Debt extinguishment

Debt extinguishment
See also
Non current liability Creation of money Cash and cash equivalents Cash discount Banking book Source of financing Capital mortgage Evergreen Loan Liquidity risk

Debt extinguishment terminates the contract and is used to normalize contractual relations in consumer and business transactions. Debt extinguishment is happening when you pay all your debt or replace it by another debt instrument. This term refers, among others, to the process of removing a liability from the company's balance sheet and also from personal finances. Earlier extinguishment of debt occurs when the enterprise recovers the debt or when the repayment is made in-substance.

Types of debt

Types of debt (P. Colla, F. Ippolito, K. Li 2013, p. 2122):

• term loans are a cash loan which pays off for a certain period of time in regular installments, usually they last from 1 to 10 years, rarely up to 30 years,
• commercial paper these are money-market securities that are sold by large companies to raise funds to cover short-term liabilities,
• capital leases is a long-term contract not subject to cancellation, consisting in the transfer of ownership from the lessor to the lessee after the end of the lease period,
• drawn credit lines this type of loan is "on demand", if you meet the relevant criteria you can use it to the maximum amount, but only for a limited time,
• senior bonds and notes these are debt securities, their holders will be the first to be repaid in the event of liquidation of the company. That is why senior bonds and notes take precedence over other debts,
• subordinated bonds and notes are an unsecured loan. Creditors with this type of loan are repaid last, which is why it is often called.

Popular methods of paying off debt

We distinguish two methods of paying off debt:

1. Debt snowball
2. Debt avalanche

Debt snowball - D. Ramsey describes this method as a metaphor for the snowball, which gradually grows as it rolls downhill. Debtors should sort their debts from the smallest to the largest and then pay them off in that order. So the money from the smallest debt previously paid off is then rolled on next debt. This pattern is repeated until the last debt is paid off (D. Ramsey 2009, p. 109).

Debt avalanche - an effective method of paying interest-bearing debt by paying off consumer debts arranged from the lowest to the highest interest rate. This method allows the debtor to eliminate first the debts with the highest interest, while reducing the total repayment time (E. McAllister 2018, p. IV).

Mathematical analysis indicates that the most effective way to pay off a debt is the "Debt avalanche" method, but the most popular and independent of the interest rate is the "Debt snowball" method. The second strategy is a faster way to pay off the debt, but the first strategy favors the debtor's mental satisfaction, because repayment of a smaller loan is more encouraging than repayment of a larger one (E. McAllister 2018, p. 14).

Examples of Debt extinguishment

• Debt restructuring: Debt restructuring is a process of renegotiating the terms of a debt agreement to make it easier for the debtor to pay. This includes reducing the interest rate, extending the repayment period, or reducing the principal amount of the loan.
• Debt consolidation: Debt consolidation is a process of combining multiple debts into one loan with one monthly payment. This helps the debtor manage multiple debts more easily and can also reduce the interest rate on the loan.
• Debt forgiveness: Debt forgiveness is a process by which a lender agrees to forgive a portion of the debt owed. This can be done for a variety of reasons, including to help borrowers who are unable to repay their debts or to help those who are facing financial hardship.
• Debt buyback: Debt buyback is a process by which a lender agrees to buy back a portion of the debt owed at a discount. This can be beneficial to borrowers who are unable to repay their debt in full, as they can recover some of the money they owe without having to pay the full amount.
• Debt refinancing: Debt refinancing is a process of replacing an existing loan with a new loan that has different terms. This can be done to reduce the interest rate, extend the repayment period, or reduce the principal amount of the loan.

Advantages of Debt extinguishment

Debt extinguishment has several advantages:

• Firstly, it can improve the current financial position of a business, as it can reduce the total amount of debt that needs to be repaid. This can free up resources for other business activities.
• Secondly, it can improve the company's credit score and make it easier for the business to access loans in the future.
• Thirdly, debt extinguishment can reduce the total amount of interest paid on the debt, thus saving money in the long run.
• Fourthly, it can reduce the stress associated with having to manage multiple debts from different lenders.
• Finally, it can help to create a healthier financial future for the business by eliminating a large portion of its debt burden.

Limitations of Debt extinguishment

• Debt extinguishment may not be possible if a debtor is unable to pay the outstanding debt in full.
• Debt extinguishment could result in a negative impact on the creditworthiness of the debtor, as it may result in a higher interest rate for future loans.
• Debt extinguishment could also lead to a loss of income for creditors, as they will not receive the payments they originally expected.
• Debt extinguishment may also trigger additional tax liabilities for the debtor, depending on the terms of the debt extinguishment agreement.
• Depending on the type of debt, debt extinguishment may also be subject to regulatory restrictions.

Other approaches related to Debt extinguishment

Debt extinguishment has other approaches, such as:

• Debt restructuring: This involves renegotiating the terms of the loan, such as changing the payment schedule, reducing the interest rate, or extending the loan term.
• Debt consolidation: This involves taking out a new loan to pay back existing debt, in order to reduce interest rates or lower the monthly payments.
• Debt forgiveness: This involves the lender writing off a portion of the debt balance, in exchange for the borrower agreeing to pay a reduced amount.
• Debt settlement: This involves negotiating a settlement with the lender in which the borrower pays a lump sum to the lender in exchange for the lender agreeing to forgive the remaining balance.

In summary, debt extinguishment involves various approaches to reducing debt, such as restructuring, consolidation, forgiveness, and settlement. These approaches can help to lighten the burden of debt and make repayment more manageable.

References

• Bartov E., Mohanram S. P. (2014), Does Income Statement Placement Matter to Investors? The Case of Gains/Losses from Early Debt Extinguishment. The Accounting Review, Vol. 89 No. 6, p. 2021-2055.
• Colla P., Ippolito F.,Li K. (2013), Debt Specialization. The Journal of Finance, Vol. LXVIII No. 5, p. 2117-2141.
• Lange D. C., Fornaro M. J. ,Buttermilch J. R. (2013), Restructurings in Nontroubled Situations: Carefully Navigating the Relevant Guidance. The CPA Journal, Vol. April 2013, p. 26-35.
• McAllister E., (2018), A snowball's chance: Debt snowball vs. debt avalanche James Madison University, p. IV-14.
• Ramsey D. (2009), The Total Money Makeover: A Proven Plan for Financial Fitness, Thomas Nelson, Nashville, Tennessee, p. 109-133.

Author: Anna Machniak