REVIEW
OF CHAPTER 16
Bonds
2.
Bonds offer the following advantages over common stock:
a.
Stockholder control is not affected.
b.
Tax savings result.
c.
Earnings per share of common stock may be higher.
3.
The major disadvantages resulting from the use of bonds are that
interest must be paid on a periodic basis, and the principal (face value) of the
bonds must be paid at maturity.
Types
of Bonds
4. Secured
bonds have specific assets of the issuer pledged as collateral for the
bonds. A mortgage bond is
secured by real estate. Unsecured
bonds are issued against the general credit of the borrower; they are also
called debenture bonds.
5. Bonds
that mature at a single specified future date are called term bonds. In
contrast, bonds that mature in installments are called serial bonds.
6. Registered
bonds are issued in the name of the owner and have interest payments made by
check to bondholders of record. Bearer
or coupon bonds are not registered; thus bondholders must send in coupons to
receive interest payments.
7. Convertible
bonds permit bondholders to convert the bonds into common stock at their
option. Callable bonds are
subject to call and retirement at a stated dollar amount prior to maturity at
the option of the issuer.
8. State
laws grant corporations the power to issue bonds.
a..... Within the corporation, formal approval by both the board
of directors and stockholders is usually required before bonds can be issued.
b..... In authorizing a bond issue, the board of directors must
stipulate the number of bonds to be authorized, total face value, and
contractual interest rate.
c..... The terms of the bond issue are set forth in a formal
legal document called a bond indenture.
Market Value of Bonds
9..... The market value
(present value) of a bond is a function of three factors:
(a) the dollar amounts to be received, (b) the length of time until the
amounts are received, and (c) the market rate of interest.
The process of finding the present value is referred to as discounting
the future amounts.
Bond Issues
10. (S.O. 2)
The issuance of bonds at face value results in a debit to Cash and
a credit to Bonds Payable.
a..... Over the term of the bonds, entries are required for bond
interest.
b..... At the maturity date, it is necessary to record the final
payment of interest and payment of the face value of the bonds.
11. Bonds
may be issued below or above face value.
a..... If the market (effective) rate of interest is higher than
the contractual (stated) rate, the bonds will sell at less than face value, or
at a discount.
b..... If the market rate of interest is less than the
contractual rate on the bonds, the bonds will sell above face value, or at a
premium.
Bond Issues at Discount
12. When
bonds are issued at a discount,
a..... The discount is debited to a contra account, Discount on
Bonds Payable, and it is deducted from Bonds Payable in the balance sheet to
show the carrying (or book) value of the bonds.
b..... Bond discount is an additional cost of borrowing that
should be recorded as bond interest expense over the life of the bonds.
Straight-Line Method
13..... The straight-line
method of amortization allocates the same amount of bond discount each
interest period. The formula is:
Bond Discount
Number of Interest Periods = Bond Discount Amortization
........ Bond discount
amortization is recorded by debiting Bond Interest Expense and crediting
Discount on Bonds Payable.
Bond Issues at Premium
14. When
bonds are issued at a premium,
a..... The premium is credited to the account, Premium on Bonds
Payable, and it is added to Bonds Payable in the balance sheet.
b..... Bond premium is a reduction in the cost of borrowing that
should be credited to Bond Interest Expense over the life of the bonds.
c..... When the straight-line method of amortization is used, the
amount is the same in each interest period.
15..... When bonds are issued
between interest dates, the investor pays the market price plus accrued interest
since the last interest date. At
the next interest date, the corporation returns the accrued interest by paying
the full amount of interest due.
Bond Retirements
16..... (S.O. 3)
When bonds are retired before maturity it is necessary to (a)
eliminate the carrying value of the bonds at the redemption date, (b) record the
cash paid, and (c) recognize the gain or loss on redemption.
A gain (loss) is reported as an extraordinary item in the income
statement.
17..... In recording the conversion
of bonds into common stock the current market prices of the bonds and the
stock are ignored. Instead, the
carrying value of the bonds is transferred to paid-in capital accounts and no
gain or loss is recognized.
Bond Sinking Fund
18..... (S.O. 4)
A sinking fund is cash or other assets set aside to retire debt.
The bond sinking fund is reported as a single amount under investments on
the balance sheet.
Long-term Notes Payable
19..... (S.O. 5)
A long-term note payable may be secured by a document called a
mortgage that pledges title to specific assets as security for a loan.
a..... Typically, the terms require the borrower to make
installment payments consisting of (1) interest on the unpaid balance of the
loan and (2) a reduction of loan principal.
b..... Mortgage notes payable are recorded initially at face
value; each installment payment results in a debit to Interest Expense, a debit
to Mortgage Notes Payable, and a credit to Cash.
Leases
20..... (S.O. 6)
A lease is a contractual agreement between a lessor (owner) and a
lessee (renter) that grants the right to use specific property for a period of
time in return for cash payments.
Operating Leases
21..... In an operating
lease the intent is temporary use of the property by the lessee with
continued ownership of the property by the lessor. The lease (or rental) payments are recorded as an expense by
the lessee and as revenue by the lessor.
Capital Leases
22..... A capital lease transfers
substantially all the benefits and risks of ownership from the lessor to the
lessee.
a..... The lessee is required to record an asset and the related
obligation at the present value of the future lease payments.
b..... The leased asset is reported on the balance sheet under
plant assets.
c..... The portion of the lease liability to be paid in the next
year is a current liability, and the remainder is classified as a long-term
liability.
Presentation and Analysis
23..... (S.O. 7)
Long-term liabilities are reported in a separate section of the balance
sheet immediately following current liabilities.
24..... The debt to total
assets ratio measures the percentage of the total assets provided by
creditors. It is computed by
dividing total debt by total assets.
25..... The times interest
earned ratio provides an indication of the company's ability to meet
interest payments as they become due. It
is computed by dividing income before interest expense and income taxes by
interest expense.
Effective-Interest Method
*26... (S.O. 8)
The effective interest method of amortization is an alternative to
the straight-line method. Under
this method,
a..... Bond Interest Expense is computed first by multiplying the
carrying value of the bonds at the beginning of the period by the effective
interest rate.
b..... The credit to Cash (or Bond Interest Payable) is computed
by multiplying the face value of the bonds by the contractual interest rate.
c..... The bond discount or premium amortization amount is then
determined by comparing bond interest expense with the interest paid or accrued.
*27. The effective interest method produces a periodic interest expense equal to a constant percentage of the carrying value of the bonds. When the amounts of bond interest expense are materially different under the two methods, the effective interest method is required under generally accepted accounting principles.