Early Extinguishment of Debt
What is meant by the Early Extinguishment of Debt? – Definition
The retirement of debt before maturity is called the early extinguishment of debt. Early extinguishment of debt occurs whenever a firm’s long-term debt is retired before maturity. Management can accomplish this extinguishment by repurchasing the bonds in the market. Other bonds are callable and give the issuing corporation the right to buy back the bonds before maturity at a specified price. This price is usually set above the par or face value of the bond because the bondholder will be foregoing future interest income. The amount above par is often referred to as a call Premium.
The early extinguishment of long-term debt is a financing decision of the management and depends on such factors as cash flows and past, existing, and anticipated interest rates. For example, it may be advantageous for a firm to repurchase bonds if market interest rates have risen since the original bond issue date. To demonstrate, assume that the Tracy Hospital Company issued $50,000, 20-year bonds at the face at the beginning of 2012. Because the bonds were issued at face or par, we can assume that at that time the market interest rates were equivalent to the stated rates for this type of bond.
By the beginning of 2020, interest rates rose to 10%, and as a result, the market value of the bonds decreased to $36,201. Therefore, the Tracy Hospital Company repurchased for that amount, all the bonds on the open market and was able to liquidate a $50,000 debt for only $36,201. This situation occurred often in the late 1970s and early 1980s when market interest rates rose and many firms did retire their debt early.
When a firm extinguishes its debt prior to maturity, there will be a gain or loss. This gain or loss is the difference between the reacquisition price and the carrying value of the bonds. In the example of the Tracy Hospital bonds, the firm would record a gain of $13,799, or $50,000 less the reacquisition price of $36,201. Prior to recording the gain or loss, the carrying value must be adjusted for any discount or premium amortization up to the date the bonds are retired. If the carrying value exceeds the reacquisition price there is a gain, and conversely, if the reacquisition price exceeds the carrying Value there is a loss. Under current accounting practices, this gain or loss is considered extraordinary and must be shown as a separate item on the income statement.
Example – Accounting for the Early Extinguishment of Debt
To illustrate the accounting for the early extinguishment of debt, assume that $100,000, 12%, 5-year term bonds that were issued at a discount of $7,024 by the Valenzuela Corporation (see the data here) were called on July 1, 2022. The bonds were reacquired at a price of 104. The firm uses the straight-line method of amortization.
The entries to record (1) the payment of interest and the amortization of the discount and (2) the retirement of the bonds are as follows (see Exhibit ‘B’ in the straight-line method of amortization for the necessary data):
* see (see the data in Issue of bonds at a discount)
The first entry records the interest payment and the discount amortization from January 2, 2022, to July 1, 2022. The second entry records the actual extinguishment of the debt. There is a loss in this case because the reacquisition price exceeds the carrying value of the bonds.