This course is the third course in the five-course Financial Reporting Specialization. This course begins with a discussion of current liabilities and contingencies and continues with long-term debt and bonds. The course next explores accounting model for leases, both lessees and lessors, and a discussion on deferred tax assets and liabilities. Participants will learn the latest accounting standards including the new accounting model for leases effective for public companies in 2019 and private companies in 2020.
Early Extinguishment of Debt
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Do curso por University of Illinois at Urbana-Champaign
Accounting Analysis II: Measurement and Disclosure of Liabilities
5 ratings
University of Illinois at Urbana-Champaign
5 ratings
Curso 3 de 5 em Specialization Financial Reporting
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Module 3: Long-Term Debt Part 2
In this module, long-term debt will be discussed more in-depth. Students will learn how to account for bonds sold at a discount or premium, between interest dates, or with conversion features. Early extinguishment of debt, modifications and troubled debt restructuring are also discussed.
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John HeppClinical Assistant Professor of Accountancy
Department of Accountancy
[MUSIC]
Welcome back, in this lesson,
we're going to talk about early
extinguishment of debt.
So what's that mean?
While many bonds are paid off or extinguished before the due date,
this can happen for a number of reasons.
It may be that the company's credit position has improved and they qualify for
a better rate.
So they might want to pay off bonds at a higher rate and
refinance with a lower rate.
Or they may have to spend an improve financial position and have
the additional cash to pay off the debt or the market rates may have gone down.
Another common reason to extinguish debt early though is to re-finance a debt
before it becomes due, and the debt is classified as a current liability.
We call that from our earlier module on current liabilities,
that if the debt is due in the coming 12 months or operating cycle,
it would be classified as current liability.
Well most companies would prefer to avoid that, as a result,
they will re-finance and generally, you will have an early extinguishment of debt.
So once upon a time gains and
losses on early extinguishment of debt were reported as an extraordinary item.
In other words, outside of net income, they were below the line,
below the net income.
This was rarely used though,
the concept of an extraordinary item was rarely used in recent years.
And the FASB eliminated the entire concept of extraordinary items in 2015.
So these gains and losses are just going to be a part of ordinary income.
You're going to recognize a gain or
loss as a separate item though in current income.
And it's going to be the difference between the reacquisition price and
the net carrying amount of the extinguished debt.
So moreover, sometimes this debt though is between related parties.
When it's been related parties, sometimes the debt is just forgiven or
it's extinguished on very favorable terms.
You have to be careful and watch in that situation and
make sure that the transaction is not in essence a capital transaction,
that one party isn't actually contributing capital to the other.
Let's use this as an example of problem we previously worked on.
Only now we're going to change it to show that the debt is extinguished early.
So this journal entry summarizes what we've seen so far.
I'm going to take off the bonds payable,
remove the any remaining discount on the bonds.
I'm going to record the cash payment and
any difference here is going to be a loss on the redemption of the bonds.
Now let's modify that just a little bit.
A lot of times when there's an early extinguishment,
there's a premium paid when the bonds are early, and this compensates investors for
reinvestment cost.
And a lot of times,
it's a provision that's written right into the bond indenture.
But let's suppose here that there's a premium of $200,000 that's paid to
the investor to compensate them for their class of reinvestment,
or as an incentive to answer the call once the bonds are called.
It's the same journal entry, but now notice the cash is 10,200,000.
Because it includes the additional premium that's paid for
the bonds and that increased the loss on redemption.
So what if the bonds had been issued at a premium?
So there could be a gain on bonds issued at a premium are a required at face value.
Here's the same situation, only now it's a premium on the bonds.
So the premium of $55,844 leads
to a gain if the bonds can be redeemed at their face value.
In other words, the investor paid more for
these bonds than really you're paying to purchase them back.
And that's reflected in an unarmortized premium, so you could have a gain on that.
However, if you include a sweetener in that situation,
the gain could actually flip from the premium and become a loss.
It's probably a more realstic situation, but
you can't assume that just because there was a premium that is going to be gained
in redemption you have to look at what the features are.
It could end up being in loss,
if there is compensation to the investors for the early redemption.
All right,
we previously talked about conversion features where you would convert debt to
stock based upon a conversion feature that's embedded within the stock.
What if there wasn't a conversion feature, nothing embedded within the stock?
But the company makes an offer to the bond holders
To convert by redeeming the debt with common stock.
It's the economic equivalent of a conversion, but
now instead of being a conversion, what I'm going to do,
is I'm going to offer you stock with a fair value of
a certain price in exchange for your bonds.
This is a non cash transaction.
So the reacquisition price now is going to be determined
from the value of common or sometimes preferred stock issued or
the value of the debt whichever's more clearly evident.
Privately held company stock may not be readily valuable,
it may not be easy to determine their value,
at least at the time when this standard was written.
Today, I think we would be more inclined to think that with modern
valuation models, it is possible to value most stock.
So this may be a little bit out of date as an accounting standard, but
this is still what's in there.
You're going to either take the value of the stock or preferred stock or
the value of the debt, whichever is more clearly evident.
If you're issuing preferred stock,
it may actually be the debt that has a fair value that's more of an in.
So here's a small example, suppose the issuer offer the bond holders
stock worth 10,500,000 in exchange for bonds of 10 million.
Now no cash will change hands,
it's not the exercise of an option that was included in the original issue.
It's a new transaction, so the accounting is different from a conversion.
How are we account for this like any other non cash transaction, so
I'm going to issue the capital stock and record that at its fair value,
which we assumed was 10,500,000.
I'm going to have the debt relieved at its face amount and
the discount will go away of 94,000.
And I'll take the difference between those and now its a loss of redemption.
Notice the difference now, when it was a conversion feature,
there was no gain or loss.
When it's a non cash transaction, when there was no option built into the bonds.
But I offer you stock in exchange for your debt, there is a gain loss,
that's the difference.
So that wraps up our discussion on conversion features and
early extinguishment.
We'll move on to modifications next.
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