9.3 Extinguishment Accounting

Under ASC 470-50-40-2, any difference between the debt’s reacquisition price (see the next section) and its net carrying amount (see Section 9.3.1.3) is recognized as an extinguishment gain or loss in earnings. It is not appropriate to defer recognition of such gain or loss to a future period. For example, a debtor cannot amortize the gain or loss over the remaining life of the extinguished debt or replacement debt issued to fund the proceeds of the extinguishment.

In addition, ASC 470-50-40-2 requires entities to identify debt extinguishment gains and losses as a separate item. Because a debt extinguishment gain or loss is akin to a financing activity, it generally should be classified as part of nonoperating income in the income statement.

The debt’s reacquisition price is the fair value of the consideration transferred to the creditor (e.g., the amount of cash paid or the fair value of any instruments, goods, or services transferred) to extinguish the debt as well as any reacquisition costs (e.g., third-party fees paid). As an exception, the reacquisition price is the fair value of the debt if common or preferred stock is used to settle the debt and the fair value of the debt is more clearly evident than the fair value of the stock (see Section 9.3.3). If the debtor issues new debt to the same creditor to settle debt or modifies existing debt, it should evaluate the transaction under the guidance on debt modifications and exchanges in ASC 470-50 (see Chapter 10). If the modification or exchange is accounted for as an extinguishment, the reacquisition price is the fair value of the new debt adjusted for the fair value of any other consideration paid to, or received from, the creditor and issuance costs (see Section 10.4.2).

If a debt extinguishment is part of a larger transaction that includes elements not related to the debt extinguishment, those other elements should be given separate accounting recognition. If a portion of the consideration paid by the debtor is related to an asset acquisition or the repurchase of the debtor’s outstanding equity shares, for example, that portion does not form part of the debt’s reacquisition price. In this scenario, the consideration paid is allocated between the debt extinguishment and the other items purchased in the transaction. Similarly, the debtor would need to allocate the consideration paid if it reacquires both debt and outstanding equity shares or contracts on its own equity (e.g., warrants) in the same transaction. The debtor should apply an allocation method, such as relative fair value or a with-and-without method, as appropriate (see Sections 3.4 and 3.5 for analogous guidance).

If an entity extinguishes debt by transferring a noncash asset, the debt’s reacquisition price is the asset’s fair value as of the date of extinguishment. The debt extinguishment gain or loss is calculated on the basis of the difference between the asset’s fair value and the debt’s net carrying amount. The difference between the net carrying amount and the fair value of the asset transferred to extinguish the debt is recognized as a realized gain or loss in earnings. For example, if an entity transferred available-for-sale debt securities to extinguish debt, it would remeasure those securities immediately before the transfer and then reclassify any unrealized gain or loss in OCI to earnings in the same manner as if it sold those securities to third parties. (Note, however, that when noncash financial assets are transferred to extinguish debt, the debtor must ensure that derecognition of those assets is appropriate under other applicable GAAP; see also Sections 9.2.3.3 and 9.2.4.2.)

The gain or loss on an extinguishment of debt in which the debtor transfers its own equity shares is generally calculated on the basis of a comparison of the fair value of the equity shares transferred and the net carrying amount of the debt; however, there is one exception that applies in certain situations (see Section 9.3.3 for further discussion).

The net carrying amount of debt that is accounted for at amortized cost equals the amount due at maturity adjusted for any remaining unamortized premium or discount or debt issuance costs as of the extinguishment date as determined by using the interest method. It includes any accrued interest to the extinguishment date even if such interest is forfeited upon settlement (i.e., accrued interest is not reversed). Further, the net carrying amount reflects any adjustment to the debt resulting from the application of fair value hedge accounting (see Section 14.2.1.2). If debt contains a bifurcated embedded derivative (e.g., a bifurcated conversion option or bifurcated share-settled put option; see Chapter 8), an entity remeasures the embedded derivative to fair value as of the extinguishment date and includes such fair value in the net carrying amount before calculating the extinguishment gain or loss. Special considerations are necessary if the debt is accounted for at fair value under the fair value option (see Section 9.3.2).

If a debtor extinguishes convertible debt that does not contain a separately recognized equity component, the extinguishment gain or loss is calculated as the difference between the debt’s net carrying amount (including the fair value of any bifurcated embedded derivative as of the extinguishment date) and the reacquisition price (see Section 9.3.1.2). This accounting applies even if the debtor pays an amount significantly in excess of the debt’s net carrying amount as a result of the fair value of the conversion feature.

A convertible debt instrument will have a separately recognized equity component only in the following circumstances:

• The convertible debt instrument was issued at a substantial premium (see Section 7.6.3).
• The convertible debt instrument was modified or exchanged in a transaction that did not result in an extinguishment but increased the fair value of the embedded conversion option (Section 10.4.3).
• The embedded conversion option in a convertible debt instrument was previously reclassified from a derivative liability to equity (Section 8.5.4.3).

In these circumstances, any extinguishment of the convertible debt instrument includes settlement of both the liability for the convertible debt instrument and the separate amount recognized in equity. Therefore, the total reacquisition price must be allocated between these two components.

If the equity component is the result of the reclassification of an embedded conversion feature from a derivative liability to equity, the amount allocated to the reacquisition of the equity component equals the fair value of the conversion option on the date of the extinguishment, in accordance with ASC 815-15-40-4. Although not specifically addressed in the Codification, if the separately recognized equity component resulted from (1) a modification or exchange that increased the fair value of the conversion option or (2) a substantial issuance premium, a portion of the reacquisition price equal to the amount that was previously recognized for that separate equity component is allocated to the reacquisition of such equity component, and the remaining portion of the reacquisition price is allocated to the liability for the convertible debt instrument.1 The amount allocated to the equity component does not result in a gain or loss because ASC 260-10-S99-2 does not apply to the settlement of the equity component if the convertible debt instrument permitted conversion into the issuer’s common stock. However, the amount allocated to the equity component will indirectly affect the extinguishment gain or loss since it reduces the amount allocated to the extinguished debt component.

The guidance in ASC 470-50-40-2 has generally been interpreted to suggest that there is a rebuttable assumption that debt extinguishment “gains” in transactions with related parties (e.g., the investor is a significant shareholder, part of management, or an affiliate of the issuer) should be recognized as equity contributions (i.e., in APIC and not in earnings) unless there is substantive evidence that the entity would have obtained the same economic outcome in an arm’s-length transaction. For example, if an entity’s outstanding debt is forgiven by a related party, the credit recognized to reflect the forgiveness should be reflected as an addition to equity. However, the guidance in ASC 470-50-40-2 does not apply when debt issued to a related party is settled in accordance with its contractual terms. In these situations, if there is an equity transaction associated with the debt issuance, it would be recognized upon issuance, not settlement, of the debt.

If a subsidiary’s debt is forgiven by its parent for no consideration, the subsidiary should record that forgiveness as a capital contribution from its parent. Evidence that an extinguishment transaction was at arm’s length includes a debt settlement that involves related parties and significant third-party investors that receive the same settlement terms (e.g., same reacquisition price).

Generally, debt extinguishment losses in transactions with related parties are recognized in earnings. However, a loss may be recognized in equity as an in-substance dividend if it represents a pro rata distribution to all shareholders.

In his remarks at the 2010 AICPA Conference on Current SEC and PCAOB Developments, then SEC Professional Accounting Fellow Sagar Teotia addressed how the SEC staff expects issuers to determine whether an extinguishment transaction with a related party represents a capital transaction. He noted that “the staff has not formed any bright line views on these types of transactions and analyzes these questions individually on a specific facts and circumstances basis.” Mr. Teotia provided the following example (footnote omitted):

Further, Mr. Teotia provided the following examples of questions the SEC staff has asked registrants related to this analysis:

Mr. Teotia emphasized that the “staff believes that a full analysis is required in assessing the substance of these types of transactions. Accordingly, the staff would expect that registrants consider all of the facts and circumstances and related party relationships in a particular transaction when making its accounting assessment.”

If another member of a consolidated group to which the entity belongs acquires the entity’s debt from a third party, the debt is accounted for as being extinguished in any consolidated financial statements that include both entities. For example, if a parent acquires debt issued by its subsidiary from a third party, the debt is accounted for as if it had been extinguished in the parent’s consolidated financial statements. Note, however, that the debt would still be included in separate financial statements of the debtor if those financial statements do not include the consolidation of the entity that acquired the debt.

If a related party (e.g., a significant shareholder) repays an entity’s debt and thereby relieves the entity of its obligation to pay it, the entity should record the transaction as a capital contribution from the related party.