Explain the Derecognition of Debt

At maturity, the discount or premium on bonds is fully amortized and the carrying amount is equal to the face value.

Upon repayment, bonds payable are reduced by the carrying amount (face value), and cash is reduced by the same amount. The repayment of bonds will appear in the statement of cash flows as a financing cash outflow.

Derecognition of Debt

In bond redemptions, bonds payable is reduced by the carrying amount of the redeemed bonds. The difference between the cash required to redeem the bonds and the carrying amount of the bonds is a gain or loss on the extinguishment of debt.

Under IFRS, debt issuance costs are part of a bond’s carrying amount. Under US GAAP, however, debt issuance costs are accounted for separately and amortized over the life of the bonds. Any unamortized debt issuance costs are written off at the time of redemption and included in the gain or loss on debt extinguishment.

Gains or losses on the extinguishment of debt are disclosed on the income statement, in a separate line item, whenever the amount is material.

In a statement of cash flows, prepared using the indirect method, net income is adjusted to remove any gain or loss on the extinguishment of debt from operating cash flows. The cash paid to redeem the bonds are classified as cash used for financing activities.

Question 1

Which of the following statements is the least accurate?

1. At redemption, bonds payable is reduced by the carrying amount of the bonds redeemed.
2. At redemption, the cash paid to extinguish a bond plus the gain (loss) on redemption is equal to the carrying amount of the bond.
3. Under US GAAP, unamortized debt issuance costs are not written off at the time of redemption and therefore are not included in the gain or loss on debt extinguishment.

Solution

The correct answer is C.

Under US GAAP, unamortized debt issuance costs are written off at the time of redemption and included in the gain or loss on debt extinguishment.

Question 2

Xtrata issued a 5-year accumulative bond at face value with an annual coupon rate of 5% in 2015. Two years after issuance, the company decided to redeem the bond. Knowing that the current market rate for the bond is 7%, which of the following would be the most appropriate value for the bond?

1. The bond’s face value.
2. The bond’s face value plus the value of the accumulated coupons after discounting for the current market interest rate.
3. The bond’s face value minus the value of the accumulated coupons after discounting for the current market interest rate.

Solution

The correct answer is B.

The fair value of a bond redeemed before its due date is its face value discounted at the current market rate.