Stockholders' Equity: Classes of Capital Stock
Read this chapter, which introduces long-term bonds, their value, how they compare with stock. Some companies expand using stock, while some use debt (bonds). The example exercises refer to Appendix A, which is included here.
Analyzing and using the financial results – Times interest earned ratio
Understanding the learning objectives
- A bond is a liability (with a maturity date) that bears interest that is deductible in computing both net income and taxable income.
- A stock is a unit of ownership on which a dividend is paid only if declared, and dividends are not deductible in determining net income or taxable income.
- Bonds may be secured or unsecured, registered or unregistered, callable, and/or convertible.
- Advantages include stockholders retaining control of the company, tax deductibility of interest, and possible creation of favorable financial leverage.
- Disadvantages include having to make a fixed interest payment each period, reduction in a company's ability to withstand a major loss, possible limitations on dividends and future borrowings, and possible reduction in earnings per share caused by unfavorable financial leverage.
- If bonds are issued at face value on an interest date, no accrued interest is recorded.
- If bonds are issued between interest dates, accrued interest must be recorded.
- If the market rate is lower than the contract rate, bonds sell for more than their face value, and a premium is recorded.
- If the market rate is higher than the contract rate, bonds sell for less than their face value, and a discount is recorded.
- The present value of the principal plus the present value of the interest payments is equal to the price of the bond.
- The contract rate of interest is used to determine the amount of future cash interest payments.
- The effective rate of interest is used to discount the future payment of principal and of interest back to the present value.
- When bonds are issued, Cash is debited, and Bonds Payable is credited. For bonds issued at a discount, Discount on Bonds Payable is also debited. For bonds issued at a premium, Premium on Bonds Payable is also credited. For bonds issued between interest dates, Bond Interest Payable is also credited.
- Any premium or discount must be amortized over the period the bonds are outstanding.
- Under the effective interest rate method, interest expense for any period is equal to the effective (market) rate of interest at date of issuance times the carrying value of the bond at the beginning of that interest period.
- Under the straight-line method of amortization, an equal amount of discount or premium is allocated to each month the bonds are outstanding.
- When bonds are redeemed before they mature, a loss or gain (an extraordinary item, if material) on bond redemption may occur.
- A bond sinking fund might be required in the bond indenture.
- Bonds may be convertible into shares of stock. The carrying value of the bonds is the capital contributed for shares of stock issued. • Bonds are rated as to their riskiness.
- The two leading bond rating services are Moody's Investors Services and Standard & Poor's Corporation.
- Each of these services has its own rating scale. For instance, the highest rating is Aaa (Moody's) and AAA (Standard & Poor's).
- The times interest earned ratio indicates a company's ability to meet interest payments when due.
- The ratio is equal to income before interest and taxes (IBIT) divided by interest expense.
- The future value of an investment is the amount to which a sum of money invested today will grow in a stated time period at a specified interest rate.&
- Present value is the current worth of a future cash receipt and is the reciprocal of future value. To discount future receipts is to bring them back to their present values.