INTERMEDIATE ACCOUNTING II (AE 16)

LEARNING MATERIAL

UNIT NUMBER/ HEADING: BONDS PAYABLE

LEARNING OUTCOMES:
At the end of the unit, the students will be able to:
a. Discuss and explain the concepts, principles and issues on bonds payable;
b. Identify the different types of bonds;
c. Demonstrate the proper accounting of bonds

INTRODUCTION:
Whenever funds being borrowed are obtained from a small number of sources,
mortgages or notes are usually used. However, when large amounts are needed, an entity
may have to borrow from the general investing public through the use of bond issue.
In this module, we will learn how are bonds payable being treated and presented in the
entity’s books and financial statements.

Activating Prior Learning

Let us learn some basic about bonds by watching this video.

https://www.youtube.com/watch?v=IuyejHOGCro

Presentation of Content

DEFINITON
 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.
 In simple language, it is a contract of debt whereby one party called issuer
borrows funds from another party called the investor.
 It is evidenced by a bond certificate or indenture between the issuer and the
lender.
 A bond indenture is a contract that lists the features of the bond, such as the
amount of the money that will be repaid in the future, called the principal (or face
value or maturity value); the maturity date which is the day the bond holder will
receive the principal amount; and the stated rate, which is the rate of interest the
issuer agrees to pay the bondholder throughout the term of the bond. A sample is
presented below.

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TYPES OF BONDS
a. As to maturity of the bonds
 Term Bonds are bonds with a single date of maturity
 Serial bonds are bonds with a series of maturity dates instead of a single one,
usually in installments.
b. As to security of the bonds
 Mortgage bonds are bonds secured by a mortgage on real properties
 Collateral trust bonds are bonds secured by shares and bonds of other
corporation
 Debenture bonds are unsecured or bonds without collateral security
c. As to registration
 Registered bonds require the registration of the name of the bondholder on the
books of the corporation
 Coupon or bearer bonds are unregistered bonds; names of the bondholder is
not recorded in the entity’s books
d. Other types
 Convertible bonds are bonds that can be exchanged for shares of the issuing
entity
 Callable bonds are bonds which may be called in for redemption prior to the
maturity date.
 Guaranteed bonds are bonds issued whereby another party promises to pay if
the borrower fails to do so.
 Junk bonds are high-risk, high-yield, bonds issued by entities that are heavily
indebted or otherwise in weak financial condition
 Zero coupon are bonds that pay no interest but the bonds offer a return in the
form of ‘deep discount’ or huge discount from the face amount
Features of bond issue
a. A bond indenture or deed of trust is the document which shows in detail the terms
of the loan and the rights and duties of the borrower and the other parties to the
contract.
b. Bond certificates are used. Each bond certificate represents a portion of the total
loan. The usual minimum denomination in business practice is P1,000.
c. If property is pledged as security for the loan, a trustee is named to hold the title to
the property serving as security.
d. A bank or trust entity is usually appointed as registrar or disbursing agent.

Initial measurement of bonds payable

 Bonds payable that are not designated at fair value through profit or loss (FVPL) shall
be measured initially at fair value(present value of the future cash payments to settle
the bond liabity) minus transaction costs that are directly attributable to the issue
of the bonds payable.
 Bond issue cost shall be deducted from the fair value or issue price of the bonds
payable but it is expensed if the bonds is designated at FVPL

Fair value = Issue Price/ Net Proceeds ex. Accrued interest

2
Subsequent measurement
 PFRS 9 provides that bonds payable shall be measured subsequently either:
a. At amortized cost, using the effective interest method
initial measurement - principal payment ± premium or discount

b. At fair value through profit or loss (FVPL)

Accounting for issuance of bonds

There are two approaches in accounting for the authorization and issuance of bonds, namely:
a. Memorandum approach
b. Journal entry approach

 Bonds can be issued at a premium (sales price > face amount) or at a discount (sales
price < face amount)
**recall the important notes we have discussed in Intermediate Accounting I last semester regarding premium and
discount including nominal and effective interest. Those will greatly help you again in this topic discussion.  E:D
= N:P
 Bond issue costs are transaction costs directly attributable to the issue of bonds
payable. Under the effective interest method, it should be “lumped” with the discount
on bonds payable and “netted” against the premium.
Illustration:
An entity issued bonds with face amount of P5,000,000 at 105.
The journal entry to record this transaction is:

Cash (P5,000,000 x 105%) P5,250,000

Bonds payable P5,000,000
Premium on bonds payable P 250,000

Assuming that the bonds are issued at a quoted price of 95. The journal entry would be:

Cash P4,750,000
Discount on notes payable P 250,000
Bonds payable P5,000,000

Issuance of bonds on interest date

On June 1, 2020, an entity sold bonds with the face amount of P5,000,000 at 97 and 12%
interest payable semiannually on June 1 and December 1. The bonds mature in 5 years.
In as much as the bonds are sold on March 1, 2020, the first payment of interest will be on
September 1, 2020.

Journal entries
2020
June 1 Cash (P5M x 97%) P4,850,000
Discount on Bonds Payable P 150,000
Bonds Payable P5,000,000

Dec. 1 Interest Expense (P5M x 12% x 6/12) P300,000

Cash P300,000

Dec. 31 Interest Expense (P5m x 12% x 1/12) P50,000

Accrued Interest Payable P50,000
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 Dec. 31 Interest Expense P17,500
Discount on bonds payable P17,500

Amortization of bond discount from June 1 to Dec 31

(P150,000/5 years = P30,000/year x 7/12 = P17,500)

Issuance of bonds between interest dates

On April 1, 2020, an entity issued bonds with face amount of P5,000,000 at P5,288,000 plus
accrued interest. The bonds are dated January 1, 2020 and mature in 5 years and pay 12%
interest semiannually on January 1 and July 1. To record the issue of the bonds on April 1,
2020:

Cash P5,378,000
Bonds payable P5,000,000
Premium on bonds payable P 228,000
Interest expense P 150,000

Issue price P5,288,000

Accrued interest from Jan. 1 to April 1 P 150,000
Total cash received P5,378,000

**Note that if the bonds are issued between interest dates, an accrued interest is involved.

Treasury bonds
 These are an entity’s own bonds originally issued and reacquired but not canceled.
 Should be debited at face amount and any unamortized premium or discount should
be canceled and any accrued interest paid is charged to interest expense
Bond refunding
 Floating of new bonds the proceeds from which are used in paying the original bonds
 Premature retirement of the old bonds by means of issuing new bonds
 Also known as bond refinancing
 When made on the date of maturity of the old bonds, no accounting problem arises
as this would simply call for the cancellation of the bond liability
 When made before the maturity date consideration must be given to the refunding
charges (unamortized bond discount or premium and redemption premium) pertaining
to the old bonds. this shall be charged to loss on extinguishment
 Shall be accounted for as an extinguishment of a financial liability.

Illustration:
1. Issuance of new 10-year 10% bonds, with face amount of P1,500,000 for P1,600,000.
2. Refunding of old 12% bonds, with remaining life of 4 years, at 102.
Bonds payable – old P1,000,000
Discount on bonds payable P 30,000
Retirement price (P1,000,000 x 102) P1,020,00

Journal entries
1. To record the issuance of the new bonds payable:

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 Cash P1,600,000
Bonds Payable P1,500,000
Premium on bonds payable P 100,000

2. To record the retirement of the old bonds payable:

Bonds payable P1,000,000

Loss on extinguishment of bonds P 50,000
Cash P1,020,000
Discount on bonds payable P 30,000

The loss on extinguishment of bonds is represented by the refunding charges of

P50,000

Unamortized discount P30,000

Redemption premium(P1,000,000 x 2%) P20,000
Total refunding charges P50,000

or

Bond Payable P1,000,000

Discount on bonds payable (P 30,000)
Carrying amount P 970,000
Retirement price (P1,020,000)
Loss on extinguishment (P 50,000)

Amortization of bond discount or premium

There are three approaches in amortizing bond premium or bond discount, namely:
a. Straight line
- equal amortization of bond premium or bond discount
- Bond Premium or Discount ÷ life of the bonds
b. Bond outstanding method
- applicable to serial bonds

Illustration 1:
Face amount of bonds P5,000,000
Issue price P5,300,000
Date of bonds January 1, 2020
Date of issue January 1, 2020
Interest rate 12%
Semiannual interest dates June 30 and Dec. 31

The bonds mature on every December 31 of each year at the rate of P1,000,000 for 5
years. The table of amortization following the bond outstanding method may appear as
follows:

Year Bond Outstanding Fraction Premium Amortization

2020 P5,000,000 5/15 P100,000
2021 4,000,000 4/15 80,000
2022 3,000,000 3/15 60,000
5
 2023 2,000,000 2/15 40,000
2024 1,000,000 1/15 20,000
P15,000,000 P300,000

*The bond outstanding is determined every bond year

*The fractions are developed from the bond outstanding column
*The annual premium amortization is computed by multiplying the fractions by the amount
of the premium

c. Effective interest method or simply “interest method” or scientific method (this is

what PFRS 9 requires to be used in amortizing discount, premium and bond issue
cost). This will be further discussed in detail in the next module.

Application

TRY THIS:
1. Superman Company was authorized to issue 12%, 10-year bonds with face amount of
P7,000,000 on April 1, 2020. Interest on the bonds is payable semiannually on April 1
and October 1 of each year. The bonds were sold to underwriters on April 1, 2020 at
106. The entity amortizes discount or premium only at the end of the fiscal year, using
the straight line method.

Required: Prepare journal entries for 2020 and 2021 including adjustments at the end of
each year.

2. On January 1, 2020, Lucky Tian Company issued 12% bonds with face amount of
P4,000,000 for P4,200,000. Interest is payable annually on December 31 and the
bonds mature on January 1, 2025. On December 31, 2020, bonds with face amount
of P1,000,000 were redeemed at 95. The entity used the straight line method of
amortization.

Required: prepare journal entries in 2020 and 2021.

Feedback

Problem 1:
Blue Company reported the following financial liabilities on December 31, 2020:
9% debentures callable in 2021, due in 2022 P3,500,000
11% collateral trust bonds, convertible into share
Capital beginning in 2021, due in 2022 P3,000,000
10%debentures, P300,000 maturing annually P1,500,000

What is the total amount of term bonds?

a. P3,000,000 b. P3,500,000 c. P5,000,000 d. P6,500,000

Problem 2:
On October 1, 2020, Shane Company issued 5,000 12% bonds with face amount of P1,000
per bond at 110. The bonds which mature on January 1, 2025, pay interest semiannually on
January 1 and July 1. The entity paid bond issue cost of P200,000. How much cash was
received from the issuance of the bonds?
a. P5,450,000 b. P5,650,000 c. P5,300,000 d. P5,550,000

6
Problem 3:
On July 1, 2020, Carol Company issued at 104, five thousand 10% bonds with face amount
of P1,000 per bond. The bonds were issued through an underwriter to whom the entity paid
bond issue cost of P125,000. On July 1, 2020, what is the carrying amount of the bonds
payable?

a. P4,875,000 b. P5,075,000 c. P5,200,000 d. P5,325,000

Problem 4:
Arc Company is authorized to issue P5,000,000 of 6%, 10-year bonds dated July 1, 2020
with interest payments on June 30 and December 31. When the bonds are issued on
November 1, 2020, the entity received cash of P5,150,000 including accrued interest. What
is the discount or premium from the issuance of the bonds?
a. P150,000 bond premium
b. P50,000 bond premium
c. P150,000 bond discount
d. No bond premium and discount

Problem 5:
On January 31, 2020, Seri’s Choice Company issued P3,000,000 maturity value, 12% bonds
for P3,000,000 cash. The bonds are dated December 31, 2019, and mature on December 31,
2029. Interest will be paid semiannually on June 30 and December 31. What amount of
accrued interest payable should be reported on September 30,2020?
a. P270,000 b. P240,000 c. P180,000 d. P90,000

Problem 6:
On January 1, 2020, 2N Box Company issued 6% bonds with face amount of P4,000,000 for
net proceeds of P3,677,600, a price that yields 8%. Interest is payable annually every
December 31. On December 31, 2020, the bonds are quoted at 95.
1. What amount should be reported as interest expense for 2020?
a. P240,000 b. P120,000 c. P294,208 d. P220,656
2. What is the carrying amount of the bonds payable on December 31, 2020?
a. P3,677,600
b. P3,800,000
c. P3,493,720
d. P4,000,000

7
 INTERMEDIATE ACCOUNTING II (AE 16)
LEARNING MATERIAL

UNIT NUMBER/ HEADING: EFFECTIVE INTEREST METHOD

LEARNING OUTCOMES:
At the end of the unit, the students will be able to:
d. Demonstrate skills in using effective interest method in the computation of
cost of borrowing;
e. Apply the effective interest method of amortizing bond premium and bond
discount;
f. Distinguish effective rate and nominal rate of interest; and
g. Compute market price or issue price of bonds payable

INTRODUCTION:
PFRS 9 requires that discount on bonds payable, premium on bonds payable and bond
issue cost shall be amortized using the effective interest method. In this module, you will
learn how to use the effective interest method in amortizing bond discount and premium and
derive to the carrying amount of bonds payable at the end of each accounting year.

Activating Prior Learning

Explain the statement below.

E:D = N:P
Presentation of Content

DEFINITON OF TERMS
 Nominal rate is the coupon or stated rate.
 Effective rate is the yield or market rate. It is the rate that exactly discounts
estimated cash future payments through the expected life of the bonds payable

If: sold at face amount – ER = NR

sold at premium - ER < NR
sold at discount - ER > NR

IMPORTANT FORMULAS TO REMEMBER:

a. Nominal interest (NR x Face amount) xx

Effective interest (ER x carrying amount) (xx)
Premium amortization xx

b. Effective interest xx
Nominal interest (xx)
Discount amortization xx

c. Face amount x Nominal rate = Interest paid

d. Carrying amount x Effective rate = Interest expense
e. Preceding Carrying amount + Discount amortization/ - Premium Amortization =
Current Carrying amount

8
 f. PV of Principal Bond Liability xx
PV of future interest payments xx
Market price or Issue Price of Bonds Payable xx

g. Face amount of the bond xx

x PV of 1 factor at the effective rate .xx
PV of Principal Bond Liability xx

h. Periodic nominal interest xx

PV of OA of 1 at the effective rate x.xx
PV of Future Interest Payments
1
1−
1 (1+𝑖)𝑛
i. PV of 1 factor = j. PV of OA =
(1+𝑖 )𝑛 𝑖
Illustration 1:

Face amount of bonds P4,000,000

Nominal rate 6%
Effective rate 8%

The bonds are issued on January 1, 2020 and mature in four years on January 1, 2024. The
interest is payable annually every December 31.

Since the effective rate is higher than the nominal rate, we can say that the bonds were issued
at a discount.
To compute for the bond amortization and PV of the bonds:

PV of Principal (P4,000,000 x .7350) P2,940,000

PV of annual interest payments
(P240,000 x 3.3121) P 794,904
Total present value P3,734,904

Face amount P4,000,000

Market price or issue price (P3,734,904)
Discount on bonds payable P 265,096

Table of amortization

Date Interest Interest Discount Carrying

Paid Expense Amortization Amount
Jan. 1, 2020 P3,734,904
Dec. 31, 2020 P240,000 P298,792 P58,792 P3,793,696
Dec. 31, 2021 P240,000 P303,496 P63,496 P3,857,192
Dec. 31, 2022 P240,000 P308,575 P68,575 P3,925,767
Dec. 31, 2023 P240,000 P314,233 P74,233 P4,000,000

Illustration 2:

Face amount of bonds P5,000,000

Nominal rate 12%
Effective rate 10%
9
The bonds are issued on January 1, 2020 and mature in three years on January 1, 2023.
The interest is payable semiannually every June 30 and December 31.

Since, the nominal rate is higher than the effective rate, we can say that the bonds were
issued at a premium. To compute for the present value and amortization:

PV of principal (P5,000,000 x .7462) P3,731,000

PV of interest (P300,000 x 5.0757) P1,522,710
Total present value P5,253,710

Market price or issue price P5,253,710

Face amount P5,000,000
Premium on bonds payable P 253,710

Table of amortization

Date Interest Interest Premium Carrying

Paid Expense Amortization Amount
Jan. 1, 2020 P5,253,710
June 30, 2020 P300,000 P262,686 P 37,314 P 5,216,396
Dec. 31, 2020 P300,000 P260,820 P 39,180 P 5,177,216
June 30, 2021 P300,000 P258,861 P 41,139 P 5,136,077
Dec. 31, 2021 P300,000 P256,804 P 43,196 P 5,092,881
June 30, 2022 P300,000 P254,644 P 45,356 P 5,047,525
Dec. 31, 2022 P300,000 P252,475 P 47,525 P 5,000,000

Illustration 3: Serial bonds

Face amount of bonds P3,000,000

Nominal rate 12%
Effective rate 10%
Date of issue January 1, 2020
Annual payment – December 31 P1,000,000
Interest is payable annually December 31

Present value of the bonds payable

Date Principal Interest (a) (b) (a x b)

Payment Payment Total PV Present
Payment Factor value
12/31/2020 P1,000,000 P360,000 P1,360,000 .9091 P1,236,376
12/31/2021 P1,000,000 P240,000 P1,240,000 .8264 P1,024,736
12/31/2020 P1,000,000 P120,000 P1,120,000 .7513 P 841,456
Total Present Value P3,102,568
Face amount (P3,000,000)
Premium on bonds payable P 102,568

10
Table of amortization

Date Interest Interest Premium Carrying

Paid Expense Amortization Amount
Jan. 1, 2020 P3,102,568
Dec. 31, 2020 P360,000 P310,257 P49,743 P2,052,825
Dec. 31, 2021 P240,000 P205,282 P34,718 P1,018,107
Dec. 31, 2022 P120,000 P101,893 P18,107

Illustration 4: Bond Issue Cost

**Bond issue costs will increase discount on bonds payable and will decrease premium on
bonds payable.

On January 1, 2020, an entity issued three-year bonds with face amount of P10,000,000 and
9% stated rate. The bonds mature on January 1, 2023 and interest is payable annually on
December 31. The bonds are issued at P9,751,210 with an effective yield rate of 10 % before
considering the bond issue cost.

The entity paid bond issue cost of P 239,880.

Face amount P10,000,000

Discount on bonds payable (P 248,790)
Issue price P9,751,210
Bond issue cost (P 239,880)
Net proceeds P9,511,330

The effective rate is 10% but because of' the bond issue the effective rate must be higher than
10%.

Thus, the problem is to find an effective rate that will equate the present value of the cash
outflows for the bonds payable to the net proceeds of P9,511,330.

The cash outflows for the bonds payable include the principal of P10,000,000 and the annual
interest payment of P900,000 for 3 years.

The effective rate cannot be computed algebraically but by means of trial and error or the
interpolation process.

The calculation of the effective rate requires the use of mathematical table of present value
of a single payment and present value of an ordinary annuity.

Again, the original effective rate is 10% but because of the bond issue cost the new effective
rate must be higher than 10%.

By interpolation and using an effective rate of 11%, the pregcnt value of 1 for three periods
is .7312. The present value of an ordinary annuity of I for three periods at 11% is 2.4437. If
you are going to compute it, coincidentally, it will be the same with the net proceeds, that’s
why the new effective rate is 11%.

Illustration 5: Premium and bond issue cost

On January 1, 2020, an entity issued 5-year bonds with face amount of P10,000,000 at 105.
The nominal rate is 10% and the interest is payable annually on December 31.

The bonds mature on January 1, 2025. The entity paid bond issue cost of P200,000.
11
Face amount P10,000,000
Premium on bonds payable P 500,000
Issue price (10,000,000 x 105%) P10,500,000
Bond issue cost (P 200,000)
Ne t proceeds P10,300,000

Under the effective interest method; the bond issue cost is "netted" against the premium on
bonds paya.ble,

Since the bonds are issued at a premium, the effective ratc must be lower than 10%.

By interpolation, using a rate of 9%, the present value of 1 for 5 periods is .6499 and the
present value of an ordinary annuity of 1 is 3.8897.

PV of principal (10,000,000 x .6499) P6,499,000

PV of interest payments (1,000,000 x 3.8897) P3,889,700
Total present value P10,388,700

The net proceeds of P 10,300,000 are lower than the present value of the bonds payable of P
10,388fi00 using a 9% interest. This means that the effective rate must be higher than 9%.
In conclusion, the effective rate must be between 9% and 10%. After further computation, we
will derive with 9.23%.

Application

TRY THIS:
Problem 1

Yellow Company received permission on January 1, 2020 to issue 12% bonds with face
amount of P6,000,000 maturing on January l, 2030. Interest is payable annually on
December 3l. The bonds are callable at 102 plus accrued interest.

On January l, 2020, the entity issued the bonds for P6,737,000 with an effective yield of 10%.
The fiscal year of the entity ends December 31. The effective interest amortization is used.

Required:
1. Prepare a table of amortization.
2. Present the bonds payable on December 31, 20'20.

Problem 2:
On January 1, 2020, Orange Company was authorized to issue 6% bonds with face amount
of P 5,000,000 maturing on December 31, 2021. Interest is payable semiannually on June
and December 31.

On January l, 2020, the entity issued all of the bonds for with an effective rate of 8%. The
fiscal year of the entity is the calendar year and the effective interest method of amortization
is used.

Required:

1. Prepare a table of amortization for the discount.

2. Prepare journal entries for 2020 and 2021.

12
 Feedback

Problem 1:
On January 1, 2020, Mar8h Company 10% bonds payable in the face amount of P6,000,000.
The bonds mature on January 1, 2030. The bonds were issued for P5,316,000 to yield 12%,
resulting in bond discount of P684,000. The entity used the effective interest method of
amortizing bond discount. Interest is payable semiannually on January 1 and July 1.

For the six months ended June 30, 2020, what amount should be reported as bond Interest
expense?

a. 300,000 b. 318,960 c. P334,200 d. 341,040

Problem 2:

On July l, 2020, Tara Company issued 4,000 bonds of 8%, P1,000 face amount for P
3,504,000. The bonds were issued to yield 10%. The bonds are dated July l, 2020 and mature
on Julv 1, 2029. Interest is payable semiannually on January I and July 1.

What amount of the bond discount should be amortized for the six months ended December
31, 2020?

a. P30,400 b. P24,800 c. P19,840 d. P15,200

Problem 3:
On January l, 2020, Moon Company issued 10% bonds payable in the face amount of
P4,500,000. The bonds mature on January 1, 2030. The bonds were issued for P3,987,000
to yield 12%, resulting in bond discount of P513,000. The entity used the effective interest
method of amortizing bond discount. Interest is payable semiannually on January 1 and July
1

For the six months ended June 30, 2020, what amount should be reported as bond interest
expense?

a. P225,000 b. P239,220 c. P250,650 d. P255,780

Problem 4:
Webb Company has outstanding 7%, 10-year P5,000,000 face amount bond. 'I'he bond was
originally sold to yield 6% annual interest. The entity used the effective interest method to
amortize bond premium. On January I, 2020, the carrying amount of the outstanding bond
was P5,250,000.

1. What amount of premium on bond payable should be reported on December 31, 2020?

a. P225,000 b. P172,500 c. P215,000 d. P52,500

2. What is the carrying amount of bonds payable on December 31, 2020?

a. P5,250,000 b. 4,785,000 c.P5,215,000 d. P5,000,000

Problem 5:

On January l, 2020, West Company issued 9% bonds in the face amount of P5,000,000,
which mature on January 1, 2030. 'l'he bonds were issued for P4,695,000 to yield 10%.
Interest is payable annually on December 31 The entity used the Interest method.

13
1. What is the interest expense for 2020?
a. P450,000 b. P469,500 c. P422,550 d. P500,000

2. What is the carrying amount of the bonds payable on December 31, 2020?
a. P4,695,000 b. P4,704,750 c. P4,714,500 d. P5,000,000

14
 INTERMEDIATE ACCOUNTING II (AE 16)
LEARNING MATERIAL

UNIT NUMBER/ HEADING: COMPOUND FINANCIAL INSTRUMENTS

LEARNING OUTCOMES:
At the end of the unit, the students will be able to:
h. Define financial instrument;
i. Define financial asset, financial liability and equity instrument;
j. Know the guideline when an instrument is a financial liability or an equity
instrument; and
k. Know the recognition of a compound financial instrument.

INTRODUCTION:
In this module, you will be introduced to the discussion of impairment of assets. You
will learn how assets are impaired and how to compute for an asset’s recoverable amount.

Activating Prior Learning

Before proceeding, watch the video with the link below about a short explanation of the
topic:
https://www.youtube.com/watch?v=T4cdcd7n0B0

Then tell me, what is your initial understanding about financial instruments.

Presentation of Content

Definition
 A financial instrument is any contract that gives rise to both a financial asset of
one entity and a financial liability o equity instrument of another entity.

 Examples of financial instruments include:

Financial Instrument Financial asset of: Financial Liability of:

1. Cash in the form of notes Holder or bearer Government
and coins
2. Cash in the form of checks Payee Drawer or issuer
3. Cash in bank Depositor Depository bank
4. Trade accounts Seller as accounts Customer or buyer as
receivable accounts payable
5. Note and loan Lender or Creditor as Note Borrower or debtor as Note
Receivable or Loan Payable or Loan Payable
Receivable
15
6. Debt Security Investor Issuer
7. Equity Security Investor Issuer

FINANCIAL ASSETS
1. Cash or Currency is a financial asset because it represents the medium of exchange
and is therefore the basis on which all transactions are measured and recognized in
financial statements
2. Deposit of Cash with a bank or similar institutions – it represents the contractual
right of the depositor to obtain cash from the bank or to draw a check against the
balance
** A gold bullion, though deposited in the bank, is not a financial asset because it is
a commodity.
3. Financial assets representing contractual right to receive cash in the future are: (a)
Trade accounts receivable, (b) Notes Receivable, (c) Loans Receivable, (d) Bonds
Receivable.

**In cases that financial instruments are exchanged with another entity, conditions are
favorable if such exchanges will result to gain or additional cash inflow to the entity such as
an option held by the holder to purchase shares of another entity at less than market price.
But if it will result to loss, conditions are unfavorable.
4. Investments in shares or other equity instruments issued by other entities, for
example, trading securities.

FINANCIAL LIABILITY
 Any liability that is contractual obligation:
a. To deliver cash or other financial asset to another entity.
b. To exchange financial instruments with another entity under conditions that are
potentially unfavorable.

 Example includes (a) trade accounts payable, (b) Notes Payable, (c) Loans Payable,
and (d) Bonds Payable.

Nonfinancial Assets Nonfinancial Liabilities

1. Physical assets, such as inventory and 1.Deferred Revenue and warranty
PPE. obligations
2. Intangible assets, such as patent and 2.Income tax Payable because it is imposed
trademark by law and noncontractual
3. Prepaid expenses for which the future 3.Constructive obligation because the
economic benefit is the receipt of goods obligation does not arise from contracts.
or services, rather than the right to
receive cash or another financial asset.
4. Right of use of asset or leased asset is
not a financial asset because control of
the underlying asset does not give rise to
a present right to receive cash or another
financial asset.

EQUITY INSTRUMENT
 Is any contract that evidences a residual interest in the assets of an entity after
deducting all of the liabilities
 Includes ordinary share capital, preference share capital and warrants or option.

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  To determine whether a financial instrument is an equity instrument rather than a
financial liability: A financial instrument is an equity instrument if the instrument
includes no contractual obligation to deliver cash or another financial asset.
 Redeemable preference share are classified as financial liability of the issuer if:
 The preference share provides for mandatory redemption by the issuer
 A preference share that gives the holder the right to require the issuer to
redeem the instrument at a particular date for a fixed or determinable amount
 The mandatorily redeemable preference share shall be classified as current or
noncurrent liability depending on the date of redemption
 Dividends paid to holders of mandatorily redeemable preference share shall be
accounted for as interest expense

INITIAL MEASUREMENT
o Financial instruments are initially measured at fair value of the consideration given
+ (or minus for financial liability) direct transaction costs
o If the financial instrument is designated at FVPL, transaction costs are not added to
fair value at initial recognition
SUBSEQUENT MEASUREMENT
o After initial recognition, financial assets are measured at:
a. Amortized cost
b. Fair value through other comprehensive income; or
c. Fair value through profit or loss

Financial liabilities:
a. At fair value through profit or loss
b. At amortized cost

COMPOUND FINANCIAL INSTRUMENT

 A financial that contains both a liability and an equity element from the perspective of
the issuer
 Common example are:
 bonds payable issued with share warrants
- bondholders are given the right to acquire shares of the issuer at a specified
price at some future time
- share warrants attached may be detachable (can be traded separately from
the bond) or nondetachable (cannot be traded separately)
- the bonds are assigned an amount equal to “market value of the bonds ex-
warrants” regardless of the market value of the warrants. The remainder or
residual amount of the issue price shall then be allocated to the warrants.
 convertible bonds payable
- give the holders the right to convert their bondholdings into share capital of the
issuing entity within a specified period of time.
- the bonds are assigned an amount equal to the market value of the bonds
without the conversion privilege
 PAS 32 mandates that if the financial instrument contains both a liability and equity
component, such component shall be accounted for separately using “split
accounting”.
 In split accounting, fair value of the liability component is first determined. Then
it is deducted from the total consideration received. The residual amount is allocated
to the equity component.

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RECOGNITION OF FINANCIAL INSTRUMENT
a. Scope
- IFRS 9 applies to all entities and to all types of financial instruments excepts those
specifically excluded, for example investments in subsidiaries, associated, joint
ventures and other joint arrangements.
b. Initial Recognition
- a financial asset or financial liability should be recognized in the statement of
financial position when the reporting entity becomes a party to the contractual
provisions of the instrument.
c. Derecognition
- it is the removal of a previously recognized financial instrument from an entity’s
statement of financial position.
- an entity should derecognize a financial asset when:
 The contractual rights to the cash flows from the financial assets expire; or
 It transfers substantially all the risks and rewards of ownership of the financial
asset to another party.
- an entity should derecognize a financial liability when it is extinguished

DISCLOSURE OF FINANCIAL INSTRUMENTS

 According IFRS 7, mandates that as well as specific monetary disclosures, narrative
commentary by issuers is encouraged by the Standards. This will enable users to
understand management’s attitude to risk, whatever the current transactions involving
financial instruments are at the period end.

Application

Your task:

1. Compare financial asset, financial liability and equity instrument

Feedback

Problem 1:

At the beginning of current year, Case Company issued P5,000,000 of 12% nonconvertible
5-year bonds at 103. In addition, each P1,000 bonds was issued with 30 detachable share
warrants, each of which entitled the bondholder to purchase, for P50, one ordinary share of
Case Company, par value P25. The quoted market value of each warrant was P4. The market
value of the bonds ex-warrants at the time of issuance is 95.

1. What is the carrying amount of the bonds payable?

a. P5,000,000 b. P4,750,000 c. P5,150,000 d. P4,550,000
2. What amount of the proceeds from the bond issue should be recognized as an increase
in shareholder’s equity?
a. P600,000 b. P300,000 c. P200,000 d. P400,000

Problem 2:
Marion Company issued P5,000,000 face amount 12% convertible bonds at 110 at the
beginning of current year. The bonds pay interest semi-annually on January 1 and July 1. It
is estimated that the bonds would sell only at 102 without the conversion feature. Each

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P1,000 bond is convertible into 10 ordinary shares with P100 par value. What is the increase
in shareholder’s equity arising from the original issuance of the convertible bonds payable?
a. P400,000 b. P500,000 c. P100,000 d. 0

Multiple Choice:
1. A financial instrument is any contract that gives rise to
a. A financial asset
b. A financial liability
c. A financial asset of one entity and a financial liability of another entity
d. A financial asset of one entity and a financial liability or equity instrument of
another entity
2. Which is not classified as a financial instrument?
a. Convertible bond
b. Foreign currency contract
c. Warranty provision
d. Loan receivable
3. Which cannot be considered a financial asset?
a. Cash
b. A contractual right to receive cash or another financial asset from another entity
c. A contractual right to exchange financial instruments with another entity under
conditions that are potentially unfavourable
d. An equity instrument of another entity
4. Which should be classified as financial asset?
a. Patent
b. Trade accounts receivable
c. Inventory
d. Land
5. A financial liability
a. Must be classified as noncurrent liability
b. Is a contractual obligation to deliver cash or another financial asset to another entity
c. Is a contractual obligation to exchange financial instrument with another entity
under conditions that are potentially favourable to the entity
d. Is a contractual obligation to deliver cash or any asset to another entity.
6. Financial liabilities include all of the following, except
a. Trade accounts payable
b. Notes payable
c. Bonds payable
d. Income tax payable
7. It is any contract that evidences residual interest in the assets of an entity after
deducting all of the liabilities
a. Equity instrument
b. Debt instrument
c. Loan receivable
d. Financial asset with indeterminable fair value

8. How should preference shares that are redeemable mandatorily be presented in the
statement of financial position?
a. Noncurrent liability
b. Current liability
c. Equity
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 d. Either current or noncurrent liability depending on redemption date
9. What is the presentation of preference dividend on mandatorily redeemable preference
share?
a. Deducted from retained earnings
b. Deducted from share premium
c. Interest expense
d. Deducted from share capital
10. Which is not an equity instrument?
a. Ordinary share capital
b. Bond payable
c. Preference share capital
d. Share option or warrant

Summary of the Unit

Issuers of financial instruments must classify them as liabilities or equity
The substance of the financial instrument is more important than its legal form
The critical feature of a financial liability is the contractual obligation to deliver cash
or another financial asset
Compound instruments are split into equity and liability parts and presented
accordingly
Interest, dividends, losses and gains are treated according to whether they relate to a
financial liability or an equity instrument.

Student’s Reflection on Learning

This part of the module will be a time for you to look back, and reflect on what you have learned
from this unit. Though, this will not be checked and recorded, I would appreciate if you will do
this wholeheartedly and with all seriousness.

Answer the following questions and put your answers in the space provided.

1. Did you learn what you expect to learn?

2. How might you use what you learned in the future in your life or profession?

References:

 Valix, C. T., Peralta, J.F & Valix C. A. M. (2019). Intermediate Accounting Vol.2. Manila,
Philippines: GIC Enterprises & Co.. Inc.
 https://www.iasplus.com/en/standards/ias/ias32
 https://www.youtube.com/watch?v=T4cdcd7n0B0

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