Chapter 14 Quiz

Both convertible bonds and bonds issued with detachable warrants have features of both debt and equity. How does the accounting treatment differ for the two hybrids securities? Why is the accounting treatment differ?

Convertible bonds is recorded as debt, as if they are nonconvertible bonds. The issue price of bonds with detachable warrants is allocated between the two different securities on the basis of their fair values. They are treated different because bonds with detachable warrants, warrants can be separated from the bonds.

What information is contained in a bond indenture? What purpose does it serve?

serves as a contract between company and bondholders-specific promises made to bondholders-face amount, stated interest rate, method to pay,-redemption call feature-specify a trustee (bank) appointed by issuing firm to represent rights of bondholders

When bonds are issued at a premium the debt declines each period. Explain

-effective int each period < cash int paid

A zero-coupon bond pays no interest. Explain

-no interest paid periodically -interest accrues at effective % * outstanding balance Zero-coupon bonds do not pay interest; instead, they are sold at a very deep discount from face amount. As the bonds get closer to maturity, carrying value approaches face amount.

Early extinguishment of debt often produces a gain or loss. How is the gain or loss determined?

Any difference between the outstanding debt and the amount paid to retire that debt represents either a gain or loss.

How are bonds and notes the same? How do they differ?

Bonds and Notes are both debt instruments but mainly vary because of their maturity period. They are both classified as liabilities in the debtor company balance sheet but are recorded as assets to the creditor who has purchased them. Bonds are classified as long term debt instruments and Notes are classified as short term debt instruments.

Compare the two commonly used methods of determining interest on bonds.

Effective interest method is an accrual concept to determine interest on bonds. Interest is accrued periodically at the effective rate or the market rate. Interest is accrued on the outstanding balance at a constant percentage of the debt each period. Straight line method the outstanding debt balance varies but the interest amount remains the same over the period to maturity equaling to the amount of premium or discount.

As a general rule, how should long-term liabilities be reported on the debtor's balance sheet?

Long-term liabilities are appropriately reported at their present values. The present value of a liability is the present value of its related cash flows—specifically the present value of the face amount of the debt instrument, if any, plus the present value of stated interest payments, if any. Both should be discounted to present value at the effective (market) rate of interest at issuance.

How is the price determined for a bond (or bond issue)?

PV periodic cash int payments (Face Amt * stated %) + PV principal payable at maturity The price will be the present value of future cash flows discounted using the market rate on the issue date.

How is periodic interest determined for outstanding liabilities? For outstanding receivables? How does the approach compare for one form of debt instrument (say bonds payable) to another (say notes payable)?

Periodic interest is calculated as the effective interest rate times the amount of the debt outstanding during the period. This same principle applies to the flip side of the transaction, that is, the creditor's receivable or investment. The approach also is the same regardless of the specific form of the debt, that is, whether in the form of notes, bonds, leases, pensions, or other debt instruments.

What are debt issue costs and how should they be reported?

The cost companies incur when issuing bonds such as; legal and accounting fees, printing cost, and registration and underwriting fees. They are treated the same as a bond discount.

When a note's stated rate of interest is unrealistic relative to the market rate, the concept of substance over form should be employed. Explain

economic essence of a transaction should prevail over its appearance