Introduction to early debt extinguishment

October 12, 2014

Corporate bonds are bought and sold in secondary financial markets around the world. This begs the question – can a company purchase its own bonds just like it can purchase its own stock?

1. Bond markets

As we have described elsewhere, a bond sells at a premium or discount whenever the stated rate of interest is different than the interest rate demanded by the market for that bond’s characteristics. Because the bonds are available for anyone to purchase, companies have the option of repurchasing their own bonds from secondary market sellers. This is referred to as debt retirement or debt extinguishment. Generally, the bond’s price will be different than its carrying value, and that results in the recognition of a gain or loss.

2. Accounting treatment

When a company purchases its own bonds, the related liability is removed from the balance sheet. In addition, any recorded premium or discount must be written off. The gain or loss on extinguishment, then, is the difference between the price paid for the bond on the open market and the face value of the liability less any discount or plus any premium.

Bond retirement can be an effective way to reduce future debt payments, especially if interest rates have risen substantially since issuance of the bond. To illustrate, imagine a bond that is originally issued at a premium when the market interest rate is 5% and the stated interest rate for the bond is 8%. If interest rates rise to 10% and the bond now sells on the market at a discount, the company can realize a gain equal to the remaining premium plus the new discount.

3. What happens when a subsidiary buys a parent’s bond?

Under U.S. GAAP, parent and subsidiary results should be consolidated and reported together, as if everything was combined in a single entity. If a subsidiary purchases the parent’s bonds on the open market – or vice versa – the consolidated entity should report a similar bond extinguishment gain or loss on its income statement for the period.

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