Early retirements of debt may occur because a company has generated sufficient cash reserves from operations and wants to stop paying interest on outstanding debt. Or interest rates may have changed, and the company wants to take advantage of more favorable borrowing opportunities; you have probably heard of individuals engaging in this type of strategy when they "refinance" a home loan.

Whether debt is being retired or refinanced in some other way, accounting rules dictate that the retired debt be removed from the books and the difference between the debt's net carrying value and the funds paid to retire the debt be recognized as a gain or loss.

Example

Assume that Cabano Corporation is retiring $200,000 face value of its 6% bonds payable. The last semi-annual interest payment occurred on April 30 and the bonds are being retired on June 30, 2010. The unamortized discount on the bonds on April 30, 2010, was $6,000, and there was a 5-year remaining life on the bonds as of that date. Further, Cabano is paying $210,000, plus accrued interest, to retire the bonds; this "early call" price was stipulated in the original bond covenant.

The first step to account for this bond retirement is to bring the accounting for interest up to date:

Interest Expense (debit): 2,200
Discount on Bonds Payable (credit): 200
Interest Payable (credit): 2,000

Then, the actual bond retirement can be recorded, with the difference between the up-to-date carrying value and the funds utilized recorded as a loss (debit) or gain (credit).

Bonds Payable (debit): 200,000
Interest Payable (debit): 2,000
Loss on Bond Retirement (debit): 15,800
Discount on Bonds Payable (credit): 5,800
Cash (credit): 212,000

Notice that Cabano's loss relates to the fact that it took a lot more cash ($210,000) to pay off the debt than was the debt's carrying value ($200,000 - $5,800 = $194,200).

Practice Question 1

Synergy Company discounts a 7%, 90-day note receivable at the bank prior to the note's maturity date. The bank's interest rate is 7.75%. Which one of the following describes the cash proceeds that Synergy will receive from the bank on the discount date? They will be ______.

I. equal to the discounted present value of the note
II. equal to the maturity value of the note
III. less than the interest expense charged by the bank
IV. less than the face amount of the note

Correct Answer: I and IV

The amount will be less than the maturity value.

Practice Question 2

Which of the following would not appear in the operating activities section of the statement of cash flows?

A. Cash collected from customers for goods and services
B. Cash payments to employees for salaries, wages, benefits, etc.
C. Cash payments for income taxes
D. Cash payments made on borrowings (repaying the amounts borrowed)

Correct Answer: D

Cash transactions relating to a firm's own debt or equity are classified as financing activities, according to SFAS No. 95. Note that D does not include interest payments!