(Bond Theory: Amortization and Gain or Loss Recognition)

Part I. The appropriate method of amortizing a premium or discount on issuance of bonds is the effective interest method.

(a) What is the effective-interest method of amortization and how is it different from and similar to the straight-line method of amortization?

(b) How is amortization computed using the effective-interest method, and why and how do amounts obtained using the effective-interest method differ from amounts computed under the straight line method?

Part II. Gains or losses from the early extinguishment of debt that is refunded can theoretically be accounted for in three ways:

1. Amortized over remaining life of old debt.

2. Amortized over the life of the new debt issue.

3. Recognized in the period of extinguishment.

(a) Develop supporting arguments for each of the three theoretical methods of accounting for gains and losses from the early extinguishment of debt.

(b) Which of the methods above is generally accepted and how should the appropriate amount of gain or loss be shown in a company’s financial statements?