ACT210 - EXAM 3 - Concepts

Change in Depreciation Estimate

Book Value, end of year - New Residual Value = New Depreciable Cost / New remaining service life = Annual Depreciation Change

A contingent liability is an existing uncertain situation that might result in a loss depending on the outcome of a future event. **POTENTIAL** liability

Examples include lawsuits, product warranties, environmental problems, and premium offers. Phillip Morris's tobacco litigation, Motorola's cell phone warranties, BP's environmental obligations, and United's frequent-flyer program are all contingent liabilities.

Copyrights

Exclusive right of protection given to the creator of a published work (books) Granted for the life of the creator plus 70 years Allows holder to pursue legal action against anyone who attempts to infringe the copyright Accounting is virtually identical to that of patents

If we dispose of an asset for more than book value we record a

Gain

Cost of Equipment

all expenditures incurred in acquiring the equipment and preparing it for use

straight-line depreciation method

allocates the depreciable cost of an asset in equal periodic amounts over its useful life

Property, Plant, and Equipment

assets with relatively long useful lives that are currently used in operating the business

Types of Common Stock

authorized, issued, outstanding

straight line depreciation

by far the most easily understood and widely used depreciation method

Features of Preferred Stock

convertible, redeemable, cumulative Convertible: shares can be exchanged for common stock Redeemable: shares can be returned to the corporation at a fixed price Cumulative: shares receive priority for future dividends if dividends are not paid in a given year

primary sections of stockholders equity

paid-in capital, retained earnings, treasury stock

intangible long term assets (lack of physical substance; existence often based on legal contract) Acquired in 2 ways: Purchased; Developed internally

patents trademarks copyrights franchises goodwill

times interest earned ratio

ratio that compares interest expense with income available to pay those charges

Capitalize =

record an asset

**TANGIBLE ASSETS** (land, land improvements, buildings, equipment, and natural resources)

recorded at cost plus all costs necessary to get the asset ready for its intended use.

Operating Lease

recorded just like rental

par value stock

stock with an assigned face value Par value is the "legal capital" per share of stock that's assigned when the corporation is first established. Par value originally indicated the real value of a company's shares of stock. Today, par value has no relationship to the market value of the common stock. Laws in most states permit corporations to issue no-par stock. No-par value stock is common stock that has not been assigned a par value. Most new corporations, and even some established corporations such as Nike or Procter & Gamble, issue no-par value common stock. In some cases, a corporation assigns a stated value to the shares. Stated value is treated and recorded in the same manner as par value shares.

Advantages and Disadvantages of a Corporation

Advantages include limited liability raise capital through stock sales, looks more professional, and easy to trade ownership. Disadvantages include cost to organize, difficult to organize, double taxation, and gov regulations

Allocating the cost of INTANGIBLE assets to expense is called

Amortization

Accounts Payable (also called trade accounts)

Amounts to be paid in the future for goods or services already acquired

Comparison of Financing Alternatives

Common Stock Preferred Stock Bonds

Treasury Stock -Corporation's own stock that it has reacquired

Companies buy back their own stock for various reasons: 1) To boost underpriced stock 2) To distribute surplus cash without paying dividends 3) To boost earnings per share 4) To satisfy employee stock ownership plans

Other current liabilities include..... (3)

Deferred revenues Sales tax payable Current portion of long-term debt

What if the delivery truck was purchased during the year, say on March 1, and then used for five years? (Recall annual depreciation = $7,000)

Depreciate for portion of the year held Year 1: $7,000 × 10/12 = $ 5,833 Years 2-5: $7,000 per year = $28,000 Year 6: $7,000 x 2/12 = $ 1,167 Total depreciation over life = $35,000

Allocating the cost of most TANGIBLE assets to expense is called:

Depreciation

Three ways to price bonds

Financial Calculator Excel Present Value Tables

When a company needs a short-term loan:

Line of Credit: 1. Informal agreement 2. Permits a company to borrow up to a prearranged limit 3. Recorded similar to notes payable (no entry made up front, since no money has yet been borrowed.) Commercial Paper: 1. Borrowing from another company rather than a bank 2. Sold with maturities ranging from 30 to 270 days 3. Interest rate is usually lower than on a bank

Franchises - McDonalds, Pizza Hut, etc.

Local outlets that pay for the exclusive right to use the franchisor's name and to sell its products within a specified geographical area The franchisee records the initial fee as an intangible asset Additional periodic payments to the franchisor are usually expensed as incurred

If we dispose of an asset for less than book value we record a

Loss

Equipment is

Machinery used in manufacturing, computers and other office equipment, vehicles, furniture, and fixtures The cost of equipment might include sales tax, shipping, assembly, and any other costs to prepare the asset for use Recurring costs such as maintenance are expensed as incurred

Bond Retirements—At Maturity -Bond retirements occur when the issuing corporation buys back its bonds from the investors -Assume $100,000 in bonds are retired at maturity (December 31, 2027)

No gain or loss is recorded on bonds retired at maturity.

Notes Payable

Note signed by a firm promising to repay the amount borrowed plus interest Interest on notes is calculated as: Interest - Face Value x Annual Interest Rate x Fraction of the Year (6/12)

Added debt could be good or bad depending on whether the company earns a return in excess of the cost of the borrowed funds.

Pepsi has higher leverage than Coke.

Sales Tax Payable

Sales tax collected from customers by the seller, representing current liabilities payable to the government

Depreciation of Long-Term Assets

The illustration portrays this concept of depreciating an asset's original purchase cost over the periods benefited.

Reporting Stockholders' Equity

Stockholders' equity in the balance sheet Presents the balance of each equity account at a point in time Statement of stockholders' equity Summarizes the changes in the balance in each stockholders' equity account over a period of time

Most companies use what type of depreciation method for financial reporting, and what type of method for tax reporting?

Straight-line method; MACRS

Intangible assets with an indefinite useful life (goodwill and most trademarks) are NOT amortized.

TRUE

Debt to Equity ration - 3 facts:

The debt to equity ratio is a measure of financial leverage. Taking on more debt (higher leverage) can be good or bad depending on whether the company earns a return in excess of the cost of borrowed funds. The times interest earned ratio measures a company's ability to meet interest payments as they become due.

Installment Notes

an obligation requiring a series of payments to the lender EXAMPLES: Car Loans and Home Loans (monthly payments over a period of time)

long term assets

assets that are expected to be used in business operations for longer than one year

Land improvements are:

assets that increase the usefulness of land, but have a limited useful life and are subject to depreciation EXAMPLES: Parking lots, Sidewalks, Fences, Lighting, Sprinklers

Capital Lease

contract in which the lessee essentially buys an asset and borrows the money through a lease to pay for the asset

Land

cost of the land and all expenditures necessary to get the land ready for its intended use Examples: Real estate commissions & fees; back property taxes, and clearing, filling and leveling the land.

gain on sale of equipment

credit

Financing Alternatives

debt financing (borrowing money) and equity financing (obtaining investment from stockholders)

Companies obtain external funds through....

debt financing (liabilities) and equity financing (stockholders' equity).

To measure a company's risk, we often calculate the

debt to equity ratio.

Cash Dividends

distributions of cash to stockholders that reduce retained earnings (Not all companies pay dividends; for example, growth companies prefer to reinvest earnings rather than distribute them)

Where is treasury stock included?

in the stockholder's equity section of the balance sheet as a reduction in stockholder's equity.

advantage of debt financing

interest is tax deductible

If a company has an operating cycle longer than one year...

its current liabilities are defined by the operating cycle rather than by the length of a year

tangible long term assets (physical substance)

land land improvements buildings equipment natural resources

Debt Analysis

long-term debt is one of the first places decision makers look when trying to get a handle on risk

Partial year depreciation calculations: What if the delivery truck was purchased during the year, say on March 1, and then used for five years? (Recall annual depreciation = $7,000) Depreciate for portion of the year held Year 1: $7,000 × 10/12 = $ 5,833 Years 2-5: $7,000 per year = $28,000 Year 6: $7,000 x 2/12 = $ 1,167 Total depreciation over life = $35,000

under the straight line and declining balance methods, the annual depreciation is multiplied by the fraction of the year for which depreciation is being calculated

Stockholder Rights Stubing's Notes: 1. Most Investors make a profit by buying stock at one price, maybe $40/share. Then selling it for a higher price, for example $50/share 2. The maximum tax rate on stock sale profits is 15%. The maximum tax rate on a regular job, interest income, or dividends is 39.6%

right to vote, right to receive dividends, right to share in the distribution of assets

Patents

Exclusive right to manufacture a product or to use a process - Granted for a period of 20 years When purchased: Capitalize the purchase price plus legal and filing fees When developed internally: Capitalize legal and filing fees only (Research and Development costs are expensed as incurred)

For all expenditures after acquisition

Expense = If they benefit only the "current" period or Capitalize = If they benefit "future" periods

Activity-Based Depreciation

allocate an asset's cost based on its use. We first compute the average depreciation rate per unit by dividing the depreciable cost (cost minus residual value) by the number of units expected to be produced. In our illustration, the depreciation rate is $ .35 per mile, calculated as shown.

Assume that a company issues 1,000 shares of 8%, $30 par value preferred stock and 1,000 shares of $1 par value common stock at the beginning of 2016 and no dividends are paid in 2016 or 2017. If the company declares a total dividend of $10,000 in 2018, how will the dividend be allocated between preferred stockholders and common stockholders?

(Non-Cumulative Preferred Stock)

Steps for recording long term assets:

1.) Date of purchase = record as an asset 2.) Over the life of the asset = record depreciation until used up 3.) EXAMPLE: Company purchases a work truck. Truck is expected to last 6 years. Each year we recognize 1/6th the cost. ($60,000 / 6 = 10,000) ** Depreciates $10,000 each year, for 6 years

What are bonds?

A bond is a formal debt instrument that obligates the borrower to repay a stated amount, referred to as the principal or face amount, at a specified maturity date. In return for the use of the money borrowed, the borrower also agrees to pay interest over the life of the bond. Bonds usually are issued to many lenders, while notes most often are issued to a single lender such as a bank. Traditionally, interest on bonds is paid twice a year (semiannually) on designated interest dates, beginning six months after the original bond issue date. For most large corporations, bonds are sold, or underwritten, by investment houses. The three largest bond underwriters are JPMorgan Chase, Citigroup, and Bank of America. The issuing company—the borrower—pays a fee for these underwriting services. Other costs include legal, accounting, registration, and printing fees. To keep costs down, the issuing company may choose to sell the debt securities directly to a single investor, such as a large investment fund or an insurance company. This is referred to as a private placement.

Cost principle assumption

Assets are recorded at historical cost, not fair market value.

authorized, issued, and outstanding

Authorized - stock it may legally issue Issued - when part of authorized is issued outstanding - amount of issued capital stock in hands of shareholders the number of shares in each class must be disclosed

Public or Private Corporation Stubing's Note - Sarbanes Oxley has made it more expensive to be public company in the United States. Some public companies have chosen to become private companies (go dark), or move a stock exchange outside the United States such as London.

Corporations may be either public or private. The stock of a publicly held corporation trades on the New York Stock Exchange (NYSE) or National Association of Securities Dealers Automated Quotations (NASDAQ), or by over-the-counter (OTC) trading. All publicly held corporations are regulated by the Securities and Exchange Commission (SEC), resulting in significant additional reporting and filing requirements. A privately held corporation does not allow investment by the general public and normally has fewer stockholders than a public corporation. Generally, corporations whose stock is privately held do not need to file financial statements with the SEC. Frequently, companies begin as smaller, privately held corporations. Then, as success broadens opportunities for expansion, the corporation goes public. For example, Facebook was a private corporation until it went public in May 2012 and raised $16 billion of outside investment funds. Similarly, Ali Baba (a Chinese online commerce company similar to eBay in the United States) went public in September 2014 and raised $25 million of outside investment funds. The result was the largest technology IPO ever.

Long-term liabilities (long-term debt)

Obligations that a company expects to pay after one year

Goodwill

Recorded only when one company acquires another company Net assets = assets acquired less liabilities assumed Goodwill is portion of purchase price that exceeds the fair value of identifiable net assets

expenditures after acquisition

Repairs and maintenance Additions Improvements Legal defense of intangible assets

When a company reissues treasury stock....

Report the difference between its cost and the cash received as an increase or decrease in additional paid-in capital.

The time it takes to produce revenue

operating cycle

Debt to Equity Ratio Formula

total liabilities/stockholders equity

Assume that a company issues 1,000 shares of 8%, $30 par value preferred stock and 1,000 shares of $1 par value common stock at the beginning of 2016 and no dividends are paid in 2016 or 2017. If the company declares a total dividend of $10,000 in 2018, how will the dividend be allocated between preferred stockholders and common stockholders?

(Cumulative Preferred Stock)

Basket Purchases

-purchase of more than one asset for one purchase price -allocate total purchase price based on the relative fair values of the individual assets

Bond

1) A means of raising funds for a corporate or government. 2) Similar to a loan. Although usually longer is duration.

When you say "Likelihood" of a contingent liability or even happening: (Three R's)

1. Remote 2. Reasonably Possible 3. Probable

Recording Bonds Payable—Issued at a Discount Issue $100,000 of bonds paying 7% interest for $93,205 (discount), assuming an 8% market interest rate

Bonds Payable - Discount

Organization Chart

A visual device that shows relationships among people and divides the organization's work; it shows who reports to whom.

Tax depreciation methods

Accelerated methods reduce taxable income more in the earlier years of an asset's life Most companies use: Straight-line for financial reporting Accelerated for tax reporting - called MACRS

Buildings are

Administrative offices, retail stores, manufacturing facilities, and storage warehouses Costs of getting a building ready for use include items such as: Real estate commissions and fees Inspection costs Remodeling costs Recurring costs such as utilities and insurance are expensed as incurred

An equity investment is the purchase of stock in?

Another corporation Recorded as an increase in assets

Line of Credit = Bank Loan

Commercial Paper = Loan between companies

Amortization of franchise In early January, Little King Sandwiches acquires franchise rights from University Hero for $800,000. The franchise agreement is for a period of 20 years. Record amortization for the first year.

Debit Amortization Expense ; Credit Franchises

current portion of long-term debt

Debt that will be paid within the next year For example, a 20-year mortgage is split and reported as the portions that are due: Within the next year (current liability) After the next year (long-term liability) Long-term obligations are reclassified and reported as current liabilities when they become payable within the upcoming year For example, a note payable that matures in 10 years is reported as a long-term liability for the first 9 years, but as a current liability in the tenth year

Leases Contractual arrangement by which the lessor (owner) provides the lessee (user) the right to use an asset for a specified period of time Types: -Operating leases: lessor owns the asset, and the lessee simply uses the asset temporarily -Capital leases: lessee buys an asset and borrows the money through a lease to pay for the asset

If you have ever leased a car or an apartment, you are familiar with leasing. A lease is a contractual arrangement by which the lessor (owner) provides the lessee (user) the right to use an asset for a specified period of time. Leasing has grown to be the most popular method of external financing of corporate assets in America. In fact, many financing companies exist for the sole purpose of acquiring assets and leasing them to others.

When do we record interest expense?

In the period in which we incur it

Canadian Falcon reissues the 100 shares of treasury stock for $35. Recall that these shares originally were purchased for $30 per share.

Now let's assume that Canadian Falcon reissues the 100 shares of treasury stock for $35. Recall that these shares originally were purchased for $30 per share, so the $35 reissue price represents a $5 per share increase in additional paid-in capital. It's not recorded as a $5 per share gain in the income statement, as we would for the sale of an investment in another company, since the company is reissuing its own stock. We record this transaction using the entry shown here.

Current Liabilities

Obligations that a company expects to pay within the next year or operating cycle, whichever is longer.

Natural Resources

Oil, natural gas, timber, and salt Distinguished from other assets by the fact that they are physically used up, or depleted Recorded at cost plus all other costs necessary to get the natural resource ready for its intended use

Disclose contingent liabilities in notes if:

Outcome is probable OR the amount is reasonably estimated EXAMPLE: company is likely to lose the lawsuit, then it should be disclosed.

Bond Terms/Features - Example 1) Dell Corporation sells bonds in $1,000 increments to general the public on April 1, 2017. 2) For 10 years beginning March 31, 2018, Dell will pay the bondholder $100 ($1,000 x 10%) 3) On March 31, 2026, Dell will pay the bond holder $1,000.

Par; Coupon Rate; Annual Coupons; Maturity; and Yield to Maturity

KEY POINT - CASH DIVIDENDS

The declaration of cash dividends decreases Retained Earnings and increases Dividends Payable. The payment of cash dividends decreases Dividends Payable and decreases Cash. The net effect, then, is a reduction to both Retained Earnings and Cash.

Pricing Bonds Using a Financial Calculator Let's first assume the market interest rate is 7%, the same as the stated interest rate. The bonds issue at face value.

The stated interest rate is the rate quoted in the bond contract used to calculate the cash payments for interest. The market interest rate (also known as effective-interest rate or yield rate) represents the true interest rate used by investors to value the bond issue. The market rate can be equal to, less than, or greater than the stated 7% interest rate paid to investors.

Repurchase of a corporation's OWN stock is: How is it recorded?

Treasury Stock Recorded as a reduction stockholder's equity (** It is NOT an asset; a company cannot invest in itself)

Example of deferred revenue

Unearned Revenue EXAMPLE: gift cards purchased but not redeemed; airline tickets purchased but not used yet

Debt to Equity Ratio

-A measure of financial leverage. -Leverage enables a company to earn a higher return using debt than without debt, in the same way a person can lift more weight with a lever than without it.

Two ratios used to measure financial risk related to long-term liabilities:

-Debt to equity ratio -Times interest earned ratio

Many students confuse par value with market value

-Par value: the legal capital per share that is set when the corporation is first established and actually is unrelated to "value." -Market value per share: equal to the current share price. In most cases, the market value per share will far exceed the par value.

Three Methods of Asset Disposal

-Sale - Can result in either a gain or loss -Retirement - Occurs when long term asset is no longer useful but cannot be sold -Exchange - occurs when two companies trade assets

The interest rate we use to calculate the bond issue price is ALWAYS the market rate, never the stated rate.

-Some students get confused and incorrectly use the stated rate to calculate present value.

**Key Features/Definitions of a Bond**

1) Bond: -Debt contract. Similar to a written Loan Agreement. -Interest-only loan. Periodic payments are interest only, no reduction in debt principal. 2) Par value: --Face amount Re-paid at maturity. Lump Sum payment at maturity date. -Assume $1,000 for corporate bonds 3) Coupon interest rate: -Stated interest rate on the bonds -Multiply by par value to get coupon payment 4) Coupon Payment - periodic, scheduled cash payment to bondholder. Often semi-annually or annually. 5) Maturity - Years until bond must be repaid (EXPIRATION DATE) 6) Yield to maturity (YTM): -The effective interest earned by the bondholder. NOT ALWAYS THE STATED COUPON RATE OF THE BOND. -Directly effected by current market rate of interest when bond is sold/bought and the credit rating of the issuing company or government. -The discount rate used to value a bond -Return if bond held to maturity -Usually = coupon rate at issue

DIVIDEND DATES: Date of Record Record Date Payment Date

1) Declaration date: date on which board of directors declares the cash dividend to be paid 2) Record date: specific date on which the company will determine who will receive the dividend (registered owners of stock) 3) Payment date: date of the actual cash distribution

Bond Terms/Features - Example

1) Dell Corporation announces it will sells $500 million of bonds at $1,000 increments to the general public on April 1, 2017. 2) For 10 years beginning March 31, 2018, Dell will pay the bondholder $100 ($1,000 x 10%). 3) On March 31, 2027, Dell will pay the bond holder $1,000.

Retained Earnings

1) Earnings retained in the corporation and not paid out as dividends 2) Equals all net income less all dividends, since the company began operations 3) Has a normal credit balance 4) Accumulated deficit: a debit balance in retained earnings

Why Do Many Companies Lease Rather Than Buy?

1) Leasing improves cash flows through up to 100% financing. In a purchase, most lenders require a down payment up to 20%. In contrast, leasing may allow you to finance up to the entire purchase price, freeing cash for other uses. 2) Leasing improves the balance sheet by reducing long-term debt. If the lease is an operating lease, the lessee reports only rent expense, avoiding the reporting of long-term debt in the balance sheet. 3) Leasing can lower income taxes. Many companies today find that purchasing equipment causes them to be faced with an extra income tax burden under the alternative minimum tax (AMT) calculations. Leasing can help avoid these additional taxes.

The primary disadvantages of the corporate form of business are:

1) additional taxes 2) more paperwork.

Key Point The distinguishing characteristics of bonds include whether they .....

1) are backed by collateral (secured or unsecured) 2) become due at a single specified date or over a series of years (term or serial) 3) can be redeemed prior to maturity date (callable) 4) or can be converted into common stock (convertible)

The primary advantages of the corporate form of business are:

1) limited liability 2) the ability to raise capital.

Recording Bonds Payable—Issued at Face Value Issue $100,000 of bonds paying 7% interest for $100,000 (face amount), assuming a 7% market interest rate

Bonds Payable - Face Value:

Recording Bonds Payable—Issued at a Premium Issue $100,000 of bonds paying 7% interest for $107,439 (premium), assuming a 6% market interest rate

Bonds Payable - Premium

Bond Retirements—Before Maturity California Coasters issued bonds on January 1, 2018, above face amount (at a premium) at $107,439. The carrying value of the bonds one year later on December 31, 2018, is $106,877. Record the bond retirement before maturity on December 31, 2018 for $114,353.

California Coasters records a loss for the difference between the price paid to repurchase the bonds ($114,353) and the bonds' carrying value ($106,877).

Recording Installment Loan Transactions

Cash (debit); Notes Payable (credit)

Stages of Equity Financing

First: raise money from founder of business, friends, and family then: Angel investors Individuals, $25-100K+ Venture capital firms Companies that specialize in bringing startups to market after the Angel investment round, more dollars, more ownership Initial public offering (IPO) An IPO is what brings a company to the market Companies trade on a stock exchange where the public can purchase the stock

Preferred stock has features of both common stock and bonds and is usually included in stockholders' equity.

However, some preferred stock (mandatorily redeemable) is so similar to bonds that we include it with bonds payable in the liability section of the balance sheet.

Bond Price - what should you pay for it?

Important Concept -The effective interest rate the bondholder earns is NOT necessarily the stated (coupon) rate. AND -Value/Price of a bond changes when current interest rates change. Why? Because market interest rates change over the life of a bond. -No investor will buy a bond at par value with 3% coupon rate issued 5 years ago, when bonds sold today have a 5% coupon rate. CONVERSELY. -No bondholder will sell a bond at par value with 8% coupon rate issued 5 years ago, when bonds sold today have a 5% coupon rate.

Assume that on January 1, 2018, California Coasters decides to raise money for development of its new roller coaster by issuing $100,000 of bonds paying a stated interest rate of 7%. The bonds are due in 10 years, with interest payable semiannually on June 30 and December 31 each year.

In practice, most corporate bonds pay interest semiannually (every six months) rather than paying interest monthly, quarterly, or annually. Thus, investors in California Coasters' bonds will receive (1) the face amount of $100,000 at the end of 10 years and (2) interest payments of $3,500 (= $100,000 × 7% × 1/2 year) every six months for 10 years. That's a total of 20 interest payments of $3,500 each (= $70,000). This illustration provides a timeline of the cash flows related to the bond issue. Over the 10-year period, bondholders will receive a total of $170,000, which is the face amount of $100,000 due at maturity plus semiannual interest payments totaling $70,000. How much are investors willing to pay today for the right to receive $170,000 over the next 10 years? Certainly less than $170,000, because the cash flows are in the future. Next, we see how to determine that price.

Canadian Falcon repurchases 100 shares of its own $0.01 par value common stock at $30 per share.

Just as issuing shares increases stockholders' equity, buying those shares back decreases stockholders' equity. Rather than reducing the stock accounts directly, though, we record treasury stock as a "negative" or "contra" account. Recall that stockholders' equity accounts normally have credit balances. So, treasury stock is included in the stockholders' equity section of the balance sheet with an opposite, or debit, balance. When a corporation repurchases its own stock, it increases (debits) Treasury Stock, while it decreases (credits) Cash. Notice that the stock's par value has no effect on the entry to record treasury stock. We record treasury stock at its cost, which is $30 per share in this example. The debit to Treasury Stock reduces stockholders' equity.

AVOID thinking the balance in Warranty Liability account is always equal to Warranty Expense.

REMEMBER: Warranty Liability account is increased when the estimated warranty liability is recorded, but then is reduced over time by actual warranty expenditures. Similar to Allowance for Uncollectible Accounts

Trademarks

Word, slogan, or symbol that distinctively identifies a company, product, or service Renewed for an indefinite number of 10-year periods Capitalize legal, registration, and design fees - Advertising costs expensed as incurred

** Bond Characteristics **

Secured, Unsecured, Term, Serial, Callable, and Convertible Secured bonds are supported by specific assets the issuer has pledged as collateral. For instance, mortgage bonds are backed by specific real estate assets. If the borrower defaults on the payments, the lender is entitled to the assets pledged as collateral. However, most bonds are unsecured. Unsecured bonds, also referred to as debentures, are not backed by a specific asset. These bonds are secured only by the "full faith and credit" of the borrower. Term bonds require payment of the full principal amount of the bond at the end of the loan term. Most bonds have this characteristic. To ensure that sufficient funds are available to pay back the bonds at the end of the loan term, the borrower usually sets aside money in a "sinking fund." A sinking fund is an investment fund to which an organization makes payments each year over the life of its outstanding debt. For example, say a company borrows $20 million by issuing term bonds due in 10 years. The company might put $2 million each year into a sinking fund, so that at the end of 10 years, $20 million is available to pay back the bonds on the due date Serial bonds require payments in installments over a series of years. Rather than issuing $20 million in bonds that will be due at the end of the 10th year, the company may issue $20 million in serial bonds, of which $2 million is due each year for the next 10 years. This makes it easier to meet its bond obligations as they become due. Since most bonds are term bonds, we focus on term bonds in this chapter. Most corporate bonds are callable, or redeemable. This feature allows the borrower to repay the bonds before their scheduled maturity date at a specified call price, usually at an amount just above face value. Callable bonds protect the borrower against future decreases in interest rates. If interest rates decline, the borrower can buy back the high-interest-rate bonds at a fixed price and issue new bonds at the new, lower interest rate. A call feature is more common than a conversion feature. Another important distinction is that callable bonds benefit the borrower, whereas convertible bonds benefit both the borrower and the lender. Convertible bonds allow the lender (the investor) to convert each bond into a specified number of shares of common stock. Prior to conversion, the bondholder still receives interest on the convertible bond. The borrower also benefits. Convertible bonds sell at a higher price and require a lower interest rate than bonds without a conversion feature.

Common Mistake - Retained Earnings

Some students think, incorrectly, that retained earnings represents a cash balance set aside by the company. In fact, the size of retained earnings can differ greatly from the balance in the Cash account. American Eagle reported $1.5 billion in retained earnings, but only $410 million in cash.

Amortization Schedule for an Installment Note

To illustrate, assume that California Coasters obtains a $25,000, 6%, four-year loan for a new delivery truck on January 1, 2018. Payments of $587.13 are required at the end of each month for 48 months. An amortization schedule provides a summary of the cash paid, interest expense, and decrease in carrying value for each monthly payment. The illustration provides a partial amortization schedule for the loan. First calculate interest expense as the carrying value times the market rate (6% × 1/12 = 0.5% per month in this example). The difference between the cash paid and interest expense each month equals the decrease in the carrying value. Finally, the prior carrying value less the decrease in carrying value equals the new balance in carrying value. Notice the following features of the amortization schedule: The carrying value (also referred to as the principal) begins at $25,000 the original amount of the loan. The carrying value decreases with each monthly payment, but only for a portion of the cash paid. By the end of the four-year loan, the carrying value equals $0. With each monthly cash payment, the portion assigned to interest expense becomes less and the portion that reduces the carrying value becomes more. Interest expense equals a constant percentage of the prior month's carrying value. Since the carrying value decreases over time, interest expense also decreases over time.

Assume a company has assets of $100 million, liabilities of $60 million, and stockholders' equity of $40 million. The company then signs a new lease to purchase long-term assets valued at $10 million.

Under an operating lease, the $10 million lease is not reported in the balance sheet. The company simply records rent expense as the payments are made and this expense is reported in the income statement. Under a capital lease, the $10 million lease is added to both assets and liabilities, to recognize the purchase of an asset and the incurrence of an additional lease liability. While stockholders' equity remains the same for both types of leases, the relationship between total liabilities and stockholders' equity differs. Under an operating lease, the ratio of total liabilities to stockholders' equity is lower, making the company appear less risky to investors and lenders from the standpoint of potential bankruptcy. That's why most companies prefer operating leases.

Accounting treatments when spending money on something......

We capitalize (record as an asset) expenditures that benefit future periods. We expense items that benefit only the current period.

Partial Year Depreciation

When an asset is purchased (or disposed of) at a time other than the beginning or end of an accounting period, depreciation is recorded for the part of the year the asset was in use.