FINANCIAL ACCOUNTING & REPORTING 1

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Accounting for Investments in Equity and Debt Instruments

Module 012 Investment in Debt Instruments

(Financial Asset at amortized cost)

A financial instrument will be a financial liability, as opposed to being an

equity instrument, where it contains an obligation to repay. Financial
liabilities are then classified and accounted for as either fair value or at
amortized cost.
The default position is, and the majority of financial liabilities are, classified
and accounted for at amortized cost.
At the end of this module, you will be able to:
1. Define and classify bonds
2. Be familiar with the measurement of bonds
3. Know the accounting rules for bonds
4. Be familiar with the methods of amortization of bond

The common applications of the lessons under this module consist of the
application of accounting rules for the measurement and amortization of
debt instruments.

Definition of a bond
A bond is a formal unconditional promise made under seal to pay a specified sum of money
at a determinable future date and to make periodic interest payments at a stated rate until
the principal amount is paid.

In simple language, a bond is a contract of debt whereby one party called the issuer
borrows funds from another party called the investor. Thus, a bond is debt security
because the bondholder is a creditor and the issuer is a debtor.

A bond is evidenced by a certificate, and the contractual agreement between the issuer and
investor is contained in another document known as bond indenture.

The interest on the bond investment is usually paid annually or every six months.

Classification of bond investments

Bonds may be acquired as current or noncurrent investments depending on the
business model of managing financial assets. Accordingly, bond investments are
classified and accounted for as follows:
• Financial assets held for trading
• Financial assets at amortized cost
• Financial asset at fair value through other comprehensive income
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• Financial asset at fair value through profit or loss by irrevocable designation

or by fair value option
Initial measurement
In accordance with PFRS 9, bond investments are recognized initially at fair value
plus transaction costs that are directly attributable to the acquisition. However,
transaction costs attributable to the acquisition of bond investments held for
trading or at fair value through profit or loss are expenses immediately.
Subsequent measurement
Subsequent to initial recognition, bond investments are measured and accounted for as
follows:
• At fair value through profit or loss
• At amortized cost
• At fair value through other comprehensive income
Acquisition of bond investments
• When bonds are acquired on an interesting date, there is no accounting problem
because the purchase price is initially recognized as the acquisition cost.
• When bonds are acquired between the interest rates, meaning the date of
acquisition is not any one of the interest rates, the purchase price normally
includes the accrued interest.
✓ That portion of the purchase price representing accrued interest should not
be reported as part of the cost of investment but should be accounted for
separately.
✓ In effect, in this case, two assets are acquired, namely, the bonds and accrued
interest. On the date of acquisition, the accrued interest is charged either to
accrued interest receivable or interest income.
When accrued interest receivable is debited, upon receipt of the first semiannual
interest, the accrued interest receivable account is closed, and interest income is
credited for the excess. When interest income is debited, the receipt of the first
semiannual interest is credited entirely to interest income.
Accrued interest on the date of acquisition
An entity acquired 12% binds with a face amount of P2,000,000 for P2,200,000,
which includes accrued interest of P20,000. The bonds are held for trading and
recorded as follows:
Trading securities 2,150,000
Accrued interest receivable 20,000
Cash 2,200,000
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Accounting for Investments in Equity and Debt Instruments

When the first semiannual interest of P120,000 is received, the journal entry is:
Cash 120,000
Accrued interest receivable 20,000
Interest income 100,000

Another approach
The accrued interest purchased or paid is charged to ‘interest income’ instead of
accrued interest receivable.
Using the same example, the journal entry to record the acquisition of the binding
investment is:
Trading securities 2,180,000
Interest income 20,000
Cash 2,200,000
The subsequent collection of interest is simply credited to interest income. Thus,
when the semiannual interest of P120,000 is received, the journal entry is:
Cash 120,000
Interest income 120,000
Illustration-Trading securities
April 1 Purchased P1,000,000 12% bonds at 96 plus accrued interest. Interest is
payable on January 1 and July 1. The bonds are held as a trading investment.
Trading securities 960,000
Interest income 30,000
Cash 990,000
Note that the accrued interest is for three months, from January 1 to April 1. The
computation of the accrued interest isP1,000,000x12%x3/12 equals P30,000.
July 1 Received semiannual interest:
Cash 60,000
Interest income 60,000
Oct. 31 Sold P600,000 face value bonds for 101 plus accrued interest.
Cash 630,000
Trading securities 576,000
Interest income 24,000
Gain on sale of trading securities 30,000
Computation
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Accounting for Investments in Equity and Debt Instruments

Sale price(600,000x101) 606,000

Add: Accrued interest from July 1 to
October 31 (600,000x12%x4/12) 24,000
Total cash received 630,000

Sale price 606,000

Less: Carrying amount of bonds sold 576,000
Gain on sale 30,000
Dec. 31 Recorded the accrued interest from July 1 to December 31 on the remaining
bonds of P400,000:
Accrued interest receivable 24,000
Interest income 24,000
The accrued interest on the P400,000 face amount is for six months, from July 1 to
December 31. The computation is P400,000x12%6/12=P24,000.
Dec. 31 The bonds are quoted at 120 at the end of the year. Changes in the fair value
of trading securities are recognized in profit or loss.
Trading securities 96,000
Unrealized gain-TS 96,000

Market value (400,000x120) 480,000

Carrying amount of remaining bonds (384,000)
Unrealized gain 96,000
When bond investment is held for “trading” or measured at fair value through profit
or loss, it is not necessary to amortize any premium or discount.
Investment in bonds at amortized cost
PFRS 9 provides that a financial asset shall be measured at amortized cost if both of the
following conditions are met:
✓ The business model is to hold the financial asset in order to collect contractual cash
flows on specified dates
✓ The contractual cash flows are solely payments of principal and interest on the
principal amount outstanding.
Amortized cost is the initial recognition amount of the investment minus repayments,
plus amortization of discount, minus amortization of premium, and minus reduction for
impairment or uncollectibility.
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Accounting for Investments in Equity and Debt Instruments

When bonds are acquired and classified as a financial asset at amortized cost, the bond
investment is classified as noncurrent investments.
Amortization of premium or discount
Investment in bonds shall be measured subsequently at amortized cost. This means that
any premium or discount on the acquisition of a long-term investment in bonds must be
amortized.
Bond premium or discount is amortized over the life of the bonds. On the part of the
bondholder, the life of the bonds is from the date of the acquisition to the date of
maturity.
Amortization is done through the interest income account.
• Amortization of bond discount
Investment in bonds xx
Interest income xx
• Amortization of bond premium
Interest income xx
Investment in bonds xx
Amortization may be made on interest dates or at the end of the reporting period. It
is more convenient to record amortization at the end of the reporting period.
Philosophy on amortization
The reason for the amortization of bond premium or discount is to bring the
carrying amount of the investment to face value on the date of maturity.
When the bonds are redeemed on the date of maturity, the entry will simply be a
debit to cash and a credit to invest in bonds at face value. The bondholder is a
creditor and will collect on the date of maturity an amount equal to only to face
value of the bonds, no more and no loss.
Conceptually, a bond premium is a loss on the part of the bondholder because the
bondholder paid more than what can be collected on the date of maturity.
Such loss is not recognized outright but allocated over the life of the bonds to be
offset against the interest income to be derived from the bond investment. On the
other hand, the bond discount is a gain on the part of the bondholder because the
bondholder paid less than what can be collected on the date of maturity.
Such gain is not recognized outright but allocated over the life of the bonds to be
added to the interest income derived from the bond investment.

Sale of bonds prior to maturity

When investing in bonds is sold prior to the date of maturity, it is necessary to
determine the carrying amount of the bond investment to be used as a basis for
computing gain or loss on the sale.
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Accounting for Investments in Equity and Debt Instruments

In such a case, amortization of the premium or discount should be recognized up to

the date of sale.
If the date of sale is between interest dates, the sale price normally includes the
accrued interest.
Accordingly, that portion of the sale price pertaining to the accrued interest should
be credited to interest income.
The difference between the sale price after deducting the accrued interest and the
carrying amount of the bond investment represents the gain or loss on the sale of
the investment.

Callable bonds
Callable bonds are those which may be called in or redeemed by the issuing entity
prior to their date of maturity. Usually, the call price or redemption price is at a
premium or more than the face amount of the binds.
The difference between the redemption price and the carrying amount of the
investment on the date of redemption is recognized in profit or loss.
Convertible bonds
Convertible bonds are those which give the bondholders the right to exchange their
bonds for share capital of the issuing entity at any time prior to maturity.
Serial bonds
Serial bonds are those which have a series of maturity dates or those which are
payable in installments.
Term bonds
Term bonds are those bonds that mature on a single date. Callable and convertible
bonds can be classified as term bonds despite their special features.
Method of amortization
• Straight line method- This method provides for an equal amount of premium or
discount amortization for each accounting period.
• Bond outstanding method- this method is applicable to serial bonds and provides
for a decreasing amount of amortization.
• Effective interest method or simply “interest method” or scientific method-
this method provides for an increasing amount of amortization.
In accordance with PFRS 9, bond investments shall be classified as financial assets
measured at amortized cost using the effective interest method.
This means that any discount or premium must be amortized using the effective
interest method.
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Accounting for Investments in Equity and Debt Instruments

The straight-line method and bond outstanding method are acceptable only when the
computation will result in periodic interest income that is not materially different from
the amount that would be computed using the effective interest method.
Straight line method- Discount
Face amount of bonds 2,000,000
Acquisition cost on January 1, 2015 1,850,000
Discount on the bonds 150,000
Date of bonds January 1, 2015
Date of maturity January 1, 2018
Interest payable semiannually on June 30 and December 31 at 12%
Following the straight-line method, the annual amortization of the discount is simply
computed by dividing the discount of P150,000 by the life of the bonds of 3 years or
P50,000. Thus, the schedule of annual amortization of the discount is:
2015 50,000
2016 50,000
2017 50,000
Total discount 150,000
Journal entries
• Acquisition on January 1
Investment in bonds 1,850,000
Cash 1,850,000
• Collection of semiannual interest on June 30: (P2,000,000x12%x6/12 orP120,000
Cash 120,000
Interest income 120,000
• Collection of semiannual interest on December 31
Cash 120,000
Interest income 120,000
• Annual amortization of discount
Investment in bonds 50,000
Interest income 50,000
Straight line method-Premium
Face amount of bonds 2,000,000
Acquisition cost in January 1, 2015 2,200,000

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Accounting for Investments in Equity and Debt Instruments

Premium on the bonds 200,000

Date of bonds January 1, 2015
Date of maturity January 1, 2019
Interest payable annually on Dec. 31 12%
Following the straight-line method, the annual amortization is simply computed by
dividing the premium of P200,000 by the life of the bonds of 4 years or P50,000.
Bond outstanding method-Discount
Face amount of bonds 2,000,000
Acquisition cost on January 1, 2015 1,900,000
Discount on the bonds 100,000
Annual installment on December 31, 2015
And every Dec. 31 thereafter 500,000
Date of bonds January 1, 2015
Interest payable semiannually on June 30
And December 31 12%
Following the outstanding bond method, the schedule of the annual amortization of
discount is as follows:

Year Bond Outstanding Fraction Discount amortization

2015 2,000,000 20/50 40,000

2016 1,500,000 15/50 30,000
2017 1,000,000 10/50 20,000
2018 500,000 5/50 10,000
TOTAL 5,000,000 100,000

The bond outstanding is determined every bond year. Thus, the bond outstanding
for 2015 is P2,000,000 and is decreased by the payment of P500,000 each year. The
fractions are developed from the outstanding bond column. The annual discount
amortization is computed by multiplying the fractions by the amount of the
discount. Thus, for 2015, 20/50 times P100,000 equals P40,000, and so on.
Bond outstanding method-Premium
Face amount of bonds 4,000,000
Acquisition cost on January 1, 2015 4,200,000
Premium on the bonds 200,000
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Annual installment on December 31, 2015, and

Every December 31 thereafter 1,000,000
Date of bonds January 1, 2015
Interest payable annually on December 31 12%
Following the outstanding bond method, the schedule of the annual amortization of
premium is as follows:

Year Bond Fraction Premium

Outstanding amortization

2015 4,000,000 4/10 80,000

2016 3,000,000 3/10 60,000
2017 2,000,000 2/10 40,000
2018 1,000,000 1/10 20,000

The bond outstanding for 2015 is P4,000,000, and this is reduced by P1,000,000
each year. The fractions are developed from the outstanding bond column. The
annual premium amortization is computed by multiplying the fractions by the
amount of the premium. Thus, for 2015, 4/10 times P200,000 equals P80,000, and
so on.

Glossary
Bond: Debt investment where the investor loans money to another entity.
Callable bonds: Can be redeemed prior to maturity.
Convertible bonds: Gives the holder the right to convert the bond
Serial bonds: Matures at regular intervals
Term bonds: Has a single maturity date, opposite of the serial bond.

References and Supplementary Materials

Books and Journals
1. Cabrera, M. B., & Ocampo, R. R. (n.d.). Financial Accounting & Reporting - Standards &
Application (2014-2015 ed., Vol. 2). Manila, Philippines.
2. Robles, N. S., & Empleo, P. M. (2014). Intermediate Accounting (2014 ed., Vol. 1).
Manila, Philippines.
3. Valix, C. T., Peralta, J. F., & Valix, C. M. (2017). Financial Accounting (2017 ed., Vol.
2).Manila, Philippines.
4. IFRS 9, Financial Instruments
5. IAS 39, Financial Instruments: Recognition and Measurement

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Accounting for Investments in Equity and Debt Instruments

6. IAS 32 Financial Instruments: Presentation

Online Supplementary Reading Materials
1. IFRS 9 — Financial Instruments; http://www.ifrs.org/issued-standards/list-of-
standards/ifrs-9-financial-instruments/; October 23, 2017
2. IAS 39 — Financial Instruments: Recognition and Measurement;
http://www.ifrs.org/issued-standards/list-of-standards/ias-39-financial-
instruments-recognition-and-measurement/; October 23, 2017
3. Debt Financing; http://open.lib.umn.edu/financialaccounting/chapter/14-1-debt-
financing/; October 23, 2017
4. The Issuance of Notes and Bonds;
http://open.lib.umn.edu/financialaccounting/chapter/14-2-the-issuance-of-notes-
and-bonds/; October 23, 2017
5. Accounting for Zero-Coupon Bonds;
http://open.lib.umn.edu/financialaccounting/chapter/14-3-accounting-for-zero-
coupon-bonds/; October
6. Pricing and Reporting Term Bonds;
http://open.lib.umn.edu/financialaccounting/chapter/14-4-pricing-and-reporting-
term-bonds/; October 23, 2017
7. Issuing and Accounting for Serial Bonds;
http://open.lib.umn.edu/financialaccounting/chapter/14-5-issuing-and-accounting-
for-serial-bonds/; October 23, 2017
8. Bonds with Other Than Annual Interest Payments;
http://open.lib.umn.edu/financialaccounting/chapter/14-6-bonds-with-other-than-
annual-interest-payments/; October 23, 2017
Online Instructional Videos
1. In a Set of Financial Statements, What Information Is Conveyed about Noncurrent
Liabilities Such as Bonds?;
http://open.lib.umn.edu/financialaccounting/part/chapter-14-in-a-set-of-financial-
statements-what-information-is-conveyed-about-noncurrent-liabilities-such-as-
bonds/; October 23, 2017