Bonds and Notes; Payables and Investments (If to be held to maturity) Flashcards
X borrows $100,000 from B for 10 years @ 12% cash interest per year. X pays the $12,000 interest in years 1 and 2 but not in year 3. On Jan 1, year 4, the debt is restructured. New terms are $90,000 principal and 10% interest, with principal due in 5 years.
PV factors are as follows:
PV of a single amount, 5 years, 12%=0.57
PV of an annuity, 5 years 12% = 3.6
What loss should B report on restructuring?
For a creditor, a restructuring loss is created when the PV of the future cash flows is less than the amount of the receivable currently on the books.
After restructuring, the PV of the total payments are as follows:
Principal of $90,000 x 0.57 = $51,300
Annual interest payments of $9,000 x 3.6 = $32,400
the amount of the receivable currently on the books is $112,000 because the total PV of the payments is $87,700 is below the current receivable the creditor recognizes a loss of $28,300
In troubled debt restructuring, what is the difference between the reporting done by the debtor and the reporting done by the creditor?
the debtor compares the amount currently owed to the total amount of cash that will be paid after restructuring. If the total amount to be paid is less than the current debt, the debt is written down to this figure and an ordinary gain is recognized.
the creditor compares the amount currently due to the PV of all future cash flows after restructuring. If the PV is less than the current receivable, the receivable is written down to the PV and an ordinary loss is recognized. For this computation, the PV is based on the interest rate of the old debt.
An entity issues 10,000 shares of preferred stock that must be redeemed for cash in 9 years. Is this preferred stock reported within the entity’s liabilities or within its stockholders’ equity?
This preferred stock is shown in the liabilities section of the balance sheet. Any financial instrument where assets will have to be used to satisfy a mandatory redemption must be shown as a liability.
An entity buys land and agrees that the purchase price will be $2 million. The entity has indicated that it will issue its own stock in exactly 12 months in order to settle this obligation. The stock is currently worth $20 per share, so 100,000 would be needed. However, the purchase contract indicates that the value of the shares on the date of conveyance must have a FV of exactly $2 million.
Is this obligation shown within stockholders’ equity or within the entity’s liabilities?
Any financial instrument that must be settled by issuing a variable # of equity shares, is reported as a liability if the monetary amount is fixed. Because the $2 million amount is set here, this obligation will be shown as a liability.
What is a term bond and a serial bond?
a term bond is one where interest is paid periodically and then the principal is paid as a lump sum at the end of the term
a serial bond is one where payments are made periodically that represent both principal and interest.
What is a convertible bond?
a convertible bond is one that can be converted into stock
What is a debenture and an indenture?
a debenture is an unsecured bond or other debt. It is a simple promise to pay and no assets are pledged as security.
an indenture is the contract for a bond or other debt. It provides all of the significant information, such as maturity date, interest rate, and interest payment dates.
What are bond issuance costs, and how are they recorded?
Bond issuance costs include legal fees, accounting fees, printing costs and underwriting and selling expenses.
bond issuance costs are reported as an asset, and then amortized to expense over the life of the debt using the straight-line method
A $100,000 bond pays 10% cash interest each year. The bond is sold to yield a rate of 12%. It is sold at 89.
How much cash is paid each year on this bond?
What is meant by sold at 89?
How was the price of the bond determined?
For cash payments, the terms of the bond contract must be followed, regardless of the price of the bond. The bond will pay $10,000 in cash each year. Cash interest payments are the face value $100,000 multiplied by the stated rate of payments which was 10%.
Bond prices are stated as a percentage of face value. Thus, being sold at 89 means the bond was sold at 89% of $100,000 face value, or at $89,000.
To determine the bond price, the cash flows required of the bond are determined. The PV of these cash flows is then determined based upon the yield rate. It is this PV that is the price paid for the bond,
An entity offers to sell a $100,000 bond that pays a 7% annual cash rate. The potential buyer wants to earn 9%. Will the buyer pay exactly $100,000, more than $100,000 or less than $100,000 for this bond?
the buyer will pay less than $100,000 to give an effective rate of 9%
A bond is sold at a discount. What happens to that discount?
The debtor amortizes the discount to interest over the life of the bond. Writing off a discount in this manner will increase the amount of interest being reported. premium paid will decrease interest.
The buyer writes off a discount in this manner only if there is an intention of holding this bond to maturity.
A bond is sold at a discount. The discount must be amortized to interest over the life of the bond. What two ways can be used to determine the amount of amortization each period? Which of these two methods is theoretically preferable?
Amortization of discount or premium on bonds can be computed by either the effective interest rate method or the straight-line method
the effective interest rate method is considered a better theoretical approach. however the SL method can be used if the resulting figures are not materially different than the effective interest rate method.
A term bond is sold at a discount. The entity is trying to decide between using the SL or ER method of amortization. What is the difference in the pattern of interest reported under each method?
SL the interest is the same each period
ER varies depending on term and discount or premium
discount - interest starts low and gradually get larger each period
premium - interest starts high and gradually get smaller each period
A 10 year term bond is sold at a $20,000 discount. The bond pays cash interest of $11,000 per year. If the SL method is being used what is reported as interest for the period?
the discount amortization increases the interest by $2,000 per year (20,000/10). when a bond is sold at a discount, interest reported on the income statement is the cash interest plus the annual amortization. Thus the interest reported is $13,000 ($11,000 + $2,000)
A 10 year term bond is sold at a $30,000 premium. The bond pays interest of $9,000 per year. If the SL method is being used, what is reported as interest for the period?
the premium amortization decreases the interest by $3,000 per year (30,000/10) when a bond is sold at a premium interest reported on the income statement is the cash interest less the annual amortization. Thus, the interest reported is $6,000 ($9,000 - $3,000)
