How to Account for an Extinguishment of Debt

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Companies must properly account for extinguished debt.
Companies must properly account for extinguished debt. (Image: business accounts image by Nicemonkey from <a href='http://www.fotolia.com'>Fotolia.com</a>)

Extinguished debt occurs when a company that a borrower owes money to decides to wipe the account clean and take a loss on the amount owed. When debt is extinguished, the borrower must account for this extinguished debt on his books, as must the company forgiving the debt.

Subtract the book value of any asset given up as part of the debt forgiveness from the total amount of debt forgiven. This is the total gain. For example, a company has a $300,000 note forgiven that has accrued interest of $40,000. Part of the forgiveness requires the company to give an asset with a $100,000 book value and $200,000 fair market value. So, $340,000 minus $100,000 equals a total gain of $240,000.

Subtract the fair value of any asset given up as part of the debt forgiveness from the total amount of debt forgiven. This is the total gain on the debt forgiveness. In the example, $340,000 minus $200,000 equals $140,000.

Debit "Notes Payable" by the face value of the debt and "Accrued Interest" by any accrued interest. Credit "Asset" by the book value of the asset given up, "Gain on Asset" by the difference between the numbers calculated in Step 2 and Step 1 and "Gain on Debt Forgiveness" by the amount in Step 2. In the example, debit "Notes Payable" by $300,000 and "Accrued Interest" by $40,000. Credit "Asset" by $100,000, "Gain on Asset" by $100,000 and "Gain on Debt Forgiveness" by $140,000.

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