FAR · Select balance sheet accounts · 6 practice questions
Debt Modification vs. Extinguishment: 10% Test and Fees
For same-lender changes, include creditor fees but exclude third-party fees in the 10% present-value test. Follow the steps below to classify the change, handle fees, and calculate any extinguishment gain or loss.
Try one first
Hint
Start by deciding whether the 10% test leads to modification or extinguishment. Then separate fees paid to the creditor from fees paid to outside third parties.
Answer D. The present value of the revised cash flows (including the lender fee) is 111% of the original remaining PV, which exceeds the 10% threshold in ASC 470-50 and requires extinguishment accounting. Under extinguishment, amounts paid to the creditor are part of the reacquisition price and affect the gain or loss, whereas third-party costs of obtaining the new borrowing (such as outside attorney fees) are capitalized as debt issuance costs of the new debt and amortized.
Why not A: This combines the treatment for a non‑substantial modification with an outcome that actually meets the extinguishment threshold. Because the 10% test is exceeded, the transaction is an extinguishment, so the lender fee is part of the reacquisition price and outside attorney fees are capitalized to the new borrowing rather than expensed against the old debt.
Why not B: This is tempting because the renegotiation was with the same lender, but the 10% PV test governs; a 111% result exceeds the 10% threshold so the exchange is an extinguishment. In addition, third-party legal fees are not typically deferred as part of the old debt in a modification scenario.
Why not C: Although extinguishment applies, only amounts paid to the creditor are included in the reacquisition calculation and affect the gain or loss. Third-party attorney fees are costs of issuing the new debt and are capitalized (and subsequently amortized), not charged to earnings immediately.
Step by step
- Use the original interest rate
For a same-lender change with no other extinguishment triggers, discount the original and revised remaining cash flows at the original effective interest rate.
- Include only creditor fees
North Pier renegotiates with its bank: original PV is $5,000,000 and revised PV before fees is $5,430,000. Add its $40,000 bank fee, but exclude its $70,000 outside legal fee.
- Apply the 10% cutoff
North Pier's test is ($5,470,000 - $5,000,000) / $5,000,000 = 9.4%, so it is a modification. A difference of at least 10%, upward or downward, requires extinguishment.
- Keep modified debt on the books
North Pier reduces the note's carrying amount by the $40,000 lender fee and expenses the $70,000 legal fee. No extinguishment gain or loss arises; existing unamortized issuance costs continue to be amortized over the revised term.
- Find extinguished debt's carrying amount
If the test requires extinguishment, net carrying amount = face + unamortized premium - unamortized discount - unamortized issuance costs. Use balances after recording amortization through the extinguishment date.
- Separate retirement and borrowing costs
Reacquisition price includes payments to retire the old debt, creditor fees, and direct extinguishment costs, but excludes accrued interest. Third-party costs of issuing replacement debt are capitalized as issuance costs of the new debt.
- Recognize the difference now
Reacquisition price - net carrying amount = extinguishment loss when positive and gain when negative. Recognize the gain or loss in current earnings.
Key points
- Remember: A lender fee can trigger extinguishment; an outside legal fee cannot enter the 10% test.
- Do not round a 9.6% change up to 10%.
- A payment below face value can still create an extinguishment loss.
- A redemption quote of 101 means 101% of face value, not carrying amount.
How the exam traps you
- Adding outside legal fees to the 10% test. Include net fees paid to the creditor; exclude third-party fees.
- Comparing the retirement payment with face value. Use net carrying amount, including unamortized premium, discount, and issuance costs.
- Including accrued interest in the retirement price. Record accrued interest separately; it does not affect the extinguishment gain or loss.
Question 2
Hint
Focus on the event that actually ends the debtor's legal obligation, not just the event that makes repayment likely.
Answer A. Under U.S. GAAP, a liability is derecognized only when the obligor's legal responsibility for the obligation is extinguished (for example, by repayment or a legal release). Simply setting aside cash or securities in an irrevocable trust, even if sufficient to pay the bonds, does not remove the liability if the company remains legally obligated. Therefore Alder should remove the bond liability only when the debt is legally extinguished.
Why not B: This distractor appeals because putting assets aside feels like the debt has been taken care of (economic or in-substance defeasance). However, under U.S. GAAP derecognition depends on legal extinguishment; without a legal release the liability remains on the balance sheet.
Why not C: This is tempting because funding sufficiency seems practical, but adequacy of trust assets is not the derecognition trigger. The key issue is whether the debtor's legal obligation has been extinguished.
Why not D: Candidates may focus on who will actually make the payment, but expected payment by the trust does not eliminate Alder's legal obligation. If Alder remains legally liable through maturity, the liability stays on the balance sheet until legal extinguishment.
Question 3
Hint
Find the debt's net carrying amount at the repurchase date before deciding whether the difference creates a gain or a loss.
Answer C. Compute the debt's net carrying amount: $2,000,000 face + $42,000 unamortized premium − $12,000 unamortized issuance costs = $2,030,000. Ridge paid $2,055,000 to retire debt carried at $2,030,000, resulting in a $25,000 loss on extinguishment. A loss reduces pretax income by $25,000.
Why not A: This reflects comparing the reacquisition price with face plus unamortized premium (2,042,000) but ignoring that unamortized issuance costs reduce the carrying amount. Omitting the $12,000 issuance costs understates the loss.
Why not B: This has the magnitude correct but reverses the sign. Paying more than the carrying amount produces a loss (decrease to pretax income), not a gain.
Why not D: This double-counts the unamortized issuance costs (adding them again after they already reduced the carrying amount). Under GAAP the issuance costs are part of the carrying amount, so they should not be added again to compute the loss.
Question 4
Hint
Start with the amount paid to retire the debt, then compare it with the debt's net carrying amount just before retirement.
Answer D. Reacquisition price = $1,020,000 (1,000,000 × 102%). Net carrying amount immediately before retirement = $1,000,000 − $24,000 − $6,000 = $970,000. Loss on extinguishment = $1,020,000 − $970,000 = $50,000.
Why not A: This equals only the 2% premium paid over face ($20,000). It ignores the fact that the gain or loss is measured against the debt's net carrying amount (which is lower than face because of the unamortized discount and issuance costs), so it understates the loss.
Why not B: This reflects subtracting only the unamortized discount (1,020,000 − (1,000,000 − 24,000) = 44,000) and omits the unamortized debt issuance costs. Under current U.S. GAAP, those costs are a direct deduction from the carrying amount and must be included in the extinguishment calculation.
Why not C: This is the 2% premium plus the unamortized issuance costs (20,000 + 6,000 = 26,000) but ignores the unamortized discount, which also lowers the carrying amount and increases the loss.
Question 5
Hint
Work from the debt's carrying amount on the retirement date, not from face amount or original cash proceeds. Ask what portions of the original discount and issuance costs are still unamortized after 3 years.
Answer A. Compute the carrying amount at the retirement date and compare to the reacquisition price. Original discount = $2,000,000 - (97% × $2,000,000) = $60,000; unamortized discount after 3 years (straight-line over 10 years) = $60,000 - 3×$6,000 = $42,000. Debt issuance costs unamortized = $50,000 - 3×$5,000 = $35,000. Carrying amount = $2,000,000 - $42,000 - $35,000 = $1,923,000. Reacquisition price = 101% × $2,000,000 = $2,020,000, so North recognizes a loss of $97,000.
Why not B: This arises if a candidate amortizes the bond discount but ignores the unamortized debt issuance costs. Using only the discount gives carrying amount = $2,000,000 - $42,000 = $1,958,000 and a loss of $62,000. Under current GAAP, remaining issuance costs reduce the carrying amount and must be included.
Why not C: This error reverses the sign. A gain would occur only if the reacquisition price were less than the carrying amount; here North paid more than carrying amount, producing a loss, not a gain.
Why not D: This results if a candidate amortizes the discount but (incorrectly) treats the full $50,000 of issuance costs as still unamortized. That gives carrying amount = $2,000,000 - $42,000 - $50,000 = $1,908,000 and a loss of $112,000. The mistake is failing to amortize issuance costs through December 31, 20X3.
Question 6
Hint
Focus on the debt's net carrying amount immediately before retirement, and be careful about what is and is not included in the reacquisition price.
Answer A. Carrying amount = face amount less unamortized discount and less unamortized debt issuance costs: $2,000,000 - $50,000 - $10,000 = $1,940,000. Reacquisition price (excluding accrued interest) = 101.5% × $2,000,000 = $2,030,000. Because the reacquisition price exceeds the carrying amount by $90,000, Rowan recognizes a $90,000 loss on extinguishment.
Why not B: Tempting if a candidate includes the unamortized discount but omits the unamortized debt issuance costs when computing carrying amount: $2,000,000 - $50,000 = $1,950,000, and $2,030,000 - $1,950,000 = $80,000, which understates the actual loss.
Why not C: Reflects comparing the reacquisition price only to face value: $2,030,000 - $2,000,000 = $30,000, which ignores both unamortized discount and issuance costs, extinguishment gain or loss is based on reacquisition price versus carrying amount.
Why not D: Incorrect, being called under contract terms does not eliminate gain or loss recognition; the debtor must compare the reacquisition price with the net carrying amount and recognize the difference in current earnings.
Common questions
How do you calculate the 10% test for debt modification?
Divide the absolute difference between revised and original cash-flow present values by the original present value. Use the original effective interest rate and include net creditor fees only in the revised amount.
Are legal fees capitalized in a debt modification?
Third-party legal fees are expensed for a same-lender modification. For an extinguishment, direct retirement costs affect the extinguishment gain or loss, while legal costs of obtaining replacement debt are capitalized as new debt issuance costs.
How do you calculate debt extinguishment gain or loss?
Subtract net carrying amount from reacquisition price, excluding accrued interest. A positive difference is a loss; a negative difference is a gain.
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