INTERMEDIATE ACCOUNTING 2

WEEK 3 LECTURE
AY 2020-2021

Chapter 3:Bonds Payable and Other Concepts

Learning objectives
1. State the initial and subsequent measurement of bond payable.
2. Account for compound financial instruments.
3. Explain the accounting for derecognition of liabilities.
4. State the requirements for the offsetting of financial assets and financial liabilities.

Bonds Payable
Bonds are a long-term debt instruments similar to notes and loans except that bond are usually offered to
the public and sold to many investors. A bond is intended to be broken up into various subunits (e.g., P1,000
each) which can be issued to a variety of investors.
A debt instrument is any contract that represents a right upon holder to receive caSh from issuer thereof or
an obligation upon the issuer to pay cash to the holder, a debt instrument represent a debtor-creditor
relationship between entities(e.g., accounts, notes, loans, bonds, redeemable preference shared issues and
other payables).
Bond Indenture is the contractual arrangement between the issuer and the bondholders. It contains
restrictive covenants intended to prevent the issuer from taking actions contrary to the interests of the
bondholders. A trustee, often a bank is appointed to ensure compliance.
A bond indenture may specify, among other things, the following:
a. Rights and duties of bondholders and issuer which may include the following;

1. Call provision- issuer’s right to call the bonds before scheduled maturity. If interest rate
decline, the issuer can call high-interest bonds and replace them with low interest bonds.
2. Redemption rights- the holder’s right to redeem the bonds before the scheduled maturity.

b. Restriction and requirements on the issuer which may include the following:
1. Sinking fund that the issuer is required to establish for the protection of the bondholders.
2. Financial ratios that the issuer is required to maintain.
3. Restriction on dividends available to the issuer’s shareholders. the issuer may be required to
appropriate a portion of its retained earnings for the protection of the bondholders.
4. Restriction on incurrence of additional obligations, the issuer may be restricted from issuing
new bonds unless the currently issued bonds are settled first or restricted from issuing new
bonds in excess of a percentage of bondable property (fixed assets).
5. Appointment of independent trustee whose qualifications are stated in the bond indenture.
6. Authorized amount of bonds that can be issued.
 c. Interest rate, payment date(s), and maturity date(s).
Bond certificate issued to the bondholder representing the amount of bonds he has purchased. Bond
are normally issued in denominations.

Issuance of bonds
Bonds can be issued in several way, for example, through underwriting, auction, or direct placement with
investors. Often bonds are issued through an underwriter.
Types of binds
❖ As to maturity
1. Term bonds- bonds that mature on a single date.
2. Serial bonds- bond in which the principal matures in installments.
3. Extendible and retractable bonds- bond that have more than one maturity date that meet their
needs.
a) Extendible bonds- bonds that give holders the right to extends the initial maturity to an
earlier date.
b) Retractable bonds – bonds that give holders the right to shorten the initial maturity to an
earlier date.
❖ As to recording point of view and payment of interest
4. Registered bonds- bond issued in the name of the holder (owner) interest are paid directly to the
holder.
5. Coupon (bearer) bonds- bond that can be freely transferred and have a detachable coupon for each
interest payment.
6. Zero coupons bonds (strip bonds or deep-discount bonds) bonds that do not pay periodic
interests. However, they sell at a deep discount from their face amount.
7. Income bonds –bonds that pay interest only if the issuer earns profit.
8. Participating bonds- bonds that participate in excess earnings of the issuer as defined in the
indenture.
9. Indexed bonds (purchasing power bonds) – bonds that pay interest that is indexed to a measure
of general purchasing power.
10. Inflation-linked bonds- bonds whose principal and interest payments are adjusted in response to
inflation.

❖ As to security and risk

11. Mortgage bonds- bonds secured by real property.
12. Collateral trust bonds – bonds secured by the issuer’s securities, which are held by a trustee the
trustee distributes the securities to the bondholders.
13. Asset-backed bonds(assets-backed securities)- bonds collateralized by a pool of asset, such as
credit card receivables and car loans .
14. Subordinated bonds-(subordinated debentures) – bonds that have a higher yield than secured
bonds but a lower priority during liquidation.
15. Debenture bonds – bonds not secured by any collateral.
16. Junk bonds- High-risk-, hig-yield bonds typically issued to finance leveraged buyouts and mergers.
 ❖ As to right of redemption
17. Callable bonds- bonds that issuer can redeem prior to maturity date the issuer can call high interest
bonds and replace with low-interest bonds.
18. Convertible bonds-bonds that the holder can exchange for the issuer’s shares of stocks.

❖ As to issuer
19. Corporate bonds- bonds issued by a corporation, issued by companies with high credit are
considered “investment grade,” whereas bonds issued by companies with low credit rating are
considered “non-investment grade’ or “junks” because of their speculative nature.
20. Government Bonds (treasury bonds) – bonds issued by a government have low financial risk
because they practically free from default.

❖ As to currency
21. International bonds- bonds issued by a foreign entity in a domestic market. International include
the following:
a. Eurobonds- bonds denominated in a currency other than the currency of the market in which
they are offered. Example, a German company that issues U.S dollar denominated bonds Japan
has issued Eurobond more specifically, a Eurodollar bond. Other types of Eurobonds include
Euroyen and Euroswiss bonds.
b. Foreign Bonds- Bond denominated in the currency of the domestic market in which they are
offered.
Japan has issued a foreign bonds are usually given nicknames that refer to the domestic market
in which they are being offered. Others example include:
i. Kangaroo bonds or Matilda bonds- Australian dollar denominated bond issued by a
foreign entity.
ii. Maple Bonds- Canadian dollar -denominated bonds issued in Canada market by foreign
entity.
iii. Matador Bonds- euro denominated bonds (spains currency is Euro) issued in Spain
market by a foreign entity.
iv. Bulldog bonds- british pound-denominated bond issued in the British market by a
foreign entity.
v. Yankee bonds -US-dollar-denomination bonds issued in the US market by a foreign
entity.
c. Global Bonds- bonds that are issued in several countries at the same times.
Accounting for bonds – bonds are accounted for in much the same way as notes and loans payable.
However bonds normally are long-term, bear interest, issued at premium or discount and entail transaction
(issue) cost.
Bond premium and discount
To reiterate the concepts of premium and discount, an outline is provided below:
 Cash proceeds Effective interest Effect of
(carrying rate compared to amortization on
amount ) Nominal interest interest expense
compared to rate
face amount
Discount Cash proceeds Effective interest Interest expense
(carrying amount rate is higher is greater than
) is less than face than Nominal interest paid
amount interest rate
Premium Cash proceeds Effective interest Interest expense
(carrying amount rate is lower than is less than
) is greater than Nominal interest interest paid
face amount rate

Accounting for transaction costs

Financial liabilities are initially measured at fair value minus transaction cost. Accordingly, transaction
costs on issuing bonds (bond issue cost) are deducted when determining the carrying amount of the bonds.
The transaction cost are amortized using the effective interest method.
Illustration : Bond issued at a face amount
On January 1,20x1. ABC co, issued 10% P1,000,000 bonds at face amount. Principal is due on Dec. 31,20x3
but interest is due annually every year -end.
Case: No transaction cost
The carrying amount is equal to the face amount because the bonds were issued at face amount and no
transaction cost incurred.

Jan1 20x1 Cash 1,000,000/

Bond payable 1,000,000
(1000x1000)

Dec 31, 20x1 Interest expense 100,000

(1Mx10%)
cash 100,000

Dec 31, 20x2 Interest expense 100,000

(1Mx10%)
Cash 100,000

Dec 31, 20x3 Interest expense 100,000

(1Mx10%)
Cash 100,000

Bonds payable 1,000,000

Cash 1,000,000
Issuance of bonds between interest payment dates
when bonds are issued between interest payment dates, the accrued interest prior to the issuance date is not
included in the initial measurement of the bonds, but rather credited to interest payable or interest expense.
Illustration:
On April 1, 20x1, ABC Co. issued 12% P1,000,000 bonds dated January 1,20x1.
Case: the bonds were issued at 97 including accrued interest.
Requirement: compute for the initial carrying amount of the bonds.
Solution:
Cash proceeds including accrued interest (1M x 97%) 970,000
Less: Accrued interest sold (1m x 12% x 3/12) (30,000)
Carrying amount of the bonds, April 1 20x1 940,000

Jan. Cash (1M x97%) 970,000

1, Discount on bonds payable (1M-940k) 60,000
20x1 Bond payable 1,000,000
Interest expense(or Interest payable) 30,000
(1MX12% X 3/12)

Issue price bonds – can be estimated by discounting the future cash flow of the bonds at a specified
effective interest rate.
Bond refunding – refers to issuance of new bonds, the proceed from which are used to retire existing
outstanding bonds.
Retirement of bonds prior to maturity - when bonds are retired, any difference between the retirement
price and the carrying amount (updated for any discount or premium amortization up to the date of
retirement) is recognized as gain or loss in profit or loss.
Illustration:RETIREMENT OF BONDS-BONDING REFUNDING
On January 1,20x1, ABC Co, issued new bonds with face MOUNT OF P10M for P10,800,000. ABC used
the proceeds to retire an existing 10-year,12% P8,000,000 bonds issued five years earlier. The unamortized
discount on the exiting bonds is P340,000. ABC retired the bonds at a call premium of P400,000. ABC
incurred P50,000 direct costs of retirement. ABC’s income tax rate is 30%.
Solution :
➢ The issuance of the new bonds is recorded as follows:
Jan Cash 10,800,000
1. Bond payable – new 10,000,000
20x1 Premium on bonds payable- new 800,000

➢ The retirement of the old bonds is recorded as follows:

Jan 1. Bond payable – old 8,000,000
20x1 Loss on extinguishment of bonds (squeeze) 790,000
Discount on bonds payable -old 340,000
Cash (8M + 400K call premium +50K direct costs) 8,450,000

Compound financial instruments- is a financial instrument that from the issuer’s perspective, contains
both a liability and an equity component as follows: Cash proceeds less fair value of debt component
without the equity feature equals Equity component.
The conversion of convertible bonds is accounted for as equity set-off. No gain or loss is recognized.
When convertible bonds are retired, the retirement price is allocated to both liability and equity
components. The amount allocated to the liability is used to determined the gain or loss on extinguishment
of debt.

• An asset swap is accounted for using the fair value of the securities issued or fair vlue of liability
extinguished, whichever is more clearly determinable.
• A modification of term is substantial if the percentage change between the old and new liabilities
is at least 10%.