Debt Flashcards
(18 cards)
Describe the following bonds
Debenture
Collateralized
Term
Serial
Debenture - unsecured bonds backed by the issuer’s general credit
Collateralized - Have some sort of collateral
Term - Bonds with a single maturity date at the end of the bond term
Serial - Mature in stated amounts at regular intervals
Album Co. issued 10-year $200,000 debenture bonds on January 2. The bonds pay interest semiannually. Album uses the effective interest method to amortize bond premiums and discounts. The carrying value of the bonds on January 2 was $185,953. A journal entry was recorded for the first interest payment on June 30, debiting interest expense for $13,016 and crediting cash for $12,000. What is the annual stated interest rate for the debenture bonds?
A. 6%
B. 7%
C. 12%
D. 14%
C. 12%
It is asking for the stated rate, and it is semiannually
On July 1, Year 7, Dean Co. issued, at a premium, bonds with a due date of July 1, Year 12. Dean incorrectly used the straight-line method instead of the effective interest method to amortize the premium. How were the following amounts affected by the error at June 30, Year 12?
Bond carrying amount Retained earnings
A. Overstated Understated
B. Understated Overstated
C. Overstated Overstated
D. No effect No effect
D. No effect No effect
At the end of the amortization period they would be the same
Ames, Inc. has $500,000 of notes payable due June 15, Year 6. Ames signed an agreement on December 1, Year 5, to borrow up to $500,000 to refinance the notes payable on a long-term basis with no payments due until Year 7. The financing agreement stipulated that borrowings may not exceed 80% of the value of the collateral Ames was providing. At the date of issuance of the December 31, Year 5, financial statements, the value of the collateral was $600,000 and is not expected to fall below this amount during Year 6. How should the obligation for these notes payable be classified in Ames’s December 31, Year 5, balance sheet?
A. Current liabilities of $500,000; long-term liabilities of $0.
B. Current liabilities of $100,000; long-term liabilities of $400,000.
C. Current liabilities of $20,000; long-term liabilities of $480,000.
D. Current liabilities of $0; long-term liabilities of $500,000.
C. Current liabilities of $20,000; long-term liabilities of $480,000.
You use the collateral number
Young Co. issues $800,000 of 10% bonds dated January 1, Year 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in five years. The current market for similar bonds is 8%. The entire issue is sold on the date of issue. The following values are given:
Present value of ordinary annuity Present value of $1
N = 10; I = 0.04 8.11090 0.67556
N = 10; I = 0.05 7.72173 0.61391
What amount of proceeds on the sale of bonds should Young report?
A. $799,997
B. $815,564
C. $849,317
D. $864,884
D. $864,884
The issue proceeds equal the sum of the PV of interest payments (ie, ordinary annuity) plus the PV of the bond maturity (ie, lump sum). Because bonds are sold to earn the market rate, this rate is used to discount the cash flows. The stated rate is used to calculate the interest payments.
Young Co.’s $800,000 5-year 10% bonds have a market rate of 8%. Because the interest payments are made semiannually, 10 periods and a rate of 4% (1/2 of 8%) are used to discount the cash flows at the market rate (ie, N = 10; I = 0.04).
Interest payments: $800,000 face × 10% stated rate × 1/2 year = $40,000
PV interest payments: $40,000 × 8.1109 (PV of ordinary annuity) = $324,436
PV bond maturity: $800,000 face × 0.67556 (PV of $1) = $540,448
The issue proceeds equal $864,884 ($324,436 PV interest payments + $540,448 PV bond maturity).
On June 30, Year 1, King Co. had outstanding 9%, $5,000,000 face value bonds maturing on June 30, Year 6. Interest was payable semiannually every June 30 and December 31. On June 30, Year 1, after amortization was recorded for the period, the unamortized bond premium and bond issue costs were $30,000 and $50,000, respectively. On that date, King acquired all its outstanding bonds on the open market at 98 and retired them. At June 30, Year 1, what amount should King recognize as gain before income taxes on redemption of bonds?
A. $20,000
B. $80,000
C. $120,000
D. $180,000
B. $80,000
In this scenario, King Co. redeemed its bonds at 98 (98% of face) on June 30, Year 1 when the unamortized premium and unamortized BIC were $30,000 and $50,000, respectively. The gain is determined by comparing the redemption date CV with the cash paid.
Bond CV ($5,000,000 face + $30,000 premium − $50,000 BIC) $4,980,000
Less: Cash paid ($5,000,000 face × 0.98) (4,900,000)
Gain on bond redemption (ie, CV > cash paid) $80,000
In Year 1, Lee Co. acquired, at a premium, Enfield, Inc. 10-year bonds as a long-term investment. At December 31, Year 2, Enfield’s bonds were quoted at a small discount. Which of the following situations is the most likely cause of the decline in the bonds’ market value?
A. Enfield issued a stock dividend.
B. Enfield is expected to call the bonds at a premium, which is less than Lee’s carrying amount.
C. Interest rates have declined since Lee purchased the bonds.
D. Interest rates have increased since Lee purchased the bonds.
D. Interest rates have increased since Lee purchased the bonds.
This creates an inverse relationship between market interest rates and bond prices. As market rates increase, the bond price decreases and vice versa.
When a bond’s stated rate is greater than the market rate (ie, 10% coupon > 8% market rate), it is priced at a premium.
When the stated rate is below the market rate (ie, 12% market rate > 10% coupon), it is priced at a discount.
Dixon Co. incurred costs of $3,300 when it issued, on August 31, Year 1, 5-year debenture bonds dated April 1, Year 1. What amount of bond issue expense should Dixon report in its income statement for the year ended December 31, Year 1?
A. $220
B. $240
C. $300
D. $3,300
B. $240
Dixon’s 5-year (ie, 60 month) bonds dated April 1, Year 1, were issued on August 31, Year 1, 5 months into the bond term. The bonds will be outstanding for 55 months (60 months – 5 months) until maturity. As a result, BIC will be expensed on a straight-line basis over the remaining outstanding bond term (ie, 55 months).
The monthly rate to expense the BIC is $60/month ($3,300 total costs / 55 months). Dixon will expense 4 months of BIC from the August 31 issue date through December 31. The total amount of BIC expensed in Dixon’s Year 1 income statement is $240 ($60/month × 4 months).
A company issued a bond with a stated rate of interest that is less than the effective interest rate on the date of issuance. The bond was issued on one of the interest payment dates. What should the company report on the first interest payment date?
A. An interest expense that is less than the cash payment made to bondholders.
B. An interest expense that is greater than the cash payment made to bondholders.
C. A debit to the unamortized bond discount.
D. A debit to the unamortized bond premium.
B. An interest expense that is greater than the cash payment made to bondholders.
It is a discount so it will be greater
Ray Corp. issued 200 of its 8%, ten-year, $1,000 face value bonds for $240,000. Each bond contained 100 detachable stock warrants, each of which was for one share of Ray’s common stock at $12 per share. Immediately after issuance, the market value of each warrant was $2, and the market value of the bonds without the warrants was $196,000. What amount of discount on the bonds should Ray record at issuance?
A. $0
B. $678
C. $4,000
D. $39,322
B. $678
In this scenario, Ray Corp. must first calculate the warrant FV before determining the relative FV percentages for bonds and warrants. Each bond contains 100 warrants with a market value of $2 each. Ray sold 200 bonds, resulting in 20,000 warrants (200 bonds × 100 warrants per bond). The warrant FV is $40,000 (20,000 warrants × $2 per warrant). The bond discount is $678, calculated as follows:
Determine relative fair value percentages:
FV of bonds (given) $196,000
FV of warrants 40,000
Total FV $236,000
% allocated to bonds ($196,000 / $236,000) = 83.05%
Allocate issue proceeds to bonds and warrants:
Proceeds $240,000
% allocated to bonds 83.05%
Carrying value (CV) of bonds $199,322
Discount on bonds payable is $678 ($200,000 face value − $199,322 CV)
On July 1, Year 1, Day Co. received $103,288 for $100,000 face amount, 12% bonds, and a price that yields 10%. Interest expense for the six months ended December 31, Year 1, should be
A. $5,000
B. $5,164
C. $6,000
D. $6,197
B. $5,164
GAAP requires using the effective interest method to calculate interest expense and amortize the bond premium; therefore, the interest expense correlates with the bond’s carrying value (CV). Interest expense is based on the amount of time the bonds are outstanding during the year.
Under the effective interest method, interest expense equals the bond’s CV × the effective interest rate (ie, yield or market rate) × the number of months outstanding during the year divided by 12 months. Day Co.’s 12% bonds have a $103,288 CV on July 1, Year 1 ($100,000 face value + $3,288 premium). Interest expense for the six-month period from July 1 through December 31 is $5,164 ($103,288 CV × 10% yield × 6/12 months).
On November 1, Year 1, Mason Corp. issued $800,000 of its 10-year, 8% term bonds dated October 1, Year 1. The bonds were sold to yield 10%, with total proceeds of $700,000 plus accrued interest. Interest is paid every April 1 and October 1. What amount should Mason report for interest payable in its December 31, Year 1, balance sheet?
A. $10,667
B. $11,667
C. $16,000
D. $17,500
C. $16,000
Mason Corp.’s cash interest payments occur on October 1 and April 1. Interest payable at year end for the 3 months from October 1 through December 31 equals $16,000 ($800,000 bond face value × 8% stated rate × 3/12 months). The accrued interest related to Mason’s bond issuance is not included in the December 31 interest payable.
Things to remember:
Interest incurred on a bond in the current period and paid in a future period is recorded as interest payable until paid. When reporting dates fall between bond interest payments, interest payable equals the bond’s face value × the stated rate × the time period.
Loeb Corp. frequently borrows from the bank to maintain sufficient operating cash. The following loans were at a 12% interest rate, with interest payable at maturity. Loeb repaid each loan on its scheduled maturity date.
Loan Date of loan Amount Maturity date Term of loan
A 11/1/Year 1 $5,000 10/31/Year 2 1 year
B 2/1/Year 2 15,000 7/31/Year 2 6 months
C 5/1/Year 2 8,000 1/31/Year 3 9 months
Loeb records interest expense when the loans are repaid. As a result, interest expense of $1,500 was recorded in Year 2. If this error is not corrected, by what amount would Year 2 interest expense be understated?
A. $540
B. $640
C. $1,440
D. $2,040
A. $540
5000 * 12% * 10/12 = 500
15000 * 12% * 6/12 = 900
8000 * 12% * 8/12 = 640
Total is $2,040
2040-1500=540
On October 1, Year 1, Brock, Inc. issued 200 of its 10%, $1,000 bonds at 101 plus accrued interest. The bonds are dated July 1, Year 1, and mature on July 1, Year 11. Interest is payable semiannually on January 1 and July 1. What amount did Brock receive from the bond issuance?
A. $197,000
B. $202,000
C. $205,000
D. $207,000
D. $207,000
A newly issued bond has a dated date when it begins to accrue interest. The issue date—the date when the bond is actually sold—can be different from the dated date. If newly issued bonds are sold after the dated date, the purchase amount includes accrued interest because the buyer will receive the entire interest payment on the next scheduled payment date (ie, January 1).
The bond’s issue price is expressed in terms of the percentage of the bond’s par value (eg, at 101). A price greater than 100 indicates the bonds were sold at a premium. Bond issue proceeds equal the bond’s carrying value (ie, Par value × Issue price) plus accrued interest from the dated date to the issue date.
In this case, Brock, Inc. issued $200,000 bonds (200 bonds × $1,000 per bond) at a stated rate of 10% on October 1, Year 1. Because the bonds are issued after the July 1 dated date, 3 months of accrued interest (October, November, and December) will be included in the bond issue proceeds.
Carrying value: $200,000 par × 101% (priced at premium) $202,000
Plus: Accrued interest: $200,000 par × 10% stated rate × 3/12 months 5,000
Bond issue proceeds $207,000
(Choice A) Proceeds of $197,000 subtract accrued interest from the carrying value.
(Choice B) Proceeds of $202,000 exclude accrued interest.
(Choice C) Proceeds of $205,000 exclude the issue price of 101 for the bonds.
Things to remember:
If newly issued bonds are sold after the dated date, the purchase amount includes accrued interest from the dated date to the issue date. Bond issue proceeds equal the bond’s carrying value (Par value × Price) plus accrued interest.
What happens if the bonds are issued after the dated date?
You will accrue interest and add it to the bond issuance.
The following information pertains to the transfer of real estate pursuant to a troubled debt restructuring by Knob Co. to Mene Corp. in full liquidation of Knob’s liability to Mene:
Carrying amount of liability liquidated $150,000
Carrying amount of real estate transferred 100,000
Fair value of real estate transferred 90,000
What amount should Knob report as a gain (loss) on restructuring of payables?
A. ($10,000)
B. $0
C. $50,000
D. $60,000
D. $60,000
Use FV
Serial bonds are attractive to investors because
A. All bonds in the issue mature on the same date.
B. The yield to maturity is the same for all bonds in the issue.
C. Investors can choose the maturity that suits their financial needs.
D. The coupon rate on these bonds is adjusted to the maturity date.
C. Investors can choose the maturity that suits their financial needs.
Norton Corp. does not elect the fair value option for recording its financial liabilities. The discount resulting from the determination of a note payable’s present value should be reported on its balance sheet as a(n)
A. Addition to the face amount of the note.
B. Deferred charge separate from the note.
C. Deferred credit separate from the note.
D. Direct reduction from the face amount of the note.
D. Direct reduction from the face amount of the note.
Discount on notes payable is a liability valuation account. It should be reported as a direct reduction from the face amount of the note (contra account). A premium on notes payable would be reported as an addition to the face amount of the note. A discount is not recorded as a separate asset because it does not provide any future economic benefit. It is not a deferred credit separate from the note because it is a debit, not a credit, and because it is inseparable from the note. Thus, a discount on notes payable should be reported on the balance sheet as a direct reduction from the face amount of the note.
