What is Extinguishment of Debt?
Extinguishment of debt mainly refers to eradicating the liability from the company’s balance sheet. This mainly occurs in cases where when bonds reach their maturity dates, and the bondholders are paid the face value of the security they hold.
During the normal course of the business, it can be seen that businesses issue long-term bonds as an important source of financing for numerous different companies.
Once these instruments mature, the bondholders are entitled to the bond’s face value.
At times, companies establish sinking funds and keep on transferring them 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 after 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, and 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 and premiums are already accounted for and subsequently amortized over the security life.
Therefore, the carrying amount of the security is said to be the same as the fair value that exists on the maturity date.
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 the fair value of the payments that are supposed to be made to the debt holder. In the same manner, the carrying amount of debt is the amount that is payable at the maturity date.
It is adjusted for unamortized premium or discount and the transaction cost.
Therefore, there is a loss on the extinguishment of debt when the repurchase price is greater than the net carrying amount.
This means that the company ends up paying more for debt extinguishment than it would have if it 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 for $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 to calculate the gain on extinguishment, there is a need to calculate the bond’s carrying value.
The Net Carrying Amount of the Bond is calculated as follows:
| Particulars | Amount |
| Face Value of the Bond | 200,000 |
| Premium (5 Years Remaining) | 5,000 |
| Issuing Cost (5 Years Remaining) | 5,000 |
| Net Carrying Amount | 200,000 |
Corresponding to the Net Carrying Amount of $200,000 Feliz Inc. is 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 = 200,000 – 205,000
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 extinguishing 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 they would be paying a lower price than they would otherwise pay at the maturity date by settling the amount today.
Example
In order to understand the concept of gain and loss of disposal, the following example is given.
Feliz Inc. has issued a bond in the 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 to calculate the gain on extinguishment, there is a need to calculate the bond’s carrying value.
The Net Carrying Amount of the Bond is calculated as follows:
| Particulars | Amount |
| Face Value of the Bond | 200,000 |
| Premium (5 Years Remaining) | 10,000 |
| Issuing Cost (5 Years Remaining) | (5,000) |
| Net Carrying Amount | 20,5000 |
Corresponding to the Net Carrying Amount of $200,000, Feliz Inc. is 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 = 205,000 – 203,000
Therefore, the Gain on Extinguishment of Debt is $2,000. This means that it would be beneficial for them to repurchase the bond at this point in time.
