Module in Liabilities intermediate accounting 2 pdf PDF

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[Date] IntermediateAccounting 2BACC121AProfessor: Dr. Glen de Leon, CPA Section/Schedule BSA 1A TTH 0730-MODULE 2: FINANCIAL LIABILITIES, NOTES PAYABLE, BONDSPAYABLE, AND DEBT RESTRUCTURINGTOPIC OVERVIEW This chapter discusses financial liabilities, it’s characteristics, classification, initial reco...

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[Date]

Intermediate Accounting 2 BACC121A

Professor: Dr. Glen de Leon, CPA Section/Schedule BSA 1A TTH 07300930

MODULE 2: FINANCIAL LIABILITIES, NOTES PAYABLE, BONDS PAYABLE, AND DEBT RESTRUCTURING TOPIC OVERVIEW This chapter discusses financial liabilities, it’s characteristics, classification, initial recognition, initial measurement, subsequent measurement, reclassification, derecognition and financial statement presentation. It also tackles the process and application of debt restructuring. LEARNING OBJECTIVES: After studying this chapter, you should be able to: 1. Identify and describe the different types of financial liabilities. 2. Describe credit risk. 3. Describe the initial recognition, initial measurements, subsequent measurement, reclassification, derecognition and financial statement presentation of financial liabilities. 4. Describe and apply debt restructuring. 5. Different accounting for financial liabilities under full PFRS and PFRS for SMEs. 6. Differentiate the accounting for FL@FVTPL, and FL@FAAC. 7. Calculate the correct amount of financial liabilities and its related accounts.

FINANCIAL LIABILITIES As discussed in the previous chapter, a is : a. a : I. to deliver cash or another financial asset to another entity, or II. to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity, or b. a contract that will or may be settled in the entity’s own equity instruments and is: I. a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or II. a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. Other liabilities that did not meet the above requirements are non-financial liabilities. COMMON EXAMPLES OF FINANCIAL LIABILITIES Examples of financial liabilities include the following: a. Accrued payable b. Notes payable c. Loans payable 1

d. e. f. g. h. i. j.

Bonds payable Mortgage payable Lease liability Salaries payable Accrued interest expense/Interest payable Utilities payable Cash dividend payable

MAJOR CLASSIFICATION OF FINANCIAL LIABILITIES 1) Financial liabilities at fair value through profit or loss (FL@FVTPL) a. Held for trading b. designated at fair value through profit or loss 2) Financial liabilities at amortized cost (FL@AC) FINANCIAL LIABILITIES AT FAIR VALUE THROUGH PROFIL OR LOSS An entity may, at initial recognition, irrevocably designate a financial liability as measured at fair value through profit or loss when doing so. a) Eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as ‘an accounting mismatch’) that would otherwise arise from measuring assets or liabilities or recognizing the gains and losses on them on different bases, or b) A group of financial liabilities or financial assets and financial liabilities is managed and its performance is evaluated in a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the entity’s key management personnel. Measurement of F:@FVTPL A. Initial Measurement-FL@FVTPL Financial liabilities at fair value through profit or loss shall be initial measured at fair value. Transaction Costs Incurred on FL@FVTPL Such costs may include printing costs of certificates, legal, accounting and other professional fees; registration fees; and commissions or underwriters or arrangers. Transaction cost or bond issuance costs directly attribute to the issuance of financial liabilities at fair value through profit or loss is treated as an outright expense during the period incurred. B. Subsequent Measurement- FV@FVTPL Subsequent to initial measurement, financial liabilities at fair value through profit or loss is measured at fair value.

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Accounting for Changes in Fair Value A. Changes in fair value of liabilities held for trading at fair value through profit or loss Changes in fair value are recognized as either unrealized gain or loss on held for trading financial liabilities at fair value through profit or loss is to be presented in profit or loss. B. loss

Changes in fair value of liabilities designated as at fair value through profit or

Changes in fair value are recognized either unrealized gain or loss on the financial liability designated as fair value through profit or loss is to be presented as follows: 1) Change in fair value not attributable to change in the credit risk- Present the unrealized gain or loss in the profit or loss. 2) Change in fair value attributable to change in the credit risk a. If it would create or enlarge an accounting mismatch in profit or loss, present all unrealized gain or losses on that liability (including the effects of changes in the credit risk of that liability) in profit or loss. b. If it would not create or enlarge an accounting mismatch in profit or loss, present the unrealized gain or loss attributable to changes in the credit risk of that liability in the other comprehensive income(OCI) c. Remaining amount on change in the fair value, present the unrealized gain or loss in the profit or loss. Credit Risk PFRS 7 defines credit risk as the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation. Determining the effects of changes in credit risk An entity shall determine the amount of change in the fair value of the financial liability that is attributable to changes in the credit risk of that liability either a.) As the amount of change in its fair value that is not attributable to changes in market conditions that give rise to market risk; or b) Using an alternative method the entity believes more faithfully represents the amount of change in the liability’s fair value that is attributable to changes in its credit risk. If the only significant and relevant changes in market conditions for a liability are changes in an observed (benchmark) interest rate, the amount of change in the fair value of the financial liability can be estimated as follows: a) First, the entity computes the liability’s internal rate of return at the start of the period using the fair value of the liability and the liability’s contractual cash flows at 3

the start of the period. It deducts from this rate of return the observed (benchmark) interest rate at the start of the period to arrive at an instrumentspecific component of the internal rate of return. b) Next, the entity calculated the present value of the cash flows associate with the liability using the liability’s contractual cash flows at the end of the period and a discount rate equal to the sum of: i. The observed (benchmark) interest rate at the end of the period and; ii. The instrument-specific component of the internal rate of return as determined in (a). c) The difference between the fair value of the liability at the end of the period and the amount determined in (b) is the change in the fair value that is not attributable in changes in the observed (benchmark) interest rate. This is the amount to be presented in other comprehensive income. This method would not be appropriate if changes in fair value arising from other factors are significant. ILLUSTRATION: Financial Liabilities at FVTPL (Interest Expense and Unrealized Gains or Losses)- No Changes Due to Credit Risk On January 1, 2016, Nation’s Foremost CPA Review Inc. issued 4-year bonds with a face value of P2,000,000 for P1,935,152. The bonds carry an interest of 8% per year payable annually on December 31. On the date of issuance, the company incurred and paid commissions to underwriters of P10,000. The bonds to be appropriately classified as financial liability at FVTPL on December 31, 2016, the bonds are quoted at 103%. Assume that there no changes due to credit risk. Requires: 1) How much is the interest expense for 2016? 2) How much is the unrealized loss (or gain) in 2016 to be recognized in the profit or loss? 3) Prepare necessary journal entries for the year 2016. SOLUTION: Requirement No.1 Face value P 2,000,000 Multiply by: Nominal ratio 8% Multiply by: Months outstanding 12/12 Interest Expense P 160,000 Requirement No.2 Fair value of the bonds

P

2,060,000 4

Less: Carrying value Unrealized loss-P&L

P

Requirement No. 3: Journal Entries 1/1/2016 Financial liability-FVTPL Commission expense Cash 12/31/16

1,935,152 124,848

1,935,152 10,000 1,945.152

Interest Expense Cash

160,000

Unrealized loss Financial liability-FVTPL

124,848

160,000

124,848

ILLUSTRATION: Unrealized Gain or Loss of FVTPL-with Change Due to Credit Risk On January 1, 2016, Bacolod Co. issues a 10-year bond with a par value of P1,500,000 and an annual fixed coupon rate of 8%, which is consistent with market rates for bonds with similar characteristics. Bacolod uses observed (benchmark) interest rate. At the date of inception of the bonds, this rate is 5%. At the end of the first year a.) Observed (benchmark) interest rate has decreased to b) The fair value interest rate of the bonds is

4.75% 7.60%

Bacolod is required to present the effects of changes in the liability’s credit risk in the other comprehensive income.

Required: 1) How much is the unrealized gain or loss to be recognized in the OCI during 2016? 2) How much is the unrealized gain or loss to be recognized in the P&L during 2016? 3) Prepare the journal entry at the end of the period. SOLUTION: Requirement No. 1 Market price of the liability, end of the period (at 7.06%) Less: FV of liability using the sum observed interest rate

P

1,538,052

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And instrument specific IRR (at 7.75%) Unrealized loss-OCI

1,523,688 14,364

P

Note:  Increase in the market price of the liability will result to an unrealized loss while decrease in the market price of the liability will result to a unrealized gain. Internal rate of return at the start of the period-yield or effective rate Less: Observed (benchmark) interest rate, date of inception Instrument specific- IRR Observed (benchmark) interest rate, end of period Add: Instrument specific- IRR Discount rate

8% 5% 3% 4.75% 3% 7.75%

Market price of the liability, end of the period using 7.60% for the remaining 9 periods Present value of Principal (1,500,000 x 0.5172) P 775,800 Add: PV of interest payments (1.5M x 8% x 6.3521) 762,252 Market price of the liability, end of the period P 1,538,052 FV of liability using the sum observed interest rate and instrument specific IRR using 7.75% Present value of Principal (1,500,000 x 0.5108) P 766,200 Add: PV of interest payments (1.5M x 8% x 6.3124) 757,488 FV of liability using the sum observed interest rate and Instrument specific IRR P 1,523,688 Requirement No. 2 Market price of the liability of the period Less: Carrying amount of FVTPL Increase in FVTPL Less: Unrealized loss in the OCI Unrealized loss in the P&L Requirement No. 3 Journal entry: Unrealized loss-OCI P Unrealized loss- P&L Financial liability at FVTPL (Increase in fair value of the liability)

P 1,538,052 1,500,000 38,052 14,364 P 23,688

14,364 23,688 P

38,052

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Derecognition of Financial Liability- FL@FVTPL 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. Derecognition gain or loss on held for financial liabilities at fair value through profit or loss is computed as the difference between the consideration paid and the carrying amount (fair value at the previous reporting date). But for financial liabilities designated as at fair value through profit or loss, the amounts presented in other comprehensive income shall not be subsequently transferred to profit or loss. However, the entity may transfer the cumulative gain or loss within equity. ILLUSTRATION: Derecognition of Held for Trading Debt Securities On January 1, 2016, Occidental Co. Acquired a 4-year bonds with a face value of P2,000,000 for P1,935,152. The bonds carry an interest of 8% per year payable every December 31. The bonds are to be appropriately classified as held for trading. On December 31, 2016, the bonds are quoted at 103%. On January 3, 2017, the bonds were retired at 104%. Required: 1) How much is the realized loss (or gain) on sale in 2017 to be recognized in the profit or loss? 2) Prepare the Journal entry on the date of sale. SOLUTION: Requirement No. 1 Retirement Price (2M x 104) Less: Carrying value Loss on sale Requirement No. 2Journal entry Financial liability at FVTPL Loss on derecognition (sale) Cash

P P

P

2,080,000 2,060,000 20,000

2,060,000 20,000 P

2,080,000

ILLUSTRATION: Realized Gain or Loss of FVTPL- with Change Due to Credit Risk On January 1, 2016, Bacolod Co. issues a 10-year bond with a par value of P1,500,000 and an annual fixed coupon rate of 8%, which is consistent with market rates for bonds with similar characteristics. 7

Bacolod uses observed (benchmark) interest rate. The entity is required to present the effects of changes in the liability’s credit risk in the other comprehensive income. On December 31, 2016, when the fair value of the financial liability is P1,538,052, Bacolod appropriately recorded unrealized loss in the other comprehensive income of P14,364 and in the profit or loss amounting to P23,688. On January 3, 2017, the bonds were retired at 104% Required: 1) How much is the realized loss (or gain) on sale in 2017 to be recognized directly in the equity? 2) Prepare the Journal entry on the date of retirement. SOLUTION: Requirement No. 1 Retirement Price (1.5M x 104%) Less: Carrying Value Loss on sale recognized directly through equity (i.e. Retained earnings)

P

1,560,000 1,538,052

P

21,948

Requirement No. 2 Journal entry Financial liability at FVTPL P 1,538,052 Retained earnings 21,948 Cash P To record the unrealized loss previously recognized in the OCI to equity

1,560,000

Financial Statement Presentation of Financial Liabilities through Profit or Loss Financial liabilities through profit or loss should be presented in the current liability section of the statement of financial position. FINANCIAL LIABILITIES AT AMORTIZED COST (FL@AC) Examples of a financial liability measured at amortized cost include the following a. Bonds payable b. Notes payable c. Loan payable The following discussion is therefore based on accounting treatment of these three financial liabilities.

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BONDS PAYABLE

Description

Characteristics A bond is a formal unconditional promise, made under seal, to pay a specified sum of money at a determinable future date, to make periodic interest payment at a started rate until the principal sum is paid. Parties involved include the bond issue (borrower), bondholder (investor/lender), and underwriter/arranger (one who serves as middleman for a free from the borrower or gain in reselling the investments).

In addition, bonds are financial instruments since they represent contractual obligation to pay cash or other financial assets. Recognition When the entity becomes a party to the contract or when transfer of resources transpired. Presentation Presented in the liability section in the statement of financial position and classified as to either current or non-current depending on the expected settlement date. Measurement-Bonds Payable A. Initial measurement Bond payable classified as FL@AC shall be initially measured at fair value minus transaction cost. Normally, it is equal to the net proceeds from the issuance of the bonds (in the case of issuance at interest date). Fair value is determined thru (in order of priority) a) Quotation from an active market. b) Present value of all principal and interest payments. Transaction Costs Incurred on Financial Liabilities at Amortized Cost Transaction cost or bond issuance cost directly attributed to the issuance of bonds payable is treated as an adjustment to premium (deducted from) or discount (added to) on bonds payable and non-treated as an outright expense. B. Subsequent measurement Bonds payable are subsequently measured at amortized cost using the effective interest method. Issuance of Bonds Bonds may be issued thru the following scheme: 9

Scheme

At face amount At a premium At a discount

Characteristics Proceeds (P) vs. Effective (E) vs. Face Amount (FA) Nominal rate (N) E=N P=FA EFA E>N P...