Intermediate Accounting II: Chapter 14

Which of the following is not an example of off-balance-sheet financing? A. Non-consolidated subsidiary. B. Special purpose entity. C. Non-interest bearing note. D. Operating lease

C. Non-interest bearing note.

The printing costs and legal fees associated with the issuance of bonds should A. be expensed when incurred. B. be reported as a deduction from the face amount of bonds payable. C. be accumulated in a deferred charge account and amortized over the life of the bonds. D. not be reported as an expense until the period the bonds mature or are retired.

C. be accumulated in a deferred charge account and amortized over the life of the bonds.

Fair Value Option

Companies have the option to record fair value in their accounts for most financial assets and liabilities, including bonds and notes payable.

Which of the following is not an example of "off-balance-sheet financing"? A. Non-consolidated subsidiary. B. Special purpose entity. C. Operating leases. D. Capital leases.

D. Capital leases.

The selling price of a bond is the sum of the present values of the principal and the periodic interest payments. The present values are determined by discounting using the A. stated rate. B. nominal rate. C. coupon rate. D. market rate

D. market rate

Note disclosures for long-term debt generally include all of the following except A. assets pledged as security. B. call provisions and conversion privileges. C. restrictions imposed by the creditor. D. names of specific creditors.

D. names of specific creditors.

Choice of Interest Rates

If a company cannot determine the fair value of the property, goods, services, or other rights, and if the note has no ready market, company must approximate an applicable interest rate

Times interest earned ratio calculated by:

Income before income taxes and interest expense/interest expense

Deep-discount (zero-interest) debenture bonds

Long-term, unsecured debt securities that do not bear interest that are sold at a discount that provides the buyer's total interest payoff at maturity.

How do you calculate the amount of interest that is actually recorded as interest expense by the issuer of the bonds?

Market Rate x Carrying Value of the Bond

How do you calculate the amount of interest that is actually paid to the bondholder each period?

Stated Rate x Face Value of the Bond

Bond discount

The difference between the face value of a bond and its selling price when the bond sells for less than face value.

Bond premium

The difference between the face value of a bond and its selling price when the bond sells for more than face value.

Special-purpose entity (SPE)

-A legal entity created to perform a special activity (issue securities, complete a project, perform R&D activities). -The company that creates the SPE guarantees that it or some outside party will eventually perform the activity. Use of the SPE enables the company that created it to avoid reporting any assets or liabilities related to the activities on its balance sheet. (p. 804).

Accounting for notes and bonds is quite similar

-A note is valued at the present value of its future interest and principal cash flows. -Company amortizes any discount or premium over the life of the note.

Mortgage notes payable

-A promissory note secured by a document called a mortgage, which pledges title to property as security for the loan.

Serial bonds

-Bond issues that mature in installments. -School or sanitary districts, municipalities, or other local taxing bodies that receive money through a special levy frequently use serially maturing bonds.

Term bonds

-Bond issues that mature on a single date. (p. 785).

Secured bonds

-Bonds backed by a pledge of some sort of collateral. -For example, mortgage bonds are secured by a claim on real estate; collateral trust bonds are secured by stocks and bonds of other corporations.

Registered bonds

-Bonds issued in the name of the owner. - At redemption or in a sale of the bond, they require surrender of the certificate.

Examples of L/T Debt

-Bonds payable -Long-term notes payable -Mortgages payable

Callable bonds

-Bonds that give the issuer the right to call and retire the bonds prior to maturity

A promissory note secured by a document called a mortgage that pledges title to property as security for the loan

-Most common form of long-term notes payable. -Payable in full at maturity or in installments. -Fixed-rate mortgage. -Variable-rate mortgages.

Off-Balance-Sheet Financing: different forms-

-Non-Consolidated Subsidiary -Special Purpose Entity (SPE) -Operating Leases

Troubled-debt restructuring

-Occurs when a creditor grants to the debtor, due to the debtor's financial difficulties, concessions that it would not otherwise consider. -A troubled-debt restructuring involves either (1) settlement of debt at less than its carrying amount, or (2) continuation of debt with a modification of terms

Face, par, principal, or maturity value

-On a bond, the amount of capital that must be repaid at maturity. -The terms face value, par value, principal amount, or maturity value are used interchangeably. (p. 786).

Types and Ratings of Bonds: Common types found in practice

-Secured and Unsecured (debenture) bonds. -Term, Serial, and Callable bonds. -Convertible, Commodity-Backed, Deep-Discount bonds. -Registered and Bearer (Coupon) bonds. -Income and Revenue bonds.

Imputation

-The process of interest-rate approximation, which occurs when a company cannot determine

Debenture bonds

-Unsecured bonds, which are issued against the general credit of the borrower (issuer). (p. 785).

Bonds which do not pay interest unless the issuing company is profitable are called A. income bonds. B. term bonds. C. debenture bonds. D. secured bonds

A. income bonds.

A bond for which the issuer has the right to call and retire the bonds prior to maturity is a A. convertible bond. B. callable bond. B. Callable bond C. retirable bond. D. debenture bond

B. Callable bond

The effective interest method calculates interest expense by multiplying the carrying value of the bonds by the stated rate of interest. A. True B. False

B. False

The loss recorded by the creditor in a troubled debt restructuring is based on the expected future cash flows discounted at the current effective interest rate. A. True B. False

B. False

When the effective rate of a bond is lower than the stated rate, the bond sells at a discount. A. True B. False

B. False

Investment community values a bond at the present value of its expected future cash flows, which consist of

(1) interest and (2) principal.

Two ratios that provide information about debt-paying ability and long-run solvency are:

*Debt-to-Assets Ratio *Times interest earned ratio

Commodity-backed bonds

-Bonds that are redeemable in measures of a commodity (e.g., barrels of oil, tons of coal, or ounces of rare metal). -Also called asset-linked bonds. -The accounting problem for such bonds is to project their maturity value in markets where commodity prices fluctuate. (p. 785).

Revenue bonds

-Bonds that pay interest from specified revenue sources (e.g., airports, school districts, counties, toll-road authorities, and governmental bodies).

Convertible bonds

-Bonds that permit holders to exchange them for ("convert them to") other securities of a corporation (typically common stock) for a specified time after issuance. (p. 785).

Off-balance-sheet financing

-Borrowing funds in a way that avoids recording the obligations. -Examples of such arrangements are nonconsolidated subsidiaries, special purpose entities, and operating leases. -way to remove debt from the balance sheet or bypass loan covenants. -In response to off-balance-sheet financing gone bad (e.g., Enron), the FASB has tightened the rules that allow off-balance sheet accounting and increased disclosure (note) requirements related to this type of financing.

When companies issue bonds on other than the interest payment dates,

-Buyers will pay the seller the interest accrued from the last interest payment date to the date of issue. -On the next semiannual interest payment date, purchasers will receive the full six months' interest payment

Debt to total assets ratio

-Coverage ratio that measures the percentage of the total assets provided by creditors. -Computed as total debt divided by total assets. The higher the percentage of debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations

Zero-interest debenture bonds

-Long-term, unsecured debt securities that do not bear interest. -They are sold at a discount that provides the buyer's total interest payoff at maturity. -Also called deep-discount bonds. (p. 785).

Straight-line method

-Method for computing bond amortization. Under the straight-line method, companies amortize a constant amount each year. -Although the FASB recommends the effective-interest method, companies may use a straight-line method if the results obtained are not materially different from those produced by the effective-interest method. (p. 789).

Notes Issued for Property, Goods, or Services: When exchanging the debt instrument for property, goods, or services in a bargained transaction, the stated interest rate is presumed to be fair unless:

-No interest rate is stated, or -The stated interest rate is unreasonable, or -The face amount is materially different from the current cash price for the same or similar items or from the current fair value of the debt instrument.

Presentation of Long-Term Debt

-Note disclosures generally indicate the nature of the liabilities, maturity dates, interest rates, call provisions, conversion privileges, restrictions imposed by the creditors, and assets designated or pledged as security. -Fair value of the debt should be discloses. -Must disclose future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next five years.

Choice of rate is affected by:

-Prevailing rates for similar instruments. -Factors such as restrictive covenants, collateral, payment schedule, and the existing prime interest rate.

Long-term debt

-Probable future sacrifices of economic benefits arising from present obligations that are not payable within a year or the operating cycle of the company, whichever is longer. -Examples are: bonds payable, long-term notes payable, mortgages payable, pension liabilities, and lease liabilities.

Market rate or effective yield .

-Rate that provides an acceptable return commensurate with the issuer's risk. -Rate of interest actually earned by the bondholders.

Stated, coupon, or nominal rate =

-Rate written in the terms of the bond indenture. Bond issuer sets this rate. -Stated as a percentage of bond face value (par).

A debtor's serious short-run cash flow problems will lead it to request one or a combination of the following modifications:

-Reduction of the stated interest rate. -Extension of the maturity date of the face amount of the debt. -Reduction of the face amount of the debt. -Reduction or deferral of any accrued interest.

Rationale of Off-Balance Sheet Financing

-Removing debt enhances the quality of the balance sheet and permits credit to be obtained more readily and at less cost. -Loan covenants often limit the amount of debt a company may have. These types of commitments might not be -considered in computing the debt limitation. -Some argue that the asset side of the balance sheet is severely understated.

Troubled-debt restructuring involves one of two basic types of transactions:

-Settlement of debt at less than its carrying amount. -Continuation of debt with a modification of terms.

Long-term notes payable

-Similar in substance, in that both have fixed maturity dates and carry a stated or implicit interest rate, but notes do not trade as readily as bonds in the organized public securities market.

Times interest earned ratio

-Solvency ratio that indicates the company's ability to meet interest payments as they come due. -Computed as income before income taxes and interest expense divided by interest expense. (p. 808).

Carrying value

-The face amount of a bond minus any unamortized discount, or plus any unamortized premium. Synonymous with the term book value. (p. 791).

Stated, coupon, or nominal rate

-The interest rate written in the terms of the bond indenture (and often printed on the bond certificate). -The issuer of the bonds sets this rate, expressed as a percentage of the bond's face value. (p. 786).

Extinguishment of debt

-The payment of debt. -If a company holds a debt security to maturity, it does not compute any gains or losses; the carrying amount will equal the maturity (face) value of the bond. -If a company extinguishes debt prior to maturity, it must calculate any gain or loss from extinguishment and report such gain or loss in net income. (p. 795).

Effective-interest method

-The preferred procedure for computing the amortization of a discount or premium. -Under this method, companies compute bond interest expense (revenue) at the beginning of the period by the effective-interest rate) and then subtract bond interest paid (calculated as the face amount of the bonds times the stated interest rate); the result is the amortization amount.

Effective yield, or market rate

-The rate of interest the bondholders actually earn on a bond (and which takes into account the frequency of compounding). -If bonds sell at a discount, the effective yield exceeds the stated rate; if bonds sell at a premium, the effective yield is lower than the stated rate.

Fair value option

-The recording of financial assets or financial liabilities at fair value, with unrealized holding gains and losses reported as part of net income. (p. 803).

Refunding

-The replacement of an existing bond issue with a new one. -A company may find it advantageous to acquire its entire outstanding bond issue and replace it with a new bond issue bearing a lower rate of interest. -The company should recognize as income the gain from the refunding in the period of redemption.

Issuance and marketing of bonds to the public

-Usually takes weeks or months. -Issuing company must -Arrange for underwriters. -Obtain SEC approval of the bond issue, undergo audits, and issue a prospectus. -Have bond certificates printed.

Zero-Interest-Bearing Notes: Issuing company records the difference between the face amount and the present value (cash received) as

-a discount and -amortizes that amount to interest expense over the life of the note.

Bond contract known as a bond indenture; Represents a promise to pay:

-sum of money at designated maturity date, plus periodic interest at a specified rate on the maturity amount (face value). -Paper certificate, typically a $1,000 face value. Interest payments usually made semiannually. -Used when the amount of capital needed is too large for one lender to supply.

Selling price of a bond issue is set by the

-supply and demand of buyers and sellers, -relative risk, -market conditions, and -state of the economy.

Settlement of debt can involve either

-transfer of noncash assets (real estate, receivables, or other assets) or -the issuance of the debtor's stock.

Bond indenture

A contract for a bond that represents a promise to pay a sum of money at a designated maturity rate, plus periodic interest at a specified rate on the maturity amount (face value)

All of the following statements are true regarding IFRS treatment of reporting and recognition of liabilities except: A. IFRS allows the recognition of liabilities for future losses. B. IFRS requires that companies present current and noncurrent liabilities on the face of the balance sheet, with current liabilities generally presented in order of liquidity. C. For contingencies, IFRS requires insurance recoveries be "virtually certain" before recognition of an asset is permitted. D. The recognition criteria for asset retirement obligations is less stringent under IFRS than it is under U.S. GAAP.

A. IFRS allows the recognition of liabilities for future losses.

Bonds that are not recorded in the name of the bondholder are called unsecured bonds. A. True B. False

A. True

Gains and losses on early extinguishment of debt are reported as other gains and losses on the income statement. A. True B. False

A. True

The covenants and other terms of the agreement between the issuer of bonds and the lender are set forth in the A. bond indenture. B. bond debenture. C. registered bond. D. bond coupon.

A. bond indenture.

If bonds are initially sold at a discount and the straight-line method of amortization is used, interest expense in the earlier years will A. exceed what it would have been had the effective-interest method of amortization been used. B. be less than what it would have been had the effective-interest method of amortization been used. C. be the same as what it would have been had the effective-interest method of amortization been used. D. be less than the stated (nominal) rate of interest

A. exceed what it would have been had the effective-interest method of amortization been used.

A debt instrument with no ready market is exchanged for property whose fair market value is currently indeterminable. When such a transaction takes place A. the present value of the debt instrument must be approximated using an imputed interest rate. B. it should not be recorded on the books of either party until the fair market value of the property becomes evident. C. the board of directors of the entity receiving the property should estimate a value for the property that will serve as a basis for the transaction. D. the directors of both entities involved in the transaction should negotiate a value to be assigned to the property.

A. the present value of the debt instrument must be approximated using an imputed interest rate.

Bellingham Inc. sold bonds with a face value of $100,000,000 and a stated interest rate of 8% for $922,780,000, to yield 10%. If the company uses the effective interest method of amortization, interest expense for the first six months would be $4,000,000 A. True B. False

B. False

Best-efforts underwriting means that the investment bank guarantees the proceeds of the bond issue will be a certain amount. A. True B. False

B. False

Boomchickapop Company elects the fair value option for a long-term note payable. In 2014, the company reported an unrealized holding gains which was reported as a component of Other Comprehensive Income. A. True B. False

B. False

If a company elects the fair value option for its long-term liabilities, a decrease in the fair value of a bond payable will result in an unrealized holding loss. A. True B. False

B. False

On January 1, Gasperson Inc. issued $100,000,000, 7% bonds at 102. The journal entry to record the issuance of the bonds will include A. a credit to Bonds Payable for $102,000,000. B. a credit to Premium on Bonds Payable for $2,000,000. C. a debit to Cash for $100,000,000. D. a credit to Interest Expense for $2,000,000.

B. a credit to Premium on Bonds Payable for $2,000,000.

A bond that matures in installments is called a: A. term bond. B. serial bond. C. callable bond. D. bearer bond.

B. serial bond.

Stonehenge, Inc. issued bonds with a maturity amount of $5,000,000 and a maturity eight years from date of issue. If the bonds were issued at a premium, this indicates that A. the market rate of interest exceeded the stated rate. B. the stated rate of interest exceeded the market rate. C. the market and stated rates coincided. D. no necessary relationship exists between the two rates.

B. the stated rate of interest exceeded the market rate.

Income bonds

Bonds that pay no interest unless the issuing company is profitable

Bearer or coupon bonds

Bonds without the name of the owner, which may be transferred from one owner to another by mere delivery

If a bond sold at 97, the market rate was: A. equal to the stated rate. B. less than the stated rate. C. greater than the stated rate. D. equal to the coupon rate.

C. greater than the stated rate.

When a bond sells at a premium, interest expense will be: A. equal to the bond interest payment. B. greater than the bond interest payment. C. less than the bond interest payment. D. None of these answer choices are correct

C. less than the bond interest payment.

Franzia Co. prepares its financial statements using IFRS. The company has a loss contingency to accrue. The loss amount can only be reasonably estimated within a range of outcomes. No single amount within the range is a better estimate than any other amount. The amount of loss accrual should be A. zero. B. the minimum of the range. C. the mid-point of the range. D. the maximum of the range.

C. the mid-point of the range.

Classification of Discount and Premium

Companies report bond discounts and bond premiums as a direct deduction from or addition to the face amount of the bond.

When a note is exchanged for property in a bargained transaction, the stated interest rate is presumed to be fair unless: A. no interest rate is stated. B. the stated interest rate is unreasonable. C. the stated face amount of the note is materially different from the current cash sales price for similar items. D. All of these answer choices are correct.

D. All of these answer choices are correct

Which one of the following statements relating to mortgage notes payable is not correct? A. Mortgage notes payable are the most common form of long-term notes payable. B. A mortgage note payable is a promissory note secured by a document that pledges title to property as security for the loan. C. Mortgage notes payable are payable in full at maturity or in installments. D. Mortgage notes payable are always reported as a long-term liability.

D. Mortgage notes payable are always reported as a long-term liability.

The interest rate written in the terms of the bond indenture is known as the A. effective rate. B. market rate. C. yield rate. D. coupon rate, nominal rate, or stated rate.

D. coupon rate, nominal rate, or stated rate.

Under the effective interest method, interest expense: A. always increases each period the bonds are outstanding. B. always decreases each period the bonds are outstanding. C. is the same annual amount as straight-line interest expense. D. is the same total amount as straight-line interest expense over the term of the bonds.

D. is the same total amount as straight-line interest expense over the term of the bonds.

A bond issued in the name of the owner is a: A. bearer bond. B. convertible bond. C. income bond. D. registered bond.

D. registered bond.

Fair Value Measurement

Non-current liabilities are recorded at fair value, with unrealized holding gains or losses reported as part of net income.

Off-balance-sheet financing is an attempt to borrow monies in such a way to prevent recording the obligations.

Off-balance-sheet financing is an attempt to borrow monies in such a way to prevent recording the obligations.

Effective-Interest Method

Produces a periodic interest expense equal to a constant percentage of the carrying value of the bonds.

Imputed interest rate

The result of interest-rate approximation, which occurs when a company cannot determine the fair value of the property, goods, services, or other rights, and if the note has no ready market.

Debt-to-Assets Ratio

Total Liabilities/Total Assets

Cost of Issuing Bonds

Unamortized bond issue costs are treated as a deferred charge and amortized over the life of the debt.

Long-term debt consist of

probable future sacrifices of economic benefits arising from present obligations that are not payable within a year or the operating cycle of the company, whichever is longer.