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Learning Material 5
Learning Material 5
Learning Material 5
BONDS PAYABLE: Fair Value Option
1. Definition of Bond
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.
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 known as “bond indenture”.
Serial bonds are bonds with a series of maturity dates instead of a single one. These bonds allow
the issuing entity to retire the bonds by installments.
Collateral trust bonds are bonds secured by shares and bonds of other corporations.
If the bondholder sells a bond, the old bond certificate is surrendered to the entity and a new bond
certificate is issued to the buyer. Interest is periodically paid by the issuing entity to bondholders
of record.
Coupon or bearer bonds are unregistered bonds in the sense that the name of the bondholder is
not recorded on the entity books.
The issuing entity does not maintain a record of two owns the bonds at any point in time.
Thus, interest on coupon bonds is paid to the person submitting a detachable interest coupon.
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.
Junks bonds are hig-risk, high-yield bond 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.
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, although smaller denominations may be
issued occasionally.
c. If property is pledged as security for the loan, a trustee is named to hold title to the property
serving as security. The trustee acts as the representative of the bondholders and is usually a bank
ir trust entity.
d. A bank or trust entity is usually appointed as registrar or disbursing agent. The borrower deposits
interest and principal payments with the disbursing agent, who then distributes the funds to the
bondholders.
8. Sale of bonds
The bonds needed for the issuance of bonds are usually too large for one buyer to pay. Very
often, the bonds are divided into various denominations of say P100, P1,000, P10,000, thus
enabling more than one buyer or investor to purchase the bonds.
Instead of selling bonds of various denominations, the bonds are sold in equal denominations of
say P1,000 only. The P1,000 denomination is called the face amount of the bonds. Each bond is
evidenced by a certificate called a bond certificate.
For example, if the bonds with face amount of 50,000,000 are sold, dividend into p1,000
denomination, there shall be 50,000 bond certificates containing a face amount of P1,000.
The sale of the bonds may be undertaken by the entity itself. Normally however, the issuing entity
does not attempt to sell the bonds directly to the public.
Instead, the entire bond issue is sold to an underwritter or investment bank that assumes
responsibility for reselling the bonds to investors.
Sometimes, the underwriter merely undertakes to sell the bonds on the basis of a commission to
be deducted from the proceeds of sale.
When an entity sells a bond issue, it undertakes to pay the face amount of the bond issue on
maturity date and the periodic interest.
Interest is usually payable semiannually or every six months as follows:
a. January 1 and July 1
b. February 1 and August 1
c. March 1 and September 1
d. April 1 and October 1
e. May 1 and November 1
f. June 1 and December 1
There are certain bonds that pay interest annually or at the end of every bond year.
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.
If the bonds are designated and accounted for “at fair value through profit or loss”, the bond issue
costs are treated as expense immediately.
The fair value of the bonds payable is the same as the issue price or net proceeds from the issue
of the bonds, excluding accrued interest.
The difference between the face amount ad present value is either discount or premium on the
issue of the 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 of issue price of bonds
payable in measuring initially the bonds payable.
Under the effective interest method of amortization, the bond issue cost must be “lumped” with
the discount on bonds payable and “netted” against the premium on bonds payable.
If the bonds are measured at fair value through profit or loss, the bond issue cost are expensed
immediately.
The periodic cash deposits plus the interest earned on sinking fund securities should cause the
fund to approximately equal the amount of the bond issue on maturity date.
When the bonds approach maturity date, the trustee sells the securities and uses the sinking fund
cash to pay the bondholders. Any excess cash is returned to the issuing entity.
The retirement of bonds prior to maturity date may present some complex accounting problems.
1. The bond premium or bond discount should be amortized up to the date of retirement.
2. The balance of the bonds premium or bond discount should be determined. This balance is
important because the amount related to the bonds retired is canceled.
3. The accrued interest to date of retirement should be determined.
4. The total cash payment should be computed. This is equal to the retirement price plus the
accrued interest. The retirement price is a certain percent of the face amount of the bonds.
5. The carrying amount of the bonds retired is determined the face amount of the bonds plus
the unamortized premium or minus the unamortized discount gives the carrying amount of
the bonds.
6. The gain or loss on the retirement of bonds is computed.
This is the difference between the retirement price and the carrying amount of the bonds.
If the retirement price is more than the carrying amount of the bonds, there is loss.
If the retirement price is less than the carryig amount of the bonds, there is gain.
7. The retirement of the bonds is then recorded by canceling the bond liability together with the
unamortized premium or discount. Any accrued interest is debited to interest expense.
Treasury bonds should be debited at face amount and any related unamortized premium or
discount should be canceled. Any accrued interest paid is charged to interest expense.
The difference between the acquisition cost and the carrying amount of the treasury bonds is
treated a gain or loss on the acquisition of treasury bonds.
Bond refunding is a premature retirement of the old bonds by means of issuing new bonds. Bond
refunding is also known as bond refinancing.
Refunding may be made on or before the date of maturity of the old bonds.
Where refunding is made on the date of maturity of the old bonds, no accounting problem arises
as this would simply call for the cancelation of the bond liability. There is no unamortized
premium or discount involved.
The retirement is handled in the usual manner and the new bond issue is recorded in the normal
way.
Where refunding is made prior to the maturity date of the old bonds, consideration must be given
to the refunding charges pertaining to the old bonds.
The refunding charges include the unamortized bond discount or premium and redemption
premium on the old bonds being refunded.
The difference between the carrying amount of the financial liability extinguished and the
consideration paid shall be included in profit or loss.
PFRS 9 requires the use of the effective interest method in amortizing discounts, premiums and
bond issue cost.
The procedures is simply to divide the amount of bond premium or bond discount by the life of
the bonds to arrive at the periodic amortization.
The life of the bonds is that period commencing on the date of sale of the bonds up to the maturity
date.
For example, bonds with face amount of P5,000,000 are issued and mature at the rate of
P1,000,000 every year for 5 years.
As the name implies, the bond outstanding amortization approach gives recognition to the
deminishing balance of the bonds.
It is based on the theory that interest expense shall decrease every year by reason of the decreasing
principal bond liability.
22. Premature retirement of serial bonds
When serial bonds are paid on the regular maturity dates, no accounting problem arises because
no unamortized discount or premium is related to such serial bonds retired.
The problem occurs when the serial bonds are retired prior to their scheduled maturity dates.
In this case, the retirement calls for the cancelation of any unamortized discount or premium
related to the serial bonds retired.
The question is how much unamortized premium or discount is applicable to the serial bonds
retired prior to their maturity date?
2. Multiply the rate computed in (1) by the face amount of the bonds retired. The answer gives the
unamortized premium or discount per year related to the bonds retired.
3. Multiply the unamortized premium or discount per year computed in (2) by the period from the
date or retirement to the scheduled maturity date of the retired bonds.
Under the fair value option, the bonds payable shall be measured initially at fair value and
remeasured at every year-end with any changes in fair value generally recognized in profit or
loss.
There is no more amortization of bond discount and bond discount and bond premium. Any
transaction cost or bond issue cost should be expensed immediately.
As a matter of fact, interest expense is recognized using the nominal or stated rate.
a. The change in fair value attributable to the credit risk of the liability is recognized in other
comprehensive income.
Credit risk is the risk that the issuer of the liability would cause a financial loss to the other
party by failing to discharge the obligation.
Credit risk does not include market risk such as interest risk, currency risk and price risk.
b. The remaining amout if the change in fair value is recognized in profit or loss.
Paragraph 5.7.8 provides, however, that if presenting the change in fair value attributable to credit
risk would create or enlarge an accounting mismatch, all gains and losses including the effects
to changes in credit risk are recognized in profit or loss.
An accounting mismatch would be created or enlarged if presenting the efffects of changes in the
credit risk in other comprehensive income would result in a material or greater differences in
profit or loss than if those amounts were presented in profit or loss.
Application Guidance B5.7.9 provides that amounts recognized in other comprehensive income
resulting from changes in fair value of credit risk of a financial liability designated at fair value
through profit or loss shall not be subsequently transferred to profit or loss.
The cumulative gain or loss recognized may be transferred withing equity or retained earnings.
B. Application Exercises
You are provided with exercises and the corresponding solution. The objective is to demonstrate the
application of the accounting principles discussed for bonds payable: fair value option.
Exercise 1
Mercury 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 semi-annually on April 1 and October 1 of each year.
The bonds were sold to underwriters on April 1, 2021 at 106. The entity amortizes discount or premium
only at the end of the fiscal year using the straight line method.
Required:
1. Prepare journal entries for 2021 and 2022 including adjustments at the end of each year. Use
memorandum approach.
2. Present the bonds payable in the statement of financial position on December 31, 2022.
Solution to Exercise 1
Requirement 1
2021
April 1 Cash (7,000,000 x 106%) 7,420,000
Bonds payable 7,000,000
Premium on bonds payable 420,000
2022
Jan. 1 Accrued interest payable 210,000
Interest expense 210,000
Requirement 2
Bonds payable 7,000,000
Premium on bonds payable (420,000 – 73,500) 346,500
Carrying Amount (Book value) 7,346,500
Exercise 2
Mars Company was authorized to issue 10-year, 12% bonds with face amount of P8,000,000. The bonds
are dated January 1, 2021, and interest is payable semiannually on June 30 and December 31. The bods
were sold as follows:
January 1, 2021 5,000,000 at 95
September 1, 2022 2,000,000 at 103 plus accrued interest
Required:
1. Prepare journal entries relating to the bonds payable in 2021 and 2022. Straight line amortization is
used, and unissued bonds payable account is set up.
2. Show how information relative to the bond issue will be reported in the statement of financial position
prepared on December 31, 2022.
Solution to Exercise 2
Requirement 1
2021
Jan. 1 Unissued bonds payable 8,000,000
Authorized bonds payable 8,000,000
2022
June 30 Interest expense 300,000
Cash 300,000
Exercise 3
Saturn Company was authorized to issue 12% bonds with face amount of P5,000,000 on April 1, 2021.
Interest on the bonds is payable semiannually on April 1 and October 1. Bonds mature on April 1, 2026.
The entire issue was sold on April 1, 2021, at 98 less bond issue cost of P50,000.
On July 1, 2022, bonds of P2,000,000 face amount were purchased and retired at 99 plus accrued interest.
Required:
1. Prepare journal entries including any adjustments relating to the issuance of the bonds for 2021 and
2022. Use memorandum approach and the straight line method of amortization.
2. Present the bonds payable in the statement of financial position on December 31, 2022.
Solution to Exercise 3
Requirement 1
2021
April 1 Cash 4,850,000
Discount on bonds payable 100,000
Bond issue cost 50,000
Bonds payable 5,000,000
Oct. 1 Interest expense 300,000
Cash (5,000,000 x 12% x 6/12) 300,000
2022
Jan. 1 Accrued interest payable 150,000
Interest expense 150,000
Requirement 2
Noncurrent liabilities:
Bonds payable 3,000,000
Discount on bonds payable ( 39,000)
Book value/Carrying amount 2,961,000
Exercise 4
Required:
1. Compute the balance of bonds payable and discount on bonds payable on December 31, 2021. The
straight line method of amortizxation is used.
2. Compute bond interest expense for the year ended December 31, 2021. Interest is payable
semiannually on January 1 and July 1.
3. Prepare adjusting entries on December 31, 2021.
Solution to Exercise 4
Exercise 5
Jupiter Company issued P8,000,000 12% bonds on December 31, 2021 at 96. Interest is payable annually
on December 31.
Bond maturity
December 31
2023 1,000,000
2024 1,000,000
2025 1,000,000
2026 1,000,000
2027 2,000,000
2028 2,000,000
8,000,000
Required:
a. Prepare a schedule showing the annual amortization of the bond discount using the bond outstanding
method.
b. Prepare journal entries from 2021 to 2024.
Solution to Exercise 5
a. Amortization table
b. Journal Entries
2021
Dec. 31 Cash 7,680,000
Discount on bonds payable 320,000
Bonds payable 8,000,000
2022
Dec. 31 Interest expense 960,000
Cash 960,000
2023
Dec. 31 Interest expense 960,000
Cash 960,000
2024
Dec. 31 Interest expense 840,000
Cash 840,000
C. Evaluation Exercises
Provide answers to the following exercises:
Choose the correct answer by writing the corresponding letter-answer and a convincing justification that
it is indeed the correct answer. Briefly explain or provide justifiable reason/s via applicable appropriate
accounting principles discussed in A.
3. Zero-coupon bonds
a. Offer a return in the form of a deep discount off the face amount
b. Result in zero interest expense for the issuer
c. Result in zero interest revenue for the investor
d. Are reported as shareholders’ equity by the issuer
4. To evaluate the risk and quality of an individual bond issue, investors rely heavily on
a. Bond ratings provided by investment houses c. Bond interest payments
b. Newspaper articles d. The audit report
9. An entity has bonds outstanding during a year in which the market rate of interest has risen. The
entity elected the fair value option. What will the entity report for the year?
a. Interest expense and a gain c. A gain and no interest expense
b. Interest expense and a loss d. A loss and no interest expense
10. How would the amortization of premium on bonds payable affect the carrying amount of bond and
net income, respectively?
a. Increase and Decrease c. Decrease and Decrease
b. Increase and Increase d. Decrase and Increase
11. How would the amortization of discount on bonds payable affect the carrying amount of bond and
net income, respectively?
a. Increase and Decrease c. Decrease and Decrease
b. Increase and Increase d. Decrease and Increase
13. When the interest payment dates of a bond are May 1 and November 1, and a bond issue is sold on
June 1, the amount of cash received by the issuer will be
a. Decreased by accrued interest from June 1 to November 1
b. Decreased by accrued interest from May 1 to June 1
c. Increased by accrued interest from June 1 to November 1
d. Increased by accrued interest from May 1 to June 1
14. The issuer of a bond sold at face amount with interest payable February 1 and August 1 should report
a. Liability for accrued interest c. Increase in deferred charge
b. An addition to bonds payable d. Contingent liability
15. A bond issued on June 1 has interest payment dates of April 1 and October 1. Bond interest expense
for the current year ended December 31 is for a period of
a. Three months c. Six months
b. Four months d. Seven months
16. A bond was issued at a discount with a call provision. When the bond issuer exercised the call
provision on an interest date, the amount of bond liability derecognized should have equaled the
a. Call price c. Face amount less unamortized discount
b. Call price less unamortized discount d. Face amount plus unamortized discount
17. When bonds are sold between interest dates, any accrued interest is credited to
a. Interest payable c. Intrerest receivable
b. Interest revenue d. Bonds payable
18. Which statement is true about accrued interest on bonds sold between interest dates?
a. The accrued interest is computed at the effective rate.
b. The accrued interest will be paid to the seller when the bonds mature.
c. The accrued interest is extra income to the buyer.
d. all of the statements are not true.
19. An entity neglected to amortize the discount on outstanding bonds payable. What is the effect of the
failure to record discount amortization on interest expense and bond carrying amount, respectively?
a. Understated and understated c. Overstated and overstated
b. Understaed and overstated d. Overstated and understated
20. An entity neglected to amortize the premium on oustanding bonds payable. What is the effect of the
failure to record premium amortization on interest expense and bond carrying amount, respectively?
a. Understated and understated c. Overstated and overstated
b. Understaed and overstated d. Overstated and understated
Solve the following problems with supporting computations presented in good form:
On December 31, 2021, cash of P3,900,000 was made available from the sale of 10-year 10% bonds
with face amount of P4,000,000.
The cash received from the new issue was used for retirement of the 12% bonds at a call price of 102
plus accrued interest.
Bond maturity
December 31
2023 1,000,000
2024 1,000,000
2025 1,000,000
2026 1,000,000
2027 2,000,000
2028 2,000,000
8,000,000
Required:
a. Prepare a schedule showing the annual amortization of the bond discount using the bond
outstanding method.
b. Prepare journal entries from 2021 to 2024.
3. On December 31, 2021, Star Company sold a 12% serial bond issue with face amount of P7,000,000
for 7,420,000.
The bonds mature in the amount of P1,000,000 on December 31 of each year beginning December
31, 2022 and interest is payable annually.
On December 31, 2023, the entity retired P1,000,000 of bonds due on that date and in addition
purchased at 105 and retired bonds with face amount of P1,000,000 which were due on December
31, 2025.
Required: Prepare journal entries from 2021 to 2023. The bond outstanding method of amortization
is used.
4. Sun Company reported the following financial liabilities on December 31, 2021:
5. On July 1, 2021, Glocal 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.
Required: Determine the carrying amount of the bonds payable on July 1, 2021.
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