Chapter 10 Characteristics of Bonds Payable Issue Bonds because: o Bondholders do not get to vote or share in the companys earnings

s o Interest expense is tax-deductible o The impact on earnings is positive: debt increases the return to owners when compared to stocks Disadvantages of Bonds: o Risk of Bankruptcy: interest payments to bondholders are fixed charges and must be paid whether the corporation earns income or incurs loss o Negative impact on cash flows: management must have sufficient cash to repay the loan or be able to refinance it Bond Principal is the amount payable at the maturity of the bond and the amount on which the periodic cash interest payments are computed o Par Value is another name for bond principal o Face Amount is another name for bond principal Stated Rate is the rate of cash interest per period stated in the bond contract o Coupon Rate is the stated rate of interest on bonds o Contract Rate is the stated rate of interest on bonds Types of Bonds: o A Debenture is an unsecured bond; no assets are specifically pledged to guarantee repayment Secured Bond would be a bond that has specific assets that are pledged as a guarantee of repayment at maturity o A Callable Bond may be called for early retirement at the option of the issuer o A Convertible Bond may be converted to other securities of the issuer (usually common stock) o An Indenture is a bond contract that specifies the legal provisions of a bond issue Reporting Bond Transactions o There are two specific payments associated with Bonds: Principal- the amount is usually a single payment that is made when the bond matures. It is also called par value or face value. Cash Interest Payments- these payments, which represent annuity, are computed by multiplying the principal amount by the interest rate stated in the bond contract. EX: A $1000 bond with an annual interest rate of 6% and a life of 10 years pays interest twice a year (semi annually). The interest payments would be $1000 x .06 x = $30 o The Market determines the price at which bonds sell. The Market Interest Rate or Yield or Effective Interest Rate is the current rate of interest on a debt when incurred. o Bonds can be sold: At Par: when the market rate equals the stated rate for the bond At a Premium: when the market rate is less than the stated rate for the bond At a Discount: when the market rate is greater than the stated rate for the bond Bonds Issued At Par 1

o Suppose Company A issues a $100,000 (par value) bond with an interest rate of 10% for 2 years paid out semi-annually (5,000 payable twice a year for two years). The market rate at this time was also 10%. The present value of the bond payments is computed as follows: Single Payment: 100,000 x .8227 Annuity: 5,000 x 3.5460 Issue Price o This would be recorded as follows: Cash (+A). Bonds Payable (+L). 100,000 100,000 82,270 17,730 100,000

o Interest Expenses would be recorded as follows: Interest Expense (+E, -SE). Cash (A-). 5,000 5,000

Bonds Issued at Discount o Suppose Company A issues a $100,000 (par value) bond with an interest rate of 10% for 2 years paid out semi-annually (5,000 payable twice a year for two years). The market rate at this time was 12%. The present value of the bond payments is computed as follows: Single Payment: 100,000 x .7921 79,210 Annuity: 5,000 x 3.4651 17,326 Issue Price 96,536 Discounted Amount is 100,000 96,536 = 3,464 o This would be recorded as follows: Cash (+A). Bonds Payable (+L). 96,536 96,536

o Reporting Interest Expense is completed through 2 steps: Compute Interest expense Unpaid Balance x Interest Rate x n/12 n= number of months in each interest period Compute Amortization Amount Interest Expense Cash Interest o For Company A, interest expense would be reported as follows: 96,536 x .06 = 5,792 Cash Interest = 5,000 Amortization Amount = 5,792 5,000 = 792

Interest Expense (+E, -SE). Bonds Payable (+L). Cash (A-).

5,792 792 5,000

o For the next period, the amortization amount will change because the bonds book value will INCREASE; therefore, you add the previous amortization amount to unpaid balance. Add previous amortization amount to Unpaid Balance: 96,536 + 792 = 97,328 Compute new Interest Expense: 97,328 x .06 = 5,840 Amortization Amount = 5,840 5,000 = 840 Interest Expense (+E, -SE). Bonds Payable (+L). Cash (-A). 5,840 840 5,000

o This process is repeated for each period of interest expense. Bonds Issued at Premium o Suppose Company A issues a $100,000 (par value) bond with an interest rate of 10% for 2 years paid out semi-annually (5,000 payable twice a year for two years). The market rate at this time was 8%. The present value of the bond payments is computed as follows: Single Payment: 100,000 x .8548 85,480 Annuity: 5,000 x 3.6299 18,150 Issue Price 103,630 Premium Amount is 103,630 100,000 = 3,630 o This would be recorded as follows: Cash (+A). Bonds Payable (+L). 103,630 103,630

o Interest Expense will be reported as follows: 103,630 x .04 = 4145 Cash Interest = 5,000 Amortization Amount = 5,000 4,145 = 855 Interest Expense (+E, -SE). Bonds Payable (-L). Cash (-A). 4,145 855 5,000

o For the following period, the amortization amount is changed because the bonds book value will DECREASE; therefore, you subtract the previous amortization amount to unpaid balance. Subtract previous amortization amount from unpaid balance:

103,630 855 = 102,775 Compute Interest Expense: 102,775 x .04 = 4,111 Amortization Amount= 5,000 4,111 = 889 4,111 889 5,000

Interest Expense (+E, -SE). Bonds Payable (-L). Cash (-A).

o This process is repeated for each period of interest expense. Early Retirement of Bonds o Assume that several years ago, BNSF issued bonds in the amount of $1 million and that the bonds sold at a discount. The bond indenture specified that BNSF had the right to call the bonds (pay them off early, provided it paid a 2% premium over par value to the bondholders. Suppose BNSF called the bonds in 2011 at 102% of par, when the amortized cost (carrying value) was $979,256. The companys accountants would make the following journal entry: Bonds Payable (-L). Loss on Retirement of Bonds (-SE). Cash (-A). 979,256 40,744 1,020,000

Chapter 11 Benefits of Stock Ownership o A voice in management o Dividends o Residual claim: receive a proportional share of remaining assets upon liquidation of the company Capital in Excess of Par = (common stock price per share x Outstanding Shares) Common Stock Retained Earnings in 2008 Net Income + Dividends Declared Retained Earnings in 2007 o Retained Earning in 2007 + Net Income Dividends Paid Retained Earnings in 2008 Authorized Numbers of Shares is the maximum number of shares of a corporations capital stock that can be issued as specified in the charter Issued Shares represents the total number of shares of stock that have been sold Outstanding Shares refers to the total number of shares owned by stockholders on any particular date o Issued Shares Treasury Stock = Outstanding Shares Common Stock is the basic voting stock issued by a corporation 4

Par Value is the nominal value per share of capital stock specified in the charter; serves as the basis for legal capital Legal Capital is the permanent amount of capital defined by state law that must remain invested in the business; serves as a cushion for creditors No-Par Value Stock is capital stock that has no par value specified in the corporate charter Initial Public offering is the very first sale of the companys stock to the public. o Suppose Company B sold 100,000 shares of its $1 par value stock for $20 per share. It would be recorded as follows:

Cash (+A). 2,000,000 Common Stock (+SE) APIC (+SE).

100,000 1,900,000

Sale of Stock in Secondary Markets: investors can sell shares of stock to other investors without directly affecting the corporation. Repurchase of Stock o Treasury Stock is a corporations own stock that has been issued but subsequently reacquired and is still being held by that corporation. These shares have no voting, dividend, or other stockholder rights while they are held in the treasury stock. o Suppose Company B bought 100,000 shares of its stock in the open market when it was selling for $20 per share. This is recorded as follows: Treasury Stock (+XSE, -SE). Cash (-A). 2,000,000 2,000,000

o Now assume Company B re-sold 10,000 shares of treasury stock for $30 per share. This is recorded as follows. Cash (+A). APIC (+SE). Treasury Stock (-XSE, +SE). 300,000 100,000 200,000

o Next, lets assume Company B had re-sold the 10,000 shares of treasury stock for only $15 per share. This would be recorded as follows: Cash (+A). APIC (-SE). Treasury Stock (-XSE, +SE). 150,000 50,000 200,000

Dividends on Common Stock o Declaration Date is the date on which the board of directors officially approves a dividend 5

o The Record Date is the date on which the corporation prepares a list of current stockholders as show on its records; dividends will be paid only to the stockholders who own stock on that date o Payment Date is the date on which a cash dividend is paid to the stockholders of record. o On June 25, Company B declares dividends of $0.09 for 649 million outstanding shares. This is recorded as follows: Retained Earnings (-SE).. Dividends Payable (+L).. 58,410,000 58,410,000

o On payment day, the transaction is recorded as followed: Dividends Payable (-L). Cash (-A). 58,410,000 58,410,000

o There are two fundamental requirements for the payment of a cash dividend: There must be sufficient retained earnings to cover the amount of the dividend There must be sufficient cash to pay the dividend and meet operating needs of the business. Chapter 12 Passive Investments are made to earn a return on funds that may be needed for future short-term or long-term purposes. This category includes investments in bonds (debt) or stock (equity securities). o Bonds: if the bond is going to be held until maturity, then it will be reported at amortized cost. If it is going to be sold before maturity, then it will be reported using the fair value method. o Stocks: the investment is presumed as passive if the investing company owns less than 20% of the outstanding voting shares of the other company. The fair value method is used to report the investment Significant Influence is the ability to have an important impact on the operating, investing, and financing policies of another company. Significant influence is presumed if the investing company owns from 20-50% of the outstanding voting shares of the other company. The equity method is used to measure and report this category of investments Control is the ability to determine the operating and financing policies of another company through ownership of more than 50% of the other companys outstanding voting shares. Purchase accounting and consolidation are applied to combine the companies. Bonds Held to Maturity: AMORTIZED COST METHOD o Held to Maturity Investments are investments in debt securities that management has the intent and ability to hold until maturity o The Amortized Cost Method reports investments in debt securities held to maturity at cost minus any premium or plus any discount

o The total cost of the bond, including acquisition costs, transfer fees, and broker commission is all debited to the Held to Maturity Investments account. o Bond Purchased at Par Value: Supposed that on July 1, 2010, Company C paid the par value $100,000 for 8% bonds that mature on June 30, 2015. Interest at 8% is paid every 6 months and management plans to hold the bond until maturity. The purchase is recorded as follows: Held to Maturity Investments (+A). Cash (-A). 100,000 100,000

o The interest earned would be recorded as follows: Cash (+A). Interest Earned (+SE). 4,000 4,000

o The principal at maturity would be recorded as follows: Cash (+A). Held to Maturity Investments (-A). 100,000 100,000

o Bond Purchased on Premium: Now, lets suppose that on July 1, 2010, Company C paid the par value $100,000 for 8% bonds that mature on June 30, 2015. The interest is paid every 6 months and management plans to hold the bond until maturity. However, the market interest is 6%. The purchase is recorded as follows: Held to Maturity Investment (+A). Cash (-A). o Interest Earned will be recorded as follows: Cash (+A) Interest Earned (+SE). Held to Maturity Investment (-A). 4,000 3256 744 108,531 108,531

o Bond Purchased on Discount: Now, lets suppose that on July 1, 2010, Company C paid the par value $100,000 for 8% bonds that mature on June 30, 2015. The interest is paid every 6 months and management plans to hold the bond until maturity. However, the market interest is 10%. The purchase is recorded as follows: Held to Maturity Investment (+A). Cash (-A). o Interest Earned will be recorded as follows: 90,258 90,258

Cash (+A). Held to Maturity Investment (+A). Interest Earned (+SE).

4,000 513 4,513

Bonds Not Held to Maturity and Passive Stock Investments: FAIR VALUE METHOD o The Fair Value Method is used to report securities at their current market value (the amount that would be received in an orderly sale). o Passive investments are reported at the fair value because: Relevance: analyst who study financial statements often attempt to study a companys future cash flow. One source of cash is the sale of securities (stock) from its passive investments portfolio. The best estimate of the cash that could be generated by the sale of these securities is their current fair value. Measurability: accountants only record items that can be measured in dollar terms with a high degree of reliability (an unbiased and verifiable measurement). o When adjustments are made to reflect the increase or decrease in the fair value amount, the Unrealized Holding Gains or Losses account is affected. Unrealized Holding Gains or Losses are amounts associated with price changes of securities or debt that are currently held. o Classifying Passive Investments at Fair Value Trading Securities are all the investments in stocks or bond held primarily for the purpose of active trading (buying or selling) in the near future (classified as short-term current assets on balance sheet). Securities Available for Sale are all passive investments other than trading securities and debt held to maturity (classified as short or longterm). These investments are not made to be actively traded, but rather, are investments that are expected to earn a return on funds that may be needed for future operating purposes. o Purchase of Securities Available for Sale and At the beginning of 2009, Company C purchases for cash 15,000 shares of Company X common stock for $10 per share. There were 100,000 outstanding shares of Company X, therefore, Company C owns 15% of Company X. The purchase would be reported as follows: Investments in SAS (+A). Cash (-A). 150,000 150,000

o Dividends Earned Suppose Company C earned a $1 per share cash dividend from Company X for the 15,000 shares Company C owns. Cash (+A). Dividends Earned (+R, +SE). 15,000 15,000

o Year-End Valuation At the end of the accounting period, these passive investments are reported on the balance sheet at fair value (the amount that would be received in an orderly sale). For 2009: Assume Company X had an $8 per share fair value at the end of the year. This means Company Cs investments lost $2 per share for the year. However, since the investment has not been sold, this loss would be unrealized holding loss. Investment Cost Fair Value for 2009 Unrealized Loss 15,000 x 10 15,000 x 8 150,000 120,000 30,000

The adjusting entry for 2009 would be as follows: Unrealized Holding Losses/Gain (-SE). Investments in SAS (-A). 30,000 30,000

For 2010: Now lets assume that Company X stocks were held through the next year and at the end of 2010, they fair value of the stock was $11 per share. The adjustment for 2010 would be as follows. Previous Book Value Fair Value for 2010 Unrealized Gain 120,000 165,000 45,000 45,000 45,000

15,000 x 11

Investments in SAS (+A). Unrealized Holding Losses/Gain (+SE).

o Sale of Securities When securities available for sale are sold, cash is increased and two accounts are eliminated: investments in SAS and unrealized holding losses/gains. Lets assume that at the end of 2011, Company C sold all of the SAS investment in Company X for $13 per share. Company C would earn $195,000 in cash for the stock it paid $150,000 for. The gain or loss on sale is computed as: Proceeds from Sale Investment Cost = Gain if + (Loss if -) In our example, we have a gain of 45,000 that would be reported on the income statements. Cash (+A). 195,000 Unrealized Holding Loss/Gain (-SE). 15,000 Investments in SAS (-A). 165,000 Gain on Sale of Investments (+SE). 45,000

o Trading Securities For trading securities, the amount of adjustment to record net unrealized holding gains and losses is included on EACH PERIODS INCOME STATEMENT. Net holding gains increase net income while net holding losses decrease net income. (See chart on page 606 for comparison to SAS) Chapter 14 When investing in stock, investors should evaluate the companys future income and growth potential on the basis of three factors: o Economy Wide Factors: overall health of the economy has a direct impact on the performance of an individual business. Investors should consider unemployment rate, general inflation rate, and changes in interest rate. o Industry Factors: certain events can have a major impact on each company within the industry but only a minor impact on companies outside the industry. o Individual Company Factors: to properly analyze a company, good analysts do not rely only on the information contained in the financial statements. They visit the company, buy its products, and read about it in the business press. The DuPont Model helps us analyze the profitability of a business and demonstrates that a variety of strategies can result in high levels of profitability. The model follows: o ROE = Net Profit Margin x Asset Turnover x Financial Leverage

Net Income / Net Sales

Net Sales / Average Total Assets

Average Total Assets / Average Stockholders' Equity

Net Income / Average Stockholders' Equity

Chapter 14 Regulators o The U.S. Securities and Exchange Commission protects investors and maintains the integrity of the securities market. The SEC oversees the work of the Financial Accounting Standards Board (FASB), o FASB: Sets the generally accepted accounting principles (GAAP) Sets the Public Company Accounting Oversight Board (PCAOB) which sets auditing standards for independent auditors (CPAs) of public companies Sets auditing standards for stock exchanges. Managers o Chairman and Chief Executive Officer (CEO) is the highest officer in the company

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o Chief Financial Officer (CFO) is the highest officer associated with the financial and accounting side of business o These two must personally certify that: Each report filed with the SEC does not contain any untrue material or does not omit a material fact There are no significant deficiencies within the internal controls over financial reporting That any weaknesses of internal control, fraud among management or other employees have been disclosed to the auditors and the audit committee board o Executives who knowingly certify false information are subject to fine of $5 million and a 20-year prison term. Members of the accounting staff also bear responsibility. Though their legal responsibility is smaller, their future success depends heavily on their reputation for honesty and competence. Board of Directors (Audit Committee) o The Board of Directors, elected by the stockholders to represent their interests, is responsible for maintaining the integrity of the companys financial reports. They are responsible for hiring the companys independent auditors. Auditors o The SEC requires publicly traded companies to have their financials audited by an independent auditor that follows the auditing standards set by the PCAOB. o An Unqualified (clean) Audit Opinion is an auditors statement that the financial statements are fair presentations in all material respects in conformity with GAAP Information Intermediaries: Financial Analysts and Information Services o Financial analysts receive accounting reports and other information about the company from electronic information services. They gather information from various different sources and create an earnings forecast. o Earnings Forecasts are predictions of earnings for future accounting periods. Users: Institutional and Private Investors, Creditors and Others o Institutional Investors are managers of pension, mutual, endowment, and other funds that invest on the behalf of others. o Private Investors include individuals who purchase shares in companies. This could be the owner or friends of the owner who invested directly, or small retail investors who invested through brokers such as Charles Schwab. o Lenders (or Creditors) include suppliers and financial institutions that lend money to companies. They are the primary external user group of financial statements of private companies. o The Cost-Benefit Constraint suggests that the benefits of accounting for and reporting information should outweigh the costs Guiding Principles for Communicating Useful Information

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o Relevant Information can influence a decision; it is timely and has predictive and/or feedback value o Reliable Information is accurate, unbiased, and verifiable o Consistent Information can be compared over time because similar accounting methods have been applied o Comparable Information allows comparisons across businesses because similar accounting methods have been applied o Material Amounts are amounts that are large enough to influence a users decision o Conservatism suggests that care should be taken not to overstate assets and revenues or understate liabilities and expenses A Press Release is a written public news announcement normally distributed to major news services. This is usually when quarterly and annual earnings are announced. Annual Reports o Four Basic Financial Statements: Income Statement, Balance Sheet, Stockholders Equity or Retained Earnings Statement, and Cash Flow Statement o Related Notes o Report of Auditors if the statements are audited Return on Assets (ROA) o ROA = Net Income / Average Total Assets o Total Asset Turnover x Net Profit Margin = ROA

Net Sales / Average Total Assets

Net Income / Net Sales

Net Income / Average Total Assets

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