FAAC Rules (Financial asset held at amortized cost)

1.) The bond shall be amortized.

Amortized Cost

Amount at which the financial asset or financial liability is measured at initial recognition minus
principal repayments, plus or minus the cumulative amortization using the effective interest
method of any difference between the initial amount and the maturity amount and, for financial
assets adjusted for any loss allowance.

The amortized cost of the investment in bonds is determined using the effective interest method.

Effective Interest Method

Method of calculating the amortized cost of a financial asset or a financial liability and of allocating
the interest income or interest expense over the relevant period.

Effective Interest Rate

Rate that exactly discounts estimated future cash payments or receipts through the expected life of
the financial instrument or when appropriate , a shorter period to the carrying amount of the
financial asset or financial liability.

Other terms : Yield Rate, Market Rate, Imputed Rate of Interest

Difference between premium and Discount

Discount Premium
Acquisition cost is less than Face Amount Acquisition cost is more than Face Amount
Effective interest rate is greater than Nominal Effective interest rate is less than Nominal Rate
Rate

Recognition of Interest Income and Interest Receivable

Interest Income Effective Interest Rate X Present Value

Interest Receivable Nominal Interest Rate X Face Amount

Problem - Premium

On January 1 , 20x1 , ABC Co. acquired 12%, P1,000,000 bonds for P1,049,737. The principal is due
on December 31, 20x3 but interest is due annually starting December 31, 20x1 . The effective
interest due on the bonds is 10%. The bonds are classified investment measured at amortized cost.
Step 1 : Confirm that the Present Value is P1,049,737

Present Value for the Principal

P1,000,000 X 1.10 ( raised to negative 3 ) = 751,315

Present Value for the Yearly Interest

P1,000,000 x 0.12 = P120,000 X 1-1.10(raised to negative 3) = 298,422

0.10
= 751, 315 + 298,422 = 1,049,737

This is considered a premium because

1.) The present value (P1,049,737) is higher than the face amount ( P1,000,000)

2.) The nominal rate (12%) is higher than effective rate (10 %)

Step 2 : Create an amortization table

Date Interest Received Interest Income Amortization Present Value

Jan. 1 , 20x1 1,049,737
Dec. 31, 20x1 120,000 104,974 15,026 1,034,711
Dec. 31, 20x2 120,000 103,471 16,529 1,018,132
Dec. 31, 20x3 120,000 101,818 18,182 1,000,000

Journal Entries – ABC Company

Jan. 1, FAAC 1,049,737

20x1 Cash 1,049,737

Dec. 31, Cash 120,000

20x1 FAAC 15,026
Interest Income 104,974

Dec. 31, Cash 120,000

20x2 FAAC 16,529
Interest Income 103,471

Dec. 31, Cash 120,000

20x3 FAAC 18,182
Interest Income 101,818
Dec. 31, Cash 1,000,000
20x3 FAAC 1,000,000

Problem – Discount

On January 1 , 20x1 , ABC Co. acquired 10% P1,000,000 bonds for P951,963. The principal is due on
December 31 , 20x3 but interest is due annually every January 1 . The yield rate on the bond is 12%
. The bonds are classified as investment account at amortized cost.

Step 1 : Confirm that the Present Value is P951,963

Present Value for the Principal

P1,000,000 X 1.12 ( raised to negative 3 ) = 711,780

Present Value for the Yearly Interest

P1,000,000 x 0.1 = P100,000 X 1-1.12(raised to negative 3) = 240,183
0.12
= 711,780 + 240, 183 = 951, 963

This is considered a premium because

1.) The face amount (P1,000,000) is higher than present value ( P951,963)

2.) The effective rate (12%) is higher than nominal rate (10 %)

Step 2 : Create an amortization table

Date Interest Received Interest Income Amortization Present Value

Jan. 1 , 20x1 951,963
Dec. 31, 20x1 100,000 114,236 14,236 966,199
Dec. 31, 20x2 100,000 115,944 15,944 982,143
Dec. 31, 20x3 100,000 117,857 17,857 1,000,000

Journal Entries – ABC Company

Jan. 1, FAAC 951,963

20x1 Cash 951,963

Dec. 31, Cash 100,000

20x1 FAAC 14,236
Interest Income 114,236
Dec. 31, Cash 100,000
20x2 FAAC 15,944
Interest Income 115,944

Dec. 31, Cash 100,000

20x3 FAAC 17,857
Interest Income 117,857

Dec. 31, Cash 1,000,000

20x3 FAAC 1,000,000