What is Extinguishment of Debt?

Extinguishment of debt mainly refers to the process of eradicating the liability from the balance sheet of the company. This mainly occurs in cases where when bonds reach their maturity dates, and the bond holders are paid the face value of the security that they hold.

During the normal course of the business, it can be seen that businesses issues long-term bonds as an important source of financing for numerous different companies. Once these instruments mature, the bond holders are then entitled to the face value of the bond.

At times, companies establish sinking funds where they keep on transferring funds periodically. This amortization then accumulates, and then the debt is said to be repaid using the sinking fund. Upon completion, the debt is said to be extinguished at the completion of the sinking fund.

In other words, debt extinguishment happens when the debt issuer recalls the securities before the maturity date itself. This might happen because of the changes in interest rates, or the issuer of the debt is able to get sufficient funds, so on and so forth.

In the case where the underlying security stays outstanding in the market till the maturity date, in that case there is no gain or loss on the extinguishment of the debt. This is because in this case discounts, as well as premiums are already accounted for and subsequently amortized over the life of the security. Therefore, the carrying amount of the security is said to be the same as the fair value that exists on the maturity date.

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Loss on Extinguishment of Debt

A loss on extinguishment of debt mainly occurs when there is a difference between the repurchase price, and the carrying amount of debt at the time of extinguishment.

The repurchase price is fair value of the payments that supposed to be made to the debt holder. In the same manner, carrying amount of debt is the amount that is payable at the maturity date. It is adjusted for unamortized premium or discount, as well as the transaction cost.

Therefore, there is a loss on the extinguishment of debt in the case where the repurchase price is greater than the net carrying amount.

This means that the company ends up paying more for debt extinguishment, than they would have paid if they had waited for the maturity date.  

Example

In order to understand the concept of gain and loss of disposal, the following example is given.

Feliz Inc. has issued a bond with an amount of $200,000 at an interest rate of 5%. The bond matures in 10 years. It was issued at a premium of $210,000, and the issuing costs of the bond amounted to $10,000.

However, Feliz Inc. was able to generate finance before 10 years, and they want to mature the bond at the end of the 5th year only. They want to buy back the same bond, at $205,000.

In the case above, it can be seen that in order to calculate the gain on extinguishment, there is a need to calculate the carrying value of the bond.

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The Net Carrying Amount of the Bond is calculated as follows:

ParticularsAmount
Face Value of the Bond200000
Premium (5 years Remaining)5000
Issuing  Cost (5 years Remaining)5000
Net Carrying Amount200000

Corresponding to the Net Carrying Amount of $200,000 Feliz Inc. are buying back the bond for $205,000. Therefore, using the formula to calculate the gain (or loss) on extinguishment of debt:

Gain (or Loss) on Extinguishment of Debt = Carrying Amount – Repurchase Price = 200000 – 205000

Therefore, Loss on Extinguishment of Debt is -$5000. This means that it would be beneficial for them to hold on to the bond.

Gain on Extinguishment of Debt

The company gains from extinguishment of debt in the case where the carrying amount of debt is higher than the repurchase price.

This is beneficial for the company because it implies that by settling the amount today, they would be paying a lower price, than they would otherwise pay at the maturity date.

Example

In order to understand the concept of gain and loss of disposal, the following example is given.

Feliz Inc. has issued a bond with an amount of $200,000 at an interest rate of 5%. The bond matures in 10 years. It was issued at a premium of $220,000, and the issuing costs of the bond amounted to $10,000.

However, Feliz Inc. was able to generate finance before 10 years, and they want to mature the bond at the end of the 5th year only. They want to buy back the same bond, at $203,000.

In the case above, it can be seen that in order to calculate the gain on extinguishment, there is a need to calculate the carrying value of the bond.

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The Net Carrying Amount of the Bond is calculated as follows:

ParticularsAmount
Face Value of the Bond200,000
Premium (5 years Remaining)10,000
Issuing  Cost (5 years Remaining)(5,000)
Net Carrying Amount20,5000

Corresponding to the Net Carrying Amount of $200,000 Feliz Inc. are buying back the bond for $203,000. Therefore, using the formula to calculate the gain (or loss) on extinguishment of debt:

Gain (or Loss) on Extinguishment of Debt = Carrying Amount – Repurchase Price = 205000 – 203000

Therefore, the Gain on Extinguishment of Debt is $2000. This means that it would be beneficial for them to repurchase the bond at this point in time.