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The accounting for debt instruments involves various stages. Initially, it begins when a company obtains debt from multiple sources. When holding that debt, the company will perform several accounting treatments. The final stage during this process is the extinguishment of debt. This process may give rise to gains or losses. Before discussing that, it is crucial to understand what debt extinguishment means.
What is the Extinguishment of Debt?
The extinguishment of debt refers to the process of getting rid of any liabilities related to a debt instrument. Usually, it occurs when a company repays its lenders. However, companies may also extinguish their debts through other means. The extinguishment of debt is the final stage within a cycle for debt instruments.
In the extinguishment of debt, a company terminates a debt instrument. For bonds, it involves repaying the holders the face value of the underlying bond. Usually, this process includes repaying the lender the full amount they paid originally. However, debt extinguishment may also involve a lower repayment amount. For that, both parties must agree to the lesser payment than agreed initially.
What is a Gain or Loss on Extinguishment of Debt?
In most cases, the extinguishment of debt does not cause a gain or loss. However, it may occur in some cases. For example, when the net carrying amount of the debt and the settlement or repurchase price differ. The former value comes from the amount payable at the maturity of the debt. However, it will include deductions like unamortized discounts, premiums, and issuance costs.
The net carrying amount for the debt may exceed or be lower than the settlement price. In these cases, a gain or loss will happen on the extinguishment of debt. If the net carrying amount exceeds the repurchase price, it is a loss. If it is lower, it falls under a gain. Companies must account for gains or losses on extinguishment of debt accordingly.
What is the journal entry for Extinguishment of Debt?
The journal entry for the extinguishment of debt is the opposite of when a company obtains it. When a company issues debt instruments, it records a liability in its books. Sometimes, it may also involve taking a loan from a lender. In either case, companies must create an obligation to record the liability in their accounts.
The accounting treatment for the extinguishment of debt is the opposite of the initial treatment. In this case, companies will eradicate the liability from their books. In exchange, they usually record a decrease in assets. If the process involves any gains or losses, companies will account for those accordingly. The primary journal entry for extinguishment of debt is as follows.
| Dr | Liability (Extinguishment of debt) |
| Cr | Cash or bank |
If there is a loss in the process, the journal entry will include the following.
| Dr | Liability (Extinguishment of debt) |
| Dr | Loss on extinguishment of debt |
| Cr | Cash or bank |
For gains, the journal entry for the extinguishment of debt will involve the following treatment.
| Dr | Liability (Extinguishment of debt) |
| Cr | Gain on extinguishment of debt |
| Cr | Cash or bank |
Example
A company, Red Co., issues bonds to various lenders. In exchange, the company receives $20,000 in finance. Red Co. promises to repay bondholders at maturity after five years. It also promises them a coupon payment based on a 5% rate. After five years, Red Co. records the extinguishment of debt through cash as follows.
| Dr | Bonds | $20,000 |
| Cr | Cash | $20,000 |
Conclusion
When companies repay debt providers, it falls under the extinguishment of debt. This process occurs when a debt instrument reaches its maturity. In some cases, it will also cause a gain or loss on the extinguishment of debt. Companies must account for these accordingly. The journal entries for extinguishment of debt reflect losses and gains as well.
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