assignment of debt accounting treatment

• Receivables
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• Assignment of Accounts Receivable
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Assignment of accounts receivable is an agreement in which a business assigns its accounts receivable to a financing company in return for a loan. It is a way to finance cash flows for a business that otherwise finds it difficult to secure a loan, because the assigned receivables serve as collateral for the loan received.

By assignment of accounts receivable, the lender i.e. the financing company has the right to collect the receivables if the borrowing company i.e. actual owner of the receivables, fails to repay the loan in time. The financing company also receives finance charges / interest and service charges.

It is important to note that the receivables are not actually sold under an assignment agreement. If the ownership of the receivables is actually transferred, the agreement would be for sale / factoring of accounts receivable . Usually, the borrowing company would itself collect the assigned receivables and remit the loan amount as per agreement. It is only when the borrower fails to pay as per agreement, that the lender gets a right to collect the assigned receivables on its own.

The assignment of accounts receivable may be general or specific. A general assignment of accounts receivable entitles the lender to proceed to collect any accounts receivable of the borrowing company whereas in case of specific assignment of accounts receivable, the lender is only entitled to collect the accounts receivable specifically assigned to the lender.

The following example shows how to record transactions related to assignment of accounts receivable via journal entries:

On March 1, 20X6, Company A borrowed $50,000 from a bank and signed a 12% one month note payable. The bank charged 1% initial fee. Company A assigned $73,000 of its accounts receivable to the bank as a security. During March 20X6, the company collected $70,000 of the assigned accounts receivable and paid the principle and interest on note payable to the bank on April 1. $3,000 of the sales were returned by the customers.

Record the necessary journal entries by Company A.

Journal Entries on March 1

Initial fee = 0.01 × 50,000 = 500

Cash received = 50,000 – 500 = 49,500

The accounts receivable don't actually change ownership. But they may be to transferred to another account as shown the following journal entry. The impact on the balance sheet is only related to presentation, so this journal entry may not actually be passed. Usually, the fact that accounts receivable have been assigned, is stated in the notes to the financial statements.

Journal Entries on April 1

Interest expense = 50,000 × 12%/12 = 500

by Irfanullah Jan, ACCA and last modified on Oct 29, 2020

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• Corporate Debt

Assignment of Accounts Receivable: Meaning, Considerations

Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University.

Investopedia / Jiaqi Zhou

What Is Assignment of Accounts Receivable?

Assignment of accounts receivable is a lending agreement whereby the borrower assigns accounts receivable to the lending institution. In exchange for this assignment of accounts receivable, the borrower receives a loan for a percentage, which could be as high as 100%, of the accounts receivable.

The borrower pays interest, a service charge on the loan, and the assigned receivables serve as collateral. If the borrower fails to repay the loan, the agreement allows the lender to collect the assigned receivables.

Key Takeaways

• Assignment of accounts receivable is a method of debt financing whereby the lender takes over the borrowing company's receivables.
• This form of alternative financing is often seen as less desirable, as it can be quite costly to the borrower, with APRs as high as 100% annualized.
• Usually, new and rapidly growing firms or those that cannot find traditional financing elsewhere will seek this method.
• Accounts receivable are considered to be liquid assets.
• If a borrower doesn't repay their loan, the assignment of accounts agreement protects the lender.

Understanding Assignment of Accounts Receivable

With an assignment of accounts receivable, the borrower retains ownership of the assigned receivables and therefore retains the risk that some accounts receivable will not be repaid. In this case, the lending institution may demand payment directly from the borrower. This arrangement is called an "assignment of accounts receivable with recourse." Assignment of accounts receivable should not be confused with pledging or with accounts receivable financing .

An assignment of accounts receivable has been typically more expensive than other forms of borrowing. Often, companies that use it are unable to obtain less costly options. Sometimes it is used by companies that are growing rapidly or otherwise have too little cash on hand to fund their operations.

New startups in Fintech, like C2FO, are addressing this segment of the supply chain finance by creating marketplaces for account receivables. Liduidx is another Fintech company providing solutions through digitization of this process and connecting funding providers.

Financiers may be willing to structure accounts receivable financing agreements in different ways with various potential provisions.​

Special Considerations

Accounts receivable (AR, or simply "receivables") refer to a firm's outstanding balances of invoices billed to customers that haven't been paid yet. Accounts receivables are reported on a company’s balance sheet as an asset, usually a current asset with invoice payments due within one year.

Accounts receivable are considered to be a relatively liquid asset . As such, these funds due are of potential value for lenders and financiers. Some companies may see their accounts receivable as a burden since they are expected to be paid but require collections and cannot be converted to cash immediately. As such, accounts receivable assignment may be attractive to certain firms.

The process of assignment of accounts receivable, along with other forms of financing, is often known as factoring, and the companies that focus on it may be called factoring companies. Factoring companies will usually focus substantially on the business of accounts receivable financing, but factoring, in general, a product of any financier.

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Assignment of Accounts Receivable Journal Entries

The assignment of accounts receivable journal entries below act as a quick reference, and set out the most commonly encountered situations when dealing with the double entry posting of accounts receivable assignment.

The assignment of accounts receivable journal entries are based on the following information:

• Accounts receivable 50,000 on 45 days terms
• Assignment fee of 1% (500)
• Initial advance of 80% (40,000)
• Cash received from customers 6,000
• Interest on advances at 9%, outstanding on average for 40 days (40,000 x 9% x 40 / 365 = 395)

About the Author

Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.

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What is the purpose of assigning accounts receivable?

For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.

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Author: Harold Averkamp, CPA, MBA

The purpose of assigning accounts receivable is to provide collateral in order to obtain a loan.

To illustrate, let’s assume that a corporation receives a special order from a new customer whose credit rating is superb. However, the customer pays for its purchases 90 days after it receives the goods. The corporation does not have sufficient money to purchase the raw materials, pay for the labor, and then wait 90 days to collect the receivable. The corporation’s bank or a finance company may lend 80% of the receivable but insists that the receivable be assigned to them as collateral for the loan.

Assigning a specific account receivable usually results in recording the receivable in a separate general ledger account such as Accounts Receivable Assigned. Some lenders require that the corporation’s customer be notified of the assignment and that the customer must remit the receivable amount directly to the bank.

Instead of assigning a specific receivable, the lender may require the corporation to assign all of its receivable as collateral for a loan.

Related Questions

• What is the accounts receivable turnover ratio?
• What is the accounts receivable collection period?
• How do you estimate the amount of uncollectible accounts receivable?
• What is the days' sales in accounts receivable ratio?
• What is a general ledger account?
• How does the aging of accounts receivable determine bad debts expense?

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• GAINS & LOSSES

Taxing the Transfer of Debts Between Debtors and Creditors

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T he frequent transfer of cash between closely held businesses and their owners is very common. If the owner works in the business, the transfer is likely to be either a salary to a shareholder/employee or a Sec. 707(c) guaranteed payment to a partner. Alternatively, the transfer may be a loan. As long as the true substance of the transaction is a loan, it will be respected for tax purposes. 1

The cash flow is not exclusively from the businesses to the owner. Many owners prefer to capitalize their closely held business with a combination of equity and debt. Once again, these loans will be respected and not reclassified as equity if they are bona fide loans.

In the normal course of business, these loans are repaid. The receipt of the repayment will be tax free except to the extent it is interest. However, in difficult economic conditions, many of these loans are not repaid. To the extent that the creditor cancels the obligation, the debtor has cancellation of debt (COD) income under Sec. 61(a)(12). This income is taxable unless the taxpayer qualifies for an exclusion under Sec. 108. In other cases, the debt is transferred between the parties either as an independent transaction or part of a larger one. This article reviews these transactions.

Two basic types of transfers have created significant tax issues. In the first, the debtor transfers the debt to the creditor. If the debtor is the owner of a business and the business is a creditor, the transfer appears to be a contribution. If the business is the debtor and the owner is the creditor, the transfer can be a distribution, liquidation, or reorganization. The other type of transfer is from the creditor to the debtor. Again, the transaction can take the form of a contribution if the creditor is the owner, or it can take the form of a distribution, liquidation, or reorganization if the creditor is the business.

Debtor-to-Creditor Transfers

Corporations.

The two seminal cases that established the framework for analyzing the transfer of a debt obligation from a debtor to a creditor are Kniffen 2 and Edwards Motor Transit Co. 3 Arthur Kniffen ran a sole proprietorship and owned a corporation. The sole proprietorship borrowed money from the corporation. For valid business reasons, Kniffen transferred the assets and liabili ties of the proprietorship to the corporation in exchange for stock of the corporation, thereby transferring a debt from the debtor to the creditor. The transaction met the requirements of Sec. 351.

The government argued that the transfer of the debt to the creditor was in fact a discharge or cancellation of the debt (a single step), which should have been treated as the receipt of boot under Sec. 351(b) and taxed currently. The taxpayer argued that the transfer was an assumption of the debt and, based on Sec. 357(a), should not be treated as boot.

The Tax Court acknowledged that the debt was canceled by operation of law. However, it did not accept the government’s argument as to the structure of the transaction. Instead, it determined that two separate steps occurred. First, the corporation assumed the debt. This assumption was covered by Sec. 357(a). After the assumption, the interests of the debtor and creditor merged and the debt was extinguished. Since the transfer was not for tax avoidance purposes, Sec. 357(b) did not apply. The result was a tax-free Sec. 351 transaction, except to the extent that the assumed debt exceeded the bases of the assets transferred, resulting in gain under Sec. 357(c). This decision established the separation of the debt transfer from its extinguishment.

Edwards Motor Transit Co. cites, and is considered to have adopted, the approach in Kniffen . For valid business reasons, the owners of Edwards created The Susquehanna Co., a holding company, and transferred Edwards’ stock to it under Sec. 351. Susquehanna borrowed money from Edwards to meet certain financial obligations. To eliminate problems that arose from having a holding company owning the stock of an operating company, the owners merged Susquehanna into Edwards under Sec. 368(a)(1)(A). The government acknowledged that the basic transaction was a nontaxable merger. However, the government wanted the company to recognize income as a result of the cancellation or forgiveness of the debt. The Tax Court ruled for the taxpayer, on the grounds that the debt transfer (from debtor to creditor) was not a cancellation of the debt. The ruling cited Kniffen as authority for this conclusion.

On its surface, Edwards Motor Transit affirmed the decision and reasoning in Kniffen . The Tax Court stated, “The transfer by the parent corporation of its assets to Edwards [its subsidiary] . . . constituted payment of the outstanding liabilities . . . just as surely as if Susquehanna had made payment in cash.” This statement relied on both Kniffen and Estate of Gilmore. 4 In Gilmore , a liquidating corporation transferred a receivable to its shareholder who happened to be the debtor. In that case, the court ruled the transaction was an asset transfer and not a forgiveness of debt. The court based its conclusion in large part on the fact that no actual cancellation of the debt occurred.

The statement in Edwards Motor Transit quoted above, however, is inapposite to the conclusion in Kniffen . A payment is not a transfer and assumption of a liability. Since Susquehanna was deemed to have used assets to repay the debt, the Tax Court should have required Susquehanna to recognize gain to the extent that the value of the assets used to repay the debt exceeded their bases. The conclusions in Kniffen and Edwards are consistent only in their holdings that these debt transfers were not cancellations of debts that would result in COD income. In Kniffen, the court ruled that the debt was assumed and then extinguished. In Edwards, the court ruled that the extinguishment of the debt constituted repayment.

It is possible that the Tax Court reached the correct outcome in Edwards Motor Transit but for the wrong reason. In Rev. Rul 72-464, 5 a debtor corporation merged into the creditor corporation in a tax-free A reorganization under Sec. 368(a)(1)(A). The ruling concluded that the debtor corporation did not recognize any gain or loss on the extinguishment of the debt within the acquiring corporation. General Counsel Memorandum (GCM) 34902 6 provided the detailed analysis behind the conclusion.

The GCM cited both Kniffen and Edwards 7 and adopted their underlying rationale. Specifically, it concluded that the basic transaction (the reorganization) results in a transfer of the debt to the acquiring corporation. It is after the transfer that the debt is extinguished by the statutory merger of interests. The transfer is an assumption of debt, which is nontaxable under Sec. 357(a). Therefore, the transferor (debtor corporation) recognizes no gain or loss.

This is exactly what happened in Ed wards . The debt was assumed, not repaid. Therefore, the Tax Court should have reached the conclusion that the transaction was nontaxable under Sec. 357(a) and not have relied on the questionable authority of Estate of Gilmore 8 or concluded that the debt was repaid.

Liquidations

The transactions discussed up to this point have been either tax-free corporate formations (Sec. 351) or tax-free reorganizations (Sec. 361). In a different transaction that is likely to occur, the creditor/shareholder liquidates the debtor corporation.

If the transaction is not between a parent and its subsidiary, taxability is determined by Secs. 331 and 336. Prior to 1986, the outcome might have been determined by Kniffen and Edwards . With the repeal that year of the General Utilities 9 doctrine (tax-free corporate property distributions) and the enactment of current Sec. 336, the outcome is straightforward. Under Sec. 336, the debtor corporation that is liquidated recognizes its gains and losses. Whether the liquidated corporation is treated as using assets to satisfy a debt requiring the recognition of gain or is treated as distributing assets in a taxable transaction under Sec. 336, all the gains and losses are recognized.

The taxation of the shareholder is a little more complex. First, the shareholder must determine how much it received in exchange for the stock. The most reasonable answer is that the shareholder received the value of the assets minus any debt assumed and minus the face amount of the debt owed to it by the liquidated corporation. This amount is used to determine the gain or loss that results from the hypothetical sale of stock under Sec. 331. Second, the shareholder must determine what was received for the debt, whether assets or the debt itself. The amount received in payment of the liquidated corporation’s debt is a nontaxable return of capital. If the shareholder is deemed to have received the debt itself, then the debt is merged out of existence. The basis of all the assets received should be their fair market value (FMV) under either Sec. 334(a) or general basis rules.

If the liquidated corporation is a subsidiary of the creditor/shareholder, the results change. Under Sec. 337, a subsidiary recognizes neither gain nor loss on the transfer of its assets in liquidation to an 80% distributee (parent). Sec. 337(b) expands this rule to include distributions in payment of debts owed to the parent corporation. Therefore, the subsidiary/debtor does not recognize any gain or loss.

The parent corporation (creditor) recognizes no gain or loss on the liquidation of its subsidiary under Sec. 332. The basis of the transferred property in the hands of the parent is carryover basis. 10 This carry­over basis rule also applies to property received as payment of debt if the subsidiary does not recognize gain or loss on the repayment. 11 In other words, the gain or loss is postponed until the assets are disposed of by the parent corporation.

One important exception to the nonrecognition rule is applied to the parent corporation. Under Regs. Sec. 1.332-7, if the parent’s basis in the debt is different from the face amount of the debt, the parent recognizes the realized gain or loss (face amount minus basis) that results from the repayment. Since this regulation does not mention any exception to the rules of Sec. 334(b)(1), the parent corporation is required to use carryover basis for all the assets received without adjustment for any gain or loss recognized on the debt.

This discussion of liquidations assumes that the liquidated corporation is solvent. If it is insolvent, the answer changes. The transaction cannot qualify under Secs. 332 and 337. The shareholder is not treated as receiving any property in exchange for stock; therefore, a loss is allowed under Sec. 165(g). The taxation of the debt depends on the amount, if any, received by the shareholder as a result of the debt.

Partnerships

The taxation of debt transfers involving partnerships is determined, in large part, by Secs. 731, 752, and 707(a)(2)(B). Specifically, the taxation of transfers by debtor partners to the creditor/partnership is determined by the disguised sale rules of Sec. 707(a)(2)(B), whereas transfers by debtor partnerships to a creditor/partner fall under Secs. 731 and 752.

Sec. 707(a)(2)(B) provides that a transfer of property by a partner to a partnership and a related transfer of cash or property to the partner is treated as a sale of property. The regulations specify the extent to which the partnership’s assumption of liabilities from the partner is treated as the distribution of the sale price.

Regs. Sec. 1.707-5 divides assumed liabilities into either qualified liabilities or unqualified liabilities. A qualified liability 12 is one that:

• Was incurred more than two years before the assumption;
• Was incurred within two years of the assumption, but was not incurred in anticipation of the assumption;
• Was allocated to a capital expenditure related to the property transferred to the partnership under Temp. Regs. Sec. 1.163-8T; or
• Was incurred in the ordinary course of business in which it was used, but only if all the material assets of that trade or business are transferred to the partnership.

The amount of qualified recourse liabilities is limited to the FMV of the transferred property reduced by senior liabilities. Any additional recourse liabilities are treated as nonqualified debt.

If a transfer of property is not otherwise treated as part of a sale, the partnership’s assumption of a qualified liability in connection with a transfer of property is not treated as part of a sale. The assumption of nonqualified liabilities is treated as sale proceeds to the extent that the assumed liability exceeds the transferring partner’s share of that liability (as determined under Sec. 752) immediately after the partnership assumes the liability. If no money or other consideration is transferred to the partner by the partnership in the transaction, the assumption of qualified liabilities in a transaction treated as a sale is also treated as sales proceeds to the extent of the transferring partner’s share of that liability immediately after the partnership assumes the liability. 13 Following the assumption of the liability, the interests of the debtor and creditor merge, thereby extinguishing the debt. The result is that generally the full amount of these assumed liabilities are part of the sale proceeds. 14

The assumed liabilities that are not treated as sale proceeds still fall under Sec. 752. Since the transaction results in a reduction of the transferor’s personal liabilities, the taxpayer is deemed to have received a cash distribution equal to the amount of the debt assumed under Sec. 752(b). Given that the debt is immediately extinguished, no amount is allocated to any partner. The end result is that the transferor must recognize gain if the liability transferred exceeds the transferor’s outside basis before the transaction, increased by the basis of any asset transferred to the partnership as part of the transaction.

A partnership may have borrowed money from a partner and then engaged in a transaction that transfers the debt to the creditor/partner. The first question is whether the initial transaction is a loan or capital contribution. Sec. 707(a) permits loans by partners to partnerships. The evaluation of the transaction is similar to one to determine whether a shareholder has loaned money to a corporation or made a capital contribution. The factors laid out in Sec. 385 and Notice 94-47 15 should be considered in this analysis.

Assuming the debt is real and it alone is transferred to the creditor/partner, the outcome is straightforward. The partner is treated as having made a cash contribution to the partnership under Sec. 752(a) to the extent that the amount of debt exceeds the amount allocated to the partner under the Sec. 752 regulations. If part of the debt is allocated to other partners, these other partners are treated as receiving a deemed cash distribution.

If the transfer is part of a larger transaction, then the analysis is a little more complex. The transfer of the other assets is governed by Secs. 737, 731, and 751. Sec. 737 requires a partner to recognize gain if, during the prior seven years, the partner had contributed property with built-in gain to the partnership and the current FMV of the distributed property exceeds the partner’s outside basis. The partner is treated as recognizing gain in an amount equal to the lesser of (1) the excess (if any) of the FMV of property (other than money) received in the distribution over the adjusted basis of such partner’s interest in the partnership immediately before the distribution reduced (but not below zero) by the amount of money received in the distribution, or (2) the net precontribution gain of the partner. The outside basis is increased by the amount of the deemed contribution because the partner assumed a partnership liability. After any gain under Sec. 737 is determined, the general distribution rules of Secs. 731 and 751(b) apply to the transaction. In effect, the transfer to a creditor/partner of a partnership debt owed to the partner is treated the same as any liability assumed by the partner. The extinguishment of the debt should not result in additional tax consequences.

Creditor-to-Debtor Transfers

In addition to debtor-to-creditor transfers, there are creditor-to-debtor transfers. The outcome of these transactions is determined by the two-step analysis in Kniffen . The creditor is treated as having transferred an asset to the debtor/owner. After the transfer, the interests of the debtor and creditor merge, resulting in the extinguishment of the debt. This extinguishment is generally nontaxable since the basis of the debt and the face amount are equal. 16 The result changes if the basis in the hands of the creditor and the adjusted issue price of the debtor are not equal. 17

One of the initial pieces of guidance that addressed this question was Rev. Rul. 72-464. 18 In this ruling, the debt was transferred in a nontaxable transaction. Consequently, the recipient (the debtor) had a carryover basis in the debt. Since this basis was less than the face amount, gain equal to the difference was recognized. This ruling did not explain the reasoning behind the gain recognition or the potential impact if the value of the debt was different from its basis. 19 These items were addressed in Rev. Rul. 93-7. 20

Rev. Rul. 93-7 analyzed a transaction between a partnership and a partner, here designated P and A , respectively. A was a 50% partner. This percentage allowed A to not be a related party to P under Sec. 707(b). P also had no Sec. 751 assets, and A had no share of P ’s liabilities under Sec. 752. These were excluded because they did not affect the reasoning behind the taxation of debt transfers. A issued a debt with a face amount of $100 for $100. P acquired the debt for $100. When the debt was worth $90, it was distributed to A in complete redemption of its interest, which had an FMV of $90 and outside basis of $25. In other words, a creditor/partnership distributed debt to the debtor/partner.

The debt was an asset, a receivable, in the hands of P . When it was distributed to A , P determined its taxation under Sec. 731(b), which provides that no gain or loss is recognized by a partnership on the distribution of property. The application of Sec. 731(b) in this transaction followed directly from Kniffen , which treated the transfer of a debt as a separate transaction from any extinguishment that follows the transfer. Under Sec. 732, A ’s basis in the transferred debt was $25. 21

The basis rules of Sec. 732 assume that a built-in gain or loss on distributed property is realized and recognized when the recipient disposes of the property. In this situation, the distributed debt was extinguished, and therefore no future event would generate taxable gain or loss. Consequently, this extinguishment became a taxable event. In this specific case, A recognized gain of $65 ($90 FMV – $25 basis) and COD income of $10 ($100 face − $90 FMV.) The ruling did not spell out the reasoning for the recognition of both gain and COD income. It is the correct outcome based on Regs. Sec. 1.1001-2. Under that regulation, when property is used to satisfy a recourse obligation, the debtor has gain equal to the difference between the value of the property and its basis, and COD income equal to the difference between the amount of debt and the value of the property used as settlement. The distributed debt is property at the time of the distribution, and the rules of Regs. Sec. 1.1001-2 should apply.

In Rev. Rul. 93-7, the value of the debt was less than the face amount. A debt’s value could exceed its face amount. In that case, the revenue ruling indicated, a deduction for the excess value may be available to the partner as a result of the deemed merger. In Letter Ruling 201105016, 22 the IRS ruled that a taxpayer was entitled to a deduction when it reacquired its debt at a premium as part of a restructuring plan. Rev. Rul. 93-7 cited Regs. Sec. 1.163-4(c)(1), and Letter Ruling 201105016 cited Regs. Sec. 1.163-7(c). Both regulations state that the reacquisition of debt at a premium results in deductible interest expense equal to the repurchase amount minus the adjusted issue price. Regs. Sec. 1.163-4(c)(1) applies to corporate taxpayers, while Regs. Sec. 1.163-7(c) expanded this treatment to all taxpayers. Based on these regulations and the treatment of the distribution as an acquisition of a debt, an interest expense deduction should be permitted when the value exceeds the amount of debt, whereas COD income is recognized when the value is less than the amount of the debt.

In Rev. Rul. 93-7, the partnership was the creditor, and the debt was transferred to a debtor/partner. The reverse transaction can occur, in which a creditor/partner transfers debt to the debtor/partnership in exchange for a capital or profits interest. Sec. 721 applies to the creditor/partner. Therefore, no gain or loss is recognized. However, Sec. 108(e)(8)(B) applies to the debtor/partnership. Sec. 108(e)(8)(B) provides that the partnership recognizes COD income equal to the excess of the debt canceled over the value of the interest received by the creditor. This income is allocated to the partners that owned interests immediately before the transfer. The partnership does not recognize gain or loss (other than the COD income) as a result of this transaction. 23 The value of the interest generally is determined by the liquidation value of the interest received. 24 If the creditor receives a profits interest, the liquidation value is zero, and therefore the partnership recognizes COD income equal to the amount of debt transferred.

Corporate Transactions

Debt transfers between corporations and shareholders are just as likely as transfers between partners and partnerships. If the transferor is a shareholder or becomes a shareholder as a result of the transaction, Secs. 1032, 118, and 351 provide basic nontaxability. However, Sec. 108 overrules these sections in certain cases.

If the shareholder transfers the debt to the corporation as a contribution to capital, Sec. 108(e)(6) may result in the recognition of COD income by the corporation. Under Sec. 108(e)(6), the corporation is treated as having satisfied the indebtedness with an amount of money equal to the shareholder’s adjusted basis in the indebtedness. Therefore, the corporation has COD income amount equal to the excess of the face amount of the debt over the transferor’s basis in the debt immediately prior to the transfer. In most cases, the face and basis are equal, and no COD income is recognized. If the transfer is in exchange for stock, Sec. 108(e)(8)(A) provides that the corporation is treated as having satisfied the indebtedness with an amount of money equal to the FMV of the stock. Therefore, the corporation recognizes COD income equal to the excess of the face value of the debt over the value of the stock received. In many cases, the value of the stock is less than the debt canceled, and therefore COD income is recognized. Sec. 351 provides that 80% creditor/shareholders recognize neither gain nor loss if the debt is evidenced by a security. If Sec. 351 does not apply, the creditor/shareholder may be able to claim a loss or bad-debt deduction.

Rev. Rul. 2004-79 25 provides a detailed analysis of the transfer of debt from a creditor corporation to a debtor shareholder. The analysis is similar to the one for partnership distributions covered by Rev. Rul. 93-7, discussed previously.

Modifying the facts of Rev. Rul. 2004-79, assume that a shareholder borrows money from his corporation. The face amount of the debt is $1,000, and the issue price is $920. The original issue discount (OID) of $80 is amortized by both the corporation and the shareholder. At a time when the adjusted issue price and basis are $950 but the FMV is only $925, the corporation distributes the debt to the shareholder as a dividend.

From the corporation’s point of view, this is a property dividend. Rev. Rul. 2004- 79 cites Rev. Rul. 93-7, but it could just as easily have cited Kniffen . As a property dividend, the transaction’s taxa tion to the corporation is governed by Sec. 311. Since the value in the revenue ruling was less than the basis, the corporation recognized no gain or loss. If the value had appreciated, the corporation would have recognized gain equal to the appreciation.

The shareholder receives a taxable dividend equal to the value of the debt; consequently, the debt has a basis equal to its FMV of $925. Since the debt is automatically extinguished, the shareholder is treated as having satisfied an obligation in the amount of $950 with a payment of $925. Therefore, the shareholder must recognize $25 of COD income.

A second fact pattern in the revenue ruling is the same, except the value of the distributed debt is $1,005. Under these facts, the shareholder would be entitled to an interest expense deduction under Regs. Sec. 1.163-4 or 1.163-7 in the amount of $55 ($1,005 − $950). In other words, the shareholder is deemed to have reacquired its own debt for a payment equal to the basis that the distributed debt obtains in the transaction.

The conclusions of Rev. Rul. 2004-79 are consistent with those in Rev. Rul. 93-7. They follow the reasoning of Kniffen .

Another transaction that could occur involving shareholder debt is a liquidation of the corporation, resulting in a distribution of the debt to the debtor/shareholder. The results should be similar to those in Rev. Rul. 2004-79. The corporation that distributes the debt is taxed under Sec. 336. Therefore, the corporation recognizes gain or loss depending on the basis of the debt and its FMV. This is the same result as in the dividend case, except that the loss is recognized under Sec. 336 instead of being denied under Sec. 311. The shareholder’s basis in the debt is its FMV under Sec. 334(a). The shareholder recognizes COD income or interest expense, depending on whether the basis is less than or greater than the adjusted issue price of the debt. These results flow from the regulations under Secs. 61 and 163 and are consistent with the conclusions in the above revenue rulings.

The results change slightly if the liquidation qualifies under Secs. 332 and 337. The IRS discussed these results in Chief Counsel Advice 200040009. 26 Sec. 332 shields the parent from recognition of income on the receipt of the debt. Sec. 337 shields the liquidating corporation from recognizing gain or loss on the transfer of the debt to its parent corporation. The basis is carryover basis under Sec. 334(b). Then, because the debt is extinguished, the parent recognizes either COD income or interest expense on the extinguishment of the debt. As in the prior revenue rulings and Kniffen , the extinguishment has to be a taxable event because the elimination of the carryover basis prevents the parent corporation from having a taxable transaction in the future involving this debt. These results are consistent with prior decisions.

The results discussed for a parent/subsidiary liquidation should also apply if the debtor/corporation acquires a corporation that owns its debt in a nontaxable asset reorganization. In this case, Sec. 361 replaces Secs. 332 and 337. The extinguishment of the debt is a separate transaction that should result in recognition of income or expense.

Acquired Debt

So far, this article has discussed transactions between the debtor and creditor. Now it turns to how the holder of the debt acquired it. In many cases, the holder acquired the debt directly from the debtor, and the acquisition is nontaxable. In other situations, the debt is outstanding and in the hands of an unrelated party. The holder acquires the debt from this unrelated party. In these cases, Sec. 108(e)(4) may create COD income.

Under Sec. 61, if a debtor reacquires its debt for less than its adjusted issue price, the debtor has COD income. Sec. 108(e)(4) expands on this rule: If a party related to the debtor acquires the debt, the debtor is treated as acquiring the debt, with the resulting COD income recognized. Related parties are defined in Secs. 267(b) and 707(b)(1).

The regulations provide that the acquisition can be either direct or indirect. A direct acquisition is one by a person related to the debtor at the time the debt is acquired. 27 An indirect acquisition occurs when the debtor acquires the holder of the debt instrument, where the holder of the debt acquired it in anticipation of becoming related to the debtor. 28 The determination of whether the holder acquired the debt in anticipation of becoming related is based on all the facts and circumstances. 29 However, if the holder acquires the debt within six months before the holder becomes related to the debtor, the acquisition by the holder is deemed to be in anticipation of becoming related to the debtor. 30

In the case of a direct acquisition, the amount of COD income is equal to the adjusted issue price minus the basis of the debt in the hands of the related party. In the case of indirect acquisitions, the calculation depends on whether the debt is acquired within six months of being acquired. 31 If the holder acquired the debt within six months of being acquired, the COD income is calculated as if it were a direct acquisition. If the holder acquired the debt more than six months before being acquired, the COD income is equal to the adjusted issue price minus the FMV of the debt instrument on the date that the holder is acquired.

When a debtor reacquires its own debt, in addition to reporting COD income, the debtor has the debt extinguished as a result of the merger of interests. When a related party acquires the debt, the debtor has COD income, but the debt remains outstanding. In these cases, the debtor is treated as issuing a new debt instrument immediately following the recognition of the COD income for an amount equal to the amount used to calculate the COD income (adjusted basis or FMV 32 ). If this issue price is less than the stated redemption price at maturity of the debt (as defined in Sec. 1273(a)(2), the difference is OID that is subject to the amortization rules of Sec. 1272.

Rev. Rul. 2004-79 provides a simple example of this transaction. In the ruling, a parent corporation, P , issued $10 million of debt for $10 million. After issuance, S , a subsidiary of P , purchased the debt for $9.5 million. Under Regs. Sec. 1.108-2(f), P had to recognize $500,000 of COD income ($10 million face − $9.5 million basis to S ). After this recognition, P was treated as having issued the debt to S for $9.5 million. Therefore, $500,000 of OID was amortizable by P and S . If S later transfers the debt to P , the previously discussed rules determine the taxation of the transfer using S ’s basis ($9.5 million + amortized OID).

Secs. 61 and 108(e)(4) apply only if the debt is acquired for less than the adjusted issue price. If the acquisition price is greater than the adjusted issue price, the acquiring party treats this excess as premium and amortizes it, thereby reducing the amount of interest income recognized by the holder.

Installment Obligations

An installment obligation differs from other obligations in that the holder recognizes income when cash is collected in payment of the obligation. The rules describing the taxation of installment obligations were rewritten as part of the Installment Sales Revision Act of 1980, P.L. 96-471. Under old Sec. 453(d) (new Sec. 453B(a)), if the holder of an installment obligation distributes, transmits, or disposes of the obligation, the taxpayer is required to recognize gain or loss equal to the difference between the basis in the obligation and the FMV of the obligation. There is an exception to this rule for distributions in liquidation of a subsidiary that are exempt from taxation under Sec. 337.

Prior to the Code revision, the regulations permitted the transfer of installment obligations without gain recognition if the transaction was covered by either Sec. 721 or 351. 33 Although the regulations have not been revised for the Code change, the IRS continues to treat Secs. 721 and 351 as overriding the gain recognition provision. 34

If the transaction results in transfer of the obligation either from the creditor to the debtor or from the debtor to the creditor, the tax result changes. The seminal case is Jack Ammann Photogrammetric Engineers, Inc. 35 In it, the taxpayer created a corporation to which he contributed $100,000 in return for 78% of the corporation’s stock. He then sold his photogrammetry business to the corporation for $817,031. He received $100,000 cash and a note for $717,031. He reported the sale under the installment method. When he was still owed $540,223 on the note, he transferred it to the corporation for stock of the corporation worth $540,223. He reported this as a disposition under Sec. 453(d) and recognized the deferred gain. Later, he filed a claim for refund, arguing that Sec. 351 prevented recognition of the deferred gain. After allowing the refund, the IRS assessed a deficiency against the corporation, arguing that the corporation came under Sec. 453(d). The corporation argued that, under Sec. 1032, it was not taxable. The Tax Court ruled for the IRS.

The Fifth Circuit reversed the decision. The underlying reasoning was that the disposition by the shareholder and the extinguishment of the debt in the hands of the corporation were separate transactions. The extinguishment did not fall under Sec. 453(d). The court indicated that the IRS should have assessed the tax against the shareholder.

Following this case, the IRS issued Rev. Rul. 73-423. 36 In this ruling, a shareholder transferred an installment obligation from Corporation X back to the corporation in a transaction described in Sec. 351. The ruling concluded that the transfer was a satisfaction of the installment agreement at other than face value under Sec. 453(d)(1)(A) and that the shareholder was required to recognize gain without regard to Sec. 351. The corporation had no gain or loss under Sec. 1032 and Ammann .

Sec. 453(d) is now Sec. 453B(a), and the rule has not changed. Therefore, if a creditor transfers an installment obligation to the debtor in an otherwise tax-free transaction, the obligation is treated as satisfied at other than its face value, and the creditor is required to recognize gain or loss as discussed in Rev. Rul. 73-423. 37

New Sec. 453B(f) covers transactions in which installment obligations become unenforceable. This section covers the extinguishment of an installment debt through a merger of the rights of a debtor and creditor. The Code treats these transactions as dispositions of the obligation with gain or loss recognized. When the debtor and creditor are related, the disposition is at FMV but no less than the face amount.

If the debtor of an installment obligation engages in a transaction in which the creditor assumes the debt, the results are consistent with those of transactions involving obligations other than installment notes. The debtor is deemed to have received cash equal to the amount of the debt. This is fully taxable unless exempted by Sec. 357, 721, or a similar provision. The creditor falls under Sec. 453B(f), with the extinguishment treated as a taxable disposition of the obligation for its FMV (which for related parties is no less than the face amount).

Business entities often incur debts to their owners, and, conversely, the owners incur liabilities to their business entities. In numerous transactions these obligations are canceled for consideration other than simple repayment of the debt. Based on Kniffen , these transactions are treated as a transfer of consideration followed by an extinguishment of the debt. If a shareholder’s debt to his or her controlled corporation is transferred to that corporation along with assets, the transaction may be tax free under Secs. 351 and 357(a). If a shareholder/creditor receives the related corporate debt in a distribution or liquidation, Sec. 311 or 336 determines the corporation’s taxation.

The cancellation of a partner’s debt to the partnership is generally governed by the distribution rules, including the constructive sale or compensation rules of Sec. 707(a)(2). When a partner cancels the partnership’s debt, the partner has made a contribution to capital. This can have consequences to all partners since the total liabilities are decreased and the partners’ bases are decreased under Sec. 752.

In most cases the merger of debtor and creditor interests is nontaxable. However, if the basis of the debt or receivable does not equal the face amount of the debt, income or loss is recognized. The exact amount and character of the income or loss depends on factors discussed in this article. It is important for the tax adviser to identify those cases in which the debt transfer is not tax free.

1 Invalid loans to shareholders have been reclassified as dividends.

2 Kniffen , 39 T.C. 553 (1962).

3 Edwards Motor Transit Co. , T.C. Memo. 1964-317.

4 Estate of Gilmore , 40 B.T.A. 945 (1939).

5 Rev. Rul. 72-464, 1972-2 C.B. 214.

6 GCM 34902 (6/8/72). The GCM also refers to Sec. 332, which will be dis cussed later.

7 As the GCM points out, by using Sec. 357(a), taxpayers could achieve the same outcome in C reorganizations.

8 See Chief Counsel Advice 200040009 (10/6/00), which suggests Estate of Gilmore ’s requirement of a formal cancellation of debt before COD income is recognized may no longer be valid.

9 General Utilities & Operating Co. v. Helvering , 296 U.S. 200 (1935).

10 Sec. 334(b)(1).

12 Regs. Sec. 1.707-5(a)(6).

13 If the partnership transfers money or other consideration in the transaction, the amount treated as sales proceeds may be limited under Regs. Sec. 1.707-5(a)(5)(i)(B).

14 Under Regs. Sec. 1.707-5(a)(3)(ii), a partner’s share of liabilities is reduced by liabilities assumed that are anticipated to be reduced. Based on Kniffen and Edwards , the reduction will be anticipated.

15 Notice 94-47, 1994-1 C.B. 357.

16 See, e.g., IRS Letter Ruling 8825048 (3/23/88).

17 The transaction that gives rise to the difference and the taxation that results are discussed later.

18 Rev. Rul. 72-464, 1972-2 C.B. 214. Although this is a debtor-to-creditor transfer, the result is the same.

19 See GCM 34902 (6/8/72).

20 Rev. Rul. 93-7, 1993-1 C.B. 125.

21 If the partnership makes a Sec. 754 election, the partnership has a Sec. 734 adjustment of $75 ($100 inside basis – $25 basis after distribution).

22 IRS Letter Ruling 201105016 (2/4/11).

23 Regs. Sec. 1.108-8, effective Nov. 17, 2011.

24 See the Regs. Sec. 1.108-8(b)(2) safe-harbor rule.

25 Rev. Rul. 2004-79, 2004-2 C.B. 106.

26 CCA 200040009 (10/6/00).

27 Regs. Sec. 1.108-2(b).

28 Regs. Sec. 1.108-2(c)(1).

29 Regs. Sec. 1.108-2(c)(2).

30 Regs. Sec. 1.108-2(c)(3).

31 Regs. Secs. 1.108-2(f)(1) and (2).

32 Regs. Sec. 1.108-2(g).

33 Regs. Sec. 1.453-9(c)(2).

34 See IRS Letter Rulings 8824044 (3/22/88) and 8425042 (3/19/84).

35 Jack Ammann Photogrammetric Engineers, Inc. , 341 F.2d 466 (5th Cir. 1965), rev’g 39 T.C. 500 (1962).

36 Rev. Rul. 73-423, 1973-2 C.B. 161.

37 Although this revenue ruling involved a corporation, the IRS believes the same rule applies to partnerships. Treasury is currently working on a revision of the regulations to clarify the results. See the preamble to Regs. Sec. 1.108-8, T.D. 9557 (11/17/11).

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How to Account for Debt Factoring or Selling of Receivables

When I was auditing the financial statements of one of our clients, I spotted a few strange things:

• Client’s receivables showed an extremely low balance. In comparison with the previous year, the balance dropped by 90%.

I was a freshman in that audit year and the first thing I did before I started to bother our senior auditor was to look at the client’s bank statements from January next year – that is AFTER the reporting date.

Guess what I discovered!

I was staring at that January bank statement with shock.

Where did this CU 900 000 go?

Just to be on the safe side, I checked also the subledger of receivables.

Not such a big surprise there – the receivables were also back to their normal levels.

Hmmm, something smells here…

Instead of bothering the senior auditor, I went to bother client’s CFO.

The nice talkative lady explained that just before the year-end, they sold a significant amount of receivables… (a Hollywood smile).

My question: Did you buy them back in January?

The smile faded slightly: “Oooh, yes….”

Me, still puzzled: “Why did you do it?”

The remaining smile is replaced with an annoyed look: “Well, there’s nothing wrong with that… we needed to meet the bank’s covenants for our loan and show enough cash on our bank account…”

OK, I understood.

However in this particular case, the client did it wrong.

In other words, it did not help at all.

You’re just about to find out!  

Why sell receivables?

Many companies regularly sell their receivables to someone else.

There are few reasons for that:

• They need cash and don’t want to (or cannot) wait until their own clients pay invoices.
• They don’t want to deal with the credit risk of their clients.
• They don’t want to employ people who try to call clients, remind them about due dates and missing payments – in other words, they don’t want to bother with collecting of receivables.
• They are trying to “window-dress” their financial statements, just as my client did – but in reality, it does not happen very often.

What is a debt factoring?

In a modern business world, factoring of receivables, or selling receivables with discount is a normal practice of cash management.

Here’s how it works:

• You (food producer in the scheme) sell your products to the customers and issue invoices.

The receivables are sold with discount that represents both:

• Your fee for having cash immediately (interest on the loan provided by the factor),
• The revenue of the factoring company.
• Your customers (retailers in the scheme) pay the invoices when they are due directly to the factoring company.

Now, the principal question is:

Well, it depends.

In fact, you need to decide whether the conditions for derecognition of financial asset were met or not.

If you remember, IFRS 9 Financial Instruments is very sticky in derecognition and it’s much easier to recognize an asset than to derecognize it.

For this reason, IFRS 9 contains a big decision tree helping you to determine whether you should derecognize your asset or not.

When you sell receivables, you need to assess whether you transfer significant risks and rewards of ownership or not in the first instance.

Then, if you don’t, you need to assess whether you retain some control or you have some continuing involvement in the receivables.

There are many types of factoring arrangements with various conditions. The three main types are:

• Factoring without recourse – in this case, the factor buys all the receivables from you with no right of return to you (if your customers do not pay, then it’s factor’s care).
• Factoring with recourse – in this case, the factor has the right to return uncollectible receivables to you.
• Factoring with limited recourse (guarantee) – in this case, you guarantee the losses up to certain amount and the factor can return the receivables only up to the guarantee.

Let me show you how to account for the first two types.  

Example: Factoring without recourse

Tradex is a trading company. Due to urgent cash shortage, it decides to transfer trade receivables to the factoring company for 90% of their nominal amount. Total transferred receivables amount to CU 300 000. The factor has no right of returning the receivables back to Tradex.

Tradex transfers all the risks and rewards resulting from the receivables to the factoring company. As a result, Tradex derecognizes the receivables fully, because the derecognition criteria in IFRS 9 are met .

Journal entries are:

Debit Bank account (CU 300 000*90%): CU 270 000

Profit or loss – finance expenses (see note below): CU 30 000

Credit Receivables: CU 300 000

Note: Most of these finance expenses represent the interest, because factoring is a form of a loan from the factor. Therefore, if material, you should accrue the interest expenses and recognize them over the period of financing (not one-time as shown here).

In this case, when the clients do not pay to the factor and go bankrupt, it’s the factor’s care and not Tradex’s care. That’s the biggest advantage of non-recourse factoring.

On the other hand, the discount (the fees) are higher than when factoring is with recourse.  

Example: factoring with recourse

The same situation as above. This time, Tadex transfers the receivables for 96% of their nominal amount. Total transferred receivables amount to CU 300 000. The factor has the full right of returning the receivables back to Tradex if they become uncollectible.

Tradex retains some risks resulting from the receivables to the factoring company. The clients’ credit risk was not transferred because the factor has the right of return.

As a result, Tradex keeps the receivables in the balance sheet, because the derecognition criteria in IFRS 9 are not met .

The amount received from factoring company is recognized as a liability.

Debit Bank account (CU 300 000*96%): CU 288 000

Debit Profit or loss – finance expenses (see note below): CU 12 000

Credit Refund liability: CU 300 000

The subsequent journal entries are:

Debit Refund liability: CU 10 000 (the amount of uncollectible receivable)

Credit Bank account: CU 10 000

Debit Refund liability: CU 50 000 (the amount actually collected by the factor)

Credit Receivables: CU 50 000

Factoring with guarantee

The most common type of factoring transaction is something in between these two “black or white” cases described above.

Factors often require a guarantee up to certain amount.

As a result, the factor does not have the right to the full return up to nominal amount of receivables, but only up to a guarantee.

Here, there is a continuing involvement in the receivables , so you cannot derecognize them fully.

In the IFRS Kit , there’s an example of this type of factoring solved in Excel file and clearly explained in the video, so please, check it out if interested!  

Let’s come back to my client from the beginning of this article.

I handed the case to our senior auditor (so finally yes, I bothered him), but this appeared to be the major audit finding.

The senior auditor revised the contract for sale of receivables and it clearly stated that our client has an obligation to buy these receivables back in January next year.

As a result, not all the risks and rewards were transferred and the client needed to put the receivables back to its balance sheet and recognize a refund liability.

Of course, the client did not agree and we issued an audit report with qualification. But that’s another story.

Did this article help?

Do you have come comments or questions?

Please, leave a comment below! Thanks!

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87 Comments

Thanks for sharing this nice article to understand debt factoring in details.

Hi Sylvia, Please when the factor release the money to the factoring company, I guess the factor will DR loans receivable, CR Cash/bank right? Does it present it the commissions and fees as finance income in its books

Excellent Article with new findings, which is the overall objective of Audit in today’s complicated business environment, thanks for sharing the deep-down knowledge,

I found the article very informative and helpful.. Thank you.

nice article

Excellent and easily understandable….Keep up the good work…… Thank you.

Using above example can you explain what accounting from factors side would look like ?

I just wanted to find out whether IFRS 9 would require the disclosure of debt factoring?

Hi Sylvia, I have a question regarding the transactions from opposite sides. I am currently looking at a debt factoring company, and I was wondering whether you have any detail or material on how to perform ECL on this debt, considering it’s purchased based on debtors who have already defaulted. Thanks

Very intersting Silvia…..even if i have not dealt with this practically, the information has really put me on a higher notch…….Thanks!

Thank you Silvia for wonderful Article. Appreciate your demonstration with examples.

Thanks for your sharing knowledge. It’s excellent and useful for everyone.

Under Example: factoring with recourse, you are mentioning “Tradex retains some risks resulting from the receivables to the factoring company.” I think Tradex retains the FULL risks

Hi Silvia, nice article. It would be helpful if you could address 1 small query regarding the discount fees. You mentioned in your article above the following: “Note: Most of these finance expenses represent the interest, because factoring is a form of a loan from the factor. Therefore, if material, you should accrue the interest expenses and recognize them over the period of financing (not one-time as shown here).” My query is – if the same of receivables are without any recourse to the Company – this means that it is akin to a sale of any other assets – like fixed assets – and therefore, the fees that the Company pays to the Discounters should be recognised immediately on the sale – and not over the period of time. The risks and rewards have already passed to the Discounter on sale and you have received 90% of the money. The fees should be recognised at this point. What is your opinion on this matter?

Great Article. Thanks for the refresher.

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Debt Extinguishment Accounting Explained

Explore the fundamentals of debt extinguishment accounting, including methods, financial reporting, and tax considerations for effective debt management.

Debt extinguishment is a critical financial strategy that involves the removal of debt from an entity’s balance sheet, typically through repayment or restructuring. This process not only impacts a company’s immediate financial health but also shapes its long-term fiscal strategies and creditworthiness.

Understanding how this process works and its implications can significantly influence business decisions and investment considerations. As companies navigate their financial paths, effective management of debt extinguishment can lead to more sustainable growth and stability.

Key Principles of Debt Extinguishment

Debt extinguishment occurs when an entity irrevocably pays off or restructures its debt under conditions that fundamentally change the terms of the original agreement. This process is governed by specific accounting principles that ensure transparency and consistency in financial reporting. One of the primary principles is the recognition of any gain or loss on the extinguishment, which must be recorded in the entity’s financial statements. This gain or loss is calculated as the difference between the net carrying amount of the debt and the actual amount paid to satisfy the debt.

Another important principle is the derecognition of the original debt instrument from the balance sheet. Once the debt is legally extinguished, the associated liabilities must be removed from the financial statements. This derecognition affects not only the balance sheet but also the entity’s debt-to-equity ratio, a significant indicator of financial health that can influence investor perception and credit ratings.

The process also involves the consideration of non-financial factors, such as the impact on stakeholder relationships and future borrowing capacity. Effective debt management requires a strategic approach that considers both the immediate financial benefits and the long-term implications for the company’s operational flexibility and growth potential.

Methods of Debt Extinguishment

Debt extinguishment can be achieved through various strategies, each tailored to the specific circumstances and financial objectives of the entity. One common method is debt repayment, where the borrower pays the outstanding balance to the lender, often using cash reserves. This straightforward approach immediately eliminates the liability and improves the company’s leverage ratios.

Refinancing is another strategy, where existing debt is replaced with new debt, typically at a lower interest rate or more favorable terms. This can reduce interest expenses and extend the maturity of the debt, providing the company with more manageable payment schedules and improved cash flow. Debt-for-equity swaps are also utilized, particularly by companies looking to strengthen their balance sheets. This involves the exchange of debt for a pre-determined amount of the company’s equity, which can be an attractive option for creditors if the company’s future growth prospects are promising.

Debt forgiveness is a less common but impactful method, where a creditor may agree to cancel all or part of the outstanding debt, often in situations where the borrower is facing financial difficulties. This can result in a significant gain for the borrower, as the forgiven debt amount is removed from the balance sheet. However, this method may come with reputational risks and potential future borrowing limitations.

Asset sales can also be employed to extinguish debt. Selling non-core or underperforming assets can generate cash that can be directly applied to debt reduction. This method not only reduces liabilities but also allows the company to streamline operations and focus on more profitable areas.

Financial Statement Presentation

When a company extinguishes debt, the financial statement presentation must transparently reflect the transaction’s impact on the company’s financial position. The income statement will display any gain or loss from the extinguishment, which provides stakeholders with insights into the transaction’s immediate financial effects. This gain or loss is typically presented as a separate line item to distinguish it from the entity’s operating income, ensuring that the nature of these irregular events is clear.

The balance sheet, on the other hand, will show a reduction in both liabilities and assets if the debt was settled with cash or other assets. This reduction directly affects the company’s liquidity and gearing ratios, which are closely monitored by investors and creditors. The statement of cash flows will also be affected, with the cash outflow from financing activities reflecting the payment made to extinguish the debt. This presentation helps stakeholders understand the company’s cash management and its ability to generate cash to meet its obligations.

The notes to the financial statements play a crucial role in providing additional context to the debt extinguishment. They may detail the terms of the extinguishment, the rationale behind the decision, and any future commitments that arise as a result of the transaction. These disclosures are integral to a comprehensive understanding of the company’s financial decisions and their implications.

Tax Implications of Debt Extinguishment

The tax implications of debt extinguishment are complex and vary significantly based on the method of extinguishment and jurisdictional tax laws. Generally, when debt is extinguished, especially in cases of debt forgiveness or a debt-for-equity swap, the entity may face tax consequences on the difference between the debt’s face value and the amount paid to settle or restructure the debt. This difference is often considered as income by tax authorities and can be subject to income tax, which could impact the company’s after-tax income and cash flows.

For instance, if a portion of debt is forgiven, the forgiven amount could be treated as cancellation of debt (COD) income, which is taxable under many tax jurisdictions. Companies must carefully consider the tax treatment of any gains resulting from debt forgiveness, as this could lead to a significant tax liability. However, there are exceptions and exclusions in certain situations, such as insolvency or bankruptcy, where COD income may not be taxable.

The method of accounting for the extinguishment also affects tax reporting. For example, if debt is extinguished through a debt-for-equity swap, the tax implications might differ based on whether the transaction is considered a taxable event. The specifics of these transactions must be meticulously documented to ensure compliance with tax laws and to optimize the tax outcomes.

Effective SMART Goal Setting in Accounting Practices

Managing asset retirement obligation accounting, you may also be interested in..., mastering aca codes for precise financial reporting, the importance of vouchers in modern accounting practices, understanding accrued expenses: characteristics and financial impact, special journals: enhancing modern financial reporting.

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COVID 19: Debt modifications

Accounting implications for CFOs

The COVID-19 global pandemic has resulted in economic consequences that many reporting entities may not have had to previously consider. One of those consequences is their ability to repay loans. In response, some lenders have agreed to changing the borrowing terms or providing waivers or modifications to debt covenant arrangements. Any changes to the terms of loan agreements, for example providing any kind of payment holidays on either principal or interest or changing interest rates, should be carefully assessed.

Borrowers need to determine the impact of these changes and then apply the guidance set out in IFRS 9 ‘Financial Instruments’ to determine whether the change is a modification (as defined in IFRS 9). In many instances, a gain or a loss might need to be recorded in profit or loss and depending on facts and circumstances, derecognition of the financial arrangement might be required as a result of modifying the financial instrument arrangement that existed.

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Debt modification accounting

Debt restructuring can take various legal forms including:

• an amendment to the terms of a debt instrument (eg the amounts and timing of payments of interest and principal) or
• a notional repayment of existing debt with immediate re-lending of the same or a different amount with the same counterparty. The borrower will usually incur costs in a debt restructuring, and other fees might also be paid or received. The accounting for the debt modification depends on whether it considered to be ‘substantial’ or ‘non-substantial’.

There are two tests to check whether the modification is substantial, and these are as follows:

• Qualitative test - A significant change in the terms and conditions such that immediate derecognition is required with no additional quantitative analysis. Examples of this type of modification include issuing new debt in different currency from old debt, or equity instrument embedded in the new debt.
• Quantitative test - The net present value of the cash flows under the new terms discounted at the original effective interest rate (EIR) is at least 10% different from the carrying amount of the original debt. This is described as the ‘10% test’.

The following flowchart sets out how to assess whether or not a debt modification is substantial:

The role of fees in the 10% test

As mentioned above, if the ‘10% test’ is exceeded in the quantitative test, this results in a substantial modification. IFRS 9 states this test should compare the discounted present value amount of the cash flows under the new term, including any fees paid net of any fees received, discounted at the original EIR, with the discounted present value amount of the remaining cash flows of the original liability.

As this test is comparing the extent of the change between borrower and lender, the reference to fees in this context should refer to the fees between borrower and lender (eg would not normally include fees paid a lawyer). This was clarified by an amendment to IFRS 9 in the ‘ Annual Improvements to IFRS Standards 2018-2020 ’ issued on 14 May 2020. Whereas above, in the final step, the fees included as an adjustment to the EIR are all fees, including external fees (such as lawyer fees).

In addition, these amendments also clarify that when the exchange or modification is not accounted for as an extinguishment, any costs or fees incurred adjust the carrying amount of the liability and are amortised over the remaining term of the modified liability. If they are accounted for as an extinguishment, they are recognised as part of the gain or loss on the extinguishment that should be recognised in profit or loss.

Modification accounting

IFRS 9 contains guidance on non-substantial modifications and the accounting in such cases. It states that costs or fees incurred are adjusted against the liability and are amortised over the remaining term. That same guidance is silent on other changes in cash flows. Prior to IFRS 9, IAS 39 ‘Financial Instruments: Recognition and Measurement’ included similar guidance, and under IAS 39 it was common for entities to account for non-substantial modifications on a ‘no gain no loss’ basis.

However, IFRS 9 clarifies in the Basis for Conclusions the IASB intends that adjustments to amortised cost in such cases should be recognised in profit or loss. This is the consequence of applying IFRS 9, according to which the liability should be restated to its revised future cash flows discounted by the original EIR.

Entity X has a non-amortising loan of CU 1,000,000 from a bank. Interest is set at a fixed rate of 5%, which is payable monthly. Maturity date is 31 Dec 2022. Transaction costs are assessed to be Nil, meaning the EIR equals the contractual interest of 5%.

On 1 July 2020, the bank agrees to waive interest for a six month period from 1 July 2020 to 31 December 2020.

The value of the non-discounted cash flows before the waiver, discounted at the original EIR is CU 1,000,000 (ie the amortised cost before the waiver). The value of the non-discounted cash flows after the waiver (with six months of less payments), discounted at the original EIR of 5%, gives a new amortised cost of CU 976,000.

In terms of the 10% test, CU 976,000 is less than 10% different to the previous carrying amount, therefore this is treated as a non-substantial modification. The liability is restated in accordance with IFRS 9 to the net present value of future cash flows discounted at 5%, which is CU 976,000.

The difference is an immediate gain of CU 24,000 (CU 1,000,000-CU 976,000) which is recognised in the profit or loss. During the periods where no interest is paid, the interest charge in the profit or loss will continue to be presented, by applying the EIR (adjusted, if need be, for any fees relating to the modification) to the revised amortised cost of the instrument.

The following journal should be recorded:

Fees paid in a non-substantial modification

As explained above, in a non-substantial modification, the liability is restated based on the net present value of the revised cash flows discounted at the original EIR. This amount is compared to the previous carrying amount and the difference is recognised in the profit or loss. However IFRS 9 specifically states in its application guidance, that costs or fees incurred are adjusted against the carrying amount. Such costs or fees therefore have some impact of altering the EIR rather than being recognised in the profit or loss.

Where the counterparty bank is paid an amount which is described as a fee, it would appear contradictory to IFRS 9 to amortise this. In our view, fees to third parties such as lawyers fees should be amortised (and the EIR adjusted). However, we believe fees paid to the counterparty bank that represent part of the cash flows should normally be accounted for in the same way as other as other cash flows on the debt instrument, which would lead to such fees being part of the gain or loss rather than amortised over the remaining life of the loan.

Assume the same scenario as the first example, however there are two additional facts. As part of this modification the entity:

• incurs a CU 10,000 arrangement fee from the bank
• incurs CU 5,000 of legal fees.

The entity carries out the 10% test:

The net present value of the future cash flows, (discounted at the original EIR inclusive of fees paid to the lender) is CU 976,000 plus CU 10,000 = CU 986,000.

For the purposes of the 10% test this is compared to CU 1,000,000 giving only a 1.4% difference. This is less than 10%, so the loan modification (waiver of 6 months of interest) considered to be a non-substantial modification.

However, for the purposes of the accounting entries, our view is the fees to the lender should be expensed while the legal fees should be amortised as explained above.

Therefore, the following journal entries should be recorded:

Extinguishment accounting

Extinguishment accounting involves:

• de-recognition of the existing liability
• recognition of the new or modified liability at its fair value
• recognition of a gain or loss equal to the difference between the carrying value of the old liability and the fair value of the new one. Any incremental costs or fees incurred, and any consideration paid or received, are also included in the calculation of the gain or loss, and
• calculating a new EIR for the modified liability, that is then used in future periods. This rate would normally equate to the market rate of interest used in the fair value calculation (see below).

The fair value of the modified liability will usually need to be estimated. It cannot be assumed that the fair value equals the book value of the existing liability. The fair value can be estimated based on the expected future cash flows of the modified liability, discounted using the interest rate at which the entity could raise debt with similar terms and conditions in the market.

One effect of extinguishment accounting is the accelerated ‘expensing’ of transaction costs. This is because the unamortised portion of any transaction costs deducted from the original loan is included in the determination of the gain or loss on extinguishment. Any additional fees or costs incurred on modification are also included in the gain or loss.

There are some narrow exceptions to this, but generally this is only where the fees do not clearly relate to the modification, but are incremental to issuing the new debt that is payable to a party other than the lender, eg stamp duty paid on new financial instrument that is put in place.

Entity X has a non-amortising loan of CU 10,000,000 from the bank. Interest is set at a fixed rate of 5%, which is payable quarterly. Maturity date is 31 December 2025.

On 1 July 2020 the bank agrees to waive interest for two quarterly periods from 1 July 2020 to 31 December 2020. In addition, the contractual rate of interest is increased to 8% starting 1 January 2021.

As part of the modification, the entity pays a CU 150,000 arrangement fee to the bank and a CU 50,000 professional service fee to its lawyers.

• the net present value of the future revised cash flows, discounted at the original EIR inclusive of fees paid to the lender is CU 10,990,426 plus CU 150,000 which is equal to CU 11,140,426.
• for the purposes of the 10% test this is compared to CU 10,000,000 giving an 11.4% difference. This is more than 10%, so the loan modification (waiver of 6 months of interest and subsequent increase of the contractual interest rate) is considered to be a substantial modification.
• the legal fees are judged not to be incremental to the issue of the new debt, as they include elements relating to advice on the pre-existing debt’s contractual terms.

The initial liability has to be extinguished and a new liability recognised at its fair value as of the date of the modification. Given the market rate of interest is 12% for a comparable liability, the fair value of the liability amounts to CU 8,122,994. The difference of CU 1,877,006 between this initial fair value of the new liability and the carrying amount of the liability derecognised (CU 10,000,000) is recognised as a gain upon extinguishment. All fees incurred (CU 200,000) are immediately expensed, thus reducing the amount of the net gain upon extinguishment to CU 1,677,006.

How Grant Thornton can help

Preparers of financial statements will need to be agile and responsive as the situation unfolds. Having access to experts, insights and accurate information as quickly as possible is critical – but your resources may be stretched at this time.

We can support you as you navigate through accounting for the impacts of COVID-19 on your business. Now more than ever the need for businesses, their auditor and any other accounting advisors to work closely together is essential. In this article is general information, not specific advice. However, if you would like to discuss any of the points raised, please speak to your usual Grant Thornton contact or your local member firm .

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Deeds of Assignment of a Debt – Your Top Questions Answered

Posted by david cammack on february 7, 2020.

Home / Blog / Deeds of Assignment of a Debt – Your Top Questions Answered

( Revised for 2023. )

Do you want to know more about what a deed of assignment of a debt is, if you need one, or what to include in it? If so, our blog article has all the answers. So today, we are answering the top questions from the Internet about deeds of assignment of a debt.

1. Can a debt be assigned? How do I assign a debt in the UK?

Yes. Banks regularly buy and sell debts. If you are a creditor, then you can do so too. But you need to do so in writing. A deed of assignment of a debt is the document to use for this. You would need to assign the whole of a debt, as you cannot assign only part of it. The debtor cannot assign the debt to someone else unless the creditor agrees and you would then do this via a deed of novation.

2. What is an assignment of a loan?

This means the same thing as an assignment of a debt. It is always the right to receive repayment of the debt or loan that you are assigning.

3. What is a deed of assignment of a debt?

This is a legal document that transfers the ownership of the debt to another person. By ‘ownership’ we mean the right to receive repayment of that debt from the same original debtor or borrower.

4. What does assignment of debt mean?

The assignment of a debt will mean that the original debtor or borrower now owes the debt to a different creditor. So the debtor will now need to repay that debt to a new person, because you have transferred the debt.

5. Is a deed of assignment of a debt a legal document?

If prepared correctly, yes, a deed of assignment is a legally-binding document. In order to make the assignment legally binding on the debtor, the creditor should give notice of the assignment to the debtor. Our template includes a notice of the assignment of the debt, so you can complete it and send it to the debtor.

6. What is a notice of assignment of a debt? What do I need to do to give notice of an assignment of a debt?

Once you have assigned a debt, then you need to give the debtor notice of the transfer of the debt. Otherwise, how will they know to repay the new owner of the debt? Ideally, the deed of assignment of debt will mention this and include a form for the notice. (Legalo’s template does.) Wikipedia explains why such notice is necessary here: https://en.wikipedia.org/wiki/Rule_in_Dearle_v_Hall#Criticisms .

7. How do you draft a deed of assignment of a debt?

If you require this deed, then the quickest way to get one is with a template from Legalo. Find our great template here: just click on this link .

8. What are the contents of a deed of assignment of a debt?

If you click on this link and scroll down to the section about the Guide to the template, then you will see the contents of our template for a deed of assignment of a debt.

9. Who can prepare a deed of assignment of a debt? Can a non-lawyer prepare a deed of assignment of a debt?

A non-lawyer can use any of the documents we sell as templates. So this includes a deed of assignment of a debt.

10. Does a deed of assignment of a debt need to be signed by both parties?

The parties who do need to sign it are (a) the original creditor and (b) the one buying (or otherwise taking) the debt from the original creditor. The debtor does not sign it.

11. Does a deed of assignment of a debt need to be witnessed?

All deeds need to be signed correctly with an adult witness, preferably one who none of the persons signing are related to.

12. Does an assignment of debt need to be a deed?

If there is no price being paid for the purchase of the debt, then the document does need to be a deed, in order to ensure it is legally binding. Otherwise, technically it does not need to be prepared and signed as a deed, but generally it is better to do it as a deed in case there is any doubt. Legalo’s template is set up to be signed as a deed.

13. Does a deed of assignment of a debt need to be registered?

Not unless you have secured the debt, for example on a property in the UK at the Land Registry. In such a case, then you would need to register the transfer of the security separately at the Land Registry. You do not register the assignment of the debt itself.

14. How long does a deed of assignment of a debt take to draft?

Legalo’s template makes it easy, so you should only need a few minutes to draft your deed of assignment.

15. How much does a deed of assignment of a debt cost? How much does a notice of assignment of a debt cost? How much do lawyers charge for deed of assignment of a debt?

Our template for a deed of assignment includes a notice of assignment and costs only £24.95. Solicitors would charge an estimated £500 plus VAT for one, so ours represents a significant cost saving.

In just a few minutes yours can be ready. What’s more, Legalo’s templates each come with a guide to make it clear how to complete it. We also provide a free helpline just in case you need any extra assistance to use it. So it could not be easier.

So if you need one, you know where to find it.

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