Gain or Loss on Extinguishment of Debt
Debt extinguishment is the process which a company paid off its debt. It will remove the debt from the liability section of the company balance sheet. It can happen when the bond issuer paid of bonds to the issuer before the maturity date. It happens due to various reasons such as interest rate changes, companies can find other low-cost funds, and so on.
The business normally finds the source of capital to support, expand and operate the operation. During the early day, they are not able to generate returns yet, they purely rely on the owners’ equity or debt from the creditors.
Debt is one of the sources of funds for the company during the start-up. It is very hard to obtain enough funds from the owner. So debt is the next target when company wants to operate or expand the business. It is very normal for a business to obtain debt to support its activities.
There are many forms of debt that company can use to obtain funds from various sources such as investors, banks or other creditors. Bonds is one of the most popular financial security that company can use to raise fund from the capital market.
Even debt is good for the company to expand the business, but they will get rid of them at a certain point in time. The company may be able to find other sources of fund which is cheaper than the cost of debt. Moreover, the company may be able to generate enough return to pay off the debt before the maturity date. The objective of debt extinguishment is to eliminate the debt to save on the cost of finance.
The company will save up a load of cash to settle the debt. They will establish the sinking fund to save up for the settlement. After a certain period of time, the fund is ready to repay the debt.
Loss on Extinguishment of Debt
Loss on extinguishment of debt happens when the debt carrying amount is smaller than the debt market value during the paid-off. It is highly likely to happen to the company which paid off the bond before the maturity date.
The bond carrying amount refers to the amount that the issuer record on their balance sheet under the liability section. It is the total of bond par value and unamortized premium or discount.
Bonds issued at discount mean that the issuer receives cash less than the book par value. After the issuing date, the bond value will increase to the par value at the end of the maturity date. If the company settles on the maturity date, there will be no gain or loss as the carrying amount is equal to the par value.
At some point in time before the majority date, the bond’s carry amount is not yet reached the par value. So if the issuer wants to pay off the bond, they have to pay the price more than the carrying amount which results in a loss.
When bonds carrying amount is lower than the market value, it means company spends more than the book value to buy back the bonds.
The journal entry is debiting bonds payable, loss on extinguishment of debt, and credit cash paid.
|Loss on Extinguishment of debt||$$$|
Gain on Extinguishment of Debt
Gain on Extinguishment of debt happens when the carrying amount of the bond is higher than the fair value. The issuer needs to pay off using the fair value to reverse the carrying amount which is higher.
In simple words, the company uses the amount of cash to buy back the bonds which have a higher carry amount on balance sheet. It is highly likely to happen on a bond that sells at a premium.
Premium bonds are the extra amount that issuers charge to the investors as they provide a higher interest rate compared to the market. The company has to amortize the premium balance to bond face value. The bond balance will keep decreasing to the par value on the maturity date.
Before the maturity date, bond value will not yet reach par value. It is still higher than this amount.
When bond carrying amount is more than the market value, it means company spends less than the book value to buy back the bonds.
The journal entry is debiting bonds payable and credit cash paid, gain on extinguishment of debt.
|Gain on Extinguishment of debt||$$$|