AC3103 SEMINAR 6

Supplementary Material
REVIEW FOR ACCOUNTING FOR BONDS AND
COMPOUND FINANCIAL INSTRUMENTS

From an issuer perspective:

 Review the accounting for bonds and compound instruments:
 Initial measurement of bonds/compound instruments upon issuance
 Subsequent measurement
 application of effective interest method to derive interest expense
 conversion of compound instruments

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RECORDING THE ISSUANCE OF BONDS

Company J sells bonds with a face value of $400,000

on the authorization date at 102.
Cash ($400,000 x 1.02) 408,000
Bonds Payable 400,000
Premium on Bonds Payable 8,000

Company M sells bonds with a face value of

$400,000 on the authorization date at 97.
Cash ($400,000 x .97) 388,000
Discount on Bonds Payable 12,000
Bonds Payable 400,0003
FRS 39 SUBSEQUENT MEASUREMENT

 For the bonds issuer, what are the subsequent journal

entries :
 For financial liabilities after initial recognition, para 47 provides
that all financial liabilities, other than “fair value through profit
or loss”, should be measured at amortized cost using the
effective interest method.
 FRS 39 requires the use of effective interest method
Interest amount as determined by market =
(Effective rate * Outstanding balance of the debt)
 Best to use Amortization schedule to work out the
balances!
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 EFFECTIVE INTEREST METHOD

Jet Company sold bonds of $100,000 face value on

January 1, 2007. The 12% bonds are sold for
$107,721.71 to yield a market rate of 10%. Interest is
paid semiannually.

At issuance:
Cash 107,721.71
Bonds Payable 100,000.00
Premium on Bonds Payable 7,721.71

How do we account using the effective interest rate method for the issuer under
FRS 39 requirements?
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Jet Company sold bonds of $100,000 face value on
January 1, 2007. The 12% bonds are sold for $107,721.71
to yield a market rate of 10%. Interest is paid
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semiannually.
Determining Interest Expense: Effective Interest
Method
The first interest payment is made on June 30.

Premium on Bonds Payable 613.91

Interest Expense 5,386.09
Cash 6,000.00
Continued

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Determining Interest Expense: Effective Interest
Method
Jet Company records the second interest payment on
December 31, 2007.

Interest Expense 5,355.39

Premium on Bonds Payable 644.61
Cash 6,000.00

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EFFECTIVE INTEREST METHOD (BOND DISCOUNT)
Getty Company sold bonds of $100,000 face
value on January 1, 2007. The 12% bonds are
sold for $92,976.39 to yield a market rate of 14%.
Interest is paid semiannually.

At issuance:
Cash 92,976.39
Discount on Bonds Payable 7,023.61
Bonds Payable 100,000.00

How do we account using the effective interest rate method for the issuer under
FRS 39 requirements? 9
Getty Company sold bonds of $100,000 face value on January
1, 2007. The 12% bonds are sold for $92,976.39 to yield a
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market rate of 14%. Interest is paid semiannually.
COMPOUND FINANCIAL INSTRUMENTS

 FRS 32, Para 29 defines a financial instrument that, from

the issuers’ perspective, contains both a liability and an
equity element.
 Two major types of compound financial instruments:
 Convertible bonds: bonds which can be converted into other
corporate securities (e.g., equity shares) at a stipulated
conversion rate during some specified period of time after
issuance.
 Bond with detachable warrants: bonds issued with warrants,
which are basically long-term options to buy equity shares at
a fixed price during a specified period of time. Warrants are
detachable and subsequent to the issue of debts, can be sold
to other investors.

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COMPOUND FINANCIAL INSTRUMENTS
 FRS 32, Para 28 requires separate recognition
of the equity and liability components.
 Separate liability and equity reporting is
generally referred to as “split accounting”.

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Compound Financial Instruments

 FRS 32, Para 31 requires the issuer to first

measure the liability component which is equal
to the fair value of a similar financial liability
without the associated equity component.
 The carrying amount of the equity component is
then determined by deducting the fair value of
the financial liability from the fair value of the
compound financial instrument as a whole.
 This is commonly known as the incremental
method of accounting.

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Compound Financial Instruments

Compound Financial Instrument F.V. (Total Proceeds)

– Liability F.V. (similar type without equity)
= Equity Component F.V.

 FRS 32, Para 31 notes that the sum of the carrying

amounts assigned to the liability and equity components
on initial recognition is always equal to the fair value
that would be ascribed to the instrument as a whole.
 No gain or loss arises from initially recognizing the
components of the instruments separately.

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CONVERTIBLE BOND ILLUSTRATION

On 1 January 2001, Matrix Ltd. issued $100,000,000

of 4% convertible bonds for $100,000,000. Assume
that the fair market interest rate was 6% p.a. and
that a straight debt with a face value of
$100,000,000 and coupon rate of 4% could be sold
for $90,000,000.

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CONVERTIBLE BOND ILLUSTRATION

Value of equity

= Total Proceeds – Amount attributable to Liability

= 100mil - 90mil = $10mil

On 1Note
 that Matrix
January 2001,Ltd. suffersLtd.
Matrix a discount
issuedon$100,000,000
the bond issue,
as follows:
of 4% convertible bonds for $100,000,000. Assume
Principal amount on bond to be repaid = 100mil
that the of
Fair value fair market interest rate
bonds was 6% p.a. and
= 90mil
thatonaconvertible
Discount straightbonddebt with=a 10milface value of
 $100,000,000 and coupon
This discount needs rate using
to amortized of 4%effective
could interest
be sold
rate method. for $90,000,000. 16
CONVERTIBLE BOND ILLUSTRATION
Journal entries on 1.1.2001 on date of issue - to record bond
element at the date of issue:

Dr Cash 90,000,000
Dr Bond discount 10,000,000
Cr 4% Bonds payable 100,000,000
Journal entries on 1.1.2001 on date of issue - to record equity
element at the date of issue:

Dr Cash 10,000,000
Cr Capital Reserve 10,000,000
Note: Alternatively, you can combine the two sets of entries together. 17
CONVERTIBLE BOND ILLUSTRATION

 On 31/12/2001 to record interest payment and interest expense:

Dr Interest Exp. ($90mil x 6%) 5,400,000
Cr Cash ($100mil x 4%) 4,000,000
Cr Bond discount 1,400,000
(Note: effective interest method is used to amortize bond discount)

 On 31/12/2002 to record interest payment and interest expense:

Dr Interest Exp ([$90mil + $1.4mil] x 6%) 5,484,000

Cr Cash ($100mil x 4%) 4,000,000
Cr Bond discount 1,484,000

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CONVERTIBLE BOND ILLUSTRATION

Assume on 1 Jan. 2003, 10% of the convertible bonds

was converted to common shares at the rate of $1 of
convertible bond for one $1 common share.
Journal Entries on conversion of bond
Dr Bond Payable $10,000,000
Dr Capital Reserve 1,000,000
Cr Bond discount a 711,600
Cr Share capital 10,288,400

a. Balance of bond discount on 1 Jan 2003 is

$10,000,000 – 1,400,000 – 1,484,000 = $7,116,000. 19

(10% of 7,116,000 is $711,600)

BONDS WITH DETACHABLE WARRANTS

 Stock warrants provide the option to purchase a

specified number of shares of common stock at a
specified option price per share within a stated
period.
 A portion of the selling price of the bonds is
allocated to the detachable stock warrants.

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BONDS WITH DETACHABLE WARRANTS

Matrix issues at par 10,000, $1,000 face value, 8% debt with

detachable warrants that permit the holder to purchase one
share of stock for $18 per share. Immediately after the issue
the bonds were selling for 98.

Incremental Method
Fair value of bonds without warrants $ 9,800,000
Amount allocated to warrants 200,000

Journal entry at date of issuance of the bonds:

Cash 10,000,000
Discount on bonds payable 200,000

Bonds payable 10,000,000

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Capital Reserve – Warrants 200,000
BONDS WITH DETACHABLE WARRANTS

Matrix issues at par 10,000, $1,000 face value, 8% debt with

detachable warrants that permit the holder to purchase one
share of stock for $18 per share. Immediately after the issue
the bonds were selling for 98.
Assume that all 10,000 warrants are exercised and
Matrix received $180,000 (10,000 × $18 per
share) and issues 10,000 shares of common stock.

Date Description Debit Credit

Cash 180,000
Capital reserves - stock warrants 200,000
Share capital 380,000
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