Chapter 12

Set-off and extinguishment of debt

12.1

A set-off is the reduction of an asset by a liability or a liability by an asset in the presentation

of a balance sheet so that only the net amount is presented.

12.2

AASB 132 allows assets and liabilities to be set-off for balance sheet purposes when a legally
recognised right of set-off exists, and the entities expect to settle the debts on a net basis.
Specifically, paragraph 42 of AASB 132 states:
A financial asset and a financial liability shall be offset and the net amount presented in
the balance sheet when, and only when, an entity:
(a) currently has a legally enforceable right to set off the recognised amounts; and
(b) intends either to settle on a net basis, or to realise the asset and settle the
liability simultaneously.

12.3

By performing a set-off of assets and liabilities a companys reported gearing ratios would
show improvement. This may be particularly beneficial for companies that are subject to debt
constraints, or where debt levels look unfavourable relative to competitors/industry norms.

12.4

A legal defeasance is not defined in AASB 132. It was formerly defined in AASB 1014. A
defeasance occurs when there is a release of a debtor from the primary obligation of a debt.
A legal defeasance is considered to occur when the release of the debtor from the primary
obligation for a debt is either acknowledged formally by the creditor or by a duly appointed
trustee of the creditor, or established by legal judgement. An example would be where a debt
is formally forgiven.

12.5

The Accounting Standards do not explicitly require disclosures relating to the set-off. To the
extent that the right of set-off exists and is exercised, then there would be no further
obligation in relation to the debt and therefore such debt, and the related receivable, would
not require disclosure.

12.6

There could be a perception that by showing lower amounts of debt on the balance sheet, and
by providing information which would lead to the calculation of lower leverage indicators,
the readers of the financial statements will assess that the reporting entity is of lower risk that
might otherwise be the case. This in turn might enable the organisation to attract funds at a
lower cost. Implicit in this answer is an assumption that the capital market may not be fully
efficient, and as result, the act of offsetting an asset against a liability (a reasonably
inexpensive exercise) will lead to material benefits.

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12.7

Firstly, we need to determine the original issue price so that we may determine the balance of
the unamortised discount at the date the debt was forgiven.
Present value of debenture principaldiscounted for 8 years at 16%
$5 000 000 x 0.3050
Present value of debenture interestannuity for 8 years discounted at 16%
$600 000 x 4.3436
Original issue price
Face value
Discount on issue

$1 525 000
$2 606 160
$4 131 160
$5 000 000
$868 840

Using the-straight line method, the balance of the discount after 3 years would be:
$868 840 x 5/8 = $543 025
The journal entries to record the forgiveness of the debt would therefore be:
Dr
Cr
Cr
12.8

Debentures
Discount on debentures
Gain on forgiveness of debt

5 000 000
543 025
4 456 975

An entity may wish to perform a set-off to reduce gearing ratios such as debt to assets, or
debt to shareholders funds. If Arthur was to perform a set-off, the post set-off balance sheet
would be:
Balance sheet
Post set-off
Loans payable
Shareholders equity

700 000 Loans receivable

1 000 000 Fixed assets
$1 700 000

900 000
800 000
$1 700 000

As we can see, as a result of the set-off, the debt-to-asset ratio has moved from 50% to
41.2%, whilst the debt to shareholders funds has moved from 100% to 70%.

12.9

Yes, the two amounts can be set-off. If one entity in an economic entity (for example, Parent
Ltd) owes an outside entity (for example, Outsider Ltd) a determinable amount and that same
outside entity (Outsider Ltd) owes another entity in the economic entity (for example, A Ltd)
a determinable amount, then a set-off may be performed for the purposes of the consolidated
balance sheet. Consequently, the consolidated balance sheet would show an amount of
$100 000 payable to Outsider Ltd. Paragraph 45 of AASB 132 states:
A right of set-off is a debtors legal right, by contract or otherwise, to settle or
otherwise eliminate all or a portion of an amount due to a creditor by applying
against that amount an amount due from the creditor. In unusual circumstances, a
debtor may have a legal right to apply an amount due from a third party against the
amount due to a creditor provided that there is an agreement between the three
parties that clearly establishes the debtors right of set-off. Because the right of setoff is a legal right, the conditions supporting the right may vary from one legal
jurisdiction to another and the laws applicable to the relationships between the
parties need to be considered.

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12.10 An insubstance debt defeasance was defined in AASB 1014 (now replaced by AASB 132) as
a defeasance, other than a legal defeasance, in which the debtor effectively achieved release
from the primary obligation for a debt, either by placing in trust assets which are adequate to
meet the servicing requirements (both interest and principal) of the debt, or by having a
suitable entity assume responsibility for those servicing requirements. It was referred to as an
insubstance defeasance as the creditor had not actually been repaid, but the substance of the
transaction was that no further amount was likely to be paid, so in substance, the debt was
effectively paid. Since the firm would have to pay nothing further in relation to the debt, they
had, in substance, paid off the debt.
From 2005, AASB 132 prohibits the removal of debt from the balance sheet as a result of an
insubstance debt defeasance. Specifically, paragraph 49 of AASB 132 notes that the
conditions set out in paragraph 42 (pertaining to the removal of debt from the balance sheet)
are generally not satisfied and offsetting is inappropriate when financial assets are set aside in
trust by a debtor for the purpose of discharging an obligation without those assets having
been accepted by the creditor in settlement of the debt. That is, the involvement of the
creditor in the action is now required.
The above prohibition now contained in AASB 132 is interesting. AASB 132 seems to take a
much more form over substance approach than the previous Australian position under
AASB 1014. If the probability that further payments will be necessary is remote because the
assets irrevocably transferred to the trust are sufficient to meet the debt servicing
requirements then it makes sense that debt should be removed from the balance sheet. That is,
the former treatment provided by AASB 1014 appears logical. It is not clear that the AASB
132 is as logical.
12.11 5 May 2011
Books of Snapper Ltd
Dr
Cr

Loan payableKirra Ltd

Gain on release from debt (a revenue item)

500 000
500 000

Books of Kirra Ltd

Dr
Cr

Loss on release of debtorSnapper Ltd (an expense

item)
Loan receivableSnapper Ltd

500 000

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500 000

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