1. ACTUAL RETIREMENTS
Bonds may be retired by the issuer prior to the maturity date of the bonds. This may occur pursuant to a provision in the bond indenture allowing the issuer to call the bonds at a date prior to their maturity or it may occur by the issuer repurchasing the bonds on the market. When the bonds are retired pursuant to a call provision in the bond indenture,
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the issuer typically is required to pay in addition to the face amount of the bonds a premium to the holders of the bonds to compensate them for the early retirement of the bonds since the issuer will normally exercise the right to call the bonds only when the market interest rates have fallen to a level below the market rate at the time of issuance.
If the bonds are purchased in the market, the amount paid to retire the bonds will depend on the market price of the bonds at that time, which may be greater or less than the face amount of the bonds.
When bonds are retired prior to their maturity, the first step in accounting for the retirement is for the issuer to record any accrued but unpaid interest on the bonds as of the date of retirement and to record amortization of any bond discount or premium for the period through the date of retirement. Similarly, the amortization of bond issue costs should be brought current to the date of retirement. The difference between (1) the amount paid to retire the bonds (including any premium paid pursuant to a call provision) and (2) the carrying amount of the bonds, including unamortized bond discount or premium and bond issue costs, as of the date of retirement is the gain or loss that is recognized as the result of the retirement of the bonds.
Assume, for example, that a $10,000,000 bond issue is retired prior to its scheduled maturity date. At the time of retirement, there is unamortized bond premium of $300,000 on the bonds and unamortized
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bond issue costs of $100,000. The issuer pays a call premium of 5% of the face value of the bonds in order to retire the bonds. The carrying amount of the bonds at the date of retirement is $10,200,000 (the $10,000,000 face value of the bonds plus the $300,000 premium and less the $100,000 of bond issue costs). The amount paid to retire the bonds is $10,500,000, the face value of the bonds plus the 5% call premium. The issuer has thus realized a loss on retirement of the bonds in the amount of $300,000. Previously, the gain or loss on early retirement of debt was reported separately as an extraordinary item (net of any tax effect) in the income statement in accordance with FASB Statement No. 4.
That Statement was repealed by FASB Statement No. 145 and the gain or loss on early retirement of the debt is now included as part of the income from continuing operations (see Chapter 17). The journal entry to record the early retirement of debt described above would be as follows:
Bonds Payable $10,000,000 Premium on Bonds Payable $ 300,000 Loss on Retirement of Bonds $ 300,000
Bond Issue Costs $ 100,000
Cash $10,500,000
The same accounting treatment applies to the retirement of the old bonds even if a new issue of bonds presumably bearing a lower coupon interest rate than the old bonds is used to generate the funds necessary to retire the old bonds (often referred
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to as a refunding). Arguments have been made that the loss on retirement should be deferred and amortized over the remaining term of the old bonds or the term of the new bonds. These arguments have been rejected and the loss (or gain) on the retirement is not deferred and amortized over the life of the new bond issue (or the remaining life of the old bond issue) but is reported in full at the time of retirement.
2. IN–SUBSTANCE DEFEASANCE
At one time, the FASB provided that a retirement of debt could result for accounting purposes from an “in-substance defeasance.” An in-substance defeasance occurred when assets that would generate sufficient cash flow to make all future payments on the outstanding debt were placed in a trust for the purpose of making future payments on the debt and certain requirements were met.
ASC 405-20-40-1 now provides that a liability can be treated as extinguished (also referred to as “derecognizing” the liability) only when one of the following conditions is met:
1. The debtor pays the creditor and is relieved from its obligations under the liability. In addition to actually paying the creditor, the creditor is deemed paid if the debtor purchases its outstanding debt securities regardless of whether the securities are actually cancelled. Thus where a company has publicly traded debt securities
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outstanding, it can purchase some or all of the securities in the market and be treated as having paid off the debt regardless of whether the securities are formally retired or cancelled.
2. The debtor is legally released from being the primary obligor on the liability either by the creditor or through judicial process. Where a “nonrecourse” debt is assumed by a third party as part of the sale of the assets that serves as the collateral for the debt, this will be treated as a legal release of the seller/debtor.
Note that these rules for extinguishing liabilities apply to all liabilities, not just formal debt securities.