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3.7 Debt extinguishment accounting
Publication date: 31 Dec 2022
us Financing guide
ASC 405-20-40-1 provides guidance on when a reporting entity should derecognize a liability. This guidance does not apply to convertible debt with a cash conversion feature. See FG 6.5.1 (post adoption of ASU 2020-06) and FG 6.6.5A (pre adoption of ASU 2020-06) for information on the derecognition (conversion or extinguishment) of such instruments.
Excerpt from ASC 405-20-40-1
Unless addressed by other guidance (for example, paragraphs 405-20-40-3 through 40-4 or paragraphs 606-10-55-46 through 55-49), a debtor shall derecognize a liability if and only if it has been extinguished. A liability has been extinguished if either of the following conditions is met:
a. The debtor pays the creditor and is relieved of its obligation for the liability. Paying the creditor includes the following:
1. Delivery of cash
2. Delivery of other financial assets
3. Delivery of goods or services
4. Reacquisition by the debtor of its outstanding debt securities whether the securities are cancelled or held as so-called treasury bonds.
b. The debtor is legally released from being the primary obligor under the liability, either judicially or by the creditor.
A reporting entity should also derecognize a debt instrument (and recognize a new one) when a debt modification or exchange is deemed an extinguishment. See FG 3.4 for information on modifications and exchanges of term loans and debt securities, and FG 3.6 for information on modifications and exchanges of loan syndications and participations.
ASC 470-50-55-9 provides guidance on situations that do not result in a debt extinguishment.
The following situations do not result in an extinguishment and would not result in gain or loss recognition under either paragraph 405-20-40-1 or this Subtopic:
a. An announcement of intent by the debtor to call a debt instrument at the first call date
b. In-substance defeasance
c. An agreement with a creditor that a debt instrument issued by the debtor and held by a different party will be redeemed.
An extinguishment should not be recognized prior to its occurrence; therefore, a debtor’s announcement of its intent to call its debt should not result in an extinguishment.
See FG 3.8 for information on debt defeasance.
3.7.1 Measuring the gain or loss on debt extinguishment
ASC 470-50-40-2 provides guidance on how to calculate a gain or loss on debt extinguishment.
A difference between the reacquisition price of the debt and the net carrying amount of the extinguished debt shall be recognized currently in income of the period of extinguishment as losses or gains and identified as a separate item. Gains and losses shall not be amortized to future periods. If upon extinguishment of debt the parties also exchange unstated (or stated) rights or privileges, the portion of the consideration exchanged allocable to such unstated (or stated) rights or privileges shall be given appropriate accounting recognition. Moreover, extinguishment transactions between related entities may be in essence capital transactions.
The ASC Master Glossary defines the reacquisition price of debt and the net carrying amount of debt.
Definitions from ASC Master Glossary
Reacquisition Price of Debt: The amount paid on extinguishment, including a call premium and miscellaneous costs of reacquisition. If extinguishment is achieved by a direct exchange of new securities, the reacquisition price is the total present value of the new securities.
Net Carrying Amount of Debt: Net carrying amount of debt is the amount due at maturity, adjusted for unamortized premium, discount, and cost of issuance.
The reacquisition price includes the fair value of any assets transferred or equity securities issued. It also includes fees (which may include noncash fees) the reporting entity pays the original lender in connection with the extinguishment. Typically, accrued interest payable is settled in cash upon extinguishment (i.e., the issuer pays the investor the accrued interest in cash). However, if accrued interest payable is not paid in cash upon extinguishment, it should be deducted from the reacquisition price (i.e., a portion of the reacquisition price should be treated as payment of interest). The net carrying amount of debt includes an unamortized premium, discount, and debt issuance costs.
If a reporting entity extinguishes a portion of a debt instrument (e.g., exercises an existing prepayment option) and all future principal payments are reduced pro-rata by the percentage of debt paid down, the unamortized premium, discount, and debt issuance costs associated with the portion extinguished should be expensed; the remaining unamortized debt issuance costs should continue to be deferred. There would be no change to the effective interest rate of the remaining debt. For example, if a reporting entity exercises an existing call option and repays 50% of the debt balance and all future principal payments of the debt are reduced by 50%, the reporting entity has extinguished 50% of the debt and should expense 50% of the unamortized costs.
However, there are situations when an entity exercises an existing call option and repays a portion of the debt balance but all of the future principal payments are not reduced pro-rata. For example, the prepayment may reduce the principal amount due at final maturity while the principal payments prior to maturity are not reduced at all. In these instances, an entity must update the effective interest rate because the amount and timing of future cash flows has changed since the effective interest rate was established. When the amount and timing of future cash flows change, one of the following methods should be applied:
- Prospective approach: A new effective interest rate is computed based on the current carrying value of the debt and the revised estimated remaining cash flows. Changes in cash flows from previous estimates are included in future interest expense on a prospective basis.
- Catch-up approach: The carrying value of the debt is adjusted to the present value of the revised estimated cash flows discounted at the original effective interest rate. Using this approach, the impact of the change in cash flows is recorded in the current period.
- Retrospective approach: A new effective interest rate is computed based on the original proceeds received, actual cash flows to date, and the revised estimate of remaining cash flows. The new effective interest rate is then used to adjust the carrying value of the debt to the present value of the revised estimated cash flows, discounted at the new effective interest rate. Using this approach, the impact of the change in cash flows is recorded in the current and future periods.
While a current period adjustment is recorded under both the catch-up and retrospective approaches, the key distinction relates to the effective interest rate. In a catch-up approach, cash flows are updated to reflect current estimates, but the rate used to discount those cash flows remains the original effective interest rate. Under the retrospective approach, the effective interest rate is changed to reflect the actual cash flows paid to date and the revised estimate of future cash flows. This change to the effective interest rate should be made on the date of the partial extinguishment and used for the remainder of the life of the debt instrument (unless another modification or extinguishment occurs). An entity should establish an accounting policy as to which method it utilizes and apply that method consistently.
See FG 3.3.5 for information on the recognition of a debt extinguishment gain when a lender also holds equity securities of the reporting entity. Extinguishment losses are typically charged to earnings unless the loss is in substance a dividend (i.e., a pro-rata distribution to all equity holders).
See FSP 12.11.1 for information on the classification of a gain or loss on debt extinguishment.
Example FG 3-8 illustrates how the gain or loss on a debt extinguishment is measured.
EXAMPLE FG 3-8
Calculating a gain or loss on debt extinguishment
Calculating a gain or loss on debt extinguishment
FG Corp reacquired its term loan for cash of $50,000,000. It paid $500,000 in fees to its original lender in connection with the extinguishment.
The carrying amount of the debt at the date of reacquisition was $50,000,000, and FG Corp had unamortized debt issuance costs of $1,000,000. There is no unamortized debt discount or premium and no accrued interest payable associated with the debt.
What is FG Corp’s gain or loss on extinguishment of its debt?
Analysis
The reacquisition price is the carrying amount of the debt and the fees paid to the lender to extinguish the debt.
The gain or loss on extinguishment is calculated as follows:
Term loan carrying amount |
$50,000,000 |
||
Less: unamortized debt issuance costs |
(1,000,000) |
||
Net carrying amount |
49,000,000 |
||
Reacquisition price |
50,500,000 |
||
Loss on extinguishment |
$1,500,000 |
FG Corp should recognize a loss on extinguishment of $1,500,000 in net income.
3.7.2 Debt extinguishment as a subsequent event
An extinguishment occurring subsequent to the end of a fiscal period but prior to the issuance of the financial statements should be accounted for as a nonrecognized subsequent event, which is not recorded in the financial statements, but may require disclosure. See FSP 28 for information on subsequent events.
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