Chapter 11 - Solution Manual

Either method however computes the premium or

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on the carrying value of the debt. Either method, however, computes the premium or discount to be amortized as the difference between the par value of the debt and the proceeds from the issuance. b. Before the interest method of amortization can be used, the effective yield or interest rate of the bond must be computed. The effective yield rate is the interest rate that will discount the two components of the debt instrument to the amount received at issuance. The two components in the value of a bond are the present value of the principal amount due at the end of the bond term and the present value of the annuity represented by the periodic interest payments during the life of the bond. Interest expense using the interest method is based upon the effective yield or interest rate multiplied by the carrying value of the bond (par value effected for unamortized premium or discount). The amount of the amortization is the difference between recognized interest expense and the interest actually paid (par value multiplied by nominal rate). When a premium is being amortized, the dollar amount of the periodic amortization will increase over the life of the instrument due to the decreasing carrying value of the bond instrument multiplied by the constant effective interest rate, which is subtracted from the amount of cash interest paid. In the case of a discount, the dollar amount of the periodic amortization will increase over the life of the bond due to the increasing carrying value of the bond instrument multiplied by the constant effective interest rate from which is subtracted the amount of cash interest paid. The varying amounts of amortization occur because of the changing carrying value of the bond over the life of the instrument. In contrast, the straight-line method of amortization yields a constant dollar amount of amortization based upon the life of the instrument regardless of effective yield rate demanded in the marketplace. c. The effective interest method of amortization does not provide an appropriate liability balance amount because the amount disclosed is not the amount necessary to retire the liability on the balance sheet date. Case 11-5 a. Gain or loss to be amortized over the remaining life of old debt. The basic argument supporting this method is that if refunding is done to obtain debt at a lower cash outlay (interest cost), then the gain or loss is truly a cost of obtaining the reduction in cash outlay. As such, the new rate of interest alone does not reflect the cost of the new debt, but a portion of the gain or loss on the extinguishment of the old instrument must be matched with the nominal interest to reflect the true cost of obtaining the new debt instrument. This argument states that this matching must continue for the unexpired life of the old debt in order to reflect the true nature of the transaction and cost of obtaining the new debt instrument.
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