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Chapter14: Bonds and Long-Term Notes

Part C: Debt Retired Early, Convertible into Stock, or Providing an Option to Buy Stock

p. 769

Early Extinguishment of Debt

As we saw in the previous section, debt paid in installments is systematically retired over the term to maturity so that at the designated maturity date the outstanding balance is zero. On the other hand, when a maturity amount is specified as in our earlier illustrations, any discount or premium has been systematically reduced to zero as of the maturity date and the debt is retired simply by paying the maturity amount. Sometimes, though, companies choose to retire debt before its scheduled maturity. In that case, a gain or a loss may result.

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   Earlier we noted that a call feature accompanies most bonds to protect the issuer against declining interest rates. Even when bonds are not callable, the issuing company can retire bonds early by purchasing them on the open market. Regardless of the method, when debt of any type is retired prior to its scheduled maturity date, the transaction is referred to as early extinguishment of debt debt is retired prior to its scheduled maturity date..

   To record the extinguishment, the account balances pertinent to the debt obviously must be removed from the books. Of course cash is credited for the amount paid—the call price or market price. The difference between the carrying amount of the debt and the reacquisition price represents either a gain or a loss on the early extinguishment of debt. When the debt is retired for less than carrying value, the debtor is in a favorable position and records a gain. The opposite occurs for a loss. Let's continue an earlier example to illustrate the retirement of debt prior to its scheduled maturity (Illustration 14-5):

Any difference between the outstanding debt and the amount paid to retire that debt represents either a gain or a loss.

ILLUSTRATION 14-5
Early Extinguishment of Debt

On January 1, 2012, Masterwear Industries called its $700,000, 12% bonds when their carrying amount was $676,288. The indenture specified a call price of $685,000. The bonds were issued previously at a price to yield 14%.

Bonds payable (face amount) ....................................................

700,000

Loss on early extinguishment9 ($685,000 − 676,288) ................

8,712

   Discount on bonds payable ($700,000 − 676,288) .................

23,712

   Cash (call price) .....................................................................

685,000

   For instance, in its income statement for the second quarter of 2009, Momentive Performance Materials Inc., a premier specialty metals company, reported a $179 million gain on the early extinguishment of debt.

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