Chapter 3 Intermediate Accounting

AE16: Intermediate Accounting 2
Chapter 3
Bonds Payable & Other Concepts
Bonds payable
Bonds are long-term debt instruments similar to notes and loans except that bonds are usually
offered to the public and sold to many investors. A bond is intended to be broken up into various
subunits (e.g., P1,000 each) which can be issued to a variety of investors.
A debt instrument is any contract that represents a right upon the holder to receive cash from
the issuer thereof or an obligation upon the issuer to pay cash to the holder thereof. A debt
instrument represents a debtor-creditor relationship between entities (e.g., accounts, notes,
loans, bonds, redeemable preference shares issued, and other payables).
Bond indenture is the contractual agreement between the issuer and the bondholders. It
contains restrictive covenants intended to prevent the issuer from taking actions contrary to the
interests of the bondholders. A trustee, often a bank, is appointed to ensure compliance.
A bond indenture may specify, among other things, the following:
a. Rights and duties of bondholders and issuer which may include the following:
1. Call provision – the issuer’s right to call bonds before the scheduled maturity.
2. Redemption rights – the holder’s right to redeem the bonds before the scheduled
maturity.
b. Restrictions and requirements on the issuer which may include the following:
Page 1
1. Sinking fund that the issuer is required to establish for the protection of the
bondholders.
2. Financial ratios that the issuer is required to maintain.
3. Restriction on dividends available to the issuer’s shareholders.
4. Restriction on incurrence of additional obligations.
5. Appointment of independent trustee whose qualifications are stated in the bond

indenture.
6. Authorized amount of bonds that can be issued.
c. Interest rate, payment date(s), and maturity date(s)
Bond certificate is issued to the bondholder representing the amount of bonds he has purchased.
Bonds are normally issued in denominations, such as ₱1,000 and ₱10,000. These small
denominations increase the affordability of bonds enabling the issuer to obtain financing from a
wider market.
Issuance of bonds
Bonds can be issued in several ways, for example, through underwriting, auction, or direct
placement with investors. Often, bonds are issued through an underwriter (e.g., investment
banker) who agrees on the price of the bonds, pays the issuer, and then resells the bonds to other
investors at a higher price. The underwriter is paid a fee for this service and may agree to
purchase any unsold bonds at a specified price.
Types of bonds
Page 2
As to maturity:
1. Term bonds – bonds that mature on a single date.
2. Serial bonds – bonds in which the principal matures in installments.
3. Extendible and Retractable bonds – bonds that have more than one maturity date
permitting investors to choose the maturity dates that meet their needs.
a. Extendible bonds – bonds that give holders the right to extend the initial maturity to
a later date.
b. Retractable bonds –bonds that give holders the right to shorten the initial maturity
to an earlier date.
Investors use extendible/retractable bonds to modify the term of their portfolio to

take advantage of movements in interest rates.
As to recording point of view and payment of interests:
4. Registered bonds – bonds issued in the name of the holder (owner). Interests are paid
directly to the holder. When the holder sells registered bonds, the bond certificate must be
surrendered and a new certificate is issued.
5. Coupon (bearer) bonds – bonds that can be freely transferred and have a detachable
coupon for each interest payment.
6. Zero-coupon bonds (strip bonds or deep-discount bonds) – bonds that do not pay
periodic interests. However, they sell at a deep discount from their face amount.
7. Income bonds – bonds that pay interest only if the issuer earns profit.
Page 3
8. Participating bonds – bonds that participates in excess earnings of the issuer as defined in
the indenture.
9. Indexed bonds (purchasing power bonds) – bonds that pay interest that is indexed to a
measure of general purchasing power, such as the Consumer Price Index (CPI).
10. Inflation-linked bonds – bonds whose principal and interest payments are adjusted in
response to inflation, providing the bondholder protection from inflation.
As to security and risk:
11. Mortgage bonds – bonds secured by real property.
12. Collateral trust bonds – bonds secured by the issuer’s securities, which are held by a
trustee. If the issuer defaults, the trustee distributes the securities to the bondholders.
13. Asset-backed bonds (Asset-backed securities) – bonds collateralized by a pool of assets,

such as credit card receivables and car loans.
14. Subordinated bonds (subordinated debentures) – bonds that have a higher yield than the
secured bonds but a lower priority during liquidation.
15. Debenture bonds – bonds not secured by any collateral.
16. Junk bonds – high-risk, high-yield bonds typically issued to finance leveraged buyouts and
mergers.
As to right of redemption:
17. Callable bonds – bonds that the issuer can redeem prior to maturity date. If interest rates
decline, the issuer can call high-interest bonds and replace them with low-interest bonds.
Page 4
18. Convertible bonds – bonds that the holder can exchange for the issuer’s shares of stocks.
As to issuer:
19. Corporate bonds – bonds issued by a corporation. Bonds issued by companies with high
credit rating are considered “investment grade”, whereas bonds issued by companies with
low credit rating are considered “non-investment grade” or “junk” because of their
speculative nature.
20. Government bonds (Treasury bonds) – bonds issued by a government. Government

bonds have low financial risk because they are practically free from default.
As to currency:
21. International bonds – bonds issued by a foreign entity in a domestic market. International
bonds include the following:
a. Euro bonds – bonds denominated in a currency other than the currency of the market
in which they are offered.
b. Foreign bonds – bonds denominated in the currency of the domestic market in which
they are offered.
c. Global bonds – bonds that are issued in several countries at the same time.
Accounting for bonds
Bonds are accounted for in much the same way as notes and loans payable. However, bonds
normally are long-term, bear interest, issued at a premium or discount, and entail transaction
(issue) costs.
Bond premium and discount
Page 5
To reiterate the concepts of premium and discount, an outline is provided below:

Cash proceeds (Carrying Effective interest rate
amount) compared to compared to Nominal Effect of amortization
Face amount interest rate on interest expense
Discount Cash proceeds Effective interest Interest expense
(Carrying amount) is rate is higher than is greater than
less than face Nominal interest Interest paid
amount rate
Premium Cash proceeds Effective interest Interest expense
(Carrying amount) is rate is lower than is less than
greater than face Nominal interest Interest paid
amount rate
There is no premium or discount if bonds are issued at face amount (except when transaction
costs are incurred). When there is no premium or discount, the effective interest rate is equal to
the nominal interest rate. Consequently, interest expense equals interest paid.
Illustration 1: Bonds issued at a discount
On January 1, 20x1, ABC Co. issued 1,000, ₱1,000, 10%, 3-year bonds for ₱951,963. Principal is
due at maturity but interest is due annually every year-end. The effective interest rate is 12%.
 Initial measurement:
The issuance of the bonds is recorded as follows:

Jan. 1, 20x1 Cash 951,963
Discount on bonds payable (1M-951,963) 48,037
Bonds payable 1,000,000
Notes:
Page 6
 There is discount because the issue price (₱951,963) is less than the face amount (₱1M).
Consequently, the effective interest rate (12%) is higher than the nominal interest rate
(10%).
 The “Bonds payable” account is credited at face amount. The discount is recorded
separately.
 The “Discount on bonds payable” account has a normal debit balance and is a contra
account (deduction) to the “Bonds payable” account when determining the carrying
amount of the bonds.
Bonds payable ₱1,000,000
Discount on bonds payable, Jan. 1, 20x1 (48,037)
Carrying amount of bonds payable, Jan. 1, 20x1 ₱ 951,963
Subsequent measurement:
Interest Interest
Date Payments Expense Amortization Present Value
Jan. 1, 20x1 951,963
Dec. 31, 20x1 100,000 114,236 14,236 966,199
Dec. 31, 20x2 100,000 115,944 15,944 982,143
Dec. 31, 20x3 100,000 117,857 17,857 1,000,000
Notice that the amortization of the discount increases the periodic interest expense. When
bonds are issued at a discount, the cash received is less than the obligation incurred. In effect,
there is loss; however, this is not recognized immediately but rather deferred and amortized as
an addition to periodic interest expense,
At maturity date, the carrying amount of the bonds is equal to the face amount because, by then,
the discount is fully amortized.
The other pertinent entries are as follows:
Page 7
Dec. 31, 20x1 Interest expense 114,236

Cash 100,000
Discount on bonds payable 14,236
To record interest expense

Cash 100,000

Cash 100,000
Bonds payable
1,000,000
Cash
1,000,000
To record the retirement of bonds
Unamortized balance of discount or premium
The unamortized balance of discount or premium as at a certain date is the difference between
the face amount and the carrying amount of the bonds at that date.
For example, the unamortized discount on the bonds as of Dec. 31, 20x1 is computed as follows:
Face amount 1,000,000

Carrying amount – Dec. 31, 20x1 (966,199)
Discount on bond payable – Dec. 31, 20x1 33,801
Page 8
Illustration 2: Bonds issued at a premium
On January 1, 20x1, ABC Co. issued 1,000, ₱1,000, 12%, 3-year bonds for ₱1,049,737. Principal is
due at maturity but interest is due annually every year-end. The effective interest rate is 10%.
The issuance of the bonds is recorded as follows:

Jan. 1, 20x1 Cash 1,049,737
Premium on bonds payable (1,049,737-1M) 49,737
Notes:
 There is premium because the issue price is greater than the face amount. Consequently,
the effective interest rate is lower than the nominal interest rate.
 Whether bonds are issued at a discount or premium, the “Bonds payable” account is
always credited at face amount.
 The “Premium on bonds payable” account has a normal credit balance and is an adjunct
account (addition) to the “Bonds payable” account when determining the carrying
amount of the bonds.
Premium on bonds payable, Jan. 1, 20x1 49,737
Carrying amount of bonds payable, Jan. 1, 20x1 ₱1,049,737
Subsequent measurement:
Interest Interest
Jan. 1, 20x1 1,049,737
Dec. 31, 20x1 120,000 104,974 15,026 1,034,711
Dec. 31, 20x2 120,000 103,471 16,529 1,018,182
Dec. 31, 20x3 120,000 101,818 18,182 1,000,000
Page 9
Notice that the amortization of premium decreases the periodic interest expense. When bonds
are issued at a premium, the cash received is more than the obligation incurred. In effect, there
is gain; however, this is not recognized immediately but rather deferred and amortized as a
reduction to periodic interest expense,
At maturity date, the carrying amount of the bonds is equal to the face amount because, by then,
the premium is fully amortized.
Premium on bonds payable 15,026
Cash 120,000
Cash 120,000
Cash 120,000

Cash 1,000,000
 Observe the following from the amortization table:
All these columns increase over the

term of the bonds issued at a discount.
Discount Amortization:
Interest Interest
Jan. 1, 20x1 951,963
Dec. 31, 20x1 100,000 114,236 14,236 966,199
Dec. 31, 20x2 100,000 115,944 15,944 982,143
Dec. 31, 20x3 100,000 117,857 17,857 1,000,000
Page 10
Only this column increases over the

term of the bonds issued at a premium.
Premium Amortization:
Interest Interest
Jan. 1, 20x1 1,049,737
Dec. 31, 20x1 120,000 104,974 15,026 1,034,711
Dec. 31, 20x2 120,000 103,471 16,529 1,018,182
Dec. 31, 20x3 120,000 101,818 18,182 1,000,000
Accounting for transaction costs
Financial liabilities are initially measured at fair value minus transaction costs. Accordingly,
transaction costs on issuing bonds (bond issue costs) are deducted when determining the
carrying amount of the bonds. Subsequently, the transaction costs are amortized using the
effective interest method. Transaction costs may require an adjustment to the effective interest
rate.
Illustration 1: Bonds issued at face amount
On January 1, 20x1, ABC Co. issued 10%. ₱1,000,000 bonds at face amount. Principal is due on
Dec. 31, 20x3 but interest is due annually every year-end.
Case 1: No transaction costs
The carrying amount is equal to the face amount because the bonds were issued at face amount
and no transaction costs were incurred. Accordingly, there is no premium or discount. The
effective interest rate is equal to the 10% nominal rate. The accounting is straightforward –
interest expense equals interest paid.
Page 11
Journal entries:
Jan. 1, 20x1 Cash 1,000,000
Bonds payable (1,000 x₱1,000) 1,000,000
Dec. 31, 20x1 Interest Expense (1M x 10%) 100,000
Cash 100,000
Cash 100,000
Cash 100,000
Cash 1,000,000
Case 2: With transaction costs
ABC Co. paid commission of ₱48,037 to underwriters.
 Initial measurement:
Jan. 1, 20x1 Cash (1M-48,037) 951,963
Bond issue cost 48,037
Notes:
 The transaction costs are recorded separately and will be subsequently amortized using
the effective interest method (similar to discount on bonds payable). The carrying
amount of the bonds is determined as follows:
Bond issue cost (48,037)
Carrying amount of bonds payable, Jan. 1, 20x1 ₱ 951,963
Page 12
 That the bonds are initially measured equal to the net issuance proceeds (₱1M cash
receipt - ₱48,037 cash payment).
 The transaction cost decreased the carrying amount of the bonds below the face amount.
Accordingly, the effective interest rate would be different from the 10% nominal interest
rate. We will compute for the effective interest rate using the “trial and error” approach.
Trial and error approach
Future cash flows x PV factor at x% = Present Value
 Future cash flows: Since the bonds pay interest, the future cash flows consists of
payments for the (1) principal and (2) interest.
 PV factors: We will use PV of ₱1 for the principal because it is due only at maturity. We
will use PV of ordinary annuity of ₱1 for the interest because it is due annually.
 Present Value: The present value of the bonds on Jan. 1, 20x1 is equal to the carrying
amount of ₱951,963.
Our working equation is as follows:
Principal: (1M x PV of ₱1 @x%, n=3) + Interest: [(1M x10%) x PV of an ordinary annuity of ₱1

@x%, n=3] = 951,963
The carrying amount of the bonds of ₱951,963 is less than the face amount. In effect, there is
discount. Therefore, the effective interest rate would be higher than the 10% nominal rate.
First trial: (using 12%)
 (1M x PV of ₱1@12%, n=3) + [(1M x 10%) x PV of an ordinary annuity of ₱1@12%, n=3] =

951,963
 (1M x 0.71178) +(100,000 x2.40183) = 951,963
 (711,780 +240,183) = 951,963 is equal to 951,963
Page 13
The effective interest rate is 12%, i.e., the rate that exactly discounts the future cash flows to the
initial carrying amount of the bonds.
 Subsequent measurement: Amortization table
Interest Interest
Jan. 1, 20x1 951,963
Dec. 31, 20x1 100,000 114,236 14,236 966,199
Dec. 31, 20x2 100,000 115,944 15,944 982,143
Dec. 31, 20x3 100,000 117,857 17,857 1,000,000
The pertinent entries are as follows:
Cash 100,000
Cash 100,000
Cash 100,000
Cash 1,000,000
Illustration 2: Bonds issued at a discount – with transaction costs
due on Dec. 31, 20x3, but interest is due annually every year-end. In addition, ABC incurred
Page 14
bond issue costs of ₱44,829. The effective interest rate is 12% before adjustment for bond issue
costs and 14% after adjustment for bond issue costs.
 Initial measurement:
Jan. 1, 20x1 Cash (951,963-44,829) 907,134
Bonds payable (1,000x₱1,000) 1,000,000
Notes:
 The bond issue costs are included in the discount on bonds payable so that both will be
amortized altogether. This simplifies recording by eliminating the need to allocate the
amortization between the bond issue costs and the discount.
 The effective interest rate to be used is 14% - the rate adjusted for the bond issue costs.
 Subsequent measurement: Amortization table
Interest Interest
Jan. 1, 20x1 907,134
Dec. 31, 20x1 100,000 126,999 26,999 934,133
Dec. 31, 20x2 100,000 130,779 30,779 964,912
Dec. 31, 20x3 100,000 135,088 35,088 1,000,000
The entry on Dec. 31, 20x1 is as follows:
Cash 100,000
If the bond issue costs are not added to the bond discount, the amortization shall be allocated to
the bond issue costs and the discount based on their outstanding balances as shown below:
Page 15
Outstanding Allocation of
balance Fraction amortization
Discount on bonds payable 48,037* 48,037/92,866 13,966
Bond issue cost 44,829 44,829/92,866 13,033
92,866 26,999
* (1,000,000 face amount – 951,963 issue price) = 48,037 discount on bonds payable.
The entries would have been as follows:
Jan. 1, 20x1 Cash 907,134
Bond issue costs 44,829
Cash 100,000
Bond issue costs 13,033
For simplicity, we will follow the previous accounting treatment of combining bond issue
cost with bond discount (or premium).
Illustration 3: Straight-line vs. Effective interest
due on Dec. 31, 20x3, but interest is due annually every year-end. The effective interest rate is
12%. ABC Co. incorrectly used the straight-line method instead of the effective interest method
to amortize the discount.
Requirements: Determine the effects of the error on the following:
a. Carrying amount of the bond on Dec. 31, 20x1

Page 16
b. Profit for 20x1
Solution:
 Erroneous amortization using straight line:
Face amount ₱1,000,000
Cash proceeds (951,963)
Discount on bonds payable – Jan. 1, 20x1 48,037
Divide by: Term of bonds (in years) 3
Annual amortization (straight line method) 16,012
Interest payment (1M x 10%) 100,000
Annual amortization 16,012
Interest expense under straight-line method 116,012
Carrying amount – Jan. 1, 20x1 951,963
Annual amortization 16,012
Carrying amount under straight-line – Dec. 31, 20x1 967,975
Amortization using effective interest method:
Interest Interest
Jan. 1, 20x1 951,963
Dec. 31, 20x1 100,000 114,236 14,236 966,199
Dec. 31, 20x2 100,000 115,944 15,944 982,142
Dec. 31, 20x3 100,000 117,857 17,857 1,000,000
Requirement (a): Effect on carrying amount
Carrying amount on Dec. 31, 20x1 – straight-line 967,975

Page 17
Carrying amount on Dec. 31, 20x1 – effective interest 966,199
Difference – overstatement under straight-line 1,776
The carrying amount of the bonds on December 31, 20x1 under the straight line method
is overstated by ₱1,776.
Requirement (b): Effect on 20x1 profit
20x1 interest expense – straight-line 116,012
20x1 interest expense – effective interest 114,236
Difference – overstatement under straight-line 1,776
Interest expense under straight-line is overstated. Consequently the profit under straight-line is
understated by ₱1,776.
The PFRS 9 requires the use of the effective interest method in amortizing discounts or
premiums on financial instruments.
Issuance of bonds between interest payment dates
When bonds are issued between interest payment dates, the accrued interest prior to the
issuance date is not included in the initial measurement of the bonds, but rather credited to
interest payable or interest expense. Moreover, the interest expense recognized for the period
represents only the post-issuance interest expense (i.e., interest incurred after issuance date).
The pre-issuance interest is not recognized as interest expense.
Illustration:
On April 1, 20x1, ABC Co. issued 12%, ₱1,000,000 bonds dated January 1, 20x1.
Case 1: The bonds were issued at 97 including accrued interest.

Page 18
Requirement: Compute for the initial carrying amount of the bonds.
Solution:
Cash proceeds including accrued interest (1M x 97%) 970,000
Less: Accrued interest sold (1Mx12%x3/12) (30,000)
Carrying amount of the bonds, April 1, 20x1 940,000
The initial carrying amount of the bonds is equal to the cash proceeds excluding the accrued
interest.
The entry to record the issuance of the bonds is as follows:
April 1, 20x1 Cash (1M x 97%) 970,000
Discount on bonds payable (1M – 940K) 60,000
Interest expense (or Interest payable) 30,000
(1M x 12% x 3/12)
Whether ‘interest expense’ or ‘interest payable’ is credited the total interest expense in 20x1
(disregarding the amortization of discount) is limited to the post-issuance interest expense of
₱90,000 (1M x 12% x 9/12). Analyze the entries below:
Page 19
“Interest expense” account was initially “Interest payable” account was initially
credited: credited:
Interest expense 120K Interest expense 90K
(1M x 12%) (1M x 12% x 9/12)
Cash 120K Interest payable 30K
To record payment of interest Cash 120K
To record payment of interest
Interest expense = 120K debit - 30K credit on Interest expense = 90,000 debit on Dec.31,
Apr. 1, 20x1 = 90,000 20x1
Case 2: The bonds were issued at 97 excluding accrued interest.
Requirement: Compute for the initial carrying amount of the bonds.
Solution:
Cash proceeds excluding accrued interest (1M x 97%) 970,000
Carrying amount of the bonds, April 1, 20x1 970,000
April 1, 20x1 Cash [1M x 97% + (1M x 12% x 3/12)] 1,000,000
Discount on bonds payable (1M – 970K) 30,000
Page 20
Issue price of bonds
The issue price of bonds can be estimated by discounting the future cash flows at a specified
effective interest rate.
Illustration:
ABC Co. plans to issue 12%, 3-year, ₱1,000,000 bonds, dated January 1, 20x1. Principal is due at
maturity but interest is due annually. The current market rate is 10%.
Case 1: ABC issues the bonds on January 1, 20x1. How much is the estimated issue price?
Solution:
Issue price of bonds = Present value of future cash flows; or
Issue price of bonds = Future cash flows x PV factor
Future cash Present

flows PV @10%, n =3 PV factors Value
Principal 1M PV of ₱1 0.751315 751,315
Interest 120K PV of ordinary annuity of ₱1 2.486852 298,422
- 1,049,737
 The issue price of the bonds on Jan. 1, 20x1 is ₱1,049,737.
Jan. 1, 20x1 Cash 1,049,737
Premium on bonds payable (1,049,737 – 1M) 49,737
Case 2: ABC issues the bonds on April 1, 20x1. How much is the total proceeds from the
issuance?
Page 21
Solution:
The issue price on April 1, 20x1 is computed by simply amortizing the Jan. 1, 20x1 issue price up
to April 1, 20x1.
Interest Interest
Date Payment Expense Amortization Present Value
Jan. 1, 20x1 1,049,737
Apr. 1, 20x1 30,000 26,243 3,757 1,045,980
The issue price pertaining only to the bonds is ₱1,045,980. However, since the bonds are issued
between interest payment dates, the total proceeds from the issuance will necessarily include
the accrued interest sold. The total issue price is computed as follows:
Issue price pertaining to bonds only 1,045,980
Accrued interest sold (1M x 12% x 3/12) 30,000
Total issue price or total proceeds 1,075,980
Jan. 1, 20x1 Cash 1,075,980
Premium on bonds payable (1,049,737 – 1M) 45,980
An alternative solution is by computing the full-year’s amortization and then allocating it to the
period prior to the issuance date:
Interest Interest
Date Payment Expense Amortization Present Value
Jan. 1, 20x1 1,049,737
Dec. 31, 20x1 120,000 104,974 15,026 1,034,711
Page 22
Carrying amounts as of January 1, 20x1 ₱1,049,737
Premium amortization up to April 1, 20x1 (15,026 x 3/12) (3,757)
Issue price pertaining to bonds only, April 1, 20x1 1,045,980
Accrued Interest sold (1M x 12% x 3/12) 30,000
Total issue price or cash proceeds 1,075,980
Bond refunding
Bond refunding refers to the issuance of new bonds, the proceeds from which are used to retire
existing outstanding bonds. The new bonds usually have lower interest than the replaced bonds.
The issuance of the new bonds is recorded in the regular manner (like in the previous
illustrations), while the old bonds are extinguished or retired.
Retirement of bonds prior to maturity
When bonds are retired, any difference between the retirement price and the carrying amount
(updated for any discount or premium amortization up to the date of retirement) is recognized
as gain or loss in profit or loss.
Illustration 1: Retirement of bonds – Bonds refunding
On January 1, 20x1, ABC Co. issued new bonds with face amount of ₱10M for ₱10,800,000. ABC
used the proceeds to retire an existing 10-year, 12%, ₱8,000,000 bonds issued five years earlier.
The unamortized discount on the existing bonds is ₱340,000. ABC retired the bonds at a call
premium of ₱400,000. ABC incurred ₱50,000 direct costs of retirement. ABC’s income tax rate is
30%.
Page 23
Requirement: Compute for the gain or loss on the retirement.
Solution:
 The issuance of the new bonds is recorded as follows:
Jan. 1, 20x1 Cash 10,800,000
Bonds payable - new 10,000,000
Premium on bonds payable – new 800,000
 The retirement of the old bonds is recorded as follows:
Jan. 1, 20x1 Bonds payable – old 8,000,000
Loss on extinguishment of bonds (squeeze) 790,000
Discount on bonds payable – old 340,000
Cash (8M + 400K call premium +50K direct costs) 8,450,000
Alternative Solution:
Carrying amount of bonds retired:
Face amount of bonds retired 8,000,000
Unamortized discount, Jan. 1, 20x1 (340,000) 7,660,000
Retirement price (Call price):
Face amount of bonds retired 8,000,000
Call premium 400,000
Expense of reacquisition 50,000 8,450,000
Loss on extinguishment of bonds (790,000)
Page 24
Notice that the loss is gross of tax. Netting of tax is normally permitted only for results of discontinued operations,
items of other comprehensive income, and retrospective adjustments to the beginning balance of retained earnings.
Illustration 2: Retirement – between interest payment dates
On January 1, 20x1, ABC Co. issued 5-year, 12%, ₱1,000,000 bonds for ₱1,075,816. Principal is
due at maturity but interest is due annually. The effective interest rate is 10%.
On July 1, 20x3, ABC retired the bonds at 102. The retirement price includes payment for
accrued interest.
Requirement: Compute for the gain or loss on the retirement.
Solution:
 An amortization table is prepared up to date of retirement.
Interest Interest
Jan. 1, 20x1 1,075,816
Dec. 31, 20x1 120,000 107,582 12,418 1,063,398
Dec. 31, 20x2 120,000 106,340 13,660 1,049,738
Jul. 1, 20x3 60,000 52,487 7,513 1,042,225
 The gain or loss is computed as follows:
Carrying amount of bonds retired 1,042,225

Retirement price (Call price):
Retirement price including payment for
accrued interest (1M x 102%) 1,020,000
Less: Accrued interest (1M x 12% x 6/12) (60,000) 960,000
Gain on extinguishment of bonds 82,225
Page 25
Since the bonds are retired between interest payment dates, the retirement price necessarily
includes payment for the accrued interest. The interest payment is excluded when computing
for the gain or loss on the retirement.
Journal entries:
July 1, 20x3 Interest expense 52,487
Interest payable 60,000
To record the premium amortization up to the

date of retirement
July 1, 20x3 Bonds payable 1,000,000
Cash 1,020,000
Gain on extinguishment of bonds 82,225
To record the retirement of the bonds
Serial Bonds
Serial bonds are bonds in which the principal matures in installments. The periodic payments on
serial bonds consist of payments for both interest and principal.
Illustration:
On January 1, 20x1, ABC Co. issued 10%, ₱3,000,000 bonds for ₱2,900,305. The principal
matures in three equal annual installments, payable at each year-end, plus interest on the
outstanding principal balance. The effective interest rate is 12%.
Page 26
Jan. 1, 20x1 Cash 2,900,305
Discount on bonds payable (3M-2,900,305) 99,695
 Subsequent measurement:
The future payments on the serial bonds are computed as follows:
Interest on
Principal outstanding Interest Total
Date Payments principal balance payments payments
Dec. 31, 20x1 1,000,000 3,000,000 x10% 300,000 1,300,000
Dec. 31, 20x2 1,000,000 2,000,000 x10% 200,000 1,200,000
Dec. 31, 20x3 1,000,000 1,000,000 x10% 100,000 1,100,000
Amortization table:
Total Interest
Jan. 1, 20x1 2,900,305
Dec. 31, 20x1 1,300,000 348,037 951,963 1,948,342
Dec. 31, 20x2 1,200,000 233,801 966,199 982,143
Dec. 31, 20x3 1,100,000 117,857 982,143 (0)
Page 27
Cash 1,300,000
Discount on bonds payable (squeeze) 48,037
Cash 1,200,000
Cash 1,100,000
Alternatively, we can modify the amortization table so that we can derive directly the discount
amortization:
Interest Interest Discount Principal Present

Date payments expense amortization payments Value
a b = e x 12% c=b-a d e = PV + c -d
1/1/x1 2,900,305
12/31/x1 300,000 348,037 48,037 1,000,000 1,948,342
12/31/x2 200,000 233,801 33,801 1,000,000 982,143
12/31/x3 100,000 117,857 17,857 1,000,000 (0)
Notice that the discount amortization is simply the difference between the interest payment and
interest expense.
Page 28
Zero-coupon bonds
Zero-coupon bonds are bonds that do not pay periodic interests. Both principal and
compounded interests are due only at a maturity date.
Illustration:
On January 1, 20x1, ABC Co. issued 10%, ₱3,000,000 bonds at a yield maturity interest of 18%.
Principal and interest are due on December 31, 20x3. (Future Value ‘FV’ of ₱1 @ 10%, n=3 is
1.331)
Face amount 3,000,000

FV of an ordinary annuity of ₱1 @ 10%, n=3 1.331
Maturity value of the bonds (Future cash flow) 3,993,000
Future cash flows 3,993,000

PV of ₱1@18%, n=3 0.6086309
Present value of bonds (issue price) 2,430,263
Alternative solution: 3M x 110% x 110% x 110% = 3,993,000 x PV of ₱1@18%,n=3 = 2,430,263.
Jan. 1, 20x1 Cash 2,430,263

569,737
Discount on bonds payable (3M-2,430,263)
Page 29
 Subsequent measurement: Amortization table (Lump sum)
Discount on Present value of

Date Interest expense bonds payable cash flow*
a =b x18% b = previous bal.+a
1/1/x1 2,430,263
12/31/x1 437,447 2,867,710
12/31/x2 516,188 ignored 3,383,898
12/31/x3 609,102 3,993,000
*The ‘Present value of cash flow’ subsequent to Jan. 1, 20x1 includes amount of interest payable.
Interest payable (3M x 10%) 300,000
Interest payable [3M+300K) x 10%] 330,000
Interest payable [3M+300K+330K) x 10%] 363,000
Dec. 31, 20x3 Bonds payable 3,000,000
Interest payable (300K+330K+363K) 993,000
Cash 3,993,000
Alternatively, we can modify the amortization table to include columns for “interest payable”, “amortization” and
“present value pertaining only to the bonds”.
Page 30
Interest PV of cash Interest PV of

Date expense flows payable Amortization bonds
b = previous c =10% x (principal e = previous
a = 18% x b balance + a + accrued interest) d=a-c balance + d
1/1/x1 2,430,263 2,430,263
12/31/x1 437,447 2,867,710 300,000 137,447 2,567,710
12/31/x2 516,188 3,383,898 330,000 186,188 2,753,898
12/31/x3 609,102 3,993,000 363,000 246,102 3,000,000
Callable bonds
Callable bonds are bonds that the issuer can redeem prior to maturity date. When measuring
callable bonds at amortized cost, the issuer should estimate its expected holding period (which
may be shorter than the original maturity date) and amortize any discount or premium over that
period. Subsequent changes are treated as changes in accounting estimates and are accounted
for prospectively.
Puttable instrument
A puttable instrument is one which the holder has the right to return (put back) to the issuer in
exchange for cash or another financial asset or is automatically put back to the issuer upon the
occurrence of a specified future event, e.g., death of the holder.
A puttable instrument includes a contractual obligation of the issuer to redeem or repurchase the
instrument. Accordingly, it is classified as a financial liability except when the instrument also
represents a residual interest in the net assets of the issuing entity, in which case the instrument
is classified as an equity instrument.
Examples of puttable financial liabilities:
a. Extendible and retractable bonds
b. Preference shares with mandatory redemption (Redeemable preference shares)
Page 31
Illustration: Redeemable preference share
On January 1, 20x1, ABC Co. issued 6% redeemable preference shares with aggregate par value
of ₱1,000,000 for ₱880,000. Transaction costs incurred amounted to ₱17,391. The shareholders
can present the shares for redemption at any time beginning January 1, 20x3. Based on ABC’s
past experience, shares are usually redeemed after 5 years. The effective interest rate is 3%.
Jan. 1, 20x1 Cash (880,000 – 17,391) 862,609
Discount on redeemable preference shares 137,391
Redeemable preference shares 1,000,000
The redeemable preference shares are presented in the financial statements under
liabilities as follows:
Redeemable preference shares (at par) 1,000,000

Discount on redeemable preference shares (137,391)
Carrying amount - Jan. 1, 20x1 862,609
 Subsequent measurement:
Interest Discount
Date expense amortization Present Value
Jan. 1, 20x1 137,391 862,609
Dec. 31, 20x1 25,878 111,513 888,487
Dec. 31, 20x2 26,655 84,858 915,142
Dec. 31, 20x3 27,454 57,404 942,596
Dec. 31, 20x4 28,278 29,126 970,874
Dec. 31, 20x5 29,126 (0) 1,000,000
Page 32
The entry on December 31, 20x1 to record the amortization is:
Discount on redeemable preference sh. 25,878
Case #1: ABC Co. declares dividends on March 31, 20x2.
Mar. 31, 20x2 Interest expense (6% x ₱1M) 60,000
Cash 60,000
Observe that the dividends are recognized as interest expense and charged to profit and
loss.
Case #2: The preference shares are redeemed at a premium of ₱100,000 on December 31,
20x5.
Dec. 31, 20x5 Redeemable preference shares 1,000,000
Loss on redemption of preference shares 100,000
Cash (1M par + 100K premium) 1,100,000
Case #3: (Disregard Case # 2). The preference shares are redeemed at a premium of
₱100,000 on December 31, 20x3.
Dec. 31, 20x3 Redeemable preference shares 1,000,000
Loss on redemption of preference shares 157,404
Discount on redeemable of preference sh. a 57,404
Cash (1M par + 100K premium) 1,100,000

a (1M par value minus 942,596 PV on 12/31/x3 see table above = 57,404 unamortized discount)
Page 33
Extendible and retractable bonds are accounted for similar to redeemable preference shares.
Compound financial instruments
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 classified and
accounted for separately.
An example of a compound instrument is convertible bonds. Convertible bonds are bonds that
can be converted into shares of stocks of the issuer. When an entity issues convertible bonds, in
effect, it is issuing two instruments – (1) a debt instrument for the bonds payable and (2) an
equity instrument for the equity conversion feature. These two components are presented
separately in the statement of financial position.
Equity is defined as a residual amount. Therefore, to separate the debt and equity components of
a compound instrument, the entity simply deducts from their fair value of the whole instrument
the fair value of the debt component without the equity feature; the remaining amount represents
the equity component. This procedure follows the basic accounting equation:
Assets - Liabilities = Equity
Cash proceeds from Fair value of debt

Less equals Equity
issuance of component
Components
compound without the
instrument equity feature
The sum of the carrying amounts allocated to the liability and equity components is always equal
to the fair value of the whole instrument. No gain or loss is recognized on the initial recognition of
the components.
The separate classifications of the components are not revised for subsequent changes in the
likelihood that the conversion option will be exercised.
Convertible bonds
Page 34
Illustration 1: Issuance of convertible bonds
On January 1, 20x1, ABC Co. issued 10%, 3-year, ₱1,000,000 convertible bonds at face amount.
Each ₱1,000 bond is convertible into 8 shares with par value of ₱100 per share. On issuance date,
the bonds were selling at 98 without conversion option. ABC incurred ₱50,000 transaction costs
on the issuance.
The issue price is allocated to the liability and equity components as follows:
Issue price 1,000,000

Fair value of debt instrument w/o equity feature (1M x 98%) (980,000)
Equity Component 20,000
The transaction costs are also allocated to the liability and equity components in
proportion to the allocated issue price
Allocated Allocation of
amounts from transaction
Component issue price Fraction costs
Debt Component 980,000 980/1,000 49,000
Equity Component 20,000 20/1,000 1,000
1,000,000 1,000/1,000 50,000
The carrying amounts of a liability and equity components are as follows:
Debt Equity
Component Component Totals
Allocation of issue price 980,000 20,000 1,000,000
Allocation of transaction cost (49,000) (1,000) (50,000)
Carrying amounts 931,000 19,000 950,000
Notice that the sum of the carrying amounts is equal to the net proceeds from the issuance (1M issue price – 50K
transaction costs = 950,000).
Page 35
 Simple entries:
Jan. 1, 20x1 Cash 1,000,000
Share premium – conversion feature 20,000
to record the issuance of convertible bonds
Jan. 1, 20x1 Discount on bonds payable (a) 49,000
Cash 50,000
to record the transaction costs
(a) The transaction costs allocated to the equity component is deducted from share premium, while that of the debt
component is included in the discount on bonds payable to simplify the subsequent recording of amortization.
 Compound entry:
Jan. 1, 20x1 Cash (1M x98% -50K transaction costs) 950,000
Illustration 2: Conversation of convertible bonds
On January 1, 20x1, ABC Co. issued 10%, 3 year, ₱1,000,000 convertible bonds at 105. Each
₱1,000 bond is convertible into 8 shares with par value of ₱100 per share. Principal is due at
maturity but interest due annually at each year-end. On issuance date, the bonds were selling at a
yield to maturity market rate of 12% without the conversion option.
On December 31, 20x2, all of the bonds were converted into equity. ABC incurred stock
issuance costs of ₱20,000.
Page 36
Initial measurement:
The fair value of the bonds without the conversion option is computed as follows:
Future cash Present

Principal 1M PV of ₱1 0.711780 711,780
Fair value of debt instrument without conversion feature 951,963
The equity component is computed as follows:
Issue price (1M x 105%) 1,050,000

Fair value of debt instrument without equity feature (951,963)
Jan. 1, 20x1 Cash (1M x 105%) 1,050,000
Discount on bonds payable (1M -951,963) 48,037
Subsequent measurement: Amortization table
Interest Interest Present

Date Payment Expense Amortization Value
Jan. 1, 20x1 951,963
Dec. 31, 20x1 100,000 114,236 14,236 966,199
Dec. 31, 20x2 100,000 115,944 15,944 982,143
Dec. 31, 20x3 100,000 117,857 17,857 1,000,000
The other pertinent entries prior to conversion are as follows:
Cash 100,000
Page 37
Cash 100,000
Conversion:
The entries on to record the conversion are as follows:
Dec. 31, 20x2 Bonds payable 1,000,000
Share capital (a) 800,000
Share premium (squeeze) 182,143

to record the conversion of bonds into shares
Dec. 31, 20x2 Share premium (squeeze) 20,000
Cash 20,000
to record the share issuance costs
Dec. 31, 20x2 Share premium – conversion feature 98,037
Share premium 98,037

to reclassify the equity component of the
compound instrument within equity
(a) (₱1M face amount ÷ ₱1,000) x 8 shares x ₱100 par value = 800,0000
Notes:
- The conversion of bonds is accounted for as equity set-off, meaning the carrying amount of the
bonds is simply derecognized, the aggregate par value of the shares issued is credited to “Share
capital” and the difference is credited to “Share premium”. No gain or loss is recognized on the
conversion.
Page 38
- The share issuance costs are treated as reduction to share premium.
- The “share premium-conversion feature” is closed to the “share premium” general account
because all of the conversion privilege has been exercised.
- Prior to conversion of the bonds, the “share premium-conversion feature” is part of share
premium but described as pertaining to the conversion feature. When the conversion feature is
exercised, such amount is just reclassified within equity (i.e., from one share premium account to
another share premium account).
- The conversion increased equity by the carrying amount of the bonds conversion date less the
transaction costs incurred on the conversion.
Carrying amount of bonds on date of conversion 982,143

Conversion cost (20,000)
Net increase in equity 962,143
Increase in share capital 800,000

Net increase in "share premium" (280,180-20,000) 260,180
Decrease in "share premium - conversion feature" (98,037)
Net increase in equity 962,143
Other scenarios:
 Partial conversion: When only some, but not all, of the bonds are converted,
only the portion of the bonds that were converted is derecognized. Also, only the portion
of the “Share premium – conversion feature” pertaining to the converted bonds is
transferred within equity.
 Conversion between interest payment dates: When bonds are converted

between interest payment dates, the accrued interest is usually settled separately in cash.
Thus, only the carrying amount of the bonds is accounted for when applying the ‘equity
set-off’ method.
Illustration 3: Retirement of convertible bonds
Page 39
On January 1, 20x1, ABC Co. issued 3 year, 10%, ₱1,000,000 convertible bonds for ₱1,100,000.
Principal is due at maturity but interest is payable every year-end. The bonds are convertible
into 6,000 ordinary shares with par value of ₱100. At issuance date, the prevailing market rate
of interest for similar debt without conversion feature is 12%.
On December 31, 20x2, all the convertible bonds were retired for ₱1,000,000. The prevailing
interest rate for a similar debt instrument without conversion feature as of December 31, 20x2 is
11%.
Future cash Present

Principal 1M PV of ₱1 0.711780 711,780
Fair value of debt instrument without conversion feature 951,963
Issue price 1,100,000

Fair value of debt instrument without equity feature (951,963)
Jan. 1, Cash 1,100,000

20x1
Subsequent measurement: Amortization table
Interest Interest Present

Date Payment Expense Amortization Value
Jan. 1, 20x1 951,963
Dec. 31, 20x1 100,000 114,236 14,236 966,199
Dec. 31, 20x2 100,000 115,944 15,944 982,143
Dec. 31, 20x3 100,000 117,857 17,857 1,000,000
Page 40
Retirement:
On retirement date, the retirement price is allocated to the liability and equity components
for purposes of determining the gain or loss on extinguishment of debt. The allocation
procedure is similar to the allocation of issue price.
Total retirement price 1,000,000

Less: Retirement price allocated to the bonds (a) (990,991)
Retirement price allocated to the equity component (b) 9,009
(a) The retirement price allocated to the bonds is equal to the fair value of the bonds without equity feature as of
retirement date:
Present
Future cash flows PV @11%, n =1 PV factors Value
Principal 1M PV of ₱1 0.900901 900,901
Fair value of debt instrument without equity feature 990,991
(b) The residual amount is allocated to the equity component.
 The gain or loss on extinguishment of bonds is computed as follows:
Carrying amount of bonds - Dec. 31, 20x2 982,143

Retirement price allocated to the bonds (990,991)
Loss on extinguishment of bonds (8,848)
 Simple entries:
Dec. 31, Bonds payable 1,000,000

20x2
Loss on extinguishment of bonds (squeeze) 8,848
Cash (amount allocated to the bonds) 990,991
to record the retirement of convertible bonds
Dec. 31, Share premium – conversion feature 9,009

20x2
Cash (amount allocated to equity) 9,009
Page 41
to record the allocation of retirement price to equity

component
Dec. 31, Share premium – conversion feature (148,037-9,009) 139,028

20x2
to record the forfeiture of conversion feature of

retired convertible bonds
 Compound entries:
Dec. 31, Bonds payable 1,000,000

20x2
Loss on extinguishment of bonds 8,848
Cash 1,000,000
Share premium (c) 139,028
(c ) The net amount closed to the share premium account is the equity component allocated from the issue price less the equity
component allocated from the retirement price:
Equity component allocated from the issue price 148,037

Equity component allocated from the retirement price (9,009)
Amount permanently closed to share premium account 139,028
The equity component is closed to the “share premium” general account because the conversion
feature is forfeited by the retirement of the bonds.
The equity component remains in equity whether the conversion feature is exercised or not.
However, it is reduced by any allocated retirement price.
Page 42
Other scenario:
 Partial retirement: When only a portion of the bonds is retired, only that
portion is derecognized. Accordingly, the gain or loss is computed only on that portion.
Also, only a portion of the “Share premium – conversion feature” is transferred within
equity.
Bonds with share warrants
To improve salability, bonds are sometimes issued with share warrants. A share warrant entitles
the holder to purchase shares of stocks of the issuer at a fixed price. Generally, the life of the
warrants is 5 years, occasionally 10 years, and very occasionally an entity may offer perpetual
warrants.
Share warrants attached to bonds may be “detachable” or “non-detachable”. A

detachable share warrant can be detached (separated) from the bond and traded as a separate
security. A non-detachable warrant cannot be sold separately from the bond.
Bonds issued with share warrants, whether detachable or not, are compound
financial instruments and are accounted for similar to convertible bonds. However, unlike
convertible bonds, the exercise of share warrants does not extinguish the bonds.
Illustration:
On January 1, 20x1, ABC Co. issued 3-year, 10%, 1,000, ₱1,000 bonds at 97. Each bond has one
detachable share warrant entitling the holder to buy 10 shares of ABC Co. with par value of ₱100
at ₱120 per share. Shortly after issuance, the bonds are selling at 95 ex-warrants.
Issue price (1,000 x ₱1,000 x 97%) 970,000

Fair value of debt instrument ex-warrants (1,000 x ₱1,000 x 95%) (950,000)
Page 43
Jan. 1, Cash 970,000

20x1
Share premium – warrants outstanding 20,000
Exercise of warrants:
Half of the warrants were exercised on September 21, 20x3.
Sep. 21, Cash (1,000 x 10 x ½ x ₱120) 600,000

20x3
Share premium – warrants outs. (20,000 x ½) 10,000
Share capital (1,000 x 10 x ½ x ₱100) 500,000
Expiration of warrants:
The remaining half of the warrants expired on December 31, 20x5.
Sep. 21, Share premium – warrants outs. (20,000 x ½) 10,000

20x3
Reclassification
PFRS 9 prohibits the reclassification of financial liabilities.
Page 44
Derecognition of a financial liability
A financial liability is derecognized* when it is extinguished, i.e., when the obligation is

discharged or cancelled or expires. A liability is extinguished in many ways, for example
through:
a. Repayment in cash
b. Transfer of non-cash assets or rendering of services
c. Issuance of equity securities
d. Replacement of the existing obligation with a new obligation
e. Waiver or cancellation by the creditor
f. Expiration, e.g., warranty obligation expires after the warranty period

*Derecognition is the removal of a previously recognized asset or liability from the entity’s statement of financial position.
Transfer of noncash assets (Asset swap)
When a debtor settles an obligation by transferring noncash assets (‘asset swap’) to the creditor,
the difference between the carrying amount of the liability extinguished and the carrying amount
of the noncash asset transferred is recognized as gain or loss in profit or loss.
Illustration:
On Jan. 1, 20x1, ABC Co. settled a ₱1,000,000 loan payable with an unamortized discount of
₱20,000 and an accrued interest of ₱90,000 by transferring to the lender old equipment with
cost of ₱3,000,000, accumulated depreciation of ₱2,200,000, and fair value of ₱900,000.
Page 45
Derecognition:
Jan. 1, Loan payable 1,000,000

20x1
Accumulated depreciation 2,200,000
Discount on loan payable 20,000
Equipment 3,000,000
Gain on extinguishment of debt (squeeze) 270,000

Notice that the fair value of the noncash asset transferred is ignored.
The gain or loss can also be computed as follows:
Carrying amount of the liability (1M loan -20K disc. +90K interest) 1,070,000
Carrying amount of noncash asset transferred (3M -2.2M) (800,000)
Gain on extinguishment of debt 270,000
Transfer of equity securities (Equity swap)
When the terms of a financial liability are renegotiated such that the debtor settles it by issuing
equity securities (‘equity swap’) to the creditor, the difference between the carrying amount of
the liability extinguished and the fair value of the securities issued or fair value of the financial
liability extinguished, whichever is more clearly determinable, is recognized as gain or loss in
profit or loss. (IFRIC 19)
Illustration 1: Fair value of securities issued
On Jan. 1, 20x1, ABC Co. settled a ₱1,000,000 loan payable by issuing to the lender 10,000 shares
with par value of ₱50 per share.
Case 1: Fair value of securities issued
The shares are selling at ₱120 per share on Jan. 1, 20x1.
Page 46
Requirement: How much is the gain (loss) on extinguishment of debt?
Solution:
Carrying amount of the liability 1,000,000

Fair value of securities issued (1,000 x ₱120) (1,200,000)
Loss on extinguishment of debt (200,000)

20x1
Loss on extinguishment of debt (squeeze) 200,000
Share capital (10,000 x ₱50) 500,000
Share premium [(₱120-₱50) x 10,000 sh.] 700,000
Case 2: Fair value of financial liability extinguished
The fair value of the shares is not reliably determinable. The loan pays annual interest of 12% at
each year and has a remaining term of 3 years. The prevailing market rate for similar debt on
Jan. 1, 20x1 is 8%.
Requirement: How much is the gain (loss) on extinguishment of debt?
Solution:
Carrying amount of the liability 1,000,000

Fair value of financial liability extinguished (a) (1,103,084)
Loss on extinguishment of debt (103,084)
(a)Future cash flows PV factors @8%,

n =3 Present Value
Principal 1M 0.793832 793,832
Interest 120K 2.577097 309,252
Fair value of financial liability extinguished 1,103,084
Page 47

20x1
Loss on extinguishment of debt (squeeze) 103,084
Share capital (10,000 x ₱50) 500,000
Share premium (1,103,084 – 500K) 603,084
Modification of terms
A borrower and lender may modify the terms of an existing financial liability, such as by
changing the stated interest rate, the maturity date or the face amount, or by reducing, deferring
or cancelling any accrued interest.
If the modification results to substantially different terms, the existing financial

liability is considered extinguished and replaced by a new one.
A modification is considered substantial if the present value of the cash flows

under the new terms, discounted at the original effective interest rate, is at least 10% different
from the carrying amount of the original financial liability. In such cases, the original liability is
derecognized and replaced with the new one. The difference between the present value of the
new liability and the carrying amount of original liability is recognized as gain or loss. A
modification can be substantial regardless of the debtor’s financial difficulty.
If the modification is not substantial (i.e., less than 10% different), the existing
financial liability is not considered extinguished. Therefore, it is continued to be recognized but
with modified cash flows depending on the modified terms. An adjustment to the effective
interest rate may be necessary. The new liability is not recognized. No gain or loss is recognized.
Direct costs of modification are accounted for as follows:
a. Included in the gain or loss, if the modification is substantial.
b. Deducted from the carrying amount of the existing financial liability and
subsequently amortized using the effective interest method, if the modification is not
substantial.
Page 48
Illustration:
On Dec. 31, 20x1, ABC Co.’s loan was modified as follows:
 The principal was reduced from ₱5,000,000 to ₱4,000,000.
 The lender forgave the accrued interest of ₱600,000.
 The maturity date was extended from Dec. 31, 20x2 to Dec. 31, 20x4.
 The nominal interest rate was reduced from 12% to 10%.
Interest is due annually at each year-end. The original effective interest rate is 12%. The current
interest rate on Dec. 31, 20x1 is 11%.
The modification is analyzed as follows:
Old Terms New Terms

Principal 5,000,000 4,000,000
Accrued interest 600,000 -
Remaining term ('n') 3 years
Nominal rate 12% 10%
The present value of the modified liability is computed as follows:
Future cash PV factors @12%,

flows n =3 Present Value
Principal 4,000,000 0.711780 2,847,121
Interest 400,000 2.401831 960,732
Present value of the modified liability 3,807,853
The modification is tested for substantiality as follows:
Present value of the modified liability 3,807,853

Carrying amount of old liability (5M Principal +600K Interest) 5,600,000
Difference (1,792,147)
Divide by: Carrying amount of old liability 5,600,000
Percentage change -32%
The modification is substantial because the change is ‘at least 10%’. Accordingly, the original
liability is derecognized and replaced with the modified liability. The difference between the
Page 49
present value of the modified liability and the carrying amount of the old liability, including
interest, is recognized as gain or loss.
Dec. 31, Loan payable-old 5,000,000

20x1
Discount on loan payable – new 192,147

(4M new principal – 3,807,853 present value)
Loan payable - new 4,000,000

Gain on extinguishment of debt 1,792,147
Present value of future cash flows (recoverable amount) 3,807,853

Carrying amount of receivable (5M Principal +600K Interest) 5,600,000
Impairment loss by lender (1,792,147)
Dec. 31, Impairment loss 1,792,147

20x1
Interest receivable 600,000
Allowance for impairment loss 1,192,147
(or Loan receivable)
Trouble-debt restructuring
In a trouble-debt restructuring, the creditor grants the debtor, who is going through financial
difficulties, concession that would not otherwise be granted in a normal business relationship.
The restructuring usually involves easing or relaxing the terms of the debt in order to
accommodate the debtor. Trouble-debt restructuring is accounted for as modification of
financial liability.
Page 50
Waiver or cancellation by the creditor
If the creditor cancels a financial liability, the debtor derecognizes the liability are recognizes
gain.
Illustration:
On Dec. 31, 20x1, the lender waives the repayment of ABC’s loan of ₱5,000,000 and related
accrued interest of ₱600,000.
The liability is derecognized as follows:
Dec. 31, Loan payable 5,000,000

20x1
Gain on extinguishment of debt 5,600,000
In-substance defeasance
In-substance defeasance is an arrangement whereby a debtor purchases securities and places

them in an irrevocable trust. The principal and interest on the securities are then used to pay-off
an existing debt as it matures.
In-substance defeasance does not release the debtor from its obligation on the
existing debt, which remains outstanding. In some cases, creditors are not even aware of the
transaction and continue to look to the debtor for repayment. Accordingly, in-substance
defeasance is not accounted for as an extinguishment of a financial liability.
Offsetting a financial asset and a financial liability
Page 51
A financial asset and a financial liability are offset and only the net amount is presented in the
statement of financial position when the entity has both:
a. A legal right of setoff; and
b. An intention to settle the amounts on a net basis or simultaneously
PAS 32 requires offsetting when doing so reflects the entity’s expected future
cash flows from settling two or more separate financial instruments. When both the legal right
to net settlement and the intention to do so exists, the entity has, in effect, only a single financial
asset or financial liability. Neither a legal right alone nor an intention alone warrants offsetting.
 A mere intention to settle net without the right to do so does not justify
offsetting because the rights and obligations associated with the individual financial asset
and financial liability remain unaltered.
 A legal right to settle net without the intention to do so also does not justify
offsetting because this does not reflect the entity’s expected future cash flows from
settling two or more separate financial instruments.
Offsetting is not appropriate for (a) financial or other assets that are pledged as
collateral for non-recourse financial liabilities and (b) sinking fund and the related
financial liability for which the fund was established.
Page 52
EXERCISES:
1. During the current year, Sunshine Co. incurred the following costs in connection
with the issuance of bonds:
Promotion cost 250,000

Printing and engraving 200,000
Legal fees 750,000
Fees paid to independent accountants for registration 120,000
Commissions paid to underwriter 1,500,000
Requirement: How much is the total bond issue costs to be amortized over the term
of the bonds? - (2 points)
Solution:
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
Page 53
2. On June 30, 2019, Funny Co. issued at 99, 5,000 bonds of 8%, ₱1,000 face
amount.
The bonds were issued through an underwriter to whom the entity paid bond issue
cost of ₱520,000.
Requirement: On June 30, 2019, what amount should be reported as bond liability? -
(2 points)
Solution:
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
3. On July 1, 2019, Cara Co. issued 4,000 bonds of 8%, ₱1,000 face amount for
₱3,504,000. The bonds were issued to yield 10%.
The bonds are dated July 1, 2019 and mature on July 1, 2029. Interest is payable
semiannually on January 1 and July 1.
Requirement: Using the effective interest method, what amount of the bond discount
should be amortized for the six months ended December 31, 2019? - (4 points)
Page 54
Solution:
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
4. On January 1, 20x1, the terms of an entity’s existing loan payable is modified as

follows:
 The principal is reduced from ₱3,000,000 to ₱2,800,000.
 The lender promises not to collect the accrued interest of ₱200,000.
 The nominal rate is decreased from 12% to 8%.
 The maturity date is extended from December 31, 20x1 to January 1, 20x6.
Requirement: Provide the entries on the following dates:
a. January 1, 20x1 - (8 points)
b. December 31, 20x1- (4 points)
Page 55
Solution:
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
___________________________________________________________________________________________________
References:
 Intermediate Accounting 2, 2019 Edition by Zeus Vernon B. Millan
 Intermediate Accounting 2, 2016 Edition by Zeus Vernon B. Millan
 CPA Examination Practical Financial Accounting Volume Two, 2018 Edition by Conrado T.
Valix, Christian Aris M. Valix
 CPA Examination Practical Accounting 1 , 2013 Edition by Conrado Uberita

Page 56

Chapter 3 Intermediate Accounting

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 3 Intermediate Accounting

Uploaded by

Copyright:

Available Formats

AE16: Intermediate Accounting 2

A bond indenture may specify, among other things, the following:

2. Financial ratios that the issuer is required to maintain.

3. Restriction on dividends available to the issuer’s shareholders.

4. Restriction on incurrence of additional obligations.

5. Appointment of independent trustee whose qualifications are stated in the bond

6. Authorized amount of bonds that can be issued.

c. Interest rate, payment date(s), and maturity date(s)

1. Term bonds – bonds that mature on a single date.

2. Serial bonds – bonds in which the principal matures in installments.

Investors use extendible/retractable bonds to modify the term of their portfolio to

As to recording point of view and payment of interests:

As to security and risk:

11. Mortgage bonds – bonds secured by real property.

13. Asset-backed bonds (Asset-backed securities) – bonds collateralized by a pool of assets,

15. Debenture bonds – bonds not secured by any collateral.

20. Government bonds (Treasury bonds) – bonds issued by a government. Government

Accounting for bonds

Bond premium and discount

To reiterate the concepts of premium and discount, an outline is provided below:

Illustration 1: Bonds issued at a discount

The issuance of the bonds is recorded as follows:

The other pertinent entries are as follows:

Dec. 31, 20x1 Interest expense 114,236

Dec. 31, 20x2 Interest expense 115,944

Dec. 31, 20x3 Interest expense 117,857

Unamortized balance of discount or premium

Face amount 1,000,000

Illustration 2: Bonds issued at a premium

The issuance of the bonds is recorded as follows:

Bonds payable 1,000,000

 Observe the following from the amortization table:

All these columns increase over the

Only this column increases over the

Accounting for transaction costs

Illustration 1: Bonds issued at face amount

Case 1: No transaction costs

Jan. 1, 20x1 Cash 1,000,000

Bonds payable (1,000 x₱1,000) 1,000,000

Dec. 31, 20x1 Interest Expense (1M x 10%) 100,000

Dec. 31, 20x2 Interest Expense (1M x 10%) 100,000

Dec. 31, 20x3 Interest Expense (1M x 10%) 100,000

Bonds payable 1,000,000

Case 2: With transaction costs

ABC Co. paid commission of ₱48,037 to underwriters.

Jan. 1, 20x1 Cash (1M-48,037) 951,963

Bond issue cost 48,037

Bonds payable 1,000,000

Bonds payable ₱1,000,000

Bond issue cost (48,037)

Carrying amount of bonds payable, Jan. 1, 20x1 ₱ 951,963

Trial and error approach

Future cash flows x PV factor at x% = Present Value

Our working equation is as follows:

Principal: (1M x PV of ₱1 @x%, n=3) + Interest: [(1M x10%) x PV of an ordinary annuity of ₱1

First trial: (using 12%)

 (1M x PV of ₱1@12%, n=3) + [(1M x 10%) x PV of an ordinary annuity of ₱1@12%, n=3] =

 (1M x 0.71178) +(100,000 x2.40183) = 951,963

 (711,780 +240,183) = 951,963 is equal to 951,963

 Subsequent measurement: Amortization table

The pertinent entries are as follows:

Dec. 31, 20x1 Interest expense 114,236

Bond issue cost 14,236