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Chapter 11 - Solution Manual

Gain or loss to be amortized over the life of the new

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Gain or loss to be amortized over the life of the new debt instrument. This argument states that the gain or loss from early extinguishment of debt actually affects the cost of obtaining a new debt instrument. However, this method asserts that the effect should be matched with the interest expense of the new debt for the entire life of the new debt instrument. This argument is based on the assumption that the debt was refunded to take advantage of new lower interest rates or to avoid projected high interest rates in the future and that any gain or loss on early extinguishment
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219 should be reflected as an element of this decision and total interest cost over the life of the new instrument should be stated to reflect this decision. Gain or loss recognized in the period of extinguishment. Proponents of this method state that the early extinguishment of debt to be refunded actually does not differ from other types of extinguishment of debt where the consensus is that any gain or loss from the transaction should be recognized in full in current net earnings. The early extinguishment of the debt is prompted for the same reason that other debt instruments are extinguished, namely, that the value of the debt instrument has changed in light of current financial circumstances and early extinguishment of the debt would produce the most favorable results. Also, it is argued that any gain or loss on the extinguishment is directly related to market interest fluctuations related to prior periods. If the true market interest rate had been known at the time of issuance, there would be no gain or loss at the time of extinguishment. Also, even if market interest rates were not known but the carrying value of the bond was periodically adjusted to market, any gain or loss would be reflected at the interim dates and not in a future period. The call premium paid on extinguishment and nay unamortized premium or discount are actually adjustments to the actual effective interest rate over the outstanding life of the bond. As such, any gain or loss on the early extinguishment of debt is related to prior-period valuation differences and should be recognized immediately. b. Recognizing the gain or loss from refunding debt in the period of extinguishment would provide a balance sheet measure that reflects the present value of the future cash flows discounted at the interest rate that is commensurate with the risk associated with the new debt issue. This measure is equivalent to the issue price of the new debt. The issue price of the new debt is set by the market. The market sets the issue price by discounting the future cash flows set forth in the debt instrument by the market rate of interest. c. Recognizing the gain or loss from refunding debt in the period of extinguishment is the generally accepted approach. Originally, these gains and losses were classified as extraordinary, hoverer, in 2002 the FASB concluded that debt extinguishments that are used as a part of an entity's risk
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