Question

CASE 11‐5 Early Extinguishment of Debt

Gains or losses from the early extinguishment of debt that is refunded can theoretically be accounted for in three ways:

1. Amortized over the life of old debt
2. Amortized over the life of the new debt issue
3. Recognized in the period of extinguishment

Required:

1. Discuss the supporting arguments for each of the three theoretical methods of accounting for gains and losses from the early extinguishment of debt.
2. Which of the three methods would provide a balance sheet measure that reflects the present value of the future cash flows discounted at the interest rate that is commensurate with the risk associated with the new debt issue? Why?
3. Which of the three methods is generally accepted, and how should the appropriate amount of gain or loss be shown in a company’s financial statements?

Answer 1

Early extinguishment of debt refers to recall the debt securities issued by the organisation before maturity of debt in order to save further finance cost or gain advantage of favourable market conditions. Sometimes, this is also happened when the interest rate is down in the market and we have already issued the debt security at higher rate of interest. In that case it is suitable to recall them and issue fresh security at lower interest rate to save finance cost.

This extinguishment of debt may be possible either in gain or loss to organisation but ultimately it will give benefit to the organisation in future year by saving finance cost.

As per accounting framework provided by Financial Accounting Standard Board (FASB) and International Accounting Standard Board (IASB), it is recommended that all the gains including the losses will be recorded in the year of extinguishment. Here, gain (loss) refers to difference between reacquisition value of debt security and net carrying value (Face Value after adjusting unamortized premium (Discount) and Cost of Issue of Security).

However, if there is any change and modification in terms of debt security then it will also treated as debt extinguishment if the present value of future cash flow of new security is varied by at least 10% from the present value of cash flow of original security.