On January 1, 2013, Brewster Company issued 2,000 of its 5-year, $1,000 face value, 11% bonds dated January 1 at an effective annual interest rate (yield) of 9%. Brewster uses the effective interest method of amortization. On December 31, 2014, Brewster extinguished the 2,000 bonds early through acquisition in the open market for $1,980,000. On July 1, 2013, Brewster issued 5,000 of its 6-year, $1,000 face value, 10% convertible bonds dated July 1 at an effective annual interest rate (yield) of 12%. The bonds are convertible at the option of the investor into Brewster's common stock at a ratio of 10 shares of common stock for each bond. Brewster uses the effective interest method of amortization. On July 1, 2014, an investor in Brewster's convertible bonds tendered 1,500 bonds for conversion into 15,000 shares of Brewster's common stock, which had a market value of $105 per share at the date of the conversion.
Required:
1. Using the information about Brewster answer the following questions:
a. Were the 11% bonds issued at par, at a discount, or at a premium? Why?
b. Is the amount of interest expense for the 11% bonds using the effective interest method of amortization higher in the first or second year of the life of the bond issue? Why?
2. Using the information about Brewster explain the following:
a. How is a gain or loss on early extinguishment of debt determined? Does the early extinguishment of the 11% bonds result in a gain or loss? Why?
b. How does Brewster report the early extinguishment of the 11% bonds on the 2014 income statement?
3. Based on the information provided about Brewster answer the following questions:
a. Does recording the conversion of the 10% convertible bonds into common stock under the book value method affect net income? What is the rationale for the book value method?
b. Does recording the conversion of the 10% convertible bonds into common stock under the market value method affect net income? What is the rationale for the market value method?