Bonds
Self Test
Intermediate Accounting 2
Self Test
Click the “Check Your Answer” box below each problem to reveal the correct answer and explanation.
1. A bond payable occurs when
a. the company borrows from a bank
b. the company borrows from a financing company
c. the company borrows from investors
d. all of the above
Answer
C. A bond payable is borrowing monies from investors. (a. & b.) is normally called long term debt or notes payable.
2. The maturity value is
a. the amount of cash exchanged when the bond is issued
b. the fair market value of the bonds at the end of the current period
c. the net amount owed at the end of every period
d. the amount that must be repaid on the maturity date
Answer
D. Maturity value is the amount that must be repaid on the maturity date. It is set by the bond contract and does not change.
3. The maturity date is
a. the date interest is paid
b. the date the maturity value must be repaid
c. the date fair market value must be repaid
d. the date the bond is issued
Answer
B. The maturity date is the date the maturity value must be repaid. The maturity date and maturity amount are set in the bond contract.
4. The stated annual interest rate is
a. the same each period
b. the rate that determines the amount of cash paid
c. the rate that is stated in the bond contract
d. all of the above
Answer
D. The stated annual interest rate is also referred to as the coupon rate. It determines the amount of cash that will be paid periodically, is stated in the bond contract, and will not change.
5. The annual market yield/effective rate is
a. the annual rate the investor earns
b. the annual rate that determines the amount of cash paid
c. a rate that is stated in the bond contract
d. all of the above
Answer
A. The annual market yield/effective rate is the rate the investor earns. The investor will determine this rate by the amount of cash invested on the issue date or on the trade date. The market rate will change as economic or risk factors change. It is not stated in the bond contract. This rate will be different than the stated rate unless the bond is issued at par.
6. The market yield/effective interest rate will
a. never change
b. change when economic or risk factors change
c. determine the amount of cash paid to the investor
d. is determined by the maturity value of the bond
Answer
B. The market rate changes when economic or risk factors change. This rate will change constantly on market exchanges. The amount of cash paid to the investor is determined by the stated (coupon) rate.
7. An investor who pays $800 for a bond with a maturity value of $1,000 will earn
a. a higher rate of return than the stated rate
b. a lower rate of return than the stated rate
c. a higher rate of return than the market effective rate
d. the same rate of return as the stated rate
Answer
A. The cash received annually from the bond for interested is stated in the contract and will not change. It is the maturity value x stated %. When the investor pays less, the interest rate earned (effective market yield) is higher.
Remember: Pay less = Earn more Pay more = Earn less
8. A discount occurs when
a. cash exchanged is less than face value
b. cash exchanged is more than face value
c. cash exchanged is the same as face value
d. the market effective yield is lower than the stated rate of return
Answer
A. A discount occurs when the cash received by the company is lower than the maturity value. This also causes a higher effective interest rate.
9. A premium occurs when
a. cash exchanged is less than face value
b. cash exchanged is more than face value
c. cash exchanged is the same as face value
d. the market effective yield is higher than the stated rate of return
Answer
B. A premium occurs when the cash received by the company is higher than the maturity value. This also causes a lower effective interest rate.
10. A bond that is issued at par will
a. always have cash paid for interest equal to interest expense incurred
b. always have cash paid for interest higher than interest expense incurred
c. always have cash paid for interest lower than interest expense incurred
d. have an effective market yield higher than the stated rate of return
Answer
A. A bond issued at par means the cash exchanged is equal to the maturity value. The stated rate is equal to the effective market rate. When the rates are the same, cash paid for interest will equal interest expense. The stated rate is the decrease to cash and the effective rate is the increase to interest expense.
11. What amount must always be repaid on the maturity date?
a. maturity rate
b. maturity value
c. maturity yield
d. maturity fair market value
Answer
B. The maturity value must be repaid on the maturity date. Both are stated in the bond contract.
12. A bond issued at a price of 96 can be purchased at
a. 96% of fair market value
b. 96% of the maturity value
c. 0.96% of the current market interest rate
d. 0.96% of the current stated interest rate
Answer
B. The price of the bond is stated as a % of maturity value. To determine the amount of cash exchanged when the bond is issued, make the number a % and multiply the % by the maturity value.
13. The market price of a bond on any given date is
a. the present value of future cash flows
b. always the fair market value on the date of issue
c. the present value of past cash flows
d. the original issue price
Answer
A. The bond price is equal to the present value of cash interest payments plus the present value of the amount received when the bond is repaid (the maturity value). The bond price will change as market interest rates change.
14. When recording the issuance of a bond, the amount owed is always recorded
a. as a credit (increase) to bonds payable at the expected fair market value on the maturity date
b. as a credit (increase) to bonds payable at the maturity value
c. as a debit to a premium
d. as a debit to a discount
Answer
B. The bond payable is always recorded for the maturity value amount. A premium (credit) occurs when cash exchanged is higher than maturity value. A discount (debit) occurs when cash exchanged is lower than maturity value.
15. Interest expense will be greater than cash paid for interest when
a. the bond is issued at par
b. the bond is issued at a discount
c. the bond is issued at a premium
d. the bond is issued at maturity value
Answer
B. Interest expense is the effective market rate times the amount of cash exchanged. When the effective market rate is higher than the coupon rate, interest expense will be higher than cash paid. The amount of cash exchanged is lower than maturity value when there is a discount.
16. The purpose of the amortization schedule is to
a. determine the price of the bond
b. determine interest expense for each period
c. determine the amount of cash paid for interest
d. determine the maturity value of the bond
Answer
B. The amortization schedule is used to determine interest expense. Interest expense changes each period as the net amount owed changes. The price of the bond is determined by the market rate at the time (a.) The amount of cash paid and the maturity value of the bond is stated in the contract (c. & d.).
17. The difference in cash paid for interest and interest expense when the bond is issued at a premium will always
a. decrease the net amount owed to the investor
b. increase the net amount owed to the investor
c. not affect the net amount owed to the investor
d. change the maturity value by this amount
Answer
A. A premium means that cash exchanged is higher than the maturity value. The difference is reduced as cash paid for interest is higher than interest expense. A bond issued at a premium is issued at a higher price than maturity value and must decrease to get to maturity value by the maturity date.
18. The amount recorded for interest expense is the amount in which column on the amortization schedule?
a. carrying value
b. discount/premium
c. effective interest
d. stated interest
Answer
C. The effective interest column always gives the amount recorded as an increase to interest expense. (a.) is the net amount owed to the investor. (b.) is the difference between cash exchanged and the maturity value. (d) is used to determine the amount of cash that is paid to the investor periodically.
19. The amount paid for interest is the amount in which column on the amortization schedule?
a. carrying value
b. discount/premium
c. effective interest
d. stated interest
Answer
D. The amount paid for interest is the amount in the stated interest column. The amount is computed as maturity value x stated interest % / # payments each year. This amount will be the same for each period.
20. The amount the bonds payable account is decreased when a bond is repaid prior to maturity date is
a. the maturity value
b. the carrying value on the date of repayment
c. the fair market value on the date of repayment
d. the agreed upon amount stated in the contract
Answer
A. The bond payable account is always at maturity value. When the bond is repaid, the total maturity value is removed from the account. The premium/discount must also be removed for the amount on the date of repayment. The full net amount of the bond on the date of repayment is removed from the books.
21. When a bond is issued after the original issue date
a. no interest is paid or received
b. the issuer receives the accrued interest on the bond on the actual issue date
c. the investor receives the accrued interest on the bond on the actual issue date
d. interest is incurred prior to the actual issuance date
Answer
B. When a bond is issued during the interest period, the issuer receives the accrued interest on the bond. The issuer must pay the full amount of the coupon even though the full period’s interest is not earned by the investor. The full amount paid less the amount received at issuance results in the investor being paid for the amount of time the funds have been borrowed by the issuer. No interest is incurred prior to the actual issuance date.
22. A convertible bond
a. is the only type of bond that can be sold at any time by the investor
b. is always convertible at the option of the issuer
c. is a bond that will always be repaid in common stock
d. is a bond that may be repaid in common stock at the option of the investor
Answer
D. A convertible bond may be repaid in common stock and this is at the option of the investor. A convertible bond has the same features as any other bond except the company may repay in common stock rather than cash at the option of the investor.
23. A callable bond
a. is the only type of bond that can be sold at any time by the investor
b. is callable at the option of the issuer
c. is a bond that will never be repaid prior to the maturity date
d. is a bond that is always secured by the assets of the issuer
Answer
B. A callable bond may be repaid at the option of the issuer in accordance with the terms of the bond agreement. A bond that is called is repaid prior to the maturity date.
24. The price of the bond is equal to
a. the present value of future cash flows at the stated rate
b. the present value of expected future cash flows at the effective rate
c. the present value of the maturity value
d. the present value of cash paid for interest
Answer
B. The price of a bond is equal to the present value of future cash flows (cash paid periodically for interest and cash paid at maturity) at the effective rate.
25. Interest expense accrued at year end should be equal to
a. interest incurred from the last time interest expense was recorded
b. the change in the net amount owed for the period
c. interest paid for the time interest has been incurred
d. interest incurred less interest paid on the last payment date
Answer
A. The accrual for interest expense should always be equal to the amount incurred for the period of time that has passed since the last time interest expense was recorded. Interest expense is always based on the effective rate, not the stated rate that is paid.