The effective interest method of amortization, when applied to a bond discount, will result in smaller

charges to interest expense in the early periods and larger charges in the later periods, indicating
lower amounts of amortization in the early periods and higher amounts later. The straight-line
method involves equal charges to interest expense each period, indicating equal amounts of
amortization. Amortization of bond discount under the straight-line method would result in higher
amortization in the early periods, causing interest expense and the carrying value of the bonds to be
overstated. With interest expense being overstated, retained earnings would be understated.
The proceeds of bonds (face value * discount or premium) issued with detachable warrants are
allocated between the bonds and the warrants based upon their relative FMV at the time of
issuance. When only the fair market value of one or the other is known, however, that amount is
allocated to that security with the remainder allocated to the other. When only the fair market value
of one or the other is known, however, that amount is allocated to that security with the remainder
allocated to the other.
Since the bonds with detachable stock purchase warrants were issued at par, the proceeds would
have been $1,000,000. These proceeds are allocated between the bonds and the warrants
according to their relative fair values. The market value of the bonds was $1,080,000 while the
market value of the warrants was $120,000 for a total of $1,200,000. As a result, the bonds
accounted for 90% of the fair market value and the warrants accounted for 10%. Under the relative
fair value method, 10% of the proceeds, or $100,000 would be allocated to the warrants (increasing
stockholders' equity) with 90% or $900,000 allocated to the bonds.
Convertible debt securities give the security holder the option of converting the bond into common
stock at a future date and at a predetermined price, which is generally higher than the stocks market
price on the date of issuance, but may be lower in the future while the bonds are convertible. As a
result of the benefit associated with the conversion feature, convertible bonds generally bear interest
at a rate that is lower than bonds that are not convertible.
Since the bonds were issued at a discount, the carrying value would be lower than the face amount.
If they are retired at 105, the amount paid to redeem the bonds would exceed the face, and therefor
the carrying value, resulting in a loss on retirement. A gain or loss on early retirement of debt is
recognized as a component of income from continuing operations.
When a company issues a bond at 98, which means the proceeds will be 98% of the face value, with
the difference recognized as a discount.
Bond issue costs are amortized on a straight-line basis over the term of the bond.
Regardless of the method used for accounting for the conversion of bonds, stockholders' equity
would be increased since debt is being converted into equity. Additional paid-in capital would be
decreased if the carrying value of the bonds was lower than the par value of the stock.
Bond discounts reduce the carrying amount of bonds and amortization of the discount increases the
carrying amount.

Since the bonds were originally issued at 98, which means 98% of the face amount of $1,500,000,
they were issued for $1,470,000 with a discount of $30,000. After 10 years, 1/3 of the discount, or
$10,000, and 1/3 of the $90,000 in bond issue costs, or $30,000 would be amortized, leaving a
discount of $20,000 and unamortized bond issue costs of $60,000. When a bond is extinguished, a
gain or loss on extinguishment will be recognized for the difference between the cost of extinguishing
the bond and its carrying value. At a redemption price of 102, the cost of extinguishing the bond was
102% of the $1,500,000 face value, or $1,530,000. The carrying value of the bond, for purposes of
recognizing a gain or loss on extinguishment, is its face value, $1,500,000, minus any unamortized
discount (or plus an unamortized premium) of $20,000 and minus any unamortized bond issue costs
of $60,000 for a net amount of $1,420,000. The difference, $1,530,000 - $1,420,000 or $110,000 will
be the loss on extinguishment.
When debt is issued at a discount, a debit to the bonds discount account is set up to equal the
difference between the proceeds from issuing the bond and the face amount. The discount will be
amortized over the life of the bond by crediting the account every interest payment. Interest expense
is debited in an amount equal to the credit to the discount account plus the credit to cash for the
amount paid.
As of 6/2/X13, 5 years of the bonds 15-year life has elapsed indicating that 1/3 of the discount would
have been amortized. The carrying value of the bonds for retirement purposes equals the face of
$500,000 less the unamortized discount of $4,000 for a net amount of $496,000.
When the effective interest rate is higher than the stated interest rate the bonds is be issued for less
than the face amount at a discount. The discount is amortized over the life of the bond and the
amortization is added to the amount paid to determine interest expense, making the expense greater
than the cash payment.
The market price of a bond is equal to the present value of the stream of payments to be made using
the market rate of interest. The stream of payments will include the principal amount, representing a
lump sum to be paid at the end of the bond term, and periodic interest, representing an annuity of
equal payments to be paid each period during the term of the bond. As a result, the market value of
the bond will be the present value of the principal plus the present value of future interest payments,
both calculated using the market rate of interest. [[ face value * present value of 1 at effective rate +
1 interest payment (which is face x stated rate) * present value of ordinary annuity at effective rate) ]]
For purposes of retirement, the carrying value of the bonds would be the face plus the unamortized
bond premium and minus the bond issue costs. This amount will be compared to the amount
required to retire the bonds to determine a gain or loss on retirement.
Interest payable is the face value times the stated rate on the coupon. This is true if the bond has a
discount or a premium. Interest expense is the carrying value of the bonds multiplied by the effective
rates.
The carrying value of the retired bonds was the face of $600,000 plus unamortized premium of
$65,000 for a total of $665,000. Since they were retired at 102, the amount required to retire the
bonds was $612,000 resulting in a gain, before taxes, of $53,000.

The net present value is the difference between the initial cash outlay and the present value of the
future cash inflows.
Interest payable is the amount that the company will have to pay in cash as a result of the time
elapsed since the previous interest payment. The amount will be equal to the face of the bond
multiplied by the stated rate times the portion of a year since the most recent interest payment.