INTERMEDIATE ACCOUNTING 11

Marylin L. Asumbra, CPA

 Table of Contents

Module 1: Overview Of Liabilities

Introduction 1
Learning Outcomes 1
Lesson 1. Conceptual Overview of Liabilities 2
Lesson 2. Nature and Definition of Current Liabilities 3
Lesson 3. Classification of Current Liabilities 4
Lesson 4. Other Liability Classification Issues 5
Lesson 5. Financial Statement Presentation of Current Liabilities 6
Lesson 6. Measurement of Current Liabilities 7
Assessment Task 8
Summary 9
References 10
Module 2. PROVISIONS, CONTINGENT LIABILITIES AND
CONTINGENT ASSETS
Introduction 11
Learning Outcomes 11
Lesson 1.Premium Liability/Obligation 12
Lesson 2.Product warranties and guarantees 14
Lesson 3. Other provisions 17
Lesson 4. Contingencies 18
Assessment Task 20
Summary 23
References 24

Module 3. BONDS PAYABLE AND OTHER CONCEPTS

Introduction 25
Learning Outcomes 25
Lesson 1. Reasons for issuance of Long-term Liabilities 26
Lesson 2. Bonds Payable and Other concepts 27
Lesson 3. Recording the Issuance of Bonds 28
Lesson 4. Initial and Subsequent Measurement of Bonds Payable 29
Lesson 5. Amortizing Discounts and Premiums 30
Lesson 6. Compound Financial instruments 31
Lesson 7. Derecognition of a financial liability 33
Lesson 8. Financial Statement Presentation of Long-term Liabilities 33
Assessment Task 34
Summary 37
References 38
Course Code: ACCTG 4

Course Description:This is the continuation of Intermediate Accounting 1

and covers the financial accounting principles relative to recognition,
measurement, valuation and financial statement presentation of liabilities
and shareholders’ equity, including disclosures requirements. The related
internal control, ethical issues and management of liabilities and owners’
equity are also included. It also deals with contemporary issues such as
accounting for changing prices, leases, employees’ retirement benefits,
deferred taxes and other current related items.

Course Intended Learning Outcomes (CILO):

At the end of the course, students should be able to:

1. Recall and define the nature of current liabilities, noncurrent
liabilities and
shareholders’ equity accounts;
2. Determine how and at what amounts these liabilities and equity
accounts
has to be measured upon initial recognition and the subsequent
measurement of these accounts;
3. Formulate entries for transactions affecting these accounts;
4. Identify information relating to these liabilities and equity accounts
required
to be disclosed in the financial statements; and
5. Apply the related accounting principles to liabilities and equity
accounts in
the preparation of financial statements.

Course Requirements:
Assessment Tasks - 60%

Major Exams
 - 40%
Periodic Grade 100%
PRELIM GRADE : Total CS% + (Prelim Exam)
MIDTERM GRADE : 30% of Prelim Grade + 70% (Total CS% +
40%of
Midterm exam)
FINAL GRADE : 30% Midterm Grade) + 70 % (Total CS% + 40% of
Final exam)
 MODULE 1

OVERVIEW OF LIABILITIES

Introduction

The need for verifiable and understandable financial information is not only
the concern of the preparers of financial statements but also of the information users.
Knowledge of information in these financial statements, the way the elements in these
financial statements are measured, and the concepts underlying these measurements and
related disclosures are of outmost importance to the users of financial statements.

While the decisions made by investors and creditors are somewhat different,
they are similar in at least one important way. They are both concerned with providing
resources to the entities, usually cash, with the expectation of receiving more cash in return
at some time in the future. In this module, it focuses on borrowed funds, meaning funds
provided by lenders and other creditors and the different claims against the assets of the
business and other obligations of the company. Also discussed in this module are the
definition, recognition, measurement, and financial statement presentation of liabilities, in
general.

Learning Outcomes

At the end of this module, students should be able to:

1. Define the nature of liabilities
2. Classify the different types of current liabilities;
3. Illustrate the measurement of current and non-current liabilities; and
4. Outline the financial statement presentation of current liabilities.

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Lesson 1. Conceptual Overview of Liabilities (Bazley, Nikolai, & Jones, 2010)

As defined in the Revised Conceptual Framework for Financial Reporting, liabilities

are “present obligations of an entity to transfer an economic resource as a result of past
events.”

The definition of liabilities involves three characteristics, namely:

1. A liability involves a responsibility that will be settled by the

probable future transfer or use of assets at a specified
determinable date, or the occurrence of a specific event or on
demand.
2. The responsibility obligates the company so that it has little or
no discretion to avoid the future sacrifice.
3. The transaction or event obligating the company has already
happened.

There are two additional factors involving a liability. First, the company does not need
to know the identity of the recipient before the time of settlement. Secondly, a legally
enforceable claim is not a prerequisite for an obligation to qualify as a liability, as in the case
of refinancing agreements and liabilities liquidated thru conversion into ordinary or preferred
shares.

We notice that the definition of liabilities involves the present, the future and the past.
It is a present responsibility to sacrifice assets in the future because of a transaction or other
events that has already happened.

Special accounting treatment for contingencies, however, is necessary to distinguish

it from the common liabilities because of its uncertainty as to whether the obligation really
exists. Discussion of contingencies will be taken in the succeeding modules.

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Lesson 2. Nature and Definition of Current Liabilities

Liabilities are generally classified as either current or long-term (non-current)

liabilities.

Current liabilities are obligations of the company that it expects to liquidate by using
existing current assets or creating other current liabilities within one year or the normal
operating cycle whichever is longer. The usual criterion is one year. However, for certain
companies, where the operating cycle – from cash to inventory to receivables and back to
cash- is longer than a year, the length of the operating cycle determines the classification of
the liability (Bazley, et. al. 2010).

Philippine Accounting Standards (PAS) 1, paragraph 69, provides that an entity shall
classify a liability as current when:

1. The entity expects to settle the liability within the operating cycle

2. The entity holds the liability primarily for the purpose of trading.

3. The liability is due to be settled within twelve months after the reporting period.

4. The entity does not have an unconditional right to defer settlement of the liability
for at least twelve months after the reporting period.

Liabilities that are settled as part of the company’s normal operating cycle (e.g., trade
payables and some accruals for employee and other operating costs) are presented as
current even if they are expected to be settled beyond twelve months after the reporting
period (Millan, 2019).

Financial liabilities held for trading are those that are incurred with an intention to
repurchase them in the near future.

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Lesson 3. Classification of Current Liabilities (Bazley, et. al. 2010)

The first section of liabilities in the statement of financial position shows the current
classification of liabilities. We may classify the primary types of current liabilities into three
groups. Many current liabilities are easily identifiable and have contractual amount. Some
current liabilities, though identifiable, have amounts that depends on operations. Others
require that amounts must be estimated.

Current liabilities having a contractual amount

The short-term liabilities in this group result from the terms or from the existence of
laws. Examples of this type of current liabilities are:

1. Trade accounts payable

2. Notes payable
3. Currently maturing portion of long-term debt
4. Dividends payable
5. Accrued items
6. Unearned items
7. Bank overdrafts
8. Income taxes payable
9. Advances and refundable deposits

Current liabilities whose amounts depend on operations

Several current liabilities and their amounts pertains to operations. Included are
liabilities which relate to sales taxes, payrolls, corporate income taxes and bonus agreements.

Companies are required by law to withhold from the pay of each employee an amount
for anticipated income tax payments, social security contributions and other payables to third
parties like union dues and group insurance premiums. Since a company must pay these
taxes and voluntary withholdings within a few months, it classifies them as current liabilities.

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Current liabilities requiring amounts to be estimated

A number of liabilities have amounts that a company must estimate as of the balance
sheet date. Unlike other liabilities, provisions must necessarily be estimated. Although some
other liabilities are also estimated, their uncertainty is generally much less compared to
provisions. Examples of this type of current liabilities are premiums, warranties, gift
certificates, award points and bonuses.

Lesson 4. Other Liability Classification Issues (Millan, 2010)

An additional two liability classification issues are discussed, in this lesson, long-term
debt falling due within one year and obligations payable on demand.

Long-term debt falling due within one year

A long-term debt that is maturing within twelve months after the reporting period is
classified as current, even if a refinancing agreement to reschedule payment on a long-term
basis is completed after the reporting period but before the financial statements are authorized
for issue.

However, the obligation is classified as non-current under the following circumstances:

a. Refinancing on a long-term basis was completed on or before the end of the

reporting period

b. The entity has the discretion to refinance or roll over an obligation for at least
twelve months after the reporting period under an existing loan facility.

Obligations payable on demand

As we noted earlier, generally the company reports the currently maturing portion of
its long-term debt as a current liability. Also, a company must report the entire amount of a

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long-term obligation as a current liability if the company is in violation of a long-term agreement
(covenants) at the balance sheet date, and the violation makes the liability callable by the
creditor within one year or the operating cycle, if longer, from the balance sheet date.

This also includes situations in which debt is not yet callable but will be callable within
the year if an existing violation is not corrected within a specified grace period.

Lesson 5. Financial Statement Presentation of Current Liabilities (Bazley, et. al. 2010)

The guidelines on financial statement suggest that a company should arrange its current
liabilities in a way that will highlight their liquidity characteristics and their effect on its financial
flexibility. Most companies report their current liabilities at the top of its Liabilities section.
Items within the current liability section may be listed (1)in the order of their average length of
maturity, (2) according to amount (largest to smallest), or (3) in the order of liquidation
preference- that is, in the order of their legal claims against the assets.

As a minimum requirement, the face of the statement of financial position shall include
the following line item for current liabilities, according to PAS 1, paragraph 54:
a. Trade and other payables
b. Current provisions
c. Short-term borrowings
d. Current portion of a long-term debt
e. Current tax liability

A company includes any major issue affecting its current liabilities in a notes to its
financial statements. This presentation is made so that the notes and other supplemental
information about current liabilities meet the requirement of full disclosure.

Lesson 6. Measurement of Current Liabilities (Bazley, et. al. 2010)

Conceptually, liabilities should record and report on its statement of financial position
at the present value of the future payments they will require. In practice, however, most
current liabilities are measured, recorded, and reported at their maturity or face amount. The

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difference between the maturity amount and the present value of the maturity amount is
usually not material because of the short time period involved (usually one year or less.
Although a slight overstatement of liabilities result from reporting current liabilities at their
maturity amounts, this overstatement is justified on the basis of cost/benefit and materiality
constraints.

Assessment Task 1

Problem 1. You were provided the following information for Simon Company as at
December 31, 2020.

Cash balance at First National Bank P250,000

Cash overdraft at Second National Bank 13,500
Accounts receivable, net of P28,500 credit balance 431,500
Estimated expenses of meeting warranties on
merchandise sold 32,000
Estimated damages on unsatisfactory performance
on a contract 125,000
Accounts payable,net of P20,250 debit balance 299,750
Deferred serial bonds of P500,000, issued at par,
payable in semi-annual installments of P50,000,
due April 1 and October 1 of each year, the last
payment shall be in October 2026. These serial
bonds bear a 10% interest that is paid semi-annually
every April 1 and October 1 500,000
Ordinary shares at par to be distributed as a result of
a share dividend declaration 40,000
Dividends in arrears on preference shares 25,000
Income tax payable 124,000
Deferred asset, net of deferred tax liabilities at
P25,400 expected to reverse next year 51,600

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Reserve for contingencies 50,000

Question 1. At year end, how much should be presented as current

liabilities?
Question 2. How much is the total of noncurrent liabilities?

Summary

Liabilities are present obligations to sacrifice assets in the future because of something
that has already occurred. The characteristics of a liability are: (1) a present responsibility for
the probable future transfer of assets, (2) the obligation cannot be avoided, and (3) the liability
transaction already has occurred(Bazley, et. al. 2010).

Current liabilities are obligations that are expected to require the use of current assets
or the creation of current liabilities within one year or the normal operating cycle of the
business, whichever is longer. In addition, current liabilities are primarily held for trading and
the entity does not have an unconditional right to defer settlement of the liability for at least
twelve months after the end of the reporting period.

Special accounting treatment for long-term debt falling due within one year and to
those liabilities which become payable on demand because of violation of certain covenants
in the contract or agreement are also to be classified as current or non-current liability
depending on the circumstances surrounding them.

Short-term obligations, including callable obligations that are expected to be

refinanced on a long-term basis can be reported as noncurrent, rather than current liabilities,
only if these two conditions, are met:

a. the firm must intend to refinance on a long-term basis, and

b. the firm must actually have demonstrated the ability to refinance on a long-term
basis.

References

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Bazley, J. D., Nikolai, L. A., & Jones, J.P., (2010). Intermediate Accounting (11th Ed.). Canada:
Rob Dewey
Millan, Z.V.B., (2019). Intermediate Accounting 2: Baguio City, Philippines: Bandolin
Enterprise

MODULE 2
PROVISIONS, CONTINGENT LIABILITIES AND

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 CONTINGENT ASSETS

Introduction

In this learning module, emphasis is given to special type of liabilities, that is, estimated
liabilities, contingent liabilities and contingent assets. Conceptually, liabilities are present
obligations to transfer economic resource as a result of past events. Estimated liabilities,
however, even though possessing all the three requirements for them to be classified as
liabilities, their amounts may require estimates; the timing of payment may be uncertain and
the payee may not be definitely identified.

The financial information that a company reports in its financial statements is based
primarily on transactions that have affected it. However, there may be some information
available about the company that is not yet recorded in the books of the entity but may be
useful in predicting what might happen to the company. Specifically, these items are
commonly referred as contingencies (Bazley, et al. 2010).

Learning Outcomes

At the end of this module, students should be able to:

1. Define the nature of provisions, contingent liabilities and contingent assets;

2. Differentiate provisions from contingent liabilities and contingent assets;
3. Compare the recognition and measurement of provisions from contingent liabilities;
4. Formulate entries to account for provisions; and
5. Solve problems involving the recognition and measurement of provisions, contingent
liabilities and contingent assets.

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Lesson 1. Premium Liability/Obligation

Many companies offer premiums such as novelty items, like mugs, small appliances,
hand towels and the like to promote their products and encourage sales. Other companies
offer cash rebates and loyalty points for redemption.

All of these offers are intended to increase the company’s sales. Matching principle
dictates that the company matches the related costs as expenses against revenues in the
period of sale. Also, at the end of the accounting period, the company reports any
outstanding offers that it expects to be redeemed or claimed within next year or operating
cycle, if longer, as a current liability(Bazley et. al. 2010).

Accounting procedures for the acquisition of premiums and recognition of premium liability
are as follows (Valix, Peralta & Valix, 2019):

1. Premiums are purchased

Premiums xx
Cash (or Accounts Payable) xx

2. Redemption from the customers and distribution of premiums

Premiums Expense xx
Premiums (or Inventory of Premiums) xx

3. End of year recording of estimated liability for outstanding premiums

Premiums expense xx
Estimated premium liability or xx
(Estimated premium claims outstanding)

Example : Premium Liability

Assume that on October 1, 2020, Melany Foods Corporation began offering to

customers a dish towel in return for 3 can labels. The cost of each premium dish towel is

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P20.00. Based on past experience, the company estimates that only 60% of the labels will be
redeemed. During 2020, the company purchased 60,000 dish towels. In 2020, the company
sold 30,000 cans of its product, at P180.00 per can. From these sales, 10,500 can labels were
returned for redemption in 2020. The company records the following entries in 2020 to match
expenses against revenues and to record its current liabilities:

1. Purchase of 60,000 dish towels

Premiums 1,200,000
Cash 1,200,000
2. Sale of 30,000 cans at P180.00
Cash (or Accounts Receivable) 5,400,000
Sales 5,400,000
3. Redemption of 10,500 can labels
Premiums Expense 70,000
Premiums 70,000

4. End-of-year recording of estimated liability for outstanding

premium offers
Premiums expense 50,000
Estimated premium liability 50,000
The company computes the year-end adjustment to premium expense as follows:
Total cans sold in 2020 30,000
Multiply by estimated percentage of redemption 60%
Total labels estimated for redemption 18,000
Less: Labels redeemed during 2020 10,500
Estimated number of labels for future redemption 7,500
Premiums expense for estimated future redemptions
[(7,500 ÷ 3) x P20] P50,000

The company reports Premium Expense as a selling expense on its 2020 income
statement. Premiums shall be shown as a current asset and the estimated premium liability
as a current liability on its December 31, 2020 balance sheet.

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 Notice that premiums expense was computed based on the gross purchase cost of
the premiums. In case the company will recover a portion of the purchase cost by requiring
cash payment from the redeeming customers, then premium expense will be recorded at the
net cost that is, deducting the cash payment from the customers from the total purchase cost.
In addition, it is important to note that premium expense is unaffected by the actual premium
distribution, since it is recorded as a deduction from the estimated liability for premium.
Moreover, premium expense for the year consists not only for the actual redemption but also
of the future estimated liability for premium.

Lesson 2. Product warranties and guarantees (Valix, et. al. 2019)

Another example of a provision is warranty liability. Many companies, especially those

selling consumer goods makes promises in the form of free repair service, replacement of
defective products within a specified period of time. These offers are often made by
companies to boost sales.

Applying the matching principle, then, any costs of making good on such
guarantees should be recorded as expenses in the same accounting period the products are
sold. Also, it is in the period of sale that the company becomes obligated to make good on a
guarantee, so it is just proper that it recognizes a liability in the period of sale.

Accounting for warranty

There are two methods of accounting for warranty costs:
a. Accrual method
b. Expense as incurred method

Accrual method
Under this method, a company recognizes the estimated warranty expense and the
estimated warranty liability for future performance in the period of sale.
Accounting procedures for recording warranty costs and estimated warranty liability:

1. Record sales of the product

Cash (or Accounts Receivable) xx

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 Sales xx

2. Recognition of warranty expense for the period

Warranty Expense xx
Estimated warranty liability xx

3. Payment of warranty costs

Estimated warranty liability xx
Cash (or other asset) xx
Example: Warranty Liability
Assume that Sebastian Appliances sells 100 units of refrigerators at P24,000 each by
the end of December 31, 2020. Each unit carries a warranty for one year. Experience from
the past has shown that warranty costs will average P2,000 per unit or a total of P200,000.
The corporation spent P90,000 in 2020 and P115,000 in the succeeding year, to fulfil the
warranty agreements for the 100 units sold in 2020. The company records these
transactions in a series of journal entries as follows:
1. Sale of 100 units of refrigerators, 2020
Cash (or Accounts Receivable) 2,400,000
Sales 2,400,000
2. Recognition of warranty expense
Warranty Expense 200,000
Estimated warranty liability 200,000
3. Payment of warranty costs, 2020
Estimated warranty liability 90,000
Cash (or other assets) 90,000
4. Payment of warranty costs, 2021
Estimated warranty liability 110,000
Warranty expense 5,000
Cash (or other assets) 115,000
The company reports the Warranty expense as an operating expense in its 2020
income statement, in the amount of P205,000. In its 2020 statement of financial position the
amount of P110,000 (P200,000 accrued minus P90,000 paid)will be shown as current liability.

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If the warranty period covers a period of more than one year, a portion of the estimated
warranty liability shall be reported as current liability and the remainder as noncurrent liability.

In the preceding journal entry, year 2021, the actual warranty costs are P5,000 more
than what is estimated. The entry debited Warranty expense for 2021 because it resulted in
a change in accounting estimate, which shall be treated currently and prospectively, if
necessary.

Expense as incurred approach (Valix, et. al. 2019)

Under the “expense as incurred approach”, the company records the warranty costs
as an expense in the period when it actually makes the payments for repairs.

Since the company does not estimate and recognize the warranty costs during the
period of sale, it does not record a liability for the future warranty costs. While this method is
conceptually unsound because it violates the matching principle, it is justified for accounting
under three conditions:

1. From a cost/benefit standpoint, when the warranty period is

relatively short,
2. When it is not possible for the company to make a reliable estimate
of the warranty obligation at the time of sale, and
3. When its results are not materially different from the accrual
approach.
The actual warranty costs incurred is simply recorded by debiting warranty expense and
crediting cash at the time it is incurred.

Lesson 3. Other provisions (Valix, et. al. 2019)

Provisions are defined as an existing liability of uncertain timing or uncertain amount.

The liability does exist on balance sheet date but the amount is indefinite or the date when

15
the obligation is due is indefinite, and in some cases, the payee cannot be identified or
determined. It is the equivalent of an estimated liability or a loss contingency that is accrued
because it is both measurable and probable.

Recognition of provision
The following conditions must be met:
a. The enterprise has a present obligation, legal or constructive, as a
result of past event;
b. It is probable that an outflow of resources embodying economic
benefits will be required to settle the obligation; and
c. The amount of obligation can be measured reliably.

Measurement of the provision

Provisions are measured at the best estimate of the expenditure required to settle
the present obligation at the end of the reporting period. The best estimate refers to the
amount that the entity would rationally pay to settle the obligation at the end of reporting period
or to transfer it to a third party at that date.

When the provision consists of a single obligation, the best estimate is normally the
most likely outcome. When the provision involves a large population of items, the best
estimate is by weighing of all possible outcomes by their respective probabilities. Midpoint of
the range is used when there is a continuous range of possible outcomes and each point in
the range is as likely as any other.

Examples of provisions
1. Warranties
2. Environmental contamination
3. Decommissioning or abandonment costs
4. Court case
5. Guarantees

Reimbursements (Millan, 2019)

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 Where some or all of the expenditure required to settle a provision is expected to be
reimbursed by another party, the reimbursement shall be recognized when, and only when, it
is virtually certain that reimbursement will be received when the entity settles the obligation.

The reimbursement shall be treated as a separate asset and not be offset with the
provision. The amount recognized for the reimbursement shall not exceed the amount of
provision.

However, in the statement of comprehensive income, the expense relating to the

provision may be presented net of the amount recognized for a reimbursement.

Lesson 4. Contingencies

Contingency is defined as “an existing condition, or a set of circumstances involving

uncertainty as to a possible gain (a “gain contingency”) or loss (a “loss contingency”) that will
be resolved when a future event occurs or fails to occur (Bazley, et. al. 2010).

Contingent liability and contingent asset defined

Contingent liability is a possible obligation that arises from past event and whose
existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain
future events not wholly within the control of the entity. It is a present obligation that arises
from past event but is not recognized because it is not probable that an outflow of resources
of economic benefits will be required to settle the obligation or the amount of the obligation
cannot be measured reliably (Valix, et. al. 2019).

On the other hand, a contingent asset is a possible asset that arises from past event
and whose existence will be confirmed only by the occurrence or non-occurrence of one or
more uncertain future events not wholly within the control of the entity (Valix, et. al. 2019).

Degrees of probability

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 PAS 37 recognizes four degrees of probability for contingencies but it gives no
guidance to the meaning of the terms. One interpretation could be:

Virtually certain probability above 95%

Probable probability above 50% and up to 95%
Possible probability of 5% up to 50%
Remote probability below 5%

Accounting for contingent liabilities and contingent assets

Contingent Liabilities Contingent Assets

Virtually certain Provide Recognize
Probable Provide Disclose by note
Possible Disclose by note No disclosure
Remote No disclosure No disclosure

Differentiate provisions from contingent liability (Millan, 2019)

A provision is a liability of an uncertain timing or uncertain amount that meets all of

the following conditions: present obligation, probable outflow of economic resources and can
be reliably estimated.

A contingent liability, on the other hand, is only a possible obligation whose existence
will be confirmed only by the occurrence or non-occurrence of one or more uncertain future
events not wholly within the control of an entity; or a present obligation but it is not probable
that it will cause an economic outflow in its settlement and its amount cannot be reliably
estimated.

Assessment Task 2

Problem Solving
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1. Sebastian Company includes one coupon in each box of hotcake mix it sells. A spoon is
offered as a premium to customers who presents 10 coupons and a cash remittance of
P10.00.

Cost of distributing the premium is P5.00. Experience indicates that only 30% of the
coupons will be redeemed 2020 2021

Boxes of hotcake mix sold 2,000,000 2,500,000

Number of spoons purchased at P50 each 50,000 80,000
Coupons redeemed 400,000 700,000
Required:

a. Compute for the premium expense for the year 2020

b. Compute the estimated premium liability on December 31, 2020
c. Compute for the premium expense for the year 2021
d. Compute for the estimated premium liability on December 31, 2021

2. During 2020, Joaquin Company introduced a new line of machines that carry a two-year
warranty against manufacturer’s defects. Based on industry experience, the estimated
warranty cost percentages related to peso sales are as follows:

Year of sale 1%
Year after sale 6%
Sales and actual warranty expenditures for 2020 and 2021 were as follows:

Year Sales Actual warranty expenditures

2020 P1,000,000 P54,000

2021 1,400,000 89,000

a. How much is the warranty expense to be recognized in 2020 and 2021,

respectively?
b. What is the estimated warranty liability as of December 31, 2020 and 2021,
respectively?

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3. Determine the implication of the following independent cases to the December 31, 2020
financial statements as per PAS 37, on Provisions, Contingent Liabilities, and Contingent
Assets.

Case 1

On December 5, 2020, an employee filed a P3,000,000 lawsuit against Lance Company for
damages suffered when one of the company’s equipment malfunctioned in August, 2020.
In your inquiry of the company’s legal counsel, the legal counsel expects the company will
lose the lawsuit and estimates the losses to be between P500,000 and P1,500,000. The
employee has offered to settle the lawsuit out of court for P1,200,000, but Lance Company
will not agree to the settlement.

Case 2

Lance Company has guaranteed a loan of P2,000,000 of one of its key officers from a bank
in 2020. By the time the financial statements of Lance Company were approved for
issuance by its BOD, it is clear that the key officer is in financial difficulties and it is probable
that Lance Company will meet the guarantee.

Case 3

On December 20, 2020, an explosion occurred at Lance Company’s plant causing extensive
property damages to adjacent areas. Although no claims had yet been asserted against
Lance Company by April 15, 2021, Lance Company’s management and legal counsel
believes that it is probable that the company will be liable for damages, and that P2.5M
would be reasonable estimate of its liability. The legal counsel further opines that the total
liability may possibly be up to P5M given the extent of damages to the neighboring areas.
Lance Company’s P10M comprehensive public liability policy has a P1M deductible clause.

Case 4

On January 12, 2021, a fire at the production area of Lance Company damaged a number of
adjacent buildings. Lance Company’s insurance policy does not cover damages to property
of others. The adjacent neighbors have filed a P2M damages suit against the company and
the legal counsel opines that it is probable that such damages will be awarded to them.

Case 1 Case 2 Case 3 Case 4

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a. Accrue liability at Disclose contingency Accrue liability at Accrue liability at

P1,200,000 at P2,000,000 P1,500,000 P2,000,000

b. Accrue liability at Disclose contingency Accrue liability at Disclose contingency

P1,000,000 at P2,000,000 P1,000,000 at P2,000,000

c. Accrue liability at Accrue liability at Accrue liability at Disclose contingency

P1,000,000 P2,000,000 P1,000,000 at P2,000,000

d. Accrue liability at Accrue liability at Accrue liability at Accrue liability at

P1,000,000 P2,000,000 P1,500,000 P2,000,000

Summary

The use of estimates in financial reporting is permitted but not in such a way that it
would mislead the information users in decision making. Financial statements deal with past
or historical information. Only those obligations arising from past events existing
independently of an entity’s future actions are recognized as provisions.

The recognition of provisions in the financial statements should conform to all of the
following conditions, (1) entity has a present obligation resulting from a past event, (2) it is
probable that an outflow of resources embodying economic benefits will be required to settle
the obligation, and (3) amount of obligation can be reliably estimated.

Premiums and warranties are examples of current liabilities requiring amounts to be

estimated. Premiums are add-ons on the product being offered for sale while warranties are
after-sale services to the customers on the products previously purchased.

Contingencies, especially contingent liabilities, is classified as possible obligation

whose existence will be confirmed only by the occurrence or non-occurrence of one or more
uncertain future events not wholly within the control of the entity.

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References

Bazley, J. D., Nikolai, L. A., & Jones, J.P., (2010). Intermediate Accounting (11th Ed.). Canada:
Rob Dewey

Millan, Z.V.B., (2019). Intermediate Accounting 2: Baguio City, Philippines: Bandolin

Enterprise

Valix, C.T., Peralta N. F., &Valix, C.A.M., (2019). Intermediate Accounting Vol. 2. Philippines:
GIC Enterprises & Co., Inc.

MODULE 3
BONDS PAYABLE AND OTHER CONCEPTS

Introduction

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 In financial management, a company’s capital structure refers to the mix of debt and
equity it uses to finance its operations. In general, debt financing involves more risks than
equity financing. Aside from paying interests and principal at specified times, it places the
owner in a subordinate position relative to creditors because the claims of creditors must first
be satisfied in case of liquidation. Nevertheless, debt can also be an advantage. It can
increase earnings, in the concept of financial leverage(Bazley, et. al. 2010). If the company
earns a return on borrowed funds which is more than the cost of borrowing the funds, the
shareholders are provided with a total return greater than what could have been earned with
equity funds alone (Spiceland, Sepe, Nelson, 2011).

In this module, some of the reasons for issuance of long-term liabilities will be taken.
In particular, discussions will focus on the characteristics of bonds payable, recording the
issuance of bonds, amortizing discounts and premiums, issuance of compound financial
instruments (debt and equity instruments), derecognition of liabilities and financial statement
presentation of related accounts.

Learning Outcomes

At the end of this module, students should be able to:

1. Relate the initial and subsequent measurement of bonds payable;

2. Compare amortization procedures for bonds issued using the straight line method and the
effective interest method;
3. Account for compound financial instruments;
4. Explain the accounting for derecognition of liabilities; and
5. Apply the accounting principles on financial statement presentation of long-term liabilities
and the adjunct/contra accounts.

Lesson 1. Reasons for issuance of Long-term Liabilities (Bazley, et. al. 2010)

A company classifies an item as a long-term liability if it is not to be repaid within one

year or the normal operating cycle, whichever is longer. When additional funds are needed
by the entity to finance its operations, it may resort to external sources to satisfy their needs.

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 There are four basic reasons why a company may resort to debt financing rather than
issuance of other type of securities.

Debt financing offers the opportunity for leverage

Trading on equity or leverage refers to a company’s use of borrowed funds. Earnings
in excess of interest charges increases earnings per share. However, if the return on
borrowed funds falls below the effective interest rate, earnings per share will deteriorate
rapidly.

The voting privilege is not shared

By issuing debt instruments, which does not provide voting rights, ownership interests
are not diluted. Corporate shareholders maintain their equity interests in the firm.

Debt financing offers an income tax advantage

Interest payments on outstanding debts are deductible as interest expenses for

income tax purposes while dividend payments on shares issued and in the hands of
shareholders are not.

Debt financing may be the only available source of financing

As in the case of small- and medium sized companies, some investors may find it too
risky to invest in equity or capital stock investments. Debt securities issued by a company
may appear less risky because interest payment is required to be paid on every interest
payment date. In addition, some types of debts are backed up or secured by a lien against
some company assets.

Lesson 2. Bonds Payable and Other concepts (Bazley, et. al. 2010)

The most common form of corporate debt is by issuing bonds. Since bonds are
issued in specified denominations, say P1,000 or P5,000 bonds, it breaks down a large
obligation into manageable parts. There are several key terms about bonds:

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  Bond - a type of note in which a company agrees to pay the holder the
face value at maturity date and pay interest periodically at a specified
rate on the face value
 Face value – or par value is the amount of money that the issuer agrees
to pay at maturity
 Maturity date - the date on which the issuer of the bond agrees to pay
the face value to the holder
 Contract rate - also called stated rate, or nominal rate is the rate at
which the issuer of the bond agrees to pay interest each period until
maturity
 Bond certificate – a legal document that specifies the face value, the
annual interest rate, the maturity date and other characteristics of the
bond issue
 Bond indenture – is a document (contract) that defines the rights of the
bondholders

Lesson 3. Recording the Issuance of Bonds (Bazley, et. al. 2010)

Three alternatives are possible for a company selling bonds:

a. Bonds sold at par – the yield (effective rate) is equal to the contract
rate, buyer of the bonds pay the face value of the bonds
b. Bonds sold at a discount – yield is more than the contract rate, buyer
of the bonds pay less than the face value of the bonds
c. Bonds sold at a premium – yield is less than the contract rate, buyer
of the bonds pay more than the face value of the bonds

When the bonds has an effective rate either lower or higher than the contract rate, the
interest expense recorded by the issuer each period is different from the interest paid. When
bonds are sold at a premium, the interest expense is less than the interest paid. When the
bonds are sold at a discount, the interest expense is more than the interest paid. The
difference between the interest expense and the interest payment is the discount or premium
amortization.

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 The company records the face value of bonds issued thru a Bonds Payable account,
and it records any premium or discount in a separate account titled Discount on Bonds
Payable or Premium on Bonds Payable. To illustrate, assume the company sells bonds with
a face value of P5,000,000 at 102. It records the sales as follows:

Cash (P5,000,000 x 1.02) 5,100,000

Bonds Payable 5,000,000
Premium on Bonds Payable 100,000

Premium on Bonds Payable is an adjunct account and is added to the Bonds Payable
account, whereas the Discount on Bonds Payable is a contra account and is subtracted from
the Bonds Payable account. The book value or carrying value of the bond issue at any time
is the face value of the bonds plus any unamortized premium or minus any unamortized
discount. Thus, in the example given, the book value on the issue date is P5,100,000.

Bonds are often sold after their authorization date and between interest payment
dates. In such instances, the company must pay interest only for the period of time the bonds
are outstanding. The company also will collect from the investors both the selling price and
the interest accrued on the bonds from the interest payment date prior to the date of sale. This
procedure reduces the record keeping for the interest payment. This interest amount collected
is credited to Interest Expense and is computed by multiplying the face value by the stated
interest rate for the fraction of the year from the interest payment date prior to the date of sale.

Lesson 4. Initial and Subsequent Measurement of Bonds Payable (Valix, et. al. 2019).

PFRS 9, paragraph 5.1.1 provides that bonds payable not designated at fair value
through profit or loss shall be measured initially at fair value minus transaction costs that are
directly attributable to the issue of bonds payable.

Bond issue costs shall be deducted from the fair value or issue price of bonds in
measuring initially the bonds payable, except that if the bonds are designated and are

26
accounted for at fair value through profit or loss, the bond issue costs are treated as expense
immediately.

After initial recognition, bonds payable shall be measured either at amortized cost
using the effective interest method or at fair value through profit or loss.

Lesson 5. Amortizing Discounts and Premiums

When a company pays the interest on the bonds, this payment is based on the stated
rate. However, to properly report the interest cost on the bonds, the Interest Expense on the
income statement must show an amount based on the effective interest rate and the book
value of the bonds. There are three approaches in amortizing bond discount or bond
premium, namely; straight line, bonds outstanding and the effective interest method (Bazley,
et. al. 2010).

PFRS 9 requires the use of the effective interest method in amortizing discount,
premium and bond issue costs (Valix, e.t al. 2019).

Straight line Method

When using the straight line method, the discount or premium is amortized to interest
expense in equal amounts each period during the life of the bonds(Bazley, et. al. 2010).The
periodic amortization is computed by simply dividing the amount of bond premium or bond
discount by the life of the bonds. Life of the bonds is the period commencing on the date of
sale up to maturity date (Valix, et. al. 2019).
Bonds outstanding Method

This method of amortization is applicable to serial bonds whether issued at a discount

or premium. Serial bonds are those with a series of maturity dates. Bond discount or bond
premium amortization is computed by multiplying the amount of the premium or the discount
by fractions developed from the diminishing balance of the bonds (Valix, et. al. 2019).

Effective Interest Method

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 Under the effective interest method, the effective interest expense is determined by
multiplying the effective rate by the carrying amount of the bonds. The carrying amount of the
bonds changes every year as the amount of premium or discount is amortized periodically.
The effective interest is then compared with the nominal interest and the difference is the
premium or discount amortization (Valix, et. al. 2019).

Lesson 6. Compound Financial instruments

A company may issue bonds that allow creditors to ultimately become stockholders by
attaching share warrants to the bonds or including a conversion feature in the bond indenture
(Bazley, et. al. 2010). A compound financial instrument is a financial instrument that, from the
issuer’s perspective, contains both a liability and an equity component. These components
are treated separately. In other words, one component of the financial instrument meets the
definition of a financial liability and another component meets the definition of an equity
instrument (Valix, et. al. 2019)

PAS 32, paragraph 11, defines a financial instrument as any contract that gives rise
to both a financial asset of one entity and a financial liability or equity instrument of another
entity.

Bonds issued with detachable share warrants (Bazley, et. al. 2010)

When a company issues with detachable share warrants, these warrants represent
rights that enable the security holder to acquire a specified number of ordinary shares at a
given price within a certain time period. This issuance requires splitting the proceeds from
issue in accordance with the new standards, that on initial recognition, the equity component
(warrants) represents the residual amount of the fair value (proceeds) of the instruments as
a whole after deducting the amount separately determined for the liability (bonds).

28
 The bonds are assigned an amount equal to the “market value of the bonds without
warrants “, regardless of the market value of the warrants. The residual amount or the
remainder of the issue price shall then be allocated to the warrants.

Convertible bonds (Valix, et. al. 2019)

The issuance of convertible bonds shall be accounted for as partly liability and partly
equity. Therefore, the issue price of the convertible bonds shall be allocated between the
bonds payable and the conversion privilege. The bonds are assigned an amount equal to
the market value of the bonds without the conversion privilege.

The residual amount or remainder of the issue price shall then be allocated to the
conversion privilege or equity component.

In the absence of market value of the bonds without conversion privilege, the amount
allocated to the bonds is equal to the present value of the principal bond liability plus the
present value of future interest payments using the effective or market interest rate for similar
bonds without conversion privilege.

Conversion of bonds

The amortized cost/carrying value of the debt, which is equal to the face value of the
instrument less any unamortized bond issue costs and unamortized bond discount or plus any
unamortized bond premium derecognized as a liability will be recognized as an equity. The
equity component at the time of issue remains in equity, although it may be transferred from
one line item within equity to another. No gain or loss is recognized from the initial recognition
of the components of the instrument.

Lesson 7.Derecognition of a financial liability (Millan, 2019)

A financial liability is derecognized when it is extinguished, that is, when the obligation
is discharged or cancelled or expires. Derecognition also calls for the removal of a previously

29
recognized asset or liability from the entity’s statement of financial position. It can be done
through various methods, namely:

a. Repayment in cash
b. Transfer of non-cash assets or rendering of services
c. Issuance of equity securities
d. Replacement of existing obligation with a new obligation
e. Waiver or cancellation of the creditor
f. Expiration of period, such as in the case of warranties (Millan, 2019 Edition)

Lesson 8. Financial Statement Presentation of Long-term Liabilities

Discount on bonds payable and premium on bonds payable are reported as

adjustments to the bond liability account.

The discount on bonds payable is a deduction from the bonds payable and the
premium on bonds payable is and addition to the bonds payable account.

The treatment is on the theory that the discount represents an amount that the issuer
cannot borrow because of interest differences, and the premium represents an amount in
excess of face amount that the issuer is able to borrow.

The discount on bonds payable and the premium on bonds payable shall not be
considered separate from the bonds payable account. Both accounts shall be treated
consistently as valuation accounts of the bond liability.

Notice the following presentation in the statement of financial position.

Noncurrent liabilities
Bonds payable xx
Discount on bonds payable (xx) xx

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 and

Noncurrent liabilities
Bonds payable xx
Premium on bonds payable xx xx

Assessment Task 3

PROBLEM SOLVING

1. On December 31, 2021, Extract Company issued a P40,000,000 5-year of P1 per value
each at an issue price of P0.90 per unit. The bond carries a coupon interest of 6% and interest
is payable on December 31 each year. Cost of issuing the bond, which included underwriting
fees, totalled P2,000,000. The prevailing market rate interest for similar risk class bonds on
December 31, 2021 was 10%.

Question 1. What is the initial carrying value of the bond on December 31, 2021 assuming
Extract Company has the policy to measure the bond at fair value to profit or loss?

Question 2. What is the initial carrying value of the bond on December 31, 2021assuming
Extract Company has the policy to measure the bond at amortized cost model?

2. Downing Company issues P5,000,000, 6%, 5-year bonds dated January 1, 2021. The
bonds pay interest semi-annually on June 30 and December 31. The bonds are issued toyield
5%. What are the proceeds from the bond issue?

2.5% 3.0% P 5.0% 6.0%

Present value of a single sum for 5 .88385
periods .86261 .78353 .74726
.78120

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 Present value of a single sum for 10
periods 4.64583 .74409 .61391 .55839
Present value of annuity for 5 periods
Present value of annuity for 10 8.75206 4.57971 4.32948 4.21236
periods
8.53020 7.72173 7.36009

3. On July 1, 2021, Glamorous Corporation issued 11% bonds in the face amount of
P2,000,000 that mature on June 30, 2025. The bonds were issued to yield 5% and interest
is payable every January 1 and July 1. Glamorous Corporation uses the effective interest
method of amortizing bond premium or discount. The following are the present value factors.
PV of 5% for an ordinary annuity of P1 after 8 periods 6.463
PV of 5% after 8 interest period .677

What is the carrying value of the debt instruments as of December 31, 2021?

4. At the beginning of 2020. Wallace Corporation issued 10% bonds with a face value of
P900,000. These bonds mature in the five years, and interest is paid semi-annually on June
30 and December 31. The bonds were sold for P833,760 to yield 12%. Wallace uses a
calendar-year reporting period. Using the effective – interest method of amortization, what
amount of interest expense should be reported for 2020? (Round your answer in the nearest
peso).
5. On January 1, 2020, Monterey Company issues 100 million unsecured bonds at an issue
price 95 cents per unit. Transaction costs, that include underwriting fee, amount to P500,000.
The bonds pay interest of 4% at the end of the first year and thereafter interest payment
increases at 1% per year. The bond mature on December 31, 2024 are redeemable at the
nominal value of P1 each. At the date of issue, Monterey Company has a credit rating of “ABB”
and its market interest rate is 7.09%. But due to the imputation of the transaction cost the
effective rate of the debt is 7.21%. What is the amortized cost of the debt as of December 31,
2022?

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6. On January 1, 2020, Trader Company issued its 8%, 4 year convertible debt instrument
with a face amount of P6,000,000 for P5,900,000. Interest is payable every December 31 of
each year. The debt instruments is convertible into 50,000 ordinary shares a par value of
P100. When the debt instruments were issued, the prevailing market rate of interest for similar
debt without conversion option is 10%.
PV of 10% for ordinary annuity of P1 after 4 periods 3.169865
PV of 10% after 4 interest period .683013

1. What is the amortized cost of the debt as of December 31, 2022?

2. What is the amount of interest expense for the year ended December 31, 2021?

7. On January 1, 2020, Shredder Company Issued its 10%, 4-year convertible debt instrument
with a face amount of P3,000,000 for P3,500,000. Interest is payable every December 31 of
each year. The debt instrument is convertible into 30,000 ordinary shares with a par value of
P100. The debt instrument is convertible into equity from the time of issue until maturity. When
debt instruments were issued, the prevailing market rate of interest for similar debt without
conversion option is 8%.

PV of 8% for an ordinary annuity of P1 after 4 periods 3.3121268

PV of 8% after 4 interest periods .7350298

On December 31, 2022, Shredder Company converted all the debt instruments by issuing
30,000 ordinary shares.

1. What is the carrying value of the compound instruments as of December 31, 2022?
2. What is the amount of interest expense should the company report in the Dec. 31,
2021 profit or loss?

Summary

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 The five basic reasons why a company might issue long-term debt rather than other
type of securities are as follows: (1) debt may be the only source of funds, (2) debt financing
offers an income tax advantage, (3) voting privilege is not shared, and (4) debt financing offers
the opportunity for leverage.

A bond is a type of note in which the company agrees to pay the holder the face value
at the maturity date and usually to pay interest periodically at a specified on the face value.

At the time of sale, the company records the face value of the bonds in a Bonds
Payable account and records any premium or discount in a separate account entitled Premium
on bonds payable or Discount on bonds payable. A premium account is an adjunct account
while a discount account is a contra account.

Under the straight line method, any discount or premium is amortized to interest
expense in equal amounts each period during the life of the bonds. The interest expense is
the sum of cash payment plus the discount amortization or minus the premium amortization.

The effective interest method applies the semi-annual yield to the book value of the
bonds at the beginning of each successive semi-annual period to determine the interest for
that period. The discount or premium amortization is the difference between the interest
expense and the cash payment.

A company may issue bonds that allow creditors to ultimately become shareholders
by attaching share warrants to the bonds or including a conversion feature. In either case,
the investor has acquired the right to receive interest on the bonds and the right to acquire
ordinary shares and to participate in the potential appreciation of the market value of the
company’s ordinary shares.

References

34
Bazley, J. D., Nikolai, L. A., & Jones, J.P., (2010). Intermediate Accounting (11th Ed.). Canada:
Rob Dewey

Millan, Z.V.B., (2019). Intermediate Accounting 2: Baguio City, Philippines: Bandolin

Enterprise

Spiceland, D.J., Sepe, J. F., & Nelson, M. W., (2011). Intermediate Accounting (6 th Ed.). New
York: McGraw Hill/ Irwin

Valix, C.T., Peralta N. F., &Valix, C.A.M., (2019). Intermediate Accounting Vol. 2. Philippines:
GIC Enterprises & Co., Inc.

35