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The Dark Side of Debt-Free

If a company pays off a debt (whether a note or a bond) early, the company must determine whether a gain or loss was incurred on the transaction. (Paying off a debt early is also referred to as debt extinguishment.) With an early payoff, any unamortized discount or premium on the debt payable is removed from the books.

Because the debt is removed, any remaining discount or premium related to the debt should also be removed. This transaction may generate a gain or loss.

When computing a gain or loss related to an early payoff, keep these points in mind:

  • The liability is always debited (reduced) for the face amount of the debt.

  • Cash is credited (reduced) for the amount paid to remove the debt.

  • An unamortized discount is credited to adjust the remaining balance to zero.

  • After you post the first three entries, consider the remaining amount you need in the journal entry to balance debits and credits. If you need a debit, it’s a loss on bond extinguishment. A credit entry would be posted as a gain.

Imagine that a company repurchases a note payable for $104,000; the face value is $100,000. It was issued at a discount, and $3,000 of the discount isn’t yet amortized at the date of repurchase. Here’s the journal entry:

  • Debit bond payable $100,000 and loss on bond extinguishment $7,000

  • Credit cash (paid to lender) $104,000 and discount on bond payable $3,000

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.

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