INVESTMENT IN DEBT SECURITIES:

2 classifications of Financial Assets

1. Financial Assets at Fair Value

2. Financial Assets at Amortized Cost

Financial Assets @ Amortized cost generally refer to investment in bonds which are neither designated at FVPL nor
held for trading.

Investment in bonds may be classified as:

1. FA at FVPL ( Designated or Held For Trading) accounted for the same way as investment in equity
securities at FVPL
2. Financial Assets at Amortized Cost
Note: It cannot be classified as FA at FVOCI

Bond investment

1. Treasury-Bonds ( Government Bonds)

2. Corporate Bonds ( Private Bonds)

This are disclosed in the notes to assessed related risk on such investment

Bond issuer vs Bond holder

 Bond Issuer is a borrower (debtor) Till the maturity of the bond, the bond issuer pays periodic (can be
annual/ semi-annual) interest to the bondholders, and upon maturity, the issuer returns the principal
amount borrowed to the holder of the bond.
 Bond holder is the lender ( creditor)
What is a Bond?

 Long term debt instrument

 Usually offered to the public and sold to many investors

What id bond indenture?

 Contractual agreement
 Restrictive covenants to protect the bondholder
 A trustee, often a bank is appointed to ensure compliance

Accounting for Investment in Bonds at amortized cost

 Similar to the accounting for notes and loans receivable

What is amortized cost?

 The amount at which a 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 initial amount and the maturity amount and minus
any reduction ( directly or through the use of an allowance account) for impairment or
uncollectibility

Note: Amortized cost of the investment in bonds is determined using effective interest method.

What is effective interest method?

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

What is effective interest rate?

 Rate that exactly discounts estimated future cash payments or receipts though the expected life
of the financial instrument or when appropriate, a shorter period to the net carrying amount of
the financial asset or financial liability.
 Other terms: yield rate, market rate, imputed rate

What is nominal rate?

 Nominal interest rate is the annual interest rate (per year) for a certain compounding period.
 Other terms: stated rate, coupon rate, annual percentage rate

When accounting for investment in bonds we must consider the following:

1. Discount or premium
2. Recognition of interest income
3. Acquired interest
4. Adjustment to effective interest due to transaction costs
5. Sale of bonds prior to maturity

1. DISCOUNT or PREMIUM

 Bonds are acquired at discount if the acquisition cost (including transaction cost) is less than the
face amount.
o Acquisition cost plus transaction cost < face amount is equal to the discount.
o Effective interest rate is greater than Nominal Rate
 Bonds are acquired at premium if the acquisition cost (including transaction cost) is greater
than the face amount.
o Acquisition cost plus transaction cost > face amount is equal to the premium
o Effective interest rate is less than Nominal Rate

Example:
1. On January 1, 2001. BTS Co. acquired 10%, P1,000,000 bonds for P951,963. The principal is
due on January 1, 2004 but interest is due annually every January 1. The yield rate on the
bonds is 12%, The bonds are classified as amortized cost.

2. On January 1, 2001. BTS Co. acquired 12%, P1,000,000 bonds for P1,049,737. The principal
is due on January 1, 2004 but interest is due annually every January 1. The yield rate on the
bonds is 10%, The bonds are classified as amortized cost

2. Amortization of discount or premium.

 Any discount or premium is included in the carrying amount of the bonds and amortized using
effective interest method
 No separate account is needed to record any discount or premium
 At maturity date, amortizing discount or premium will bring the carrying amount of the bonds
equal to the face value at maturity date

Bonds acquired at discount Bonds acquired at premium

In effect there is gain ( the bonds are
acquired lower than the face amount)
This gain is deferred and amortized as
addition to interest income
Amortization of bond discount
increases interest income over the
period bonds are held
Affects only interest income and not
interest receivable
In effect there is loss ( the bonds are acquired
higher than the face amount)
This loss is deferred and amortized as
reduction to interest income
Amortization of bond premium decreases
interest income over the period bonds are
held
Affects only interest income and not interest
receivable
 Recognition of interest income/investment income

How to compute interest income?

 Interest income on bonds is computed using effective interest method
 Interest income = Present value of the bonds x original effective interest rate
 Interest income already includes the amortization of any premium or discount during the period

How to compute interest receivable?

 Interest receivable = Outstanding face amount x nominal rate

How to compute discount or premium amortization

 Interest receivable - Interest income= Discount/ Premium Amortization

How to compute for unamortized discount discount/premium?

 Present value – face amount= unamortized discount/premium

Sample Problem:
1. On January 1, 2001. BTS Co. acquired 10%, P1,000,000 bonds for P951,963. The principal is
due on January 1, 2004 but interest is due annually every January 1. The yield rate on the
bonds is 12%, The bonds are classified as amortized cost.

Date Interest Interest Income Amortization Present Value

Receivable ( EIR x PV)
( Nominal rate x
Face amount)
January 1, 2001 951,963
January 1, 2002 100,000 114,236 14,236 966,199
January 1, 2003 100,000 115944 15,944 982,143
January 1, 2004 100,000 117,857 17,857 1,000,000

1. On January 1, 2001. BTS Co. acquired 12%, P1,000,000 bonds for P1,049,737. The principal
is due on January 1, 2004 but interest is due annually every January 1. The yield rate on the
bonds is 10%, The bonds are classified as amortized cost

Date Interest Interest Income Amortization Present Value

Receivable
January 1, 1,049,737
2001
 January 1,2002 120,000 104,974 15,026 1,034,711
January 1,2003 120,000 103,471 16,529 1,018,182
January 1,2004 120,000 101,818 18,182 1,000,000

Discount vs Premium

DISCOUNT PREMIUM
Discount amortization increases interest Premium amortization decreases interest
income income
Discount amortization increases present Premium amortization decreases present
value value
Interest Income, Amortization and Present Amortization Column on the amortization
Value columns increase over the life of the table increases over the life of the bonds
bonds

Acquired Interest
 Bonds may be purchased in between scheduled interest payment dates
 When unpaid interest has accrued before acquisition date of bonds, subsequent receipt of
interest is allocated between pre-acquisition and post-acquisition periods.

60,000 60,000
Debit to Interest Recognize as
Receivable/
Interest income
Interest income

January 1 July 1 December 31

ACQUISITION DATE

 Only post acquisition portion is recognized as interest income.

 Accrued interest during the period the bonds were not held should not be recognized as interest
income.
 Usually accrued interest prior to the acquisition is sold to the investor. However this should not
be included as part of the cost of the investment. It is debited to interest receivable or interest
income. Purchased accrued interest increases cash outlay on acquisition but does not affect cost
of investment.
Sample:
On April 1, 20x1 BTS Co. Acquired 12% P1,000,000 bonds dated January 1, 2021 at 98 excluding
interest. The bonds mature on December 31, 20x3 but pay annual interest at each year end.

Journal entry at acquisition date:

April 1, 20x1 Investment in bonds @amortized cost 980,000

Interest Receivable 30,000
Cash in bank 1,010,000
Acquisition of Investment in Bonds at amortized cost
Dec 31, 20x1 Cash in bank 120,000
Interest Receivable 30,000
Interest Income 90,000
Receipt of interest

April 1, 20x1 Investment in bonds @amortized cost 980,000

Interest Income 30,000
Cash in bank 1,010,000
Acquisition of Investment in Bonds at amortized cost
Dec 31, 20x1 Cash in bank 120,000
Interest Income 120,000
Receipt of interest

On April 1, 20x1 BTS Co. Acquired 12% P1,000,000 bonds dated January 1, 2021 at 98 including
interest. The bonds mature on December 31, 20x3 but pay annual interest at each year end.

Journal entry at acquisition date:

April 1, 20x1 Investment in bonds @amortized cost 950,000

Interest Receivable 30,000
Cash in bank 980,000
Acquisition of Investment in Bonds at amortized cost
Dec 31, 20x1 Cash in bank 120,000
Interest Receivable 30,000
Interest Income 90,000
Receipt of interest

April 1, 20x1 Investment in bonds @amortized cost 950,000

Interest Income 30,000
Cash in bank 980,000
Acquisition of Investment in Bonds at amortized cost
Dec 31, 20x1 Cash in bank 120,000
 Interest Income 120,000
Receipt of interest

On August 1, 20x1 BTS Co. Acquired 12% P1,000,000 bonds dated January 1, 2021 at 98
including interest. The bonds mature on December 31, 20x3 but pays semi- annual interest at
every January 1 and July 1

Journal entry at acquisition date:

April 1, 20x1 Investment in bonds @amortized cost 970,000

Interest Receivable 10,000
Cash in bank 980,000
Acquisition of Investment in Bonds at amortized cost
Dec 31, 20x1 Cash in Bank 60,000
Interest Receivable 10,000
Interest Income 50,000
Receipt of interest

ADJUSTMENT TO EFFECTIVE INTEREST DUE TO TRANSACTION COST

What is transaction cost?

Transaction costs are expenses incurred when buying or selling a good or service. Transaction costs
represent the labor required to bring a good or service to market, giving rise to entire industries
dedicated to facilitating exchanges. In short, transaction cost that are directly attributable to the
acquisition of the financial asset.

 The transaction cost incurred in the acquisition of bonds at amortized cost are included as part
of the cost of investment.
 Pre-acquisition accrued interest only increases the cash outlay in the acquisition of bonds but
it does not affect the cost of the investment.

What is the effect of the transaction cost?

When transaction cost is incurred, the effective interest rate may need to be adjusted in order to
exactly discount the estimated future cash flows equal to the initial carrying amount.

Adjustment to effective interest rate:

On January 1, 2021 BTS Co. acquired 12%, P1,000,000 bonds at 98. Commission paid to brokers
amounted to P51, 000. Principal is due on December 31, 20x4 but interest payments are due annually
starting December 31, 2021. The bonds are classified at investment @ amortized cost.

How much is the initial cost or initial carrying amount of the bonds?
Investment in Bonds acquired at 98% = 980,000

Transaction cost ( Capitalized) = 51,000

Initial Cost = 1,031,000

Trial and error with interpolation

Approximate Yield to maturity ( Approximate EIR) = C + F-P/n

F+P/2

C= coupon/ nominal interest payment

F= Face amount
P= Market price
n= years to maturity

= 120,000 + ( 1,000,000 -1,031,000)/4

(1,000,000 +1,031,000)/2
= 120,000 +(-7750)/ 1,015,500
=112,250/1,015,500
= 11.05% (Approximate)

Effective interest Rate = Exactly discounts future cash flows

Between 10% -11%

 Compute the initial carrying amount using 10% effective interest rate

Principal 1,000,000 x ( PV factor of 1) .6830 = 683,000

Interest 12% x 1,000,000= 120,000 x ( PV of OA 10%, 4 years) 3.1698 = 380,376
Initial CA/ PV of future cash flows Jan, 1 , 2021 1,063,376 = 1,031,000 ( Not Equal)

 Compute the initial carrying amount using 11% effective interest rate

Principal 1,000,000 x ( PV factor of 1, 11%, 4years) .6587 = 658,700

Interest 12% x 1,000,000= 120,000 x ( PV of OA 11%, 4 years) 3.1024= 372,288
Initial CA/ PV of future cash flows Jan, 1 , 2021 =1,030,988 =1,031,000 ( Not equal) 12pesos

If 12 pesos is insignificant or immaterial =we can use 11% as our adjusted effective interest rate

Interpolation

=X% -lower rate

Higher rate – lower rate

= 1,031,000 – 1,063,376 = -32,376

1,030,988 -1,063,376 = -32388
=.9996
= 10% + .9996% = 10.9996%

SALE of Bonds prior to maturity date

 When bonds are sold prior to maturity, the difference between the net disposal proceeds and
the carrying amount of the bonds, adjusted for any discount or premium amortization up to
the date of disposal, is recognized as gain or loss in profit or loss ( Gain on sale of the
investment in bonds)

 Net disposal proceed is computed as Sale price( including purchased interest) less selling cost
less purchased interest.

 If the bonds are sold in between scheduled interest payment dates, the sales price normally
includes accrued interest.

 The portion of the sales price pertaining to the accrued interest should be recognized as
interest income and not included in the gain or loss on the sale.

 The difference between the net disposal proceeds after deducting the accrued interest portion
and the updated CA represents gain or loss of sale of the investment

 When there is a partial sale of FAAC prior to maturity, the unsold portion may still continue to
be measured at amortized cost. If the business model is to collect the contractual cash flows.
Solely the principal and the interest. Even if the portion sold is significant

 Gains or losses on derecognition of the financial assets at amortized cost are required to be
presented separately on the face of the statement of profit and loss and other comprehensive
income.

Sample Problem:

On January 1, 2021, BTS Co. acquired 10% P1,000,000 bonds for 951,963. The principal is due on
January 1, 2004 but interest is due annually starting December 31, 2001. The yield rate on the bonds is
12%. The bonds were classified as investment measured at amortized cost.

Case 1: On January 1,2003 the entire bonds were sold at 110. Commission paid to broker amounted to
10,000.
Compute for Net disposal Proceeds:
Formula:
Sales Price ( Including accrued interest if there’s any) 1,100,000
Less: Selling cost 10,000
Net Disposal Proceeds 1,090,000
CA, Jan 1, 2003 982,143
Gain on Sale 107,857

Date Interest received Interest income amortization PV

Jan1, 2001 951,963
Dec 31, 2001 100,000 114,236 14,236 966,199
Dec 31, 2002 100,000 115,944 15,944 982,143
Dec 31, 2003 100,000 117,857 17,857 1,000,000

Journal Entry

Jan1, 20003 Cash in bank 1,090,000

Investment in bonds at amortized cost 982,143
Gain on sale 107,857

Case 2: On January 1,2003 the half of the bonds were sold at 110. Commission paid to broker
amounted to 10,000

Case 3: On July 1,2003 the entire bonds were sold at 110. Commission paid to broker amounted to
10,000

Case 4: On July 1,2003 the half of the bonds were sold at 110. Commission paid to broker amounted to
10,000

Step 1: Update the CA as of the date of disposal. ( Use the amortization table)

Date Interest Received Interest Income Amortization PV

Compute for the gain or loss on sale

Formula:
Sale including purchased interest if there’s any
Less: Selling cost
Less: Purchased interest
Net Disposal proceeds
CA, Jan 1 ,2003
Case 1

Date Particulars Debit Credit

Jan 1, 2023

Case 2
Date Particulars Debit Credit
Jan 1, 2023

Date Interest Received Interest Income Amortization PV

Case 3
Date Particulars Debit Credit
July 1, 2003
To record the amortization of
discount
July 1,2003
To record the sale

Case 4
Date Particulars Debit Credit
July 1, 2003
To record the amortization of
discount
July 1,2003
To record the sale

How to compute the Purchase Price of the bonds?

It is computed as the PV of future cash flows of the bonds discounted at a specified effective interest
rate.

BTS Co. is contemplating on 12% , 3 year, P1,000,000 bonds to be classified as investment measured
at Amortized cost. Principal is Due at maturity but interest is due annually at each year end. What is
the purchased price of the bonds?
Case 1: BTS Co. determines that the market rate on January 1, 2001 is 10%
Case 2: BTS Co. plans to acquire the bonds on April 1, 2001

BTS Co. is contemplating on 12% , 3 year, P1,000,000 bonds to be classified as investment measured
at Amortized cost. Principal is Due at maturity but interest is due semi-annually every July 1 and
December 31. What is the purchased price of the bonds?

Case 1: BTS Co. determines that the market rate on January 1, 2001 is 14%
Case 2: BTS Co. plans to acquire the bonds on April 1, 2001

Other KINDS of Bonds

1. SERIAL BONDS
2. Zero –Coupon Bond
3. Callable bonds
4. Puttable Financial Assets