Loss that corresponds to the remaining Unamortized Issuance Fees
when the repayment happens. That Loss will increase the Book Value, so it'll accelerate the
increase of the Book Value and boost it right up to the Face Value upon repayment.

With this option, we're also going to need to do some checks to make sure that we have the
right year and that we don't amortize too much, and a few other things like that. So, let's go
over and see how this works.

[13:00]

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First off, for the year number, for the full debt repayment, I'm going to use data validation here.
And then I'm going to set this to list. And then we'll go up here and say that they can repay the
Debt in any year, from Year 1 through Year 5. To this, and I'll just change it to Year 3 for now.
So, we can test this a bit and see how it works.

So, with the Debt, Principal Repayments & Maturities, we do need to make a change here. And
instead of linking to cell E13, we need to change it to cell E16 now. And I will just copy this
across. And so now our Debt is fully repaid in Year 3.

And you can see the problem here, that even though the repayment happens, we keep this
Amortization going, which is not correct. So, we need to do something to fix this. For the
Amortization of Debt Issuance Fees, we can do a simple IF check here. And I can say that if our
current year number is less than or equal to the year number of full debt repayment right here,
anchor that, then we'll show that number, otherwise, we'll just say 0. And we'll copy that
across. And now we can see that we don't get any amortization in the last two years here.

[14:07]

For the Loss on Debt Extinguishment, once again, we need to do a check and we need to look at
our current year. And if it's equal to this year number for the full debt repayment, then we're
going to take our remaining Unamortized Debt Issuance Fee. So, we'll take the balance from the
previous year and then whatever we amortize this year, and we'll say that that is equal to our
Loss. So, the total remaining balance simply adds to our Book Value of Debt and shows up as a
negative item on the Income Statement in this year. If this is not true, then we'll just say 0 for
this one. And you can see how it works right here. If we repeat this in Year 3, we have
remaining balance of $1.2. So, that will boost our Book Value up to the full $100. And then
that's what we end up repaying right here and so the Book Value goes to $0.

[14:56]

For the Unamortized Debt Issuance Fees, we need to do a check here as well, and we need to
look at the year number. And if this is before the year number for the full debt repayment, we'll
use this normal formula. Otherwise, we'll say 0 to avoid showing too much for this number in
this schedule. Also, I forgot to anchor the E16 here. So, let's just fix that. And now we can see
that this is working correctly.

Looking down here, our Interest Expense seems to be working correctly, and our Amortization
of Debt Issuance Fees also seems to be working. So, all that is fine. Let's just fix the formatting
here.

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And then for the Loss on Debt Extinguishment on the Income Statement, we can just link up to
our number right here. Let's test this out a little bit first before linking it anywhere else. So, if I
change this to Year 4, this seems to work properly, our Unamortized Issuance Fees go right to
zero and the remaining balance just counts as a Loss in Year 4.

[15:58]

If we change it to Year 1, this also seems to work correctly, everything goes to 0. We get the
correct Loss number. Year 2 is also correct. Year 3 we saw before, and Year 5 is also still correct
right here. So, I'll just keep this in Year 3 for now.

Let's now go down and link this to the statements. On the Income Statement, we have to link in
the Loss. So, I'll use a negative sign and go up here. And I'll just copy this across. So, we have
that. And then going down, we need to include this on the Cash Flow Statement. This will be a
non-cash add-back. So, I can actually link to it in a couple of ways, but I'll just link to it on the
Income Statement and flip the sign right here and copy this across. So, we have that.

And then there's nothing else to link on the Cash Flow Statement. So, the only remaining
change we need to make is for the Total Debt right here. We also need to factor in the Loss on
Debt Extinguishment. So, I will change this, and I'll link to cell E106.

[17:00]

I'll add that, and then we need to be really careful because we can't exactly copy this formula
across because it's slightly different in Year 2. So, I will just make this in addition plus F106. And
now we have that. And so now you can see how it works.

In this case, of the early Debt Repayment, we simply end up with a lower final Book Value on
the Balance Sheet before the full repayment. But because of the way we recognized the Loss
here, the accounting still works out. We immediately reverse that contra-liability account for
the financing fees. And the Book Value simply goes up to the full Face Value upon this early
repayment in Year 3. That's how that works. As always, I have some notes over here on the
side.

And then one final point I want to mention here is about Deferred Taxes. You might be looking
at this and wondering, are any of these items Cash-Tax Deductible? You saw before how items
like Stock-Based Compensation and Amortization of intangibles often are not.

[17:54]

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The short answer is that it's complicated, but under U.S. GAAP, these types of items, the
Amortization of Issuance Fees and Discounts and Premiums do appear to be Tax-Deductible.
But the treatment could also differ based on cases where a company repays debt in full versus
cases when it simply swaps it out for new debt.

This point about the taxes, it barely makes a difference because the annual amortization is so
small, so we're pretty much going to ignore it here and in the upcoming lessons. If you wanted
to factor it in, and if you want to see what happened when you assume these items are not
Cash-Tax Deductible, you could just take the same setup for the Book versus Cash Tax schedule
from the previous module and add the non-deductible items, namely the Amortization and the
Loss on Debt Extinguishment, to calculate Cash Taxable Income, but we're not going to bother
with that here.

That takes us to the end of this lesson. So, let's do a recap and summary now. Going back to the
slides, as I mentioned, you don't really need to complete these lessons for interview prep. We
do cover some topics here that will be helpful later on. The most useful ones are probably this
first one on Book Value versus Face Value and then the summary lesson on Book Value, Face
Value, and Market value. Also, look at the ones on Equity Investments and Noncontrolling
Interest. But, really, most of this is here for your reference and to help you better understand
some of the other case studies later on.

[19:11]

In this lesson in Excel, you saw how the issuance fees on debt work. And the short version of it
is that when a company issues Debt, they're going to record a lower number for the Book Value
on the Balance Sheet because these issuance fees have to be deducted. So, if it's a 3% fee, the
Book Value is going to be 3% less. You amortize these issuance fees over time, and you group
them together with interest on the Income Statement. So, you list both the Interest Expense
and the Amortization of these fees here.

On the Cash Flow Statement, you add back the fees as non-cash expenses. And then when
you're making the links on the Balance sheet, you need to make sure you're linking to the old
debt balance, you link to the Amortization of Debt Issuance Fees, and then the Debt Issuances,
the cash outflow for the issuance fees and then their Debt Repayments.

[20:00]

If there is an early repayment, as you saw here, all that happens is that the remaining
Unamortized Issuance Fees are shown as a Loss on Debt Extinguishment. And they immediately

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boost the Debt’s Book Value up to its Face Value when this repayment happens so that all the
accounting works out. This Loss then is shown on the Income Statement. It's added back on the
Cash Flow Statement as a non-cash item there, and it also links into the Debt balance on the
Balance Sheet.

That's it for this lesson. Coming up next, you will learn about the Market Value of Debt, how
that factors in, why you might look at it, and how it could affect some of these more advanced
accounting scenarios with debt line items.

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