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Date Created: 02/06/15
A312 Quiz 1 Review 3 Accounting Perspectives Preparer s Perspective impact of events on the financial statement 0 Making the journal entries and constructing the financial statements Users Perspective analysis of financial statements Ratio Analysis allows you to compare varying companies on a level playing field Measures of Profitability 0 Return on Assets ROA Net Income Interest Expense 1 tax rate Average Total Assets I Interest Expense Tax accounts for the difference in financing companies may receive I ROA Asset Turnover Profit Margin I Measures firms performance in using assets to get earning Revenue 0 Asset Turnover Average Total Assets I Ability for a company to sell assets Net Income Interest Expense 1 tax rate 0 Profit Margin Revenues I Ability for a firm to make a profit Net Income Pre f erred Dividends 0 Return on Common Equity ROE Average Common Equity I Measure how a firm uses its assets to generate earning for COMMOM shareholders 0 Cost of Debt on a spectrum and as the demand for debt changes so will the cost I Without calculating ROE you can know some info from looking at Cost of Debt and ROA Cost of Debt gt ROA than ROE lt ROA Cost of Debt lt ROA than ROE gt ROA 0 Most common scenario and is what makes Equity holders like debt because it gives them more of a return 0 ROE and ROA can be used to value stocks Measures of Risk 0 Debt to Asset Ratio of asses financed through borrowing 0 Current Ratio measure the ability of the firm to pay of debts due Current Assets Curent Liabilites Value of Future Payoffs o Dividend Discounts Model value of expected future dividends I Not commonly used because every successful company may not pay dividends I Places most value on the last year I Ex Google Formula Dl DZ DT 1 re 1 raz re ax re 1 Re 9 cost of capital A312 Quiz 1 Review 0 Discounted Cash Flows Model present value of expected future free cash ows I Make a lot of assumptions with this model very similar to Dividend Discount I Values the business as a whole and not just common equity C1 C2 CT 1 Te 1 Te2 139e g17 eT391 Formula 0 Residual Income Model BV of equity plus the PV of the expected residual income I Commonly used at Hedge Funds I Places the most value on the EV which is now less of an assumption I Suggests value comes earnings and value comes from ROE and growth R11 R12 RIT Formula BVO 1re 1re2 reg1reT1 I Residual Income Income Required Income 0 Required Income is BV Cost of Capital Standard Setters Perspective political and economic environment for rule making FASB sets the standards with in uences coming from 1 Conceptual Framework a Main base for standards Accounting Bible Managers Companies SECCongress Auditors Investors Users 0 All these in uences want different things out of the standards and it makes it difficult because of lobbying to base them solely of the framework 9195 quot Market Efficiency 0 Strong Form stock prices re ect all available information public and private I Make it impossible to predict future because all the information is known and factored in already 0 SemiStrong stock prices re ect all publicly available information 0 Reality market is a mix of both because Hedge Funds and regular investors market does not re ect everything perfectly I Hedge Funds will take the public information and dig deeper to try to predict things A312 Quiz 1 Review 0 Managers Earnings Management 0 Earning management often happens when you are right on the edge of being positive they will try to defer expenses so that they can show a positive 0 Upward Earnings Management avoid reporting losses decline in earnings I Usually done before offering stocks mergers or if a debt covenants may be close to being violated I These are all situations when you want the company to look as good as possible 0 Downward Earnings Management filling the cookie jar taking a massive loss in the year in hopes to show a large gain in the following I Done around buyouts potential lawsuits before stock options are releases Debt Financing LT Debt usually has periodic interest and principal payments Loan mixture of paying interest and principal at same time 0 Anyone can issue a loan 0 PV calculation using calculator 0 Ex Purchase a car using loan with 3 payments at 10 interest PMT 4000 Motor Vehicle 9947 Loan Payable 9947 I PMT will total 12000 so some of that money will go to interest payments rather than paying off the loan Bond only pay interest until you pay principal at maturity usually issued by larger companies and could be traded on the Bond Market 0 Bond Contract Bond Indenture contains restrictions and covenants for the lender and borrower I Dividend Restrictions Additional Debt issuance restrictions 0 Issued to an Investment Bank who that sell them to multiple investors 0 Sold as Public or Private I Public will be sold on the primary or secondary market I Private less costly but very few people operate in this market so it is less common 0 Bond Types I Term mature at one date I Serial matures in installments I Zero Coupon issued at a deep discount and there is no interest until maturity o Risky because if company fails you don t get any money I Variable Rate interest rates vary I Callable company can pay off the bond before maturity A312 Quiz 1 Review 0 Interest Rate go down and the company could get financing at a better rate 0 When a company issues a callable bond the investors usually know that the company is going to exercise their right so they are issued at a lower price I Putable Owner can sell the bond back to issuer at a specified price 0 Owner could sell back to the company at a higher rate than the market is offering I Convertible bond could be traded in for common stock in the company 0 Terminology I Stated Rate Coupon Rate I Effective Rate Discount rate I Yield to Maturity actual rate the bond is trading at in the market Stated Rate Effective Rate Issued at Par Stated Rate lt Effective Rate Issued at a Discount Low coupon but get at a cheaper price Stated Rate gt Effective Rate Issued at a Premium Higher coupon PMTs so pay more upfront I When a company issues a bond they actual get the PV of the bond I SampP and Moody s will rate the quality of the bond based on the financial status of the issuer 0 AAA BBB are investment grade bonds 0 BB D are junk bonds Discount Journal Entries Cash 776000 Discount on Bond Payable 24000 Bond Payable 800000 Interest Expense 41200 Discount on Bond Payable 1200 Cash 40000 Premium Journal Entries Cash 824000 Premium on Bond Payable 24000 Bond Payable 800000 Interest Expense 38800 Premium on Bond Payable 12 00 A312 Quiz 1 Review Cash 40000 Amortization Discount Interest PMT Interest Discount Bond Discount CV of Bond Expense Amortized Balance Stated Rate Effective Exp Bond Discount CV Principal Rate CV PMT Discount Amortized Discount Amortized Premium Interest PMT Interest Premium Bond Premium CV of Bond Expense Amortized Balance Stated Rate Effective PMT Bond Premium CV Principal Rate CV Exp Premium Amortized Premium Amortized Bonds could also be straight line amortized meaning that the journal entry would be the same each period 0 Discount amount paid off each time is divided equally throughout the entire time What if you want to know the CV of a bond in middle of the issuance without creating an Amortization Schedule Calculate for the PV by changing the periods to re ect the time left till maturity A312 Quiz 1 Review Accounting for Bonds Prorating Bond Interest Companies Fiscal Year end is not the same as their interest payments on their Bonds Interest PMT for 123107 when Fiscal Yr ends 731 with table shown below Interest Expense Interest Discount Bond Discount CV of Bond PMT Amortized Balance 7405 6000 1405 13466 186534 Interest Expense 7405 56 6171 Discount 1405 56 1171 0 It has been 5 months since the last accrual which is why 5 6 is used Interest Exp 6171 Interest Payable 1000 Cash 6000 Discount 1171 When it is the year end the Interest needs to be accrued for that month 0 Do the same calculations as above but there will be no cash brought in Interest Exp 1234 Discount 234 Interest Payable 1000 Extinguishing Bonds company can pay back bonds before their maturity 0 Accounting Gain gain will occur when the market rate is higher than the effective rate I MV lt BV 0 Accounting Loss loss will occur when the market rate is lower than the effective rate I MVgt BV 0 MV is calculated using the new rate on the market 0 0n the books the company may show a gain loss but what is the overall Economic Effect I There would only be a positive effect if the company does not have to reissue bonds they have enough cash on hand to buy back and still have enough on reserve I The liabilities of the company will be reduced A312 Quiz 1 Review Debt Disclosures Literally lists the amount of debt the company has left out currently Debt Covenant Agreement between company and creditors to operate within certain limits 0 A breach usually means creditor can demand immediate payment 0 Disclosure of violations are not required to be shared Fair Value Option Allows companies to report assets or liabilities at fair value and these changes then being reported on the income statement 0 The unrealized gains and losses are reported as a part of Net Income 0 Unrealized gain and loss Change in the fair value of the liability Ex 500000 issued and the value drops to 480000 in the market Entry made for the loss in value which is a reduction in liability and results in unrealized holding gain 0 Decline in value could be from interest rates increasing or because the bonds are more likely to default Chapter 14 Long Term Liabilities A312 Debt Clock Rising Total Matters 0 If government debt rises faster than economic output 9 implies state interference in the economy and higher taxes in the future 0 Debt must be rolled over in consistent intervals 0 Corporate Debt lower interest rates than the bank with tightened lending I The longer the bond the more the people believe in the economy and the company Bonds Payable LT Debt probably future sacrifices of economic benefit arising from present obligations that will not be payable within the year Usually have covenants restrictions which include the rates and amount issued working capital and dividend restrictions limits to issuing more debt Issuing Bonds Bond Indenture promising to pay a sum of money at maturity and interest payments at a certain rate Usually takes some time to issue bonds because SEC must approve and the company will go through an audit week or month long process Types of Bonds Secured Bonds backed by a pledge of some collateral 0 Ex Mortgage Bonds secured with the real estate Debenture Bond unsecured by collateral 0 Ex Iunk Bonds Convertible Bonds after issuance convertible into other securities for a certain time Commodity Backed Bonds redeemable in measures like oil coal or an agreed price upon maturity whichever is greater at the time Deep Discount Bonds Zero Interest sold at a discount but bear the full amount at maturity Income Bonds pay no interest unless the company is profitable Revenue Bonds Interest paid by them come from certain revenue sources Valuation of Bonds Payable Discount and Premium Selling Price of bond is set by the supplydemand risk economy conditions Coupon Rate vs Stated Rate Effective Yield rate of interest actually earned by the bondholders 0 Discount effective rate will exceed the stated rate Bonds Issued at Par on Interest Date No premium or discount exists interest is paid though Usually done if the company really needs money Cash 800000 Bond Payable 800000 Chapter 14 Long Term Liabilities A312 Bonds Issued at Discount or Premium on Interest Date Amortize the discount and charge it to interest expense over time Straight Line Method amortizes a constant amount each period 0 Meaning your journal entries will never change as they do with the regular method Discount Cash 776000 Discount on Bond Payable 24000 Bond Payable 800000 Interest Expense 41200 Discount on Bond Payable 1200 Cash 40000 Premium Cash 824000 Premium on Bond Payable 24000 Bond Payable 800000 Interest Expense 38800 Premium on Bond Payable 12 00 Cash 40000 Amortization of a discount increases interest expense Amortization of a premium decreases interest expense Bonds Issued Between Interest Dates If not issued exactly on an interest payment date buyers of bond will pay the seller the interest accrued from the last interest payment to date of issue 0 Then on the payment date the buyer will receive the full 6 month payment Effective Interest Method Preferred method for amortization of a discount or premium 1 Calculate Bond Interest Expense CV Effective Rate 2 Determine Bond Discount Premium by comparing the bond interest to cash to be paid 2 methods have the same interest expense over time but the annual amounts are materially different Discounts Premiums are seen as a direct deduction or addition to the face value of the bond Cost of Issuing Bonds Legal accounting printing promotion costs and other costs are charges to the asset account of Unamortized Bond Issues Costs 0 Note that it should be considered an Expense but there is no definite rule yet so it get deferred Chapter 14 Long Term Liabilities A312 Extinguishment of Debt Company holds bonds to maturity no gain loss 0 Reacquisition Price amount paid on extinguishment or redemption The extinguishment of debt often has the same economic effect when they re issue bonds at the lower price so it is only beneficial to do if they will not issue new bonds Long Term Notes Payable Fair Value Option Companies have the option to record fair value for their notes and bonds payable 0 The unrealized gains and losses are reported as a part of Net Income 0 Unrealized gain and loss Change in the fair value of the liability Ex 500000 issued and the value drops to 480000 in the market Entry made for the loss in value which is a reduction in liability and results in unrealized holding gain 0 Decline in value could be from interest rates increasing or because the bonds are more likely to default Reporting and Analyzing Liabilities Off Balance Sheet Financing Attempt to borrow money in such a way that you don t have to record the obligations 0 Any company that does this risks that their stock holders will drop their stock Presentation and Analysis of Long Term Debt
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