IA2-module-3 - Lecture notes 3 PDF

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INTERMEDIATE ACCOUNTING II (AE 16)LEARNING MATERIALUNIT NUMBER/ HEADING: BONDS PAYABLELEARNING OUTCOMES:At the end of the unit, the students will be able to: a. Discuss and explain the concepts, principles and issues on bonds payable; b. Identify the different types of bonds; c. Demonstrate the prop...

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INTERMEDIATE ACCOUNTING II (AE 16) LEARNING MATERIAL UNIT NUMBER/ HEADING: BONDS PAYABLE LEARNING OUTCOMES: At the end of the unit, the students will be able to: a. Discuss and explain the concepts, principles and issues on bonds payable; b. Identify the different types of bonds; c. Demonstrate the proper accounting of bonds INTRODUCTION: Whenever funds being borrowed are obtained from a small number of sources, mortgages or notes are usually used. However, when large amounts are needed, an entity may have to borrow from the general investing public through the use of bond issue. In this module, we will learn how are bonds payable being treated and presented in the entity’s books and financial statements. Activating Prior Learning Let us learn some basic about bonds by watching this video. https://www.youtube.com/watch?v=IuyejHOGCro

Presentation of Content DEFINITON  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, it is a contract of debt whereby one party called issuer borrows funds from another party called the investor.  It is evidenced by a bond certificate or indenture between the issuer and the lender.  A bond indenture is a contract that lists the features of the bond, such as the amount of the money that will be repaid in the future, called the principal (or face value or maturity value); the maturity date which is the day the bond holder will receive the principal amount; and the stated rate, which is the rate of interest the issuer agrees to pay the bondholder throughout the term of the bond. A sample is presented below.

TYPES OF BONDS a. As to maturity of the bonds  Term Bonds are bonds with a single date of maturity  Serial bonds are bonds with a series of maturity dates instead of a single one, usually in installments. b. As to security of the 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 security c. As to registration  Registered bonds require the registration of the name of the bondholder on the books of the corporation  Coupon or bearer bonds are unregistered bonds; names of the bondholder is not recorded in the entity’s books d. Other types  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 pay 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 are bonds that pay no interest but the bonds offer a return in the form of ‘deep discount’ or huge discount from the face amount Features of bond issue a. A bond indenture or deed of trust is the document which shows in detail the terms of the loan and the rights and duties of the borrower and the other parties to the contract. b. Bond certificates are used. Each bond certificate represents a portion of the total loan. The usual minimum denomination in business practice is P1,000. c. If property is pledged as security for the loan, a trustee is named to hold the title to the property serving as security. d. A bank or trust entity is usually appointed as registrar or disbursing agent. Initial measurement of bonds payable  Bonds payable that are not designated at fair value through profit or loss (FVPL) shall be measured initially at fair value(present value of the future cash payments to settle the bond liabity) minus transaction costs that are directly attributable to the issue of the bonds payable.  Bond issue cost shall be deducted from the fair value or issue price of the bonds payable but it is expensed if the bonds is designated at FVPL Fair value = Issue Price/ Net Proceeds ex. Accrued interest

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Subsequent measurement  PFRS 9 provides that bonds payable shall be measured subsequently either: a. At amortized cost, using the effective interest method initial measurement - principal payment ± premium or discount b. At fair value through profit or loss (FVPL) Accounting for issuance of bonds There are two approaches in accounting for the authorization and issuance of bonds, namely: a. Memorandum approach b. Journal entry approach  Bonds can be issued at a premium (sales price > face amount) or at a discount (sales price < face amount) **recall the important notes we have discussed in Intermediate Accounting I last semester regarding premium and discount including nominal and effective interest. Those will greatly help you again in this topic discussion.  E:D = N:P

 Bond issue costs are transaction costs directly attributable to the issue of bonds payable. Under the effective interest method, it should be “lumped” with the discount on bonds payable and “netted” against the premium. Illustration: An entity issued bonds with face amount of P5,000,000 at 105. The journal entry to record this transaction is: Cash (P5,000,000 x 105%) Bonds payable Premium on bonds payable

P5,250,000 P5,000,000 P 250,000

Assuming that the bonds are issued at a quoted price of 95. The journal entry would be: Cash Discount on notes payable Bonds payable

P4,750,000 P 250,000 P5,000,000

Issuance of bonds on interest date On June 1, 2020, an entity sold bonds with the face amount of P5,000,000 at 97 and 12% interest payable semiannually on June 1 and December 1. The bonds mature in 5 years. In as much as the bonds are sold on March 1, 2020, the first payment of interest will be on September 1, 2020. Journal entries 2020

June 1

Cash (P5M x 97%) Discount on Bonds Payable Bonds Payable

P4,850,000 P 150,000 P5,000,000

Dec. 1

Interest Expense (P5M x 12% x 6/12) Cash

P300,000 P300,000

Dec. 31

Interest Expense (P5m x 12% x 1/12) Accrued Interest Payable

P50,000 P50,000

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Dec. 31

Interest Expense Discount on bonds payable

P17,500 P17,500

Amortization of bond discount from June 1 to Dec 31 (P150,000/5 years = P30,000/year x 7/12 = P17,500) Issuance of bonds between interest dates On April 1, 2020, an entity issued bonds with face amount of P5,000,000 at P5,288,000 plus accrued interest. The bonds are dated January 1, 2020 and mature in 5 years and pay 12% interest semiannually on January 1 and July 1. To record the issue of the bonds on April 1, 2020: Cash Bonds payable Premium on bonds payable Interest expense Issue price Accrued interest from Jan. 1 to April 1 Total cash received

P5,378,000 P5,000,000 P 228,000 P 150,000

P5,288,000 P 150,000 P5,378,000

**Note that if the bonds are issued between interest dates, an accrued interest is involved. Treasury bonds  These are an entity’s own bonds originally issued and reacquired but not canceled.  Should be debited at face amount and any unamortized premium or discount should be canceled and any accrued interest paid is charged to interest expense Bond refunding  Floating of new bonds the proceeds from which are used in paying the original bonds  Premature retirement of the old bonds by means of issuing new bonds  Also known as bond refinancing  When made on the date of maturity of the old bonds, no accounting problem arises as this would simply call for the cancellation of the bond liability  When made before the maturity date consideration must be given to the refunding charges (unamortized bond discount or premium and redemption premium) pertaining to the old bonds. this shall be charged to loss on extinguishment  Shall be accounted for as an extinguishment of a financial liability. Illustration: 1. Issuance of new 10-year 10% bonds, with face amount of P1,500,000 for P1,600,000. 2. Refunding of old 12% bonds, with remaining life of 4 years, at 102. Bonds payable – old P1,000,000 Discount on bonds payable P 30,000 Retirement price (P1,000,000 x 102) P1,020,00 Journal entries 1. To record the issuance of the new bonds payable:

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Cash

P1,600,000 P1,500,000 P 100,000

Bonds Payable Premium on bonds payable

2. To record the retirement of the old bonds payable: Bonds payable Loss on extinguishment of bonds Cash Discount on bonds payable

P1,000,000 P 50,000 P1,020,000 P 30,000

The loss on extinguishment of bonds is represented by the refunding charges of P50,000 Unamortized discount Redemption premium(P1,000,000 x 2%) Total refunding charges

P30,000 P20,000 P50,000

or

Bond Payable Discount on bonds payable Carrying amount Retirement price Loss on extinguishment

P1,000,000 (P 30,000) P 970,000 (P1,020,000) (P 50,000)

Amortization of bond discount or premium There are three approaches in amortizing bond premium or bond discount, namely: a. Straight line - equal amortization of bond premium or bond discount - Bond Premium or Discount ÷ life of the bonds b. Bond outstanding method - applicable to serial bonds Illustration 1: Face amount of bonds Issue price Date of bonds Date of issue Interest rate Semiannual interest dates

P5,000,000 P5,300,000 January 1, 2020 January 1, 2020 12% June 30 and Dec. 31

The bonds mature on every December 31 of each year at the rate of P1,000,000 for 5 years. The table of amortization following the bond outstanding method may appear as follows: Year Bond Outstanding 2020 P5,000,000 2021 4,000,000 2022 3,000,000

Fraction 5/15 4/15 3/15

Premium Amortization P100,000 80,000 60,000 5

2023 2024

2,000,000 1,000,000 P15,000,000

2/15 1/15

40,000 20,000 P300,000

*The bond outstanding is determined every bond year *The fractions are developed from the bond outstanding column *The annual premium amortization is computed by multiplying the fractions by the amount of the premium c. Effective interest method or simply “interest method” or scientific method (this is what PFRS 9 requires to be used in amortizing discount, premium and bond issue cost). This will be further discussed in detail in the next module. Application TRY THIS: 1. Superman Company was authorized to issue 12%, 10-year bonds with face amount of P7,000,000 on April 1, 2020. Interest on the bonds is payable semiannually on April 1 and October 1 of each year. The bonds were sold to underwriters on April 1, 2020 at 106. The entity amortizes discount or premium only at the end of the fiscal year, using the straight line method. Required: Prepare journal entries for 2020 and 2021 including adjustments at the end of each year.

2. On January 1, 2020, Lucky Tian Company issued 12% bonds with face amount of P4,000,000 for P4,200,000. Interest is payable annually on December 31 and the bonds mature on January 1, 2025. On December 31, 2020, bonds with face amount of P1,000,000 were redeemed at 95. The entity used the straight line method of amortization. Required: prepare journal entries in 2020 and 2021. Feedback Problem 1: Blue Company reported the following financial liabilities on December 31, 2020: 9% debentures callable in 2021, due in 2022 P3,500,000 11% collateral trust bonds, convertible into share Capital beginning in 2021, due in 2022 P3,000,000 10%debentures, P300,000 maturing annually P1,500,000 What is the total amount of term bonds? a. P3,000,000 b. P3,500,000

c. P5,000,000

d. P6,500,000

Problem 2: On October 1, 2020, Shane Company issued 5,000 12% bonds with face amount of P1,000 per bond at 110. The bonds which mature on January 1, 2025, pay interest semiannually on January 1 and July 1. The entity paid bond issue cost of P200,000. How much cash was received from the issuance of the bonds? a. P5,450,000 b. P5,650,000 c. P5,300,000 d. P5,550,000 6

Problem 3: On July 1, 2020, Carol Company issued at 104, five thousand 10% bonds with face amount of P1,000 per bond. The bonds were issued through an underwriter to whom the entity paid bond issue cost of P125,000. On July 1, 2020, what is the carrying amount of the bonds payable? a. P4,875,000

b. P5,075,000

c. P5,200,000

d. P5,325,000

Problem 4: Arc Company is authorized to issue P5,000,000 of 6%, 10-year bonds dated July 1, 2020 with interest payments on June 30 and December 31. When the bonds are issued on November 1, 2020, the entity received cash of P5,150,000 including accrued interest. What is the discount or premium from the issuance of the bonds? a. P150,000 bond premium b. P50,000 bond premium c. P150,000 bond discount d. No bond premium and discount Problem 5: On January 31, 2020, Seri’s Choice Company issued P3,000,000 maturity value, 12% bonds for P3,000,000 cash. The bonds are dated December 31, 2019, and mature on December 31, 2029. Interest will be paid semiannually on June 30 and December 31. What amount of accrued interest payable should be reported on September 30,2020? a. P270,000 b. P240,000 c. P180,000 d. P90,000 Problem 6: On January 1, 2020, 2N Box Company issued 6% bonds with face amount of P4,000,000 for net proceeds of P3,677,600, a price that yields 8%. Interest is payable annually every December 31. On December 31, 2020, the bonds are quoted at 95. 1. What amount should be reported as interest expense for 2020? a. P240,000 b. P120,000 c. P294,208 d. P220,656 2. What is the carrying amount of the bonds payable on December 31, 2020? a. P3,677,600 b. P3,800,000 c. P3,493,720 d. P4,000,000

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INTERMEDIATE ACCOUNTING II (AE 16) LEARNING MATERIAL UNIT NUMBER/ HEADING: EFFECTIVE INTEREST METHOD LEARNING OUTCOMES: At the end of the unit, the students will be able to: d. Demonstrate skills in using effective interest method in the computation of cost of borrowing; e. Apply the effective interest method of amortizing bond premium and bond discount; f. Distinguish effective rate and nominal rate of interest; and g. Compute market price or issue price of bonds payable INTRODUCTION: PFRS 9 requires that discount on bonds payable, premium on bonds payable and bond issue cost shall be amortized using the effective interest method. In this module, you will learn how to use the effective interest method in amortizing bond discount and premium and derive to the carrying amount of bonds payable at the end of each accounting year. Activating Prior Learning Explain the statement below.

E:D = N:P Presentation of Content DEFINITON OF TERMS  Nominal rate is the coupon or stated rate.  Effective rate is the yield or market rate. It is the rate that exactly discounts estimated cash future payments through the expected life of the bonds payable If:

sold at face amount – ER = NR sold at premium - ER < NR sold at discount - ER > NR

IMPORTANT FORMULAS TO REMEMBER: a. Nominal interest (NR x Face amount) Effective interest (ER x carrying amount) Premium amortization

xx (xx) xx

b. Effective interest Nominal interest Discount amortization

xx (xx) xx

c. Face amount x Nominal rate = Interest paid d. Carrying amount x Effective rate = Interest expense e. Preceding Carrying amount + Discount amortization/ - Premium Amortization = Current Carrying amount

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f. PV of Principal Bond Liability PV of future interest payments Market price or Issue Price of Bonds Payable

xx xx xx

g. Face amount of the bond x PV of 1 factor at the effective rate PV of Principal Bond Liability

xx .xx xx

h. Periodic nominal interest PV of OA of 1 at the effective rate PV of Future Interest Payments

xx x.xx

1−

1 i. PV of 1 factor =

j. PV of OA =

(1+𝑖)𝑛

1 (1+𝑖)𝑛

𝑖

Illustration 1: Face amount of bonds Nominal rate Effective rate

P4,000,000 6% 8%

The bonds are issued on January 1, 2020 and mature in four years on January 1, 2024. The interest is payable annually every December 31. Since the effective rate is higher than the nominal rate, we can say that the bonds were issued at a discount. To compute for the bond amortization and PV of the bonds: PV of Principal (P4,000,000 x .7350) PV of annual interest payments (P240,000 x 3.3121) Total present value

P2,940,000 P 794,904 P3,734,904

Face amount Market price or issue price Discount on bonds payable

P4,000,000 (P3,734,904) P 265,096

Table of amortization Date Jan. 1, 2020 Dec. 31, 2020 Dec. 31, 2021 Dec. 31, 2022 Dec. 31, 2023

Interest Paid

Interest Expense

Discount Amortization

Carrying Amount

P240,000 P240,000 P240,000 P240,000

P298,792 P303,496 P308,575 P314,233

P58,792 P63,496 P68,575 P74,233

P3,734,904 P3,793,696 P3,857,192 P3,925,767 P4,000,000

Illustration 2: Face amount of bonds Nominal rate Effective rate

P5,000,000 12% 10% 9

The bonds are issued on January 1, 2020 and mature in three years on January 1, 2023. The interest is payable semiannually every June 30 and December 31. Since, the nominal rate is higher than the effective rate, we can say that the bonds were issued at a premium. To compute for the present value and amortization: PV of principal (P5,000,000 x .7462) PV of interest (P300,000 x 5.0757) Total present value

P3,731,000 P1,522,710 P5,253,710

Market price or issue price Face amount Premium on bonds payable

P5,253,710 P5,000,000 P 253,710

Table of amortization Date

Interest Paid

Interest Expense

P300,000 P300,000 P300,000 P300,000 P300,000 P300,000

P262,686 P260,820 P258,861 P256,804 P254,644 P252,475

Premium Amortization

Jan. 1, 2020 June 30, 2020

Dec. 31, 2020 June 30, 2021

Dec. 31, 2021 June 30, 2022

Dec. 31, 2022

P P P P P P

37,314 39,180 41,139 43,196 45,356 47,525

Carrying Amount P5,253,710 P 5,216,396 P 5,177,216 P 5,136,077 P 5,092,881 P 5,047,525 P 5,000,000

Illustration 3: Serial bonds Face amount of bonds Nominal rate Effective rate Date of issue Annual payment – December 31 Interest is payable annually

P3,000,000 12% 10% January 1, 2020 P1,000,000 December 31

Present value of the bonds payable Date

Principal Payment

Interest Payment

12/31/2020 P1,000,000 P360,000 12/31/2021 P1,000,000 P240,000 12/31/2020 P1,000,000 P120,000 Total Present Value Face amount Premium on bonds payable

(a) (b) Total PV Payment Factor P1,360,000 .9091 P1,240,000 .8264 P1,120,000 .7513

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(a x b) Present value P1,236,376 P1,024,736 P 841,456 P3,102,568 (P3,000,000) P 102,568...