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Topic 1: Accounting for Financial Liabilities (MFRS 139)

Objectives
1. 2.

To describe long-term liabilities and describe how they are valued To identify the nature and types of long-term liabilities-bond

3.
4.

To explain the methods of bond discount and premium amortization


To prepare the related journal entries

5.

To describe the accounting treatment for other long term liabilities


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Long-Term Liabilities
Consists of present obligations not payable within the operating cycle of the business, or a year whichever is longer. Long-term creditors have no vote in management affairs and only receive a stated rate of interest regardless of the level of earnings. Covenants or restrictions, for the protection of both lenders and borrowers, are stated in the bond indenture or note agreement Example: Bond payable, Long-term notes payable, Long-term loans, mortgages payable
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FINANCIAL LIABILITY
MFRS 132 defined as any liability that is:
(a)

a contractual obligation:
i. to deliver cash or other financial asset to another entity; or ii. to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or

FINANCIAL LIABILITY FINANCIAL LIABILITY


(b)

a contract that will or may be settled in the entitys 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 entitys own instrument; or 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 entitys own equity instrument.

ii.

Bonds Payable

Arises from a contract known as a bond indenture. Represents a promise to pay the principle(face value) at maturity and periodic interest based on the stated interest rate and the face value of the bond

the different types of bonds such as:


term bonds, serial bonds, secured and unsecured bonds, registered and coupon bonds. convertible bonds & commodity-backed bonds, Callable bond deep discount bonds Junk bonds (Keiso&Weygandt, 2005; Stice & Stice, 2010(p696))

Bonds Payable
Bond contract known as a bond indenture.

Represents a promise to pay:


(1) sum of money at designated maturity date, plus (2) periodic interest at a specified rate on the maturity

amount (face value).


Paper certificate, typically a RM1,000 face value. Interest payments usually made semiannually.

Purpose is to borrow when the amount of capital needed is too large for one lender to supply.
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Bursa Malaysia- Bond


Conventional
1)
2) 3) 4)

Cagamas MBS Berhad Petronas Capital Limited AmBank (M) Berhad Asian Development Bank

Bursa Malaysia: Islamic Bond - Sukuk


1. 2. 3. 4. 5. 6. 7. 8. Cagamas MBS Berhad Petronas Global Sukuk Ltd. GE Capital Sukuk Ltd. CIMB Islamic Bank Berhad Rafflesia Capital Limited Cherating Capital Ltd. Paka Capital Ltd Khazanah Nasional Berhad

Accounting for the Issuance of Bonds


1. The face value of the bond is always reflected in the Bond Payable account.
Dr. Cash Cr. Bond Payable (issue at par) xx xx

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Accounting for the Issuance of Bonds (cont.)


2. When a bond sells at a discount, the difference between the sales price and the face value is debited to Discount on Bonds Payable. This is a contra-account to Bonds Payable. xx xx xx

Dr. Cash Dr. Discount on Bond Cr. Bond Payable

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Accounting for the Issuance of Bonds (cont.)


3.

When a bond sells at a premium, the difference between the sales price and the face value is credited to Premium on Bonds Payable. This is an adjunct account to Bonds Payable. Dr. Cash Cr. Bond Payable xx xx

Cr. Premium on Bond

xx

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Accounting for the Issuance of Bonds (cont.)


4. Bonds sold between interest dates: i. The price includes the interest accrued since the last interest payment. ii. The accrued interest is credited to Bond Interest Expense.

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Example 1: Bonds Payable


CINB Bhd issued RM200,000 of 8% bonds on 1 Jan 2010. The bonds are due on 1 Jan 2015, with interest payable each 1 July and 1 Jan. Compute the issue price at (as a percentage of face value): a) 100 b) 97

c) 105
Prepare journal entries for CINB Bhd.
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Solution (000):
at 100 (at par) at 97 (at discount) at 105 (at premium) Dt Cash Kt Bonds Payable 200

200

Dt Cash 194 Dt Disc. bonds 6 Kt Bonds Payable 200 Dt Cash 210 Kt Bonds Payable 200 Kt Premium Bonds 10
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Issuance of Bonds-

Price of bond is based on present value of bond

Occur when rate employed by buyer is differs from stated rate. Example 2: RHD Bhd issues RM300,000 of 9% bonds, due in 10 years, with interest payable semiannually. At the time of issue, the market rate for such bonds is 10%. Compute the issue price of the bonds.

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Valuation of Bonds Payable


A bond's price is equal to the sum of the present value of the principle and the present value of the periodic interest.

The price of a bond is determined by the interaction between the bond's stated interest rate and its market rate. If
a) the stated rate = the market rate, sell at par. b) the stated rate < the market rate, sell at a discount. c) the stated rate > the market rate, sell at a premium.

Term: Stated rate = contract rate Market rate = yield/effective interest rate

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Valuation of Bonds
Interest Rates
Stated, coupon, or nominal rate = The interest rate written in the terms of the bond indenture.

Market rate or effective yield = rate that provides an acceptable return on an investment commensurate with the issuers risk characteristics. Rate of interest actually earned by the bondholders.

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Solution for Example 2:


n = 10 x 2 i = 10%/2 113,067

PV of the principal: 300,000 x PVn=20, i=5% (0.37689)

PVOA of interest payable: [(9% x 300,000)/2] x PVAn=20, i=5%


13,500 x Price of bond 12.46221 168,240 281,307

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Amortization of bond discounts and premiums


Two methods:
1.

Effective interest method is the preferred procedure used to calculate periodic interest expense. The carrying amount of the bonds at the start of the period is multiplied by the effective interest rate to determine the interest expense.
Straight-line method may be used if the results are not materially different from those produced by the effective interest method.
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2.

Effective interest method


Carrying Value of Bonds = Face Value + Premium ; or = Face Value - Discount Interest Payable = Stated Rate x Face Value of Bonds Interest Expense= Effective Rate x Carrying Value of Bonds If a premium exists: Dr Interest Expense XX Dr Premium on Bonds Payable XX Cr Interest Payable XX

If a discount exists: Dr Interest Expense XX Cr Discount on Bonds Payable Cr Interest Payable

XX XX
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Example 3: Amortization of Bond Premium


BIMD Bhd issued RM600,000 of 10%, 20-year bonds on 1 Jan 2012, at 102. Interest is payable semiannually on 1 July and 1 Jan. BIMD Bhd uses straight-line method of amortization for bond premium/discount.
Prepare the journal entries to record: a)The issuance of the bonds b)The payment of interest on 1 July c)The accrual of interest on 31 Dec

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Solution for Example 3


a)

Issuance of bonds

Dr Cash (600,000 x 1.02) Cr Bonds Payable Cr Premium on bond


b)

612,000
600,000 12,000 29,700 300

Payment of interest on July 1


Dr Interest expense Dr Premium on Bond Cr Cash

30,000

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Solution for Example 3 (cont.)


c)

Accrual interest on 31 Dec

Dr Interest expense Dr Premium on Bond Cr. Interest payable

29,700 300
30,000

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Example 4: Amortization of Discount Bonds


PMB Bhd issued RM600,000 of 10%, 20-year bonds on 1 Jan 2012. Interest is payable semiannually on 1 July and 1 Jan. PMB Bhd uses effective interest method of amortization for bond premium/discount. Assume an effective rate yield of 11.5%
Prepare the journal entries to record: a)The issuance of the bonds

b)The payment of interest on 1 July


c)The accrual of interest on 31 Dec
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Solution for Example 4


a) Issuance of bonds

i=11.5/2, n=20x2
PV 600,000 x 0.10685 PVOA 30,000 x 15.5330 Price on 1 Jan Dr Cash Dr Discount on bond Cr Bonds payable = 64,110 = 465,990 = 530,100 530,100 69,900 600,000
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Solution for Example 4 (cont.)


Cash Interest exp. 30,481a 30,508 Amort. Disc 481b 508 Balance of Bonds 530,100 530,581c 531,089

1/7/12 1/1/13

30,000 30,000

1/7/13

30,000

30538

538

531,627

a: 11.5% x 530,100 x 6/12 = 30,481


b: 30,481 30,000 = 481 c: 530,100 + 481 = 530,581
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Solution for Example 4 (cont.)


b)

Interest expense on 1 July 2012 Dr Interest expense Cr. Discount on Bond Cr. Cash 30,481 481 30,000

c)

Interest expense on 31 December 2012 Dr Interest expense Cr Discount on Bond Cr. Interest payable 30,508

508 30,000
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Cost of Bonds Issue

The issue of bonds involve numerous costs:

Legal and accounting expense, administrative expense (printing doc/prospectus), underwriting fees.

These costs do NOT represent an asset Methods of recognition: 1) As an expense charge to income statement immediately 2) Capitalized & amortized debited to a deferred charge account & amortize over bond period
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Example 5: Cost of Bond Issue


Assume that Cyber Bhd issued a RM40,000,000 five-year bond at its par value on 1 January 2012. The bond carries a coupon interest of 10% and interest is payable on 31 Dec each year. Costs of issuing the bond, which included underwriting fees, totaled RM1,000,000. The costs were capitalized as a deferred charge and amortized on the straight line method. Show the entries to (a) record the issue of bond on 1 Jan 2012 (b) recognize the amortization of the bond issue cost and interest expense
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Solution for Example 5


a)

1/1/12: to record the issuance of the bond Dt Cash 39,000,000 Dt Deferred bond issue cost 1,000,000 Kt Bonds Payable 40,000,000

b)

31/12/12 : to recognize amortization of deferred charge Dt Amortization expense 200,000 Kt Deferred bond issue cost 200,000 to recognize interest expense Dt Interest expense Kt Cash 4,000,000 4,000,000
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Bonds Issued between Interest Dates

When bonds are issued between interest dates, the purchase price is increased by an amount equal to the interest earned on the bonds since the last interest payment date. Buyers will pay the seller the interest accrued from the last interest payment date to the date of issue. Cash paid by buyer is the price of the bonds together with the accrued interest. Price of bonds is the present value of the bond at the date of issue.
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Bonds Issued between Interest Dates

On the next interest payment date, the bondholder will receives the entire interest payment. However, the amount of interest expense to the issuing corporation is the difference between the interest payment and the amount of interest prepaid by the purchaser.

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Example 6
Cumi Bhd purchased bond from Ciki Bhd. The following is the information on the bond.
Date of bond Maturity date June 30, 2009 June 30, 2014

Date of selling the bond


Date of interest payment Stated interest rate Face value of bond

Sept 1, 2009
Dec 31 and June 30 9% RM200,000

Prepare journal entries on 1 Sept and 31 Dec


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Solution for Example 6


Issued at par:
Effective interest rate = 9%
Price of bond at 30/6/2009: Face value [PV4.5%, 10 200,000 = 0.64393 x 200,000] Interest [PVOA4.5%, 10 9,000 = 7.91272 x 9,000] Present Value on 30 June 2009 (+) Increment of bonds value from 30/6 1/9 [200,000 x 9% x 2/12]

128,786 71,214 200,000 3,000 203,000 (3,000) 200,000


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(-) Cash paid for interest from 30/6 1/9 [200,000 x 9% x 2/12] PRICE OF BOND AT 1/9/2009

Solution for Example 6 (cont.)


Journal entries
Sept 1 Dr Cash Cr Interest Payable Bonds Payable 200,000 + 3,000 (interest) 2. 200,000 x 9% x 2/12 Dec. 31 Dr Interest Payable Interest Expense Cr Cash 1. 200,000 x 9% x 4/12
1.

203,0001

3,0002 200,000

3,000 6,0001

9,000
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Solution for Example 6 (cont.)


Issued at discount: Effective interest rate = 11% Price of bond at 30/6/2009: Face value [PV5.5%, 10 200,000 = 0.58543 x 200,000] Interest [PVOA5.5%, 10 9,000 = 7.53763 x 9,000] Present Value (+) Increment of bonds value from 30/6 1/9 [184,925 x 11% x 2/12] (-) Cash paid for interest from 30/6 1/9 [200,000 x 9% x 2/12] PRICE OF BOND at 1/9/2009

117,086 67,839 184,925 3,390 188,315 (3,000) 185,315


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Solution for Example 6 (cont.)


Journal entries
Sept 1 Dr Cash Disc on Bond Cr Interest Payable Bonds Payable
1. 2. 3.

188,3151 14,6852

3,0003 200,000

185,315 + 3,000 (interest) 200,000 185,315 200,000 x 9% x 2/12

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Solution for Example 6 (cont.)


Amortisation of discount schedule
Date Cash Interest Paid Expense Amortisation Carrying of discount amount of bond

30/6/09
31/12/09 30/6/10

9,000 9,000

10,171 10,235

1,171 1,235

184,925
186,096 187,331

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Solution for Example 6 (cont.)


Journal entries

Dec. 31 Dr Interest Expense Interest Payable Cr Disc on Bonds Cash


1. 2.

6,7811 3,000

7812 9,000

10,171 x 4/6 1,171 x 4/6

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RETIREMENT OF BONDS
Before the maturity date Examples of bonds retirement: 1. Refunding 2. Convertible Bond 3. Callable Bond At the maturity date If bond is retired at the maturity date, no profit or loss is recorded Carrying Amount of Bond = Face Value of Bond Journal entry for payment made at the maturity date: Dr Bonds Payable XX Interest expense XX Cr Cash XX Discounts on Bonds Payable XX 41

Refunding

Bond is retired by issuing new bond.

At the retirement, all records on bonds and any related records to the old bond will be eliminated. Interest expense and amortisation of discount/premium needs to be recorded in advance until the retirement date.

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Example 7
On January 1, 2008, Wira Bhd issued RM100,000, 10-year bond at par and with stated interest rate of 5% paid every 30/6 and 31/12. On January 1, 2012, the buyer agreed to receive bond of RM90,000, 20-year, with stated interest rate of 8% paid at the same dates. Market interest rate is 8%. Prepare journal entries for issuance of bond and refunding.

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Solution for Example 7

At the issuance of the bond:

1/1/08

Dr Cash 100,000 Cr Bonds Payable 100,000

At refunding Value of new issuance of bond = RM90,000 (at par) 1/1/12 Dr Bonds Payable,5% 100,000 Cr Bonds Payable,8% 90,000 Cr Gains from retirement 10,000

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Callable Bonds
Normally the bond is repaid at the maturity date. CAN be repaid at any time if it is called up. Normally the bond is callable when the market interest increase due to lower callable price. At the callable date, the company should record all interest expense and amortise the discount/premium until that date.

When the bond is callable, it is retired. Thus, all record of the bonds and any related to it will be eliminated.
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Example 9
On 1 January 2004, Beztax Bhd issued bonds with a par value of RM800,000 at 97, due in 20 years. Bond issue cost totalling RM16,000 were incurred. Eight years after the issuance, the entire issue is called at 101 and canceled. Discount on bond payable and bond issue cost are amortized using straight-line basis.

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Solution for Example 9


Reacquisition price (RM800,000 x 1.01) 808,000

Net carrying amount of bonds redeemed:


Face value 800,000 Unamortized discount 24,000 x 12/20 (14,400) Unamortized issue cost 16,000 x 12/20 (9,600) Loss on redemption

776,000 32,000

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Solution for Example 9


Journal entry:

Bond Payable
Loss on redemption Discount on Bond

800,000
32,000 14,400

Deferred bond issue cost


Cash

9,600
808,000

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Compound Financial Instruments

Hybrid Securities:
Securities or financial instruments that have characteristic of both debt and equity. They often combine traditional and derivative financial instruments

Hybrid instruments consist of two parts:


A debt security referred to a (host security) An option to convert to shares of ordinary shares (embedded derivative)

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Compound Financial Instruments


Compound Financial Instruments

Are classified by the issuer according to substance of contractual arrangement and the definition of a financial liability and an equity instrument. Their components are classified separately as financial liabilities, financial assets or equity instruments. Example: Covertible bond payable

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Convertible Bonds

Bonds can be converted into shares Reasons for conversion: to increase the equity capital without giving up more ownership control. to make the bond marketable Purchased by investors who desire the security of a bond holding-guaranteed interest-plus the added option of conversion if the value of the shares appreciates significantly.
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Convertible Bonds
Entries for issuing of the bonds MFRS 132 para 29, require separate recognition of the equity and liability component A bond or similar instrument convertible by the holder into a fixed number of ordinary shares of the entity is a compound financial instrument. From the perspective of the entity, such an instrument comprises two components: a financial liability (a contractual arrangement to deliver cash or another financial asset) and an equity instrument (a call option granting the holder the right, for a specified period of time, to convert it into 52 a fixed number of ordinary shares of the entity

Example 8: Converted Bonds


Tania Bhd sold RM500,000 bonds, 8% at 105 (RM525,000). Every RM1,000 bond can be exchanged to 1,000 shares of Tania Bhd at any time after 2 years of bond issued. The is expected to be sold at the rate of 96 if there is no conversion privilege. All bonds are exchanged to shares. Par value of Tania Bhd share is RM1. Half of the discount/premium has been amortised at the exchange date. Record the journal entries:
a) On issuance date b) Exchange date
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Solution for Example 8


At issuance date: Price of bonds without conversion privilege Face value of bond Selling price of bond without conversion privilege (0.96 x 500,000) Discount on bonds payable Price of bond with conversion privilege: Cash received from the sale of bonds Selling price without conversion Total can be used for conversion 525,000 (480,000) 45,000
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500,000 480,000 . 20,000

Solution for Example 8


At issuance date:

Journal entry:
Dr Cash 525,000 Discounts on bonds payable 20,000 Cr Bonds payable 500,000 Premium on shares 45,000

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Solution for Example 8


At exchange date: Dr Bonds payable 500,000 Sharee premium 10,000 Cr Discounts on bonds payable 10,000 Ordinary shares (RM1x500,000) 500,000

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Redeemable preference shares

Issued with the condition that the company can buy back the shares at a specified date in the future The terms of redemption will be stated in the Articles of Association If it provide a mandatory redemption or where the option of redemption is exercisable by the shareholders SHOULD be classified as a financial liability.

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Redeemable Preference Share with Discretionary Dividends

Redeemable preference share on which dividends are non-cumulative and at the discretion of the issuer are compound instruments. The present value of the redemption value is a liability, the unwinding of the interest is expense, dividends paid relate to the equity are recognised as distribution of equity.

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Other Instrument for Long Term Liabilities


1.

Convertible Bonds (CULS)


Debt securities that are exchangeable into ordinary shares at the option of the holder and under specified terms and conditions

2.

Warrants (Transferable Subscription Rights)


Gives the holder right to subscribe specific number of shares at the pre-determine exercise price and within a specified period of time

Other Instrument for Long Term Liabilities (cont.)


3.

Irredeemable Convertible Loan Stocks (ICULS)


Quasi-debt pay annual coupon over their tenure but irredeemable in future, means there will be no repayment of principle at maturity

Mandatory converted
Faced value of ICULS will be converted into new ordinary shares based on stipulated conversion ratio

Exercise: ICULS
On 1 Jan 2008, DRG Bhd issues RM1 million ICULS 2008/2012 value at RM1.00 per ICULS. The five-year ICULS paid 7.5% coupon per year. This ICULS can be converted into ordinary shares based on conversion ratio of RM5 ICULS for one new shares (RM1.00, par)

Prepare journal entries at issuance and conversion?

Solution:
At Issuance DR Cash CR ICULS 1,000,000

1,000,000

At Conversion (maturity date) RM1 million ICULS = # shares? New shares = 1,000,000 5 = 200,000 units shares DR ICULS 1,000,000 CR Ordinary shares 200,000 CR Premium on shares 800,000

Treatment of interest, dividends, losses and gains

The accounting treatment and presentation of interest, dividends, losses and gains depend on whether the items are related to liability or equity.
If they relate to liability, they should be reported in the income statement as expense or income such interest on bonds If they relate to equity instrument, they should be recorded directly to the statement of changes in equity.

BKAF3063

Financial Accounting & Reporting 3

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Treatment of interest, dividends, losses and gains

Charges to Income Statement:


Interest on borrowing Gains or losses associated with redemption or refinancing of liability are expenses in the income statement. Premiums and discounts on liability are charged in the income statement.

Dividend on redeemable preference shares is an expenses to be disclosed in the income statement.


BKAF3063 Financial Accounting & Reporting 3 64

Treatment of interest, dividends, losses and gains

Changes in equity: Dividends on equity shares are disclosed in the statement of changes in equity. Transaction cost on equity transactions such as registratin and professional fees, stamp duties and printing costs on the issue or share buy back are deducted from equity.

BKAF3063

Financial Accounting & Reporting 3

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Disclosure of Financial Instruments

Purpose:
To enhance understanding of the significance of financial instrument to the entitys financial position, performance and cash flows. To assist in assessing the amounts, timing and certainty of future cash flows associated with those instruments
Provide information to the extent of risk related to financial instrument

BKAF3063

Financial Accounting & Reporting 3

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Disclosure of Financial Liabilities


Statement of Financial Position

Categories of financial liabilities (para 8)


The carrying amounts shall be disclosed either on the face of the balance sheet or in the notes: e)financial liabilities at fair value through profit or loss, showing separately (i) those designated as such upon initial recognition and (ii) those classified as held for trading in accordance with MFRS 139; and f) financial liabilities measured at amortised cost.

Disclosure of Financial Liabilities


Statement of Financial Position

Financial liabilities at fair value through profit or loss (para 10)


(a) the amount of change, during the period and cumulatively, in the fair value of the financial liability that is attributable to changes in the credit risk of that liability (b) the difference between the financial liability's carrying amount and the amount the entity would be contractually required to pay at maturity to the holder of the obligation.

Disclosure of Financial Liabilties


Statement of Comprehensive Income
An entity shall disclose the following items of income, expense, gains or losses either on the face of the financial statements or in the notes: (para 20)
(a) net gains or net losses on: (i) financial assets or financial liabilities at fair value through profit or loss, showing separately those on financial assets or financial liabilities designated as such upon initial recognition, and those on financial assets or financial liabilities that are classified as held for trading in accordance with MFRS 139; (v) financial liabilities measured at amortised cost;

Disclosure of Financial Liabilities


Para 20 (cont..):
(b)

total interest income and total interest expense (calculated using the effective interest method) for financial assets or financial liabilities that are not at fair value through profit or loss; fee income and expense (other than amounts included in determining the effective interest rate) arising from:

(c)

(i) financial assets or financial liabilities that are not at fair value through profit or loss; and

END OF TOPIC 1

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