NEW BRIGHTON SCHOOL OF THE PHILIPPINES, Inx`C.

Module No. 4
Subject: Intermediate Accounting 2 Date of Submission: ____________
Name of Student: __________________________________________________
Course and Year: __________________________________________________
Semester and School Year: __________________________________________

FINANCIAL INSTRUMENT
PAS 32, paragraph 11, defines a financial instrument as any contract that gives rise to both a financial asset of one
entity and a financial liability or equity instrument of another entity.

Thus, the term “financial instrument” encompasses a financial asset, a financial liability and an equity instrument.

From the definition, the characteristics of a financial instrument are:

a. There must be a contract.
b. There are at least two parties to the contract.
c. The contract shall give rise to a financial asset of one party and financial liability or equity instrument of
another party.

Examples of financial instrument

1. Cash in the form of notes and coins – This is a financial asset of the holder or bearer and a financial liability of
the issuing government.

2. Cash in the form of checks – This is a financial asset of the payee and a financial liability of the drawer or
issuer.

3. Cash in bank – This is a financial asset of the depositor and a financial liability of the depository bank.

4. Trade accounts – This is a financial asset of the seller as accounts receivable and a financial liability of the
customer or buyer as accounts payable.

5. Notes and loans – This is a financial asset of the lender or creditor as notes receivable or loans receivable and
a financial liability of the borrower or debtor as notes payable or loans payable.

6. Debt securities – This is a financial asset of the investor and a financial liability of the issuer.

7. Equity securities – This is a financial asset of the investor and an equity of the issuer.
Note that most financial instruments involve one party having a contractual right to receive cash or another financial
asset and another party having a contractual obligation to deliver cash or another financial asset.

Financial liability

A financial liability is any liability that is a contractual obligation:

a. To deliver cash or other financial asset to another entity.

b. To exchange financial instruments with another entity under conditions that are potentially unfavorable.

Examples of financial liabilities

Financial liabilities representing a contractual obligation to deliver cash in the future include:
a. Trade accounts payable
b. Notes payable
c. Loans payable
d. Bonds payable

Nonfinancial liabilities

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a. Item such as deferred revenue and warranty obligations are not financial liabilities because the outflow of
economic benefits associated with them is the delivery of goods and services rather than a contractual obligation to
pay cash or another financial asset.

b. Liabilities, such as income taxes payable that are created as a result of statutory requirements imposed by
government are not also financial liabilities.

c. Constructive obligations are not financial liabilities because the obligations do not arise from contracts.

A contractual obligation to exchange under potentially unfavorable condition is an option written or issued by the issuer
to sell shares in a specified entity at less than market price. This contractual obligation is a financial liability.

Equity instrument

An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of
its liabilities. It reflects the basic accounting equation that equity equals asset minus liability.

Equity instruments include ordinary share capital, preference share capital and warrants or option.

Compound financial instrument

PAS 32, paragraph 28, defines a 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, one component of the financial instrument meets the definition of a financial liability and another
component of the financial instrument meets the definition of an equity instrument.

The common examples of compound financial instrument are as follows:

a. Bonds payable issued with share warrants

b. Convertible bonds payable
Accounting for compound instrument

The issuer of a financial instrument shall evaluate the terms of the instrument whether it contains both a liability and an
equity component.

If the financial instrument contains both a liability and an equity component, PAS 32 mandates that such components
shall be accounted for separately. The approach in accounting for a compound financial instrument is to apply “slip
accounting”.

This means that the consideration received from the issuance of the compound financial instrument shall be allocated
between the liability and equity components.

In other words, the fair value of the liability component is first determined.

The fair value of the liability component is then deducted from the total consideration received from the issuance of the
compound financial instrument. The residual amount is allocated to the equity component.

Bonds payable issued with share warrants

Share warrants are granted to enable the holders to acquire equity shares at a specified price during a definite period.

When the bonds are sold with share warrants, the bondholders are given the right to acquire shares of the issuing entity
at a specified price at some future time.

Actually, in this case, two securities are sold – the bonds and the share warrants.

Share warrants attached to a bond may be detachable or nondetachable.

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Detachable warrants can be traded separately from the bond and nondetachable warrants cannot be traded separately.

Bonds issued with share warrants are considered as compound financial instrument. Accordingly, the issuer of the
bonds payable shall classify the liability and equity components separately.

PAS 32 does not differentiate whether the equity component is detachable or nondetachable.

Whether detachable or nondetachable, the warrants have a value and therefore shall be accounted for separately.

Allocation of issue price

The bonds are assigned an amount equal to the “market value of the bonds ex-warrants”, regardless of the market
value of the warrants. The residual amount or remainder of the issue price shall then be allocated to the warrants.

Illustration
An entity sells 5,000 10-year bonds, face value P1,000, at 105. Each bond is accomplished by one warrant that permits
the bondholder to purchase 20 equity shares, par P50, at P55 per share, or a total of 100,000 share, 5,000 x 20.
The market value of the bond ex-warrant at the time of issuance is 98.

1. To record the issuance of the bonds:

Cash (5,000,000 x 105) 5,250,000

Discount on bonds payable 100,000
Bonds payable 5,000,000
Share warrants outstanding 350,000

Issue price of bonds with warrants 5,250,000

Market value of bonds ex-warrants (5,000,000 x 98) (4,900,000)
Residual amount allocated to warrants 350,000

2. To record the exercise of 60% of the warrants:

Cash (60,000 shares x 55) 3,300,000

Share warrants outstanding (60% x 350,000) 210,000
Share capital (60,000 shares x 50) 3,000,000
Share premium 510,000

3. To record the expiration of the remaining warrants:

Share warrants outstanding 140,000

Share premium – unexercised warrants 140,000

Market value of bonds ex-warrants unknown

In the preceding illustration, the market value of the bonds ex-warrants of 98 is available. Suppose such market value is
not known.

In such a case, the amount allocated to the bonds 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 interest rate for similar bonds without the
warrants.

Using the preceding illustration, assume the interest is payable annually at a nominal rate of 10% per annum. When
the bonds are issued, the prevailing market rate of interest for similar bonds without warrants is 12% per annum.

The present value of 1 at 12% for 10 periods is 0.322 and the present value of an ordinary annuity of a1 at 12% for 10
periods is 5.65.

The present value of the bonds payable is computed as follows:

Present value of principal (5,000,000 x 0.322) 1,610,000

Present value of interest payments (10% x 5,000,000 = 500,000 x 5.65 ) 2,825,000
Total present value 4,435,000

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Issue price of bonds with warrants 5,250,000
Present value of bonds payable (4,435,000)
Residual amount allocated to warrants 815,000

The journal entry to record the issuance of the bonds is:

Cash 5,250,000
Discount on bonds payable 565,000
Bonds payable 5,000,000
Share warrants outstanding 815,000

Convertible bonds

Convertible bonds are those which give the holders the right to convert their bond holdings into share capital or other
securities of the issuing entity within a specified period of time.

For example, a 15-year, P1,000 bond may be convertible into 20 shares of capital during the first five years from the
date of issue, 10 shares of capital the next five years and may not be convertible during the last five years.

When convertible bonds are issued at a premium or discount, amortization period is up to the maturity date instead of
the conversion date because it is impossible to predict, if at all, that the conversion privilege will be exercised.

Accounting problems arise in two situations, namely:

a. When the convertible bonds are originally issued
b. When the convertible bonds are converted
Original issuance
Convertible bonds are conceived as compound financial instruments. Accordingly, the issuance of convertible bonds
shall be accounted for as partly liability and partly equity.

In other words, the issue price of the convertible bonds shall be allocated between the bonds payable and the
conversion privilege.

Allocation of issue price

The economic effect of issuing convertible bonds is substantially the same as issuing simultaneously bonds payable
with share warrants.

The bonds are assigned an amount equal to the market value of the bonds without the conversion privilege. The
residual amount or remainder of the issue price shall then be allocated to the conversion privilege or equity
component.

In the absence of market value of the bonds without conversion privilege, the amount allocated to the bonds is equal to
the present value of the principal bond liability plus the present value of future interest payments using the
effective or market interest rate for similar bonds without conversion privilege.

Illustration
An entity issued 5,000, 5-year bonds, face amount P1,000 each at 105.

The bonds contain a conversion privilege that provides for an exchange of a P1,000 bond for 20 equity shares with par
value of P50. It is reliably determined that the bonds would sell only at 98 without the conversion privilege.

Cash (5,000,000 x 105%) 5,250,000

Discount on bonds payable 100,000
Bonds payable 5,000,000
Share premium – conversion privilege 350,000

Total issue price 5,250,000

Issue price of bonds without conversion privilege (5,000,000 x 98%) (4,900,000)
Residual amount allocated to conversion privilege 350,000

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Bonds payable 5,000,000
Allocated issue price 4,900,000
Discount on bonds payable 100,000

Market value of bonds unknown

Using the preceding illustration, assume that the interest on the bonds is payable semiannually at a nominal rate of 8%
per annum. When the bonds are issued, the prevailing market rate of interest for similar bonds without conversion
privilege is 10% per annum.

The present value of 1 at 5% for 10 periods is 0.6139 and the present of an ordinary annuity of 1 at 5% for 10 periods is
7.72.

Note that the interest is payable semiannually. Since the life of the bonds is 5 years, then there are 10 interest periods.

The present value of the convertible bonds is computed as follows:

Present value of principal (5,000,000 x 0.6139) 3,069,500

Present value of semiannual interest payments (5,000,000 x 4% x 7.72) 1,544,000
Total present value 4,613,500

Issue price of bonds with conversion privilege 5,250,000

Present value of bonds payable (4,613,500)
Residual amount allocated to conversion privilege 636,500

Journal entry

Cash 5,250,000
Discount on bonds payable 386,500
Bonds payable 5,000,000
Share premium – conversion privilege 636,500

Conversion of bonds

If bonds are converted into share capital of the issuing entity, the accounting problem is the determination of a value to
be assigned to the share capital issued.

The carrying amount of the bonds is the measure of the share capital issued because the carrying amount is the
“effective price” for the shares issued as a result of the conversion.

Application Guidance 32 of PAS 32 provides that there is no gain or loss on conversion at maturity.

The reason is that the convertible bond is viewed in substance as an equity and the conversion is really an exchange of
one type of equity capital for another.

Any cost incurred in connection with the bond conversion shall be deducted from share premium or debited to “share
issue cost”.

The carrying amount of the bonds is equal to the face amount plus accrued interest if not paid, plus unamortized
premium or minus unamortized discount and bond issue cost.

Accounting procedures

a. The amortization of discount and issue cost or premium up to the date of conversion shall be recorded.
b. The face amount of the bonds converted shall be canceled together with the related unamortized premium or
discount and issue cost.

If only a portion of the bonds is converted, the unamortized premium or discount and issue cost balance shall be
canceled proportionately.

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 c. Normally, conversion is at an interest date. When at other dates, the accrued interest up to the dates of
conversion is ordinarily paid.

If the interest is not paid, it is added to the face amount of the bonds converted to get the carrying amount of the
bonds for conversion purposes. The accrued interest is charged to interest expense.

Illustration

The statement of financial position shoed the following balance at year-end:

Bonds payable- 12% convertible 5,000,000

Premium on bonds payable 200,000
Share capital, P40 par, 400,000 shares
authorized and 250,000 shares issued 10,000,000
Shares premium-issuance 3,000,000
Share premium- conversion privilege 500,000

On the same date, the bonds are converted into share capital.
The conversion ratio is 20 shares for each P1,000 bond or a total of 100,000 shares,

Cost incurred in connection with the conversion amounts to P100,000. The accrued interest on the bonds payable on the
date of conversion is P150,000 which is paid in cash.

Bonds payable 5,000,000

Premium on bonds payable 200,000
Share premium- conversion privilege 500,000
Total consideration 5,700,000
Par value of share capital issued
(100,000 shares x 40) 4,000,000
Share premium 1,700,000

Journal entry for the conversion

Bonds payable 5,000,000

Premium on bonds payable 200,000
Share premium- conversion privilege 500,000
Interest expense 150,000
Share capital 4,000,000
Share premium- issuance 1,700,000
Cash 150,000

Share premium- issuance 100,000

Cash 100,000

Note that the share premium from conversion privilege is canceled upon conversion because this would effectively
form part of the total consideration received for the shares ultimately issued as a result of the conversion.

Payment of convertible bonds at maturity

On December 31, 2020, the statement of financial position showed the following balances before payment:

Bonds payable - due December 31, 2020 5,000,000

Share capital 10,000,000
Share premium – issuance 4,000,000
Share premium – conversion option 400,000

The bonds are convertible and originally issued on January 1, 2011. The stated rate interest is 10% payable annually
every December 31. The original issue price of the convertible bonds was P6,000,000 allocated as follows:

Original issue price 6,000,000

Issue price of bonds without conversion option (5,600,000)
Share premium-conversion option 400,000

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Issue price of bonds without conversion option 5,600,000
Face amount 5,000,000
Premium on bonds payable 600,000

Since the bond already matured, the premium on bonds payable is already fully amortized on December 31, 2020.

The convertible bonds are not converted but fully paid on December 31, 2020.

Journal entries

1. To record the payment on December 31, 2020:

Bonds payable 5,000,000

Interest expense (10% x 5,000,000) 500,000
Cash 5,500,000

The payment at maturity is equal to the face amount plus interest.

2. To close the share the premium from conversion privilege:

Share premium – conversion option 400,000

Share premium – issuance 400,000

Payment of convertible bonds before maturity

On December 31, 2020, the entity showed the following balances:

Bonds payable – 8% convertible, due December 31, 2025 5,000,000

Premium on bonds payable 300,000
Share capital 8,000,000
Share premium – issuance 1,000,000
Share premium – conversion privilege 600,000

The interest is payable annually every December 31. The convertible bonds are not converted but fully paid on
December 31, 2020.

On December 31, 2020, the quoted price of the convertible bonds with conversion privilege is 108 which is the
payment to the bondholder plus interest.

However, the quoted price of the bonds without the conversion privilege is 103.

Fair value of bonds with conversion privilege (5,000,000 x 108) 5,400,000

Fair value of bonds without conversion privilege (5,000,000 x 103) 5,150,000
Fair value of equity instrument 250,000

Bonds payable 5,000,000

Premium n bonds payable 300,000
Carrying amount of bonds payable 5,300,000
Payment equal to the fair value of bonds without conversion privilege (5,150,000)
Gain on extinguishment 150,000

Note that the total payment of P5,400,000 to the bondholders is partly liability of P5,150,000 and partly equity of
P250,000.

Journal entries
1. To record the payment before maturity:
Bonds payable 5,000,000
Premium on bonds payable 300,000
Share premium – conversion privilege 250,000
Cash 5,400,000
Gain on extinguishment 150,000

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 Interest expense 400,000
Cash 400,000

2. To close the remaining balance of the share premium form conversion privilege:

Share premium – conversion privilege 350,000

Share premium – issuance (600,000-250,000) 350,000
References

Valix, C. & Valix, C.A. (2018). Practical Accounting 1 vol 2. GIC Enterprises and Co., Inc. Manila, Philippines

Valix, C. & Valix, C.A. (2013). Theory of Accounts 2013 edition. GIC Enterprises and Co., Inc. Manila, Philippines

Valix, C. Valix, C.A. (2019). Financial Accounting and Reporting vol 2. GIC Enterprises and Co., Inc. Manila,
Philippines

Robles, N. & Empleo P. (2016). The Intermediate Accounting Series Vol 2. Millenium Books, Inc., Mandaluyong City

Uberita, C. (2012). Practical Accounting 1 2013 Edition. GIC Enterprises and Co, Inc. Manila, Philippines

Testbanks and CPA Examination Reviewers

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