BUS103: Introduction to Financial Accounting

9a. Describe the difference between bonds and capital stock 

• What is a bond?
• What does stock represent?
• How do stocks and bonds differ?
  

A bond is a long-term debt, or liability, owed by the company that issues it. Bonds have a face value, which is the principal amount payable at maturity, or the due date, and a stated interest rate, payable at regular periods, typically semiannually, until the maturity date. A bond-holder is a creditor of the company that issued the bond.
 
A share of stock is a unit of ownership in a corporation. Investors purchase stock hoping that the share price will appreciate in value and/or that they will be paid dividends. Dividends are a payment to shareholders of the profits from the corporation's business. Stockholders, as owners of the company, can vote on major issues affecting the corporation and select managers to act in their interest.
 
Bonds differ from stock in several important ways:

• A bond is a liability, while a share of stock represents an ownership interest in the company.
• Bonds have maturity dates, while stocks do not.
• Bonds typically require periodic interest payments by contractual obligation. Stocks may pay dividends but are under no legal obligation to do so.
• The company can deduct the interest paid to bondholders but not dividends paid to stockholders.

 
To review, see Valuing Long-Term Bonds, and Stockholders' Equity: Classes of Capital Stock.
 

9b. describe par value, discount, and premium as they relate to bonds 

• What does par value represent in relation to bonds?
• Why do bonds sell at a premium or discount?
  

A bond's par value is its face value, or stated amount due at maturity. Most often, corporate bonds are issued with $1,000 par values. When a corporation issues a $1,000 par value bond, they are promising to pay the creditor that $1,000 back on the maturity date and typically make regular interest payments each period between the issue date and maturity date.
 
When bonds are issued, they typically have a fixed interest payment associated with the bond. That interest rate may or may not be attractive in the marketplace, depending on what other bonds are paying and what is happening to interest rates in general. Since the bond's interest rate is fixed, the only factor that can change to account for this change in attractiveness is the bond's price. A bond that sells above face/par value is said to sell at a premium. A bond that sells below face/par value is said to sell at a discount.
 
To review, see Valuing Long-Term Bonds.
 

9c. Explain how interest rates affect bond prices 

• What is the relationship between interest rates and bond prices?
• How are bond prices determined?
  

A bond is sold at face value, a discount, or a premium. The price at which a bond is sold depends on the market rate of interest and how it compares to the contract rate of interest. When interest rates in the market go up, since the interest rate the bond is paying is fixed, the bond will look less attractive. The bond must sell at a discount to entice buyers when it is less attractive. When interest rates in the market decrease, the fixed rate on the bond will look relatively more attractive. Investors will want the bond that pays the higher rate and will bid up the price. The bond will sell at a premium. Thus, interest rates and bond prices are inversely related: when rates increase, prices decrease, and when rates decrease, prices increase.
 
Bond prices are determined by taking the present value of the cash flows associated with the bond. These cash flows include the repayment of principal at maturity and the periodic interest payments. The present value is calculated using the current market rate on similar bonds as the discount rate. Thus:

Price(bond) = PV principal repayment at maturity + PV periodic interest payments

To review, see Valuing Long-Term Bonds.
 

9d. Prepare accounting entries for bonds issued at par, a discount, or a premium 

• What is the accounting entry for a bond issued at par?
• What is the accounting entry for a bond issued at a discount?
• What is the accounting entry for a bond issued at a premium?
  

A bond issued at par value is a straightforward entry:

 
This shows that the full amount is due (bonds payable) at maturity, but less cash is received up front.
 

This shows that more cash is received than what the company will owe at maturity.
 
To review, see Valuing Long-Term Bonds.

9e. Contrast common stock and preferred stock

• What are the main differences between preferred and common stock?
• Why do companies issue preferred stock?

Common stock is the most frequently issued class of stock and provides holders the following rights:
 

• the right to vote on major corporate issues, including the election of the board of directors
• a preemptive right to purchase additional shares whenever stock is issued by the corporation
• right to receive cash dividends if they are paid
• residual claim on corporate assets

Preferred stock is a class of stock that receives preference in the payment of dividends and a claim to assets in the event of liquidation. Preferred stockholders generally do not have the right to vote but have a higher claim on dividends and assets than common stockholders do. Companies issue preferred stock to avoid issuing debt, to not dilute common stockholders' earnings per share, and to avoid diluting common stockholders' voting control.
 
To review, see Stockholders' Equity: Classes of Capital Stock.

9f. Prepare a statement of shareholders' equity

• What does a statement of stockholder's equity show?
• Where does the information from the stockholder's equity statement appear on the balance sheet?

A statement of stockholders' equity is presented with the income statement, the balance sheet, and the statement of cash flows. If a company has changes in their stock or paid-in capital, they show them in the columns of the statement of shareholder's equity. Each column reports changes to each of the accounts within the stockholders' equity section. It would be reasonable to expect columns for preferred stock, common stock, additional paid-in capital, retained earnings, and treasury stock.
 
Each column reports a beginning balance and then reports transactions that affect the beginning balance. Finally, the ending balances are totaled to arrive at a total amount of stockholders' equity.
 
The accounts from the stockholder's equity statement are transferred in summary form to the equity section of the balance sheet.
 
To review, see Stockholders' Equity: Classes of Capital Stock.

9g. Develop accounting entries for paid-in capital, cash dividends, stock dividends, stock splits, and retained earnings appropriations

• What is paid-in capital?
• Are retained earnings the same as profits?
• How do cash dividends and stock dividends differ?
• What is a stock split?

Paid-in capital is simply the money contributed by stockholders and reported under the Stockholders' Equity section of the balance sheet. It includes all classes of stock recorded at par value plus the amount received in excess of par.
 
Retained earnings are also listed under the Stockholders' Equity section of the balance sheet and represent all the earnings that have accumulated in the business to date and have not been paid out as dividends. When retained earnings and cash are sufficient, and the retained earnings have not been appropriated (set aside) for another use, a corporation's board of directors may decide to share the retained earnings with shareholders in the form of a dividend payment. If they do that, then profits and retained earnings will not be the same.
 
A cash dividend is the most common form of dividend payment and is paid out of retained earnings, which decreases a corporation's cash. Rather than declare a cash dividend, a corporation may elect to declare a stock dividend that distributes additional shares of stock to common stockholders. A stock dividend also decreases retained earnings but does not decrease cash.
 
A corporation's board of directors may also vote to declare a stock split which decreases the par value of stock and increases the number of common shares. A stock split will divide each share of stock into two or more shares. For instance, a 4:1 (4 for 1) stock split will turn one share of stock into four shares and simultaneously divide the par value by four. To further illustrate, one share of stock with a par value of $40 that is split 4:1 will now equal four shares of stock with a par value of $10 each.
 
Dividends are declared by a corporation's board of directors after a review of the retained earnings and cash of the corporation and a vote.
 
To practice, name the three significant dates associated with the payment of dividends. Know the journal entries associated with each of the significant dates.
 
To review, see Stockholders' Equity: Classes of Capital Stock.
 

Unit 9 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• bond
• common stock
• discount
• dividend
• face value
• maturity
• paid-in capital
• par value
• preemptive right
• preferred stock
• premium
• retained earnings
• statement of stockholders' equity
• stock
• stock dividend
• stock split