1. Under the book value method earnings are not affected by conversion. a gain or los is recorded and thus earnings are affected by conversion if the market value differs from the book value of the convertible bonds. I this case, the million fair value of the common stock is higher than the book value of the bonds because the book value would be some amount less than the face amount 20% x 50 million. A loss would be recorded for the difference, reduction earnings. 2. The 7% bonds were issued at a discount. For the reason that the stated rate is less than market rate of bonds. Hence, the bonds would have to be sold at a discount for them to yield 8%. 3. The amount of interest expense would be less in the first year of the term to maturity than in the second year of the life of the bond issue. That is because the 8% effective interest rate is applied to an increasing bond carrying amount, and result in higher interest expense in each successive year. 4. We determine gain or loss on early extinguishment of debt by comparing the book value of the bonds at the date of extinguishment with the purchase price. If more is paid than the book value, a loss result. If less is paid than the book value, a gain result. In this case, a loss results. The bonds were issue at discount so the book value of the bonds at the date of extinguishment must be less than the face amount. Thus, the reacquisition price is more than the book value

On August 31, 2012, Cabell Industries issued $50 million of its 30-year, 6% convertible bonds dated August 31, priced to yield 5%. The bonds are convertible at the option of the investors into 3,000,000 shares of Cabell's common stock. Cabell records interest expense at the effective rate. On August 31, 2015, investors in Cabell's convertible bonds tendered 20% of the bonds for conversion into common stock that had a market value of $20 per share on the date of the conversion. On January 1, 2014, Cabell Industries issued $60 million of its 20-year, 7% bonds dated January 1 at a price to yield 8%. On December 31, 2015, the bonds were extinguished early through acquisition in the open market by Cabell for $60.5 million. Required: 1. Using the book value method, would recording the conversion of the 6% convertible bonds into common stock affect earnings? If so, by how much? Would earnings be affected if the market value method is used? If so, by how much? 2. Were the 7% bonds issued at face value, at a discount, or at a premium? Explain. 3. Would the amount of interest expense for the 7% bonds be higher in the first year or second year of the term to maturity? Explain. 4. How should gain or loss on early extinguishment of debt be determined? Does the early extinguishment of the 7% bonds result in a gain or loss? Explain