Chapter 10 and 11 Accounting

A company might choose to issue bonds instead of stock to avoid diluting shareholders' interests, to benefit from the tax deductions associated with paying interest, and to potentially increase the return to shareholders.

From the perspective of the issuer, what are some advantages of issuing bonds instead of stock?

They DON'T!

How do changes in the market interest rate affect the bond on the financial satement?

A bond is a liability issued to the investing public so that a corporate or government entity can raise capital to finance operations or expansion. Bonds are traded on established exchanges, such as the New York Bond Exchange. When a company issues bonds, it receives money from investors. Investors purchase bonds in order to earn interest over the life of the bond. At the end of a bond's life, investors receive the bond principal amount back from the company.

How does a bond work?

Several characteristics typically associated with preferred stock are: (1) lack of voting rights, (2) less risky than common stock since in the event of bankruptcy, preferred stockholders have preferential rights to assets over common stockholders, and (3) a fixed dividend rate. Preferred stock may also have a dividend preference and it may be cumulative.

What are the usual characteristics of preferred stock?

Bond covenants are designed to protect bond investors by limiting what a company can do while the bond is still outstanding.

What is a bond covenant?

The charter of a corporation, sometimes called the articles of incorporation, is a legal document submitted by a corporation to a state government. The charter specifies details such as the name of the corporation, its purpose, and the kinds and number of shares of stock the corporation can issue.

What is a corporate charter?

The book value of a bond is the bond's principal amount plus any premium or minus any discount. A bond's book value is what a company reports on its balance sheet.

What is the book value of a bond?

Unsecured bonds are not backed by any type of asset as a guarantee of repayment at maturity. Secured bonds are backed by specific assets as a guarantee of repayment at maturity.

What is the difference between an unsecured and a secured bond?

The formula used to calculate the cash payment bond investors receive for interest each period is: principal amount x coupon rate. The formula used to calculate interest expense reported each period is: book value of the bond at the beginning of the period x the market rate of interest on the date of issuance.

What is the formula used for calculating the cash payment bond investors will receive for interest each period? What is the formula used to calculate interest expense each period?

A

When a bond issue sells at a discount, subsequent amortization of the discount A. increases interest expense B. decreases interest expense C. has no effect upon interest expense D. decreases interest in the bond E. None of the above

The market interest rate reflects the return investors demand to invest in a security with a given level of risk, so it is the rate used to discount a bond's future cash flows when calculating a bond's present value.

When calculating the present value of a bond's future cash flows, do investors use the coupon rate or market interest rate as the discount rate?

When market interest rates increase, bond prices decrease. This concept is easily understood by remembering that the market rate of interest is the discount rate used to calculate the present value of a bond's future cash flows. The higher the discount rate the lower the present value of the bond.

When market interest rates increase, do bond prices increase or decrease?

a secured bond

1) A bond for which assets are specifically pledged to guarantee repayment is called

B

10) McGuire Company had the following information: Capital stock, par $10 (20,000 shares issued) $200,000Capital in excess of par value 15,000Retained earnings, balance January 1, 2020 80,000Revenues earned during 2020 400,000Expenses (excluding income tax) incurred during 2020 320,000Cash dividends declared and pain during 2020 30,000Treasury stock (2,000 shares at cost) 25,500Income tax rate 30% At what amount per share was the treasury stock purchased? A. $10.00 B. $12.75 C. $15.00 D. $17.00 E. None of the above

sufficient retained earnings or net income, sufficient cash

2 requirements for payment of a cash dividend

debt and equity

A companies capital structure is a combination of

bond certificate

A legal document that indicates the name of the issuer, the face value of the bonds, and other data such as the contractual interest rate and the maturity date of the bonds.

stock dividend

A pro rata (proportional to ownership) distribution of the corporation's own stock to stockholders.

preferred stock

A special type of stock whose owners, though not generally having a say in running the company, have a claim to profits before other stockholders do.

Coupon rate

the interest rate that a bond issuer will pay to a bondholder, used too compute the bonds period cash interest payments.

debenture bonds

Bonds that are unsecured (i.e., not backed by any collateral such as equipment).

convertible bonds

Bonds that can be converted into common stock at the bondholder's option

When stock with a par value is issued, the par value times the number of shares is credited to the stock account, and any "additional capital" raised is credited to the additional paid-in capital account. Thus, the balance in the additional paid-in capital account reflects capital raised in excess of a stock's par value.

Define additional paid-in capital.

A stock dividend involves the issuance of additional shares of stock to stockholders. It differs from a cash dividend in that it does not distribute any assets of the corporation to stockholders or change total stockholders' equity. In contrast, a cash dividend reduces total stockholders' equity by the amount of the dividend.

Define stock dividend. How does a stock dividend differ from a cash dividend?

A stock split distributes additional shares of stock to stockholders by "splitting" their existing shares into some multiple of additional shares. Though a stock split and a stock dividend both distribute additional shares of stock to stockholders, they are accounted for differently. A stock dividend requires a journal entry and redistributes amounts within the stockholders' equity section of a company's balance sheet. A stock split does not require a journal entry nor does it change any amounts in the stockholders' equity section of the balance sheet. To record a stock split a corporation merely increases the number of outstanding shares and proportionately decreases the par value of each share.

Define stock split. How does a stock split differ from a stock dividend?

A corporation is a legal entity separate and distinct from its owners. Owners are those who own shares of stock in the corporation. The primary advantages of the corporate form are: (a) transferability of ownership, (b) limited liability to the owners, and (c) the ability to raise large amounts of capital because both small and large investors can easily purchase stock.

Define the term corporation and identify the primary advantages of organizing as a corporation.

Treasury stock is a corporation's own stock that was sold (issued) and subsequently reacquired by the corporation. Corporations frequently repurchase shares of their own stock for sound business reasons, such as to obtain shares needed for employee bonus plans, to influence the market price of the stock, to increase earnings per share amounts, and to have shares on hand for use in the acquisition of other companies. Treasury stock, while held by the issuing corporation, confers no voting, dividend, or other stockholder rights.

Define treasury stock. Why do corporations purchase treasury stock?

legal capital

the permanent amount of capital defined by state law that must remain invested in the business; serves as a cushion for creditors

A bond's coupon rate (also called the stated rate, contract rate, or nominal rate) is the interest rate specified on a bond and is the rate used to compute the bond's periodic cash interest payment. The market rate of interest (also known as the yield or effective interest rate) is the rate of return investors demand for a company's bonds on the date the bonds are issued. Any difference between a bond's coupon rate and the market rate of interest on the date of issuance creates a bond discount or a bond premium depending on whether the coupon rate is lower or higher than the market rate.

Differentiate between a bond coupon rate and the market rate of interest.

A bond indenture is a legal document that specifies all the details of a bond offering. A prospectus is a regulatory document filed with the Security and Exchange Commission. It also provides details of the bond offering. A bond indenture and a bond prospectus provide similar information.

Differentiate between a bond indenture and a bond prospectus.

Common stock—the usual or normal stock of a corporation. It is the voting stock and generally ranks after the preferred stock for dividends and assets distributed upon dissolution. Common stock may have a par value or be no-par value common stock. Preferred stock—another form of stock, that typically has both favorable and unfavorable features in comparison with common stock. A favorable feature is that any dividends that are declared are first paid to preferred shareholders before being paid to common shareholders. An unfavorable feature is that preferred stock typically does not have voting rights. Preferred stock usually has a par value, and dividends are typically defined as a percentage of par value.

Differentiate between common stock and preferred stock.

Cumulative preferred stock has a dividend preference such that, should the dividends on the preferred stock for any year or series of years not be paid, dividends cannot be paid to the common stockholders until all such dividends in arrears are paid to the preferred stockholders. Noncumulative preferred stock does not have this preference; therefore, dividends not paid in past periods do not have to be paid in the future.

Differentiate between cumulative and noncumulative preferred stock.

(a) Authorized shares: The maximum number of shares of stock that a corporation can issue as specified in the charter of the corporation.(b) Issued shares: The total number of shares of stock that a corporation has issued to stockholders at a particular date.(c) Outstanding shares: The number of shares currently owned by stockholders.

Explain each of the following terms: (a) authorized shares, (b) issued shares, and (c) outstanding shares.

The stockholders' equity section of the balance sheet reflects two kinds of capital: contributed capital and earned capital.Contributed capital—the amount invested by stockholders. Contributed capital is represented in a company's common and preferred stock accounts and any additional paid-in capital accounts. Earned capital—the accumulated amount of all net income/losses since the organization of the corporation, less the accumulated amount of dividends paid by the corporation since organization. Earned capital is represented in the Retained Earnings account.

Explain the difference between contributed capital and earned capital. How is each represented in the stockholders' equity section of a company's balance sheet?

Par value is a nominal value per share established in the corporate charter. The original purpose of establishing a par value was to protect creditors by specifying a permanent amount of capital that owners could not withdraw before a bankruptcy, which would leave creditors with something in the event that a company did not succeed. No-par value stock does not have an amount per share specified in the charter.

Explain the distinction between par value and no-par value stock.

indenture

the written agreement between the corporation and the lender detailing the terms of the debt issue

Treasury stock is reported in the stockholders' equity section of the balance sheet as a negative amount. If a corporation resells treasury shares at a price above what it paid to originally acquire the treasury shares, it increases additional paid-in capital by the difference. If a corporation resells treasury shares at a price below what it paid to originally acquire the treasury shares, it decreases additional paid-in capital or retained earnings by the difference.

How is treasury stock reported on the balance sheet? If a corporation resells treasury stock at a price above or below the price paid to originally acquire the treasury shares, how does it record this difference?

Present value of principle+present value of interest payment

How to calculate present value of bond

With respect to dividends, the three important dates are: Declaration date—the date on which the board of directors votes to declare a dividend. The declaration of a cash dividend creates a liability. Date of record—the date on which a corporation records who owns its stock. Owners of a company's stock on the date of record will receive any declared dividend. No journal entry is associated with the date of record. Date of payment—the date on which cash is paid to owners listed on the date of record. The payment of a dividend eliminates the liability created on the declaration date and reduces cash.

Identify and explain the three important dates with respect to dividends.

IPO

Initial public offering, a corporation's first offer to sell shares to the public

B

Irish Corporation issued (sold) 10,000 shares of its no par common stock for $70 per share. The bylaws established a stated value of $10 per share. The transaction would increase common stock by A. zero B. $100,000 C. $600,000 D. $700,000 E. None of the above

3 big bong rating agencies

Moodys, S&Ps, Fitch, rate from AAA to DDD

D

On January 1, 2020, Broker Corp. issued $3,000,000 par value 12%, 10 year bonds which pay interest each December 31. If the market rate of interest was 14%, the issue price of the bonds should be? (The present value factor for $1 in 10 periods at 12% is .3220 and at 14% is .2697. The present value of an annuity of $1 factor for 10 periods at 12% is 5.6502 and at 14% is 5.2161.) A. $3,339,084 B. $2,843,172 C. $3,000,000 D. $2,686,896 E. None of the above

C

On January 1, 2020, Tonika Corporation issued a four-year, $10,000, 7% bond. The interest is payable annually each December 31. The issue price was $9,668 based on an 8% effective interest rate. Assuming effective-interest amortization is used, the interest expense on the income statement for the year ended December 31, 2020 would be (to the nearest dollar) A. $ 1,547 B. $ 883 C. $ 773 D. $ 700 E. None of the above

Cumulative Dividend Preference

Preferred stock feature that requires specified current dividends not paid in full to accumulate for every year in which they are not paid. These cumulative preferred dividends must be paid before any common dividends can be paid.

(1) cash on hand or the ability to obtain cash sufficient to pay the dividend and (2) a sufficient balance in retained earnings. A cash dividend reduces both assets (cash) and stockholders' equity (retained earnings) by the amount of the dividend.

What are the two basic requirements to support the declaration of a cash dividend? What are the effects of a cash dividend on assets and stockholders' equity?

common stock

Term used to describe the total amount paid in by stockholders for the shares they purchase.

D

The balance sheet of Werther Company showed the following data about its common stock, par $1: authorized shares, 10,000,000; outstanding shares, 4,300,000; and issued shares 4,700,000. Therefore, the number of treasury stock shares was A. 0 B. 4,700,000 C. 4,300,000 D. 400,000 E. None of the above

e

The par value of common stock is the a) average market price of the stock during the period in which it is sold B) ceiling (maximum) amount above which the stock may not be sold initially C) the current market price of the stock D) selling price of the stock on the date it was issued by the corporation E) . None of the above

1) Risk of bankruptcy 2) Negative impact on cash flows

What are some disadvantages of issuing bonds

D

Which of the following is not a reason that a corporation would want to issue bonds instead of stock? a) Interest payments can be deducted for income tax purposes. B) Stockholders maintain control C. The impact on earnings may be positive D. There is more cash outflow resulting from bonds E. None of the above

C

Which of the following represents the shares currently in the hands of investors A. Authorized shares B. Issued shares C. Outstanding shares D. Unissued shares E. None of the above

1) Stockholders maintain control 2) Portion of Interest is Tax deductible 3) Issues bonds can increase returns for shareholders

Why do companies issue bonds?

Trustee

an independent party appointed to represent the bondholders

secured bonds

bonds that are backed by specific collateral that must be forfeited in the event that the issuing firm defaults

callable bonds

bonds that the issuing company can redeem (buy back) at a stated dollar amount prior to maturity

Principle * coupon rate * time

calculating cash interest payments

principle * Factor( use market interest IR)+ annuity payment* Factor

calculating present value of bond

par bond price

coupon rate=market rate

premium bond price

coupon rate>market rate

prospectus

document issued to possible buyers of a stocks and bonds outlining the financial condition of the company issuing those securities

in notebook

find journal entries

set up table with cash owed for interest( principle*rate*time), interest expense( beginning of period book value*market rate*time), interest expense cash owed( subtracted 2 values) and add or subtract value to book value of bonds payable.

how to do a bond amortization schedule

treasury shares

issued shares that have been reacquired by the corporation

Covenants

legally binding agreements between a bond issuer and a bondholder

discount bond price

market rate>coupon rate

earnings per share

net income - preferred dividends / weighted average common shares outstanding

face value, par value, maturity value

other names for bond principle

dividends in arrears

preferred dividends that were supposed to be declared but were not declared during a given period

issued shares

represent the total number of shares of stock that have been sold

authorized shares

shares of common stock that a firm's corporate charter allows it to issue

BOND PRINCIPLE

the amount (a) payable at the maturity of the bond and (b) on which the periodic cash interest payments are computed

payment date

the date cash dividend payments are made to stockholders

declaration date

the date on which the board of directors officially approves a dividend

record date

the date when the company determines ownership of outstanding shares for dividend purposes

stock split

the division of a single share of stock into more than one share

Current Dividend Preference

the feature of preferred stock that grants priority on preferred dividends over common dividends