CFA Level I Exam · Topics in Long-Term Liabilities and Equity

Debt Derecognition, Fair Value Option and Covenants

Updated 7 October 2026 · Fact-checked

Derecognition removes a bond liability from the balance sheet when it is repaid or extinguished. Gain or loss equals carrying amount minus the amount paid. Paying less than carrying amount gives a gain. The fair value option measures a liability at fair value. Covenants are lender-imposed promises that limit borrower actions.

Understand Derecognition, Fair Value Option and Debt Covenants

A bond is a liability. You remove it from the balance sheet (derecognition) when the obligation is discharged, cancelled or expires. This most often happens when the issuer repays at maturity or buys the bond back before maturity (redemption or extinguishment).

At maturity, the carrying amount has been amortized up to face value. You pay face value, so there is no gain or loss. Before maturity, the carrying amount is the book value at that date: face value plus unamortized premium or minus unamortized discount. Under IFRS, unamortized issuance costs also reduce the carrying amount. If the issuer pays more than the carrying amount to retire the debt, it records a loss. If it pays less, it records a gain. The gain or loss is recognised in profit or loss. Because unamortized issuance costs are already inside the carrying amount, they are written off through this gain or loss. Analysts usually treat it as non-recurring when assessing earnings quality.

The cash paid for repayment is a financing outflow (CFF). Under the indirect method, the gain or loss is a non-cash adjustment that is removed from net income in operating cash flow, so it is not counted twice.

Under IFRS, most financial liabilities are measured at amortized cost. The fair value option lets an entity designate a liability at fair value through profit or loss when it removes or reduces an accounting mismatch, or when a group of liabilities is managed on a fair value basis. The choice is made at initial recognition and is irrevocable. A common quirk: if the issuer's own credit quality falls, the fair value of its debt falls. Under IFRS, the part of the change due to own credit risk goes to other comprehensive income, and the rest goes to profit or loss. The exception is where the OCI treatment would create or enlarge an accounting mismatch in profit or loss; then the whole change goes to profit or loss. Analysts watch for this exception because a deterioration in own credit would then produce a gain in profit or loss that can flatter reported earnings.

Debt covenants are terms in the bond or loan agreement that protect lenders. Affirmative covenants say what the borrower must do, such as pay interest and principal on time, maintain insurance, deliver financial statements and comply with laws. Negative covenants say what the borrower must not do, such as take on more debt beyond a limit, pay dividends above a cap, sell key assets, or breach a required ratio (for example, a minimum interest coverage or maximum debt to EBITDA). A breach can lead to default, higher interest, or immediate repayment. Analysts use covenants to judge credit risk and how much room management has.

Key formulas to remember

Carrying amount of a bond: Carrying amount = Face value + Unamortized premium (or − Unamortized discount) − Unamortized issuance costs (IFRS); Under the effective interest method, it equals the present value of the remaining cash flows discounted at the effective rate set at issue. Under IFRS, unamortized issuance costs reduce the carrying amount.
Gain or loss on extinguishment: Gain (loss) = Carrying amount − Cash paid to retire (including any call premium); Positive means gain. Negative means loss. The carrying amount is net of unamortized issuance costs under IFRS, so those costs are included in the gain or loss.
Partial retirement: Carrying amount retired = Total carrying amount × (Face value retired ÷ Total face value); Use when only part of an issue is bought back.
Cash flow treatment: CFF outflow = cash paid; CFO adjustment = − gain (or + loss); Indirect method only. The gain or loss is non-cash in the CFO reconciliation.
Fair value option (IFRS): Change in fair value from own credit risk → OCI; remainder → profit or loss; Designation is irrevocable and made at initial recognition. If OCI treatment would create or enlarge an accounting mismatch in profit or loss, the whole change goes to profit or loss.

How to solve Derecognition, Fair Value Option and Debt Covenants questions

Use this order for any derecognition, fair value option or covenant question.

1Identify what the question tests: extinguishment calculation, fair value option effect, or covenant type and effect.
2For extinguishment, find the carrying amount at the repurchase date: face value plus premium or minus discount, after amortization to that date.
3Find the cash paid, which is price times face value retired. Include any call premium.
4Compute carrying amount minus cash paid. Positive is a gain, negative is a loss. Scale by the fraction retired if partial.
5Check the statement effects: income statement gain or loss, CFF outflow, and the CFO non-cash adjustment.
6For fair value option, ask whether credit risk or market rates moved. A drop in fair value of a liability is a gain; split own-credit effects to OCI under IFRS.
7For covenants, classify as affirmative (must do) or negative (must not do), then link to lender protection and breach consequences.

Quickest way: Carrying amount versus price paid

When to use it: Any numeric extinguishment question where you need only the sign and size of the gain or loss.

Write carrying amount on the left and price paid on the right.
If carrying amount is bigger, it is a gain. If price paid is bigger, it is a loss.
Check the answer order: with options listed smallest to largest, a negative value (loss) is usually the smallest option.
Eliminate options that have the wrong sign, then confirm the size by multiplying by the fraction retired.

Common mistakes in Derecognition, Fair Value Option and Debt Covenants

Using face value instead of carrying amount to compute the gain or loss
Face value is the number you see first in the question.
Fix: Always adjust face value for unamortized premium or discount at the repurchase date.
Reversing the sign of the gain or loss
Students think paying more means a bigger gain.
Fix: Paying more than carrying amount is a loss. Paying less is a gain.
Treating the gain or loss as a cash flow in CFO
The repurchase is a cash event, so it feels operating.
Fix: Cash paid is CFF. Remove the gain or loss from net income in the indirect CFO reconciliation.
Ignoring the call premium or unamortized issuance costs
Questions list them in a separate sentence.
Fix: Add the premium to cash paid and include unamortized costs in the carrying amount.
Thinking a fall in a company's credit quality always hurts income under the fair value option
Bad news seems to mean a loss.
Fix: A lower fair value of a liability is a gain. Under IFRS the own-credit part goes to OCI.
Mixing up affirmative and negative covenants
The names sound like good and bad.
Fix: Affirmative means the borrower must do something. Negative means the borrower must refrain from something.

Worked examples

Example 1

A company issued bonds with face value €10,000,000. At the date of repurchase, the carrying amount is €10,400,000. The company buys back all the bonds for €10,150,000. What is the gain or loss? A) −€250,000 (a loss) B) +€250,000 (a gain) C) +€400,000 (a gain)

Show the solution

Carrying amount = €10,400,000.
Cash paid = €10,150,000.
Gain = 10,400,000 − 10,150,000 = €250,000.
Paid less than carrying amount, so it is a gain. Option A has the wrong sign. Option C is carrying amount minus face value (10,400,000 − 10,000,000), which ignores the cash actually paid.
The options as signed values (−250,000, +250,000, +400,000) run from smallest to largest.

Answer: B) +€250,000, a gain. Report in profit or loss, show €10,150,000 as a CFF outflow, and deduct €250,000 in the indirect CFO reconciliation.

Example 2

A company has bonds with face value $5,000,000 and unamortized discount of $200,000. It retires 40% of the face value by paying 99 per 100 of face. What is the gain or loss? A) Loss of $60,000 B) Loss of $12,000 C) Gain of $60,000

Show the solution

Face retired = 40% × 5,000,000 = $2,000,000.
Carrying amount of total issue = 5,000,000 − 200,000 = $4,800,000.
Carrying amount retired = 4,800,000 × 40% = $1,920,000.
Cash paid = 99% × 2,000,000 = $1,980,000.
Gain (loss) = 1,920,000 − 1,980,000 = −$60,000, a loss.
Cash paid exceeds carrying amount, so it is a loss. That rules out the gain in option C. The computed loss is $60,000, so the $12,000 loss in option B is wrong.

Answer: A) Loss of $60,000. The carrying amount is 96 per 100 of face, so paying 99 gives a loss of 3% × $2,000,000 = $60,000.

Exam tips

For numeric questions, compute carrying amount at the repurchase date first. The wrong options are often built from face value.
Remember the sign rule: carrying amount above price paid is a gain.
For cash flow items, the repayment sits in CFF and the gain or loss is removed from CFO under the indirect method.
For covenant questions, match the wording: must do equals affirmative, must not do equals negative.
Treat extinguishment gains as non-recurring when judging earnings quality.

Practice questions from Topics in Long-Term Liabilities and Equity

Derecognition, Fair Value Option and Debt Covenants: frequently asked questions

How do you calculate gain or loss on early extinguishment of debt?

Subtract the cash paid, including any call premium, from the carrying amount of the debt at that date. A positive result is a gain. A negative result is a loss. Include unamortized issuance costs in the carrying amount if relevant.

Where does the gain or loss on debt extinguishment appear in the financial statements?

It appears in the income statement. The cash paid is a financing outflow in the cash flow statement. Under the indirect method, the gain or loss is adjusted out of net income in operating cash flow.

What is the fair value option for financial liabilities?

It lets an entity measure a liability at fair value through profit or loss instead of amortized cost. It is allowed when it removes an accounting mismatch or when a group of liabilities is managed on a fair value basis. The choice is made at initial recognition and cannot be reversed.

What are affirmative and negative debt covenants?

Affirmative covenants require the borrower to take actions such as paying on time, keeping insurance and providing financial statements. Negative covenants restrict actions such as taking on extra debt, paying large dividends or selling key assets. Both protect lenders.