Answer The Following Question In A Minimum Of 500 Words

Answer the Following Question in a Minimum of 500 words

On August 31, 2010, Chickasaw Industries issued $25 million of its 30-year, 6% convertible bonds, priced to yield 5%. The bonds were convertible at the investor's option into 1,500,000 shares of Chickasaw's common stock. Chickasaw records interest expense using the effective interest method. On August 31, 2013, investors tendered 20% of these bonds for conversion into common stock, which had a market value of $20 per share on the conversion date. Additionally, on January 1, 2012, Chickasaw issued $40 million of 20-year, 7% bonds at a yield of 8% and later extinguished these bonds early in December 2013 by purchasing them for $40.5 million in the open market. This comprehensive analysis addresses four main questions related to these transactions, focusing on the accounting treatments and their impact on earnings, bond valuation, interest expense, and gain or loss on early extinguishment.

1. Impact of Bond Conversion on Earnings using Book Value and Market Value Methods

Using the book value method, the conversion of Chickasaw's 6% convertible bonds into common stock does not directly affect reported earnings at the time of conversion. Instead, the book value method entails removing the carrying amount of the bonds from liabilities and recognizing an additional paid-in capital account, assuming the carrying amount and the value of shares issued are accounted for accordingly. As a result, the book value of the bonds is transferred to common equity, and no gain or loss is recognized on conversion, which means there is no immediate impact on net income (Kieso, Weygandt, & Warfield, 2019). Therefore, under the book value approach, the conversion does not affect earnings directly.

In contrast, if the market value method is employed, the conversion could potentially impact earnings. Under this method, the bonds are converted based on the fair market value of the shares issued or the bonds payable, and any difference between the carrying amount of the bonds and the fair value of the equity issued is recognized as a gain or loss. For instance, in this case, the market value of the shares issued upon conversion can be calculated as 1,500,000 shares at $20 per share, totaling $30 million. Since the bonds' book value is less than this value, recognizing the difference as a loss would be necessary, indicating a potential decrease in earnings.

However, under GAAP, most companies favor the book value method for converting bonds, which generally buffers earnings from the immediate impact of conversions. The market value method might lead to recognized gains or losses at conversion, affecting earnings based on the difference between book and market values (Kieso et al., 2019).

2. Issuance of the 7% Bonds: At Face Value, Discount, or Premium?

The 7% bonds issued at a yield of 8% imply that they were not issued at face value. Since the coupon rate (7%) is lower than the yield (8%), these bonds were issued at a discount. Soldiers' bond valuations show that bonds offering lower coupon payments than prevailing market rates are issued below par to compensate investors for the lower interest income relative to market conditions. Therefore, the issuance price would be less than $40 million, indicating issuance at a discount (Ross, Westerfield, & Jaffe, 2019).

3. Interest Expense in First vs. Second Year of Bonds

The interest expense for the 7% bonds would likely be higher in the second year than in the first. When bonds are issued at a discount, the effective interest rate (8%) is higher than the coupon rate (7%), resulting in amortization of the discount over the bond's life. Initially, the unamortized discount is at its maximum and decreases over time as amortization progresses (Kieso et al., 2019). Consequently, the interest expense, which includes the amortized portion of the discount, would be higher in the early years and gradually decrease as the discount is amortized. Therefore, the second year's interest expense would be greater than the first, reflecting the declining discount amortization in the earlier years.

4. Gain or Loss on Early Extinguishment of Debt & Impact of Extinguishing 7% Bonds

Gains or losses on early extinguishment of debt are determined by comparing the carrying amount of the bonds at extinguishment with the cost to settle them, which includes the purchase price paid in the open market. If the acquisition cost exceeds the carrying amount, a loss is recognized; if it is less, a gain is recorded (Kieso et al., 2019).

In this case, Chickasaw purchased the bonds for $40.5 million, exceeding their book value, leading to a loss on extinguishment. Since the bonds were originally issued at a discount, their carrying amount would probably be below the $40.5 million acquisition cost, resulting in a loss upon early extinguishment. This loss reflects the difference between the purchase price and the bonds’ carrying amount, which includes the amortized discount and principal balance (Ross et al., 2019).

Conclusion

In summary, bond conversions primarily impact earnings depending on whether the book value or market value approach is employed, with the book value method typically not affecting earnings immediately. The issuance of bonds at a yield higher than the coupon rate indicates issuance at a discount, which influences interest expense over time. The gain or loss on early extinguishment depends on the difference between the reacquisition cost and the bonds' carrying amount, with Chickasaw incurring a loss due to paying more than the book value. These financial activities exemplify crucial accounting principles that ensure accurate financial reporting and reflect operational realities (Kieso, Weygandt, & Warfield, 2019; Ross, Westerfield, & Jaffe, 2019).

References

• Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2019). Intermediate Accounting (16th ed.). Wiley.
• Ross, S. A., Westerfield, R. W., & Jaffe, J. F. (2019). Corporate Finance (12th ed.). McGraw-Hill Education.
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