chapters 9 accounting

If $100,000 face value bonds are issued at 96, how much cash would the corporation receive for the bonds?

96,000

debt to total assets ratio long term debt to total equity

=total liabilities/total assets =long term debt/total equity

What does it mean if a bond is "convertible"?

A convertible bond gives the lender the option to convert the bond into other securities, typically shares of common stock. This "conversion" will usually take place if the value of the common stock is greater than the interest and principal payments supplied by the debt instrument.

Face value

(also called par value or principal)- amount of money the borrower agrees to repay at maturity

Bower Company sold $100,000 of 20-year bonds for $95,000. The stated rate on the bonds was 7%, and interest is paid annually on December 31. What entry would be made on December 31 when the interest is paid? (Numbers are omitted.)

interest expense discount on BP cash

Coupon notes, debentures, or bonds

interest payments were made when a bondholder detached a coupon from the debt contract and mailed it to the company on the interest payment date

retained earnings

is a measure of internally generated equity (worth) but it is only one component of equity. Paid in Capital represents externally generated equity as it includes all amounts received from investors in exchange for ownership of the company.

Sean Corp. issued a $40,000, 10-year bond, with a stated rate of 8%, paid semiannually. How much cash will the bond investors receive at the end of the first interest period?

1,600

The formula for the debt to equity ratio is

total liabilities/total equity

The formula for the debt to total assets ratio is

total liability/total asset

Bonds Payable

transactions are recorded by corporations, issuance, buy back, bondholder converts bond to common stock *no entry when bondholder sells to another investor *prices are quoted as a % of the face value *bond payable is long term *bond interest payable is short term

What is the stated or coupon rate of a bond?

The stated or coupon rate of a bond is the rate of interest paid on the face (or par) value. The borrower pays this interest to the creditor each period until maturity.

Kinsella Corporation's balance sheet showed the following amounts: current liabilities, $75,000; total liabilities, $100,000; total assets, $200,000. What is the long-term debt to equity ratio?

0.25

Willow Corporation's balance sheet showed the following amounts: current liabilities, $5,000; bonds payable, $1,500; lease obligations, $2,300. Total stockholders' equity was $6,000. The debt to equity ratio is

1.47

How is total interest for long-term debt calculated?

Total interest on long-term debt equals the excess of the amount paid to the lender over the amount borrowed throughout the entire life of the bond.

Under the effective interest rate method, describe the difference in calculating the (a) interest payment and (b) interest expense for the period.

Under the effective interest rate method, interest payments are calculated by multiplying the face value of the bond by the stated interest rate multiplied by time (in years). The interest expense, however, is calculated by multiplying the carrying value by the yield rate multiplied by the time (in years).

If bonds are issued at 101.25, this means that

a. a $1,000 bond sold for $1,012.50.

Bonds are sold at a premium if the

a. market rate of interest was less than the stated rate at the time of issue.

The bond issue price is determined by calculating the

a. present value of the stream of interest payments and the present value of the maturity amount.

Bonds are a popular source of financing because

bond interest expense is deductible for tax purposes, while dividends paid on stock are not

Which of the following accounts is credited in every bond issuance whether at par, premium, or discount?

bond payable

Most debt contracts require that the

borrower make regular interest payments

bond payment-discount= bond payment+premium

carrying value

Usually, lenders set the interest rate to reflect the

desired market rate.

Which of the following is true of the balance sheet presentation of a bond issued at a discount?

discount is subtracted from bond payable

if carrying value>call price= CV<CP

gain loss

Calculate the market price of long-term debt using present value techniques.

i. Bonds are issued at the present value of future cash flows. ii. The interest payments and repayment of the bond principal (or face value) are the future cash flows. iii. These amounts must be discounted at the market rate of interest (or yield).

When bonds are issued by a company, the accounting entry typically shows an

increase in assets and an increase in liabilities.

market/yield rate

market rate of interest demanded by creditors (function of economic factors and the creditworthiness of the borrower-may differ from the stated rate)

When bonds are issued at a discount, the interest expense for the period is the amount of interest payment for the period

plus the discount amortization for the period.

Stated rate

rate of interest paid on the face or par value (borrower pays the interest to the creditor each period until maturity)

If the term of a lease is less than 1 year, the leasing company will record __________ as it makes lease payments.

rent expense

present value maturity (face) + present value annuity (interest)=

sum of issue price

retirement bonds

the gain or loss is the difference between carrying value and cash paid *update bond interest expense *CV=CP NONE *CV>CP GAIN *CV<CP LOSS

bond certificate

certificate is issued/proof of investor's claim face value=principal due at maturity contractual interest rate=stated rate *usually expressed as an annual rate and usually paid semiannually

What best describes the discount on bonds payable account?

contra liability

What is long-term debt?

Long-term debt generally refers to obligations that extend beyond 1 year. Long-term notes, bonds, and capital leases are examples of long-term debt.

A bond is priced as

PV of principal payment + PV of interest payments.

When interest-bearing bonds are issued at a premium, how is the interest expense for the period calculated using the effective interest rate method?

The amount of interest payment for the period minus the premium amortization for the period.

Describe how the bond issue price is calculated.

The bond issue price is determined by adding the present value (of annuity) of the interest payments and the present value (single amount) of the principal payments.

Which of the following is NOT an advantage of debt?

The debt payment schedule is flexible.

What does the face (or par) value of a bond represent?

The face value (also known as par value or principal) of a bond represents the amount paid to a bondholder at the maturity date (generally stated in denominations of $1,000). It is the nominal value or dollar value of a security stated by the issuer and the amount of principal paid back to the lender at maturity.

What is the maturity date of a bond?

The maturity date of a bond is a specified date in the future when the issuer repays the purchaser the face value of the bond.

Instead of paying off the principal at maturity, classic installment debt requires a portion of the principal to be paid each period along with some interest. Which of the following is NOT true of classic installment debt?

The portion that is considered interest remains the same from payment to payment.

How does a bond's stated rate differ from its yield rate? Which one is used to calculate the interest payment?

The yield rate is the market interest rate demanded by creditors. It often differs from the stated rate. The stated rate is the interest rate used to calculate interest payments. If the stated rate is less than the yield (or market) rate, the bond will be sold at a discount (less than face value). If the stated rate is greater than the yield rate, the bond will be sold for a premium (more than face value).

The amount paid to the lender in excess of the amount borrowed represents

interest expense

The use of borrowed capital to produce more income than needed to pay the interest on the debt is called

leverage

Compare and contrast short- and long-term leases.

-A long-term lease (i.e., lease term of one year or longer) is a noncancelable agreement that is, in substance, a purchase of the leased asset. -Long-term leases must recognize an asset and liability at the time the lease is signed. -Short-term leases (i.e., leases under one year) do not recognize an asset or liability at the time the lease is signed. -This accounting treatment is a recent change to GAAP. Under previous rules, which will stay in effect until 2019, companies were able to avoid recognizing an asset or liability at the time of signing the lease for many long-term leases. -Despite the rule change, leasing does provide many advantages over purchasing: Less cash is needed for a down payment Better protection against obsolescence and more flexibility Lower cost of financing

Describe debt securities and the markets in which they are issued.

-Debt securities are issued in exchange for borrowed cash. -In return for the borrowed cash, the borrower typically makes periodic interest payments and repays the face, or par, value at maturity. -These securities may be placed directly with a creditor such as a bank or pension fund or they may be more widely distributed with the help of an underwriter.

Use the effective interest rate method to account for premium/discount amortization.

-GAAP requires the effective interest rate method to be used to amortize any premium or discount, unless the straight-line method is not materially different. -Under this method, premiums and discounts are amortized in a manner that results in the interest expense for each accounting period being equal to a constant percentage of the bond book, or carrying, value. -That is, the interest expense changes every period, but the effective interest rate on the bond book value is constant. -This constant percentage is called the "yield" and represents the market rate of interest at the date of issue.

Use the straight-line method to account for premium/discount amortization.

-In the straight-line method, equal amounts of premium or discount are amortized to interest expense each period. -This results in a constant interest expense each period. -Although GAAP requires use of the effective interest rate method, the straight-line method may be used if the results are not materially different from the effective interest rate method.

Determine the after-tax cost of financing with debt and explain financial leverage.

-Since interest expense is deductible for tax purposes, the presence of interest expense lowers the taxes owed. -The formula for the after-tax effect of interest expense is (1 − Tax Rate) × Interest Expense.

Account for the issuance of long-term debt.

-The issue price of long-term debt is typically quoted as a percentage of face value. -At the time of issuance the borrower records the face value of the debt in bonds payable (or notes payable). -Any amount of cash received over the face value is credited to a premium. -Any amount of cash received under the face value is debited to a discount. -The bonds payable (or notes payable) is netted with the premium or discount when reported on the balance sheet.

McLaughlin Corporation's balance sheet showed the following amounts: current liabilities, $75,000; total liabilities, $100,000; total assets, $200,000. What is the debt to total assets ratio?

0.50

Assume a company issues a bond with a face value of $100,000. The bond matures in 10 years and has a 12% interest rate. If interest on the bond is paid monthly, how much interest will be paid on the bond each month?

1,000

Dominic Incorporated issued 5-year, $1,000,000, 8% bonds at 98. The discount at the time of the sale was $20,000. These bonds pay interest semiannually. What amount of the discount will be amortized each semiannual period?

2,000

Strong Company has the following data from its year-end financial statements: Total assets $300,000; total liabilities $50,000; total equity $250,000; long-term debt $20,000; operating income $30,000; interest expense $10,000. What is the debt to equity ratio for Strong Company for this year?

20%

Bonds in the amount of $100,000 with a life of 10 years were issued by the Roundy Company. If the stated rate is 6% and interest is paid semiannually, what would be the total amount of interest paid over the life of the bonds?

60,000

Mason Company issued $1,000,000 of 8% bonds due in 5 years with interest payable annually on December 31. The yield rate was 7%. The bond currently has a carrying value of $1,018,080. How much will interest expense be?

71,266

How does a firm "leverage" its capital structure? When is leverage advantageous? When is it disadvantageous? Who receives the advantage or bears the disadvantage of leverage?

A firm can "leverage" its capital structure by using capital supplied by creditors in the hope of producing more income than is needed to cover the interest on the related liability, which is fixed by the lending agreement. When the resultant income is sufficiently high, the leverage is advantageous, and operating income in excess of the interest accrues to the stockholders. However, if income is not sufficiently high, the leverage is disadvantageous, and the excess of the (guaranteed) interest over the related income is borne by the stockholders.

How does a secured bond differ from an unsecured bond?

A secured bond provides collateral (such as real estate or another asset) for the lender. If the borrower fails to make payments on the debt, the lender can "repossess" the collateral. Debt that does not have this pledged collateral is called an unsecured (or debenture) bond.

Dominic Incorporated issued 5-year, $1,000,000, 8% bonds at 99. The discount at the time of the sale was $10,000. These bonds pay interest semiannually, and $1,000 of the discount will be amortized each semiannual period. Which of the following represents the correct entry for the semiannual period?

Debit interest expense, credit cash and credit discount

company retired bonds with FV of 600,000 and CV of 583,000 for a price of 595,000. record bond retirement *example #2 same as before but with a price of 577,000

Debit: Bonds payable 600,000 Loss of Retirement Bond 12,000 **LOSS makes stockholders' equity decrease Credit: Cash 595,000 Discount on BP 17,000 ***makes CV decrease Debit: Bonds payable 600,000 Credit: Cash 577,000 Gain on retirement bonds 6,000 **SHE goes up Discount on BP 17,000

**actual payments of bond interest are driven by the bond document **interest expense will be based on the market or effective rate of interest

FACE*RATE*TIME (contractual rate) CV*RATE*TIME

What does it mean if a bond is "callable"?

If a bond is callable, it means that the borrower has the option to pay off the debt prior to maturity. This option is often exercised if (1) the interest rate being paid on the debt is much greater than the current market rate. (2) the borrower has the means to pay back the creditor.

Describe how the relationship between the stated rate and yield rate affect the price at which bonds are sold.

If the stated rate is less than the yield (or market) rate, the bond is sold at a discount (less than face value). If the stated rate is greater than the yield rate, the bond is sold for a premium (more than face value).

What is a junk bond?

Junk bonds are unsecured and very risky (typically due to the borrower's poor credit quality), and, therefore, pay a high rate of interest to compensate the lender for the added risk of the borrower being unable to meet interest payments and/or repay the principal.

An alternative to the outright purchasing of assets by firms seeking to expand their operations is to lease the property through a short- or long-term lease. Which of the following statements is true for a lease?

Less cash is needed to sign a lease than to purchase an asset.

Describe the process that businesses follow to sell new issues of long-term debt.

New issues of long-term debt are sold directly to institutions such as insurance companies or pension funds or to the public through underwriters. When debt securities are sold directly to lenders, the company gives information about its profitability, financial position, cash flows, and future plans to potential lenders and negotiates directly with them regarding the terms of the borrowing. When debt securities are sold through underwriters, the underwriters negotiate with businesses for the right to sell the debt securities to individual investors and financial institutions. Underwriters examine the provisions of the debt security and the credit standing of the borrower to determine either the fee they will charge or the price they will offer the borrower for the debt securities. The underwriters make their profits either by charging the borrower a fee or by selling the debt securities for more than was paid to the borrower.

How are premiums and discounts presented on the balance sheet?

Premium on long-term debt is presented on the balance sheet as an addition to the face (or par) amount of the debt. The sum of the premium and the face amount is the carrying amount of the liability. Discount on long-term debt is a contra-liability item and is presented with the face amount of the debt on the balance sheet. Subtracting the discount from the face amount produces the carrying amount of the long-term debt. The following excerpt from a balance sheet illustrates the presentation: Bonds payable and add premium or bonds payable and minus discount

How do premiums and discounts on long-term debt securities affect interest expense?

Premiums and discounts serve to adjust the stated interest rate to the market rate. If a bond is sold for a premium, it is sold for an amount greater than the face value of the long-term debt security to balance out the fact that the stated interest rate on the bond is higher than the market rate. A bond is sold at a discount (less than face value) to balance out the fact that the stated interest rate on the bond is lower than the market rate. If bonds are issued at a discount, the interest expense will be higher than the interest payment. If bonds are issued at a premium, the interest expense will be lower than the interest payment.

Describe how recent rule changes will require leases to be accounted for beginning in 2019.

Recent rule changes require all leases with a lease term of one year or longer to recognize an asset and liability at the time the lease is signed. Leases with a lease term of under one year do not require an asset or liability to be recognized at the time the lease is signed.

How can there be interest expense each period for non-interest bonds if there are no interest payments?

Since zero-coupon bonds have a 0% interest rate, they are sold at a relatively large discount with the full-face value being repaid at the maturity date. This large discount will be amortized over the life of the bond and can be thought of as interest that is paid in full at maturity.

How do the old lease accounting rules differ from the new lease accounting rules?

Under the old lease accounting rules, many leases with a lease term of one year or longer were able to be structured in a way that no asset or liability needed to be recognized at the time the lease was signed.

What is the difference between a bond and a note? How do the accounting treatments differ?

When a company borrows money from a bank, it typically signs a formal agreement or contract called a "note." Frequently, notes are also issued in exchange for a noncash asset such as equipment. Larger corporations typically elect to issue bonds instead of notes. A bond is a type of note that requires the issuing entity to pay the face value of the bond to the holder when it matures and usually to pay interest periodically at a specified rate. A bond issue essentially breaks down a large debt into smaller chunks because the total amount borrowed is too large for a single lender. Accounting treatment for bonds and notes is conceptually identical.

What is the difference between the straight-line and effective interest rate methods of amortizing premiums and discounts?

When using the straight-line method to amortize premiums and discounts, the initial discount or premium is divided by the number of interest payments made over the life of the bond to determine the amount to amortize each period. Using the straight-line method, the amortization will be the same each period. When using the effective interest rate method to amortize a premium or discount, the per-period amount of the amortized premium or discount is equal to the difference between the current carrying value of the bond multiplied by the market rate of interest and the predetermined cash payment (Face Value × Stated Rate). Using the effective interest method, the amortization will vary each period.

In 2019, Drew Company issued $200,000 of bonds for $189,640. If the stated rate of interest was 6% and the yield was 6.73%, how would Drew calculate the interest expense for the first year on the bonds using the effective interest method?

a. $189,640 × 6.73%

Installment bonds differ from typical bonds in what way?

a. A portion of each installment bond payment pays down the principal balance.

Analyze a company's long-term solvency using information related to long-term liabilities.

a. Although long-term creditors are concerned with a company's short-term liquidity, they are primarily concerned with its long-term solvency. i. Long-term creditors focus on ratios that incorporate: 1. Long-term debt 2. interest expense/payments

Serenity Company issued $100,000 of 6%, 10-year bonds when the market rate of interest was 5%. The proceeds from this bond issue were $107,732. Using the effective interest method of amortization, which of the following statements is true? Assume interest is paid annually.

a. Amortization of the premium for the first interest period will be $613.

Which of the following statements regarding the new accounting rules, which take effect in 2019, for leases is false?

a. If the lease term is less than one year, an asset must be recognized.

Which of the following statements regarding bonds payable is true?

a. The entire principal amount of most bonds mature on a single date.

The result of using the effective interest method of amortization of the discount on bonds is that

a. a constant interest rate is charged against the debt carrying value.

The premium on bonds payable account is shown on the balance sheet as

a. an addition to a long-term liability.

When bonds are issued at a premium, the interest expense for the period is the amount of interest payment for the period

a. minus the premium amortization for the period.

Long-term debt that is due to mature over the next year is reported as a

current liability