DANIEL B.

PEÑA MEMORIAL COLLEGE FOUNDATION

Tabaco City

PROJECT FOR PRE-FINALS

ACCOUNTING 4
(Financial Accounting Theory and Practice P-2)

Submitted by:

BEVERLY B. BRULAND

(BS ACCOUNTANCY - III)

Submitted to:

MS. CHRISTINE V. YONG, CPA, MBA

(Instructor)
BONDS PAYABLE

Bonds payable are a form of long-term debt usually issued by corporations, hospitals,
and governments. The issuer of bonds makes a formal promise/agreement to pay
interest usually every six months (semiannually) and to pay the principal or maturity
amount at a specified date some years in the future. The agreement containing the
details of the bonds payable is known as the bond indenture.

Philippines corporations issue bonds instead of common stock for the following reasons:
Debt is less costly than common stock; The interest on bonds is deductible for income
tax purposes; Bondholders are not owners and therefore the ownership interest of the
existing stockholders will not be diluted.

Bonds are a form of long-term debt. You might think of a bond as an IOU issued by a
corporation and purchased by an investor for cash. The corporation issuing the bond is
borrowing money from an investor who becomes a lender and bondholder.

A bond is a formal contract that requires the issuing corporation to pay the
bondholders: Interest every six months based on the bond's stated interest rate, and
the principal or face amount on the bond's maturity date.

There are two significant advantages for a corporation to issue bonds instead of
common stock: Bonds will not dilute the ownership interest of the stockholders, and
bonds have a lower cost than common stock.

Bonds have a lower cost than common stock because of the bond's formal contract to
pay the interest and principal payments to the bondholders and to adhere to other
conditions. A second reason for bonds having a lower cost is that the bond interest paid
by the issuing corporation is deductible on its U.S. income tax return, whereas dividends
are not tax deductible.

The market value of an existing bond will fluctuate with changes in the market interest
rates and with changes in the financial condition of the corporation that issued the
bond. For example, an existing bond that promises to pay 9% interest for the next 20
years will become less valuable if market interest rates rise to 10%. Likewise, a 9% bond
will become more valuable if market interest rates decrease to 8%. When the financial
condition of the issuing corporation deteriorates, the market value of the bond is likely
to decline as well.

Present value calculations are used to determine a bond's market value and to calculate
the true or effective interest rate paid by the corporation and earned by the investor.
Present value calculations discount a bond's fixed cash payments of interest and
principal by the market interest rate for the bond.

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IAS 32 Financial Instruments: Presentation requires compound financial instruments to
be split into their component parts, i.e.: a financial liability (the debt component); and
an equity instrument (the option to convert into shares).

The financial instrument is split by first determining the debt component. The debt
component is calculated as the present value of future cash flows of the instrument
discounted using the current interest rate for similar bonds without the conversion
rights. The equity component is then calculated by deducting the debt component from
the proceeds of the instrument.

Any transaction costs are then apportioned to the debt and equity components in
proportion to the allocation of proceeds.

When a corporation issues a bond, it promises to pay the bondholder: Interest every six
months at the bond's stated interest rate, and the principal or face amount when the
bond comes due at its maturity date.

One source of financing available to corporations is long‐term bonds. Bonds represent

an obligation to repay a principal amount at a future date and pay interest, usually on a
semi‐annual basis. Unlike notes payable, which normally represent an amount owed to
one lender, a large number of bonds are normally issued at the same time to different
lenders. These lenders, also known as investors, may sell their bonds to another investor
prior to their maturity.

There are many different types of bonds available to interested investors. Some of the
more common forms are:

Serial bonds. Bonds issued in groups that mature at different dates.

Sinking fund bonds. Bonds that require the issuer to set aside a pool of assets used only
to repay the bonds at maturity. These bonds reduce the risk that the company will not
have enough cash to repay the bonds at maturity.

Convertible bonds. Bonds that can be exchanged for a fixed number of shares of the
company's common stock. In most cases, it is the investor's decision to convert the
bonds to stock, although certain types of convertible bonds allow the issuing company
to determine if and when bonds are converted.

Registered bonds. Bonds issued in the name of a specific owner. This is how most bonds
are issued today. Having a registered bond allows the owner to automatically receive
the interest payments when they are made.

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Bearer bonds. Bonds that require the bondholder, also called the bearer, to go to a bank
or broker with the bond or coupons attached to the bond to receive the interest and
principal payments. They are called bearer or coupon bonds because the person
presenting the bond or coupon receives the interest and principal payments.

Secured bonds. Bonds are secured when specific company assets are pledged to serve as
collateral for the bondholders. If the company fails to make payments according to the
bond terms, the owners of secured bonds may require the assets to be sold to generate
cash for the payments.

Debenture bonds. These unsecured bonds require the bondholders to rely on the good
name and financial stability of the issuing company for repayment of principal and
interest amounts. These bonds are usually riskier than secured bonds. A subordinated
debenture bond means the bond is repaid after other unsecured debt, as noted in the
bond agreement.

The price of a bond is based on the market's assessment of any risk associated with the
company that issues (sells) the bonds. The higher the risk associated with the company,
the higher the interest rate. Bonds issued with a coupon interest rate (also called
contract rate or stated rate) higher than the market interest rate are said to be offered
at a premium. The premium is necessary to compensate the bond purchaser for the
above average risk being assumed. Bonds are issued at a discount when the coupon
interest rate is below the market interest rate. Bonds sold at a discount result in a
company receiving less cash than the face value of the bonds.

Normally, a bond's interest payments occur semiannually. This means that the
corporation issuing a bond will pay to the bondholders one-half of the annual interest at
the end of each six-month period as long as the bond is outstanding. The formula for
calculating the semiannual interest payments is:

Face Amount of the Bond x Stated Annual Interest Rate x 6/12 of a Year

The following terms mean the same as a bond's stated interest rate: face interest rate;
nominal interest rate; coupon interest rate; contractual interest rate

Throughout our explanation of bonds payable we will use the term stated interest rate
or stated rate. Usually a bond's stated interest rate is fixed or locked-in for the life of the
bond.

A bond's principal payment is the dollar amount that appears on the face of a bond. This
is the amount that the issuing corporation must pay to the bondholders on the date that

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a bond matures or comes due. Here are some names that refer to a bond's principal
amount: face value; par or par value; maturity value or maturity amount; stated value

Throughout our explanation we will use these terms interchangeably. In addition, we

assume that the bond's principal amount will be due on a single date.

Bonds payable is a liability account that contains the amount owed to bond holders by
the issuer. This account typically appears within the long-term liabilities section of the
balance sheet, since bonds typically mature in more than one year. If they mature
within one year, then the line item instead appears within the current liabilities section
of the balance sheet.

Terms of bonds payable are contained within a bond indenture agreement, which states
the face amount of the bonds, the interest rate to be paid to bond holders, special
repayment terms, and any covenants imposed on the issuing entity.

An entity is more likely to incur a bonds payable obligation when long-term interest
rates are low, so that it can lock in a low cost of funds for a prolonged period of time.
Conversely, this form of financing is less commonly used when interest rates spike.
Bonds are typically issued by larger corporations and governments.

The effective interest method is an accounting practice used for discounting a bond.
This method is used for bonds sold at a discount; the amount of the bond discount is
amortized to interest expense over the bond's life.

The preferred method for amortizing (or gradually writing off) a discounted bond is the
effective interest rate method or the effective interest method. Under the effective
interest rate method, the amount of interest expense in a given accounting period
correlates with the book value of a bond at the beginning of the accounting period.
Consequently, as a bond's book value increases, the amount of interest expense
increases.

When a discounted bond is sold, the amount of the bond's discount must be amortized
to interest expense over the life of the bond. When using the effective interest method,
the debit amount in the discount on bonds payable is moved to the interest account.
Therefore, the amortization causes interest expense in each period to be greater than
the amount of interest paid during each year of the bond's life.

The effective interest method is used when evaluating the interest generated by a bond
because it considers the impact of the bond purchase price rather than accounting only
for par value.

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Though some bonds pay no interest and generate income only at maturity, most offer a
set annual rate of return, called the coupon rate. The coupon rate is the amount of
interest generated by the bond each year, expressed as a percentage of the bond's par
value.

Par value, in turn, is simply another term for the bond's face value, or the stated value
of the bond at the time of issuance. A bond with a par value of $1,000 and a coupon
rate of 6% pays $60 in interest each year.

A bond's par value does not dictate its selling price. Bonds that have higher coupon
rates sell for more than their par value, making them premium bonds. Conversely,
bonds with lower coupon rates often sell for less than par, making them discount bonds.
Because the purchase price of bonds can vary so widely, the actual rate of interest paid
each year also varies.

In accounting, the effective interest method examines the relationship between an

asset's book value and related interest. In lending, the effective annual interest rate
might refer to an interest calculation wherein compounding occurs more than once a
year. In capital finance and economics, the effective interest rate for an instrument
might refer to the yield based on the purchase price.

All of these terms are related in some way. For example, effective interest rates are an
important component of the effective interest method.

An instrument's effective interest rate can be contrasted with its nominal interest rate
or real interest rate. The effective rate takes two factors into consideration: purchase
price and compounding. For lenders or investors, the effective interest rate reflects the
actual return far better than the nominal rate. For borrowers, the effective interest rate
shows costs more effectively.

Put another way, the effective interest rate is equal to the nominal return relative to the
actual principal investment. In terms of bonds, this is the same as the difference
between the coupon rate and yield.

An interest-bearing asset also has a higher effective interest rate as more compounding
occurs. For example, an asset that compounds interest yearly has a lower effective rate
than an asset with monthly compounding.

Unlike the real interest rate, the effective interest rate does not take inflation into
account. If inflation is 1.8%, a Treasury bond (T-bond) with a 2% effective interest rate
has a real interest rate of 0.2% or the effective rate minus the inflation rate.

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The primary advantage of using the effective interest rate figure is simply that it is a
more accurate figure of actual interest earned on a financial instrument or investment,
or of actual interest paid on a loan, such as a home mortgage.

The effective interest rate calculation is commonly used with regard to the bond
market. The calculation provides the real interest rate returned in a given time period,
based on the actual book value of a financial instrument at the beginning of the time
period. If the book value of the investment declines, then the actual interest earned will
decline as well.

Investors and analysts often use effective interest rate calculations to examine
premiums or discounts related to government bonds, such as the 30-year U.S. Treasury
bond, although the same principles apply to corporate bond trades. When the stated
interest rate on a bond is higher than the current market rate, then traders are willing to
pay a premium over the face value of the bond. Conversely, whenever the stated
interest rate is lower than the current market interest rate for a bond, the bond trades
at a discount to its face value.

The effective interest rate calculation reflects actual interest earned or paid over a
specified time frame. It is considered preferable to the straight-line method of figuring
premiums or discounts as they apply to bond issues because it is a more accurate
statement of interest from the beginning to the end of a chosen accounting period (the
amortization period).

On a period-by-period basis, accountants regard the effective interest method as far

more accurate for calculating the impact of an investment on a company's bottom line.

To obtain this increased accuracy, however, the interest rate must be recalculated every
month of the accounting period; these extra calculations are a disadvantage of using the
effective interest rate. If an investor uses the simpler straight-line method to calculate
interest, then the amount charged off each month doesn't vary; it is the same amount
every month.

Whenever an investor buys, or a financial entity such as the U.S. Treasury or a

corporation sells, a bond instrument for a price that is different from the bond's face
amount, then the actual interest rate being earned is different from the bond's stated
interest rate. The bond may be trading at a premium or at a discount to its face value. In
either case, the actual effective interest rate differs from the stated rate.

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When it comes to loans such as a home mortgage, the effective interest rate is also
known as the annual percentage rate. It takes into account the effect of compounding
interest, along with all other costs that the borrower pays for the loan.

The effective interest method is a technique for calculating the actual interest rate in a
period based on the amount of a financial instrument's book value at the beginning of
the accounting period. Thus, if the book value of a financial instrument decreases, so
too will the amount of related interest; if the book value increases, so too will the
amount of related interest. This method is used to account for bond premiums and
bond discounts. A bond premium occurs when investors are willing to pay more than
the face value of a bond, because its stated interest rate is higher than the prevailing
market interest rate. A bond discount occurs when investors are only willing to pay less
than the face value of a bond, because its stated interest rate is lower than the
prevailing market rate.

The effective interest method is preferable to the straight-line method of charging off
premiums and discounts on financial instruments, because the effective method is
considerably more accurate on a period-to-period basis. However, it is also more
difficult to compute than the straight-line method, since the effective method must be
recalculated every month, while the straight-line method charges off the same amount
in every month. Thus, in cases where the amount of the discount or premium is
immaterial, it is acceptable to instead use the straight-line method. By the end of the
amortization period, the amounts amortized under the effective interest and straight-
line methods will be the same

A compound financial instrument is a financial instrument that has the characteristics of

both an equity and liability (debt). An example would be a bond that can be converted
into shares. It doesn't matter whether the bondholders will ultimately opt for
conversion. As long as there is the option to convert into shares, the financial
instrument would carry an equity component.

IAS 32 Financial Instruments: Presentation requires compound financial instruments to

be split into their component parts, i.e.: a financial liability (the debt component); and
an equity instrument (the option to convert into shares).

The financial instrument is split by first determining the debt component. The debt
component is calculated as the present value of future cash flows of the instrument
discounted using the current interest rate for similar bonds without the conversion
rights.

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The equity component is then calculated by deducting the debt component from the
proceeds of the instrument.

Any transaction costs are then apportioned to the debt and equity components in
proportion to the allocation of proceeds.

IAS 32 specifies presentation for financial instruments. The recognition and

measurement and the disclosure of financial instruments are the subjects of IFRS 9 or
IAS 39 and IFRS 7 respectively.

For presentation, financial instruments are classified into financial assets, financial
liabilities and equity instruments. Differentiation between a financial liability and equity
depends on whether an entity has an obligation to deliver cash (or some other financial
asset).

However, exceptions apply. When a transaction will be settled in the issuer’s own
shares, classification depends on whether the number of shares to be issued is fixed or
variable.

A compound financial instrument, such as a convertible bond, is split into equity and
liability components. When the instrument is issued, the equity component is measured
as the difference between the fair value of the compound instrument and the fair value
of the liability component.

Financial assets and financial liabilities are offset only when the entity has a legally
enforceable right to set off the recognized amounts, and intends either to settle on a
net basis or to realize the asset and settle the liability simultaneously.

While the vast majority of financial instruments create a financial asset in one entity and
a financial liability or equity instrument in the accounts of another entity, it is possible
that a single financial instrument can create a financial asset in one entity and a financial
liability and an equity instrument in another entity. The classic example of this arises
when an entity issues a convertible bond.

Convertible bonds are basically debt instruments but they also contain an option to
convert into equity shares and this means that a convertible bond contains both debt
and equity elements. The option to convert into equity is strictly a derivative that is
embedded into the host contract. The option will be exercisable by the holder of the
bond who has the option to require settlement of the debt in equity shares rather than
being repaid in cash. For accounting purposes it will be necessary on initial recognition
to split out the debt and equity elements so that they can be separately accounted for.

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The fair value of the option is highly subjective, but the fair value of the debt element is
more easily measured by discounting the future cash flows. The assumption is then
made that the fair value of the option is the balancing figure.

The new standard applies to all types of financial assets, except for investments in
subsidiaries, associates and joint ventures and pension schemes, as these are all
accounted for under various other accounting standards.

IFRS 9, Financial Instruments has simplified the way that financial assets are accounted.
As with financial liabilities the standard retains a mixed measurement system for
financial assets, allowing some to be stated at fair value while others at amortized cost.
On the same basis that when an entity issues a financial instrument it has to classify it as
a financial liability or equity instrument, so when an entity acquires a financial asset it
will be acquiring a debt asset (e.g. an investment in bonds, trade receivables) or an
equity asset (e.g. an investment in ordinary shares). Financial assets have to be classified
and accounted for in one of three categories: amortized cost, FVTPL or Fair Value
Through Other Comprehensive Income (FVTOCI). They are initially measured at fair
value plus, in the case of a financial asset not at FVTPL, transaction costs.

A financial asset that is a debt instrument will be subsequently accounted for using
amortized cost if it meets two simple tests. These two tests are the business model test
and the cash flow test.

The business model test is met where the purpose is to hold the asset to collect the
contractual cash flows (rather than to sell it prior to maturity to realize its fair value
changes). The cash flow test will be met when the contractual terms of the asset give
rise on specified dates to cash flows that are solely receipts of either the principal or
interest.

These tests are designed to ensure that the fair value of the asset is irrelevant, as even if
interest rates fall – causing the fair value to raise – then the asset will still be passively
held to receive interest and capital and not be sold on.

However, even if the asset meets the two tests there is still a fair value option to
designate it as FVTPL if doing so eliminates or significantly reduces a measurement or
recognition inconsistency (an 'accounting mismatch') that would otherwise arise from
measuring assets or liabilities or recognizing the gains and losses on them on different
bases. An example of where it is appropriate to use the fair value option and, thus,
avoid an accounting mismatch is where an entity holds a financial asset that is debt and
that carries a fixed rate of interest, but is then hedged with an interest rate swap that
swaps the fixed rates for floating rates. The interest swap is a financial instrument that
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would be held at FVTPL and so, accordingly, the financial asset classified as debt also
needs to be at FVTPL to ensure that the gains and losses arising from both instruments
are naturally paired in income and, thus, reflect the substance of the hedge. If the
financial asset classified as debt was accounted for at amortized cost, then this would
create the accounting mismatch.

All other financial assets that are debt instruments must be measured at FVTPL.

Accounting for financial assets that are equity instruments (for example, investments in
equity shares)

Equity investments have to be measured at fair value in the statement of financial

position. As with financial assets that are debt instruments, the default position for
equity investments is that the gains and losses arising are recognized in income (FVTPL).
However, there is an election that equity investments can at inception be irrevocably
classified and accounted as FVTOCI, so that gains and losses arising are recognized in
other comprehensive income, thus creating an equity reserve, while dividend income is
still recognized in income. Such an election cannot be made if the equity investment is
acquired for trading. On disposal of an equity investment accounted for as FVTOCI, the
gain or loss to be recognized in income is the difference between the sale proceeds and
the carrying value. Gains or losses previously recognized in other comprehensive income
cannot be recycled to income as part of the gain on disposal.

As we have seen once an equity investment has been classified as FVTOCI this is
irrevocable so it cannot then be reclassified. Nor can a financial asset be reclassified
where the fair value option has been exercised. However if, and only if the entity's
business model objective for its financial assets changes so its previous model
assessment would no longer apply then other financial assets can be reclassified
between FVTPL and amortized cost, or vice versa. Any reclassification is done
prospectively from the reclassification date without restating any previously recognized
gains, losses, or interest.

Under the suggested new requirements of IFRS 9, Financial Instruments, only financial
assets measured at amortized cost will be subject to impairment reviews. It is also
proposed that an expected loss model towards impairment reviews be introduced when
reviewing these financial assets. The expected loss model requires that entities
determine and account for expected credit losses when the asset is originated or
acquired rather than wait for an actual default. This is achieved by making an allowance
for the initial expected losses over the life of the asset by considering a reduction in the
interest revenue.

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