Accounting Chapter 12
A call option protects a corporation from
declines in market interest rates
When the bonds are retired, the bondholders will receive more than they paid for the bonds. This payment, equal to the discount, is the extra interest that
enables the bondholders to earn an effective interest rate above the stated interest rate.
If the market interest rate on the bond is below the stated interest rate, investors are not willing to pay full price for a bond that yields a below market rate
false
If the market price of the corporation's common stock rises above the conversion price, bondholders will not be willing to convert their bonds to common stock
false
a call option protects a corporation from increases in the market interest rates
false
the amount of interest expense of bonds issued at a discount will decrease each year
false
Because corporations have loans that don't need to be paid until several years into the future
the loan can be paid out of future earnings accumulated over several years.
effective interest rate
the market interest rate at the time bonds are issued
disadvantage of issuing more stock
the ownership is spread over more shares and more owners.
A board of directors must consider
the short- and long-term impact of the following qualities of capital stock and bonds:
A corporation sets the stated interest rate of a bond issue
to approximate the current market interest rates
generally accepted accounting principles require the bonds
to be recorded at face value -the premium being recorded in Premium on Bonds Payable
A corporation in the restaurant business would record a loss on the sale of investments as an Other Expense
true
IFRS requires that the estimated value of the conversion option be recorded in a separate account from Bonds Payable
true
a bond issued at a premium will also be purchased by the investor at the premium
true
an advantage of borrowing additional capital is that stockholder's equity is not spread over additional shares of stock
true
interest expense is calculated based on the carrying value of bonds, multiplied by the effective interest rate
true
the carrying value of the bonds purchased at a discount will gradually increase to equal the bonds' total face value
true
the redemption amount for a bond is almost always above the carrying value, resulting in a loss
true
the stated interest rate of a bond issue rarely equals the market interest rate on the day the bonds are issued.
true
Corporations pay the interest amount to a trustee,
who handles the payments to each individual bondholder.
A securities dealer purchases the bonds at a price that
yields the market interest rate
If market interest rates increase, the corporation
benefits from having issued bonds at lower rates.
If the market price of the corporation's common stock rises above the conversion price,
bondholders may elect to convert their bonds to common stock.
Similar to preferred stock,
bonds can be issued with a conversion option
term bonds
bonds that all mature at the same time
Bonds are similar to notes payable because
both are written promises to pay
How can a business raise additional capital within the next year?
by issuing additional stock or by borrowing the money.
Discount on Bonds Payable
contra account to a liability account -normal debit balance.
Regardless of the amount received,
the face value of the bonds is credited to Bonds Payable.
What is a disadvantage of borrowing additional capital?
-Interest must be paid on the loan, which decreases the net income. This decrease in net income decreases the amount available for dividends. -the amount borrowed must be repaid in the future.
What are two advantages of raising needed capital by issuing stock?
-The additional capital becomes part of a corporation's permanent capital. Permanent capital does not have to be returned to stockholders as long as the business continues to operate. -dividends do not have to be paid to stockholders unless the earnings are sufficient to warrant such payments.
What are two reasons why the stated interest rate of a bond will vary from the market interest rate?
-Unlike market interest rates, the stated interest rate is often a rounded percentage, such as 6%, 6.5%, or 7%. During the final weeks of the registration process, market interest rates can be expected to change. -Investors will adjust the price they are willing to pay for the bond, based on the current market interest rate.
disadvantage of borrowing
-interest must be paid on the loan, which decreases the net income. -This decrease in net income decreases the amount available for dividends. -the amount borrowed must be repaid
differences between bonds and notes payable
-most notes payable are for one year or less -bonds generally run for a long period of time, such as 5, 10, or 20 years. -bonds payable tend to be issued for larger amounts than notes payable.
Large loans are sometimes difficult to
-obtain for short periods -obtain from one bank or one individual
advantage of issuing stock
-the additional capital becomes part of a corporation's permanent capital. -Permanent capital does not have to be returned to stockholders as long as the business continues to operate. -dividends do not have to be paid to stockholders unless the earnings are sufficient to warrant such payments
Why the difference between the stated and market interest rate?
1. Unlike market interest rates, the stated interest rate is often a rounded percentage -During the final weeks of the registration process, market interest rates can be expected to change. 2. Investors will adjust the price they are willing to pay for the bond, based on the current market interest rate.
How does the accounting for a bond discount differ between the issuing corporation and an institutional investor?
A bond issued at a discount or premium is also purchased at a discount or premium. Bonds purchased by an institutional investor are recorded in Investment Securities. Unlike the issuing corporation, the buyer does not record the discount or premium in a separate account.
What would encourage a corporation to call a bond issue?
A corporation would call a bond issue to eliminate the annual overpayment of interest for the remaining years of the bond term.
bond
A long-term promise to pay a specified amount on a specified date and to pay interest at stated intervals.
bond issue
All bonds representing the total amount of a loan.
What amount is debited to the Bonds Payable account when a bond is retired?
Bonds Payable is debited for the total amount of the bond issue.
Retired a bond issue at its face value, $250,000.00.
D: Bonds Payable $250,000 C: Cash $250,000
What is the formula for calculating periodic interest expense on a bond?
Carrying value of bonds times effective interest rate times the faction of the year.
Redeemed an $800,000.00 bond issue with a call option of 103%. The bonds have a carrying value of $765,000.00
D: Bonds Payable $800,000 Loss on redemption of bonds (824,000 - 800,000) + 35,000 = $59,000 C: discount on bonds payable $800,000 - $765,000 = $35,000 Cash $800,000 x 1.03 = $824,000
OpeLin Industries, $120,000 of 6% bonds, purchased to yield 5.9%; $120,422.07 carrying value. Received the semiannual interest payment on the OpeLin Industries bonds. R643.
D: Cash ($120,000 x 0.06) / 2 = $3,600 C: Interest Revenue ($120,422.07 x 0.059) / 2 = $3,552.45 Investment Securities $3,600 - $3,552.45 = 47.55
OpeLin Industries, $120,000 of 6% bonds, purchased to yield 5.9%; $120,422.07 carrying value. Sold the OpeLin bonds, $122,754.00.
D: Cash $122,754 C: Investment Securities $120,422.07 - 47.55 = $120,374.52 Gain on Sale of investments $122,754 - $120,374.52 = $2,379.48
Received cash for 50 five-year, 7.0%, $5,000.00 face-value bonds, issued to yield 6.7%, $253,142.42
D: Cash $253,142.42 C: Bonds Payable 50 x $5,000 = $250,000 Premium on bonds payable $253,142.42 - $250,000 = 3,142.42
Received cash for 600 five-year, 6.5%, $1,000.00 face-value bonds, issued to yield 6.6%, $595,658.06
D: Cash $595,658.06 Discount on Bonds Payable $600,000 - $595,658.06 = $4341.94 C: Bonds Payable (first) 600 x $1,000 = $600,000
Paid cash to trustee for the semiannual interest payment on a $300,000.00, 6.0% bond issue having a carrying value of $296,190.63 and a 6.3% effective interest rate.
D: Interest Expense ($296,190.63 x 0.063) / 2 = 9,330 C: Discount on Bonds Payable $9,330 - 9,000 = 330 Cash ($300,000 x 0.06) / 2 = 9,000
Paid cash to trustee for the semiannual interest payment on a $500,000.00, 6.5% bond issue having a carrying value of $506,365.13 and a 6.2% effective interest rate.
D: Interest Expense ($506,365.13 x 0.062) / 2 = $15697.32 Premium on Bonds Payable $16,250 - 15697.32 = 552.68 C: Cash ($500,000 x 0.065) / 2 = $16,250
PlatMat Corporation, $75,000 of 5% bonds, purchased to yield 5.2%; $74,588.27 carrying value. Received the semiannual interest payment on the PlatMat Corporation bonds. R642.
D: Investment securities $1939.30 - $1875 Cash ($75,000 x 0.05) / 2 = 1875 C: Interest Revenue ($74,588.27 x 0.052) / 2 = 1939.30
Purchased 40 of Mason Electronic Corporation's $5,000.00 face-value bonds at $5,158.16 each, totaling $206,326.40. C624.
D: Investment securities $206,326.40 C: Cash $206,326.40
call option
The right of a corporation to repurchase its security for a specified price.
What account is debited when an institutional investor purchases a bond?
Investment Securities is debited for the total amount paid for the bonds.
institutional investors
Organizations that manage the investments of individual investors.
Loss on Redemption of Bonds
Other Expense on the income statement.
Bond Amortization
Reducing the amount of a bond discount or premium over time.
What amount is recorded in the Bonds Payable account when the bonds are sold at a premium or discount?
Regardless of the amount received, the face value of the bonds is credited to Bonds Payable
What is the primary difference between a term bond and a serial bond?
Term bonds mature on the same date. Serial bonds mature on different dates.
How does the amount of interest expense change over the term of a bond issued at a discount?
The amount of interest paid on a bond is the same whether the bond is issued at a discount or a premium.
face value
The amount to be paid to a bondholder at the bond maturity date.
What is the conversion price of a $5,000.00 bond having a conversion ratio of 25?
The conversion price is $200.
What are three names for the face value of a bond?
The face value is also known as par value, principal, or maturity value.
carrying value
The face value of a bond adjusted for any unamortized discount or premium
How does the effective interest rate impact the amount of interest paid on bonds with semiannual interest payments?
The interest expense is calculated using the current carrying value of the bonds, multiplied by the effective interest rate.
What amounts are used to calculate the amount of interest revenue earned on a bond investment?
The interest revenue is calculated using the current carrying value of the bonds multiplied by the effective interest rate multiplied by the time as a fraction of a year.
How is a loss on calling a bond issue reported in the financial statements?
The loss is recorded in Loss on Redemption of Bonds. This account is classified as an Other Expense on the income statement.
stated interest rate
The rate of interest used to calculate periodic interest payments on a bond.
A corporation issues $600,000.00 of convertible bonds for $610,000.00. The underwriters projected that the bonds would be sold for $585,000.00, until the corporation added a conversion option. What amount should be recorded in Bonds Payable, using GAAP? IFRS?
Using GAAP, the amount should be $600,000. Using IFRS, the amount should be $585,000.
Investors are willing to pay more for
a bond issue that has a conversion option. As a result, the conversion option reduces the corporation's interest expense.
callable bond
a bond that can be called before its maturity date
IFRS consider the value of the conversion option to be
a contribution to stockholders' equity.
The redemption amount is almost always
above the carrying value, resulting in a loss.
The estimated value of the conversion option is recorded
in a stockholders' equity account, Conversion Option.
The trustee writes checks to
individual bondholders.
advantage of serial bonds
interest does not have to be paid on the total bond issue for the 10 total years
The corporation was relatively young and had only become profitable in the past year. As a result, management knew that it would have to offer
investors additional incentives to purchase its bonds.
If the market interest rate is above the stated interest rate,
investors are not willing to pay full price for a bond that yields a below-market rate. -Thus, the bond will be issued at a discount.
if the market interest rate is below the stated interest rate,
investors are willing to pay extra to earn an above-market rate. -This bond will be issued at a premium.
If current market interest rates fall, the corporation
is burdened by having to pay higher-than-market interest rates.
Without a call option, the corporation
is obligated to pay the stated interest rate for the term of the bond.
securities dealer
known as an underwriter, to sell the bonds
Bonds Payable
liability the total amount of the bond issue zero balance
This final process
may require several weeks
Premium on Bonds Payable
normal credit balance.
conversion price
par value/conversion ratio
retiring a bond issue
paying the amounts owed to bondholders for a bond issue
serial bonds
portions of a bond issue that mature on different dates
Who are hired to audit the information that will be included in the registration statement filed with the Securities and Exchange Commission?
public accountants
the stated interest rate
rarely equals the market interest rate on the day the bonds are issued
A corporation usually sells an entire bond issue to a
securities dealer, who sells individual bonds to the public.
advantage of borrowing
stockholders' equity is not spread over additional shares of stock
What is an advantage of raising additional capital by borrowing?
stockholders' equity is not spread over additional shares of stock.
How does the amount of the carrying value change over the term of a bond issued at a premium?
the carrying value is reduced each period
The registration process begins when
the company determines what type of security it will issue
As the registration process nears conclusion,
the corporation will decide on the number, face value, interest rate, and term of the bonds
IFRS recognize
the estimated value of the conversion option. The estimated value of the bonds without the conversion option is recorded in Bonds Payable.
The total payment is calculated using
the face value of the bonds and the stated interest rate