CHAPTER 27

PAS 37
PROVISON, CONTINGENT
LIABILITY AND ASSET
TECHNICAL KNOWLEDGE
To understand the nature of a provision
To know the conditions for the recognition
of a provision
To know the measurement of a provision
To understand the nature of the contingent
liability and contingent asset
Provision
A provision is an
existing liability of
uncertain timing or
uncertain amount.
Recognition of provision
• PAS 37, paragraph 14, provides that a provision
shall be recognized as a liability in the financial
statements under the following conditions:
a. The entity has a present obligation, legal or
constructive, as a result of a past event.
b. It is probable that an outflow of resources
embodying economic benefits would be required
to settle the obligation.
c. The amount of the obligation can be measured
reliably.
 Present obligation
The present obligation may be legal or
constructive. It is fairly clear what a legal
obligation is.

Legal obligation
A legal obligation is an obligation arising from
a contract, legislation, or other operation of
law.
 Constructive obligation
• A constructive obligation is an obligation that is
derived from an entity’s action where:
a. The entity has indicated to other parties that it will
accept certain responsibilities by reason of an
established pattern of past practice, published
policy, or a sufficiently specific current statement.
b. And as a result, the entity has created a valid
expectation on the part of other parties that it will
discharge those responsibilities.
 Past event
• The past event that leads to a present
obligation is called an obligating event.
• An accounting provision cannot be created
in anticipation of a future event.
• The event must have already occurred
which gives rise to the legal or constructive
obligation.
Probable outflow of economic
benefits
• For a provision to qualify for recognition there
must be not only a present obligation but also
a probable outflow of resources embodying
economic benefits to settle the obligation.
• An outflow of resources is regarded as
probable if the event is more likely that not to
occur, meaning, the probability that the event
will occur is greater than the probability that it
will not occur.
• As a rule of thumb, “probable” means
more than 50% likely occur.

• “Possible” means 50% or less likely to

occur.

• “Remote” means 10% or less likely to

occur or very slight occurrence.
 Reliable estimate
• Paragraph 25 of PAS 37 provides that the
use of estimates is an essential part of the
preparation of financial statements and does
not undermine their reliability.
• This is especially true in the case of provision
because by nature, a provision is more
uncertain that most items in the statement of
financial position.
Measurement of provision
• The amount recognized as a provision should
be the best estimate of the expenditure
required to settle the present obligation at the
end of reporting period.
• The best estimate is the amount that an entity
would rationally pay to settle the obligation at
the end of reporting period or to transfer it to
a third party at that time.
Measurement considerations
The following items are taken into consideration in
recognizing and measuring a provision.
1. risks and uncertainties
2. .present value of obligation
3. future events
4. expected disposal of assets
5. reimbursements
6. change in provision
7. use of provision
8. future operating losses
9. onerous contract
 Risks and uncertainties
• The risks and uncertainties that
inevitably surround events and
circumstances shall be taken into account
in reaching the best estimate of a
provision.
• Risk describes variability of outcome.
 Present value of obligation
• Where the effect of the time value of money is
material, the amount of provision shall be
present value of the expenditure expected to
settle the obligation.
• The discount rate should be a pretax rate that
reflects the current market assessment of the
time value of money and the risk specific to
the liability.
 Future events
• Future events that affect the amount
required to settle an obligation shall be
reflected in the amount of a provision where
there is sufficient evidence that they will
occur.
• Such future events include new legislation
and changes in technology.
 Expected disposal of
assets
• Gains from expected disposal of assets
shall not be taken into account in measuring
a provision.
• Instead, an entity shall recognize gain on
disposal at the time of the disposal of the
assets.
 Reimbursement
• When some or all of the expenditure required
to settle a provision is expected to be
reimbursed by another party, the
reimbursement shall be recognized when it is
virtually certain that the reimbursement
would be received if the entity settles the
obligation.
 Changes in provision
• Provisions shall be reviewed at every end
of the reposting period and adjusted to
reflect the current best estimate.
• The provision shall be reversed if it is no
longer probable that an outflow of economic
benefits would be required to settle the
obligation.
 Use of provision

• A provision shall be sued only for expenditures

for which the provision was originally
recognized.
• For example, a provision for plant
dismantlement cannot be used to absorb
environmental pollution claims or warranty
payments.
Future operating losses

• Provision shall not be recognized for future

operating losses.
• In other words, a provision for operating
losses is not recognized because a past
event creating a present obligation has not
occurred.
 Onerous contract
• If an entity has an onerous contract, the
present obligation under the contract shall
be recognized and measured as a provision.
• An onerous contract is a contract in which
the unavoidable costs of meeting the
obligation under the contract exceed the
economic benefits expected to be received
under it.
 Examples of provision
1. Warranties- the best estimate of the warranty cost
is recognized as a provision because there is a
clear constructive obligation arising from an
obligating event which is the sale of the product
with warranty.
2. Environmental contamination- if an entity has
an environmental policy such that other parties
would expect the entity to clean up any
contamination, or if the entity has broken current
environmental legislation then a provision for
environmental damage shall be made.
3.Decommissioning or abandonment costs-
when an oil entity initially purchases an oil field, it
is put under a legal obligation to decommission the
site at the end of the life. The costs of
abandonment or decommissioning shall be
recognized as a provision.
4.Court case- after a wedding in the current year,
ten people died possibly as a result of food
poisoning from products sold by the entity. Legal
proceedings are started seeking damages from the
entity.
5.Guarantee- in the current year, an
entity gives a guarantee of certain
borrowings of another entity. During the
year, the financial condition of the
borrower deteriorates and at year-end.,
the borrower files a petition for
bankruptcy.
 Contingent liability
• PAS 37, paragraph 10, defines a contingent
liability in two ways:
• A contingent liability is a possible obligation
that arises from past event and whose
existence will be confirmed only by the
occurrence or nonoccurrence of one or more
uncertain future events not wholly within the
control of the entity.
 Contingent liability and
provision
• The second definition states that a
contingent liability is a present
obligation.
• However, the present obligation is
either probable or measurable but not
both to be considered a contingent
liability.
 Treatment of contingent liability
• A contingent liability shall not be recognized in the
financial statements but shall be disclosed only. The
required disclosures are:
a. Brief description of the nature of the contingent
liability.
b. An estimate of its financial effects.
c. An indication of the uncertainties that exist.
d. Possibility of any reimbursement.
• If a contingent liability is remote, no disclosure is
necessary.
 Contingent asset
• PAS 37, paragraph 10, defines contingent
asset as a possible asset that arises from
past event and whose existence will be
confirmed only by the occurrence or
nonoccurrence of one or more uncertain
future events not wholly within the control of
the entity.
 QUESTIONS
1. Explain the meaning of a provision.
2. What are the three conditions necessary for the recognition of a
provision as a liability?
3. Define a legal obligation and constructive obligation.
4. What is the measurement of a provision?
5. Discuss briefly each of the following in connection with
measurement of a provision.
a. Risks and uncertainties
b. Present value obligation
c. Future events
d. Expected disposal of assets
e. Reimbursement
f. Changes in provisions
g. Use of provision
h. Future operating losses
i. Onerous contract
6.Define a contingent liability.
7.Distinguish a contingent liability from a
provision
8.Explain the treatment of a contingent
liability.
9.Define a contingent asset.
10.Explain the treatment of a contingent
asset.
 PROBLEMS
Problem 25-1 (IAA)
• Eastern company had several contingent liabilities on December 31,
2019. The auditor obtained the following brief description of each
liability.
• In May 2019, Eastern Company became involved in litigation. In
December 2019, the court assessed a judgment for P1,600,00
against Eastern Company.

• The entity is appealing the amount of judgment. The entity’s

attorneys believed it is probable that the assessment can be
reduced on appeal by 50%.

• In July 2019, Pasig City brought action against Eastern Company for
polluting the Pasig River with its waste products.
• It is probable that Pasig City will be successful but
the amount of damages Eastern Company might
have to pay should not exceed P1,500,00.

 A personal injury liability suit for P500,000 was

brought against Eastern Company in December
2019.

• The management and legal counsel of Eastern

Company concluded that it is not probable that
Eastern Company will be responsible for
damages and that P200,000 is the best estimate
of damages.
• What total amount should be accrued
as provision on December 31, 2019?
a.2,000,000
b.2,500,000
c.3,100,000
d.2,300,000
 Problem 25-2 (AICPA Adapted)
• Star company, a publisher, is preparing the 2019 financial
statements and must determine the proper accounting treatment
for each of the following situations:
• An author filed a suit for breach of contract seeking damages of
P2,000,000 against Star Company on July 1, 2019

• The entity’s legal counsel believed that an unfavorable outcome is

probable.

• The best estimate of the court’s award to be plaintiff is P1,500,000.

• During December 2019, a competitor filed a suit against Star

Company for industrial espionage, claiming P3,000,000 in damages.
 • Management and legal counsel believed it is probable that
damages will be awarded to the plaintiff and the best estimate of
the damages is P1,000,000

 Star Company signed as guarantor for P2,000,000 loan by PNB to

Moon Company shall pay the P2,000,000 loan with only 60%
recovery anticipated from Moon Company.

What total amount should be accrued as provision on December

31, 2019?
a. 3,700,000
b. 3,300,000
c. 2,500,000
d. 7,000,000
 Problem 25-3 (AICPA Adapted)
• On February 5, 2020, an employee filed a P2,000,000 lawsuit
against Steel Company for damages suffered when a plant exploded
on December 29, 2019.
• The legal counsel believed the entity would probably lose the lawsuit
and estimated the loss to be P500,000.
• The employee offered to settle the lawsuit out of court for P900,000
but the entity did not agree to the settlement.
On December 31, 2019, what amount should be reported as
liability from lawsuit?
a. 2,000,000
b. 1,000,000
c. 900,000
d. 500,000
 Problem 25-4 (AICPA Adapted)
• On November 5, 2019, a Dunn Company truck was in an accident with an
auto driven by Bell. Dunn received notice on January 15, 2020 of a lawsuit for
P700,000 damages for personal injuries suffered by Bell.
• The entity’s counsel believed it is probable that Bell will be awarded an
estimated amount in the range between P200,000 and P450,000, and no
amount is a better estimate of potential liability than any other amount because
each point in the range is as likely as any other.
• The 2019 financial statements were issued on March 1, 2020.
What amount of loss should be accrued on December 31, 2019?
a. 450,000
b. 200,000
c. 325,000
d. 0
 Problem 25-5 (IAA)
• Winter Company is being sued for illness caused to local residents as a
result of negligence on the entity’s part in permitting the local residents to be
exposed to highly toxic chemicals from its plant.
• The entity’s lawyer stated that it is probable that the entity would lose the
suit and be found liable for a judgment costing the entity anywhere from
P1,200,000 to P6,000,000. However, the lawyer estimated that the most
probable cost is P3,600,000.
What amount should be accrued and disclosed?
a. Accrue a loss of P1,200,000 and disclose an additional loss contingency of
P4,800,000.
b. Accrue a loss of P3,600,000 and disclose an additional loss contingency of
P2,400,000.
c. Accrue a loss of P3,600,000 but not disclose any additional contingency.
d. No loss accrual but disclose a contingency of P1,200,000 to P6,000,000.
 Problem 25-6 (AICPA Adapted)
• During 2019, Beal Company became involved in a tax dispute
with the BIR. On December 31, 2019, the tax advisor believed
that an unfavorable=e outcome was probable and a reasonable
estimate of additional taxes was P500,000.
• After the 2019 financial statements were issued, the entity
received and accepted a BIR settlement offer of P550,000.
What amount of accrued liability should have been reported
on December 31, 2019?
a. 650,000
b. 550,000
c. 500,000
d. 0
 Problem 25-7 (AICPA Adapted)
• In May 2019, Caso Company filed a suit against Wayne Company seeking
P1,900,000 damages for patent infringement.
• A court verdict in November 2019 awarded Caso P1,500,000 in damages
but Wayne’s appeal is not expected to be decided before 2020.
• Caso’s counsel believed it is probable that Caso will be successful against
Wayne for an estimated amount in the range between P800,000 and
P1,100,000 with P1,000,000 considered the most likely amount
What amount should Caso record as income from the lawsuit for the year
ended December 31, 2019?
a. 1,500,000
b. 1,100,000
c. 1,000,000
d. 0
 Problem 25-8 (AICPA Adapted)
• During the latter part of the year, Haze Company won a litigation
award for P1,500,000 which was tripled to P4,500,000 to include
punitive damages.
• The defendant, who is financially stable, has appealed only the
P3,000,000 punitive damages.
• The entity was awarded P5,000,000 in an unrelated suit it filed
which is being appealed by the defendant. Counsel is unable to
estimate the outcome of these appeals.
What amount should be reported as pretax gain for the year?
a. 1,500,000
b. 4,500,000
c. 5,000,000
d. 9,500,000
 Problem 25-9 Multiple Choice
(PAS 37)
1.Which is the correct definition of a
provision?
a.A possible obligation arising from past
event
b.A liability of uncertain timing or amount
c.A liability which cannot be easily measured
d.An obligation to transfer funds to an entity
 Problem 25-9 Multiple Choice
(PAS 37)
2. A provision shall be recognized as liability when

a. An entity has a present obligation as a result of a past

event.
b. It is probable that an outflow of resources embodying
economic benefits will be required to settle the
obligation.
c. The amount of the obligation can be measured
reliably.
d. All of these are required for the recognition of a
provision as liability.
 Problem 25-9 Multiple Choice
(PAS 37)
3. A legal obligation is an obligation that
is derived from all of the following,
except
a.Legislation
b.A contract
c.Other operation of law
d.An established pattern of past practice
 Problem 25-9 Multiple Choice
(PAS 37)
4. A constructive obligation is an obligation

I. That is derived from an entity’s action that the entity

will accept certain responsibilities because of past
practice, published policy or current statement.
II. The entity has created a valid expectation in other
parties that it will discharge those responsibilities.
a. I only
b. II only
c. Both I and II
d. Either I and II
 Problem 25-9 Multiple Choice
(PAS 37)
5. It is an event that creates a legal or
constructive obligation because the
entity has no other realistic alternative
but to settle the obligation,
a.Obligating event
b.Past event
c.Subsequent event
d.Current event
 Problem 25-9 Multiple Choice
(PAS 37)
6. An outflow of resources embodying economic
benefits is regarded as probable when

a. The probability that the event will occur is greater than

the probability that the event will not occur.
b. The probability that the event will not occur is greater
that the probability that the event will occur.
c. The probability that the event will occur is the same as
the probability that the event will not occur.
d. The probability that the event will occur is 90% likely.
 Problem 25-9 Multiple Choice
(PAS 37)
7. Where there is continuous range of
possible outcomes, and each point in
that range is as likely as any other, the
range to be used is the
a.Minimum
b.Maximum
c.Midpoint
d.Sum of the minimum and maximum
 Problem 25-9 Multiple Choice
(PAS 37)
8. When the provision involves a large
population of items, the estimate of the amount

a. Reflects the weighing of all possible outcomes by

their associated probabilities.
b. Is determined as the individual most likely
outcome.
c. May be the individual most likely outcome
adjusted for the effect of other possible outcomes.
d. Midpoint of the possible outcomes.
 Problem 25-9 Multiple Choice
(PAS 37)
9. When the provision arises from a single
obligation, the estimate of the amount

a. Reflects the weighting of all possible outcomes by

their associated probabilities.
b. Is determined as the individual most likely
outcome.
c. Is the individual most likely outcome adjusted for
the effect of other possible outcomes.
d. Midpoint of the possible outcomes.
 Problem 25-9 Multiple Choice
(PAS 37)
10. Which statement is incorrect where the expenditure
required to settle a provision is expected to be reimbursed
by another party?

a. The reimbursement shall be recognized only when it is

virtually certain that the reimbursement would be received if
the entity settles the obligation.
b. The amount of the reimbursement shall not exceed the
amount of the provision.
c. In the income statement, the expense relating to the provision
may be presented net of the reimbursement.
d. The reimbursement shall not bet treated as separate asset
but “netted” against the estimated liability for the provision.
 Problem 25-10 Multiple Choice
(PAS 37)
1. Which statement is not true in relation to the measurement of a
provision?

a. The risks and uncertainties that inevitably surround many events

and circumstances shall be taken into account in reaching the best
estimate of a provision.
b. Where the effect of the time value of money is material, the amount
of a provision shall be the present value of the expenditure expected
to settle the obligation.
c. Future events that may affect the amount required to settle the
obligation shall be reflected in the amount of the provision where
there is sufficient objective evidence that the future events will occur.
d. Gains from expected disposal of assets shall be taken into account
in measuring a provision.
 Problem 25-10 Multiple Choice
(PAS 37)
2. Which of the following is incorrect
regarding the discount rate used in
measuring a provision?

a.Reflects current market assessment of the

time value of money
b.Reflects risks specific to the liability
c. Does not reflect risks for which future cash
flow estimates have been adjusted
d.Is a post-tax discount rate
 Problem 25-10 Multiple Choice
(PAS 37)
3. Which statement is incorrect concerning recognition
of a provision?
a. Provisions shall be reviewed at the end of each reporting
period and adjusted to reflect the current best estimate.
b. A provision shall be used only for expenditures for which
the provision was originally recognized.
c. Provisions shall be recognized for future operating
losses.
d. If an entity has an onerous contract, the present
obligation under the contract shall be recognized and
measured as a provision.
 Problem 25-10 Multiple Choice
(PAS 37)
4. It is a contract in which the unavoidable
costs of meeting the obligation under the
contract exceed the economic benefits to be
received under the contract.
a.Onerous contract
b.Executory contract
c. Executed contract
d.Sale contract
 Problem 25-10 Multiple Choice
(PAS 37)
5. The unavoidable costs under an onerous contract
represent the least net cost of exiting from the contract
which is equal to

a. Cost of fulfilling the contract

b. Penalty arising from failure to fulfill the contract
c. Lower between the cost of fulfilling the contract and the
penalty arising from failure to fulfill the contract
d. Higher between the cost of fulfilling the contract and the
penalty arising from failure to fulfill the contract
 Problem 25-10 Multiple Choice
(PAS 37)
5. The unavoidable costs under an onerous contract
represent the least net cost of exiting from the contract
which is equal to

a. Cost of fulfilling the contract

b. Penalty arising from failure to fulfill the contract
c. Lower between the cost of fulfilling the contract and the
penalty arising from failure to fulfill the contract
d. Higher between the cost of fulfilling the contract and the
penalty arising from failure to fulfill the contract
 Problem 25-11 Multiple Choice
(PAS 37)
1.Contingent liability will or will not
become actual liability depending on

a.Whether probable and measurable

b.The degree of uncertainty
c.The present condition suggesting a liability
d.The outcome of a future event
 Problem 25-11 Multiple Choice
(PAS 37)
2. The likelihood that the future event will or
will not occur can be expressed by a range of
outcome. Which range means that the future
event occurring is very slight?
a. Probable
b. Reasonably possible
c. Certain
d. Remote
 Problem 25-11 Multiple Choice
(PAS 37)
3. Which statement is incorrect concerning a
contingent liability?

a. A contingent liability is not recognized in the

financial statements
b. A contingent liability is disclosed only
c. If the contingent liability is remote, no disclosure
is required
d. A contingent liability is both probable and
measurable
 Problem 25-11 Multiple Choice
(PAS 37)
4. A contingent liability
a.Has a most probable value of zero but
may require a payment if a given future
event occurs
b.Definitely exists as a liability but the
amount or due date is indeterminate
c.Is reported of current liability
d.Is not disclosed in the financial statements
 Problem 25-11 Multiple Choice
(PAS 37)
5. How should a contingent liability be
reported in the financial statements when
it is reasonably possible?
a.As a deferred liability
b.As an accrued liability
c.As a disclosure only
d.As an account payable
 Problem 25-11 Multiple Choice
(PAS 37)
6. Contingent asset is usually recognized
when
a.Realized
b.Occurrence is reasonably possible and the
amount can be reliably measured
c.Occurrence is probable and measurable
d.The amount can be reliably measured
 Problem 25-11 Multiple Choice
(PAS 37)
7. Which is the proper treatment of
contingent asset?

a.An accrued account

b.Deferred income
c.An account receivable
d.A disclosure only
 Problem 25-11 Multiple Choice
(PAS 37)
8. Gain contingency that is remote and
measurable
a. Must be disclosed in a note to the financial
statements
b. May be disclosed in a note to the financial
statements
c. Must be reported in the body of the financial
statements
d. Should not be reported or disclosed.
 Problem 25-11 Multiple Choice
(PAS 37)
9. Disclosure usually is not required for

a.Contingent gain that is probable and

measurable
b.Contingent loss that is possible and
measurable
c. Contingent loss that is probable and cannot be
reliably measured
d.Contingent loss that is remote and measurable
 Problem 25-11 Multiple Choice
(PAS 37)
10. Reporting in the financial statements is
required for
a.Loss contingency that is probable and
measurable
b.Gain contingency that is probable and
measurable
c. Loss contingency that is possible and
measurable
d.All loss contingencies
CHAPTER 26
PAS 32
FINANCIAL INSTRUMENTS-
PRESENTATION
 Technical knowledge
• To define financial instrument
• To define financial asset, financial liability
and equity instrument
• To know the guideline when an instrument
is a financial liability or an equity instrument
• To know the recognition of a compound
financial instrument
 Financial instrument
• PAS 32, paragraph 11, defines a financial
instruments as any contract that gives rise to
both a financial asset od one entity and a
financial liability or equity instrument of another
entity.
• Thus, the term “financial instrument”
encompasses a financial asset, a financial
liability and an equity instrument.
 Characteristics of a financial
instrument
a.There must be a contract
b.There are at least two parties to the
contract
c.The contract shall give rise to a financial
asset of one party and financial liability or
equity instrument of another party
 Examples of financial
instrument
Cash in the form of notes and coins- this
is a financial asset of the holder or bearer
and a financial liability of the issuing
government.

Cash in the form of checks- this is a

financial asset of the payee and a financial
liability of the drawer or issuer.
Cash in bank- this is a financial asset of the
depositor and a financial liability of depository
bank.

Trade accounts- this is a financial asset of

the seller as accounts receivable and a
financial liability of the customer or buyer as
accounts payable.
Note and loan- this is a financial asset of the
lender or creditor as note receivable or loan
receivable and a financial liability of the borrower
or debtor as note payable or loan payable.

Debt security- this is a financial asset of the

investor and a financial liability of the issuer.

Equity security- this is a financial asset of the

investor and equity of the issuer.
 Examples of financial assets

• Cash or currency is a financial asset

because it represents the medium of
exchange and is therefore the basis on
which all transactions are measured and
recognized in financial statements.
• A deposit of cash with a bank or similar
financial institution is a financial asset because it
represents the contractual right of the depositor to
obtain cash from the bank or to draw a check
against the balance in favor of a creditor in
payment of a financial liability.
Financial assets representing a contractual
right to receive cash in the future include:

a.Trade accounts receivable

b.Notes receivable
c.Loans receivable
d.Bonds receivable
 Nonfinancial assets
a. Physical assets, such as inventory and property,
plant and equipment
b. Intangible assets, such as patent and trademark
c. Prepaid expenses for which the future economic
benefit is the receipt of goods or services, rather
than the right to receive cash or another financial
asset.
d. Right of use asset or leased asset is not a
financial asset because control of the underlying
asset does not give rise to a present right to
receive cash or another financial asset.
 Financial liability
A financial liability is any liability that is a
contractual obligation:
a.To deliver cash or other financial asset to
another entity.
b.To exchange financial instruments with
another entity under conditions that are
potentially unfavorable.
Examples of financial
liabilities

a.Trade accounts payable

b.Notes payable
c.Loans payable
d.Bonds payable
 Nonfinancial liabilities
a. Deferred revenue and warranty obligations are not
financial liabilities because the outflow of
economic benefits is the delivery of goods and
services rather than a contractual obligation to pay
cash.
b. Income tax payable is not a financial liability
because it is imposed by law and non contractual.
c. Constructive obligations are not financial liabilities
because the obligations do not arise from contract.
 Equity instruments

• The definition of an equity instrument is

very brief and succinct. It reflects the basic
accounting equation that equity equals
asset minus liability.
• An equity instrument is any contract that
evidences a residual interest in the assets
of an entity after deducting all of the
liabilities.
 When liability and when equity

PAS 32, paragraph 15, provides that the

issuer of a financial instrument shall classify
the instruments as a financial liability or
equity instrument in accordance with the
substance of the contractual arrangement
and the definition of a financial liability,
financial asset and equity instrument.
Redeemable preference share

a. A preference share that provides for mandatory

redemption by the issuer for a fixed or determinable
amount at a future date is a financial liability of the
issuer because the issuer has a contractual obligation
to pay cash at some future time.
b. A preference share that gives the holder the right to
require the issuer to redeem the instrument at a
particular date for a fixed or determinable amount is
also a financial liability because the issuer has a
contractual obligation to pay cash at some future time.
 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.”
 Common examples of
compound financial
instrument
• Bonds payable issued with share
warrants
• Convertible bonds payable
 Accounting for compound
instrument
• The issuer of a financial instrument shall evaluate
the terms of the instrument whether it contains both
a liability and an equity component.
• If the financial instrument contains both a liability
and an equity component, PAS 32 mandates that
such components shall be accounted for separately.
• The approach in accounting for a compound
financial instrument is known as “split accounting.”
• This means that the consideration received from
the issuance of the compound financial instrument
shall be allocated between the liability and equity
components.

• The fair value of the liability component is then

deducted from the total consideration received
from the issuance of the compound financial
instrument.
 Bonds payable issued with share
warrants
• When the bonds are sold with share
warrants, the bondholders are given the right to
acquire shares of the issuer at a specified price
at some future time.
• Actually, in this case, two securities are sold-
the bonds and the share warrants.
• Share warrants attached to a bond may be
detachable or non detachable.
• Detachable warrants can be traded
separately from the bond and non
detachable warrants cannot be traded
separately.

• Whether detachable of non detachable,

the warrants have a value and therefore
shall be accounted for separately.
 Allocations of issue price
• The bonds are assigned an amount equal
to the “market value of the bonds ex-
warrants”, regardless of the market value of
the warrants.
• The residual amount or remainder of the
issue price shall then be allocated to the
warrants.
For example, an entity issued bonds with face amount of
P5,000,000 at 105. Each P1,000 bond is accompanied by
one warrant that permits the bondholder to purchase 20
shares, par P50, at P55 per share.
The market value of the bond ex-warrant at the time of the
issuance is 98.
Issue price of bonds with warrants
(5,000,000 x 105%) 5,250,000
Market value of bonds ex-warrants-liability
(5,000,000 x 98%) (4,900,000)
Residual amount allocated to share
warrants-equity 350,000
 Convertible bonds
• An entity frequently makes its bond issue
more attractive to investors by making the
bonds convertible.

• Generally, an entity can obtain financing at

a lower interest rate by issuing convertible
bond.
 Allocation of issue price
• The bonds are assigned on 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.
For example, an entity issued bonds with face amount of
P5,000,000 at 105. The bonds contain a conversion
privilege that provides for an exchange of a P1,000 bond
for 20 shares with par value of P50.
It is reliably determined that the bonds would sell only at 95
without the conversion privilege.
Total issue price (5,000,000 x 105%) 5,250,000

Issue price of bonds without conversion

privilege (5,000,000 x 95%) (4,750,000)

Residual amount allocated to

conversion privilege-equity 500,000
 QUESTIONS
1. Define a financial instrument
2. Define a financial asset
3. Give examples of financial asset
4. Define a financial liability
5. Give examples of financial liability
6. Define an equity instrument
7. What is the guideline in determining whether a financial instrument
is a financial liability or an equity instrument?
8. Explain a redeemable preference share
9. Explain the accounting for a compound financial instrument
10.Explain the accounting for bonds payable issued with share
warrants and convertible bonds.
 Problem 26-1 Multiple Choice
(PAS 32)
1.A financial instrument is any contract that
gives rise to
a.A financial asset
b.A financial liability
c. A financial asset of one entity and a financial
liability of another entity
d.A financial asset of one entity and a financial
liability or equity instrument of another entity.
 Problem 26-1 Multiple Choice
(PAS 32)
2. Which is not classified as a financial
instrument?

a.Convertible bond
b.Foreign currency contract
c.Warranty provision
d.Loan receivable
 Problem 26-1 Multiple Choice
(PAS 32)
3. Which cannot be considered a financial
asset?
a.Cash
b.A contractual right to receive cash or another
financial asset from another entity.
c. A contractual right to exchange financial
instruments with another entity under
conditions that are potentially unfavorable
d.An equity instrument of another entity.
 Problem 26-1 Multiple Choice
(PAS 32)
4. Which should be classified as financial
asset?

a.Patent
b.Trade accounts receivable
c.Inventory
d.Land
 Problem 26-1 Multiple Choice
(PAS 32)
5. A financial liability
a.Must be classified as noncurrent liability.
b.Is a contractual obligation to deliver cash or
another financial asset to another entity.
c. Is a contractual obligation to exchange
financial instrument with another entity under
conditions that are potentially favorable to the
entity.
d.Is a contractual obligation to deliver cash or
any asset to another entity.
 Problem 26-1 Multiple Choice
(PAS 32)
6. Financial liabilities include all of the
following, except

a.Trade accounts payable

b.Notes payable
c.Bonds payable
d.Income tax payable
 Problem 26-1 Multiple Choice
(PAS 32)
7. It is any contract that evidences
residual interest in the assets of an entity
after deducting all of the liabilities.
a.Equity instrument
b.Debt instrument
c.Loan receivable
d.Financial asset with indeterminable fair
value.
 Problem 26-1 Multiple Choice
(PAS 32)
8. How should preference shares that are
redeemable mandatorily be presented in
the statement of financial position?
a.Noncurrent liability
b.Current liability
c.Equity
d.Either current or noncurrent liability
depending on redemption date
 Problem 26-1 Multiple Choice
(PAS 32)
9. What is the presentation of the
preference dividend on mandatorily
redeemable preference shares?
a.Deducted from retained earnings
b.Deducted from share premium
c.Interest expense
d.Deducted from share capital
 Problem 26-1 Multiple Choice
(PAS 32)
10. Which is not an equity instrument?

a.Ordinary share capital

b.Bonds payable
c.Preference share capital
d.Share option or warrant
 Problem 26-2 Multiple Choice
(PAS 32)
1. What is the principal accounting for a compound instrument?

a. The issuer shall classify a compound instrument as either a liability

or equity based on evaluation of the predominant characteristics of
the contractual arrangement.
b. The issuer shall classify the liability and equity components of a
compound instrument separately as liability or equity.
c. The issuer shall classify a compound instrument as an equity in the
entirety.
d. The issuer shall classify a compound instrument as a liability in the
entirety, until converted equity.
 Problem 26-2 Multiple Choice
(PAS 32)
2. How are the proceeds from the issuing a compound instrument
allocated between the liability and equity components?
a. First, the liability component is measured at fair value, and then the
remainder of the proceeds is allocated to the equity component.
b. First, the equity component is measured at fair value, and then the
remainder of the proceeds is allocated to the liability component.
c. First, the fair values of both the equity component as the liability
component are estimated. Then the proceeds are allocated to the
liability and equity components based on the relation between the
estimated fair value.
d. The equity component is measured at its intrinsic value. The liability
component is measured at the face amount less the intrinsic value
of the equity component.
 Problem 26-2 Multiple Choice
(PAS 32)
3. Which bonds are issued with share warrants,
the equity component is equal to

a. Zero
b. The excess of the proceeds over the face
amount of the bonds.
c. The market value of the share warrants
d. The excess of the proceeds over the fair value of
the bonds without the share warrants.
 Problem 26-2 Multiple Choice
(PAS 32)
4. When bonds are issued with share warrants,
a portion of the proceeds should be allocated
to equity when the bonds are issued with

a. Detachable share warrants

b. Non detachable share warrants
c. Both detachable and non detachable share
warrants
d. Neither detachable nor non detachable share
warrants
 Problem 26-2 Multiple Choice
(PAS 32)
5. The proceeds from an issue of bonds payable with
share warrants should not be allocated between the
liability and equity components when

a. The fair value of the warrants is not readily available.

b. The exercise of the warrants within the next reporting
period seems remote.
c. The warrants issued are non detachable.
d. The proceeds should be allocated between liability and
equity under all of these circumstances.
 Problem 26-3 Multiple Choice
(PAS 32)
1. A bond convertible by the holder into a
fixed number of ordinary shares of the
issuer is
a.A compound financial instrument
b.A primary financial instrument
c.A derivative financial instrument
d.An equity instrument
 Problem 26-3 Multiple Choice
(PAS 32)
2. Convertible bonds
a.Have priority over other indebtedness
b.Are usually secured by a mortgage
c.Pay interest only in the event net
income is sufficient
d.May be exchanged for shares of the
issuer
 Problem 26-3 Multiple Choice
(PAS 32)
3. Convertible bonds
a.Are separated into liability and expense
b.Allow an entity to issue debt financing at
lower rate
c.Are separated into liability and equity
components based on fair value
d.Are not accounted for as compound
instrument
 Problem 26-3 Multiple Choice
(PAS 32)
4. What is the accounting for issued
convertible bond?
a. The instrument should be recorded solely as
bond
b. The instrument should be recorded as either
bond or equity but not both
c. The instrument should be recorded solely as
equity
d. The instrument should be recorded as part bond
and part equity.
 Problem 26-3 Multiple Choice
(PAS 32)
5. Issued convertible bonds are
a.Separated into liability and equity with the
liability recorded at fair value and the
residual assigned to the equity
b.Always recorded using fair value
c.Recorded at face amount for the liability
d.Recorded at par value of the shares