Notes & Bonds Flashcards
What is the stated rate? What is it used for?
This is the rate that is stated on the face of the bond, the rate that you have agreed to pay when you completed the contract for the bond.
This rate is used to determine the monthly cash payments.
What is the effective rate? What is it used for?
The Effective rate is the rate that others in the market are willing to pay for a certain investment. This is also called the market rate. This rate is used to determine the issuance price of the bond.
If a $100,000 bond has an annual stated rate of 12%, how much interest will be earned monthly?
$1000
A $100,000 bond payable is issued on June 1, Year One for 104. The bond pays annual cash interest of 12 percent per year with payments every June 1 and December 1. The bond was sold to yield an effective interest rate of 10 percent per year. If the effective rate method is being used, what amount (rounded) should be reported for the liability as of December 31, Year One?
$103,200
What is a yield rate?
The yield rate is the same thing as the market rate, also called the effective rate. It’s called a yield rate because your making money not paying it out.
If a $100,000 bond is sold at 104, what is the book value of the bond? What is the face value?
The book value of the bond would be 104,000.
The face value is 100,000 because that’s the amount the bond holder will receive at maturity.
A $100,000 bond payable is issued on June 1, Year One for 106. The bond comes due in exactly five years. The bond pays annual cash interest of 12 percent per year with payments every June 1 and December 1. If the straight-line method is being used, what amount (rounded) should be reported for the liability as of December 31, Year One? - See more at: http://www.cpareviewforfree.com/exams.cfm?name=question&test_id=2753551#sthash.FIDLNcMb.dpuf
The bond is being sold at a $106,000 or with a premium of $6,000. As a five-year bond, because the straight-line method is being applied, the premium will be reduced at the rate of $1,200 per year ($6,000/5 years) or $100 per month ($1,200/12 months). The bond was outstanding for seven months during Year One so the reduction is $700 ($100 times 7 months). That reduces the book value from $106,000 to $105,300.
What is the effective rate method?
When using the effective rate method, interest expense is determined by taking the book value of the bond (the principal) and multiplying times the yield rate that was used in determining the issuance price.
What does it mean for an amount to be compounded?
To be compounded means that the amount is added to the principal.
On January 1, Year One, a $100,000 bond with a 6 percent annual stated interest rate is issued for 89 to yield an effective rate of 9 percent per year. Interest payments are made each December 31. If the effective rate method is being applied, what amount of interest expense (rounded) is reported on the company’s income statement at the end of Year Two?
Cash interest of $6,000 is paid each year on December 31 ($100,000 face value times 6 percent stated interest rate). For Year One, the interest expense recognizes is the book value of $89,000 times the yield rate of 9 percent or $8,010. The $2,010 difference between the interest expense ($8,010) and the cash interest payment ($6,000) is compounded; that is, added to the principal of the bond. The compounding increases the book value by $2,010 from $89,000 to $91,010. Interest expense for Year Two is the new book value of $91,010 times the yield rate of 9 percent or $8,191 (rounded).
To find cash interest do you use the face value or the book value of the bond?
Face value
On December 31, Year Three, the Ideal Corporation owes a local bank $900,000 on a 6 percent note along with one year of accrued interest. The note itself comes due in exactly five more years. Because Ideal is undergoing financial difficulties, the two parties restructure the note. The accrued interest is eliminated and the principal of the note is reduced to $600,000 which is now due in 10 years. The annual interest rate drops from 6 percent to 4 percent ($24,000 per year) although the current interest rate on such risky loans is now 12 percent. The present value of these new future cash flows at a 4 percent annual rate is assumed to be $600,000 while at a 6 percent annual rate is assumed to be $480,000 and at 12 percent it is $260,000. What loss should the bank recognize on this troubled debt restructuring?
In a troubled debt restructuring, the creditor reduces the amount that is currently owed ($954,000, the face value of $900,000 plus one year of accrued interest or $54,000) down to the present value of the future cash flows. According to the authoritative literature, this present value is determined using the same rate as the original note receivable. In this case, that is 6 percent which gives a present value of $480,000. Reducing the receivable from $954,000 to $480,000 causes the bank to recognize a $474,000 loss.
On December 31, Year Three, the Eveland Corporation owes a local bank $900,000 on a 6 percent note along with one year of accrued interest. The note itself comes due in exactly five more years. Because Eveland is undergoing financial difficulties, the two parties restructure the note. The accrued interest is eliminated and the principal of the note is reduced to $600,000 which is now due in 10 years. The annual interest rate drops from 6 percent to 4 percent ($24,000 per year) although the current interest rate on such risky loans is now 12 percent. The present value of these new future cash flows at a 4 percent annual rate is assumed to be $600,000 while at a 6 percent annual rate is assumed to be $480,000 and at 12 percent it is $260,000. What amount of interest revenue should the bank recognize at the end of Year Four?
According to the authoritative literature, the creditor (the bank) reduces the reported receivable to the present value of the future cash flows based on the interest rate that was originally established (6 percent in this case). Thus, the receivable is now reported as $480,000. Subsequently, interest revenue is recognized using the original rate and multiplying it takes the book value of the receivable. In Year Four, that is $480,000 times 6 percent or $28,800.
On April 23, Year Four, Harding Corporation owes the local bank $600,000 on an 8 percent note plus $90,000 in accrued interest. The note itself comes due in exactly six more years. Because Harding is undergoing severe financial difficulties, the two parties restructure the note. The accrued interest is eliminated and the principal of the note is reduced to $500,000 which is now due in exactly 10 years. The annual interest rate drops from 8 percent to 5 percent although the current interest rate on such questionable loans is 15 percent. Assume that the present value of these future cash flows at 5 percent interest is $500,000 and at 8 percent is $390,000 and at 15 percent is $220,000. What gain should Harding recognize on this troubled debt restructuring?
According to the authoritative literature, in a troubled debt restructuring the debtor compares the amount owed to the total cash flows that will now be paid. The current debt is $954,000 (the face value of $900,000 plus one year of accrued interest or $54,000). The future cash flows will be $24,000 interest per year for 10 years ($240,000 in total) plus the $600,000 new face value for a total of $840,000. The debtor reduces the reported liability from $954,000 to $840,000 and recognizes a gain of $114,000.
