Chapter 10, Financial Accounting

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What is listed after current liabilities and will not be satisfied in one year?
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long-term liabilities
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Types of Long-Term Liabilities
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Bonds or notes, Leases, Deferred taxes
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Bond
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Security of financial instrument that allows firms to borrow large sums of noney and repay the loan over a long period of time.
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Bonds are sold or issued to investors who want what?
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a return on their investment
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Borrower
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promises to repay the principle on a specified date, the due date, or maturity date.
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Bonds payable result from what?
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from borrowing funds and are generally issued in denominations of $1000
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Face Value
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The principle amount of the bond as stated on the bond certificate (This is the amount that the firm must pay at the maturity date of the bond)
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How long are bond maturities?
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up to 30 years
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Why do investors in bonds want to sell them?
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If interest rates paid by competing investments become more attractive or if the issuer becomes less credit worthy. Buyers are betting that interest rates will reverse course of that he company will get back on its feet
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Collateral
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Represents that assets that back the bonds in case the issuer cannot make the interest and principle payments and must default on the loan
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Debenture bonds
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Bonds that are not backed by specific collateral Investor must examine the general credit worthiness of the issuer
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If a bond is a secured bond
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Certificate indicates specific assets that serve as collateral in case of default
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Due date
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Specifies the date that the bond principal must be repaid
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Normal bonds = Term bonds
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Entire principle amount is due on a single date
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Serial bonds
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Not all the principle is due on the same date
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Why might firms prefer serial bonds?
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Firm does not ned to accumulate the entire amount for principle repayment at one time
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Convertible bonds
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can be converted into common stock at a future time. Allows the investor to buy a security that pays a fixed interest rate by that can be converted @ a future date into an equity security (STOCK) if the issuing firm is growing and profitable
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Why are convertible bonds advantageous to issuing firms
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normally carry a lower rate of interest
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Callable bonds
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Bonds that may be redeemed or tiered before their specified due date Paid at redemption price/reacquisition price
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Important characteristics of bonds payable include
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par value Due date Interest rate An indication of whether the bonds are convertible or callable Any property collateralizing the bonds
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Face rate
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Amount of interest that will be paid on each interest period specified on the bond certificate, determines that cash to be paid each interest period.
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Other names for Face rate of interest
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Stated rate, nominal rate, contract rate, coupon rate
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Face Rate Example, $10,000 bonds, 8% annual face rate of interest. How must $interest would be paid at the end of each period?
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800$ (10,000×8%x1 year)
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Face Rate Example, $10,000 bonds, 8% annual face rate of interest. How must $interest would be paid at the end of each period to be paid semi annually?
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400$ (10,000×8%x1/2 year)
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Market rate
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Rate that bondholders could obtain by investing in other bonds that are similar to the issuing firm’s bonds. Rate bondholders could obtain from other similar bonds in the market.
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Other names for market rate of interest
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Effective rate, bond yield
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How is market rate determined?
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By the bond market on the basis of many transactions for similar bonds
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What does the market rate incorporate?
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All of the “market’s” knowledge about economic conditions and all of its expectations about future conditions.
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Bond issue price
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= Bond issue price of the annuity of interest payments + the present value of the the principle
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How is the bond Issue price determined?
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by the relationship between the face rate and market rate of interest, and by market’s perception of risk.
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Bond issue price Representation
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= present value of interest payments (annuity) discounted at market rate + present value of maturity value discounted at market rate
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Two types of cash flows that the bond will produce for the investor?
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Interest recepits, Repayment of principle (face value)
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What is the repayment of principle, when does it occur?
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One time receipt that occurs at the END of the term of the bonds.
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Premium
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= Issue price – Face Value
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When are bonds issued a premium?
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When the face rate exceeds the market rate
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What is a premium an addition of?
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The bonds payable liability on the balance sheet
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(Journal Entry) To record the issuance of bonds payable Premium
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Debit cash -> credit, bonds payable, premium on bonds payable
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Balance sheet representation of premium on bonds payable
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Long term Liabilities: Bonds payable, plus premium on bonds payable
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Discount
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= Face value – issue price
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When are bonds issued at a discount?
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When the market rate of interest exceeds te face rate. What is a discount a deduction of?: The bonds payable liability (Contra liability)
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(Journal Entry) To record the issuance of bonds payable Discount
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Debit, Cash, discount on bonds payable -> Credit, bonds payable
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Balance sheet representation of discount on bonds payable
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Long term Liabilities: Bonds payable, Less Discount on bonds payable
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If Market rate = Race rate
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Bond are issued at a face value amount
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If Market rate > Race rate
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Bond are issued at discount
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If Market rate < Race rate
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Bond are issued at a premium
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The relationship between interest rate and bonds is always?
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Inverse
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Amortization
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Process of transferring an amount from the discount or premium account to interest expense each time period to adjust interest expense.
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Amortization of premium or discount on bonds payable allocates the difference in what?
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interest rates over the life of the bond so that interest expense each period reflects the effective rate, or the market rate, of the borrowing.
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Effective interest method of amortization
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The process of transferring a portion of the premium or discount to interest expense; this method results in a constant effective interest rate.
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Effective Interest method calculates
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Interest on the net liability every period at the market rate.
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Effective interest method, bonds issued at a discount
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Net liability starts below face value and increases every period until discount is fully amortized at maturity.
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Effective interest method, bonds issued at a premium
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Net liability starts above face value and decreases every period until the premium is fully amortized at maturity
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Effective rate
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=Annual interest expense/carrying value
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Carrying value for discount
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The face value – unamortized Discount
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Carrying value for premium
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The face value + unamortized Discount
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Cash interest
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= Bond face value x Face rate
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Interest expense
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= Carrying value x Effective rate
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Discount amortized
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= Interest expense – Cash Interest

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