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Course Code AE 16
Introduction
PFRS 9 requires the use of Effective interest method in amortizing discount on bonds payable,
premium on bonds payable and bond issue cost.
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PFRS 9 requires that discount on bonds payable, premium on bonds payable and bond issue cost
shall be amortized using the effective interest method.
The effective rate is the rate that exactly discounts estimated cash future payments through the
expected life of the bonds payable or when appropriate, a shorter period to the net carrying amount
of the bonds payable.
• When bonds are sold at a premium, the effective rate is lower than the nominal rate.
• When bonds are sold at a discount, the effective rate is higher than the nominal rate.
Under the effective interest method, the effective interest expense is determined by multiplying
the effective rate by the carrying amount of the bonds.
The carrying amount of the bonds changes every year as the amount of premium or discount is
amortized periodically.
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Cash 964,540
Discount on bonds payable (1,000,000 – 964,540) 35,460
Bonds payable (at face amount) 1,000,000
Note: Payment of semiannual interest and the periodic amortization of the discount are
compounded in one entry. This items can be recorded separately.
Another illustration
On January 1, 2020, Wolf company issued 10% bonds in the face amount of P5,000,000,
which mature on January 1, 2030. The bonds were issued for P5,675,000 to yield 8%,
resulting in the premium of P675,000.
The entity used the interest method of amortizing bond premium. Interest is payable annually
on December 31.
Required:
1. What is the balance of the premium on bonds payable on December 31, 2020?
2. What is the carrying amount of bonds payable on December 31, 2020?
Answers:
Interest Premium Carrying
Interest Paid
Date Expense amortization amount
1.
Premium on bonds payable (5,675,000 – 5,000,000) 675,000
Less: Premium amortization – 12/31/20 46,000
Balance of the premium on bonds payable – 12/31/20 629,000
2. Carrying amount of bonds payable on 12/31/20: 5,629,000
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The market price or issue price of bonds payable is equal to the present value of the principal
bond liability plus the present value of the future interest payments using the effective or market
rate of interest.
The present value of the principal bond liability is equal to the face amount of the bond multiplied
by the present value of 1 factor at the effective rate for a number of interest periods.
The present value of the future interest payments is equal to the periodic nominal interest
multiplied by the present value of an ordinary annuity of 1 factor at the effective rate for a number
of interest periods.
In other words, the market price of bonds payable is equal to the sum of the following:
a. Present value of bonds payable (face amount of bonds x PV of 1 factor)
b. Present value of the total interest payments (Periodic nominal interest x PV of an ordinary
annuity of 1 factor)
Note: The semiannual interest payment of P300,000 is computed by multiplying the face
amount of P5,000,000 by the semiannual nominal rate of 6% (12% / 2).
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PFRS 9 provides that transaction costs that are directly attributable to the issue of
financial liability shall be included in the initial measurement of financial liability.
Transaction costs are fees and commissions paid to agents, advisers, brokers and dealers,
levies by regulatory agencies and security exchange, and transfer taxes and duties.
Transaction costs include bond issue costs.
These bond issue costs will increase discount on bonds payable and will decrease
premium on bonds payable.
Under the effective interest method, bond issue cost must be “lumped” with the discount on
bonds payable and “netted” against the premium on bonds payable
Note: The effective rate is 10% but because of the bond issue cost, the effective rate must be
higher than 10%. The problem is to find an effective rate that will equate the present value
of the cash outflows for the bonds payable to the net proceeds of P9,511,330.
The effective rate cannot be computed algebraically but by means of trial and error or the
interpolation process.
By trial and error, using a new effective rate of 11%:
Present value of 1 for 3 periods is - .7312
Present value of an ordinary annuity of 1 is – 2.4437
The present value of the bonds payable using an interest rate of 11% is computed as follows:
PV of principal (10,000,000 x .7312) 7,312,000
PV of interest payments (900,000 x 2.4437) 2,199,330
Total present value of bonds 9,511,330
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12/31/20 – Payment of annual interest and discount amortization using effective interest
method.
Interest expense (10,000,000 x 9%) 900,000
Cash 900,000
Interest expense 146,246
Discount on bonds payable (9,511,330 x11%) - (10,000,000 x 9%) 146,246
Again, the problem is to find an effective rate applicable to the proceeds of P9,300,000. Since,
the bonds are issued at a discount, the effective rate must be higher than nominal rate of 10%.
By interpolation, using a rate of 11%, the PV of 1 for 5 periods is .5935 and the PV of an
ordinary annuity of 1 is 3.6959. The total present value of bonds would be P9,630,900.
The net proceeds of P9,300,000 are lower than the present value of bonds payable of
P9,630,900 using 11% interest rate. This means that the effective rate must be higher than
11%.
So, another interpolation is made using the rate of 12%. The PV of 1 for 5 periods at 12% is
.5674. The PV of an ordinary annuity of 1 for 5 periods at 12% is 3.6048. Thus, the total present
value of bonds would be P9,278,800.
This time, the net proceeds of P9,300,000 are higher than the present value of bonds payable
of P9,278,800 using 12% interest rate. This means that the effective rate must be lower than
12%.
In conclusion, the effective interest rate must be between 11% and 12%.
The difference between 11% and 12% is interpolated as follows:
Let X as the unknown effective interest rate
(X – 11%) / (12% - 11%)
(9,300,000 – 9,630,900) / (9,278,800 – 9,630,900)
330,900 / 352,100 = 0.94
This difference of .94 between 11% and 12% is added to 11% to get an effective rate of
11.94%.
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Thus, the PV of 1 for 5 periods at 11.94 % effective rate is .56895 and the PV of an ordinary
annuity of 1 for 5 periods at 11.94% effective rate is 3.61014. The present value of bonds is
computed as follows:
PV of principal (10,000,000 x .56895) 5,689,500
PV of interest payments (1,000,000 x 3.61014) 3,610,140
Total present value of bonds 9,299,840 or 9,300,000
Answers:
1. Interest expense (5,700,000 x 12% x 6/12) 342,000
Interest paid (6,000,000 x 10% x 6/12) 300,000
Discount amortization – 7/1/2020 42,000
Add: carrying amount – 1/1/2020 5,700,000
Carrying amount of bonds payable – 7/1/2020 5,742,000
-end-
Prepared by:
Instructor
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