CHAPTER 2 LONG-TERM FINANCIAL LIABILITIES AND DEBT RESTRUCTURING

TOPIC OVERVIEW:

This module discusses bonds payable and notes payable, its characteristics, classification, initial
recognition, initial measurement, subsequent measurement, and financial statement presentation.
It explains the effective interest method and compound financial instruments. It also tackles the
process and application of debt restructuring.

LEARNING OBJECTIVES:

After studying this module, the students should be able to:

1. Identify and describe bonds payable and notes payable.
2. Explain the initial and subsequent measurement of bonds payable and notes payable.
3. Journalize the transactions regarding bonds payable and notes payable.
4. Explain the effective interest method of amortizing discount and premium on bonds payable.
5. Explain the accounting for a compound financial instrument.
6. Discuss debt restructuring using asset swap, equity swap, and modification of terms.
BONDS PAYABLE

 Define bonds.
 Bonds are used primarily by corporations and government units.
 A bond is a formal unconditional promise, made under seal, to pay a specified sum of
money at a determinable future date and to make periodic interest payment at a stated
rate until the principal sum is paid.
 In simple language, a bond is a contract of debt whereby one party called the issuer
borrows funds from another party called the investor.
 A bond is evidenced by a certificate and the contractual agreement between the issuer
and investor is contained in a document called "bond indenture".
 Enumerate the different types of bonds.
 Term and Serial bonds
Term bonds are bonds with single date of maturity while serial bonds are bonds with
a series of maturity dates. In other words, serial bonds allow the issuing entity to
retire the bonds by installments.
 Secured and unsecured bonds
Mortgage bonds are bonds secured by a mortgage on real properties.
Collateral trust bonds are bonds secured by shares and bonds of other corporation.
Debenture bonds are unsecured or bonds without collateral or security.
 Registered and bearer bonds
Registered bonds require the registration of the name of the bondholders on the books
of corporation.
Coupon or bearer bonds are unregistered bonds in the sense that the name of the
bondholder is not recorded on the entity books.
 Convertible bonds are bonds that can be exchanged for shares of the issuing entity.
 Callable bonds are bonds which may be called in for redemption prior to the maturity
date.
 Guaranteed bonds are bonds issued whereby another party promises to make payment
if the borrower fails to do so.
  Junk bonds are high-risk, high-yield bonds issued by entities that are heavily indebted
or otherwise in weak financial condition.
 Zero-coupon bonds are bonds that pay no interest but the bonds offer a return in the
form of a "deep discount" or huge discount from the face amount.
 Explain the measurement of bonds payable.
 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 the bonds payaple.
The fair value of the bonds payable is equal to the present value of the future cash
payments, to settle the bond liability.
Bond issue costs shall be deducted from the fair value or issue price of the bonds
payable in measuring initially the bonds payable.
However, if the bonds are designated and accounted for "at fair value through profit
or loss", the bond issue costs are treated as expense immediately.
PFRS 9, paragraph 5.3.1, provides that after initial recognition, bonds payable shall
be measured either:
a. At amortized cost using the effective interest method
b. At fair value through profit or loss
The "amortized cost" of bonds payable is the amount at which the bond liability is
measured initially minus principal repayment, plus cumulative amortization of
discount or minus cumulative amortization of premium using the effective interest
method.
 Explain the "fair value option" of measuring bonds payable.
 PFRS 9, paragraph 4.2.2, provides that at initial recognition, bonds payable may be
irrevocably designated as at fair value through profit or loss.
In other words, under the fair value option, the bonds payable shall be measured
initially at fair value and remeasured at every year-end at fair value and any changes
in fair value are recognized in profit or loss.
However, any change in fair value attributable to the credit risk of the bond payable
designated at fair value through profit or loss is recognized in other comprehensive
income.
There is no more amortization of bond issue cost, bond discount and bond premium.
As a matter of fact, interest expense is recognized using the nominal or stated interest
rate and not the effective interest rate.
 Accounting for issuance of bonds
a. Memorandum approach
b. Journal entry approach

Illustration

On January 1, 2020, an entity is authorized to issue 10-year, 12% bonds with face amount of
P5,000,000, interest payable January 1 and July 1, consisting of 5,000 units of P1,000 face
amount. The bonds are sold at face amount to an underwriter.

 Memorandum approach
o The following memorandum entry is made in the general journal and a notation of the
amount authorized:
On January 1, 2020, an entity is authorized to issue P5,000,000 face amount, 10-year
12% bonds, interest payable January 1 and July 1, consisting of 5,000 units of P1,000
face amount.
 o To record the sale of the bonds at face amount

Cash 5,000,000

Bonds Payable 5,000,000

In the succeeding discussions, the memorandum approach of accounting for bonds

will be employed as this is the one generally followed.
 Journal entry approach
o To record the authorization of the bonds

Unissued Bonds Payable 5,000,000

Authorized Bonds Payable 5,000,000

o To record the sale of bonds at face amount

Cash 5,000,000

Unissued Bonds Payable 5,000,000

 Explain the issuance of bonds at a premium

 If the sales price is more than the face amount of the bonds, the bonds are said to be
sold at premium.
 For example, an entity issued bonds with face amount of P5,000,000 at 105.
Journal entry would be:

Cash 5,250,000

Bonds Payable 5,000,000

Premium on bonds payable 250,000

P5,000,000 × 1.05 = 5,250,000 ; Premium = P5,250,000 - 5,000,000

 The bond premium is in effect a gain on the part of the issuing entity because it
receives more than what is obligated to pay under the terms of the bond issue.
However, it is not reported as an outright gain. It means that the investor or the buyer
is amenable to receive lower interest than the nominal or stated rate of interest.
 Thus, effective interest rate is lower than nominal or stated rate.
 Explain the issuance of bonds at a discount
 If the sales price is less than the face amount of the bonds, the bonds are said to be
sold at a discount.
For example, an entity issued bonds with face amount of P5,000,000 at 95.
Journal entry would be:

Cash 4,750,000

Discount on bonds payable 250,000

Bonds Payable 5,000,000

P5,000,000 × 0.95 = 4,750,000 ; Discount = P4,750,000 - 5,000,000

  The bond discount is in effect a loss on the part of the issuing entity because it
receives less than what is obligated to pay under the terms of the bond issue.
However, it is not reported as an outright loss. It means that the investor or the buyer
wants to accept a rate of interest that is somewhat higher than the nominal rate.
 Presentation of discount and premium
 Discount and premium on bond payable are reported as adjustments to the bond
liability account. (Discount as deduction and premium as addition)
 Bond issue costs
 Bond issue costs are costs directly attributable to the issue of bonds payable.
 Such costs include printing and engraving cost, legal and accounting fee, registration
fee with regulatory authorities, commission paid to agents and underwriters and other
similar charges.
 Under PFRS 9, bond issue costs shall be deducted from the fair value or issue price of
bonds payable in measuring initially the bonds payable.

Illustration

On June 30, 2020, Huff Company issued at 99, five thousand bonds of 8%, P1,000 face amount.

The bonds were issued through an underwriter to whom the entity paid bond issue cost of
P425,000.

On June 30, 2020, what amount should be reported as bond liability?

Solution:

Bonds Payable P 5,000,000

Discount on bonds payable (50,000)

Bond issue cost (425,000)

Carrying amount of bonds payable P 4,525,000

Illustration

On March 1, 2020, Cain Company issued at 103 plus accrued interest 4,000 bonds of 9%, P1,000
face amount. The bonds are dated January 1, 2020 and mature on January 1, 2030.

Interest is payable semiannually on January 1 and July 1. The entity paid bond issue cost of
P200,000.

What is the net cash received from the bond issuance?

Solution:

Issue price (4,000,000 × 103%) P 4,120,000

Accrued Interest from January 1 to March 1 (4M × 9% × 60,000

2/12)

Total 4,180,000

Bond issue cost (200,000)

Net cash received from bond issuance P3,980,000

SERIAL BONDS

ILLUSTRATION: Issuance on Interest Date of Serial Bonds

Biliran Corporation issued bonds with face value of P6,000,000 on January 1, 2018. The nominal
rate of 6% is payable annually on December 31. The bonds are issued with an 8% effective yield.
The bonds mature on every December 31 each year at the rate of P2,000,00 for three years.

Required: Based on the preceding information, determine the following: (Round off present
value factors to four decimal places)

1) Issue price of the serial bonds

2) Interest expense in 2018

3) Carrying value of the serial bonds payable at December 31. 2018

SOLUTION:

1) Issue Price

Present value of Principal Payments

(P2,000,000X2.5771) P5,154,200

Present value of Interest Payments

2018(P6,000,000X6%X0.9259) P333,324

2019(P4,000,000X6%X0.8573) P205,752

2020(P2,000,000X6%X0.7938) P95,256 P634,332

Total P5,788,532

Amortization table

Date Total Payment Interest Reduction to Present Value

Expense principal

01/01/2018 P5,788,532

12/31/2018 2,360,000 463,083 1,896,917 3,891,615

12/31/2019 2,240,000 311,329 1,928,671 1,962,944

12/31/2020 2,120,000 157,035 1,962,944 0

Note: Total payment consists of principal and interest payment.

2) Interest expense

Interest expense, 2018= P463,083

3) Carrying amount
Carrying amount, 12/31,2018= P3,891,615

Note: Alternatively, the present value of serial bonds may be computed as follows (any difference
is due to rounding-off):

Date Total Payment PV Of 1 Present Value

12/31/2018 2,000,000+360,000 .9259 P2,185,124

12/31/2019 2,000,000+240,000 .8573 P1,920,352

12/31/2020 2,000,000+120,000 .7938 P1,682,856

P5,788,332

Entries to record transactions in 2018

1. To record the issuance of the bonds on January 1, 2018

Cash 5,788,532

Discount of bonds payable 211,468

Bonds payable(@face amount) 6,000,000

2. To record interest payment of December 31, 2018

Interest Expense 360,000

Cash(P1,000,000x12%x6/12 360,000

3. To record principal payment on December 31, 2018

Bonds payable 2,000,000

Cash 2,000,000

4. To record discount amortization on December 31,2018

Intest Expense 103,083

Discount on bonds payable 103,083

Financial Statement Presentation (2018)

Statement of Financial Position

Current liability section
*Bonds Payable -current portion P1,928,671

Non-current liability section

Bonds Payable- noncurrent portion P1,962,944

Statement of Comprehensive Income

Interest Expense P463,083

Notes to Financial Statements

Bonds Payable P 4,000,000

Less: Discount on Bonds Payable (P108,385)

Net carrying amount P3,891,615

*Reduction of principal in 2019. See amortization table above.

ILLUSTRATION: Issuance of Bonds between Interest Dates

On March 1, 2018, Samar Co. issued 12%, five-year P 1,000,000 at 98 including accrued
interest. These bonds were dated January 1, 2018. In addition, interests in these bonds are due
annually every December 31, 2018.

Required: Compute for the initial carrying amount of the bonds on March 1, 2018.

SOLUTION:

When bonds are issued between interest dates, the total proceeds from the issuance is composed
of two; (1) amount received from issuance of bonds; and (2) amount received for interest which
had accrued from interest.

In the given data, the bonds were issued at 98% of the face amount or P 980,000
(P1,000,000x98%). This is allocated as follows:

Total proceeds P980,000

Less: Accrued interest (P1,000,000x12%x2/12 P20,000

Proceeds applicable to the bonds P960,000

The transaction is then recorded as follows:

Cash 980,000

Discount on bonds payable 40,000

Bonds payable 1,000,000

 Interest expense* 20,000

*The accrued interest may also be credited to interest payable account

Pro-forma entries for transaction related to the issuance in 2018 include:

If accrued interest is credited to the interest expense

Interest expense 120,000

Cash (P1,000,000x12%) 120,000

If accrued interest is credited to the interest payable

Interest expense 100,000

Interest payable 20,000

Cash (P1,000,000x12%) 120,000

2. To record discount amortization on December 31, 2018

Interest expense 120,000

Discount on bonds payable (P40,000/5x10/12) 120,000

Note: To amortize these bonds, an effective interest rate shall be computed through
interpolation.

ILLUSTRATION: Issuance of Term Bonds between Interest Dates

On January 1, 2018, Leyte Co. is planning to issue a 12%, five-year P 1,000,000 bonds. Interests
on these bonds are due annually every year-end. Leyte determines that the current market rate on
January 1 is 15%.

Required: Compute for the amount of proceeds received from issuance assuming bonds were
issued on (Round off present value factors into four decimal places)

1) January 1, 2018

2) March 1, 2018

SOLUTION:

1) Bonds were issued on January 1, 2018

Present value of Principal Payments

(P1,000,000x0.4972) P497,200

Present value of Interest Payments

(P1,000,000x12%x3.3522) P402,264

Total P899,464

2) Bonds were issued on March 1, 2018

In computing for proceeds from issuance between interest dates, we can simply compute for the
carrying amount on issue date assuming the bonds were issued at interest date. In this example,
let us compute for the carrying amount on March 1, 2018 assuming that the bonds were issued on
January 1, 2018.

Since we have already computed for the issuance price on January 1, 2018, all we have to do is
to amortize it as follows:

Date Interest Interest Discount Carrying Value

Payment Expense Amortization

01/01/2018 P899,464

12/31/2018 120,000 134,920 14,920 P914,384

12/31/2019 120,000 137,158 17,158 P931,541

12/31/2020 120,000 139,731 19,731 P951,272

12/31/2021 120,000 142,691 22,691 P973,963

12/31/2022 120,000 146,094 26,036 P1,000,000 *

Based on the above amortization table, we can say that the issue price on March 1, 2018 is
between the carrying value of January 1, 2018 and December 31, 2018 amounting to P 899,464
and P 914,384, respectively. Also, let us note that the difference between these two amounts
represent the discount amortization for one year or twelve (12) months.

With these, the issue price would be:

Carrying amount, January 1, 2018 P899,464

Add: Discount amortization from January 1 to March 1 (P14,920x2/12) 2,487

Proceeds applicable to the bonds 901,951

Add: Accrued interest (P1,000,000x12%x2/12) 20,000

Total proceeds from issuance P921,951

Alternatively, the proceeds applicable to the bonds may be computed as if the bond issued on
interest date (January 1, 2018) was amortized for two months or up to March 1, 2018.

Date Interest Interest Discount Carrying Value

Payment Expense Amortization

01/01/2018 P899,464

03/01/2018 20,000 22,487 2,487 P901,951

Derecognition - Bonds Payable

A financial liability should be removed from the statement of financial position when, and only
when, it is extinguished, that is, when the obligation specified in the contract is either discharged,

cancelled, or expired.

Retirement of Nonconvertible Bonds Payable

(Note: If the problem is silent, assume that the bonds are nonconvertible)

Summary of accounting treatments

Procedural approach in retiring regular bonds

Step1 Update the amortization of the bonds payable as of the date of retirement.

Step2 Compute for the gain or loss on retirement using this formula:

Retirement price applicable to principal less carrying amount on bonds payable = loss/(gain) on
retirement of bonds

Note: No gain or loss on retirement of bonds on maturity

Step3 Record the transaction as follows:

Bonds payable (@face amount) xxx

Premium on bonds payable (if applicable) xxx

Loss on retirement of bonds (if applicable) xxx

Cash (retirement price) xxx

Discount on bonds payable (if applicable) xxx

Gain on retirement of bonds (if applicable) xxx

ILLUSTRATION: Retirement of Bonds

Tacloban Corporation is authorized to issue P1,000,000 of five-year bonds dated June 30, 2017
with a stated interest rate of 10%. Interest on the bonds is payable semi-annually on June 30 and
December 31. The company uses the effective interest method. The bonds were sold to yield 8%.

Required: Determine the amount of gain or loss assuming the bonds were sold retired under the
following independent situations:
1) On January 1, 2018 at face amount

2) On April 1, 2020 at 105

3) On June 30, 2022

SOLUTION:

Table of Amortization

Date Interest Interest Premium Carrying Value

Payment Expense Amortization

06/30/2017 P1,081,145

12/31/2017 50,000 43,246 6,754 1,074,391

06/30/2018 50,000 42,976 7,024 1,067,366

12/31/2018 50,000 42,695 7,305 1,060,061

06/30/2019 50,000 42,402 7,598 1,052,464

12/31/2019 50,000 42,099 7,901 1,044,562

06/30/2020 50,000 41,782 8,218 1,036,345

12/31/2020 50,000 41,454 8,546 1,027,798

06/30/2021 50,000 41,112 8,888 1,018,910

12/31/2021 50,000 40,756 9,244 1,009,667

06/30/2022 50,000 40,387 9,666 P1,000,000 *

*Prior to principal payment

1) January 1, 2018 at face amount

Retirement price P 1,000,000

Less: Carrying amount (see amortization table) (1,074,391)

Gain on retirement of bonds (P 74,391)

2) April 1, 2020 at 105

Retirement price (P1,000,000 × 105) P1,050,000

Less: Carrying amount (see amortization

table)

Carrying amount, 12/31/2019 P 1,044,562

Less: Amortization up to 4/1 (4,109) (1,040,053)

Loss on retirement of bonds P 9,547

3.) June 30, 2022

Zero. On June 30, 2022 maturity date, the retirement price and the carrying amount is equal to
the face amount of the bonds. Thus, no gain or loss shall be recognized.

EFFECTIVE INTEREST METHOD

 Explain nominal rate and effective rate of interest.

 The nominal rate is the rate appearing on the face of the bonds while the effective rate
is the actual interest incurred on the bond issue.
The nominal rate is also known as coupon or stated rate.
 The effective rate is the rate that exactly discounts estimated cash future payments
through the expected life of the bonds payable or when appropriate, a shorter period
to the net carrying amount of the bonds payable.
The effective rate is also known as yield or market rate.
 Explain the relationship between nominal rate and effective rate of interest.
 If the bonds are sold at face amount, the nominal rate and effective rate are the same.
If the bonds are sold at a discount, the effective rate is higher than nominal rate.
If the bonds are sold at a premium, the effective rate is lower than nominal rate.
 Explain the effective interest method of amortizing discount and premium on bonds
payable.
 The effective interest method or simply "interest method" or scientific method
recognizes two kinds of interest rate, nominal rate and effective rate.
The annual amortization of premium or discount is the difference between the
effective interest expense and nominal interest expense.
The effective interest expense is computed by multiplying the carrying amount of the
bonds payable at the beginning of the year by the effective rate.
The nominal interest expense is computed by multiplying the face amount of the
bonds payable by the nominal rate.
The effective interest method provides for an increasing amount of discount
amortization and increasing amount of interest expense.
The effective method provides for an increasing amount of premium amortization but
a decreasing amount of interest expense.
 Explain the treatment of bond issue cost under the effective interest method.
 The calculation of effective interest rate shall include all transaction costs, premiums
and discounts.
Under the effective interest method, bond issue cost must be "lumped" with the
discount on bonds payable and netted against the premium on bonds payable.
Accordingly, bond issue costs will increase discount on bonds payable and will
decrease premium on bonds payable.

Illustration:

On July 1, 2018, Tara Company issued 4,000 bonds of 8%, P 1,000 face amount for P 3,504,000.
The bonds were issued to yield 10%.

The bonds are dated July 1, 2018 and mature on July l, 2028. Interest is payable semiannually on
January 1 and July 1.
Using the effective interest method, what amount of the bond discount should be amortized for
the six months ended December 31, 2018?

Solution:

Interest Expense (3,504,000 × 5%) P 175,200

Interest Paid (4,000,000 × 4%) 160,000

Discount Amortization P 15,200

Another Illustration:

On January 1, 2018, Carrow Company issued 10% bonds in the face amount of P 1,000,000 that
will mature on December 31, 2027.

The bonds were issued for P 886,000 to yield 12%, resulting in bond discount of P 114,000.

The entity used the interest method of amortizing bond discount. Interest is payable on June 30
and December 31.

For the year ended December 31, 2018, what amount should be reported as bond interest
expense?

Solution:

Date Interest Paid Interest Expense Discount Carrying

Amortization Amount

1/1/2018 886,000

6/30/2018 50,000 53,160 3,160 889,160

12/31/2018 50,000 53,350 3,350 892,510

Total 100,000 106,510 6,510

COMPOUND FINANCIAL INSTRUMENT

 Define a compound financial instrument.

 PAS 32, paragraph 28, defines a compound financial instrument as a financial
instrument that contains both a liability and an equity element from the perspective of
the issuer.
 Explain the accounting for a compound financial instrument.
 If the financial instrument contains both a liability and an equity component, PAS 32,
paragraph 29, mandates that such components shall be accounted for separately in
accordance with the substance of the contractual arrangement and the definition of a
financial liability and an equity.
 This means that the consideration received from the issuance of the compound
financial instrument shall be allocated between the liability and equity components.
In other words, the fair value of the liability component is first determined.
The fair value of the liability component is then deducted from the total consideration
received from issuing the compound financial instrument.
The residual amount is allocated to the equity component.
 Explain the accounting for bonds payable issued with share warrants.
 Bonds issued with share warrants are considered as compound financial instrument.
Accordingly, the proceeds from the issuance of the bonds payable with share warrants
shall be accounted for as partly liability and partly equity.
The proceeds shall be allocated between the bonds payable and the share warrants.
PAS 32 does not differentiate whether the equity component is detachable or non-
detachable.
Whether detachable or non-detachable, share warrants have a value and therefore
shall be accounted for separately.
PAS 32, paragraph 31, provides that equity instruments are instruments that evidence
a residual interest in the assets of an entity after deducting all of its liabilities.
Therefore, the bonds are assigned an amount equal to the "market value of the bonds
ex-warrant", regardless of the market value of the warrants.
The residual amount or remainder of the issue price shall then be allocated to the
share warrants.
If the bonds have no known market value ex-warrant, the amount allocated to the
bonds is equal to the present value of the bonds payable.
The present value of bonds payable is the sum of the present value of the principal
bond liability and the present value of the future interest payments using the effective
or market interest rate for similar bonds without the share warrants.
 Explain the accounting for convertible bonds at the time of original issuance.
 Convertible bonds are conceived as compound financial instrument.
Accordingly, the issuance of convertible bonds shall be accounted for as partly
liability and partly equity.
The issue price of the convertible bonds shall be allocated between the bonds payable
and the conversion privilege.
Accordingly, 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.
 Explain the accounting for the conversion of convertible bonds into share capital.
 Application Guidance 32 of PAS 32 provides that on conversion of a convertible
instrument at maturity, the entity derecognizes the liability component and recognizes
it as equity.
There is no gain or loss on conversion at maturity.
Accordingly, the carrying amount of the bonds payable is the measure of the share
capital issued because the carrying amount is the "effective price" for the shares
issued as a result of the conversion.
Any cost incurred in connection with the bond conversion shall be deducted from
share premium, if any.
Otherwise, the cost incurred is treated as expense.

Illustration:
On December 31, 2018, Moses Company issued P 5,000,000 face amount, 5-year bonds at 109.

Each P 1,000 bond was issued with 50 detachable share warrants, each of which entitled the
bondholder to purchase one ordinary share of P5 par value at P25. Immediately after issuance,
the market value of each warrant was P5.

The stated interest rate on the bonds is 11% payable annually every December 31. However, the
prevailing rate of interest for similar bonds without warrants is 12%.

The present value of 1 at 12% for 5 periods is 0.57 and the present value of an ordinary annuity
of 1 at 12% for 5 periods is 3.60.

1. What is the carrying amount of the bonds payable on December 31, 2018?

2. On December 31, 2018, what amount should be recorded as discount or premium on bonds
payable?

3. What is the equity component arising from the issuance of bonds payable?

4. What is the share premium if all of the warrants are exercised?

Answers:

1.

PV of principal (5,000,000 × .57) P 2,850,000

PV of annual interest payments (550,000 × 3.60) 1,980,000

Total present value of bonds payable P 4,830,000

2.

Bonds Payable P 5,000,000

PV of bonds payable (answer in no. 1) 4,830,000

Discount on bonds payable P 170,000

3.

Issue price of bonds with warrants (5,000,000 × 109%) P 5,450,000

Present value of bonds payable 4,830,000

Residual amount allocated to warrants 620,000

Journal entry to record the issue of bonds with share warrants

Cash 5,450,000

Discount on Bonds Payable 170,000

 Bonds Payable 5,000,000

Share warrants outstanding 620,000

4. Journal entry to record the exercise of all of the share warrants

Cash (5,000 × 50 × P25) 6,250,000

Share Warrants Outstanding 620,000

Share Capital (5,000 × 50 × P5) 1,250,000

Share Premium 5,620,000

NOTE PAYABLE

 Explain the initial measurement of note payable.

 PFRS 9, paragraph 5.1.1, provides that a note payable shall be measured initially at
fair value minus transaction costs that are directly attributable to the issue of the note
payable.
In other words, transaction costs are included in the measurement of note payable.
However, if the note payable is irrevocably designated at fair value through profit or
loss, the transaction costs are expensed immediately.
 Explain the subsequent measurement of note payable.
 PFRS 9, paragraph 5.3.1, provides that after initial recognition, a note payable shall
be measured either:
a. At amortized cost using the effective interest method
b. At fair value through profit or loss
PFRS 9, paragraph 4.2.2, provides that at initial recognition, a note payable may
be irrevocably designated as at fair value through profit or loss.
Under the fair value option, the note payable shall be measured initially at fair
value and remeasured at every year-end at fair value and any changes in fair value
are recognized in profit or loss.
Interest expense is recognized using the nominal or stated interest rate and not the
effective interest rate.
 Explain the fair value of note payable.
 The fair value of the note payable is equal to the present value of the future cash
payment to settle the note payable.
The term "present value"' is the discounted amount of the future cash outflow in
settling the note payable using the market rate of interest.
a. When a note is issued solely for cash, the present value is equal to the cash
proceeds.
b. When a property or noncash asset is acquired by issuing a note payable which is
interest bearing, the property or asset is recorded at the purchase price.
The purchase price is reasonably assumed to be the present value of the note payable.
When a noninterest bearing note is issued for property, the property is recorded at the
cash price of the property.
The cash price is assumed to be the present value of the note issued.
 The difference between the cash price and the face amount of the note payable
represents the imputed interest.

Illustration - Issuance of Interest-Bearing Note - Lump Sum

On January 1, 2018, Aklan Co. acquired a machine from Antique Co. In lieu of cash payment,
Aklan gave Antique a 3-year, P 600,000, 3% note payable. Principal is due on December 31,
2020 but interest is due annually every December 31. The prevailing interest rate for this type of
note is 10%.

Required: Compute for the carrying amount of the note payable on December 31, 2018.

Solution:

Since there is no available fair value, the note shall be measured at discounted or present value.

Present value of principal (P600,000 × 0.7513) P 450,780

PV of interest payments (P600,000×3%×2.4869) 44,764

Present value of notes payable P 495,544

Amortization Table

Date Interest Payment Interest Expense Discount Present Value

Amortization

1/1/2018 P495,544

12/31/2018 18,000 49,554 31,554 527,099

Carrying amount, 12/31/2018 = P 527,099

It is to be presented as noncurrent liability because the principal amount of the note is payable
beyond one year from the reporting date.

Illustration - Issuance of Non-Interest Bearing Note with One-Time Payment of the

Principal

On January 1, 2018, Capiz Co. acquired a machine from Guimaras Co. In lieu of cash payment,
Capiz gave Guimaras a 3-year, P 600,000 non-interest bearing note payable due on December
31, 2020. The prevailing rate of interest for this type of note is 10%.

Required: How much is the amount that should be recorded as a net liability on December 31,
2018?

Solution:

Present value of Principal (P600,000 × 0.7513) = P450,780

Amortization Table

Date Interest Expense Present Value

1/1/2018 P 450,780
 12/31/2018 45,078 495,858

Carrying amount, 12/31/2018 = P 495,858

It is to be presented as noncurrent liability because the principal amount of the note is payable
beyond one year from the reporting date.

Illustration - Issuance of Non-Interest Bearing Notes with Uniform Payment of the

Principal

On January 1, 2018, Iloilo Co. acquired a machine from Negros Co. In lieu of cash payment,
Iloilo gave Negros a 3-year P 600,000 noninterest-bearing note payable. Principal is due in equal
payments every December 31 beginning on December 31, 2018. The prevailing rate of interest
for this type of note is 10%.

Required: How much is the amount that should be recorded as a net liability on December 31,
2018?

Solution:

Present Value of principal (P 200,000 × 2.4869) = P 497,380

Amortization Table

Date Annual Payment Interest Expense Principal Present Value

1/1/2018 P497,380

12/31/2018 200,000 49,738 150,262 347,118

12/31/2019 200,000 34,712 165,288 181,830

12/31/2020 200,000 18,170 181,830 -

The amount to be reported as net liability is P 347,118.

Current Liability = P 165,288 Noncurrent Liability = P 181,830

Illustration - Noninterest Bearing Note - With Cash Price Equivalent

On January 1, 2018, Oriental Co. acquired inventory with a list price of P 800,000 and a cash
price of P 497,380 by issuing a 3-year, P 600,000 noninterest-bearing note payable. Principal is
due in equal payments every December 31, beginning on December 31, 2018. The effective rate
of interest interpolated for the cash price is 10%.

Required: Determine the following:

1. The carrying amount of the note on initial recognition.

2. The carrying amount of the note for the year ended December 31, 2018.

Solution:

Requirement 1. The carrying amount of the note on initial recognition is equal to the cash prize
of P 497,380.
Requirement 2.

Date Annual Payment Interest Expense Principal Present Value

1/1/2018 P497,380

12/31/2018 200,000 49,738 150,262 347,118

12/31/2019 200,000 34,712 165,288 181,830

12/31/2020 200,000 18,170 181,830 -

Carrying amount, 12/31/2018 = P 347,118

DEBT RESTRUCTURING
 What is meant by debt restructuring?
 Debt restructuring is a situation where the creditor, for economic or legal reasons
related to the debtor's financial difficulties, grants to the debtor concession that would
not otherwise be granted in a normal business relationship.
The concession either stems from an agreement between the creditor and debtor, or is
imposed by law or a court.
The objective of the creditor in a debt restructuring is to make the best of a bad
situation or maximize recovery of investment.
Thus, the creditor usually sustains an accounting loss on debt restructuring and the
debtor realizes an accounting gain.
The common forms of debt restructuring are:
a. Asset swap
b. Equity swap
c. Modification of terms
 Explain an asset swap.
 Asset swap is the transfer of any asset such as real estate, inventory or investment by
the debtor to the creditor in full settlement of an obligation.
Under PFRS 9, paragraphs 3.3.1 and 3.3.3, asset swap is treated as a derecognition of
a financial liability or extinguishment of an obligation.
The difference between the carrying amount of the financial liability and the
consideration given shall be recognized in profit or loss.

Illustration - Asset Swap

Siquijor, Inc. provided the following balances on December 31, 2018:

Notes Payable........................... P 1,600,000

Accrued Interest Payable..........P 200,000

On December 31, 2018, the entity transferred to the creditor land recorded at a cost of
P1,500,000. As of this date, the land has a fair value of P 2,000,000.

Required: Determine the amount of gain or loss to be recorded in the company's statement of
comprehensive income.

Solution:

Carrying amount of land P 1,500,000

Less: Carrying amount of liability extinguished (1.6M + 200k) 1,800,000

Gain on extinguishment of debt P 300,000

To record the transaction

Note Payable 1,600,000

Accrued interest payable 200,000

Land 1,500,000

Gain on extinguishment of debt 300,000

 Explain an equity swap.

 An equity swap is a transaction whereby a debtor and creditor may renegotiate the
terms of a financial liability with the result that the liability is fully or partially
extinguished by the debtor issuing equity inetruments to the creditor.
Simply stated, equity swap is the issuance of share capital by the debtor to the
creditor in full or partial payment of an obligation.
This accounting issue of extinguishment of a financial liability by issuing equity
instruments is now well-settled under IFRIC 19.
The equity instruments issued to extinguish a financial liability shall be measured at
the following amounts in the order of priority:
a. Fair value of equity instruments issued
b. Fair value of liability extinguished
b. Carrying amount of liability extinguished
The difference between the carrying amount of the financial liability extinguished and
the "initial measurement" of the equity instruments issued shall be recognized in
profit or loss.
Such gain or loss on extinguishment shall be disclosed as a separate line item in the
income statement.

Illustration - Equity Swap

Lapu-lapu Corporation showed the following data on December 31, 2018:

Bond Payable............................ P 4,500,000

Accrued interest payable........... P 300,000

On December 31, 2018, the entity issued share capital with a total par value of P2,000,000. Both
share capital issued and bonds payable are quoted in an active market at P4,400,000 and
P4,700,000, respectively.

Required: Determine the following:

1. Amount of gain or loss to be recorded in the company's income statement

2. Amount credited to share premium from the extinguishment of the liability.

Solution:
1.

Carrying amount of land P 4,400,000

Less: Carrying amount of liability extinguished (4.5M + 300k) 4,800,000

Gain on extinguishment of debt P 400,000

2. P 4,400,000 - 2,000,000 = P 2,400,000

To record the transaction:

Bonds payable 4,500,000

Accrued interest payable 300,000

Ordinary shares 2,000,000

Share Premium 2,400,000

Gain on extinguishment of debt 400,000

 Explain the accounting for substantial modification of terms.

 PFRS 9, paragraph 3.3.2, provides that substantial modification of terms of an
existing financial liability shall be accounted for as an extinguishment of the old
liability and the recognition of a new financial liability.
Under Application Guidance B3.3.6 of PFRS 9, there is substantial modification or
terms if the gain or loss on extinguishment is at lease 10% or 10% or more of the
carrying amount of the old financial liability.
The difference between the carrying amount of the old liability and the present value
of new or restructured liability shall be accounted for as gain or loss on
extinguishment.
The present value of the new liability shall be determined using the original effective
interest rate.
Any costs or fees incurred as a result of the substantial modification of terms shall be
recognized as part of gain or loss on extinguishment.
 No substantial modification
If the gain or loss on extinguishment of the old liability is less than 10% of the
carrying amount of the old liability, there is no substantial modification of terms.

Illustration - Modification of Terms - Substantially modified

Mandaue Company has an overdue note payable to National Bank of P8,000,000 and recorded
accrued interest of P840,000, based on 12% interest rate.

As a result of a settlement on December 31, 2017, National Bank agreed to the following
restructuring arrangement:

 Reduced principal obligation to P7,000,000

 Forgave the P840,000 accrued interest
 Extended the maturity date to December 31, 2019
  Annual interest of 10% is to be paid on December 31, 2018 and 2019

Required: Determine the amount of gain or loss to be recorded in the company's income
statement (round off present value factor into four decimal places)

Solution:

Fair value of new liability

PV of principal (7M × 0.7972) P 5,580,400

PV of interest (700k × 1.6901) 1,183,070 P 6,763,470

Less: Carrying amount of liabilities extinguished

Notes Payable P 8,000,000

Accrued interest payable 840,000 8,840,000

Gain on extinguishment of debt P 2,076,530

Note: The old interest rate of 12% was used to determine the present value factors.

Computation of the percentage of gain or loss over carrying amount of the old liability

P 2,076,530 / P 8,840,000 = 23.49%

Since the gain is more than 10%, the debt instrument is considered "substantially different
terms". Any gain or loss is recognized immediately.

To record the transaction

Notes payable (old) 8,000,000

Accrued interest payable 840,000

Discount on Notes Payable 236,530

Notes payable (new) 7,000,000

Gain on extinguishment of debt 2,076,530

Illustration - Modification of Terms - Not Substantially Modified

Lapu-lapu Company has a note payable to National Bank of P 8,000,000. The note bears interest
of 12%.

As a result of a settlement on December 31, 2017, National Bank agreed to the following
restructuring agreement:

 Extended the maturity date to December 31, 2019

 Annual interest of 10% is to be paid on December 31, 2018 and 2019

Required: Determine the amount of gain or loss to be recorded in the company's income
statement (round off present value factor into four decimal places)
Solution:

Fair value of new liability

PV of principal (8M × 0.7972) P 6,377,600

PV of interest (800k × 1.6901) 1,352,080 P 7,729,680

Less: Carrying amount of liabilities extinguised 8,000,000

Gain on extinguishment of debt P 270,320

Computation of the percentage of gain or loss over carrying amount of the old liability

P 270,320 / P 8,000,000 = 3.38%

To record the transaction

Discount on notes payable 270,320

Gain on modification of debt 270,320

References:

Valix, et. al. (2019). Intermediate Accounting Volume 2, Manila, Philippines

Asuncion, et. al. (2018). Applied Auditing Book 2 of 2, Baguio City: Real Excellence Publishing
Valix, et. al. (2016). Financial Accounting Volume 2, Manila Philippines
Assessment:

Exercise 1. On January 1, 2018, Kayayan Company issued 10% bonds in the face amount of
P1,000,000 that will mature on December 31, 2027.

The bonds were issued for P 886,000 to yield 12%, resulting in bond discount of P 114,000.

The entity used the interest method of amortizing bond discount. Interest is payable on June 30
and December 31.

For the year ended December 31, 2018, what amount should be reported as bond interest
expense?

Exercise 2. On January 1, 2018, Labanpa Co. acquired a machine from Kaya Co. In lieu of cash
payment, Labanpa gave Kaya a 3-year P 1,800,000 noninterest-bearing note payable. Principal is
due in equal payments every December 31 beginning on December 31, 2018. The prevailing rate
of interest for this type of note is 10%.

Required: How much is the amount that should be recorded as a net liability on December 31,
2018?

Exercise 3. Online Company has an overdue note payable to La Bank of P10,000,000 and
recorded accrued interest of P1,050,000, based on 12% interest rate.

As a result of a settlement on December 31, 2017, National Bank agreed to the following
restructuring arrangement:

 Reduced principal obligation to P7,000,000

 Forgave the P840,000 accrued interest
 Extended the maturity date to December 31, 2019
 Annual interest of 10% is to be paid on December 31, 2018 and 2019

Required: Determine the amount of gain or loss to be recorded in the company's income
statement (round off present value factor into four decimal places).

Exercise 4.

Papasa Corp. showed the following data on December 31, 2018:

Bond Payable............................ P 9,000,000

Accrued interest payable........... P 600,000

On December 31, 2018, the entity issued share capital with a total par value of P4,000,000. Both
share capital issued and bonds payable are quoted in an active market at P8,800,000 and
P9,400,000, respectively.

Required: Determine the following:

1. Amount of gain or loss to be recorded in the company's income statement

2. Amount credited to share premium from the extinguishment of the liability.