Financial Accounting Final Exam

Bonds

Bonds are debt certificates. When firms borrow money from the public rather than banks, they often issue bonds. The firm then pays the bondholders interest and principal.

Bond Terminology

Principal/face/par value (amount paid at maturity date), Term of the bond (how long it is active), Coupon Rate (rate used to compute cash interest payments) and Frequency of Interest Payments (how often interest is paid to bondholders)

Two Kinds of Interest Rates

1. Stated Interest Rate (coupon) - used to compute the amount of cash paid each interest period. Set by the bond issuer.

2. Market Interest Rate - used to compute the bond issuance price and the amount of interest expense recognized each period on the books. Set by the market.

Bond Issue Price

PV of the principal payment + PV of cash interest payments

Par vs. discount vs. premium

1. Par - Market Rate = Coupon Rate - Interest Expense = Cash interest payments

2. Discount - Market Rate > Coupon Rate - Interest Expense > cash interest payments.

3. Premium - Market Rate < Coupon Rate - Interest Expense < Cash Interest Payments

Calculating Interest Expense for Bonds

Interest Expense = Market Rate * Book (carrying) Value

Accounts Involved in Early Bond Retirement

Bonds Payable (face value), Bond premium (premium @ time of retirement), Cash (price sold at), Gain/Loss on early bond retirement (price - carrying value)

Times Interest Earned Ratio

= (Net Income + Interest Expense + Income Tax Expense) / Interest Expense

• Measures the firm’s ability to meet current interest obligations from profits. Generally, the higher the ratio the better.

Debt to Equity Ratio

= Total Liabilities / Stockholders’ Equity

• Measures the relationship between creditor financing and owner financing.

Two primary components of Stockholders’ Equity

1) Contributed Capital - Equity Contributed by owners

• Stock Accounts (par value)

• Additional paid-in capital accounts

2) Retained Earnings - cumulative net income — cumulative dividends since company inception

Share Breakdown

Authorized Shares (max # of shares of stock allowed to be sold to the public) —> Issued (shares that have been sold) VS. Unissued (never been sold) —> Issued Shares 2 components —> Outstanding Shares (currently owned by stockholders) and Treasury Shares (shares repurchased by the firm)

Types of Stock Ownership

1. Common Stock - Voting Rights, Dividends, & Liquidation

2. Preferred Stock - No voting rights, & preference over common stockholders for dividends and in the event of liquidation.

Treasury Stock

Firms may buy back their own stock. As long as they do not retire the stock, it will be held in the “treasury” and must be disclosed in stockholders’ equity. It is a “contra-equity” account. Remember, “Additional paid-in capital - treasury stock” account CANNOT go below zero, so fill the rest with retained earnings!!

3 Important Dates for Dividends

1. Declaration Date - date that the board of directors announces the dividends

2. date of record - date on which a shareholder must own the stock in order to receive the dividend

3. payment date - date when the firm pays the dividend to all shareholders on the date of record

Earnings per Share

= (Net income - preferred dividends) / Weighted Avg. of Common Shares Outstanding

• Measures the firm’s profitability

• Standardizes net income by the number of common shares a firm has outstanding

• required disclosure on the income statement

Return on Equity (ROE)

= Net Income / Average Shareholders’ Equity

• Measures how much the firm earned in profits for each dollar of shareholder investment