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BALIUAG UNIVERSITY

Integrated Accounting Course II


Summer 2017

MODULE 8: Bonds Payable LVC

 RELATED STANDARDS: IFRS 9 - Financial Instruments; IAS 32 - Financial Instruments: Presentation

 Definition of Term
Effective interest method - The method that is used in the calculation of the amortized cost of a financial asset or a
financial liability and in the allocation and recognition of the interest revenue or interest expense in profit or loss over the
relevant period.
Effective interest rate - The rate that exactly discounts estimated future cash payments or receipts through the expected
life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortized cost of
a financial liability.
Equity instrument - Any contract that evidences a residual interest in the assets of an entity after deducting all of its
liabilities.
Financial instrument - Any contract that gives rise to a financial asset of one entity and a financial liability or equity
instrument of another entity.
Financial asset - Any asset that is:
a. Cash
b. An equity instrument of another entity
c. A contractual right:
i. to receive cash or another financial asset from another entity; or
ii. to exchange financial assets or financial liabilities with another entity under conditions that are
potentially favorable to the entity; or
d. A contract that will or may be settled in the entity’s own equity instruments and is:
i. a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s
own equity instruments
ii. a derivative that will or may be settled other than by the exchange of a fixed amount of cash or
another financial asset for a fixed number of the entity’s own equity instruments.
Financial liability - Any liability that is:
a. A contractual obligation:
i. to deliver cash or another financial asset to another entity
ii. to exchange financial assets or financial liabilities with another entity under conditions that are
potentially unfavorable to the entity
b. A contract that will or may be settled in the entity’s own equity instruments and is:
i. a non-derivative for which the entity is or may be obliged to deliver a variable number of the
entity’s own equity instruments
ii. derivative that will or may be settled other than by the exchange of a fixed amount of cash or
another financial asset for a fixed number of the entity’s own equity instruments.
Transaction costs - Incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset
or financial liability.

 Basic principles of bonds


 A bond is a formal unconditional promise, made under seal, to pay a specified sum of money at a determinable
future date, and to make periodic interest payment at a stated rate until the principal sum is paid.
 Bonds are fixed-income debt securities.
 A bond is evidenced by a bond certificate which represents a portion of the total debt. The contractual agreement is
contained in a document called bond indenture.
 Types of debt securities issued (bonds)
1. Term bonds – Single maturity
2. Serial bonds – Series of maturity, payable in installments
3. Debenture bonds – No security/collateral
4. Asset-backed bonds – With collateral/security (i.e. mortgage bonds, collateral trust bonds)
5. Registered bonds – With registration of bondholders
6. Coupon bond/bearer bonds – Unregistered bonds, payable to holder
7. Convertible bonds – Convertible into other form of securities such as shares of stocks.
8. Callable bonds – May be called in for redemption prior to maturity.

 Initial measurement of bonds payable


 Bonds payable measured at fair value through profit or loss = fair value of the bonds at the time of issuance.
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 Bonds payable measured at amortized cost = fair value of the bonds at the time of issuance minus transaction cost
(bond issue cost).
 The fair value of the bonds payable is equal to the present value of future cash payment to settle the liability.
 Fair value of the bonds payable is the same as the issue price or net proceeds from the issue of the bonds,
excluding accrued interest.
 Net proceeds from bonds = Par value +/- premium/discount (market price) minus bond issue cost plus accrued
interest

 Subsequent measurement of bonds payable


1. Bonds payable at amortized cost
 Amortized cost of the bonds payable = initial measurement minus principal repayment, and plus discount
amortization (if any), or minus premium amortization (if any).
 Difference between the face amount and the present value of the bonds payable is treated as discount or
premium.
 Discount or premium on bonds payable is amortized to interest expense using effective interest method.

2. Bonds payable at fair value through profit or loss (irrevocable designation)


 An entity shall present a gain or loss on a bonds payable that is designated as at fair value through profit or loss
as follows:
a. The amount of change in the fair value that is attributable to changes in the credit risk of the bonds payable
shall be presented in other comprehensive income.
b. The remaining amount of change in the fair value of the bonds payable shall be presented in profit or loss.
 Amount recognized in other comprehensive income shall not be subsequently transferred to profit or loss.
Cumulative gain or loss in other comprehensive income may be transferred within equity (retained earnings).

 Premium or discount on bonds


Premium Discount
Issue price Market price > Par value Market price < Par value
Interest rate Effective rate < Stated rate Effective rate > Stated rate
Amortization Credited to interest expense Debited to interest expense

 Bond issue cost and accrued interest


 Bond issue cost is deducted from fair value of the bonds payable if it is classified as a financial liability at amortized
cost. This transaction cost is lumped with the discount on bonds payable and netted against the premium on bonds
payable.
 Bond issue cost is expensed immediately if the bonds payable is classified as financial liability at fair value through
profit and loss.
 Since the issuing corporation will pay the full periodic interest on all bonds outstanding at an interest date, the
bondholder is usually required to purchase the interest that has accrued from the most previous interest date to
the date of sale.
 This accrued interest is added to the issue price of the bond to determine the total cash proceeds from the bond
issuance.

 Retirement of Bonds
a. Retirement of bonds at maturity:
 If bonds retire at their maturity date, any premium or discount will have been completely amortized.
 The retirement is recorded as an ordinary payment of debt, and no gain or loss is recognized upon the retirement
on maturity date.
 The amount of cash paid to the bondholders equals the face value of the bonds.
b. Retirement of bonds before maturity:
 Retirement price is less than the carrying amount of the bonds, a gain on retirement of debt.
 If the retirement price is greater than the carrying value, loss on retirement of debt.
 Gain or loss on the retirement of bonds is reported in profit or loss as an operating gain or loss.
 If bonds are retired before maturity date, the following must be observed:
o The amortization of premium or discount must be updated to determine the carrying amount of the bonds
at the date of retirement.
o Any accrued interest on the retired bonds from the most recent interest payment date up to date of
retirement must be recorded and paid.

 Treasury bonds
 Treasury bonds are an entity’s own bonds originally issued and reacquired but not canceled.

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 When treasury bonds are acquired, the “treasury bonds account” is debited at face value and any related unamortized
premium or discount or issue cost is canceled.
 Acquisition cost is less than the carrying amount of the bonds, gain on acquisition of treasury bonds.
 Acquisition cost is greater than the carrying amount of the bonds, loss on acquisition of treasury bonds.
 Treasury bonds are reported in the statement of financial position as a deduction from bonds payable.

 Bond refunding
 Bond refunding is the floating of new bonds payable the proceeds from which are used in paying the original bonds
payable.
 Bond refunding is the premature retirement of the old bonds payable through the issuance of new bonds payable.
 The refunding charges include the unamortized bond discount or premium, unamortized bond issue cost and
redemption premium on the bonds being refunded.
 IFRS 9, provides that bond refunding is an extinguishment of a financial liability. Further provides that the difference
between the carrying amount of the financial liability extinguished and the consideration paid shall be included in
profit or loss.
 Accordingly, the refunding charges shall be accounted for as loss on early extinguish of debt.

 Compound financial instruments


 The issuer of a non-derivative financial instrument shall evaluate the terms of the financial instrument to determine
whether it contains both a liability and an equity component. Such components shall be classified separately as
financial liabilities, financial assets or equity instruments. (IAS 32)
 According to IAS 32, an entity recognizes separately the components of a financial instrument that:
a. Creates a financial liability of the entity.
b. Grants an option to the holder of the instrument to convert it into an equity instrument of the entity.
 The issue price of the convertible component is comprised of two components: a financial liability and an equity
instrument.
 The total issue price to be bifurcated using the residual approach.
 The carrying amount of the equity instrument represented by the option to convert the instrument into ordinary
shares is then determined by deducting the fair value of the financial liability from the fair value of the compound
financial instrument as a whole. (IAS 32)

1. Bonds with warrants


 Corporations may issue bonds that allow creditors to ultimately become shareholders by either attaching
share warrants to the bonds or including a conversion feature in the bond indenture.
 In either case, the investor has acquired a dual set of rights, namely: the right to receive interest and principal
payment on the bonds and the right to acquire ordinary shares and participate in the potential appreciation
of the market value of the shares.

2. Convertible bonds
 Convertible bonds give the holders thereof the right to exchange their bondholding into ordinary shares or
other securities of the issuing company within a specified period of time.
 The principle of splitting the issue price of a compound financial instrument to its debt component and equity
component is applied.

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Illustrative Problems

1. Defined by IAS 32 as any contract that evidences a residual interest in the assets of an entity after deducting all of
its liabilities.
A. Financial instrument C. Financial liability
B. Financial asset D. Equity instrument
2. Defined by IAS 32 as any contract that gives rise to a financial asset of one entity and a financial liability or equity
instrument of another entity.
A. Financial instrument C. Financial liability
B. Financial asset D. Equity instrument
3. According to the definition of financial asset, financial asset does not include
A. Cash
B. Equity instrument of the issuing entity
C. A contractual right to receive cash or another financial asset from another entity
D. A contract that will or may be settled in the entity’s own equity instruments
4. Which of the following is least likely to be considered a financial instrument?
A. Deferred revenues C. Trade accounts
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B. Cash in bank D. Debt securities
5. Debentures are
A. Term bonds C. Unsecured bonds
B. Serial bonds D. Secure bonds
6. Costs incurred in connection with the issuance of 10-year bonds which is sold at a slight premium shall be
A. Charged to retained earnings when the bonds are issued
B. Expensed in the year in which incurred
C. Capitalized as organization cost
D. Reported in the statement of financial position as a deduction from bonds payable and amortized over the 10-
year bond term
7. Which of the following statements is true in relation to the fair value option of measuring a bond payable?
I. At initial recognition, an entity may revocably designate a bond payable at fair value through profit or loss.
II. The bond payable is remeasured at every year-end at fair value and any changes in fair value are recognized in
other comprehensive income.
A. I only C. Both I and II
B. II only D. Neither I nor II
8. After initial recognition, bonds payable shall be measured at
I. Amortized cost using the effective interest method.
II. Fair value through profit or loss
III. Fair value through other comprehensive income
A. I and II C. II and III
B. I and III D. I,II and III
9. How would the amortization of premium affect the carrying amount of bonds payable and net income, respectively
A. Increase and increase C. Decrease and increase
B. Decrease and decrease D. Increase and decrease
10. The amortization of discount on a term bonds payable using effective interest method will lead to
A. Decreasing interest expense and decreasing carrying amount of bonds over time.
B. Increasing interest expense and increasing carrying amount of bonds over time.
C. Decreasing interest expense and increasing carrying amount of bonds over time.
D. Increasing interest expense and decreasing carrying amount of bonds over time.
11. Bonds issued at a premium
A. Effective rate exceeds the nominal rate C. Effective rate and nominal rate are equal
B. Nominal rate exceeds effective rate D. No relationship between the two rates
12. An entity issued a bond with stated rate that is less than the effective rate. Bond issuance date coincides with
interest date. The entity should report on the first interest payment
A. An interest expense that is less than the cash payment
B. An interest expense that is greater than cash payment
C. A debit to discount on bonds payable
D. A debit to premium on bonds payable
13. At the beginning of the first year, an entity issued bonds at a discount. The entity incorrectly use straight line
method instead of effective interest method of amortization. How would the following be affected at year-end of
the first year?
Carrying amount of bonds Retained earnings
A. Overstated Understated
B. Understated Overstated
C. Overstated Overstated
D. Understated Understated
14. A five-year term bond was issued on January 1 of year 1 at a premium. The carrying amount of the bonds on
December 31 of year 2 would be
A. Higher than the carrying amount on January 1 of year 1.
B. Higher than the carrying amount on December 31 of year 1.
C. Higher than the carrying amount on December 31 of year 3.
D. Lower than the carrying amount on December 31 of year 3.
15. When using effective interest method of amortization, the periodic amortization on a term bond would
A. Increase if the bonds were issued at a discount.
B. Decrease if the bonds were issued at a premium.
C. Increase whether the bonds were issued at a discount of premium.
D. Decrease whether the bonds were issued at a discount of premium.
16. When bonds issuance includes payment of bond issue cost, the bond issue cost
A. Increases both bond discount and carrying amount of bonds payable.
B. Increases both bond premium and carrying amount of bonds payable.
C. Increases bond premium and decreases carrying amount of bonds payable.
D. Increases bond discount and decreases carrying amount of bonds payable.
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17. There would be a loss on early retirement of bonds payable if
A. Retirement price exceeds carrying amount of bonds payable
B. Carrying amount of bonds payable exceeds retirement price
C. The bonds were originally issued at a discount.
D. The bonds were originally issued at a premium.
18. Gain or loss on the retirement of bonds is
A. A component of other comprehensive income C. Part of a share premium
B. Direct adjustment to retained earnings D. Recognized in profit or loss
19. The floating of new bonds payable the proceeds from which are used in paying the original bonds payable.
A. Treasury bond C. Early retirement of bond
B. Bond refunding D. Bond refinancing
20. Which of the following is an example of compound financial liability
A. Treasury bonds C. Share warrants
B. Preference shares D. Convertible bonds
21. When cash proceeds from bonds issued with warrants exceeds the fair value of the bonds without the warrants, the
excess shall be credited to
A. Share capital C. Retained earnings
B. Share premium D. Premium on bonds payable
22. On March 01, Year 1. Lagpak Inc. issued at 102 plus accrued interest, 1,000 of its 9% P1,000 par value bonds. The
bonds are dated January 01, Year 1 and mature on January 01, Year 11. Interest is payable semi-annually every June
30 and December 31. Lagpak paid transaction costs directly attributable to bond issuance amounting to P5,000. The
company elected the fair value option of measuring financial liabilities. The bonds are quoted at 103 on December
31, Year 1. Realized net cash flow from the bond issuance would be
A. 1,025,000 C. 1,040,000
B. 1,030,000 D. 1,045,000
23. Refer to the preceding problem. What amount of gain/(loss) from change in fair value of bonds would the entity
recognized for Year 1.
A. 15,000 gain C. 10,000 gain
B. 15,000 loss D. 10,000 loss
24. A 12%, P1 million total par value bonds were issued for P1,049,737 and yielded 10% effective rate. The bond was
issued on March 1, Year 1 and matures after 3 years. Interest is payable every March 31. What is the interest
expense to be recognized for Year 2?
A. 104,973 C. 101,818
B. 103,471 D. 103,722
25. Refer to the preceding problem. What is the carrying amount of bonds on December 31, Year 2?
A. 1,034,711 C. 1,020,937
B. 1,037,215 D. 1,018,182
26. Nga-nga Corp. issued a total of P4 million par value bonds on January 01, Year 1. Nominal interest is 10% and effective
interest is 9%. Interest is payable annually every December 31 and the bonds will mature on December 31, Year 4.
Pertinent present value factors are as follows:
9% 10%
Present value of 1 for 4 periods 0.70843 0.68301
Present value of ordinary annuity of 1 for 4
periods 3.23972 3.16987
What is the issue price of the bonds?
A. 4,000,000 C. 4,129,608
B. 4,400,000 D. 4,119,520
27. Refer to the preceding problem. What amount of interest expense would be recognized for Year 1?
A. 371,665 C. 366,335
B. 369,115 D. 363,305
28. Refer to the preceding problem. What is the carrying amount of the bonds payable on December 31, Year 1?
A. 4,129,608 C. 4,070,387
B. 4,101,273 D. 4,036,722
29. Refer to the preceding problem. After interest and principal payments of the bonds on December 31, Year 2, the
40% of the bonds were retired at 99. What amount of gain/(loss) on early retirement of bonds would be
recognized?
A. 44,155 loss C. 56,509 loss
B. 44,155 gain D. 56,509 gain
30. Lagota Co. issued a total of P4 million par value bonds on January 01, Year 1. Nominal interest is 9% and effective
interest is 10%. Interest is payable annually every December 31. Likewise, the bonds mature annually for four years
in equal installments beginning December 31, Year 1. Pertinent present value factors are as follows:

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9% 10%
Present value of ordinary annuity of 1 for 4
periods 3.23972 3.16987
Present value of 1 for 1 period 0.91743 0.90909
Present value of 1 for 2 periods 0.84168 0.82645
Present value of 1 for 3 periods 0.77218 0.75131
Present value of 1 for 4 periods 0.70843 0.68301
What is the issue price of the bonds?
A. 3,916,991 C. 1,973,559
B. 2,948,690 D. 3,948,690
31. Refer to the preceding problem. What is the interest expense for Year 2
A. 391,699 C. 294,869
B. 360,000 D 270,000
32. After interest and principal payments of the bonds on December 31, Year 2, the remaining bonds were reacquired
at 99. What amount of gain/(loss) on acquisition of treasury bonds would be recognized?
A. 6,441 loss C. 21,310 loss
B. 6,441 gain D. 21,310 gain
33. During Year 1, Royal Corporation issued at 95, one thousand of its 8%, P5,000 par value bonds due in 10 years. One
detachable share warrants entitling the holder to buy 20 ordinary shares (P50 par) of Royal’s ordinary shares for
P55.was attached to each bond. Shortly after issuance, the bonds are selling at 10% ex-warrant, and each warrant is
quoted P60. The PV of 10% for an ordinary annuity of P1 for 10 periods is 6.145 and the PV of P1 at 10% for 10
periods is 0.385. What amount of the proceeds from bond issuance will be recorded as part of shareholders’
equity?
A. 60,000 C. 250,000
B. 225,000 D. 367,000
34. Refer to the preceding problem. If the warrants were exercised, the journal entry to record the exercise of warrants
would include a credit to share premium - ordinary amounting to
A. 100,000 C. 467,000
B. 327,000 D. none
35. On January 1, Year 1, Trader Company issued its 8%, 5-year convertible bonds with face amount of P6 million for
P5,900,000. Interest is payable every December 31. The debt instrument is convertible into 50,000 ordinary shares
with P100 par. When the bonds were issued, the prevailing market rate for similar debt without conversion option
is 10%. (Use 4 decimal places for PV factors) What is the portion of the proceeds representing the component of
equity?
A. None C. 355,016
B. 100,000 D. 454,800
36. When the conversion option was exercised, the bonds have carrying amount of P5,850,000. The journal entry on
the exercise of the conversion privilege will include a credit to share premium amounting to
A. 850,000 C. 504,320
B. 353,470 D. 1,205,016

- End of discussion

“The only person who is educated is the one who has learned how to learn and change.” - Carl Rogers

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