Early extinguishment of debt occurs when the issuer of debt recalls the securities prior to their scheduled maturity date. This action is usually taken when the market rate of interest has dropped below the rate being paid on the debt. By recalling the debt and reissuing it at the current market rate, the issuer can reduce its interest expense.
When a borrower extinguishes a debt, the difference between the net carrying amount of the debt and the price at which the debt was settled is recorded separately in the current period in income as a gain or loss. The net carrying amount of the debt is considered to be the amount payable at maturity of the debt, netted against any unamortized discounts, premiums, and costs of issuance.
If there is an exchange or modification of debt that has substantially different terms, treat the exchange as a debt extinguishment. Such an exchange or modification is considered to have occurred when the present value of the cash flows of the new debt instrument vary by at least 10% from the present value of the original debt instrument. When determining present value for this calculation, the discount rate is the effective interest rate used for the original debt instrument. Substantially different terms have also been achieved when:
- The change in the fair value of an embedded conversion option is at least 10% of the carrying amount of the original debt instrument; or
- The debt modification either adds or eliminates a substantive conversion option
If a debt extinguishment involves the payment of fees between the debtor and creditor, associate the fees with the extinguishment of the old debt instrument, so they are included in the calculation of any gains or losses from that extinguishment.