Debt extinguishment definition
/What is Debt Extinguishment?
Debt extinguishment occurs when a debt instrument is terminated. This occurs when the borrower repays the lender or bonds are retired by the issuer. Extinguishment may not involve full repayment of a debt; the two parties may agree on a lesser repayment amount if the borrower is unable to make a full repayment of the amount owed.
When Does a Debt Extinguishment Occur?
A debt extinguishment can occur under any of the following circumstances:
Full debt repayment. When the borrower makes the final payment on a debt, it is extinguished because the entire obligation is fulfilled. The lender no longer has any claim against the borrower.
Early debt retirement. Borrowers sometimes extinguish debt before its maturity date by repurchasing or paying it off. This may occur if the borrower has excess cash, access to better financing terms, or if interest rates have fallen since the debt was issued, making refinancing more attractive.
Debt restructuring. If a borrower is in financial distress, it may negotiate with creditors to restructure the terms of the debt, which can include partial forgiveness of the debt. If a portion of the debt is forgiven, that forgiven portion is extinguished.
Conversion to equity. Debt holders may convert their convertible debt into equity in the company. This transaction extinguishes the debt as it’s replaced with an equity interest in the issuer.
Debt extinguishment. When a company goes through bankruptcy, certain debts may be discharged as part of the proceedings, meaning the borrower is no longer legally obligated to repay them.
Each of these circumstances involves removing the debt from the borrower’s financial statements, often resulting in a gain or loss on the transaction depending on the carrying amount of the debt compared to the repayment or settlement amount.
Accounting for a Debt Extinguishment
The exact outcome of a debt extinguishment will vary, depending on the terms that the parties agree upon. It is likely that the lender will be forced to record a loss. However, the borrower might end up recording a gain, if this party pays less to settle a debt than the amount of the original obligation.