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Chapter 11 - Solution Manual

As this amount 213 is accumulated by charges to

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interest on the amount borrowed ($975,000) that will not be paid until maturity. As this amount
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213 is accumulated by charges to interest expense and credits to the bond liability, the effective amount of the liability gradually approaches maturity value. It should be noted that bond issue costs are disregarded in computing the effective amount of the bond liability. Though they are usually added to the discount or deducted from the premium, bond issue costs should properly be treated as an asset. Such costs are incurred in the process of acquiring borrowed funds and should be amortized over the period during which the funds are used. $1,000,000. This basis for valuing bond liabilities, the amount due at maturity, is widely used in practice. Its use is frequently supported on the grounds that it represents the amount of true legal liability, since it is this amount that would be due and payable in the event of default. This support disregards the accounting assumption of the going concern and, instead, emphasizes liquidation values. This valuation basis is also supported on the grounds that the discount represents prepaid interest and should therefore be classified as an asset. This argument has no merit because the discount represents unpaid interest, not prepaid interest. Any bookkeeping entry which classifies discount as prepaid interest does so only by failing to properly adjust to amount borrowed to its effective amount. The practice of recording bond liabilities at maturity value and setting up the discount as a deferred charge is defensible only if the amounts involved are not material and it can be shown that this treatment is expedient. $1,780,000. The basis for this alternative--the total amount the Company is obligated to repay over the remaining life of the bonds ($1,000,000 at maturity, plus 39 semiannual interest payments of $20,000 each)--has no justification. It would require the difference between the amount actually borrowed ($975,000) and the total amount the Company became obligated to repay ($1,800,000) to be treated as an asset or a loss when the bonds were issued. To assume that assets were acquired in excess of the amount actually borrowed or that a loss was incurred in an arm's-length transaction is indefensible. The original bondholders invested $975,000 for the right to receive $1,800,000 under the conditions stipulated in the contract (an annuity of $20,000 for forty periods and $1,000,000 at the end of the fortieth period). Thus, at the date of issuance the Company incurs a liability equal to the amount of the bondholders' investment. The difference between this amount and $1,800,000 is the total amount of interest which will accrue with the passage of time. It does not exist at the date the bonds are issued. Except for the materiality of the amounts involved, the use of this alternative as a valuation basis suffers from the same theoretical shortcomings as does the use of face value when bonds are issued at a discount.
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As this amount 213 is accumulated by charges to interest...

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