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What is Extinguishment of Debt?
Extinguishment of debt occurs when debt is eliminated from a company’s balance sheet. This can happen for a number for reasons. The most common example of debt extinguishment is when bonds reach their maturity dates and bondholders get paid.
Issuing long-term bonds is an important source of capital for companies. When a bond is issued, the company issuing the bond will pay the bondholders a coupon rate, which is a payment a bondholder can expect while holding the security. At maturity, bondholders are paid the face value of the bond.
Debt extinguishment occurs when the bond issuer recalls the securities before the maturity date, which can happen for a variety of reasons, such as if interest rates change. When a bond issuer extinguishes debt prior to maturity, there will be either a gain or loss.
Gain or Loss on Extinguishment of Debt
When debt is extinguished, the difference between the repurchase price and the amount of debt at the time of extinguishment will determine whether there will be a gain or a loss.
A gain on extinguishment of debt occurs when the repurchase price is lower than the net carrying amount of debt, meaning the bond issuer pays less than what they expect to pay at maturity.
A loss on extinguishment of debt occurs when the repurchase price is higher than the net carrying amount of debt, meaning that the bond issuer will lose money if they don’t wait until maturity.
Formula and Example
Let’s pretend Company ABC issues a bond with an amount of $500,000 at an interest rate of 7% for 10 years. It was issued at a premium of $520,000 and the issuing costs are $10,000.
After 5 years, which is halfway to maturity, Company ABC would like to repurchase the bond for $510,000. What is the gain or loss on extinguishment of debt?
The formula for calculating the gain or loss is:
Gain or Loss on Extinguishment of Debt = Carrying Amount – Repurchase Price
The Net Carrying Amount is calculated by adding the remaining premium and subtracting remaining costs from the face value. The Net Carrying Amount is calculated as follows:
|Net Carrying Amount|
|Remaining Premium ($20,000 * 50%)||$10,000|
|Remaining Cost ($10,000 * 50%)||($5,000)|
|Total Net Carrying Amount||$505,000|
The Repurchase Price is what Company ABC is buying back the bond for, which in this example is $510,000.
|Net Carrying Amount||$505,000|
|Gain or (Loss) on Extinguishment of Debt||($5,000)|
In this example, Company ABC recorded a loss on extinguishment of debt of $5,000 on its income statement. Since the company is recording a loss, it wasn’t a good decision to extinguish the bond and the company would have been better off waiting to maturity.
How to Account For Debt Extinguishment
To account for debt extinguishment, there will be a debit to bonds payable, debit to premiums payable, debit to loss on extinguishment of debt, credit to cost of bond issuance, and credit to cash. The journal entries for the above example would be as follows:
|Loss on Extinguishment of Debt||$5,000|
|Cost of Bond Issuance||$5,000|
Debt Extinguishment Related to Paycheck Protection Program (PPP)
Another example of debt being eliminated from a company’s balance sheet is debt forgiveness. A recent example of this was PPP loan forgiveness.
Due to the impacts of the coronavirus pandemic, businesses received PPP loans from the government to keep employees on payroll with the expectation that the loans would be fully forgiven. When the PPP loans were forgiven, they were removed from liabilities and a corresponding gain from extinguishment of debt was recorded.