Chapter 14 Gain or loss recognized in the period of extinguishment

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C14-4 (continued)

1. (continued)

c. Gain or loss recognized in the period of extinguishment. Proponents of this method

state that the early extinguishment of debt refunded actually does not differ from

other types of extinguishment of debt where the consensus is that any gain or loss

2. The immediate recognition principle is the only acceptable method of reflecting gains or

losses on the early extinguishment of debt.

C14-5 (AICPA adapted solution)

1. The market price of the serial bonds is determined by computing the market price for

each serial separately in the same way that a term bond is determined. That is, the

2. Immediately after the serial bond issue was sold, the current asset–cash–is increased by

3. To determine the amount of interest expense for the serial bonds for 2010, the net carrying

C14-6 (AICPA adapted solution)

1. a. From the point of view of the issuer, the conversion feature of convertible debt results

in a lower cash interest cost than in the case of nonconvertible debt. In addition, the

C14-6 (continued)

1. a. (continued)

calling the issue for redemption. Under these market conditions, the issuer can

effectively eliminate the debt. On the other hand, if the market value of the common

stock does not increase sufficiently to result in the conversion of the debt, the issuer will

2. a. The view that separate accounting recognition should be accorded the conversion

feature of convertible debt is based on the premise that there is an economic value

inherent in the conversion feature or call on the common stock and that the value of

this feature should be recognized for accounting purposes by the issuer. It may be

b. The most important reason given in support of treating convertible debt as a single

element is the inseparability of the debt and equity characteristics. The options

3. The method used by the company to record the exchange of convertible debentures for

common stock can be supported on the grounds that when the company issued the

2.

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C14-6 (continued)

3. (continued)

On the other hand, recording the issue of the common stock at the book value of the

debentures is open to question. It may be argued that the exchange of the stock for the

debentures completes the transaction cycle for the debentures and begins a new cycle

for the stock. The consideration or value used for this new transaction cycle should then

C14-7 (AICPA adapted solution)

1. a. When the debt instrument and the option to acquire common stock are inseparable,

as in the case of convertible bonds, the entire proceeds of the bond issue are

allocated to the debt and the related premium or discount accounts. (An exception

b. In the case of convertible debt there are two principal reasons why all the proceeds

are assigned to the debt. First, the option is inseparable from the debt. Investors in

C14-7 (continued)

1.b. (continued)

c. Arguments have been advanced that accounting for convertible debt should be the

same as for debt issued with detachable stock purchase warrants. Convertible debt

has features of debt and stockholders’ equity, and separate recognition should be

2. Journal entries

Cash 6,680,000

Discount on Notes Payable 1,320,000

C14-8 (AICPA adapted solution)

1. a. A note received in exchange for property, goods, or services is recorded at its present

value, which is presumably the value of the property exchanged. In the case of a

note bearing interest at a reasonable rate and issued in an arm’s-length transaction,

the face value of the note is used, as explained below.

C14-8 (continued)

1.a. (continued)

b. When a note bears no interest (or has a stated interest rate that differs sharply from

the prevailing rate) and/or is not issued in an arm’s-length transaction, the present

value is determined through consideration of the economic substance of the

transaction.

The note and the sales price of the property, goods, or services exchanged for the

The variety of transactions encountered precludes any specific interest rate from

being applicable in all circumstances. However, some general guides may be stated.

The choice of a rate may be affected by the credit standing of the issuer, restrictive

covenants, the collateral, payment, other terms pertaining to the debt, and the tax

2. a. If the recorded value of a note differs from its face value, the difference is treated as

discount or premium and amortized as interest over the life of the note in such a way

C14-8 (continued)

2. (continued)

b. The discount or premium is not an asset or liability separable from the note that gives

rise to it. Therefore, the discount or premium is reported in the balance sheet as a

C14-9 (AICPA adapted solution)

1. (a) The selling price of the bond is the present value of all of the expected net future cash

(b) Immediately after the bond issue is sold, the current asset, cash, is increased by the

2. The following items related to the bond issue are included in Wesley’s 2010 income

statement:

(a) Interest expense is included for ten months (March 2, 2010 to December 31, 2010) at

(b) Interest expense (or bond issue expense) is included for ten months of amortization of

3. The amount of bond discount amortization is lower in the second year of the life of the

bond issue. The interest method of amortization uses a uniform interest rate based upon a

changing carrying value and provides for increasing amortization each year.

C14-10 (AICPA adapted solution)

1. a. The 11% bonds were issued at a premium (more than face value). Although the

2. a. A gain or loss on early extinguishment of debt is determined by comparing the

carrying amount of the bonds at the date of extinguishment with the reacquisition

price. If the carrying amount exceeds the reacquisition price, a gain results. If the

3. a. Net income is not affected by conversion under the book value method. The book

value method views the convertible bonds as possessing substantial characteristics of

equity capital. The conversion represents the completion of a prior transaction (the

C14-11 (amounts in millions)

1. The interest expense was $456 (p. 66), the interest paid was $405 (p. 88), so the difference

was $51.

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C14-12

Note to Instructor: This case does not have a definitive answer. From a financial reporting

perspective, GAAP is identified and summarized. From an ethical perspective, various

issues are raised for discussion purposes.

From a financial reporting perspective, there are two issues. First, in regard to convertible

debt issued at the beginning of the year, although there definitely is a value to the

conversion feature, GAAP is very clear that the value cannot be recognized. (If the

From an ethical perspective, the accountant (and the president) have limited flexibility.

As discussed above, GAAP provides no flexibility in the accounting, although there may

be a little flexibility in how the older bond issue is classified in the balance sheet. Of

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ANSWERS TO RESEARCH SIMULATIONS

R14-1

Note to Instructor: Students are expected to cite references to GAAP in their research of

this issue. They might use the FARS electronic database, pronouncements listed on the

1. To: President, York Company

From: Student

I have researched the issue of how to account for the note received from the president of

the supplier. According to APB 21, par. 11, (FASB Cod. # 310-10-30) a note issued solely for

cash with no other right or privilege exchanged is presumed to have a present value at

issuance measured by the cash proceeds exchanged. Therefore, the note is accounted

for as follows:

At issuance

Note Receivable 100,000

Cash 100,000

Annual interest

Cash 1,000

Interest Revenue 1,000

However, this accounting assumes that there really were no other rights or privileges

exchanged. If there were, then a value would have to be assigned to those rights or

privileges and a more realistic value assigned to the note and to the subsequent interest.

2. The answer would not change except that the interest revenue would be $16,000 per

year.

3. Students may raise ethical issues, such as:

R14-2

Note to Instructor: Students are expected to cite references to GAAP in their research of this

To: President, Wales Company

From: Student

I have researched the issue of how to account for the note receivable from the Spenser

Company. According to APB 21, par. 12-13, (FASB Cod. # 835-30-25) the transaction must