Debt Modification and Extinguishment Accounting

When a company alters the terms of its existing debt, it triggers a specific accounting analysis. This process involves a change to a loan’s interest rate, repayment schedule, or principal amount. The objective is to determine whether the changes are so significant that they create a new loan, or if they merely represent an adjustment to the existing one. Depending on the outcome, the company will either adjust the existing debt on its books (a modification) or remove it entirely and record a new loan (an extinguishment), ensuring the financial impact is properly recognized.

Information Required for Analysis

Before any accounting determination can be made, a company must gather specific data from both the original and new debt agreements. The first piece of information is the carrying amount of the original debt on the modification date, which includes the face value adjusted for any unamortized premium, discount, or issuance costs. A company must also compile the complete terms for both the original and new debt, along with all associated fees.

This information includes:

• The principal amount, interest rate, payment schedule, and maturity date for the original debt.
• The new principal amount, interest rate, payment schedule, and maturity date for the modified debt.
• Any fees paid to or received from the lender as part of the agreement.
• Any costs paid to external third parties, such as legal or advisory fees.

Modification vs Extinguishment Determination

The process for determining if a debt restructuring is a modification or an extinguishment is guided by a quantitative assessment. The Financial Accounting Standards Board (FASB) issued a proposed update in April 2025 that could introduce a preliminary step. This proposal suggests that certain transactions, like a contemporaneous exchange of cash and new debt to multiple creditors, would be an extinguishment without performing the 10% test. For other transactions, the existing guidance applies.

The core of the analysis is determining if the changes are “substantially different” using a quantitative test. This “10% test” compares the present value of the cash flows under the new debt terms to the present value of the remaining cash flows under the original terms. If the difference is 10% or more, the transaction is a debt extinguishment; if it is less than 10%, it is a modification.

A key element is the discount rate used to find the present value of both sets of cash flows. The effective interest rate of the original debt must be used for both calculations to ensure a consistent analysis. The cash flows for the new debt include all principal and interest payments, plus any fees paid to or received from the lender. The cash flows for the original instrument are its remaining contractual payments.

For example, consider a loan with a $1,000,000 principal and a 6% original effective interest rate. The company renegotiates to a 5% interest rate and extends the maturity. To perform the 10% test, the company calculates the present value of the original remaining cash flows (three interest payments of $60,000 and a principal payment) using the 6% rate. Next, it calculates the present value of the new cash flows (four interest payments of $50,000 and a principal payment) using the same 6% original rate. If the present value of the new cash flows is 5% less than the present value of the old, the transaction is a debt modification. Accounting standards also note that certain significant qualitative changes, such as adding a substantive conversion option, could also lead to an extinguishment.

Accounting for a Debt Modification

When a transaction is a debt modification, the accounting treatment avoids recognizing a gain or loss. The existing debt liability remains on the balance sheet, but its carrying amount is adjusted. The company establishes a new carrying value for the debt based on the present value of the modified cash flows, discounted at the original effective interest rate.

The treatment of fees is specific under modification accounting. Fees paid directly to the lender are capitalized, meaning they are added to the carrying amount of the debt. These costs are then amortized over the remaining life of the modified debt as an adjustment to interest expense. In contrast, fees paid to third parties, such as legal advisors, are expensed as they are incurred.

Following the adjustment to the debt’s carrying amount, a new effective interest rate must be calculated. This new rate equates the revised carrying amount of the debt, including capitalized lender fees, with the new future cash payments. This rate will then be used to recognize interest expense in subsequent periods for the remainder of the loan’s term.

For example, if a loan’s carrying amount is adjusted downward and lender fees of $10,000 are paid, the new carrying amount would be the adjusted value plus the $10,000. Subsequent interest expense entries would use the new effective rate. This rate would likely be different from both the original effective rate and the new stated rate on the loan.

Accounting for a Debt Extinguishment

If the 10% test is met, the transaction is a debt extinguishment, and the accounting is different from a modification. The old debt is considered settled, and a new debt is issued. The original debt must be derecognized, meaning its entire carrying amount is removed from the balance sheet, including any related unamortized premium, discount, or issuance costs.

Simultaneously, the new debt instrument is recorded on the balance sheet at its fair value on the date of the exchange. Fair value is the price that would be paid to transfer a liability in an orderly transaction between market participants. This establishes the initial carrying amount of the new liability for future interest expense calculations.

An outcome of extinguishment accounting is the recognition of a gain or loss on the income statement. This is calculated as the difference between the carrying amount of the extinguished debt and the fair value of the new debt. All fees paid, including to the lender and third parties, are included in this calculation, reducing any gain or increasing any loss.

For instance, a company extinguishes debt with a carrying amount of $980,000. It issues new debt with a fair value of $950,000 and pays $15,000 in fees to the lender and $5,000 to lawyers. The total reacquisition price is the fair value of the new debt plus all fees, or $970,000. The gain on extinguishment would be $10,000, calculated as the old carrying amount of $980,000 less the reacquisition price of $970,000.