EITF 96-19: Debt Modification and Extinguishment

When a company alters the terms of its existing debt, it must determine how to account for the change. The Financial Accounting Standards Board’s (FASB) Emerging Issues Task Force (EITF) provides guidance for these situations. The EITF was formed to resolve new and unusual financial accounting issues that are not explicitly covered by existing Generally Accepted Accounting Principles (GAAP). Its conclusions, known as consensuses, represent authoritative guidance for public companies.

EITF Issue No. 96-19, now primarily codified within ASC 470-50, offers a specific framework for a debtor’s accounting when it modifies or exchanges a debt instrument. The purpose of this guidance is to establish whether the changes are so significant that they effectively terminate the old debt and create a new one. This determination dictates the accounting treatment, distinguishing between a minor “modification” and a more substantial “extinguishment.”

Scope of EITF 96-19

The guidance in EITF 96-19 applies to a wide range of transactions involving changes to debt agreements. This includes direct modifications of debt terms between a debtor and a creditor, such as altering interest rates, extending maturity dates, or changing collateral requirements. It also covers exchanges where a debtor issues a new debt instrument to a creditor in return for the cancellation of an existing one. The rules are applicable to nearly all forms of debt, including notes, bonds, and debentures.

This framework is intended for non-troubled debt situations. A distinction is made for transactions classified as troubled debt restructurings (TDRs). A TDR occurs when a creditor, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider. The guidance for debtors in ASC 470-60 remains in effect.

If the debtor is not experiencing financial difficulty and the creditor is not providing a concession, the transaction falls squarely within the scope of EITF 96-19. This guidance also applies regardless of whether the exchange is with the original creditor or a new one, ensuring a consistent approach to evaluating the substance of the change.

The 10 Percent Cash Flow Test

The accounting treatment is determined by a quantitative assessment known as the “10 percent cash flow test.” This test measures whether the changes to a debt instrument are “substantially different” from the original terms. If the present value of the cash flows under the new terms is at least 10 percent different from the present value of the remaining cash flows under the old terms, the transaction is considered an extinguishment. Otherwise, it is treated as a modification.

The calculation begins by identifying all the cash flows required by the modified debt instrument. This includes all future principal and interest payments as dictated by the new agreement. These calculations generally exclude the impact of changes to the fair value of any embedded conversion options, which are analyzed separately.

Next, the present value of these new cash flows is calculated. A specific discount rate must be used for this calculation: the effective interest rate of the original debt instrument. This rate is the one that was used to amortize any bond premium or discount over the life of the original debt.

A parallel calculation is then performed for the original debt. The present value of the remaining contractual cash flows under the original terms is determined, again using the original effective interest rate as the discount factor. The final step is to compare the two present value figures. If the present value of the new cash flows is more than 10 percent higher or lower than the present value of the old cash flows, the test is met, and extinguishment accounting is required.

This framework may be subject to change. In April 2025, the FASB issued a proposed update that, if finalized, would alter the accounting for certain debt exchanges. Specifically, it could require transactions that involve a contemporaneous exchange of cash between the debtor and creditor to be accounted for as an extinguishment, bypassing the 10 percent cash flow test.

Accounting for an Extinguishment

When the 10 percent cash flow test indicates a substantial modification, the debtor must account for the transaction as a debt extinguishment. The process involves removing the old debt from the balance sheet and recognizing the new debt at its current market value.

The first step is to derecognize the carrying amount of the original debt. This amount includes the face value of the debt, adjusted for any unamortized premium or discount and any unamortized debt issuance costs. Simultaneously, the new debt instrument is recorded on the balance sheet at its fair value on the date of the exchange.

The difference between the carrying amount of the old debt and the fair value of the new debt results in a gain or loss on extinguishment. For example, if the old debt had a carrying amount of $1,000,000 and the new debt issued has a fair value of $950,000, the debtor would recognize a gain of $50,000. This gain or loss is reported in the income statement for the period.

Accounting for a Modification

If the 10 percent cash flow test is not met, the change in terms is not considered substantial, and the transaction is accounted for as a debt modification. The existing carrying amount of the debt is adjusted, and a new effective interest rate is established to account for the revised payment schedule.

Under modification accounting, the debtor does not recognize a gain or loss at the time of the change. The new effective interest rate is the one that equates the present value of the future cash flows under the modified terms with the current carrying amount of the original debt. This effectively reprices the debt on a prospective basis.

Any fees paid directly to the lender as part of the modification are not expensed immediately. Instead, these fees are added to or subtracted from the carrying amount of the debt. The fees, along with any previous unamortized discounts or premiums, are then amortized into interest expense over the remaining life of the modified debt using the newly calculated effective interest rate.

Treatment of Associated Fees and Costs

The accounting for fees and costs incurred in connection with a debt exchange or modification depends on the outcome of the 10 percent cash flow test. The distinction between an extinguishment and a modification dictates whether these costs are recognized immediately or capitalized and amortized over time.

In the case of an extinguishment, the accounting for associated costs is bifurcated. Fees paid directly to the creditor are included in the calculation of the gain or loss on extinguishment. Costs paid to third parties, such as legal or accounting fees, are treated as new debt issuance costs. These third-party costs are capitalized and amortized over the term of the new debt.

If the transaction is accounted for as a modification, the treatment of fees is also bifurcated. Fees paid to third parties are considered period costs and are expensed as they are incurred. Fees paid directly to the lender are capitalized as an adjustment to the carrying amount of the debt and are amortized as part of the new effective interest rate over the modified debt’s remaining term.