Exam #1
*Commercial Paper. What are the 5 characteristics?*
UNSECURED short-term loans issued by large companies with good credit - Minimum denominations = $25,000. - Maturity dates from 1 to 270 days (any longer would require registering the securities with the SEC). - Usually discounted. - Usually backed by lines of credit (lowers risk, which lowers discount rates)
*Bond Ratings*
Used by investors to help determine the appropriate bond price - Standard & Poors (S&P) and Moody's provide these
*Effective Interest Rate Method*
Used to recognize interest on outstanding obligations at a constant rate over the accounting period (rate used is the effective interest rate) - Interest Paid = Stated Rate X Face Amount - Interest Expense = Effective Market Rate of Interest X Outstanding Balance During Period (When bonds are sold with discounts or premiums, the outstanding balance changes over time, so interest expense changes over time as well) - Interest Accrued = Interest Expense - Interest Paid
Are contingent gains accrued like contingent losses? Are they disclosed?
U.S. GAAP does not allow for the accrual of contingent gains, but they may be disclosed as long as the disclosure isn't misleading.
*Loss Contingencies*
UNCERTAIN, possible future event that will give rise to a liability, but only if the future event happens (lawsuit)
*Mortgage Bond. *
Secured bond backed by specific real estate
*What are the 2 ways to determine interest expense for bonds? Of the 2, which one is favored by GAAP?*
1. Effective Interest Method - Favored 2. Straight-line Method
*What are the 2 types of trade accounts?*
1. Accounts Payable: Obligations to suppliers of inventory or services on open account. - Credit instrument is the sales invoice = INFORMAL credit agreement - No interest. - Paid within 30 to 60 days. 2. Trade Notes Payable: Similar to accounts payable except that the credit arrangement is MORE FORMAL (bigger amounts of $) - Credit instrument is often a written, promissory note - Some interest - Payment terms are a little longer than accounts payable
*What are the 2 ways to measure loss contingencies?*
1. If amount is known = Use that amount 2. If amount is unknown, but a range can be estimated = Use the amount that is most likely, or if equally likely, use the lowest amount
Household Solutions manufactures kitchen storage products. During the year, the company became aware of potential costs due to: - Situation 1: a recently filed lawsuit for patent infringement for which the probability of loss is remote and damages can be reasonably estimated. - Situation 2: another recently filed lawsuit for food contamination by the plastics used in Household Solutions' products for which a loss is probable but the amount of loss cannot be reasonably estimated. - Situation 3: a new product warranty that is probable and can be reasonably estimated. Which of the situations should be accrued?
1 = no 2 = no, but disclosed 3 = yes and disclosed
*What are the 2 common examples of long-term liabilities?*
1. Bonds - Debenture - Subordinated Debenture - Mortgage - Coupon - Callable - Sinking Fund Debentures - Serial - Convertible - Zero Coupon Bonds 2. Long-term Notes - Notes Payable - Note Issued for Cash - Note Exchanged for Assets or Service - Installment Notes
*Sinking Fund Debentures vs. Serial Bonds*
1. Bonds with a call provision that requires calling a specified amount on the bonds on a YEAR BY YEAR basis - Sinking Fund: Balance sheet account with cash set aside for redeeming bonds 2. Similar to sinking fund debentures, but LESS COMMON - Bonds = retired piecemeal (may not be every year, but every 2 years, 10 years, 12 years, etc.)
*What are the 2 ways to account for conversion bonds?*
1. Conversion Feature Not Exercised: Exactly the same as nonconvertible debt. 2. Typical Voluntary Exercise of Conversion Feature: Conversion feature is exercised, all accounts related to the debt (book value) are removed from the books and new equity shares are issued for exactly the same amount.
Indicate the way each of the items listed below should be reported in the balance sheet at December 31, 2021. 1. Commercial paper. 2. Noncommitted line of credit. 3. Customer advances. 4. Estimated quality-assurance warranty cost. 5. Accounts payable. 6. Long-term bonds that will be callable by the creditor in the upcoming year unless an existing violation is not corrected (there is a reasonable possibility the violation will be corrected within the grace period). 7. Note due March 3, 2022. 8. Interest accrued on note, December 31, 2021. 9. Short-term bank loan to be paid with proceeds of sale of common stock. 10. A determinable gain that is contingent on a future event that appears extremely likely to occur in three months. 11. Unasserted assessment of taxes owed on prior-year income that probably will be asserted, in which case there would probably be a loss in six months. 12. Unasserted assessment of taxes owed on prior-year income with a reasonable possibility of being asserted, in which case there would probably be a loss in months. 13. A determinable loss from a past event that is contingent on a future event that appears extremely likely to occur in three months. 14. Note payable due April 4, 2024. 15. Long-term bonds callable by the creditor in the upcoming year that are not expected to be called.
1. Current 2. Disclosure only 2. Current 4. Current 5. Current 6. Current - not probable it will be corrected = have to reclassify 7. Current 8. Current 9. Long-term 10. Disclosure only - gain not loss 11. Current - probable 12. Not reported - only reasonably possible 13. Current 14. Long-term 15. Current
Of the following, what portion should be current and noncurrent: 1. $10 million of 9% bonds were issued for $10 million on May 31, 1999. The bonds mature on May 31, 2029, but bondholders have the option of calling (demanding payment on) the bonds on May 31, 2022. However, the option to call is not expected to be exercised, given prevailing market conditions. 2. $14 million of 8% notes are due on May 31, 2022. A debt covenant requires Newman to maintain current assets at least equal to 175% of its current liabilities. On December 31, 2021, Newman is in violation of this covenant. Newman obtained a waiver from National City Bank until June 2022, having convinced the bank that the company's normal 2 to 1 ratio of current assets to current liabilities will be reestablished during the first half of 2022. 3. $7 million of 11% bonds were issued for $7 million on August 1, 1989. The bonds mature on July 31, 2022. Sufficient cash is expected to be available to retire the bonds at maturity.
1. Current = Whole 10 million because it is callable within the next year 2. Current = Whole 14 million because of the maturity date in the next year (if wasn't maturing = noncurrent with waiver) 3. Current = Whole 7 million because of the maturity date in the next year
*Bonds issued at face amount: What is the accounting treatment by both the borrower (company) and lender?
1. Debit: Cash ; Credit: Bonds Payable (Face amount) 2. Debit: Investment in Bonds ; Credit: Cash (Face amount)
*What are the 2 types of advance collections from customers? What 3 journal entries do each of them have?*
1. Deposits: Refundable deposits create liabilities (for apartment) - Cash is received: debit Cash; credit Liability-Deposits. - If cash is returned: debit Liability-Deposits; credit Cash - If deposit is forfeited: debit Liability-Deposits; credit Revenue-Misc. 2. Advances: Customers pay for products or services in advance, a liability is created (deferred revenue) until the unearned revenue is earned (subscriptions, GIFT CARDS, layaways, plane tickets) - Advance is collected: debit Cash; credit Deferred Revenue - Revenue is earned: debit Deferred Revenue; credit Revenue - Gift Cards: Recorded as deferred revenue when issued, then as revenue when redeemed or probability of redemption is remote (gift card breakage)
*What are the 3 required disclosures of long-term debt?*
1. Disclosure of the fair values of bonds, notes and other financial instruments is required. - Market prices are used for actively traded debt securities. - Present values using current discount rates are used for other liabilities. 2. Disclosure of the aggregate amount of long-term debt payments for each of the next 5 years. 3. Disclosures also include extensive descriptions of the liabilities, including interest rates, maturity dates, call provisions, conversion options, pledged assets, etc.
*What are the 2 accounting treatments of loss contingencies?*
1. If the event that gave rise to the loss contingency occurred BEFORE the balance sheet date - Accrue and disclose if PROBABLE AND REASONABLY ESTIMABLE - Disclose but do NOT accrue if: a. Probable but NOT estimable b. Reasonably possible but NOT probable, whether estimable or not. - Neither accrue nor disclose if only a REMOTE chance of the future event. 2. If the event that gave rise to the liability occurred AFTER the balance sheet date then no accounting treatment is required at all.
*Determining fair value for: 1. Actively traded securities 2. Securities that aren't traded*
1. Market value = trading price at reporting date 2. Market value = PV of future cash flows discounted using the current interest rate for debt of similar risk
Skill Hardware is the plaintiff in a $16 million lawsuit filed against a supplier. The litigation is in final appeal and legal counsel advises that it is virtually certain that Skill will win the lawsuit and be awarded $12 million. 1. Is this a loss contingency? 2. Is the future event probable? 3. Can this contingency be reasonably estimated? 4. Is this contingency accrued? 5. Should a disclosure note describe the contingency?
1. No, it is a GAIN contingency 2. Yes 3. Yes 4. No, because it is a gain not a loss 5. Yes even though it is a gain
*What are the 3 types of notes payable?*
1. Note Issued for Cash: Interest rate usually negotiated at the time the note is issued, so the market rate and stated rate tend to be the SAME (no discount or premium) 2. Note Exchanged for Assets or Services: Market rate = different from stated rate - Implicit Rate of Interest: Stated rate + (Issuance Price - Purchase Price) - SUBSTANCE OVER FORM = Unrealistic Interest Rate - Implicit part is recorded as Discount on Notes Payable and AMORTIZED over the life of the note 3. Installment Note: Notes with annuity payments that include both an interest portion and a principal portion sufficient that by maturity, the principal has been completely repaid (mortgages, auto loans) - Installment Payment = Loan Amount ÷ Present Value Factor of Annuity - RECORDED AT NET BOOK VALUE (without a discount or premium account) because the book value is gradually reduced to zero rather than gradually adjusted to the face value as in notes with a lump sum payment at maturity.
*What are the 2 types of warranties?*
1. Quality Assurance (Regular): Warranties that are NOT separate performance obligations because they aren't sold separately, but they guarantee products free from defects for a period of time. - ALWAYS accrued because estimates can be made from historical or industry data. - Measurement: Time value of money is usually ignored due to materiality and if time horizon if sufficiently long, GAAP says to compute an expected value using estimated probabilities of possible outcomes. 2. Extended Warranties: SOLD SEPARATE from the underlying product and are treated as separate performance obligations - Cash collected: recognize deferred revenue (liability) - Recognize revenue ratably over the warranty period as it's earned (1/3 each year)
*Rebates, Premiums, and Coupons. What are they used to do?*
1. Rebate: Cash back for purchases - Reduce sales revenue by estimated cash rebates in period of sale and recognize liability for same amount 2. Premiums: Offer smaller items (happy meal toys) in exchange for proof-of-purchase - Allocate part of sales revenue to premium as a separate deliverable and defer recognition of that amount as revenue when premium is delivered 3. Coupon: Offer to sell at less than regular price in exchange for presenting the offer at point of sale - Either accrue an expense and liability for estimated redemptions when coupons are issued OR wait to record expense when coupons are actually redeemed - Difference = immaterial (doesn't matter)
*What are the 7 common examples of current liabilities?*
1. Trade Accounts - Accounts Payable - Trade Notes Payable 2. Institutional Loans - Short-term Notes Payable (secured or not secured) - Lines of Credit (noncommited or committed) - Noninterest-Bearing Note - Commercial Paper 3. Accrued Liabilities 4. Advance Collections from Customers - Deposits - Advances (gift cards) 5. Payables to 3rd Parties 6. Current Maturities of Long-term Debt 7. Callable Liabilities
*Debenture Bond vs. Subordinate Debenture*
1. Unsecured (no collateral) bond, which makes the bondholder a "general creditor" in the event of liquidation (no special treatment) 2. Similar to debenture, but bondholder is subordinate to other general creditors in liquidation (others get paid first)
*What are the 5 common examples of loss contingencies?*
1. Warranties - Quality Assurance (Regular) - Extended 2. Rebates, Premiums, Coupons 3. Litigation Claims (Lawsuits) 4. Subsequent Events 5. Unasserted Claims
Bell International estimates that a $10 million loss will occur if a foreign government expropriates some company property. Expropriation is considered reasonably possible. 1. Is this a loss contingency? 2. Is the future event probable? 3. Can this contingency be reasonably estimated? 4. Is this contingency accrued? 5. Should a disclosure note describe the contingency?
1. Yes 2. No, it is only reasonably possible 3. Yes 4. No because it is reasonably possible 5. Yes since it is reasonably possible
Consultants notified management of Goo Goo Baby Products that a crib toy poses a potential health hazard. Counsel indicated that a product recall is probable and is estimated to cost the company $5.5 million. 1. Will this contingent liability be accrued? 2. What will be the effect on income, if any? 3. What will be the effect on the balance sheet, if any?
1. Yes, it is probably and reasonably estimable 2. It will decrease income 3. Increase liabilities
*Which of the following liabilities would normally be recorded at its maturity amount? a. Deferred Revenue. b. Pension Obligations. c. Mortgages Payable. d. Lease Obligations*
A
When bonds are sold at a premium... a. interest expense is less than cash interest payments. b. interest expense is more than cash interest payments. c. interest expense equals the stated rate times the face amount. d. interest expense is equal to cash interest payments.
A
If an equal amount of interest expense is recognized for each interest period, what might explain this? a. there is no discount or premium. b. the straight-line method is used to amortize any discount or premium. c. there is an equal amount of discount and premium on the bond issue. d. both a and b are correct.
D
An investor purchases a 20-year, $1,000 par value bond that pays semiannual interest of $40. If the semiannual market rate of interest is 5%, what is the current market value of the bond? a. $828. b. $893. c. $1,000. d. $1,686.
A 1. N=40, I=5, FV=-1,000, PV=142 2. N=40, I=5, PMT=-40, PV=686 3. 142+686 = $828
*Liabilities*
A PROBABLY, FUTURE SACRIFICE of economic benefits that arises from a PRESENT OBLIGATION to transfer assets or provide services to other entities. - RESULT OF PAST transaction or event.
*Secured Loan*
A type of short-term note that is guaranteed/secured using some assets as collateral - Most common collateral for short-term business loans = Inventory or Receivables (pledging receivables)
*Debt Issuance Costs*
Accounting and legal fees, printing costs, registration fees and underwriting fees incurred in connection with the issuance of a bond - Added to any discount OR subtracted from any premium and amortized over the life of the bond. - Reduce the net cash proceeds from a bond issue = effectively increase interest costs.
What is the asymmetric treatment of contingent gains and losses an example of?
Accounting conservatism
*When the accounting year ends between interest payment dates, what must you do with interest expense?*
Accrue it for the part of the year since last interest payment date
Who do corporations usually sell each entire debt issue to and what do they do with it?
An underwriter that resells them to other securities dealers and the public - Underwriting bank charges UNDERWRITING FEE
*How are noncurrent liabilities reported in the balance sheet? Where are the current portions recorded?*
As a single amount, net of any discounts/premiums (rather than showing contra accounts) - In current liabilities as Current Maturities of Long-term Debt
*At what wage rate and when should employer's accrue the cost of future employee absences (vacation days)? Are sick days and bonuses accrued?*
At the current wage rate IF: 1. Obligation is attributable to services already performed by the employee. 2. Paid absence can be taken in a later year, will be compensated if the employee is terminated (vested), or the benefit can be accumulated over time. 3. Payment is PROBABLE and REASONABLY ESTIMABLE - Sick days = not accrued because they depend on illness and there is too much uncertainty - Bonuses = compensation expense of the period they are EARNED
*Firms collect and/or hold money for third parties. Which of the following collections has no associated revenue or expense? a. FICA taxes (employment taxes). b. Sales taxes. c. Employee health insurance. d. Court-ordered wage garnishments*
B
*Which of the following is an actual, unsecured current liability? a. Mortgages Payable. b. Commercial Paper. c. Committed Lines of Credit. d. Non-committed Lines of Credit*
B
Most corporate bonds are a. Mortgage bonds b. Debenture bonds c. Secured bonds d. Junk bonds
B
Paying off debt (bonds) early by paying more than the book value of the bonds... a. results in a gain on early extinguishment b. results in a loss on early extinguishment c. increases stockholders' equity d. must always be approved by the bondholder
B
*ABC Corp., a calendar year firm, issued a $100, 6-month note on October 1. Then stated rate of interest was 10%. What amount of interest expense would be recognized on December 31? a. $ 0.00 b. $ 2.50 c. $ 5.00 d. $ 10.00*
B 100 x 10% x 3/12 = $2.50
*XYZ Corp. issues a $100 non-interest bearing note discounted at 10% on January 1, which is to be repaid with interest on March 31. The effective rate of interest on the note is closest to... a. 10.0% b. 10.3% c. 11.4% d. 14.3%*
B (100 x 10%) / {100-(100 x 10% x 3/12)} = 10.25%
*In 2020, Turfworks pays an average wage of $100 per day and its employees earn an average of 300 days of unused, compensated absences in 2020. Compensated absences can be carried over indefinitely once earned. Turworks' management believes all the unused absences will be used in 2021, when the average rate of pay is expected to increase to $110 per day due to already negotiated raises. However, management is only 70% sure that all the paid absences will be used by the end of 2021. In relation to the cost of compensated absences, Turfworks should... a. not accrue any expense in 2020 because of the uncertainty involved. b. accrue expense of $30,000 in 2020. c. accrue expense of $33,000 in 2020. d. accrue expense of $28,000 in 2020*
B 1. Attributable to services already performed 2. Can be carried over 3. Probable & reasonably estimable
*Convertible Bonds. What are the 4 reasons why a firm would issue these?*
Bondholder can convert bonds into stock at specified terms of exchange - To get a lower interest rate (higher bond price). - Use as a medium of exchange in mergers and acquisitions. - Enables small firms or debt heavy firms (higher credit risk firms) to access the bond market. - To effectively issue stock when existing shareholders are resistant to issuing additional equity.
*Induced Conversion*
Bondholders may be reluctant to convert to shares because rising stock prices also raises the price of their convertible bonds.
What is the most common long-term liability?
Bonds
*Coulson Company is in the process of refinancing some long-term debt. Its fiscal year ends on December 31, 2021, and its financial statements will be issued on March 15, 2022. Under current U.S. GAAP, how would the debt be classified if the refinancing is completed on December 15, 2021? What if instead it is completed on January 15, 2022?*
Both would still be considered long-term because: 1. They INTEND to refinance 2. They had the ABILITY to actually refinance BEFORE the financial statements are ISSUED
*Which of the following does NOT increase revenue? a. a forfeited refundable customer deposit. b. a gift card for which the possibility of redemption has become remote. c. the collection of sales tax on a customer sale. d. delivery of a service to a customer who had paid in advance*
C
For firms that choose to account for their long-term debt at fair value, increases in the general market rate of interest would... a. increase net income but not comprehensive income b. increase comprehensive income but not net income c. increase net income and comprehensive income d. decrease net income but not comprehensive income
C
The rate of interest that is actually incurred on a bond payable (recorded as interest expense) is called the: a. Face rate. b. Contract rate. c. Effective rate. d. Stated rate.
C
When bonds become callable by the issuing corporation... a. they should be moved to current liabilities on the balance sheet. b. they should be converted to equity securities. c. there is no accounting treatment unless the corporation actually calls the bonds. d. none of these are correct.
C
*Payables to 3rd Parties*
Collections on behalf of a 3rd party create liabilities, (sales taxes, FICA taxes, union dues, employee insurance) - Sales Taxes = recognized as liabilities when collected and the liability is removed when remitted (NO REVENUE)
*Fair Value Option*
Companies have the option to report some or all of their financial assets and liabilities at fair value. - For each liability, firms make an irrevocable choice at the issuance date to report it at amortized cost or fair value for financial reporting purposes. - The same market forces (mainly changing interest rates) that cause changes in the fair value of an investment in bonds, also cause changes in the fair value of the liability...just the other side of the same transaction (WHEN INTEREST RATES FALL = BOND PRICES RISE)
$77 million of 8% notes are due on May 31, 2025. The notes are callable by the company's bank, beginning March 1, 2022. Should they be recorded as current or long-term liabilities on Dec. 31, 2021?
Current - Callable within 1 year
*A contingent liability/loss must be disclosed but not accrued when... a. the loss is probable but not estimable. b. the loss is reasonably possible and estimable. c. the loss is reasonably possible but not estimable. d. all of the above*
D
*A quality assurance warranty typically results in... a. recognizing revenue and warranty expense evenly over the warranty period. b. recognizing revenue and warranty expense when warranty expenditures are made. c. recognizing revenue and warranty expense at the end of the warranty period. d. recognizing revenue and warranty expense at the point of sale*
D
*Compensated future absences result in... a. a deferred expense. b. an accrued expense. c. an accrued liability. d. both b and c are correct*
D
Cash payments for interest are NOT calculated using the... a. stated rate b. coupon rate c. nominal rate d. effective rate
D
For a bond issue that sells for more than the bond face amount,...: a. the effective interest rate is less than the rate printed on the face of the bond. b. the bonds are said to have sold at a premium. c. the effective interest rate is more than the rate stated on the face of the bond. d. both a and b are correct.
D
The cash received by the borrower when issuing bonds is equal to... a. the bonds' face amount b. the present value of the interest payments. c. the bonds' face amount plus the present value of interest payments. d. the sum of the present values of bonds' face amount and interest payments.
D
Are bonds usually sold at a discount or a premium?
Discount
*When is there a premium for current liabilities?*
Effective interest rate < stated rate
*When is there a discount?*
Effective interest rate > stated rate
*Subsequent Events*
Event of material economic significance that occurs AFTER the balance sheet date BUT BEFORE the financial statements are issued and should ALL be disclosed - If it is something that sheds light on conditions that EXISTED AT the balance sheet date, like loss contingencies, then the information the subsequent event provides should be used to determine the likelihood and amount of the contingency or even accrual of the contingent liability - If the condition giving rise to the contingency DIDN'T EXIST AT the balance sheet date, you do not accrue a liability, but you do disclose.
*Accrued Liabilities*
Expenses incurred but not yet paid. - Recorded as adjusting entries made to accrue expenses. - Accrued salaries & accrued interest.
*Changes in fair value. In what 2 ways are they accounted for?*
Fair value changes as interest rates faced by the firm change - Accounting for fair value changes depends on the reason for the interest rate change: 1. Changes in Market Rates of Interest (changes in the RISK-FREE rate) - Increases (decreases) in market rates result in an unrealized gain (loss) that is reported as PART OF NET INCOME and goes on the income statement. 2. Changes in Credit Risk: Changes in the issuer's credit rating cause changes in the interest rate it faces. - Increases (decreases) in market rates result in an unrealized gain (loss) that is reported as PART OF OTHER COMPREHENSIVE INCOME (OCI) - For BOTH: The offsetting debit (credit) to a contra account called "Fair Value Adjustment - Liability"
How are bond prices usually quoted in the financial press?
In terms of a % of the face amount - Quoted price of 101 = 101% of face amount
*Bonds*
Issued by corporations/big companies for capital and obligates them to pay the MATURITY AMOUNT (face value) at a specified maturity date + Interest - Maturities = 10-40 years - Interest = Paid SEMIANNUALLY and stated at an ANNUAL rate
*Callable Bonds*
Issuer can buy back the bonds before maturity at terms specified in the indenture. - Call price is usually higher than the face amount = Premium - "No Call" Provisions: prevent the issuer from calling the bonds for a specified number of years - Corporate has control = can call back whenever they want to, lender can't force them to pay
*Litigation Claims*
Lawsuits - Despite the fact that most large firms face litigation claims on a perpetual basis, the contingent liabilities are SELDOM ACCRUED (too uncertain) - Normally only accrue legal fees until cases are resolved - Sometimes they don't accrue after settlement if appeals are planned - Contingent liabilities should be disclosed in detail including the range of possible loss, but firms seldom comply with this because they don't want the plaintiffs to see it.
*Long-Term Liabilities*
Liabilities that are satisfied longer than 1 year or 1 operating cycle, whichever is longer, and generally involves paying cash at a specified future date. - Reported at the PRESENT VALUE of the related cash flows discounted at the effective rate of interest - Interest accrues on the debt over time.
*Current Liabilities*
Liabilities that must be satisfied within 1 year or 1 operating cycle from the balance sheet date, whichever is LONGER (otherwise they are noncurrent) and are expected to be satisfied with current assets or by creating other current liabilities. - Recorded at their MATURITY AMOUNT because it is easier and NOT MATERIALLY DIFFERENT from the present values because of the short time horizon.
$102 million of 8% notes are due on May 31, 2026. A debt covenant requires Future to maintain a current ratio (ratio of current assets to current liabilities) of at least 2 to 1. Future is in violation of this requirement but has obtained a waiver from the bank until May 2022, since both companies feel Future will correct the situation during the first half of 2022. Should they be recorded as current or long-term liabilities on Dec. 31, 2021? What if it was just a violation?
Long-term - Don't have to reclassify since they got a waiver and both companies feel situation will be corrected - If just a violation, it would be current
*Is the straight-line method an alternative to the effective interest rate method?*
NO, it is an application of the materiality concept
*Coupon Bonds*
Name for bonds that comes from the fact that most bonds used to be "bearer bonds", meaning that whoever held the paper coupon that came with a bond certificate could present it for interest payments. (NO RECORDS) - Today, most bonds are registered, so the issuing corporation keeps a record of who owns the bond and sends interest payments to them directly.
Classical is the plaintiff in a $4 million lawsuit filed against a supplier. The suit is in final appeal and attorneys advise that it is virtually certain that Classical will win the case and be awarded $2.5 million. Would this be accrued?
No - Contingent Gain
*Noninterest-Bearing Note (Discounted Note). What additional rate can be computed with these?*
Note that is sometimes marketed as zero-interest note despite the fact that nobody really lends money for free! - Interest portion of the loan is deducted (discounted) up front from the cash proceeds - Debit: Cash Proceeds (Face Value - Entire Interest Charge) - Debit: Discount on Notes Payable (CONTRA-LIABILITY) - Credit: Notes Payable - Effective Rate = Entire Interest Charge/Cash Proceeds
*Detachable Warrants*
Options to buy a specified amount of shares at the option price - Results in lower interest rates on the bonds. - Can be separated from the bonds and traded in the market separately from the bonds at their own price. (essentially 2 different securities) - Issue price of the bonds = allocated between the bond and the warrant based on fair values, in which at least one fair value must be determinable. - Value of the warrant: Credit "Equity - Stock Warrants" at issuance. - When exercised cash is debited for the amount received, the stock warrants account is also debited to remove it, and Common Stock is credited to make debits equal credits.
*Current Maturities of Long-term Debt. What are the 3 exceptions?*
Original long-term debt reclassified because it will mature or be settled within 1 year or 1 operating cycle if that is longer - Borrower doesn't have to reclassify the current portion of long-term debt IF: a. Company INTENDS to refinance on a long-term basis, AND b. Company has demonstrated the ABILITY to refinance by actually refinancing before statements are issued OR entered into agreement to do so - FORM OF REFINANCING DOESN'T MATTER
*Callable Liabilities. What are the 2 exceptions?*
Otherwise long-term liabilities that are callable by the lender within 1 year or operating cycle must be reclassified as current (even if it is not expected to be called and includes obligations made callable by violations of debt covenants) UNLESS: - It is probable the violation will be corrected within the grace period, OR - Call is waived by the creditor - Creditor has control = Can force you to pay whenever
*Unasserted Claims*
POTENTIAL claims against the firm that management is aware of but the claims have NOT yet been ASSERTED. - If probable that the claim will be asserted, they get the same accounting treatment as any other contingent loss (treatment depends on probability of unfavorable outcome after assertion and estimability of the amount) - If less than probable that the claim will be asserted, they aren't accounted for at all.
Zero Coupon Bonds
Pay NO interest, so they are sold at DEEP DISCOUNTS - Relatively small amount of the bond market. - Advantage: Issuer gets to deduct interest expense even though no cash interest is paid, which makes cash flows better until the bonds are settled. - Investor reports interest revenue for tax reporting even though they get no cash to pay taxes with (Because of this, the investors in zero-coupon bonds usually have a tax deferred or tax exempt status, e.g., pension funds)
*Lines of Credit. What are the 2 types?*
Prearranged agreements by banks to provide the borrower with funds only when needed (as the borrower withdraws it). - Noncommitted: Prearranged upper limits that the borrower may use without going through as many formal loan procedures (May have compensating balance borrower must keep on deposit, which raises the effective interest rate) - Committed: More formal agreement that ensures the bank will maintain funds up to the limit for the borrower to access if needed (May have a compensating balance and an annual commitment fee).
What is the best amount to initially record any liability? What kind of liability is it only used for?
Present Value - Only used for long-term liabilities, not current
*How do you get the selling price of a bond? *
Present value of all future cash outflows (interest and face value) discounted at the market/effective rate of interest - PV of principal + PV of interest
What do managers use early extinguishment to do?
Prop up income in bad years
*Institutional Loans. What is the interest expense equation?*
Require formal interest payments, which can result in another current liability called INTEREST PAYABLE (result of accruing instead of paying interest expense) - Interest Expense = Face amount X Annual Rate X Fraction of Year Interest Was Incurred (Debit)
*Discount for bonds*
Selling Price < Maturity Amount Market Rate > Stated Rate - Increases stated rate to match the market rate - Debit: Discount on Bonds Payable (reduces carrying value) - Amortized over life of bond = Increase interest expense
*Premium for bonds*
Selling Price > Maturity Amount Market Rate < Stated Rate - Decreased stated rate to match the market rate - Credit: Premium on Bonds Payable (increases carrying value) - Amortized over life of bond = Decrease interest expense
*Short-term Notes Payable (Notes Payable/Bank Loan). What kind of rate does it include? What 2 reasons make these popular?*
Short-term debt financing with FORMAL credit terms (promissory note) that may or may not be secured - Stated Rate: Actually printed in the contract - Lower interest rates = Less risk with shorter repayment periods - Flexibility in choosing long-run financing activities b/c it buys time
*Bond Indenture. What happens when a company fails to live up to the bond indenture?*
Specific PROMISES (loan agreement) - Legal action by trustee (bank)
Private Placement Sales
When a bond issuer sells the entire bond issue to a SINGLE investor (insurance company or pension fund) rather than an underwriter = No underwriting fee and don't have to be registered with the SEC because they aren't publicly traded.
*Early Debt Extinguishment*
When a company settles its own debt before the maturity date in the loan agreement and can be accomplished by: - Using the Call Options included in debt agreements to protect the borrower from falling interest rates. - Purchasing the debt securities in the open market even if it isn't callable. - Rake all accounts associated with the debt off the books and reduce cash by the amount paid = Any difference is recorded as Gain/Loss on Early Debt Extinguishment.
*Straight-line Method*
When computing interest expense, any discounts or premiums are amortized on a straight-line basis = same amount of interest expense being recognized in each payment period. - NOT favored by GAAP, but allowed only if difference with the Effective Interest Method is immaterial (not misleading)
*Notes Payable*
When firms borrow by issuing a PROMISSORY NOTE in exchange for cash or some other asset (equipment bought on credit) - Accounted for like Bonds Payable
Are most corporate bonds callable?
Yes
Since the indenture sets the interest payments and the maturity value (cash outflows), what is the only way to adjust the stated rate of interest to the market rate?
by selling the bonds at a discount or for a premium (adjusting cash inflows), which causes the bond to ultimately yield the market rate.
