CHAPTER 7: BONDS PAYABLE

Introduction

When an entity is in need to generate cash, it issues bonds. The entity is the
issuer of the bonds and becomes a borrower. Thus, the issuance of the bonds by the
entity establishes a liability.

Moreover, bond is a debt security in which the bond issuer is obliged to pay
interest and principal when the maturity date is due. Commonly, bonds are issued
with an intention to hold it for a long period of time. Typically, it is classified as a long-
term obligation hence; it is presented in the noncurrent liabilities portion of the
statement of financial position. However, the current portion of the bonds is
presented as current liabilities in the statement of financial position.

Consequently, this chapter will discuss the accounting treatment and

procedure for bonds payable, its measurement, manner of issuances and
amortization method. It will also discuss the accounting treatment for a compound
financial instrument and retirement of the bonds.

Learning Outcomes

Upon completion in this chapter, students should be able to:

 Define bond and identify its classification.

 Discuss the measurement of a bond payable.
 Explain the issuance of a bond payable.
 Define bond refunding and explain its accounting treatment.
 Explain the methods of amortizing bonds payable.
 Define compound financial instrument.
 Explain the accounting for compound financial instruments
 Explain the accounting for retirement of bonds payable.

LESSON 1: DEFINITION OF BOND AND ITS CLASSIFICATION

The standards defines a bond as 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. In other
words, a bond is contract whereby one party, called the issuer, borrows fund from
another company, called the investor, and agreed to pay the interest and principal
when it matures.

The issuance of the bonds is evidenced by a certificate and a contract of debt

known as bond indenture.

 Classification of bonds

1. Term bond – bond that matures in a single date

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 2. Serial bond – bond that matures in a series of payments.

3. Mortgage bond – bond secured by a real property

4. Collateral bond – bond secured by shares or bonds by another entity

5. Debenture bonds – bond without security or collateral

6. Registered bond – bond registered in the books of the entity as a bondholder

7. Coupon or bearer bond – bond that are unregistered in the books of the entity

8. Convertible bond – bond that is converted or exchanged for shares of stocks

of the issuing company

9. Callable bond – bond which can be called for or redeemed prior to its maturity
date

10. Junk bond – bond which are high-risk, high-yield bonds issued by entity that
are heavily indebted

11. Zero-coupon bond – bond that pay no interest but it offers a return in the form
of “deep discount” or huge discount from the face amount.

12. Treasury bond – bond of the issued by the issuing company but reacquired but
not cancelled.

LESSON 2: MEASUREMENT

 Initial Measurement – carried at cost minus incidental cost incurred that are
directly attributable to the issuance of the bond, also called bond issue cost.

However if the bonds is designated at fair value, it is measured at fair value

less any incidental cost incurred that is directly attributable to the issuance of
the bond. Bond issue cost in this bond is to be expensed outright.

 Subsequent Measurement

a. Amortized cost, using the effective interest method as the benchmark

treatment

b. If designated at fair value through profit or loss – carried at fair value

LESSON 3: ISSUANCE OF THE BONDS PAYABLE

 Issuance on the interest date

There is no problem when the bond is issued on the interest date. It could
mean that the issue price of the bond has no inclusion of any accrued interest.

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  Issuance between interest date

When bond is issued between interest dates, any accrued interest is part of
the issue price. Any accrued interest included in the issue price considered as sold
and credited to interest expense.

 Issuance at a premium

Bonds can be issued at a premium or a discount. There is a premium when:

1. Issue Price > Face amount; or

2. Nominal Rate > Effective Rate

Premium on bonds payable is a gain on the part of the issuer because it

receives more than what he is obliged to settle.

 Issuance at a discount

There is a discount when:

1. Issue Price < Face amount; or

2. Nominal Rate < Effective Rate

Discount on bonds payable is a loss on the part of the issuer because it

receives less than what he is obliged to settle.

 Computation for issue price

The following are formulas to compute for the issue price of the bond:

1. Term bond

PV of Face amount xx
Add: PV of interest xx
Issue Price xx

2. Serial bond

Issue Price = Sum of (PV of interest + Installment payment)

LESSON 4: AMORTIZATION OF PREMIUM OR DISCOUNT

1. Straight-line method – provides for equal amortization

Premium∨Discount
Amortization=
Life

2. Bond outstanding method – applies to a serial bond

Bond Outstanding
Amortization= x Premium/ Discount
Total Bond Outstanding

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 3. Effective interest method – benchmark treatment

The terms and formula are used to compute for the amortization
using the effective interest method:

a. Nominal rate/stated rate/coupon rate – rate that is agreed and

written in the bond certificate.

b. Effective rate/market rate/yield rate –rate that discounts the

future payments

c. Interest Paid∨Nominal Interest=Face Amo unt x Nominal Rate

d.
Interest Expense∨Effective Interest =Carrying Amount x Effective Rate

e. Amortization=Nominal Interest −Effective Inter est

f. Premium Amortization=Nominal Interest > Effective Interest

OR

Premium Amortization=Nominal Interest−Effective Interest

g. Discount Amortization=Nominal Interest < Effective Interest

OR

Discount Amortization=Effective Interest + Nominal Interest

h.
Carrying amount ( if premium )=Carrying amount−Premium Amortization

Carrying amount ( if discount )=Carrying amount + Discount Amortization

LESSON 5: ACCOUNTING FOR BONDS PAYABLE

Issuance of bonds payable can be accounted by applying either

memorandum entry or journal entry.

Memorandum Entry Journal Entry

Authorization No entry Unissued bonds payable xx
Authorized bonds payable xx
Issuance of bonds Cash xx Cash xx
Bonds payable xx Unissued bonds payable xx
This is commonly used
method to account for
bonds payable

The following are additional entries to account for bonds payable:

Transaction Premium Discount

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 Issuance of Cash xx Cash xx
bonds Bonds payable xx Discount on bonds payable xx
Premium on bonds payable xx Bonds payable xx
Payment of Interest Expense xx
interest Cash xx
Accrual of Interest Expense xx
interest Accrued Interest Payable xx
Amortization Premium on bonds payable xx Interest Expense xx
Interest Expense xx Discount on bonds payable xx

LESSON 6: COMPOUND FINANCIAL INSTRUMENT (PAS 32)

 Financial liability

PAS 32 defines financial liability as any liability that is a contractual obligation

to:

1. Deliver cash or other financial asset to another entity; or

2. Exchange financial instruments with another entity under conditions that

are potentially unfavorable.

Example of financial liability includes trade accounts payable, notes payable,

loan payable, bonds payable and etc.

 Equity instrument

PAS 32 defines equity instrument as any contract that evidences a residual

interest in the assets of an entity after deducting all of the liabilities. It includes,
ordinary capital, preference capital, share warrant and share option.

 Financial liability vs. Equity instrument

To classify an instrument as either financial liability or equity instrument, PAS

32 provides that it will be in accordance with the contractual arrangement and the
definition of a financial liability, financial asset and equity instrument.

PAS 32 further provides that to classify an instrument as an equity instrument,

if it has no contractual obligation to deliver cash or another financial asset.

 Compound financial instrument

PAS 32 defines compound financial instrument as a financial instrument that

contains both a liability and an equity element from the perspective of the issuer.

In other words, these are financial instruments that meet the criteria for
recognition both as a financial liability and equity instrument.

Examples of compound financial instrument are bonds payable with share

warrants and convertible bonds.

 Accounting for compound financial instrument

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 PAS 32 requires that when a financial instrument meets the definition of a
compound financial instrument it should be accounted for separately. The process of
separating compound financial instrument is called split accounting. It means that the
issue price is allocated between the financial liability and the equity instrument. The
fair market value of the financial liability is determined first and the residual is for the
equity instrument.

LESSON 7: BONDS PAYABLE ISSUED WITH SHARE WARRANTS

Bonds payable issued with share warrants consists of a bond payable, which
is the financial liability component, and share warrants, as the equity component.
Share warrants can be classified as detachable or non-detachable. However PAS 32
provides that in accounting for bonds payable issued with share warrants, it does not
differentiate whether it is detachable or non-detachable.

 Accounting Procedure

1. Determine the issue price of the bonds payable with share warrant.

2. Determine the market value of the bonds without share warrant. In the
absence of the market value, present value of the bond.

3. Deduct the market value of the bonds without share warrant from the issue
price. The difference is the equity component or the share warrant
outstanding.

 Journal entries – (same entries on interest expense, accrual of interest and amortization)

Transaction Entry/ies
Cash xx
Discount on bonds payable xx
Issuance of bonds
Bonds payable xx
payable
Premium on bonds payable xx
Share warrant outstanding xx
Cash xx
Exercise of share Share warrant outstanding xx
warrant Share capital xx
Share premium xx
Expiration of share Share warrant outstanding xx
warrant Share premium – unexercised warrant xx

LESSON 8: CONVERTIBLE BONDS

Convertible bonds are bonds which gives the holder the right to convert each
bond into shares capital within the specified period of time.

 Convertible bonds issued originally

Issuances of the convertible bonds are considered as compound financial

liabilities. Therefore, it meets the definition as a financial liability and equity
instrument.

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  Accounting Procedure

1. Determine the issue price of the bonds payable with conversion privilege.

2. Determine the market value of the bonds without conversion privilege. In the
absence of the market value, present value of the bond.

3. Deduct the market value of the bonds without share warrant from the issue
price. The difference is the equity component.

4. Any expenses incurred in relation to the conversion are to be accounted as a

deduction from share premium or debited to share issue cost.

5. The amortization of discount and issue cost or premium will be up to the date
of conversion.

6. The bonds payable converted shall be cancelled together with its related
unamortized discount or premium. If only a portion of the bonds payable is
converted, only the allocated portion will be cancelled.

 Journal entries – (same entries on interest expense, accrual of interest and amortization)

Transaction Entry/ies
Cash xx
Discount on bonds payable xx
Issuance of bonds
Bonds payable xx
payable
Premium on bonds payable xx
Share premium – conversion privilege xx
Bonds payable xx
Premium on bonds payable xx
Share premium – conversion privilege xx
Conversion of
Interest expense (accrued interest, if any) xx
bonds payable
Share capital xx
Share premium – issuance xx
Cash (for accrued interest) xx
Payment of bonds Bonds payable xx
payable on Interest expense xx
maturity Cash xx
Bonds payable xx
Payment of bonds Premium on bonds payable xx
payable before Share premium – conversion privilege xx
maturity Cash xx
Gain on extinguishment xx
Expiration of Share premium – conversion option xx
conversion Share premium – issuance xx
privilege

LESSON 9: BOND REFUNDING

Bond refunding or refinancing is issuing another bonds to pay for the existing
bonds payable. It could be done on or before the maturity date of the original and
existing bonds. It is merely cancellation of the old bonds payable by issuing new
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bonds payable. The cancellation or retirement is done in the usual manner. The
difference between the carrying amount of the old bonds payable and the
consideration paid is included in profit or loss. Any refunding charges are to be
accounted in the profit or loss statement as loss on extinguishment of bonds. The
refunding charges include any unamortized discount or premium and the redemption
premium on the old bonds payable to be refunded.

LESSON 10: RETIREMENT OF BONDS PAYABLE

Retirement of bonds payable means that it is to be paid by the entity. The

retirement can either be on or before the date of maturity. In case the bonds are
retired prior to its maturity, all related accounts shall also be charged against the
retired bonds payable. Discount or premium and bond issue cost is to be amortized
until the related bonds payable is retired. If only a portion of the bonds payable is
retired, all related accounts to the retired bonds payable will be only be prorated
against the entire bonds payable.

The difference between the retirement price and the carrying amount of the
bonds is to be accounted for as a gain or loss on retirement of the bonds. There is
gain when the retirement price is lesser than the carrying amount of the bonds.
However there is a loss when the retirement price is greater than the carrying amount
of the bonds. The retirement price includes the cash payment plus any accrued
interest.

EXERCISES

Solve the following problems independently. Write your solution and double rule your
answers.

1. On March 1, 2019, Rons Corporation issued at 103 plus accrued interest, 1,000
of its 9%, P 1,000 bonds. The bonds are dated January 1, 2019 and matured on
January 1, 2029. Interest is payable semi-annually on January 1 and July 1. Rons
paid transaction costs of P 5,000. Based on the given information, how much
would Rons realize as net cash receipts from the bond issuance?

2. Ejun Co. issues P 5,000,000, 6% 5-year bonds dated January 1, 2019. The
bonds pay interest semiannually on June 30 and December 31. The bonds are
issued to yield 5%. What is the proceeds from the bond issue?

3. On July 1, 2019, Sheena Corp. issued 11% bonds in the face amount of P
2,000,000 that mature on June 30, 2023. The bonds were issued to yield 5% and
interest is payable every January 1 and July 1. Glamorous Corp. uses the
effective interest method of amortizing bond premium or discount. What is the
carrying amount of the debt instrument on December 31, 2019?

4. At the beginning of 2019, Deo Company issued 10% bonds with a face value of P
900,000. These bonds mature in five years, and interest is paid semiannually on
June 30 and December 31. The bonds were sold for P 833,760 to yield 12%. Deo
uses a calendar year reporting period. Using the effective-interest method of
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 amortization, what amount of interest expense should be reported for 2019?
(Round your answer to the nearest peso)

5. On January 1, 2015, Aracelli Company issued its 8%, 4-year convertible debt
instrument with a face amount of P 6,000,000 for P 5,900,000. Interest is payable
every December 31 of each year. The debt instrument is convertible into 50,000
ordinary shares with a par value of P100. When the debt instruments were
issued, the prevailing market rate of interest for similar debt without conversion
option is 10%. What is the amortized cost of the debt as of December 31, 2019?

6. On January 1, 2017, Agnes Company issued its 10%, 4-year convertible debt
instrument with a face amount of P 3,000,000 for P 3,500,000. Interest is payable
every December 31 of each year. The debt instrument is convertible into 30,000
ordinary shares with a par value of P100. The debt instrument is convertible into
equity from the time of issue until maturity. When the debt instruments were
issued, the prevailing market rate of interest for similar debt without conversion
option is 8%. On December 31, 2019, Agnes Company converted all the debt
instruments by issuing 30,000 ordinary shares. What is the carrying amount of
the compound instruments as of December 31, 2019?

7 – 10 items are based on the following information:

On January 1, 2017, Janice Company issued its 8%, 5-year convertible debt
instrument with a face amount of P 8,000,000 for P 7,700,000. Interest is payable
every December 31 of each year. The debt instrument is convertible into 50,000
ordinary shares with a par value of P100. When the debt instruments were issued,
the prevailing market rate of interest for similar debt without conversion option is
10%. On December 31, 2019, all the convertible debt instruments were retired for P
8,000,000. The prevailing rate of interest on a similar debt instrument as of
December 31, 2019 is 9% without the conversion option.

7. What is the carrying amount of the debt instruments as of December 31, 2019?

8. On the date of retirement, what amount of the payments represents the equity
component?

9. What amount of gain or loss that should be reported in the profit or loss on the
retirement of the convertible debt instruments?

10. What amount of gain or loss that should be reported directly in the shareholder’s
equity on the retirement of the convertible debt instrument?

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