Chapter 9: Reporting and Interpreting Non-Current Liabilities Flashcards
What are the major reasons for companies to issue debt?
1) Shareholders maintain control. Debt does not dilute ownership of the company.
2) Interest expense is tax deductible. In contrast, dividends are not tax deductible.
3) If company’s spend a low interest rate and invests in projects with a high rate of return, it can increase the return to shareholders.
What are the disadvantages to using long-term debt?
1) Risk of bankruptcy. Whether you generate a gain or loss, you have to pay interest.
2) Negative impact on cashflows. Management must be able to generate sufficient cash to repay the debt or have the ability to refinance it.
What are the types of long term debt?
Private debt: from financial service organizations: banks, insurance companies, pension fund
-Bank loans
-Notes
-Mortgages
Issue publicly traded debt:
-Bonds and Debentures.
What is the bond principal? What is it’s term? What is the coupon rate? What is it’s frequency?
Principal: Amount paid at maturity date
Term: When is it due
Coupon Rate: Rate used to compute cash interest payment.
Frequency of interest payments: Is it annual? semi-annual? quarterly?
What are the main 4 types of bonds, and their corresponding characteristics?
1) Unsecured Bonds(or debenture) are backed solely on the general creditworthiness of the issuer rather than specific assets. Often issued by financially stable corporations such as Apple or government like U.S. Treasury bonds. The issuer benefits because they don’t tie up their assets with collateral. And the returns for investors are higher because they are riskier. However, it can be risker for investors because if the issuer defaults, they have no claim to assets. And the issuer may not like paying that more money.
2) Secured Bond
3) Callable Bond
4) Convertible Bond
What are the key advantages and disadvantages of unsecured bonds
1) Unsecured Bonds(or debenture)
Advantages: The issuer benefits because they don’t tie up their assets with collateral. And the returns for investors are higher because they are riskier.
Disadvantages: However, it can be risker for investors because if the issuer defaults, they have no claim to assets. And the issuer may not like paying that more money.
What is a bond’s coupon rate?
A coupon rate(also called the stated rate, contract rate, or nominal rate), is stated as the annual interest payments.
What are the characteristics of an unsecured bond(or debenture)?
No assets are pledges as a guarantee of repayment at maturity.
What are the characteristics of a secured bond?
Specific assets are pledged as a guarantee of repayment at maturity.
What are the characteristics of a callable bond?
Contains a call feature that allows the bond issuer the option of retiring the bonds early.
What are the characteristics of a convertible bond?
Contains a conversion feature that allows the bonds to be converted into shares of the issuer’s common shares.
Walk me through the bond issuance process?
-An indenture is a bond contract that specifies the legal provisions of a bond issue.
-The bond indenture contains covenants designed to protect the creditors.
-The bond issuer also prepares a prospectus, which describes the company, the bonds, and how the proceeds of the bonds will be used.
-The trustee makes sure the issuer fulfills all of the provisions of the bond indenture.
-Most companies work with an underwrite that either buys the entire issue of bonds and then resell to individual creditors(firm commitment); or no obligation to purchase (best efforts). E.g. BMO Nesbitt Burns, CIBC World Markets, Desjardins Securities, National Bank Financial, RBC Dominion Securities, Scotia Capital, TD Securities.
-Bond dealers typically sell bonds to institutional investors, usually high volume, over-the-counter (OTC) market, not through a formal bond exchange.
What are debt covenants, otherwise known as maintenance tests?
-These are restrictions placed on a corporation’s operationsa nd financial activities to keep the loan in good standing.
What are the four most popular accounting-based covenants?
1) Maximum debt/equity ratio
2) Minimum interest coverage ratio
3) Minimum inventory turnover (i.e. the relationship between cost of goods sold and inventory
4) restrictions on dividend payout
How does risk correlate with investment grade with regards to bonds?
-The lower the risk of the bond, the higher investment grade it has. And it will also likely have an A attached to it. The lower risk and the higher investment grade it gets, it will reach AAA.
-The higher the risk of the bond, the lower investment grade it has. Depending on the agency(Standard&Poor’s, Moody’s, Fitch) it could be at D, C, or DDD, so it gets tricky.
Why may bond prices change?
-Changes in creditworthiness of the bond issuer
-The risk that the company will default either on its interest or principal payments
-Changes in market interest rates
-Risk free rate: the rate at which the federal government can borrow money for the long term.
What is the formula to determine the issue price of the bond?
Present Value of the Principal (a single payment)+Present Value of the Interest Payments(an annuity)=Issue Price of the Bond
What are the steps to calculating the amortization discount or amortized premium for a bond?
Step 1: Compute the interest expense
-Interest expense=Unpaid balanceEffective interest raten/12.
Step 2: Compute the interest to be paid
-Bond face value*Coupon rate per period
Step 3: Compute the amortization amount
-Amortization of=Interest expense-Interest paid (or accrued) bond discount or premium.
Note: When the next period comes up, the “discount on bond payable” from the previous peiod will come back.
If the market rate is less than the bond contract rate, is the bond selling at a premium, par, or discount?
-The bond is selling at premium.
-Because the bond pays more of a coupon rate than what you would get elsewhere, you will likely have to pay more than the face value to purchase the bond.
If the market rate is on par with the bond contract rate, is the bond selling at a premium, par, or discount?
-The bond is selling at par with the market.
-The bond pays the same coupon rate as what you would get elsewhere, so you will likely pay the face value for the bond.
If the market rate is greater than the coupon rate, is the bond selling at a premium, par, or discount?
-The bond is selling at a discount.
-The bond pays less of a coupon rate than what you would get elsewhere, so they have to charge less than the face value to make the purchase attractive.
Which interest method of amortization is preferred by IFRS? What does ASPE allow?
The effective-interest method of amortization is preferred by IFRS.
ASPE allows straight-line amortization if it is not materially different from the effective interest amortization.
What is the four step process to calculate straight-line amortization?
1) Identify the amount of the bond discount
2) Divide the bond discount by the number of interest periods
3) Include the discount amortization amount as part of the periodic interest expense entry.
4) The discount may be reduced to zero by the maturity date.
What are the two methods that may be used in accounting for bond issue costs?
1) Deduct the issue costs from the net proceeds of the bonds, and thereby include them in the bond premium or discount.
2) Account for the issue costs seperately as a deferred charge that is amortized over the life of the bond issue.
What are zero coupon bonds?
Zero coupon bonds do not pay periodic interest because there is no interest annuity.
What is the times interest earned ratio? What does it tell us?
Times Interest Earned Ratio=Net earnings+Interest expense+Income tax expense/Interest Expense
What are the steps taken to amortize the bond discount over the life of the bonds?
Step 1: Compute the amortization amount
-Amortization of bond discount=Bond discount/Number of periods
Step 2: Compute the interest to be paid
-Bond face value*Coupon rate per period
Step 3: Compute the interest expense
-Interest expense=Interest to be paid+Amortized discount/-Amortized premium
Finally… that gives you the Carrying Amount
What are some things that can lead to shifts in the prices of bonds?
1) Macoreconomic interest rate shifts
2) Reassessment of firm risk by investors
What is a lessor? What is a lessee?
-The party that owns the asset is referred to as the lessor.
-The party that pays for the right to use the asset is referred to as the lessee.
What is the formula to calculate payments over a period, where interest=i, and n=#of periods?
PMT=face value*interest rate(for the period)/1-(1+interest rate(for the period))^-n
What is discount of bond amortization?What is the formula to find discount of bond amortization using the straight line method?
-Discount of bond amortization is the maturity value-issue price. The bond is amortized each year as you get closer to paying out that issue price, according to the matching principle. You can calculate the yearly bond amortization by taking that number and dividing it by the number of years the bond is amortized for.
What is the formula to find amortization for the year?
Amortization for the year=(Carrying AmountMarket Interest)-(Carrying AmountCoupon Rate of Bond)
What is the formula to find bond interest expense?
Bond interest expense=Bond Liability*Market interest rate
What two numbers do you need when calculating the present value of an annuity?
1) Market interest
2) #of periods
What two numbers added together gives you bond interest expense?
Bond Interest Expense=Interest paid+Amortization
What two numbers do you need when calculating the present value of interest payments?
1) Coupon rate
2)# of periods
