A-201 Exam 3
What details of the bond offering does the prospectus offer?
- Maturity date - Rate of interest to be paid - Date of each interest payment - Other characteristics such as if the bond is callable or convertible - How the proceeds will be used by the company
Companies reporting under IFRS could _____________ when companies recording under GAAP would simply _____________.
- Record a liability - Disclose the information
What are the two ways in which liquidity is measured?
- The current ratio - The dollar amount of working capital
Refinancing of the debt must take place by _____________ to affect the classification as current or long term.
- by the balance sheet date
Bond principal is also called:
- face value - par value - maturity value
If a company _____________ to refinance a current maturing loan with a new long-term loan and has the _____________ the current loan should be classified as a long-term liability.
- intends - ability to do so
The ______ is the interest rate on the date the bonds are issued and used to determine the amount of interest expense.
- market rate of interest - yield - effective rate of interest
The coupon rate is also called:
- stated rate - contract rate - nominal rate
Why would companies and the government issue bonds rather than borrowing from an individual bank.
Borrowing a large amount from an individual bank is often impractical so they turn to the investing public instead
How are companies able to reduce the cost of long term borrowing with bonds?
By issuing more liquid debt that investors can easily buy and sell in the bond markets
_____________ also pay FICA taxes and are charged unemployment taxes through FUTA and SUTA
Employers
Companies record interest expense for _____________, regardless of when they actually pay the bank cash for interest.
a given accounting period
When a bond is issued to an investors, the investor receives a __________________.
bond certificate
Amazon agrees to make two types of payments n the future: a single payment of $100,000 when the bond matures in two years and an annuity of $5,000 [100,000 * (10% * 0.5 year)] payable twice a year for two years. The 10% equation is the __________________.
bond's coupon rate
Bond prices are reported each day in the __________________ based on __________________.
business press transactions that have occurred on the bond exchange
Liabilities are recorded at their _____________.
current cash equivalent This is the cash amount a creditor would accept to settle the liability immediately
For long term liabilities the _____________ must be calculated to determine the liability balance reported on the balance sheet.
current value of the amount due in the future (the "present value")
When the market rate of interest equals the coupon rate, the present value of the future cashflows associated with a bond always __________________.
equals the bond's face value amount
Journal entries are never made for __________________ contingencies
gain contingincies
A bond usually requires the payment of __________________ over its life with repayment of __________________ on the maturity date.
interest principal
The market interest rate on a bond is the interest rate ______.
investors demand on the day a bond is issued and is used to calculate interest expense
We use the bond's __________________ per period (in this case 10% / 2 = 5%) to compute the bonds present value as follows: single principal payment at maturity: $100,000 * (.82270) = $82,270 + annuity cash interest payment: $5,000 * (3.54595) = $17,730 issue (sale) price of bonds = $100,000
market interest rate
If the bond contract is 10% and the market rate is exactly 10%, the bond price is issued at
par
Contingent liabilities are...
potential liabilities that are created as a result of a past event and will be resolved when one or more events occurs or fails to occur.
The amount of money a company receives when it sells bonds is the __________________ associated with the bonds.
present value of the future cash flows
The price of a bond equals the present value of the ______.
principal amount plus the present value of the periodic interest payments
Instead of paying off a loan, a company may choose to refinance by _____________.
renegotiating the loan or by taking out a new loan and using the proceeds to pay off the old loan.
From the firm's perspective, debt is considered _____________ than equity
riskier
An "overestimated" contingent loss/liability results in __________________.
the future year's net income to be overstated.
The reason bonds sell at their face value is because ______.
the market interest rate equals the stated interest rate
A company's capital structure is....
the mixture of debt and equity it uses to finance its operations.
A bond's selling price is determined by __________________.
the present value of its future cash flows, not the face value.
The bond market determines the price of the bonds by computing...
the present value of the bonds using the market rate of interest on the day the company issues the bonds.
When calculating the present value involving both Annuity and Single Payment, one must be sure to keep _____________ consistent.
the rate and period
After bonds are issued they are...
traded on exchanges such as the New York Bond Exchange
Regardless of whether a bond is issued at par, at a discount, or at a premium, investors always __________________.
will earn the market rate of return.
Income expense is typically reported just below __________________ on the income statement.
"income from operations" Because interest is related to financing activities rather than operating activities, it is usually not included in operating expenses on the income statement.
All bonds have a face value which is usually __________________, but it can be any amount.
$1000
Discounters, Inc. issued $50,000, 4-year, 6% bonds that pay interest annually on January 1 when the going market interest rate was 7%. On the issue date, the carrying value of bonds, net of discount or including premium, rounded to the nearest $1, is ______
$48,307 = ($50,000 x 0.7629) + (($50,000 x 0.06) x 3.3872)
On January 1, Klondike issued 10-year bonds with a stated rate of 10% and a face value of $100,000. The bonds pay interest annually. The market rate of interest is 12%. Calculate the issue price of the bonds. Round to the nearest dollar.
$88,699 = (5.65022 x $10,000 interest payments) + (0.32197 x $100,000 face value)
What are the reasons that firms view debt as riskier than equity?
- Debt payments are legal obligations - Creditors can force bankruptcy - Creditors can require sale of assets
What are some examples of contingent liabilities that can occur?
- Lawsuits - Product Warranties - Environmental Issues
The acquisition of assets is finances from two sources (capital structure):
1) Debt: Funds from creditors 2) Equity: Funds from owners
What are the 2 disadvantages of bonds?
1) Risk of bankruptcy exists because the bond interest payments must be paid each period whether the corporation earn income or incurs a loss 2) Negative impact on cash flows because bonds must be repaid at a specific time in the future. Company must be able to repay the debt or refinance it.
What are the 3 advantages of bonds?
1) Stockholders maintain control because bondholders do not vote or share in any dividend payment 2) A portion of interest expense is tax deductible which reduces the cost of borrowing 3) The return to shareholders can be positive if money is borrowed at a low interest rate and invested in projects that earn a high interest rate.
The bond principal is:
1) the amount a company must pay to bondholders at the maturity date 2) the amount used to compute the bond's periodic cash interest payments
How do you calculate the Average Days to pay payables?
365 days / Accounts Payable Turnover Ratio
What is a bond indenture?
A legal document that specifies all the details of the bond offering
What is a bond prospectus?
A regulatory document that is filed with the securities and exchange commission
What is an annuity?
A series of consecutive payments: - An equal dollar amount each period - Interest periods of equal length - The same interest rate each period
If given multiple market rates, which is used to get PV?
Always use the MARKET interest rate to DISCOUNT the payments to get present value.
What is a trustee?
An independent party appointed to represent the bondholders.
Assume that you purchase a piece of equipment and agree to pay $1,000 cash each December 31 for three years. How much would you need to deposit today at an annual interest rate of 10% to make each $1000 payment?
Annuity Finding Present Value Future Value = 1000 Interest Rate - 10% Periods = 3 Table Value = 2.48685 1000 * (2.48685) = $2486.85
On January 1, 2019, Amazon issues bonds with a coupon rate of 10 percent and a face value of $100,000. The bonds start accruing interest on January 1, 2019, and will pay interest each June 30 and December 31, 2020. Investors are willing to pay $100,000 in cash for the bonds meaning the bonds are sold __________________.
At par
What is the purpose of a bond rating agency?
Because of the large amounts of money involved and the complexities associated with bonds, several agencies exist to evaluate the risk that a bond issuer will not be able to meet the requirements specified in the prospectus
Accounts Payable Turnover Ratio
COGS / Average Accounts Payable
Callable Bond
Contains a call feature that allows the bond issuer the option of retiring the bonds early
Convertible Bond
Contains a conversion feature that allows the bonds to be converted into shares of the issuers common stock
Working Capital =
Current Assets - Current Liabilities (always a dollar amount)
Journal entry to record the Note Payable
Debit: Cash for Original Amount Borrowed (not including interest) Credit: Note Payable for Original Amount Borrowed (not including interest)
Journal entry to record the purchase of equipment by signing a note
Debit: Equipment at Present Value (may have to calculate if not given) Credit: Note Payable also at Present Value
Journal entry to record interest expense of equipment purchased by singing a note (Single Payment)
Debit: Interest Expense at [Present Value * (Annual Interest Rate) * (Number of Months / 12)] Credit: Note Payable at [Present Value * (Annual Interest Rate) * (Number of Months / 12)] IMPORTANT: Add this amount to the Present Value of the Notes Payable and use it to calculate the next Interest Expense
Journal entry recorded at the end of the first year that a company has purchased equipment by signing a note (Annuity)
Debit: Interest Expense at [Present Value * (Annual Interest Rate) * (Number of Months / 12)] Debit: Note Payable at [Present Value - Interest Expense] Credit: Cash at Future Value IMPORTANT: Subtract the debited Note Payable amount from the Present Value in order to arrive at the new liability amount. Use this as the new liability amount in recording next years interest expense.
Journal entry to record interest owed but not actually paid at the end of the accounting period
Debit: Interest Expense for Amount of Interest Incurred throughout the Accounting Period (but not yet paid) Credit: Interest Payable for Amount of Interest Incurred throughout the Accounting Period (but not yet paid)
Journal entry to record paying interest owed
Debit: Interest Expense for Amount of Interest Incurred throughout the Accounting Period (but not yet paid) Debit: Interest Payable for Amount of Interest Incurred throughout the last Accounting Period (but not yet paid) Credit: Cash for total amount of interest paid
Journal entry to record loan repayment amount
Debit: Note Payable at Future Value Credit: Cash at Future Value
Equation to calculate Net Pay for Payroll
Gross Pay Less deductions from paycheck: - Federal and State income taxes withheld - Employee portion of FICA tax (Social Security & Medicare) - Other deductions such as health insurance premiums, parking, retirement contributions, etc. = Net Pay
Define long-term liabilities
Include all obligations not classified as current liabilities, such as long-term notes payable and bonds payable.
What does an Accounts Payable Turnover Ratio of 12 mean?
Management is paying their suppliers 12 times a year
What does IFRS define 'probable' as?
More likely than not or >50%
When given a range of loss use the __________________.
When given a range of loss use the LOW end of the range to make the journal entry
How is interest expense calculated?
Interest expense is calculated using the liability balance * interest rate.
How is a contingent liability that is NOT remote defined on the balance sheet?
It is disclosed in the notes
What does the Accounts Payable Turnover measure?
It measures how quickly management is paying its suppliers.
What does GAAP define 'probable' as?
Likely or >70%
Unsecured Bond
No assets are pledged as a guarantee of repayment at maturity
Definition of Deferred Revenues (Unearned Revenues)
Obligations arising when cash is received prior to the related revenue being earned
Definition of Accrued Liabilities (Accrued Expenses)
Obligations related to expenses that have been incurred but have not been paid at the end of the accounting period (adjusting entries)
Definition of Notes Payable
Obligations supported by a formal written contract
Definition of Accounts Payable (or Trade Accounts Payable)
Obligations to pay for goods and services used in the basic operating activities of the business.
Interest =
Principal x Annual Interest Rate x Number of Month / 12 months
Define the probabilities of occurrence for a contingent liability
Probably - Highly Likely Reasonably Possible - More than remote but less than likely Remote - slight to no chance
What is the definition of liabilities?
Probably future sacrifice of economic benefits that arise from past transactions
What is a bond's yield as reported in the business press?
Reflects a return on investment of ______% for those investors who purchased the bond at its current price and hold it to maturity.
A company has _____________ if it has the ability to pay current obligations.
liquidity
Assume that you need to make a $1000 cash payment in three years. At an interest rate of 10% per year, ho much would you need to deposit today to have exactly $1,000 at the end of three years?
Single Payment Finding Present Value Future Value = 1,000 Periods = 3 Rate = 10% Table Value = .75131 1000 * (0.75131) = $751.31
Secured Bond
Specific assets are pledged as a guarantee of repayment at maturity
Starbucks bought a new coffee roasting equipment and agreed to pay the supplier $1000 per month for 20 months and an additional $40,000 at the end of 20 months. The supplier charges 12 percent interest per year, or 1% per month. Find the present value...
Step 1: Find present value of annuity Future Value = $1000 Period = 20 months Interest Rate = 1% per month Factor = 18.04555 based on 1% over 20 periods 1,000 * 18.04555 = $18,046 Step 2: Compute present value of single payment Future Value = $40,000 Period = 20 months Interest Rate = 20 months Factor = .081954 based on 1% over 20 periods 40,000 * .081954 = $32,782 Step 3: Add the two amounts to determine the present value of the total obligation $18,046 + $32,782 = $50,828
What does a high Accounts Payable Turnover ratio normally suggest?
That a company is paying its suppliers in a timely manner
What is an advantage of bonds to investors?
The ability to sell a bond is an advantage to investors because it provides them with liquidity.
What conditions must be met in order for a Contingent Liability to be recorded on the balance sheet?
The contingent liability must be probably and subject to estimate
What is the coupon rate?
The interest rate specified on a bond, and the rate used to compute the bond's periodic cash interest payment.
What are covenants and where can they be found?
The prospectus contains covenants which are designed to protect the bondholders such as: - limitations on new debt that the company might issue in the future - limitations on the payment of dividends to shareholders - requirements that the company maintain certain minimum accounting ratios, such as the current ratio or the debt-to-equity ratio
What is default risk?
The risk that a bond issuer will not be able to meet the requirements specified in the prospectus
Times Interest Earned purpose
This ratio shows whether a company is generating sufficient resources from its profit-making operations to meet its current interest obligations. Shows the amount of resources generated for each dollar of interest expense
Higher-quality bonds have __________________ default risk, while lower-quality bonds have __________________ default risk.
lower higher
The Discount on bonds payable account ______.
is a contra account to Bonds payable
When one investor decides to sell his bond to another investor, the issuer...
is not a part of the transaction. The bond issuer's financial statements are not affected by the current price listed in the business press.
The relationship between the market interest rate and the bond's coupon rate determines whether the bond is....
issued at par, at a premium, or at a discount