ASC 470-50: Accounting for Debt Modifications & Extinguishments

When a company alters the terms of its existing debt, it must follow specific accounting rules. The Financial Accounting Standards Board (FASB) provides this guidance in its Accounting Standards Codification (ASC) Topic 470-50, Debt—Modifications and Extinguishments. This standard dictates how a borrower must account for changes to its debt agreements, such as loans, notes, or bonds. This guidance helps a company analyze whether a change to a debt instrument is a continuation of the old loan, known as a modification, or if the change is so significant that it effectively closes out the old loan and starts a new one, which is called an extinguishment. The accounting treatment for a modification differs significantly from that of an extinguishment, making the distinction important for financial reporting.

Scope and Core Concepts of Debt Restructuring

ASC 470-50 applies broadly to all entities that are debtors and have restructured the terms of a debt instrument, including term loans, lines of credit, and bonds. A debt modification occurs when the terms of an existing agreement are altered, but the change is not substantial enough to be considered a termination of that debt. Conversely, a debt extinguishment is the removal of a liability from the balance sheet when changes are so significant that the original debt is considered settled and replaced.

A development in this area was the elimination of the accounting model for Troubled Debt Restructurings (TDRs). Previously, a TDR was a concession granted by a creditor to a borrower experiencing financial difficulty and followed a unique set of accounting rules. With this model now eliminated, restructurings involving borrowers facing financial hardship are evaluated using the same extinguishment or modification framework that applies to all other debt restructurings under ASC 470-50.

The Extinguishment versus Modification Analysis

The determination of whether a debt restructuring is an extinguishment or a modification hinges on a quantitative assessment known as the “10 percent test.” This test compares the present value of the cash flows of the modified debt with the present value of the remaining cash flows of the original debt. If the difference between these two values is 10 percent or more, the transaction is accounted for as a debt extinguishment; if the difference is less than 10 percent, it is treated as a debt modification.

The first step is to calculate the present value of all cash flows required under the new, modified debt instrument. The second step is to calculate the present value of the remaining cash flows that would have been paid under the original debt instrument. Both present value calculations must use the original debt’s effective interest rate as the discount rate to ensure a valid comparison, which is the rate used to amortize any bond discount, premium, or issuance costs over the life of the original loan.

For example, consider a company with a loan that has a remaining principal of $1,000,000, a five-year term, a 6% stated interest rate, and a 6.5% original effective rate. The company renegotiates the loan to extend the maturity to seven years and reduce the interest rate to 5%. To perform the 10 percent test, the company would first calculate the present value of the new cash flows (seven years of payments at 5%) discounted at the 6.5% effective rate. Next, it would calculate the present value of the original remaining cash flows (five years of payments at 6%) also discounted at the 6.5% effective rate. The absolute difference between these two present values is then divided by the present value of the original remaining cash flows to see if the result is 10% or greater.

Accounting for a Debt Extinguishment

When the 10 percent test indicates an extinguishment, the accounting reflects the termination of the old debt. The company must derecognize, or remove, the carrying value of the original debt from the balance sheet, including the principal amount and any related unamortized premium, discount, or debt issuance costs. A gain or loss on the extinguishment is then calculated and recognized in the income statement. This gain or loss is determined by comparing the debt’s reacquisition price with its net carrying amount.

The reacquisition price is the fair value of the new debt and any fees paid to the creditor. In contrast, any costs paid to third parties, such as legal fees, are expensed as incurred. For example, assume the net carrying amount of the old debt is $990,000 and the fair value of the new debt is $1,020,000. If the company also pays $5,000 in fees to the creditor, the total reacquisition price is $1,025,000. The difference between this reacquisition price and the $990,000 carrying amount results in a loss on extinguishment of $35,000.

Accounting for a Debt Modification

If the 10 percent test results in a modification, the accounting is different. The original debt is not derecognized from the balance sheet, and no gain or loss is recognized. Instead, its terms are adjusted prospectively, and the carrying amount of the original loan is carried forward. Fees paid directly to the creditor are capitalized as an adjustment to the carrying amount of the existing debt and are then amortized into interest expense over the modified loan’s remaining life. In contrast, costs paid to third parties are expensed as incurred.

A new effective interest rate is established based on the modified future cash flows. This rate is the one that equates the present value of the new cash flows with the current carrying amount of the debt, after adjusting for any fees paid to the creditor. For instance, if the carrying amount of a loan is $500,000 and the company pays a $10,000 modification fee to the lender, the new carrying amount becomes $510,000. The company would then determine the new effective interest rate that amortizes this $510,000 balance to zero over the new term.

Required Financial Statement Disclosures

When a company engages in a debt restructuring, specific disclosures are required in the footnotes to the financial statements to provide important information about the transaction’s financial impact. For a debt extinguishment, the company must provide a qualitative description of the transaction. This includes explaining the reasons for the extinguishment and the general terms of the new debt instrument. The amount of gain or loss recognized on the extinguishment must also be disclosed.

In the case of a debt modification, disclosures also require a qualitative description of the changes, such as alterations to interest rates, maturity dates, or payment amounts. For modifications involving borrowers experiencing financial difficulty, disclosure requirements are more extensive, providing further detail on the nature and financial effects of the restructuring. For all material restructurings, it is also common practice to disclose the carrying amount of the debt both before and after the transaction and, for modifications, information about how capitalized fees are being amortized.