Chapter 11

Financial Instruments
Historical market interest rate: discount rate prevailing at the date of the
initial borrowing.
Current market interest rate: discount rate at any date subsequent to the
date of the initial borrowing.
1) Amortized Cost
a. Use the historical market interest rate to compute the carrying
value of the notes and bonds while these obligations are
outstanding and disclose in the notes to the financial statements
the fair values of these financial instruments based on the
current market interest rate.
2) Fair Value
a. Measure notes and bonds at fair value each period
Accounting for Notes
Co borrows 125000 from its bank to purchase land. The co pledges the land
as collateral for the loan. Interest accrues on the unpaid balance of the loan
at 12 percent compounded emiannually (6p each six months). Co pay 17k
on June 30 and Dec 31 of each year for four and a half years, and pay 16782
at the end of five years.
Initial valuation: 125000 (equals present value of the future cash payments
discounted at the yiled required by the lender)
When the stated interest rate for a loan (6p compounded
semiannually) equals the yield required by the lender (6%) then the amount
borrowed equals the principal amount of the loan.
Jan 1 2014
Cash 125000
Note Payable 125000
Jan 1 2014
Land 125000
Cash 125000
Measurement Subsequent to the Date of the Initial Loan
During first 6mo, interest of 7500 (.06x125000) accrues on the loan. The firm
then makes the required cash payment of 17000.
June 30 2014
Interest Expense 7500
Note Payable 9500
Cash 17000

Balance in Note payable on Jan 1 2014 125000

Plus Interest for first six mo 7500
Less Cash Payment on Jun 30 2014 (17000)
Balance in NP on June 30 2015 115000
The carrying value of the loan on Jun 30 equals the present value of
the remaining cash flows discounted at 12% compounded
semiannually
The amount reported on the balance sheet throughout the life of a loan
(carrying value) equals the present value of the remaining cash flows
discounted at the historical market rate (12% compounded semiannually).
The current market interest rate usually differs from the historical market
rate during the life of the loan. A firm that does not account for long-term
notes and bonds using the fair value option uses the historical market
interest rate to account for the loan white it is outstanding.
Amortization Schedule pg 420 lit
ACCOUNTING FOR BONDS
Co issues 250m of 8p seminannual 20 yr coupon bonds. The bond indenture
requires co to make coupon payments of 10m (0.08x250mx6/12) every
sixmo forfor 20yrs and to repay the 250m principal at the end of 20 yrs. 250
mill is the principal or face value of the bound and 8p rate is the coupon
interest rate. In this case 250m is also the maturity value of the bond.
Co issues 180m of 15 yr serial bonds. The bond indenture requires co to pay
10409418 every six mo for 15 yrs. Each periodic payment includes interest
plus repayment of a portion of the principal. Principal = 180m
Co issues 300m of 10yr zero coupon bonds. They do not require periodic
interest payments. Instead the 300m maturity value includes both principal
and interest. Although these onds do not state an interest rate, there is an
implicit interest rate embedded in the maturity value.
BOND TERMINOLOGY
- Bond contract specifices the basis for omputing the fture cash flows for
that bond issue. Identifying those cash flows is the starting pt to
account for the oind both initially and at each subsequent
measurement date.
- Face value: amount printed on the face of the bond
o Face value is equal to maturity value on coupon and zero coupon
but not on serial bonds
- Principal: the same as face value on coupon and serial but not zero
coupon

Maturity value: amount paid by issuer at the maturity date of the

bonds
Fair value: amount at which bonds sell in the market either at date of
issue or at any subsequent date while the bonds are outstanding
Coupon rate: rate stated in the bond contract that when multiplied
time the face value or principal amount of coupon bonds equals the
required periodic cash payment. Stated rate is aalways annual.
Historical market interest rate or Initial yield to maturity: interest rate
that discounts all future cash flows such that their present value equals
the initial issue price of the bond
Current market interest rate: the interest rate that discounts all future
cash flows such that their present value equals the fair value of the
bond

Initial measurement of bond depends on 1. Promised cash payments

indicated in the bond contract 2. Yield to maturity required by investors to
induce them to purchase the bonds
Back to example 2 with 250m principal at the end of 20yrs.
When the coupon rate equals the historical market interest rate of initial
yield to maturity, then the initial issue price equals the face value of the
bonds
ISSUE PRICE
When the market-required yield to maturity exceeds the coupon rate, the
bonds initially sell for less than face value, or a discount to face value. Viceversa, premium to face value.
Issued at Par: ex. Macaulay issues 100000 face value of 12p semiannual
coupon debenture bonds on Jul 1 Year 1. Macaulay must repay the principal
amount five years later on Jul 1 Year 6. Macaulay owes periodic payments
(coupons) on Jan 1 and july 1 of each year. The coupon payments promised
at each payment date total 6000.
Effective interest method
Fair value option
Fair value is the amoun ta firm would receive if it sold an asset or would pay
if it transferred or settled, a liability in an orderly transaction with a market
participant at the measurement date

1) Level one: observable market prices in active markets for identical

asset or liabilities tha the reporting entity is able to access at the
measurement date
2) Level 2: Observable inputs other than market prices within level 1
3) Level 3: Unobservable inputs refleting the reporting entitys own
assumptions about the assupmtions market participants would use in
pricing an asset or settling aliability
ACCOUNTING FOR LEASES
Distinguishes between operating leases and capital leases
Capital: lessee records both the right to use leased asset and a lease
liability, like if it had borrowed to purchase the asset
Ex. Food Barn wants to acquire a computer that has a three year life and a
purchase price of 45k. Assume that Food Barn must pay 8% per yr to borrow
funds for three years. The computer manufacturer will sell the computer to
FB for 45k or lease it for three yars for 17461.51 per year, payable at the end
of each year. In practice, lessees usually make payments in advance, but
assuming the payments occur at the end of the year simplifies the
computations. Food Barn must ay for property taxes, maintenance, and
repairs of the computer whether it purchases or leases. Food Barn signs the
leases on Jan 1 2013.
Operating Lease (old rules)
The owner retains risks and rewards of ownership. The lessee pays for the
right to use it. Ie. When you rent a car. Food Barn would make not entry on
Jan 1 it would make one on Dec 31
Rent Expense 17461.51
Cash 17561.51
Capital lease (old)
Lessee has risks and rewards
When Food Barn signs the lease, it records both an asset and a liability at the
present value of the cash payments
Jan 1 2013
Leased Assets - Computer 45000
Lease Liability 45000
At the end of each year food barn must account for the lease asset and the
lease liability. Many firms treat the right to use the leased asset similarly to
the asset itself and recognize depreciation expense. Assuming straight-line
and zero salvage, Food Barn makes the following entry at the end of each
year:

Dec 31
Depreciation Expense (on Computer) 15000
Accumulated Depreciation Computer 15000
Dec 31 2013
Interest Expense 3600
Lease Liability 13861.51
Cash 17461.51
Capital lease method results in larger long-term deb and debt-equity ratios
during the life of a lease than the operating lease method. A larger debt ratio
makes a firm appear more risky. Thus, lessees prefer operating lease.
GAAP Criteria for lease accounting (old) -> to qualify for a capital lease.
1. Lease transfers ownership of the leased asset to the lessee at the end
of the lease term
2. The lease provides the lessee with a bargain purchase option
3. The lease extends for at least 75% of the assets expected useful life
4. Present val of the contractual minimum lease payments equals or
exceeds 90% of the fair value of the asset at the time the lessee signs
the lease
Accounting by the Lessor
Operating
Jan 1
Equip (computer leased to customers) 39000
Inventory 39000
Dec 31
Cash 17461.51
Rent revenue 17461
Dec 31
Depreciation Expense 13000
Accumulated dep 13000
Capital
Jan 1 2013
Lease Receivable 45000
Sales Revenue 45000
Jan 1 2013
COGS 39000
Inventory 39000

(recognizing 6000 gross margin)

Dec 31 (monthly, changes)
Cash 17461.51
Interest Revenue 3600 (0.08x45000)
Lease Receivable 13861 (45000 + 3600 17461.41)
15! Shareholders equity
1) Capital contributions: firms issue common or preferred stock to obtain
funds to finance operating and investing activities or to compensate
employees
2) Distributions: firms distribute assets to shareholders as dividends or by
repurchasing common stock
3) Earnings or losses: firms use assets financed by creditors and owners
to generate net income
Shareholders equity is a residual interest. It represents the shareholders
claim on the assets of a firm after the firm statisfies all other laims.
All corps issue common shares. Some also issue preferred shares, which has
claim that is senior to that of the common shareholders.
Common stock usually has a par or stated value. Firms report amounts
receied from issuing commo stock in excess of the par or stated value as
Additional Paid-In Capital, or Capital in Excess of Par Value.
Firms accumulate info about revenues and expeneses during a reporting
period to prepare the income statement.
Retained earnings measures the cumulative net assets generated by
earnings in excess of dividends declared.
Firms may periodically distribute net assets generated by earnings to
shareholders as a dividend.
CAPITAL CONTRIBUTIONS
- Corporations provide the owner with limited liability
o Creditors can claim only the assets of the corporate entity in the
case that the corp become insolvent
- Corp form allows firm to raise funds by issuing shares to investors
- The corp form facilitates the transfer of ownership interests because
owners can sell their shares without affefcting the ongoing operations
of the firm
Laws
-

governing rights and obligations of shareholder:

Corporate laws
Corporate charter
Corporate bylaws
Capital stock contract

Issuing capital stock:

- For cash
o Ex. Great Deal issues 1000 shares of its .10 par value common
stock for 100000
o Cash 100000
Common Stock 100
Additional Paid-In Capital 99000
- For noncash assets (to acquire another firm)
o Ex. Greate deal issues 1000 shares of its .10 par value common
stock (Fair value = 100 per share) to acquire another firms
assets having the following fair values: AR 6000, inventories
12000, land 10000, bldg. 62000, equip 10000
o AR 6000
o Inventories 12000
o Land 10000
o Bldg 62000
o Equip 10000
Commons Stock 100
Additional Paid-In Capital 99000
- For services received
o Ex. Great Deal issues 100 shares of its .10 par value common
stock to attorneys for 10000 of legal services
o Legal expense 10000
Common Stock 100
Additional Paid-In Capital 9900
Preferred Shareholders Equity
- Senior status and special rights reduce the risks of preferred
shareholders
- Therefore expect a lower return
-

Dividend rights

o Must pay all current and previously postponed preferred

dividends before it can pay common share dividends
- Call provisions
o Callable preferred shares provide the issuer with the right to
repurchase preferred shares at a speicified price
o Valuable to issuing firm
- Convertible preferred shares
o Gives holder right to convert the preferred shares into common
shares under certain conditions
CORPORATE DISTRIBUTIONS
Dividends
- Board of directors has the legal authority to declare dividends

o Legal limits
Must pay out of earnings
o Directors usually declare dividends less than the legal maximum
and therefore allow RE to increase because
Available cash did not increase by as much as the earnings,
so paying the maximum would require raising more cash
Restricting dividends in prosperous years may permit
stable or growing dividend payments in poor years
The firm may need funds for expansion of working capital
or for plant/equip
Using cash to reduce the amount of borrowings, rather
than pay dividends, may be prudent
ACCOUNTING FOR DIVIDENDS BITCHES
- Cash dividends decalred for 150000
- Retained Earnings (Dividends Declared) 150000
o Dividends Payable 150000
- When they pay it
- Dividends payable 150000
o Cash 150000
- Property dividends
- Stock dividends
o Do not affect shareholders equity
o Reallocates amounts from retained earnings to the contributed
capital accounts
- Ex. Firm has 1000000 shares of no-par common stock outstanding prior
to declaring a 5% stock dividend. The shares traded at a price of 18
per share. The 5% stock dividend resulted in the issuance of 50000
(0.05x1000000) additional shares. The journal entry to record the stock
dividend is as follows:
o Retained Earnings (Dividends declared) 900000
Common Stock no par values 900000
o The stock dividend relabels a portion of the retained earnings
that was legally available for dividend declarations as a more
permanent form of shareholders equity.
Stock Splits
1) Reduce the par value of the common stock in proportion to the new
number of shares issued.
a. A corporation may have 1000 shares of 10dollar par value stock
outstanding and exchange those shares for 2000 shares of 5 par
value stock
2) Make no change in par value but issue additional shares of the same
par value

Stock purchases