MODULE 4

FINANCIAL MARKET

SESSION TOPIC 1: Bonds Payable

LEARNING OUTCOMES:
The following specific learning objectives are expected to be realized at the end of the session:
1. Account for bonds payable under the amortized cost.
2.

KEY POINTS

Bonds Carrying Amount Discounts Premium

Nominal Interest Effective Interest

CORE CONTENT
Introduction:
This module covers the discussion of interest rate, features of bonds, and bonds valuation

IN-TEXT ACTIVITY

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.

Bond indenture is the contractual arrangement between the issuer and the bondholder. It contains restrictive
covenants intended to prevent the issuer from taking actions contrary to the interests of the bondholder. A
trustee, often a bank, is appointed to ensure compliance.

Types of bonds

a. Term bonds i. Indexed bonds

b. Serial bonds j. Mortgage bonds
c. Extendible and retractable bonds k. Collateral trust bonds
d. Registered bonds l. Asset-backed bonds
e. Coupon bonds m. Subordinated bonds
f. Zero-coupon bonds n. Debenture bonds
g. Income bonds o. Junk bonds
h. Participating bonds

Debt Securities Classified as Financial Liabilities at Fair Value Through Profit or Loss are initially recognized
at purchased price which equals its fair value at the date of acquisition. Transactions costs incurred are
treated as expenses and do not form part of securities’ costs.

Interest Rates and Yield Rate

Interest rate and yield are two terms commonly used by banks, financial firms, brokers, investment funds,
etc., for luring investors into their manifold schemes. While investing in a commodity, it is imperative that an
investor brushes up his knowledge about what is actually meant by these financial jargons, which are rapidly
thrown up at dime a dozen.

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Yield can be understood as the collective profit earned by investing in financial commodities like shares,
debentures, bonds, etc. Yield is more accurate and gives a precise understanding of the total earning made
from an investment. The reason behind this is that yield also takes into consideration factors such as tax
benefits. To understand how yield works, one has to first delve into the concept of an interest rate.

An interest rate is nothing but the percentage of amount gained or paid, on a principal amount. In
case of income investments such as fixed deposits, recurring deposits, etc., the rate of interest
signifies the percentage of amount to be received, over the initial investment made. While in terms
of borrowing or lending loans, an interest rate means the percentage of amount to be paid by the
borrower to the lender, over the total amount borrowed.

Yield can be calculated only after taking the interest rate into consideration. For instance, if an
investor has invested $1000 in a dividend at an interest rate of 5% compounded quarterly, the yield
of this investment can only be arrived at after calculating the interest earned. The interest on this
investment would be $50 for the first quarter, but second quarter onwards, interest would be gained
on a collective amount obtained by adding the previous interest to the principal amount, i.e. $1050
and so on.

Issuance of bonds, example:

ABC Corporation, on March 1, 2015, issued 15% of P1,000,000 face value bonds to XYZ Corporation for
P1,110,401. These bonds mature on March 1, 2020 pay interest semi annually on March 1 and September
1. The securities at the date of acquisition, were designated as FVPL. On December 31, 2015, the bonds
were quoted in the market at 112. On May 1, 2016, ABC paid the bonds at 111.5 plus accrued interest.

The following are the entries that reflect ABC Corporation’s transactions for the years 2015 and 2016.

Mar. 1 Cash P 1,110,410

Bonds Payable P 1,110,410

Sep 1 Interest Expense P75,000

Cash P 75,000

Dec 31 Interest Expense P 50,000

Interest Payable P 50,000
P1,000,000 X 15% X 4/12

Dec 31 Losses from Change in Fair Value of Bonds Payable P 9,599

Bonds Payable P 9,599
Market Value (112% X P1,000,000) 1,200,000
Cost 1,110,401
Increase in Market Value 9,599
2016
Mar 1 Interest Payable P 50,000
Interest Expense P 25,000
Cash 75,000

May 1 Bonds Payable 1,120,000

Interest Expense P 5,000
Cash 1,140,000

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 Gain on early retirement of bonds P 25,000

Buying Price (P1,000,000 x 111.5% 1,115,000

Accrued interest expense from March to May P25,000
1,000,000 X 15% X 2/12
Total cash payment 1,140,000

Selling price 1,115,000

Carrying Value 1,120,000
Gain on early retirement P 5,000

For FVPL the gain should be reflected in the current P/L statement- provided that the instrument
satisfactorily met the criteria.

Accounting for bonds are 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 cost.

Bonds are commonly presented as financial liabilities under amortized costs.

Bond discount and premium:

Cash proceeds Effective interest rate Effect of amortization

(Carrying amount) compared to Nominal on interest Expense
compared to Face interest rate
Amount

Discount Cash process is less Effective interest rate is Interest Expense is

than the face amount higher than nominal rate greater than interest
paid
Premium Cash process is greater Effective interest rate is Interest Expense is less
than the face amount lower than nominal rate than

Illustration of Bonds issued at premium:

ABC Corporation, on March 1, 2015, issued 15% of P1,000,000 face value bonds to XYZ Corporation for
effective rate of 12%. These bonds mature on March 1, 2018 pay interest semi-annually on March 1 and
September 1.

Using the effective interest method, these bonds were issued at premium

Present value of all interest P1,000,000 X 7.5% X Ordinary annuity of P 368,799

discounted using the effective 6% for six periods*
interest rate *three years semi-annual interest payments

Present value of the principal P1,000,000 X Present value of 1 of 6% P 704,961

for six periods
Carrying amounts of the bonds P 1,073,760

The amortization table would be:

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 Period Carrying Interest Paid Interest Premium Carrying value
amount of (Face value times Expense Amortization (Previous Carrying
bonds Nominal Rate) (Carrying amount (Interest Paid less amount less Premium
times effective rate) Interest Expense) Amortization)

- 1,073,760
1 1,073,760 75,000 64,426 10,574 1,063,185
2 1,063,185 75,000 63,791 11,209 1,051,977
3 1,051,977 75,000 63,119 11,881 1,040,095
4 1,040,095 75,000 62,406 12,594 1,027,501
5 1,027,501 75,000 61,650 13,350 1,014,151
6 1,014,151 75,000 60,849 14,151 1,000,000

The entries for the transaction above shall include

Mar. 1 Cash P 1,073,760

Bonds Payable P 1,000,000
Premium on Bonds Payable 73,760

Sep 1 Interest Expense P75,000

Cash P 75,000

Premium on Bonds Payable P 10,574

Interest Expense P 10,574
To record the amortization

Dec 31 Interest Expense P 50,000

Interest Payable P 50,000

Illustration of bonds issued at discount:

ABC Corporation, on March 1, 2015, issued 10% of P1,000,000 face value bonds to XYZ Corporation for
effective rate of 12%. These bonds mature on March 1, 2018 pay interest semi-annually on March 1 and
September 1.

Using the effective interest method, these bonds were issued at premium

Present value of all interest P1,000,000 X 5% X Ordinary annuity of P 245,866

discounted using the effective 6% for six periods*
interest rate *three years semi-annual interest payments

Present value of the principal P1,000,000 X Present value of 1 of 6% P 704,961

for six periods
Carrying amounts of the bonds P 950,827

The amortization table would be:

Period Carrying Interest Paid Interest Discount Carrying value

amount of (Face value times Expense Amortization (Previous Carrying
bonds Nominal Rate) (Carrying amount (Interest Paid less amount less Premium
times effective rate) Interest Expense) Amortization)

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 - 950,827
1 950,827 50,000 57,050 7,050 957,876
2 957,876 50,000 57,473 7,473 965,349
3 965,349 50,000 57,921 7,921 973,270
4 973,270 50,000 58,396 8,396 981,666
5 981,666 50,000 58,900 8,900 990,566
6 990,566 50,000 59,434 9,434 1,000,000
The entries for the transaction above shall include

Mar. 1 Cash P 950,827

Discount on Bonds Payable 49,173
Bonds Payable P 1,000,000

Sep 1 Interest Expense P50,000

Cash P 50,000

Interest Expense P 7,050

Discount on Bonds Payable P 7,050
To record the amortization

Dec 31 Interest Expense P 50,000

Interest Payable P 50,000

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SESSION SUMMARY

Amortization of Bond is commonly performed under the effective interest method.

Bonds may be issued at discount, at par, or at premium.

SELF-ASSESSMENT

REFERENCES
Refer to the references listed in the syllabus of the subject.

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Problem 1:

On January 1, 2011, an entity issues bonds with face amount of P5,000,00 for P5,733,129. The bonds
mature on December 31, 2013 and pay annual interest of 14%, The effective interest rate is 8%.

a. Prepare the amortization table for the bonds and the required journal entries.
b. Prepare all the journal entries during the term of the bonds.

Problem 2:

On January 1, 2011, an entity issues bonds with face amount of P8,000,00 for P8,600,000. The bonds
mature on December 31, 2014 and pay annual interest of 11%, The effective interest rate is 9%. The
entity incurs transactions cost of P81,645.

Required:

a. Compute for the initial valuation of the bonds.

b. Compute for net discount or premium from the initial recognition
c. Are the periodic interest payments greater than or less than the periodic interest expenses?
d. Prepare all the journal entries during the term of the bonds.

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