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Gruenwald Corp. issues 10,000, $1,000 face amount bonds. Each bond can be converted into 25 shares of common stock. At the bond issue date, the company's common shares trade for $44 per share. At the date of issue, Gruenwald should recognize an addition to equity of

$1,000,000. Reason: $1000/25 shares = $40 per share conversion price (44 - 40) x 10,000 x 25 shares

determining the selling price of a bond

-a bond issue will be priced by the marketplace to yield the market rate of interest for securities of similar risk and maturity -the price will be the present value of the periodic cash interest payments (face x stated rate) plus the present value of the principal payable at maturity, both discounted at the market rate

the straight-line method

-a company is allowed to determine interest indirectly by allocating a discount or a premium equally to each period of the term to maturity- if doing so produces results that were not materially different from the usual (and preferable) interest method -decision should be guided by whether this method would tend to mislead investors or creditors in a particular circumstance -varies from the effective interest method in that constant dollar amounts are not produced when the effective interest method is used (effective interest method results in dollar amounts of interest varying over a term to maturity because the percentage rate of interest remains constant but is applied to a changing debt balance) -a practical expediency permitted in some situations by the materiality concept

what does a difference between the stated rate and the market rate result in

-a discount or premium -this is due to the inevitable delay between the date the terms of issue are established and the date the issue comes to market

bond indenture

-a document that describes the specific promises made to bondholders -held by a trustee, usually a commercial bank or other financial institution, appointed by the issuing firm to represent the legal rights of the bondholders -if company fails to live up to the terms of the indenture, the trustee may bring legal action against the company on behalf of the shareholders

Installment Notes

-a note that allows you to pay a portion of the price over a long time period via installment payments -installment payments are usually in equal amounts each period -each payment includes both an amount that represents interest and an amount that represents a reduction of the outstanding balance (principal reduction) -the periodic reduction of the balance is sufficient that at maturity the note is completely paid -outstanding balance of the note does not become its face amount as it does for notes with designated maturity amounts. instead the balance at maturity is 0. -procedure is the same as a note whose principal is paid at maturity, but for an installment note the periodic cash payments are larger and there is no lump-sum payment at maturity -each interest payment includes both an amount that represents interest and an amount that represents a reduction of principle

accounting for debt issue costs

-accounted for the same way as a bond discount -companies incur costs such as legal and accounting fees, printing costs, and registration and underwriting fees -costs are recorded by combining them with any discount (or subtracting them from any premium) on the debt -the combined valuation account is reported in the balance sheet as a direct deduction from the liability and amortized over the life of the debt

how can debt be a risk?

-debt increases risk -debt requires payment, usually on specific dates and failure to pay debt interest and principal on time may result in default or even bankruptcy -debt to equity ratio (total liabilities/shareholders equity) often is calculated to measure the degree of risk. the higher this ratio, the higher the risk. this type of risk is called default risk, indicates a likelihood a company will default on its obligations

financial statement disclosures

-in the balance sheet, long term debt (liability for debtor; asset for creditor) typically is reported as a single amount, net of any discount or increased by any premium, rather than at its face amount accompanied by a separate valuation account for the discount or premium. any portion of the debt to be paid (received) during the upcoming year, or operating cycle if longer, should be reported as a current amount -fair value of financial instruments must be disclosed in either the body of the financial statements or in disclosure notes. fair values are available for bonds and other securities traded on market exchanges in the form of quoted market prices. financial instruments not traded on market exchanges require other evidence of market value -disclosure notes for debt include the nature of the company's liabilities, interest rates, maturity dates, call provisions, conversion options, restrictions imposed by creditors, and any assets pledged as collateral. should also include the aggregate amounts payable for each of the next 5 years -in the statement of cash flows, issuing bonds or notes are reported as cash flows from financing activities by the issuer (borrower) and cash flows from investing activities by the investor (lender). as debt is repaid, the issuer (borrower) reports a financing activity while the investor (lender) reports an investing activity. both parties report interest expense and interest revenue among operating activities

debt issue costs - private placement

-issuing company may choose to sell the debt securities directly to a single investor (often a pension fund or an insurance company) -issue costs are less because privately placed securities are not subject to the costly and lengthy process of registering with the SEC and that is required of public offerings -underwriting fees are also avoided

debt issue costs - underwriter

-rather than sell bonds to the public, corporations usually sell an entire issue to an underwriter who then resells them to other security dealers and the public -by committing to purchase bonds at a set price, investment banks are said to underwrite any risks associated with a new issue -the underwriting fee is the spread between the price the underwriter pays and the resale price

convertible bonds

-retired as a consequence of bondholders choosing to convert them into shares of stock

what does the amoritization schedule look like for a bond issued at a premium

-since more cash is paid each period than the effective interest, the debt outstanding is reduced by overpayment -debt declines each period, premium is reduced by amoritization and the book value declines towards face value -opposite happens with a discount but with either, the outstanding balance becomes the face amount at maturity

induced conversion

-sometimes investors are reluctant to convert bonds to stock because they are afraid the market price of the convertible bonds will rise along with the market prices of stock -sometimes companies try to induce conversion, motivated to reduce debt and become a better risk to potential lenders or achieve a lower debt to equity ratio -ways to induce conversion: 1. call provision- when the specified call price is less than the conversion value of the bonds (the market value of the shares), calling the convertible bonds provides shareholders with incentive to convert. bondholders will choose shares rather than lower call price 2. companies may try to encourage voluntary coversion by offering added inducement in the form of cash, stock warrants, or more attractive conversion ratio, recorded as an expense of the period

what does the return on equity indicate

-the effectiveness of employing resources provided by the owners -return on equity = net income / shareholders equity

coupon bonds

-the name of the owner of the coupon bond is not registered -to collect interest on a coupon bond the holder clipped an attached coupon and redeemed it in accordance with instructions in the indenture

implicit rate of interest

-the value of an asset (cash or noncash) or service exchanged for the note establishes the market rate -the rate implicit in the agreement -sometimes the value of the asset or service is not readily determinable, but the interest rate stated in the transaction is unrealistic relative to the rate that would be expected in a similar transaction under similar circumstances -deciding what the appropriate rate should be is called inputing an interest rate

what effect do debt issue costs have on the effective interest rate?

-they reduce the cash proceeds from the issuance of debt, so it makes sense that they should reflect a higher cost of borrowing -by deducting debt issue costs, we lower the carrying amount of the debt, which effectively increases the interest rate of the debt -aka, the net amount borrowed is less, but interest payments are the same, so the effective rate of borrowing is higher

debenture bonds

-what most corporate bonds are, backed by the "full faith and credit" of the issuing corporation -no specific assets are pledged as security -investors in debentures usually have the same standing as the firm's other general creditors -an exception is a subordinated debenture, which is not entitled to receive any liquidation payments until the claims of other specified debt issues are satisfied

early extinguishment of debt

-when debt of any type is retired prior to its scheduled maturity date -any difference between the outstanding debt and the amount paid to retire that debt represents a gain or loss -when the debt is retired for less than book value, the debtor is in a favorable position and records a gain -opposite occurs for a loss

what do you do when an accounting period ends in between interest dates

-you must record interest that has accured since the last interest date by an adjusting entry prior to preparing the financial statements

On January 2, 20X1, MLK Corp. issued $10 million of 8% bonds at 104. Each $1,000 bond is accompanied by 25 stock warrants. Each warrant permits the holder to purchase one share of no-par common stock for $20. Immediately after issuance, the warrants were listed on the stock exchange for $2 each. During 20X1, half of the warrants were exercised. As a result, MLK will debit equity-stock warrants for

250,000 Reason: $10million/$1,000 = 10,000 total $1,000 bonds - each are accompanied by 25 stock warrants. During 20X1, half of the warrants were exercised so 5,000 bonds x 25 stock warrants each = 125,000 x $2

bonds that sell for less than face amount are sold at a

discount

what happens when a bond sells for less than face

discount

what happens when a bond sells for more than face

premium

the lower the perceived riskiness of the corporation issuing bonds,

the higher the price those bonds will command

Which of the following is correct regarding the recognition of the value of a conversion feature associated with a convertible bond consistent with IFRS?

-The value of the conversion feature is recognized as equity.

determining interest- effective interest method

- the market rate of interest multiplied by the outstanding balance of the debt -the difference between the effective interest rate and the interest paid increases the existing liability -the outstanding amount of debt is its book value, which is the face amount minus the balance in the discount -this causes the balance to continually increase, eventually becoming the face amount at maturity

Nattel Corp. issues 10,000, $1,000 face amount bonds at 104. Each bond can be converted into 25 shares of no-par common stock. Two years after issuance, 25% of the bondholders convert their bonds. The balance in the premium on bonds payable account is $300,000. Nattel should recognize this conversion by crediting common stock for

-$2,575,000 -Reason: (10,000 x 1,000 + 300,000) x 25%

Nattel Corp. issues 10,000, $1,000 face amount bonds at 104. Each bond can be converted into 25 shares of no-par common stock. Two years after issuance, when the share price is $50, half of the bondholders convert their bonds. The balance in the premium on bonds payable account is $300,000. If Nattel uses the market value method, it should recognize the conversion by crediting

-6,250,000 -25 x 5,000 x 50

On April 1, Munchin Company sells $800,000 face amount, 6% bonds. The bonds pay interest semi-annually on June 30 and December 31. The effective rate for this company is also 6%. When the bonds are sold, Munchin should receive:

-812,000 -Reason: These bonds are sold between interest payment dates so the price includes accrued interest since the last interest date. $800,000 + ($800,000 x 0.06 x 3/12)

which of the following is correct regarding the recognition of the value of a conversion feature associated with a convertible

-The value of the conversion feature is not recognized separately.

detachable stock purchase warrants

-another less common way to sweeten a bond issue -gives the investor an option to purchase a stated number of shares of common stock at a specified option price, often within a given period of time -usually mean lower interest rate and allow a company to issue debt when borrowing would not be feasible -can be seperated from bonds, can be excercised independently or traded in the market seperately from bonds, having their own market price. two different securities- the bonds and warrants- are sold as a package for a single issue price -price is allocated between two different securities on the basis of their fair values

mortgage bond

-backed by a lien on specified real estate owned by the issuer -considered less risky than debentures, will typically command a lower interest rate

what additional things should managers monitor?

-be alert to gains and losses that have nothing to with a company's normal operating activities -should actively monitor risk management activities

Nattel Corp. issues 10,000, $1,000 face amount bonds at 104. Each bond can be converted into 25 shares of no-par common stock. Two years after issuance, when the share price is $50, half of the bondholders convert their bonds. The balance in the premium on bonds payable account is $300,000. If Nattel uses the market value method, it should recognize the conversion by debiting

-bonds payable for $5 million -premium on bonds payable for $150,000 -loss on bond conversion for $1,100,000

convertible bonds

-can be exchanged for shares of stock at the option of the investor -reasons for issuing convertible bonds rather than straight debt are: 1. to sell the bonds at a higher price (meaning a lower effective interest cost) 2. to use as a medium of exchange in mergers and acquisitions and 3. to enable smaller firms or debt-heavy companies to obtain access to the bond market -sometimes serve as an indirect way to issue stock when there is shareholder resistance to direct issuance of additional equity -conversion feature is attractive to investors because it has features of both debt and equity -because of the inseparability of their debt and equity features, the entire issue price of convertible bonds is recorded as a debt, as if they are nonconvertible bonds -components of compound financial instruments such as convertible bonds are valued and reported separately under IFRS

how can debt be an advantage?

-can be used to enhance the return to shareholders, known as leverage -managers want to try to create favorable financial leverage, a situation where a company earns a return on borrowed funds in excess of the cost of borrowing the funds, thus providing shareholders with a total return greater than what could have been earned with equity funds alone

mix and match

-companies choose which financial instruments to report at fair value

option to report liabilities at fair value

-companies have the option to value financial assets and liabilities at fair value -change in interest rate causes a change in fair value of liabilities

sinking fund

-corporation may be required to redeem the bonds on a prespecified, year-by-year basis -bonds requiring this are often labeled sinking fund debentures -mandatory sinking fund redemptions retire a bond gradually over its term to maturity

On December 31, 20X1, Werner Inc. has $1 million face amount, 6% bonds outstanding. The bonds were issued at a discount and pay interest semi-annually on March 31 and September 30. On 3/31/X2, Werner Inc. should

-credit discount on bonds payable -debit interest expense -credit cash -debit interest payable

for a bond issue that sells for more than the bond face amount, the effective interest rate is

-less than the stated rate

note payable

-loan liability that occurs when a company borrows cash from a bank and signs a promissory note -note may also be issued in exchange for a non-cash asset, such as purchasing equipment on credit

what does the times interest earned ratio tell you?

-measures the companies ability to pay its debt -divides income, before subtracting interest expense or income tax expense, by interest expense -net income plus interest plus taxes / interest

callable

-most bonds are callable -allows the issuing company to buy back, or call, outstanding bonds from bondholders before their scheduled maturity date -affords companys protection against being stuck with relatively high-cost debt in the event interest rates fall during the period before maturity -call price must be pre-specified and often exceeds the bond's face amount (a call premium), sometimes declining as maturity approached

which of the following are terms that can be used to refer to the periodic interest rate paid by bond issuers?

-nominal rate -coupon rate -stated rate

Bonds

-obligate the issuing corporation to repay a stated amount (variously referred to as the principal, par value, face amount, or maturity value) at a specified maturity date, typically ranging from 10-40 years -in return for the use of money borrowed, the company also agrees to pay interest to bondholders between the issue date and the maturity date -periodic interest is a stated percentage of the face amount (referred to as the stated rate, coupon rate, or nominal rate), usually paid semiannually on designated interest dates -a bond issue divides a large liability into many smaller liabilities

zero coupon bonds

-pay no interest -offers return in the form of a deep discount from the face amount -good reminder that we accrue the interest expense (or revenue) each period at the effective rate regardless of how much cash interest is actually paid -advantage is that corporation can deduct the annual interest expense for tax purposes but have no related cash outflows until the bond matures

what does the rate of return on assets indicate

-profitability without regard to how those resources are financed -rate of return on assets = net income / total assets

serial bonds

-provide a more structured (and less popular) way to retire bonds on a piecemeal basis -retired in installments during all or part of the life of the issue -each bond has its own specified maturity date

On January 2, 20X1, MLK Corp. issued $10 million of 8% bonds at 104. Each $1,000 bond is accompanied by 25 stock warrants. Each warrant permits the holder to purchase one share of no-par common stock for $20. Immediately after issuance, the warrants were listed on the stock exchange for $2 each. During 20X1, half of the warrants were exercised. As a result, the common stock account will increase by

Reason: $10million/$1,000 = 10,000 total $1,000 bonds - each are accompanied by 25 stock warrants. During 20X1, half of the warrants were exercised so 5,000 bonds x 25 stock warrants each = 125,000 x $22 each