Ch 10 Y 11

Front 1

1. What are the primary characteristics of a bond? For what purposes are bonds usually issued?

Back 1

A bond is a liability that may or may not be secured by a mortgage on specified assets. Bonds usually are in denominations of $1,000 or $10,000, are transferable by endorsement, and may be bought and sold daily by investors. A bond specifies a maturity date and rate of interest that will be paid on the principal amount. Bonds usually are issued to obtain cash for long-term asset acquisitions (operational assets) and expansion of the entity.

Front 2

2. What is the difference between a bond indenture and a bond certificate?

Back 2

A bond indenture is an agreement drawn up by a company planning to sell a bond issue. The indenture specifies the legal provisions of the bond issue such as maturity date, rate of interest, date of interest payments, and any conversion privileges. When a bond is sold, an investor receives a bond certificate (i.e., a bond). All of the bond certificates for a single bond issue are identical in most respects. That is, each certificate states the same maturity date, interest rate, interest dates, and other provisions of the bond issue.

Front 3

3. Differentiate secured bonds from unsecured bonds.

Back 3

Secured bonds are supported by a mortgage or pledge of specific assets as a guarantee of payment. Secured bonds are designated on the basis of the type of asset pledged, such as real estate mortgage bonds and equipment trust bonds. Unsecured bonds are not supported by a mortgage or pledge of specific assets as a guarantee of payment at maturity date. Unsecured bonds usually are called debentures.

Front 4

4. Differentiate between callable and convertible bonds.

Back 4

Callable bonds—bonds that may be called for early retirement at the option of the issuer. Convertible bonds—bonds that may be converted to other securities of the issuer (usually common stock) after a specified future date at the option of the bondholder.

Front 5

From the perspective of the issuer, what are some advantages of issuing bonds instead of capital stock?

Back 5

Several important advantages of bonds compared with capital stock benefit the issuer. The issuance of bonds establishes a fixed amount of liability and a fixed rate of interest on the bond, and interest payments to the bondholders are deductible on the income tax return of the issuer. This deduction for tax purposes reduces the net cost of borrowing. For example, a corporation with a 40% average tax rate and bonds payable with a 10% interest rate would incur a net interest rate of 10% x 60% = 6%.

Front 6

6. As the tax rate increases, the net cost of borrowing money decreases. Explain.

Back 6

The higher the tax rate is, the lower the net cost of borrowing money because the interest paid on borrowed money is deductible on the income tax return of the borrower. The higher the income tax rate the less the net cost of interest for the borrower. For example, a corporation with an average tax rate of 40% and debt with 10% interest per annum incurs a net interest rate of 10% x 60% = 6%. In contrast, the same corporation with a 20% average tax rate incurs a net interest rate of 10% x 80% = 8%.

Front 7

At the date of issuance, bonds are recorded at their current cash equivalent amount. Explain.

Back 7

At the date of issuance, bonds are recorded at their current cash equivalent amount; that is, the amount of cash received for the bonds when issued. The recording is in conformity with the cost principle.

Front 8

8. Explain the nature of the discount and premium on bonds payable.

Back 8

When a bond is issued (sold) at its face amount, it is issued at par. In contrast, when a bond is sold at an amount lower than the par amount, it is issued at a discount, and conversely, when it is sold at a price above par, it is issued at a premium. A bond will sell at a discount when the market, or effective, rate of interest is higher than the stated rate of interest on the bond. In contrast, when the market or effective rate of interest is lower than the stated rate, the bond will sell at a premium. Discounts or premiums on bonds payable are adjustments to the effective interest rate on the bonds. Therefore, the discount or premium is amortized over the life of the bonds as an increase or decrease in the amount of interest expense for each period.

Front 9

What is the difference between the stated interest rate and the effective-interest rate on a bond?

Back 9

The stated rate of interest is the rate specified on a bond, whereas the effective rate of interest is the market rate at which the bonds are selling currently.

Front 10

10. Differentiate among the stated and effective rates of interest on a bond (a) sold at par, (b) sold at a discount, and (c) sold at a premium.

Back 10

When a bond is sold at par, the stated interest rate and the effective or market interest rate are identical. When a bond is sold at a discount, the stated rate of interest is lower than the effective rate of interest on the bond. In contrast, when a bond is sold at a premium, the stated rate of interest is higher than the effective rate of interest.

Front 11

what is the book value of a bond payable?

Back 11

A bond issued at par will have a book or carrying value, or net liability, equal to the par or principal of the bond. This amount should be reported as the carrying value on each balance sheet date. When a bond is sold at a premium or discount, the premium or discount must be amortized over the outstanding life of the bond. When there is bond discount or premium, the par amount of the bond less the unamortized discount, or plus the unamortized premium, must be reported on the balance sheet as the net liability as follows:Bonds payable $100,000 $100,000Less:Unamortized discount 12,000Plus unamortized premium 12,000Book value (carrying value, net liability) $88,000 $112,000

Front 12

Explain the basic difference between the straight-line and the effective-interest methods of amortizing a bond discount or premium. Explain when each method should or may be used.

Back 12

The basic difference between straight-line amortization and effective-interest amortization of bond discount and premium is that, under straight-line amortization, an equal amount of premium or discount is amortized to interest expense each period. Straight-line amortization per interest period is computed by dividing the total amount of the premium or discount by the number of periods the bonds will be outstanding. Under effective-interest amortization, the amount of premium or discount amortized is different each period. Effective-interest amortization of bond premium and discount correctly measures the current cash equivalent amount of the bonds and the interest expense reported on the income statement based on the issuance entry. It measures the amount of amortization by relating the market (yield) rate to the net liability at the beginning of each period. For this reason interest expense and the bond carrying value are measured on a present value basis. The straight-line method can be used only when the results are not materially different from the results of the effective-interest method.