Extinguishment of Debt
The term extinguishment of debt refers to the process of removing this liability from the balance sheet of a company. Normally, this occurs as bonds reach their maturity date and holders are paid the face value of the security. Early extinguishment occurs when debt is reacquired by the company, or when in-substance defeasance is arranged.
Issuing long-term bonds represents an important source of financing for many companies. When issued, they typically pay holders of the security a rate of interest known as the coupon rate. At maturity, holders are entitled to the face value of the bond.
Oftentimes, companies establish what is known as a sinking fund whereby debt is repaid by placing money into this fund each year in installments known as amortization. When the bond matures, the money from the sinking fund is used to repay investors. The debt is said to be extinguished at the completion of this process.
Debt is considered extinguished when there is no further obligation to an external party to transfer economic benefits. At this point, the obligation can be removed from the balance sheet. If a company retires debt before the scheduled maturity date, the transaction is referred to as the early extinguishment of debt. Typically, this happens via two mechanisms:
- Reacquisition: a company can buy back its debt on the open market and hold it as treasury bonds, or if the bonds have a call feature, the company can exercise that option.
- In-Substance Defeasance: instead of creating a sinking fund, the company purchases securities and places them into an irrevocable trust. The principal and interest of those securities is then used to pay off the principal and interest of the bonds issued by the company.
Accounting rules require companies to report the gain or loss that occurs with early extinguishment of debt. In the past, this was reported as an extraordinary item. FASB ASC 470-50-45: Debt-Modifications and Extinguishments-Other Presentation Matters now states they are only classified as an extraordinary item if the event is considered both unusual in nature and infrequent in occurrence.