acc 3 study guide

7/31/2019 ACC 3 Study Guide

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Chapter 10

Characteristics of Bonds Payable

Issue Bonds because:o Bondholders do not get to vote or share in the company’s earnings

o

Interest expense is tax-deductibleo 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 losso 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 whichthe 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 bondso 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 guaranteerepayment

Secured Bond would be a bond that has specific assets that are pledged as aguarantee of repayment at maturity

o A Callable Bond may be called for early retirement at the option of the issuero 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 Transactionso There are two specific payments associated with Bonds:

Principal- the amount is usually a single payment that is made when the bondmatures. It is also called par value or face value.

Cash Interest Payments- these payments, which represent annuity, arecomputed by multiplying the principal amount by the interest rate stated in thebond contract.

EX: A $1000 bond with an annual interest rate of 6% and a life of 10years pays interest twice a year (semi annually). The interest payments

would be $1000 x .06 x ½ = $30o 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



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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). Themarket rate at this time was also 10%. The present value of the bond payments iscomputed as follows:

Single Payment: 100,000 x .8227 82,270Annuity: 5,000 x 3.5460 17,730Issue Price 100,000

o This would be recorded as follows:

Cash (+A)…. 100,000Bonds Payable (+L)…. 100,000

o Interest Expenses would be recorded as follows:

Interest Expense (+E, -SE)…. 5,000Cash (A-)…. 5,000

Bonds Issued at Discounto 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). Themarket rate at this time was 12%. The present value of the bond payments iscomputed as follows:

Single Payment: 100,000 x .7921 79,210Annuity: 5,000 x 3.4651 17,326

Issue Price 96,536 Discounted Amount is 100,000 – 96,536 = 3,464



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 Interesto 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



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Interest Expense (+E, -SE)…. 5,792Bonds Payable (+L)…. 792Cash (A-)…. 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 tounpaid 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)…. 5,840Bonds Payable (+L)…. 840Cash (-A)…. 5,000

o This process is repeated for each period of interest expense.

Bonds Issued at Premiumo 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). Themarket rate at this time was 8%. The present value of the bond payments is computedas follows:

Single Payment: 100,000 x .8548 85,480Annuity: 5,000 x 3.6299 18,150Issue Price 103,630Premium Amount is 103,630 – 100,000 = 3,630



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)…. 4,145Bonds Payable (-L)…. 855

Cash (-A)…. 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 tounpaid balance.

Subtract previous amortization amount from unpaid balance:



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103,630 – 855 = 102,775

Compute Interest Expense: 102,775 x .04 = 4,111

Amortization Amount= 5,000 – 4,111 = 889

Interest Expense (+E, -SE)…. 4,111

Bonds Payable (-L)…. 889Cash (-A)…. 5,000

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 andthat the bonds sold at a discount. The bond indenture specified that BNSF had theright to call the bonds (pay them off early, provided it paid a 2% premium over parvalue to the bondholders. Suppose BNSF called the bonds in 2011 at 102% of par,when the amortized cost (carrying value) was $979,256. The company’s accountantswould make the following journal entry:

Bonds Payable (-L)…. 979,256Loss on Retirement of Bonds (-SE)…. 40,744

Cash (-A)…. 1,020,000

Chapter 11

Benefits of Stock Ownershipo A voice in managemento Dividendso 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 DeclaredRetained Earnings in 2007

o Retained Earning in 2007+ Net Income – Dividends PaidRetained Earnings in 2008

Authorized Numbers of Shares is the maximum number of shares of a corporation’scapital 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 anyparticular date

o Issued Shares – Treasury Stock = Outstanding Shares

Common Stock is the basic voting stock issued by a corporation



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Par Value is the nominal value per share of capital stock specified in the charter; servesas the basis for legal capital

Legal Capital is the permanent amount of capital defined by state law that must remaininvested 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 company’s stock to the public.

o Suppose Company B sold 100,000 shares of its $1 par value stock for $20 pershare. It would be recorded as follows:

Cash (+A)…. 2,000,000Common Stock (+SE) 100,000APIC (+SE)…. 1,900,000

Sale of Stock in Secondary Markets: investors can sell shares of stock to other investorswithout directly affecting the corporation.

Repurchase of Stock o Treasury Stock is a corporation’s own stock that has been issued but

subsequently reacquired and is still being held by that corporation. Theseshares have no voting, dividend, or other stockholder rights while they areheld in the treasury stock.

o Suppose Company B bought 100,000 shares of its stock in the open marketwhen it was selling for $20 per share. This is recorded as follows:

Treasury Stock (+XSE, -SE)…. 2,000,000

Cash (-A)…. 2,000,000

o Now assume Company B re-sold 10,000 shares of treasury stock for $30 pershare. This is recorded as follows.

Cash (+A)…. 300,000APIC (+SE)…. 100,000Treasury Stock (-XSE, +SE)…. 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)…. 150,000APIC (-SE)…. 50,000

Treasury Stock (-XSE, +SE)…. 200,000

Dividends on Common Stock o Declaration Date is the date on which the board of directors officially

approves a dividend



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o The Record Date is the date on which the corporation prepares a list of currentstockholders as show on its records; dividends will be paid only to thestockholders who own stock on that date

o Payment Date is the date on which a cash dividend is paid to the stockholdersof record.

o On June 25, Company B declares dividends of $0.09 for 649 millionoutstanding shares. This is recorded as follows:

Retained Earnings (-SE)….. 58,410,000Dividends Payable (+L)….. 58,410,000

o On payment day, the transaction is recorded as followed:

Dividends Payable (-L)…. 58,410,000Cash (-A)…. 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 futureshort-term or long-term purposes. This category includes investments in bonds (debt) orstock (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 reportedusing 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 fairvalue 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 presumedif the investing company owns from 20-50% of the outstanding voting shares of the othercompany. 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 anothercompany through ownership of more than 50% of the other company’s outstanding

voting shares. Purchase accounting and consolidation are applied to combine thecompanies.

Bonds Held to Maturity: AMORTIZED COST METHOD

o Held to Maturity Investments are investments in debt securities thatmanagement has the intent and ability to hold until maturity

o The Amortized Cost Method reports investments in debt securities held tomaturity at cost minus any premium or plus any discount



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o The total cost of the bond, including acquisition costs, transfer fees, andbroker commission is all debited to the Held to Maturity Investments account.

o Bond Purchased at Par Value: Supposed that on July 1, 2010, Company Cpaid 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)…. 100,000Cash (-A)…. 100,000

o The interest earned would be recorded as follows:

Cash (+A)…. 4,000Interest Earned (+SE)…. 4,000

o The principal at maturity would be recorded as follows:

Cash (+A)…. 100,000Held to Maturity Investments (-A)…. 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 thebond until maturity. However, the market interest is 6%. The purchase isrecorded as follows:

Held to Maturity Investment (+A)…. 108,531Cash (-A)…. 108,531

o Interest Earned will be recorded as follows:

Cash (+A)… 4,000Interest Earned (+SE)…. 3256Held to Maturity Investment (-A)…. 744

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 thebond until maturity. However, the market interest is 10%. The purchase isrecorded as follows:

Held to Maturity Investment (+A)…. 90,258Cash (-A)…. 90,258

o Interest Earned will be recorded as follows:



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Cash (+A)…. 4,000Held to Maturity Investment (+A)…. 513

Interest Earned (+SE)…. 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 marketvalue (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 company’s future cash flow. One source of cash is the sale of securities (stock) from its passive investments portfolio. The bestestimate of the cash that could be generated by the sale of thesesecurities is their current fair value.

Measurability: accountants only record items that can be measured indollar 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 heldprimarily for the purpose of active trading (buying or selling) in thenear future (classified as short-term current assets on balance sheet).

Securities Available for Sale are all passive investments other thantrading securities and debt held to maturity (classified as short or long-

term). These investments are not made to be actively traded, but rather,are investments that are expected to earn a return on funds that may beneeded 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 were100,000 outstanding shares of Company X, therefore, Company Cowns 15% of Company X. The purchase would be reported as follows:

Investments in SAS (+A)…. 150,000Cash (-A)…. 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)…. 15,000Dividends Earned (+R, +SE)…. 15,000



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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 bereceived 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 C’s 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 15,000 x 10 150,000Fair Value for 2009 15,000 x 8 120,000Unrealized Loss 30,000

The adjusting entry for 2009 would be as follows:

Unrealized Holding Losses/Gain (-SE)…. 30,000

Investments in SAS (-A)…. 30,000

For 2010: Now lets assume that Company X stocks were held throughthe 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 120,000Fair Value for 2010 15,000 x 11 165,000Unrealized Gain 45,000

Investments in SAS (+A)…. 45,000Unrealized Holding Losses/Gain (+SE)…. 45,000

o Sale of Securities When securities available for sale are sold, cash is increased and two

accounts are eliminated: investments in SAS and unrealized holdinglosses/gains.

Lets assume that at the end of 2011, Company C sold all of the SASinvestment 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 onsale 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 onthe income statements.

Cash (+A)…. 195,000Unrealized Holding Loss/Gain (-SE)…. 15,000

Investments in SAS (-A)…. 165,000Gain on Sale of Investments (+SE)…. 45,000



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o Trading Securities For trading securities, the amount of adjustment to record net

unrealized holding gains and losses is included on EACH PERIOD”SINCOME STATEMENT. Net holding gains increase net income whilenet holding losses decrease net income. (See chart on page 606 for

comparison to SAS)

Chapter 14

When investing in stock, investors should evaluate the company’s future income andgrowth potential on the basis of three factors:

o Economy Wide Factors: overall health of the economy has a direct impact onthe performance of an individual business. Investors should considerunemployment rate, general inflation rate, and changes in interest rate.

o Industry Factors: certain events can have a major impact on each companywithin the industry but only a minor impact on companies outside theindustry.

o Individual Company Factors: to properly analyze a company, good analystsdo not rely only on the information contained in the financial statements. Theyvisit 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 thata variety of strategies can result in high levels of profitability. The model follows:

o ROE = Net Profit Margin x Asset Turnover x Financial Leverage

Chapter 14

Regulatorso The U.S. Securities and Exchange Commission protects investors and

maintains the integrity of the securities market. The SEC oversees thework 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.

Managerso Chairman and Chief Executive Officer (CEO) is the highest officer in the

company

Net Income /Net Sales

Net Sales / Average Total

Assets

Average Total Assets / Average

Stockholders'

Equity

Net Income / Average

Stockholders'Equity



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o Chief Financial Officer (CFO) is the highest officer associated with thefinancial 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 controlsover financial reporting That any weaknesses of internal control, fraud among management

or other employees have been disclosed to the auditors and theaudit 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. Thoughtheir legal responsibility is smaller, their future success dependsheavily on their reputation for honesty and competence.

Board of Directors (Audit Committee)o

The Board of Directors, elected by the stockholders to represent theirinterests, is responsible for maintaining the integrity of the company’sfinancial reports. They are responsible for hiring the company’sindependent auditors.

Auditorso The SEC requires publicly traded companies to have their financials

audited by an independent auditor that follows the auditing standards setby the PCAOB.

o An Unqualified (clean) Audit Opinion is an auditor’s statement that thefinancial statements are fair presentations in all material respects inconformity with GAAP

Information Intermediaries: Financial Analysts and Information Services

o Financial analysts receive accounting reports and other information aboutthe company from electronic information services. They gatherinformation from various different sources and create an earnings forecast.

o Earnings Forecasts are predictions of earnings for future accountingperiods.

Users: Institutional and Private Investors, Creditors and Otherso 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 CharlesSchwab.o Lenders (or Creditors) include suppliers and financial institutions that lend

money to companies. They are the primary external user group of financialstatements of private companies.

o The Cost-Benefit Constraint suggests that the benefits of accounting forand 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 haspredictive and/or feedback value

o Reliable Information is accurate, unbiased, and verifiableo Consistent Information can be compared over time because similar

accounting methods have been appliedo

Comparable Information allows comparisons across businesses becausesimilar accounting methods have been appliedo Material Amounts are amounts that are large enough to influence a user’s

decisiono 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 majornews services. This is usually when quarterly and annual earnings are announced.

Annual Reportso Four Basic Financial Statements:

Income Statement, Balance Sheet, Stockholder’s Equity or

Retained Earnings Statement, and Cash Flow Statemento Related Noteso Report of Auditors if the statements are audited

Return on Assets (ROA)o ROA = Net Income / Average Total Assetso 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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