Intermediate ch 14
Times interest earned ratio
(net income + interest expense + tax expense) / interest expense
Bonds Discount
- When a bond is sold for LESS than its face value, the difference between the face value of a bond and its selling price is called a discount - A discount on bonds payable is NOT AN ASSET, it is a CONTRA ACCOUNT DEDUCTED FROM BONDS PAYABLE - Market Rate ABOVE Face Value
Bonds Premium
- When a bond is sold for MORE than its face value, the difference between its face value and selling price is called a premium - When the market rate of interest is LOWER than the contractual interest rate - ADD THE PREMIUM onto BONDS PAYABLE - Premium is considered to be a reduction in the cost of borrowing because the borrower is not required to pay the bond premium at the maturity date of the bonds
Bonds
A certificate issued by a government or private company which promises to pay back with interest the money borrowed from the buyer of the certificate: The city issued bonds to raise money for putting in new sewers.
debenture bonds
Bonds that are unsecured (i.e., not backed by any collateral such as equipment). Secured only by "full faith and credit"
Which of the following is true concerning financial statement disclosure for debt instruments? a.The fair value of financial instruments must be disclosed either in the body of the financial statements or in disclosure notes b.Disclosures should include the aggregate amounts payable for each of the next five years for any long-term borrowing c.Both the issuer and the investor report interest as an operating activity on the statement of cash flows d.All of the above
D-all of the above
face amount of a bond
Face value is a financial term used to describe the nominal or dollar value of a security, as stated by its issuer. For stocks, the face value is the original cost of the stock, as listed on the certificate.
Effective interest rate ex: On June 30, 2021, Mabry Corporation issued $15 million of its 8% bonds for $13.8 million. The bonds were priced to yield 10%. The bonds are dated June 30, 2021. Interest is payable semiannually on December 31 and July 1. If the effective interest method is used, by how much should the bond discount be reduced for the 6 months ended December 31, 2021?
Interest expense ($13,800,000 × .10 × 6/12) 690,000 Discount (difference) 90,000 Cash ($15,000,000 × .08 × 6/12) 600,000
Bonds sold at premium ex: On January 1, 2021, Masterwear Industries issued $700,000 of 12% bonds dated January 1. Interest of $42,000 is payable semi-annually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 10% United Intergroup, Inc., purchased the entire bond issue, planning to hold the bonds until maturity
Interest: 42k * 5.07569 (PVOA n=6 i=5%) Principal: 700k * .74622 (PV n=6, i=5%) Total : 735,533 JE: Masterwear (Issuer) Cash 735,533 Bonds Payable 700,000 Premium on bonds pay 35,533 United (investor) Investment in bonds (face amount) 700,000 Premium on bond investment 35,533 Cash 735,533
Debt Issue Costs
Legal and accounting fees and printing costs in addition to registration and underwriting fees Direct: Directly to a single investor (private placement) Ex: Pension fund or an insurance company Issuing company incurs only issue costs Indirect: Indirectly through underwriters who: Commit to purchase bonds at a set price then resell them to other security dealers and the public Ex: Investment banks Issuing company pays underwriting fee
JE for the following: On January 1, 2021, Masterwear Industries issued $700,000 of 12% bonds. Interest of $42,000 is payable semi-annually on June 30 and December 31. The bonds mature in three years. The entire bond issue was sold at the face amount United Intergroup, Inc., the sole investor in the bonds, planned to hold the bonds to their maturity
Masterwear (Issuer) Cash 700k Bonds Payable 700k United (Investor) Investment in bonds (face amount) 700k Cash 700k
Rate of return on shareholder's equity
Net income/shareholder's equity
Rate of return on assets
Net income/total assets
Debt issue costs ex INTEREST:
Now, the effective rate is the one that would cause the present value of the six interest payments and the maturity amount of $700,000 to be $652,633. That semiannual rate is 7.4389%.
principal, par value, and maturity value
Other names for face amount
Bond price =
Present value of the principal payable at maturity + present value of the periodic cash interest payments
Implicit rate of interest
Rate is not expressly stated in the agreement
effective interest method
Refers to recording interest each period as the effective market rate of interest multiplied by the outstanding balance of the debt In previous ex: 666,633*(14%/2) = 46,664 is effective interest
serial bonds
Retired in installments during all or part of the life of the issue with each bond having its own specified maturity date
Bond sold on discount ex: On January 1, 2021, Masterwear Industries issued $700,000 of 12% bonds dated January 1. Interest of $42,000 is payable semi-annually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 14% United Intergroup, Inc., purchased the entire bond issue, planning to hold the bonds until maturity
Semi annual: n=6 i=7% Interest: 42k*4.76654(PVOA n=6 i=7) = 200195 Principal (face amount): 700000*0.66634 (PV n=6 i=7)=466438 Total: 666,633 JE: Masterwear (Issuer) Cash 666,633 Discount on bonds payable 33,367 Bonds Payable (face amount) 700,000 United (Investor) Investment in bonds (face amount) 700,000 Discount on bond investment 33,367 Cash 666,633
Amortization Schedules Ex:
Semiannual effective rate = $344,632 ÷ $11,487,747 = 3% Interest expense = $341,261 + ($11,316,611 × 3%) = $680,759
In each subsequent cash payment on an installment note:
The amount of principal paid increases
Reporting changes in fair value ex: Zimmern Foods has bonds outstanding during a year in which the general (risk-free) rate of interest has not changed. Zimmern elected the fair value option for the bonds upon issuance. What will Zimmern report for the bonds in its income statement for the year? a.Interest expense and a gain b.Interest expense and a loss c.A gain and no interest expense d.Interest expense and no gain or loss
The correct answer is d. Because general interest rates did not change, we assume any change in the fair value is due to a change in credit risk, so any gain or loss would be reported as OCI, not part of net income.
Periodic Interest
The effective interest rate times the amount of the debt outstanding during the interest period.
Stated rate (coupon rate or nominal rate)
The interest rate written in the terms of the bond indenture (and ordinarily printed on the bond certificate).
Induced Conversion
Through the call provision •When the specified call price is less than the conversion value of the bonds Encouraging voluntary conversion •By offering an added inducement in the form of cash, stock warrants, or a more attractive conversion ratio
Bond Prices
Typically stated in terms of a percentage of face amounts Ex: A price quote of 98 means $1000 bond will sell for $980; a bond priced at 101 will sell for $1010.
bond indenture
a legal document that specifies both the rights of the bondholders and the duties of the issuing corporation. Held by a trustee (usually a commercial bank or other financial institution)
Mortgage bonds (secured bonds)
bonds secured by a lien on specific assets of the company, such as real estate. Due to less risk, commands a lower interest rate
callable bonds
bonds that the issuing company can redeem (buy back) at a stated dollar amount prior to maturity. Call price must be prespecified and often exceeds the bond's face amount
convertible bonds
can be converted into common stock at the bondholder's option
Debt Issue Costs are recorded by:
combining with any discount or premium; combined valuation account is reported as a direct deduction from the liability; amortized over the life of the debt
When an accounting period ends between interest dates:
it's necessary to record interest that has accrued since the last interest date
Long-term notes
loans written for periods of 1 to 15 years When a company borrows cash from a bank and signs a promissory note, the firm's liability is reported as a note payable
subordinate debenture
not entitled to receive any liquidation payments until the claims of other specified debt issues are satisfied
zero coupon bond
pay no interest, offers a return in the form of a "deep discount" from the face amount, issuers can deduct for tax purposes the annual interest expense, even though no related cash outflow is incurred until the bonds mature Investors receive no periodic cash interest, even though annual interest revenue is reportable for tax purposes
Sinking fund redemption
the redemption schedule where bonds have a maturity dates and are subject to an annual call in accordance with a pre-specified retirement schedule
convertible bonds
•Can be exchanged for shares of stock at the option of the investor •Issued to: -Sell bonds at higher price -Use as a medium of exchange in mergers and acquisitions -Enable smaller firms or debt-heavy companies to obtain access to the bond market
Imputing an interest rate
•Deciding the appropriate rate when value of asset or service is not readily determinable
Reporting Changes in Fair Value
•If the fair value option is elected, a change in fair value creates a gain or loss •Any portion of that gain or loss that is a result of a change in the "credit risk" of the debt is reported as other comprehensive income (OCI) •Any portion of that gain or loss that is a result of a change in the general (risk-free) interest rate is reported as part of net income
Installment notes
•Installment payments are equal amounts each period •Periodic reduction of the balance is sufficient that at maturity the note is completely paid
If a company elects the fair value option:
•It's not necessary to report all of the financial instruments at fair value or even all instruments of a particular type at fair value •It can "mix and match" on an instrument-by-instrument basis •It must make the election when the item originates
Debt to Equity Ratio
•Measures the degree of risk •The type of risk measured is the default risk •It presumably indicates the likelihood a company will default on its obligations total liabilities/shareholders equity
early extinguishment of debt
•Refers to the transaction when debt is retired prior to its scheduled maturity date •Accounting for early extinguishment: -Account balances of the debt must be removed from the books -Any difference between the outstanding debt and the amount paid to retire that debt represents either a gain or a loss
Liabilities at Fair Value
•The market forces that influence the fair value of an investment in debt securities (interest rates, credit risk, etc.) influences the fair value of liabilities •Companies are not required to, but have the option to, value some or all of their financial assets and liabilities at fair value
Installment Notes Calculate by:
•The periodic amount is easily calculated by dividing the amount of the loan by the appropriate discount factor for the present value of an annuity
Credit risk
•The risk that the investor in the bonds will not receive the promised interest and maturity amounts at the times they are due •Any change in fair value that exceeds the amount caused by a change in the general (risk-free) interest rate is the result of credit risk changes