You are on page 1of 34

1

Chapter 10

Two ways to finance acquisition of assets:

1)Debt- creditors (riskier due to the legal obligation of interest)

2)Equity – cash raised from investors (contributed capital)

Liabilities

Liability- probable debt or obligations of the entity from past


transactions

-Measured at current cash equivalent at the time incurred

Current vs non-current

Current if it matures in a year or less

1
Non-current if it matures in more than one year
But if a 30 year Note Payable is in its 29th year then it needs to be
classified as a Current Liability

More on Notes Payable . . .

Interest:

Each note payable specifies an interest rate that corresponds to that


note payable

Lender vs. Borrower

If you are lending the money, then interest is a revenue on


your books

If you are borrowing the money, then interest is an expense


in your books

Formula:

Principle x interest rate x time

Note: Time can be in fractions if it is less than a year

2
Example:

Dwight Schrute Inc. borrows $1,000,000 for 3 months (to buy beet
fertilizer) at an interest rate of 10%. Make the journal entries for the
loan period.

What about an installment note?


An installment note is where you pay off a loan over time similar to a
3
car loan or home mortgage.
Bullwinkle’s borrows 100,000 from the bank to be paid over 3 years
with an 8% interest rate. The payments are to be made annually for
38,803 at the end of the year

Principle Payment Payment Interest Reduction


in princ

4
What if the question had said that the payments were made monthly?
Just apply the equation…

Present value

Time Value of Money (TVM)

Because of interest - A DOLLAR RECEIVED TODAY IS MORE


VALUABLE THAN A DOLLAR RECEIVED TOMORROW.

• We are going to receive $1,000 one year from today. Would this
be worth more than, less than, or equal to $1,000 for us TODAY?

5
Formula: PVt = FV
(1+i)t

Where: FV = Future Value


t = # of periods
i = discount rate

Discount rate = the interest rate at which we will discount our cash flows

Example: Assuming a discount rate of 10%, what would be the present


value of $1,000 received in one year?

PV1 = 1,000 = $909.09


(1.10)1

What would the present value of $1,000 received in two years?

What would be the present value of $1,000 received in two years


assuming a discount rate of 12% ?

6
Bonds

Bonds are a major form of long-term liability

Issuing bonds is a major way to raise money for a company (many big
companies do this instead of taking out a bank loan). Basic idea:

1) We the company borrow money from investors


2) We give them a piece of paper with two promises
a. We will pay them back a fixed amount of money at a set date
b. We will also make periodic interest payments at a fixed
interest rate at set dates

Types of Bonds:

Ordinary Bonds: the full face amount is due at the maturity

Serial Bonds: The principal is paid in installments on a series of


specified maturity dates

Callable Bonds: Can be retired and repaid at any time at the discretion of
the issuer

Convertible Bonds: May be exchanged for other securities of the issuer


at the option of the bondholder

Registered Bonds: Interest payments are made to the bond holders


whose names and addresses are registered

7
Here is what a bond looks like:

$10,000 FACE VALUE

10% COUPON (STATED) RATE

Interest is paid ANNUALLY

ISSUE DATE: 1/1/04

MATURITY DATE: 12/31/06 (3 years)

PRICE of the bond….


- depends on the MARKET interest rate

Now, find the PRICE of the bond if the current market rate is 10%…….

This bond is ISSUED AT PAR. (CR=MR)

*Rule
Always use the Market Rate at the issue date when discounting cash
flows to find bond price. Use the Coupon Rate only to find the cash
interest payments.

What if the market, on average, was paying 12% and our bond have a
stated rate of 10%. Will price of this bond be greater than, equal to, or
less than the $100,000 FV?

This bond is ISSUED AT A DISCOUNT. (CR<MR)

8
What if the market, on average, was paying 8% and our bond has a
stated rate of 10%? Will price of this bond be greater than, equal to, or
less than the $100,000 FV?

This bond is ISSUED AT A PREMIUM. (CR>MR)

Note: Premium bonds are not very common… why?

*Terminology: a bond issued at 102 means the issuer receives 102% of


the face value of the bond in cash when the bond is issued. Therefore,
the bond is issued at a premium.

If the bond was issued at 95, the issuer would receive 95% of the face
value of the bond in cash when the bond is issued. This means that the
bond was issued at a discount.

9
EXAMPLE: We are given the following information about a bond our
company is issuing:

$10,000 FACE VALUE


10% COUPON (STATED) RATE
12% MARKET RATE
Interest is paid ANNUALLY
ISSUE DATE: 1/1/04
MATURITY DATE: 12/31/06 (3 years)
Issued at 95

At what price will we issue these bonds?

Give the journal entry to record the issue.

Discount on Bonds Payable is a contra-liability account. It makes the


value of the bonds less on our balance sheet.

10
EXAMPLE: We are given the following information about a bond our
company is issuing:

$10,000 FACE VALUE


10% COUPON (STATED) RATE
8% MARKET RATE
Interest is paid ANNUALLY
ISSUE DATE: 1/1/04
MATURITY DATE: 12/31/06 (3 years)
Issued at 105

At what price will we issue these bonds?

Give the journal entry to record the issue.

Premium on Bonds Payable is an adjunct account. It makes the value of


11
the bonds greater on our Balance Sheet.

Amortization of Bond Discounts and Premiums

As time goes by, we have to amortize (use up) any discounts or


premiums on our bonds.
It’s a pain in the ass.

Amortization:

As a bond gets closer to maturity, the carrying value will get closer and
closer to the face value

12
Effective Interest Method:

• The amount of interest expense is the EFFECTIVE(market)


interest rate multiplied by the carrying value of the bond.

• The difference between the actual cash interest payment (face


value * stated rate) and the interest expense (carrying value * the
market interest rate) is the amortization of the discount or
premium.

13
Example:
On 1/1/01 Martha Fokker Inc. issues a 5 year annual bond with a Face
Value of $30,000. The Stated Rate is 10% and the market rate is 12%.
Issued at 93

What is the entry to record this transaction?

What is the adjusting entry needed at 12/31/01, effective interest


method?

What is the adjusting journal entry needed at 12/31/02 assuming


effective interest method?

14
EXAMPLE: On 1/1/01 Initech Inc. issued a 5 year, annual bond with a
face value of $200,000 and a stated rate of 10%. The market rate is 8%.
Issued at 108

Issued at a discount or a premium?

Journal entry to record the issue:

Give the adjusting journal entry at 12/31/01.

15
What is the carrying value of the bond at 1/01/02?

Give the required journal entries at 12/31/02.

What’s the carrying value for 1/1/03

16
Chapter 11: Stock

Corporation – a company that is a separate legal entity


- formation is governed by state law

Corporate Charter – a document that establishes a corporation


- states the types of stock that a company is allowed to issue
- states the number of shares the corporation is ever allowed to issue
(Authorized Shares)
- states the PAR VALUE of the company’s stock
o Par Value tells us how much $ to put in the stock accounts
o Par Value IS NOT Market Value

Publicly Held Corporation – stock is traded by the public on a stock


exchange
- NYSE, NASDAQ
- Usually many shareholders

Privately Held Corporation – stock is not publicly traded


- usually fewer shareholders

17
Corporation Characteristics

Benefits

- separate legal entity


- limited liability for shareholders
o If we own stock in a corp. and it goes bankrupt, the bank
can’t take our house
o Our loss is limited to our stock investment
- easier to raise capital (sell more stock)
- infinite life
o corporation continues if shareholders die or sell their stock

Drawbacks

- increased taxes
o corporations pay tax on their NI AND shareholders pay
taxes on dividends
 DOUBLE TAXATION
- increased government regulation

18
Other Stuff

When people buy and sell our stock in the stock market, it has NO
ACCOUNTING EFFECT for us, the company.

Why? Those people are outside of our company.

Debt vs Equity

Some differences between debt and equity:

- debt holders have no ownership in our company


o stockholders own our company
- debt holders receive guaranteed payments (interest and face value)
o our company does not have to make any payment to
shareholders
- debt holders have the first rights to take our assets when we go
bankrupt
o shareholders get whatever assets are left over
- debt holders have no decision making rights (no vote) (usually)
o shareholders have a vote on big decisions

Bonds are BORROWING money, whereas stock is SELLING a piece of


the company.

19
Stock

PAR VALUE DOES NOT EQUAL MARKET VALUE – IT’S JUST


A VALUE GIVEN BY THE CHARTER
- Par value will be used for some calculations, although it has no real
meaning anymore!

When an individual buys shares of a company’s stock, they have certain


rights to the company:
1) Right to vote on company issues (use of assets, liabilities incurred,
strategic/operating policies, elect people to Board of Directors, etc.)

2) Right to receive a proportionate amount of profits from company,


determined by the number of shares owned; i.e. cash dividends or
increase in stock value

3) Right to transfer the ownership of the corporation to someone else

4) Right to maintain ownership % if we issue more stock


- EX: We own 1 out of 10 shares in a corporation. We own 10% If
the company issues 10 new shares of stock, we have a right to buy 1
of the shares.

2 Types of Stock
1) Common Stock
- Basic voting stock
2) Preferred Stock
- Stock with no voting rights, but certain advantages

20
Common Stock

Common Stock is issued in order to raise cash for investment and


operating purposes

Characteristics of Common Stock


1) Payments from the company are not required (unlike bonds
requiring interest payments)
2) Voting rights

Stock Terms
Authorized Shares – Maximum number of shares a company can issue.

Issued Shares – Shares that have been issued by the company at some
point in time

Unissued Shares – Shares that have never ever been issued by the
company

Outstanding shares – Shares currently owned by stockholders

Treasury Stock – Stock that had previously been issued, but was then
repurchased by the company (no longer outstanding)

Authorized Shares = Issued Shares + Unissued Shares


21
Issued Shares = Outstanding Shares + Treasury Stock

When someone buys stock from a company, that stock is said to be


“outstanding”. If the company buys back that stock from the individual,
the stock does not become unissued. It becomes what is called “treasury
stock”.

EX: Fah Q, Inc. authorized 200,000 shares of stock. There are 100,000
shares outstanding and 30,000 unissued shares. How many shares are in
the treasury?

22
Other Terms
IPO (Initial Public Offering) – The first time a company sells shares to
the public

Seasoned New Issue – subsequent sales of corporate stock by the


company

Secondary Markets – when outside parties exchange a companies stock,


NO accounting effect for the company – Why not?

Sale of Stock (Issuing Stock)


When we, the company, sell stock, it is considered CONTRIBUTED
CAPITAL because it is capital (money) that is being contributed by
owners (the new shareholders). To record the sale of stock:

Cash XX
Common stock (# of shares x Par value) XX

*Additional Paid-in Capital (APIC) – Common Stock


XX

*APIC – the excess of cash received from the sale of stock above Par
value (your book
also calls this Capital in Excess of Par)

23
EX: Stacey Rhect Inc. sells 300 shares of common stock for $6,000.
Par value is $5 per share. Give the journal entry to record the
transaction.

24
Treasury Stock
When the company repurchases its own stock, it is called Treasury Stock
- Treasury Stock is a contra-equity account (a reduction in
Stockholder’s Equity)

Companies have many reasons for purchasing Treasury Stock including:


- by stock to be used for stock options
- increase the MV of our stock (make our stock harder to buy)
- to get shares used in buying other companies
- prevent hostile takeover
o if people buy enough of our stock, they will get enough votes
to take over our company
- increase earnings per share (Net income over number of common
shares outstanding)

To record the purchase of the treasury stock bought at the market price
we paid:

Treasury Stock XX
Cash XX

25
If the company decides to sell the stock that they repurchased, and the
market price at the time that the stock is being sold is more than the
price that the company bought it for, the entry would be:

Cash XX
Treasury Stock XX
APIC – Treasury Stock XX

If the market price at the time that the stock is being sold is less than the
price that the company bought it for, the entry would be:

Cash XX
APIC – TS XX
Treasury Stock XX

NO GAIN OR LOSS IS RECORDED IN TREASURY STOCK


TRANSACTIONS
Why?

We can’t make money off of stock, but we still get cash

26
EX: On 7/1/05, Haywood Jablowme, Inc. bought back 4,000 shares of
their own stock when the market price of the shares was $25.00. Record
the entry made on 7/1/05.

9/15/05, Haywood Jablowme, Inc. sold 2,000 shares of the treasury


stock acquired on 7/1/05. The market price at the time of sale was
$30.50. Haywood Jablowme, Inc. had $1,000 in APIC – Treasury
Stock.

27
Dividends

3 Dates for Dividends

- Declaration Date – the day we say we will pay a dividend


- Date of Record – we will pay dividends to everyone who is a
shareholder at this date
- Date of Payment – the day we actually pay the dividend

Cash dividends are only recorded when the Board of Directors declares
a dividend. At that point in time, the entry made would be:

Dividends Declared XX
Dividends Payable XX

When the company actually pays the dividend, the entry would be:

Dividend Payable XX
Cash XX

28
EX: On 4/30/05, Café Divorcé Inc. declares a dividend of $5,000 to
only its single middle age mom shareholders (which happens to be all of
them). What is the necessary journal entry on 4/30/05?

On 7/31/05, CD Inc. pays the dividend it declared on 4/30/05. Give the


necessary journal entry.

Does Treasury stock receive dividends? Why?

29
Preferred Stock

Characteristics of Preferred Stock


1) A fixed dividend per year
2) Receive dividends before common stockholders
3) No voting rights
4) First rights in case of bankruptcy
5) May be cumulative or non-cumulative
6) Sometimes convertible into common stock

Sale of Stock
The sale of preferred stock is the same as it is for common stock, with
one minor account difference:

Cash XX
Preferred Stock (# of shares x Par value)
XX
APIC – Preferred Stock
XX

EX: On 5/15/05, Wayne Kerr Inc. issues 100 shares of 6% preferred


stock, with a par value of $2.00, when the market price is $15.00.
Record the entry on 5/15/05 when Wayne Kerr, Inc. issues the stock.

30
Dividends- Preferred Stock
Dividends for preferred stockholders are determined by a fixed
percentage of the par value per year.

EX: 6% preferred stock, with a par value of $10.00 will have pay a
dividend
per share of 6% of $10.00
- 6% * 10.00 = $0.60 dividend per share

Cumulative vs. Non-cumulative

Cumulative
Dividends that have not been paid to preferred stockholders are called
dividend in arrears (dividend owed from a previous year). These
dividends in arrears must be paid to cumulative preferred stockholders
before any dividends may be distributed to non-cumulative preferred
stockholders and common stockholders. (If we NEVER pay dividends,
then no liability.)

Non-Cumulative
Dividends in arrears are not paid to non-cumulative preferred
stockholders. However, they still receive dividends before common
stockholders.

31
EXAMPLE: Yerma Wildo, Corp. has the following classes of stock:

• Preferred stock, 8%, $100 par, 10,000 shares issued and


outstanding, non-Cumulative

• Preferred Stock , 10% $200 par, 1,000 shares issued and


outstanding, cumulative

• Common stock, par $5, 100,000 shares issued, 50,000 outstanding.

YM paid no dividends in its first two years of existence (2000 and


2001). In 2002, the board of directors of YM declared a total dividend
of $240,000 to be paid to the holders of preferred and common stock in
the current year of 2002. How much was paid to cumulative Preferred
Stock shareholders?

How much was paid to non-cumulative Preferred stock Shareholders?

How much was paid to each share of common stock?

32
Other Issues

Stock Splits
When a company decides to increase the total amount of shares in the
company (i.e. 2-1 stock split); the effects are:
1) Proportionate change of total shares of stock (2-1 stock split 
1,000 shares to
2,000 shares)
2) Proportionate change in par value per share (2-1 stock split 
Par value from $6 to $3)

NO JOURNAL ENTRY IS NEEDED!!


SE DOES NOT CHANGE!!

EX: Grog Inc. declares a 3-1 stock split on its common stock. Before
the split, Grog had 6,000 common shares outstanding with a par value
of $12. What is the par value and the total number of shares outstanding
after the split?

33
Stock Dividends
A stock dividend is where the company issues additional stock to its
shareholders in lieu of cash. The effects of a stock dividend are:
1) No change in equity
2) No change in par value
3) No change in ownership interests.
Small (<20 to 25%) - record at market

Large (>25%) – record at par

Ex: Enron has 100,000 shares outstanding at $1 Par value. On 12/31/01


the market rate is $30 and they issue stock dividends.
Make journal entries assuming they are issuing 10% stock dividends:

Assuming 50% stock dividend:

34