Chapter 9: Long-Term Liabilities Flashcards
a formal agreement or contract a company signs when borrowing money from a bank. They are frequently issued in exchange for a non cash asset such as equipment.
notes payable
Larger corporations issue ______ instead of notes.
bonds
a type of note that requires the issuing entity to pay the face value of the bond to the holder when it matures and usually to pay interest periodically at a specified rate. (generally paid semi-annually)
bond
A bond issue essentially breaks down a large ______ (large corporations frequently borrow hundreds of millions of dollars) into smaller chunks (usually $1,000) because the total amount borrowed is too large for a _____ lender.
debt; single
Accounting for notes payable and bonds payable is _________, besides the name (Notes Payable/Bonds Payable).
identical
the amount a borrower must repay at maturity
face value (also called par value or principal)
Typically face value is paid at maturity, but some are paid in monthly installments. These contracts typically require ______ payments to be made each period. A portion of each payment is _______ and a portion is _______.
Equal; principal; interest
What are 3 installment loan examples?
Car, student, and home loans
Historically, interest payments were called _______ payments. Terminology is still used today, but now the payments are automatically sent to the registered ________.
coupon; bondholder
What are 3 other names for bond interest rate?
- Stated Rate
- Coupon Rate
- Contract Rate
What is the formula to calculate the periodic bond interest payment?
Face Value x Interest Rate x Time (in years)
(time in years= the number of interest payments per year)
a bond with pledged collateral against the corporation’s ability to pay.
secured bond
A secured bond is (more/less) risky, more attractive to (borrowers/lenders), secured by companies _______, and a (higher/lower) interest rate.
less; lenders; assets; lower
a bond secured by real estate
mortgage bond
a mortgage bond is a type of ______ bond.
secured
a bond with no collateral attached, which relies on the general credit of the corporation
unsecured bond (also called debenture bond)
T or F: most bonds are unsecured.
true
Unsecured bondholders are the (first/last) lenders to be paid in bankruptcy (only the stockholders follow).
last
Unsecured bonds are (more/less) risky, and have a (lower/higher) stated interest rate.
more; higher
unsecured bonds where the risk of the borrower failing to make the payments is relatively high.
junk bond
Why would anyone lend money for a junk bond?
Because they receive a high enough rate of interest to compensate them for the risk.
a bond that gives the borrower (corporation) the right to call in the bond prior to its maturity date, thus paying off the bondholders earlier than expected.
callable bond
For a callable bond, the borrower typically “calls” debt when the interest rate being paid is much (higher/lower) than the current market conditions.
higher
T or F: a callable bond is not as attractive to investors.
true
a bond that gives the bondholder the right to convert the bond into another security, usually common stock; these bonds will specify the conversion ratio
convertible bonds
issuer of the bonds, seller
borrower
bondholder/creditor
lender
debt instruments that require borrowers to pay the lender the face value and usually to make periodic interest payments.
notes/bonds
amount of money the borrower agrees to repay at maturity.
face value/par value/ principal
date on which the borrower agrees to pay the creditor the face (or par) value.
maturity date
rate of interest paid on the face (or par) value. For bonds, the borrower pays the interest to the creditor each period until maturity.
stated/coupon/contract rate
market rate of interest demanded by creditors. This is a function of economic factors and the creditworthiness of the borrower. It may differ from the stated rate.
market/yield/effective rate
Borrowing through the use of notes/bonds is attractive to businesses as a source of money because the relative cost of issuing debt (the interest payments) is often (higher/lower) than the cost of issuing equity (giving up ownership shares).
lower
Bonds are frequently sold to the public through an ________.
underwriter
generate a profit either by offering a price that is slightly less than the expected market price (thereby producing a profit on resale) or by charging the borrower a fee.
underwriters
Businesses may sell bonds directly to institutions such as: (2)
insurance companies or pension funds
Underwriters examine what 3 things to determine the market (yield) rate of interest for the bond?
1.the provisions of the instrument (secured or unsecured, callable or not callable, convertible or not convertible)
2. the credit standing of the borrowing business
3. the current conditions in the credit markets and the economy as a whole
Why can the market rate possibly differ from the stated rate? (3 things)
- The underwriter disagrees with the borrower as to the correct market/yield rate
- Changes in the economy
- Changes in the creditworthiness of the borrower between the date of setting the stated rate and the date of issue.
T or F: Market value of bonds is always the same as their face value.
false; NOT always
When market/yield rate = stated rate of interest, the bond sells at ______.
par (the face value)
When market/yield rate is LESS than the stated rate of interest, the bond sells at a _______.
premium
When bonds are sold at a _______, the bonds represent particularly good investments because the interest payments are (higher/lower) than the market.
premium; higher
when a bond’s selling price is above face value.
premium
When market/yield rate is GREATER than the stated rate of interest, the bond sells at a _______.
discount
When bonds are sold at a discount, this (increases/decreases) the cost of borrowing.
increases
when a bond sells at a price below face value, due to the yield being greater than the stated rate of interest.
discount
When bonds are sold at par, the interest expense is _______ to interest paid.
equal
When bonds are sold at a premium, the interest expense is (greater/less than) the interest paid.
less than
When bonds are sold at a discount, the interest expense is (greater than/less than) the interest paid.
greater than
What are the 3 basic cash flows for which the issuing corporation must account?
- Issuance
- Interest
- Repayment
One of the 3 basic cash flows:
- the cash received when the bonds are issued (the issue or selling price)
issuance
The market price for debt is typically quoted as a ________ of _____ ______.
percentage; face value
At the time of issue, the borrower records the face value of the bonds in a _______ ______ account and records any premium or discount in a separate account called ______ on ______ ______ or _______ on ______ ______.
bond payable; premium on bonds payable; discount on bonds payable
The premium and discount accounts are called “_________” accounts because they affect the value at which the ________ is shown on the balance sheet.
valuation; liability
Both the premium and discount accounts are netted with bonds payable on the balance sheet, so on the date of issue the ______ value of the bonds payable is equal to the ______ value.
book; market
The principal amount repaid is equal to the _______ ______ of the note.
face value
To record the repayment of principal, what two things do you do?
Debit note/bond payable and credit cash
Example problem: when the bonds were issued at a premium, the amount of cash received when issued was $103,000 ($3,000 greater than the face value), but only the face value ($100,000) is repaid at maturity. The $3,000 difference represents an _______ ________ of the amount of interest paid to the borrower.
effective reduction
Example problem: When the bonds were issued at a discount, the amount of cash received was $96,000 ($4,000 less than the face value), but the entire face value ($100,000) must be repaid at maturity. The additional $4,000 effectively represents _______ _______.
additional interest
the process used to determine the amount of interest to be recorded in each of the periods the liability is outstanding.
interest amortization
The interest amortization allocation has two parts:
- Actual interest payment made to the lender during the period
- Amortizing any premium or discount on the bond.
What are the two methods for amortizing any premium or discount?
- Straight-Line Method
- Effective Interest Rate Method
For the effective interest rate method, interest expense for the period is always the _______ times the _______ (or ____) value of the bonds at the beginning of the period.
yield (the effective/market interest rate); carrying (book)
Which method of amortization is this?
represents a simple approximation of effective interest amortization. Equal amounts of premium or discount are amortized to interest expense each period.
straight-line method
Although the effective interest rate method is _______, the straight-line method may be used if it produces approximately the same numerical results as the effective interest rate method.
GAAP
Straight-Line Method:
If bonds are issued at par (100% of face value), no premium or discount is recorded. Total interest expense is _______ to the total interest payments.
This situation typically happens when a business borrows from a _____ creditor. Why?
equal; single; bc the two parties can easily agree on a stated rate that equals the appropriate market/yield.
The sale of a bond at a discount/premium affects the borrower’s _______ _______. → Why?
interest expense; bc total interest expense = the difference between the payments to the lenders and the amount received by the borrowing business.
At maturity, carrying value will =
face value
Carrying value will (increase/decrease) over the life of the bonds when issued at a discount.
increase
If bonds are issued at a discount:
- the total interest expense is equal to:
- the periodic interest expense is equal to:
- the total interest payments PLUS the discount
- the periodic interest payment PLUS a portion of the discount.
If bonds are issued at a premium:
- the total interest expense is equal to:
- the periodic interest expense is equal to:
- the total interest payments MINUS the premium
- the periodic interest payment MINUS a portion of the premium.
Carrying value will (increase/decrease) over the life of the bonds when issued at a premium.
decrease (as the premium is amortized, the premium balance declines and the carrying value moves closer to face value).
When bonds are issued at a discount, how do you calculate carrying value?
Carrying Value = Face Value - Unamortized Discount
When bonds are issued at a premium, how do you calculate carrying value?
Carrying Value = Face Value + Unamortized Premium
At issuance (the day bonds are sold), carrying value = ______ ______.
selling price
Which amortization method is more widely used in the business world?
Effective Interest Rate Method
What is the difference between the Effective Interest Rate Method and the Straight-Line Method? (2)
- Calculating interest expense (interest expense varies)
- Calculating amortization (varies under effective interest rate method).
What is the similarity between the Effective Interest Rate Method and the Straight-Line Method?
Calculating interest payment (will be constant)
When a bond is sold at _____, the straight-line method and effective interest rate method are _______ because there are no premiums or discounts to amortize.
par; identical
T or F: Even when premiums or discounts exist, the total interest expense over the life of the bonds is identical regardless of the amortization method used. However, the interest expense allocated to the individual accounting periods differs because premiums and discounts are amortized in different manners.
True
When using the effective interest rate method:
- interest expense will equal a _______ of the bond’s _____ ______.
- ## percentage; carrying value
When using the effective interest rate method:
The total interest expense (changes/stays the same) every period, but the effective interest portion of that amount (changes/stays the same)
changes; stays the same
When using the straight-line method:
The total interest expense (changes/stays the same) every period, but the effective interest portion of that amount (changes/stays the same).
stays the same; changes
When using the effective interest rate method, a calculation is made for what two things?
- the cash interest payment
- the effective interest expense
When using the effective interest rate method, the cash interest payment portion is calculated as:
Cash Interest Payment = Face Value x Stated Rate x Time (in years)
When using the effective interest rate method, the effective interest expense portion is calculated as:
Effective Interest Expense = Carrying Value x Yield (Market) Rate x Time (in years)
What are the 2 ways to calculate carrying value?
- Face Value - Discount Balance
- Face Value + Premium Balance
How do you calculate the total cost of borrowing?
Total Cost of Borrowing = Periodic Interest Expense x Interest Periods
an agreement that enables a company to use property without legally owning it; helps to keep a big debt off your balance sheet.
lease
T or F: Leases create an obligation to make payments whether the asset is in use or not.
true
Why are long-term leases very similar to purchasing?
Whether you purchase or lease, you obtain substantially all the risks and benefits.
A long term lease is for what period of time?
for one year or longer
A short term lease is for what period of time?
for one year or less
What are 3 advantages of leasing over purchasing assets?
- Less cash is needed to obtain and use the asset
- Protection against obsolescence and flexibility for assets such as computer equipment
- Lower cost financing through tax advantages
What is the disadvantage of leasing over purchasing assets?
you don’t own it, so you’re not building any equity on it.
T or F: If the lease term is one year or more = an asset and liability are recognized at the time the lease is signed. (asset is _______ to recognize the benefits that the leased asset will provide in the future and a liability is _______ to recognize the obligation to make future lease payments)
True; debited; credited
T or F: If the lease term is over one year = no assets or liabilities are recognized on the balance sheet at the time the lease is signed (no journal entry is made when the lease is signed). Instead, you will record rent expense as you make the lease payments.
False = if the lease term is UNDER one year, then it’s true
Although long-term creditors are concerned with a company’s short-term liquidity, they are primarily concerned with its long term _______.
solvency
ability to pay ALL your debts.
solvency
Solvency includes what?
long-term debt and interest expense/payments.
What are the three ratios used to analyze a company’s debt load?
- Debt to Equity
- Debt to Total Assets
- Long-Term Debt to Equity
How do you calculate Debt to Equity?
Debt to Equity = Total Liabilities / Total Equity
How do you calculate Debt to Total Assets?
Debt to Total Assets = Total Liabilities / Total Assets
How do you calculate Long-Term Debt to Equity?
Long-Term Debt to Equity = Long-Term Debt (including current portion) / Total Equity
T or F: It is better to have your assets acquired through equity than through debt.
True
The Debt to Total Assets (increases/decreases) over time
increases
When evaluating a company’s solvency, a major concern is whether all debt was properly recorded. Companies have long engaged in transactions designed to hide debt. Such transactions are typically called
off-balance sheet financing
T or F: Many off-balance sheet financing transactions are illegal and considered to be unethical by most.
False; are LEGAL and considered to be ETHICAL by most
