The Dark Side of Debt-Free
Finally, that wonderful day comes when the debt is paid off. You may not think of it as a thorny accounting situation — and it isn’t, as long as the debt is held to maturity. In other words, there’s no problem as long as the debtor doesn’t pay it off early.
However, if an event occurs that leads a company to pay off debt (whether a note or a bond) early, the company may have to figure gain or loss on the transaction. The regular amortization journal entries did not zero out any discount or premium on the debt payable.
If the acquisition price is greater than the carrying value of the debt, there’s a loss on extinguishment. A gain occurs if the acquisition price is less than the carrying value.
A good example of how gain may occur is the accounting for callable debt, which means the issuer can pay off the debt before the maturity date. In the business world, this scenario happens if the interest rate falls and it’s possible to reissue the debt at 6 percent. This situation is often referred to as the debt being callable.
Need an example on the accounting for the early extinguishment of debt?
Imagine that a company repurchases a note payable for $104,000 whose face value was $100,000. It was issued at a discount, of which $3,000 isn’t yet amortized at the date of repurchase. Gain or loss on the transaction?
Remember that a business can remove the debt from its balance sheet only if one of the following occurs:
The debtor pays the creditor and is totally relieved of the obligation. For example, the debt was for $10,000 and the debtor paid the creditor the full $10,000 plus all required interest.
The creditor legally releases the debtor from any further obligation. For example, the creditor agrees to cancel a portion of the debt.
Troubled debt restructuring is an advanced financial accounting topic. This takes place when there are market or legal reasons why terms of the debt are modified. A good example of this when the financial institution lowers the interest rate they are charging the business for the debt.
On the personal side, you may have had friends participating in a residential short sale, which means a house is sold for less than the mortgage debt still owed on it with the lender taking a loss on the sale.
Accounting Glossary
accounting equation
The equation Assets = Liabilities + Equity, which demonstrates the two-sided nature of accounting and is useful for explaining the concept of double-entry accounting (or double-entry bookkeeping).
Accounting Glossary
accounting period
The time period for which financial information is being tracked in a business, such as monthly, quarterly, or annually.
Accounting Glossary
accounts receivable
An account that records the amounts that customers owe to a business.
Accounting Glossary
adjusting entry
A correction made to a bookkeeping account that adjusts for accounting errors or other necessary changes at the end of the accounting period.
Accounting Glossary
cash flows
Used to describe the source or sources of cash or how cash is used.
Accounting Glossary
Chart of Accounts
A list of all the accounts used by a business, including what types of transactions go into each account.
Accounting Glossary
debit
An accounting entry that increases an asset or expense account, and decreases a liability or income account.
Accounting Glossary
dividends
A portion of a company’s profits paid by share of common stock on a quarterly or annual basis.
Accounting Glossary
FASB
Financial Accounting Standards Board. FASB is the highest-ranking authority in the private (non-government) sector of the U.S. for making pronouncements on GAAP and for keeping accounting standards up-to-date.
Accounting Glossary
Federal Unemployment Tax
In the U.S., the fund that used to be known simply as Unemployment. Employers contribute to the fund, and states also collect taxes to fill their unemployment fund reserves. (The acronym FUTA means Federal Unemployment Tax Act.)
Accounting Glossary
fidelity bonds
A type of insurance — typically carried by employers for their employees — that helps guard against theft and reduce the risk of loss.
Accounting Glossary
FIFO
First-in, first-out. A method for costs of goods sold in which a business charges out product costs to cost of goods sold expense in the chronological order in which the goods were acquired.
Accounting Glossary
fungible
Describes a product that is interchangeable and virtually indistinguishable from another product.
Accounting Glossary
General Ledger
A summary of all of a business’s accounts and transactions.
Accounting Glossary
IASB
International Accounting Standards Board. The IASB (based in London) is the main authoritative accounting standards setter outside the U.S.
Accounting Glossary
Journals
The location in which bookkeepers keep records (in chronological order) of daily company transactions.
Accounting Glossary
LIFO
Last-in, first-out. A method for costs of goods sold that selects the last item you purchased first, and then works backward until you have the total cost for the total number of units sold during the period.
Accounting Glossary
LLP
Limited liability partnership. A legal structure that state laws offer to qualified professionals in which all the partners have limited liability.
Accounting Glossary
PC
Professional corporation. A legal structure that state laws offer to qualified professionals who otherwise would have to operate as an unlimited partnership liability.
Accounting Glossary
petty cash
A cash account that businesses keep on hand for unexpected expenses.
Accounting Glossary
revenue
Monies that are collected in the process of selling a company’s goods and services.
Accounting Glossary
salvage value
The amount that an asset is worth after it has been fully depreciated.
Accounting Glossary
statement of cash flows
A financial statement that summarizes a business’s cash inflows and outflows during an accounting period.
Accounting Glossary
transactions
Economic exchanges between a business or other entity and the parties with which the entity interacts and makes deals.
Accounting Glossary
worker’s compensation insurance
A type of insurance carried by employers that covers its employees in case they are injured on the job.
