VHINSON - Intacc 2 (2023-2024)

2023 - 2024
EDITION
ACCOUNTING
INTERMEDIATE
VHINSON JAY GARCIA, CPA
The Book R̶e̶a̶d̶e̶r̶s̶ Raiders | Nevule

INTERMEDIATE
ACCOUNTING 2
BASED ON PFRSs, PASs AND
PHILIPPINE GAAP
Well Organized
Comprehensive
Illustrative
Simplified
Philippine Financial Reporting Standards (PFRSs) Updated
Self-taught
Designed for OBE
An Integrated Principle-based Approach
A Guide to Understanding and Mastering Financial Accounting

Principles and Applications
For
Accountancy students
CPA Board Exam candidates
Finance & Business students
Practitioners
and
Instructors
By
VHINSON JAY S. GARCIA, CPA
The
The Book
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Philippine Copyright, 2023
by
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source. Violators Pin
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ALL RIGHTS RESERVED
ISBN: 978-971-95940-8-6
Published and distributed by:
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ABOUT THE AUTHOR
CPA Board Exam Top 1
National CPA Reviewer in Financial Accounting and Reporting (FAR)

National CPA Reviewer in Auditing Theory (AT)
Member of Technical Team and

Academics Officer
Real Excellence Online CPA Review
Lecturer
Wesleyan University-Philippines, Cabanatuan City
Mary the Queen College, Pampanga
Holy Angel University, Pampanga
National University - Baliwag, Bulacan
Former Auditor
Sycip, Gorres, Velayo (SGV) & Company
Makati City
Credit Derivatives Reviewer

[a multinational bank]
Bonifacio Global City, Taguig
Summa Cum Laude, BS Accountancy

Wesleyan University-Philippines, Cabanatuan City
Valedictorian, High School

San Antonio Montessori School, San Antonio, Nueva Ecija
Salutatorian, Elementary
San Francisco Elementary School, San Antonio, Nueva Ecija
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DEDICATION
To the Supreme Being up above, who gave me the strength and knowledge in
finishing this craft,
To my parents, Papa, Vic Garcia and Mama, Lorna Garcia, who always give their
unwavering support, guidance and inspiration from the beginning until now,
To my grandparents, Itay, Cipriano Samson and Inay, Conchita Samson, who guided
me ata very young age and raised me from a very humble beginning,
To my uncles, Tito Rod, Tito Cris and Tito Dennis, who showed me at a very young
age that I can achieve many things through hardwork and perseverance,
To my former professors in Wesleyan University - Philippines, as spearheaded by

then Dean, Dra. Maria Victoria Mones-Cruz, who nurtured and equipped me with
the knowledge that greatly contributed to what I have achieved so far,
To every student and professor in quest of real excellence,
This book is dedicated to you.
A special thanks to my former students who gave feedback and suggestions for the
improvement of this book, to my friends and colleagues in REO CPA Review, and to
Sir Nifio Jerald Cruz, Seanne Veniene Esguerra, and Robert Carl Arrojo, who shared
their expertise in reviewing this craft.
A dearest thanks to Sir Rex Banggawan, who inspired me to create this book and
share my knowledge to a wider audience, and to Wency Giron and Khim Aflonuevoe
for their utmost support.
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INSTRUCTION TO READERS
Dear readers,
Financial Accounting and Reporting is a complex and interesting topic, yet itis
one of the most integral fields of knowledge inherent to finance and accounting
professionals. Thus, an adequate understanding of Financial Accounting and Reporting
is a hallmark of a true accountant. Although the topic at hand may seem daunting, the
author shall do his best to make the subject easily understandable.
Financial Accounting and Reporting is complex because it establishes the

foundation of accounting rules, pronouncements, and standards. Here, students will
learn about the different classes of assets, liabilities, and equity. Each classification of
assets and liabilities will have their own corresponding standards, principles, and
disclosure requirements. This book shall follow a standard-based discussion to ensure
a practical understanding of the topics at hand. Furthermore, the author devised a
principle-based structural presentation of Financial Accounting and Reporting to aid in
the understanding of the concepts through concept maps, diagrams, and simple
discussions. The aim is to inculcate a thorough understanding for long-term concept
retention and decisive application.
In studying the text, focus on the principles before the application. These
principles are derived directly from the Financial Reporting Standards. Afterwards,
mastery of the topic is achieved through the application of the principles through
computational problem discussions further supported by self-test exercises on the
concepts and problems.
The author has carefully arranged the topics in this book from chapter to
chapter and volume to volume. I strongly recommend that you read the book from the
first chapter to the end. References between chapters are being made in order to
strengthen the interconnectedness of the topics. One must not forget the past topics as
they delve deeper into the book. Your understanding of previous concepts will always
be needed in later chapters.
After understanding the chapters, practice is the stepping stone to mastery.

Thus, always answer the end-of-chapter self-test exercise to gauge your understanding
of the topic. The discussion questions serve as summaries of the concepts. The theory
questions are for strengthening your understanding based on the accounting standards.
The numerical problems are for practice of the application of the theories, However, we
advised our beloved readers that the solution manual of the book is restricted only
to financial accounting professors of adopting schools. This is to ensure that
students attempt and successfully master the concepts, theories, and problems.
It is in my sincerest hope that this humble piece of work will be able to guide,
shape, and teach our future CPAs. | hope this book will be able to deliver its objective
and assist you in your goals. Welcome to the world of financial accounting! May this
book serve as your partner and your guide. God Bless!
For commentaries, inquiries, or suggestions:
The
We highly value your feedback. Please share your thought with us. Please fee]
free to e-mail us at realexcellence.publishing@yahoo.com. You may also contact Real
Excellence Publishing at 09669063062 / 09603130705. Thank you!
Interested readers may secure copies of our books from Real Excellence
Publishing.
Vhinson Jay S. Garcia, CPA
REAL EXCELLENCE PUBLISHING - Intellectual Property Rights Advisory

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The
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INTERMEDIATE ACCOUNTING VOLUME 2
2023 EDITION
VERVIE F CONTENT
CHAPTER 1 Introduction to Liabilities 1-25

CHAPTER 2 Accounts Payable and Notes Payable 26-56
CHAPTER 3_ Introduction to Provisions 57-84
CHAPTER 4 Warranties 85-105
CHAPTER 5 Premiums, Rebates, Discounts and Deferred Income 106-139
CHAPTER 6_ Bonds Payable and Loans Payable 140-172
CHAPTER 7 Compound Financial Instruments 173-191
CHAPTER 8_ Extinguishment of Liabilities © 192-223
CHAPTER 9 Lessee Accounting - Basic Considerations 224-260
CHAPTER 9A _ Lessee Accounting - Other Matters 261-295
CHAPTER 10 Lessor Accounting - Finance Lease 296-325
CHAPTER 10A Lessor Accounting - Operating Lease and Other Matters 326-354
CHAPTER 11 Sublease, and Sale and Leaseback 355-380
CHAPTER 12 Employee Benefits - Part 1 381-408
CHAPTER 12A Post-Employment Benefits 409-444
CHAPTER 13 Accounting for Income Taxes 445-490
CHAPTER 14 Accounting for Derivatives 491-516
CHAPTER 15 Shareholders’ Equity - Contributed Capital 517-561
CHAPTER 15A Shareholders’ Equity - Retained Earnings 562-595
CHAPTER 16 Equity-Settled Share-Based Payments 596-628
CHAPTER 16A Cash-Settled Share-Based Payments 629-658
The
TABLE OF CONTENTS
CHAPTER 1 Introduction to Liabilities 1-2 5
Requisites for the existence of a liability I
Obligation |
Obligation to transfer an economic resource 2
Present obligation as a result of past events 2
General classifications of liabilities 2
Accounting for financial liabilities 3
Accounting for non-financial liabilities 3
Financial reporting of liabilities 4
Criterion 1 - current liability 4
Convertible bonds payable 8
Liabilities - breach of covenants and grace period 8
Liabilities payable on demand 10
Accrued interest payable 11
Other items to be considered 12
Comprehensive illustration - current/noncurrent classification 12
Chapter summary 14
Exercise Drills 15-25
CHAPTER 2 Accounts Payable and Notes Payable 26-56

Accounting for accounts payable 26
Transactions affecting accounts payable 27
Adjustments to accounts payable balance 29
Unreleased, stale and postdated checks 29
Premature or late recording of invoices from suppliers 30
Notes payable - introduction 32
Notes payable - initial recognition and measurement 32
Subsequent accounting for promissory notes 35
Interest-bearing note with stated rate = market rate, lump-sum 36
Interest-bearing note with stated rate = market rate, installment 36
Noninterest-bearing note payable lump-sum 37
Noninterest-bearing note payable in installment 38
Interest-bearing note with stated rate # market rate 39
Promissory notes issued during the year 40
Financial liabilities - fair value through profit or loss 43
Exceptions to the recognition in profit or loss 44
Determining changes in FV arising form entity’s own credit risk 45
Chapter summary 47
CHAPTER 3 Introduction to Provisions 57-84

Provisions vs contingent liabilities 57
Recognition of provisions 58
Condition 1 - present obligation as a result of past event 58
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Condition 2 - probable outflow of resources 60
Condition 3 = reliable estimate can be made 61
General principles in measuring the obligation 61
Specific measurement guidelines 62
Expected value method 63
Mid-point of range 64
Events after the reporting period 64
Plaintiff's offer or out-of-court settlement 65
Consideration of future events 65
Expected gain from the disposal of an asset 66
Subsequent measurement of provisions 66
Changes in the estimated amount of provisions 67
Changes in the probability of outflow of economic benefits 68
Specific applications of provisions 69
Future operating losses 69
Onerous contracts 69
Restructuring - general concepts 70
Restructuring — measurement of provision 71
Contingent assets 72
Chapter summary 74
CHAPTER 4 Warranties 85-105

Reasons for warranties 85
Accounting classification of warranties 86
Assurance-type warranty vs service-type warranty 86
‘Accounting for assurance-type warranty 87
Assurance-type warranty - provision of replacement product 90
Assurance-type warranty with expiration 91
Changes in warranty estimates 93
Accounting for service-type warranty under PFRS 15 95
Chapter summary 97
CHAPTER 5 Premiums, Rebates, Discounts and Deferred Income 106-139

Premiums 106
Accounting for premiums 106
PAS 37 vs PFRS 15 accounting for premiums 107
Accounting for premiums under PAS 37 107
Accounting for premiums under PFRS 15 109
Further comparison of PAS 37 and PFRS 15 approaches 113
Customer loyalty programs (CLP) 113
Accounting for CLP - principal vs agent 114
CLP - accounting if the entity is the principal 114
CLP - accounting if the entity is the agent 116
Rebates, discounts, coupons and free products 118
Accounting for income received in advance 118
Gift certificates 121
Accounting for gift certificates - basic case 121
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Accounting for gift certificates - with expected breakage 122
Sales with right of return 123
Chapter summary 125
CHAPTER 6 Bonds Payable and Loans Payable 140-172

Long-term financing 140
Bonds payable vs loans payable 140
Bonds payable - introduction 141
Fundamental features of a bond 141
Bond indenture 142
Classifications of bonds 142
Initial measurement of bonds payable 143
Subsequent measurement of bonds payable 145
Methods of amortizing premium and discount 145
Straight-line method 145
Bond outstanding method 147
Effective interest rate method 150
Effects of bond issue costs - initial recognition 152
Effects of bond issue costs - subsequent measurement 153
Semi-annual and quarterly interest payments 154
Applying effective interest rate method on serial bonds 156
Issuance date not on the interest payment date of the bonds 157
Reporting date not falling on one of interest payment dates 159
Loans payable 161
Chapter summary 162
CHAPTER 7 Compound Financial Instruments 173-191

Common examples of compound financial instruments 173
Accounting for compound financial instruments 173
Allocation of issuance proceeds 173
Allocation of bond issue costs 175
Actual exercise of share warrants or convertibility option 177
Retirement of the bonds in compound financialinstruments 181
Non-exercise of the share warrants or convertibility option 183
Chapter summary 184
CHAPTER 8 Extinguishment of Liabilities 192-223

Payment of cash 192
Payment of noncash assets 193
Issuance of an entity’s own equity instruments 194
Accounting for issuance of an entity's own equity instruments 195
Accounting for partial extinguishment of financial liability 198
Accounting for extinguishment not oninterest payment date 199
Modification of terms of financial liability 202
Determining whether the modification is substantial or not 202
Accounting when there is no substantial modification 204
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Accounting when there is substantial modification 207
Chapter summary 212
CHAPTER 9 Lessee Accounting - Basic Considerations 224-260

Background of lease transactions 224
Some reasons why lessees enter into lease contracts 224
Lessee accounting for leases (general lessee accounting model) 225
Right-of-use asset - initial measurement 225
Lease liability - initial measurement 225
Discount rate in discounting lease liability 226
Lease liability - lease payments 226
Fixed lease payments 227
Variable payments based on index or rate 229
Residual value guarantees 229
Purchase options 230
Subsequent measurement of right-of-use asset 232
Subsequent measurement of lease liability 233
Consideration of extension and termination option 240
Exceptions to the general lessee accounting model 243
Short-term leases 243
Lease of low-value assets 244
Annex 1 - Lease contracts in practice 245
Chapter summary 247
CHAPTER 9A Lessee Accounting - Other Matters 261-295

Reassessment vs modification 261
Reassessment of lease liability 261
Accounting for reassessment of lease liability 262
Reassessment of lease term 263
Reassessment of the decision in exercising purchase option 266
Reassessment of the residual value guarantee 270
Reassessment of variable lease payments base on rate or index 273
Lease modifications | 275
Increase in the scope of the lease 275
Decrease in the scope of the lease 279
All other lease modifications 281
Presentation of ROU asset and lease liability 281
Current and noncurrent presentation 282
Presentation in the statement of cash flows 284
Disclosure in the notes to the financial statements 284
Chapter summary 284
CHAPTER 10 Lessor Accounting - Finance Lease 296-325

Lessors 296
Advantages of being a lessor 296
Lessor’s accounting for leases (risks and rewards assessment) 297
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When are risks and rewards substantially transferred? 297
Initial recognition and measurement - finance lease 300
Components of lease payments receivable by the lessor 301
Guaranteed and unguaranteed residual value 302
Types of finance leases 304
Direct financing lease vs manufacturer's lease 304
Limit on revenue to be reported on manufacturer’s lease 307
Implicit rate onthelease —_, 308
Applications of implicit rate calculations 310
Computation of annual lease payments - direct financing 310
Computation of annual lease payments - manufacturer’s lease 311
Subsequent measurement of net investment in the lease 311
Return of asset to the lessor at the end of the lease term 315
Chapter summary 317
CHAPTER 10A Lessor Accounting - Operating Lease and Other Matters 326-354
Operating leases 326
General accounting for operating leases 326
Accrued rent receivable vs unearned rent income 327
Other matters affecting operating leases 331
Lease of land and building together 333
Changes in lease classification 336
Lease modification of finance lease 336
Lease modification from finance lease to operating lease 337
Lease modification - no change in finance lease classification 338
Lease modification of operating lease 340
Lease modification - no change in operating lease classification 341
Lease modification from operating lease to finance lease 342
Leases in the lessee’s and lessor’s perspectives 343
Chapter summary 346
CHAPTER 11 Sublease, and Sale and Leaseback 355-380

Subleases : 355
Accounting for subleases - lessor and sublessee 355
Accounting for subleases - original lessee/intermediate lessor 356
Sublease — general lessee accounting modelin the headlease 356
Sublease- short-term lease in the head lease 356
Sublease as finance lease vs sublease as OprtsHng lease 356
Sale and leaseback transactions 361
Accounting for sale and leaseback 361
Transfer is considered as a sale in sale and leaseback 361
Selling price is equal to the fair value of transferred asset 362
Lease liability from sale and leaseback 362
ROU asset from sale and leaseback 362
Gain or loss from sale and leaseback 362
Selling price is NOT equal to the fair value of transferred asset 364
Selling price is higher than the fair value of transferred asset 365
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Selling price is lower than the fair value of transferred asset 367
Sale and leaseback transaction involving loss 368
Transfer is NOT considered as a sale in sale and leaseback 370
Chapter summary 371
CHAPTER 12 Employee Benefits - Part 1 381-408

Employee benefits 381
Accounting for employee benefits 381
Different classifications of employee benefits 382
Short-term employee benefits 382
Accounting for short-term employee benefits 383
Special considerations of short-term employee benefits 384
13% month pay 384
Determining the amount of 13 month pay 384
Accounting for 13‘ month pay 386
Paid absences 386
Accumulating and non-accumulating paid absences 387
Vesting and non-vesting accumulating paid absences 387
Accounting for paid absences (expense and liability) 388
Profit-sharing and bonus plans 390
Accounting for profit-sharing and bonus plans 390
Different bases of bonus 391
Employee and employer statutory contributions 393
Other long-term employee benefits 396
Other long-term employee benefits — long-term disability 396
Termination benefits 396
Recognition and measurement of termination benefits 398
Chapter summary 400
CHAPTER 12A Post-Employment Benefits 409-444

Post-employment benefits 409
Minimum amount of retirement benefits 409
Different types of post-employment benefit plans 409
Defined contribution plan vs defined benefit plan 410
Accounting for defined contribution plans 411
Accounting for defined benefit plans 412
Accounting for defined benefit obligation 412
Actuarial valuation method 413
Attribute the benefit to periods of service 413
Making actuarial assumptions 413
Resulting amounts after applying the three-step approach 414
Service costs, interest expense, actuarial gains and losses 414
Defined benefit obligation - individual employee basis 415
Defined benefit obligation - entity level basis 417
Accounting for plan assets 418
Transactions and amounts affecting plan assets 419
Accounting for actual returns 420
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Computation of interest income and remeasurement gain/loss 429
Effects of contributions and payments in interest income 42]
Comprehensive accounting for plan assets 422
Presentation of net retirement asset or liability 42%
Accounting for total retirement costs A24
Accounting for asset ceiling 427
Chapter summary 43)
CHAPTER 13 Accounting for Income Taxes 445-490

Accounting for income tax 445
Determining the accounting income 446
Determining the taxable income 446
Primer on Philippine income taxation 446
Differences between accounting income and taxableincome 448
Reconciling accounting income to taxable income 449
Components of total tax expense 450
Current income tax 451
Temporary differences (and resulting assets and liabilities) 452
Determining the amount of deferred taxes 453
Income statement approach 453
Balance sheet approach 457
Tax base of assets and liabilities 457
Application of balance sheet approach 458
Comparison of income statement and balance sheet methods 460
Recognition of income taxes outside profit or loss 465
Net operating loss carry-over (NOLCO) 466
Changes in income tax rates © 467
Effects of scheduled changes in tax rates 471
Subsequent reversal of deferred taxes 471
Effective income tax rate 473
Annex 1 - Accounting and taxable income usual differences | 474
Chapter summary 476
Exercise Drills : 478-490
CHAPTER 14 Accounting for Derivatives 491-516

Derivatives - introduction 491
Definition and characteristics of derivate products 491
Different derivative products 492
Elements ofa derivative contract 492
Manners of settling derivative contracts 493
General accounting model for derivative products 493
Determining the pay-off from forwards/futures 494
Accounting for derivative products - forwards/futures 496
Determining the position in option contracts 499
Call options vs put options 499
In-the-money vs out-of-the money vs at-the-money options 500
Net amount of pay-off from option contracts 501
Fair value of options (time value + intrinsic value) 502
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Accounting for derivative products - options 503
Other forms of derivatives 505
Chapter summary 508
CHAPTER 15 Shareholders’ Equity - Contributed Capital 517-561

Equity instruments 517
Equity compared to liability 517
Introduction to shareholders’ equity 518
Components of shareholders’ equity 518
Contributed capital 519
Legal capital 520
Accounting for issuance of share capital 521
Basket issuance of different classes of shares 523
Subscription of shares 524
Delinquent subscription of shares 526
Retirement of shares 528
Treasury shares 529
Share issuance costs 532
Costs of initial public offering of shares 534
Donation of an entity’s own shares 536
Donation of asset 537
Conversion of preference shares 537
Share splits 538
Redeemable preference shares 539
Authorized vs issued vs outstanding number of shares 540
Transactions affecting issued and outstanding shares 541
Comprehensive illustration 543
Chapter summary 546
CHAPTER 15A Shareholders’ Equity - Retained Earnings 562-595

Transactions affecting unappropriated retained earnings 562
Dividends - in general 563
Cash dividends - ordinary shares 564
Cash dividends - preference shares 565
Cash dividends - allocation to ordinary and preference shares 566
Property dividends 568
Share dividends 572
Small and large share dividends 573
Liquidating dividends S74
Effects of different types of dividends - comparison S75
Comprehensive illustration for dividends 575
Appropriation of retained earnings 576
Quasi-reorganization 578
Chapter summary 582
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CHAPTER 16 Equity-Settled Share-Based Payments 596-628
Share-based payment arrangements 596
Equity-settled share-based payment - a primer 596
Employee equity-settled share-based payment plans 597
Vesting conditions 597
Subject and not subject to vesting conditions 598
Estimating the amounts of compensation expense 598
Accounting for the exercise of vested share options 600
Illustrations - Changes in the number component 602
Illustrations - Changes in the period component 604
Illustrations - Changes in the value component 605
Accounting when share options’ FV is not determinable 607
Intrinsic value method 607
Failure to meet vesting conditions 609
Modifications 611
Cancellation and settlement of share-based payment 614
Chapter summary 616
CHAPTER 16A Cash-Settled Share-Based Payments 629-658

Equity-settled vs cash-settled share-based payment 629
Share appreciation rights 630
Changes in the estimates during the vesting period 633
Share-based arrangements with share and cash alternatives 634
Accounting if the counterparty has the choice of settlement 634
Modification from cash-settled to equity-settled 639
Modification from equity-settled to cash-settled 641
Share-based payment transactions among group entities 643
Classification of group share-based payment transactions 643
Accounting for group share-based payment transactions 645
Chapter summary 647
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Chapter 1 — Introduction to Liabilities
CHAPTER 1
INTRODUCTION TO LIABILITIES
Chapter Overview and Objectives
After this chapter, readers are expected to comprehend:

1. The requirements for the existence of a liability.
2. The different types of liabilities.
3. The classification of liabilities into current and noncurrent amounts.
4. The computation of accrued interest payable.
INTRODUCTION TO LIABILITIES
Inlayman’s terms, liabilities are considered to arise from the borrowing of funds by
an entity or by a person. However, in accounting, liabilities arise not just from
borrowing of funds but also from many other sources _as long as the criteria for
the recognition of a liability are met.
According to the Conceptual Framework (the “Framework’”), a liability is a present
obligation of the entity to transfer an economic resource as a result of past events.
ALL of the following criteria shall be met for a liability to exist:

a. the entity has an obligation; preset Ova Fan hae
b. the obligation is to transfer an economic resource; and i" & de 4
c. the obligation is a present obligation that exists as a result of past events,
Each of these criteria will be discussed in the succeeding sections.
OBLIGATION
An obligation is a duty or responsibility which an entity has no practical ability to
avoid. [Framework 4.29]. An obligation may arise from any of the following:
a. contract, laws, and regulations (collectively known as “legal obligation”); or
b. entity’s customary practices, published policies or specific statements with an
entity having no practical ability to avoid (“constructive obligation’).
i
* It is not required
watnene
to specifically recognize the identity of the counterparty
for an
obligation to exist. For example, estimated warranty liability will still be
recognized even though an entity does not know who of its customers will
ultimately claim its right under the warranty. Warranties will be discussed in
Chapter 4.
In addition, an obligation exists even if the exact amount of the obligation is unknown,
provided that it can be reliably estimated. Using warranties again as an example,
related liability is recognized even though its amount is based solely on a reliable
estimate.
CAIN DIVTIND PAYADY, - Labi 2

OHIRE OVID PiyAbyE - oct a Uovilsdy
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OBLIGATION TO TRANSFER AN ECONOMIC RESOURCE

Obligations to transfer an economic resource include, for example:
a. obligations to pay cash - for accounts payable to suppliers, accrued expenses,
and borrowings (i.e., loan and bond payables).
b. obligations to deliver goods or provide services - for income received in
advance or provision of warranty coverage.
c. obligations to exchange economic resources with another party on unfavorable
terms - for derivative liabilities.
d. obligations to transfer an economic resource ifa specified uncertain future event
occurs — for conditional obligations.
PRESENT OBLIGATION AS A RESULT OF PAST EVENTS

There shall be a present obligation as a result of past events for an entity to
recognize a liability. Obligations that will be incurred in the future shall not be
recognized as there is no present obligation to account for.
A good example of future obligation is when an entity orders an item of equipment.
On the date the equipment was ordered, no obligation shall be recognized since the
equipment is yet to be delivered to the entity. It is only when the equipment was
delivered to the entity that a liability is recognized since there is already a past
event (i.e., the receipt of the equipment from the supplier).
A present obligation exists as a result of past events only if:
a. the entity has already obtained economic benefits or taken an action; and
b. aS a consequence, the entity will or may have to transfer an economic resource
that it would not otherwise have had to transfer.
The following are examples of ways an entity obtains economic benefits and the
resulting obligation:
a. An entity acquiring inventory will recognize a corresponding amount of liability
(i.e., accounts payable) if it has alréady taken title over the goods.
b. Utilities (e.g., electricity or water) provide an entity economic benefit as they are’
consumed. Because of these consumed utilities, an entity will now be required
to pay a corresponding amount to the utilities provider (i.e., accrued expenses).
GENERAL CLASSIFICATIONS OF LIABILITIES

For accounting purposes, liabilities can be broadly classified into financial and non-
financial liabilities:
LIABILITIES
[se Financial Liabilities | fa Non-financial Liabilities et

Financial liability is any liability that gives rise to a contractual obligation:
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Chapter 1 - Introduction to Liabilities
a. to deliver cash or another financial asset to another entity; or

b. to exchange financial assets or financial liabilities with another entity under
conditions that are potentially unfavorable to the entity. [PAS 32.11].
The following are examples of liabilities that are considered as financial liabilities:
a. accounts and trade payables
b. notes payable
c. bonds and loans payable
d. derivative liability
The following are considered as non-financial liabilities:
a. Unearned income (income received in advance) - the obligation of the entity is to
deliver goods or provide services to customers rather than delivering cash or
another financial asset.
b. Estimated warranty liability - the obligation is to provide service to correct the
defects or malfunctions of products previously sold.
c. Income tax payable, deferred tax payable, and other tax liabilities - the obligation
does not arise from contracts but rather as a statutory requirement.
d. Constructive obligations - the obligation does not arise from contracts but from
the expectations of relevant parties.
It should be noted that certain liabilities such as lease liabilities and employee
benefits appear to be financial liabilities, but these are accounted differently
(different accounting standards) from the rest of the “true” financial liabilities.
ACCOUNTING FOR FINANCIAL LIABILITIES

Generally, according to PFRS 9, financial liabilities are initially measured at their
fair value less the transaction costs incurred. Subsequently, financial liabilities
are generally measured at their amortized cost.
The accounting for amortized cost is similar to investments at amortized cost,

albeit the point of view is now on the issuer rather than the investor's point of view.
Details of this measurement basis will be discussed in Chapters 2 and 6.
As a way of exception, an entity, on initial recognition, may irrevocably
designate a financial liability at fair value through profit or loss (FVTPL) and
recognize changes in the liability’s fair value in profit or loss. This alternative is
normally applicable to bonds payable as their fair values are reliably determinable.
Details of this alternative accounting will be discussed again in Chapter 2.
ACCOUNTING FOR NON-FINANCIAL LIABILITIES

For non-financial liabilities, different accounting procedures are followed depending
on the relevant accounting standard that applies. For example:
a. Provisions are accounted for under PAS 37, Provisions, Contingent Liabilities and
Contingent Assets (see Chapter 3).
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b. Lease liabilities are accounted for under PFRS 16, Leases (see Chapters 9 to 11).
c. Liabilities for employee benefits are accounted for under PAS 19, Employee
Benefits (see Chapters 12 and 124A).
Other non-financial liabilities are measured in the following manner:
a. Estimated amount to be incurred or paid to the counterparties (e.g., warranties,
income taxes payable or value-added tax payable); or
b. Equal to the amount received from customers that are not yet earned (e.g.,
advances from customers, unearned income, liability from gift certificates).
FINANCIAL REPORTING OF LIABILITIES

Generally, in the entity’s statement of financial position, liabilities are classified as
eithercurrent or non-current.
An entity shall classify a liability as current when:
a. it expects to settle the liability within its normal operating cycle;
b. it holds the liability primarily for the purpose of trading;
c. the liability is due to be settled within twelve months after the reporting period;
or
d. it does not have an unconditional right to defer settlement of the liability for at
least twelve months after the reporting period.
An entity shall classify all other liabilities as non-current. [PAS 1.69].

It should be noted that any one of these criteria is enough to classify a liability as
current. Each of these criteria will be discussed in greater detail in the succeeding
sections.
CRITERION 1 - It expects to settle the liability within its normal operating cycle
The operating cycle of an entity is the time between the acquisition of assets for
processing and their realization in cash or cash equivalents. Graphically, the
length of the operating cycle can be shown as follows:
normal operating cycle
\
{ \
ae ee ee
y { y
Date of acquisition of Date of selling the Date of realization of
goods for processing, goods on credit accounts receivable
to be sold later into cash
When the entity’s normal operating cycle is not clearly identifiable, it is assumed to
be twelve months. [PAS 1.68].
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This criterion is made for trade payables such as the following:

a. accounts payable
b. notes payable for operating purposes
c. accrued operating expenses
d. unearned income; and
e. warranty liabilities.
These are normally classified as current even if they will be settled beyond 12
months after the reporting date as long as it will be paid within the normal
operating cycle.
For example, an accounts payable that is due to be paid in 15 months is still

considered as current if the entity’s normal operating cycle is 18 months.
CRITERION 2 - Holds the liability primarily for the purpose of trading
A liability is considered as held for trading if (using the definition under PFRS 9):
a. itis acquired for the purpose of selling or repurchasing it in the near term;
b. on initial recognition is part of a portfolio of identified financial instruments
where there is evidence of recent actual pattern of short-term profit-taking; or
c. derivative (except those designated and effective hedging instrument).
Under this criterion and in the absence of additional information (i.e., silent
treatment), financial liabilities at FVTPL are usually classified as current. The
reason for this is that, in the absence of contrary information, the financial liabilities
at FVTPL are assumed to be held for trading. Prime example of this is the derivative
liability.
However, financial liability at FVTPL that was irrevocably designated as such on
initial recognition is not necessarily considered as current mainly because it may not
be held for trading.
CRITERION 3 - The liability is due to be settled within twelve months after the
reporting period ee .
This criterion covers nontrade liabilities such as:
bank overdraft
dividends payable
mmpaoop
current and deferred income taxes and indirect taxes

notes payable issued other than for operating purposes
loans and bonds payable (including accrued interest)
lease liabilities
pension liability
In the absence of additional information, bonds payable, mortgage payable, and

pension liabilities are normally classified as non-current liabilities.
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For these liabilities to be considered as current, they must be settled within twelve
months after the reporting date, regardless of the original term of the liability,
This can be summarized as follows:
Scenarios Classification
Reporting date to Maturity date $12 months Current
Reporting date to Maturity date >12 months Non-current
Applying this principle, the following non-trade payables are current:

a. bank overdraft and dividends payable
b current income tax payable and indirect taxes payable
.
c. accrued interest payable
d . notes, loans, and bonds payable maturing within 12 months after the reporting
date, regardless of the length of their original term.
portion of notes payable, loans payable, bonds payable, and lease liability that
are due to be settled within 12 months after the reporting date.
However, deferred tax liability is ALWAYS considered as non-current.

Illustration 1. ROSARIO Company had the following non-trade payables as of
December 31, 2023:
7-year bonds payable with maturity of July 1, 2024. P4,000,000
3-year bonds payable with maturity of December 31, 2025 2,000,000
5-year loan payable borrowed last October 1,2019 5,000,000
4-year loan payable borrowed last April 1, 2022 1,000,000
10-year loan payable borrowed last June 30, 2023; principal is
payable in 10 equal annual installments starting on June 30,2024 10,000,000
6-year loan payable with P400,000 semi-annual principal payments
every January 1 and July 1 of each year 8,000,000
Accrued interest payable 625,000
Required: From these given liabilities, determine the amounts to be classified as

current and noncurrent.
Solution:
Current Non-current
7-year bonds payable P4,000,000
3-year bonds payable P2,000,000
5-year loan payable 5,000,000
4-year loan payable 1,000,000
10-year loan payable 1,000,000 9,000,000
6-year loan payable 800,000 7,200,000
Totals P11,425,000 P19,200,000
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The following are the rationale regarding the classification of each liability:
Period from
12/31/23 to
Liabilities Maturity Date Maturity Date Remarks
Classified as current
yea 07/01/24 6 months regardless of the 7-year
bonds original term.
3-year bond 12/31/25 24 months Non-current
9-year loan 10/01/24 9 months 2019 plus 5 years is 2024
4-year loan 04/01/26 27 months 2022 plus 4 years is 2026
P1 million - P1 million - 6 P1 million is classified as
10-year 06/30/24; months; current, while P9 million
loan P9 million - P9 million - >12 is classified as non-
starting 2025 months current
P400K each on _ | P800K (P400Kx 2) is
01/01/24 and aa Me Se classified as current,
6-year loan 07/01/24; P7.2 million - >12 ’ | while P7.20 million (P8M
P7.2 million - ‘ h - P800K) is classified as
starting 2025 mens non-current
Accrued interest payable amounts are normally classified as current since they are
normally paid at least once a year.
CRITERION 4 - It does not have an unconditional right to defer settlement of the

liability for at least twelve months after the reporting period/date.
As previously discussed, a liability that is due to be settled within 12 months is
normally classified as current, in the absence of both of the following:
a. unconditional right of the entity to defer the settlement of the liability; and
b. the deferment is at least twelve months after the reporting date.
The unconditional right of an entity can also mean “sole discretion” of the entity,
which means that a borrowing entity may make a decision without needing for an
agreement with the other parties.
Deferment means extending the maturity date beyond the original one. Ifan entity
has the sole discretion to extend the maturity date, the period of extension shall also
be considered in classifying the liability as current or non-current. This deferment
is also known as “refinancing”.
Illustration 2. As of December 31, 2023, DELGADO Company had a loan payable

maturing on June 30, 2024. The Company has the sole discretion to extend the
maturity date up to June 30, 2025.
Based on this information, the loan payable shall be classified as non-current since it
has an unconditional right to defer the settlement for at least twelve months after
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December 31, 2023. This is regardless of the loan’s original maturity date of June 30,
2024, which is just six months after December 31, 2023.
Illustration 3. Going back to DELGADO Company, except that the maturity date
may be extended to June 30, 2025 provided the lender will agree.
Based on the revised information, the loans payable shall still be classified as current
as the Company does not have unconditional right to defer th This is
because the agreement with the lender is needed to extend the maturity date to June
30, 2025.
Illustration 4. At the end of 2023, CANLAS Company had a bond payable maturing
on April 1, 2024. The Company has the sole discretion to extend the maturity date
up to October 1, 2024.
The bond payable shall still be classified as current. Yes, there is an unconditional
right to defer the maturity date, but the deferred maturity date of October 1, 2024 is
still less than twelve months from December 31, 2023. This only shows that it is also
important to consider the length of deferment, in addition to assessing whether there
is an unconditional right to defer.
CONVERTIBLE BONDS PAYABLE Seify\c\\l) Wayans

Some bonds may be converted into equity securities of the issuer (this feature will
be discussed in Chapter 7). Despite this feature, it shall not be considered in
classifying bonds payable as current or non-current. Instead, CRITERION 3 shall be
applied by assessing the period from the reporting date to maturity date.
Illustration 5. As of the end of 2023, TARLAC Company had the following

convertible bonds payable:
10-year bond payable maturing on September 30, 2024 P7,000,000
5-year bond payable maturing on April 1, 2027 2,000,000
In this case, the convertibility feature of each bond payable shall be ignored. The 10-
year bond payable shall be classified as current since its maturity date is nine months
after December 31, 2023. On the other hand, the 5-year bond payable shall be
classified as noncurrent since its maturity date is more than 12 months after
December 31, 2023.
LIABILITIES - BREACH OF COVENANTS AND GRACE PERIOD

Loans payable and bonds payable normally contain covenants that contain
restrictions and/or conditions that the borrower is required to follow. The purpose
of these covenants is to highly discourage the borrower from doing activities that
may diminish its ability to pay the liability.
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eee ( } ch (mand
If these covenants were breached, the related liabilities will now become current,
regardless of the liability’s remaining term before maturity.
y\\ However, despite the breach, the creditor may decide to give the borrower a grace
= period, where the creditor will temporarily not demand the immediate payment
and will allow the borrower to rectify the restriction/s and/or conditions breached
(i.e, curing of breach of covenants). The following flowchart may be used in
€ oe, the classihication o the related liability:
Dod (iy x tet, nd
Is the liability due to be settled

within twelve months after
reporting date?
Is there any breach of loan or

bond covenants?
Has the lender granted the entity

a grace period?
Is the grace period granted on or

before the reporting date?
Does the grace period end at

least 12 months after the
renorting date?
v
Present the liability as Present the liability
noncurrent as current
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However, even if the grace period has been granted after the reporting date, it shal|
be disclosed in the financial statements.
Illustration 6. SASMUAN Company had a loan payable as of December 31, 2023
with remaining period to maturity of 5 years. One of the loan’s covenants is for the
Company to maintain a current ratio of at least 3.0 at all times. However, as of the
same date, the current ratio was 2.7, which is below the minimum ratio.
Because of the breach of a covenant, the loan payable shall be classified as current,
regardless of the 4-year remaining maturity, in the absence of any grace period.
Illustration 7. At the beginning of 2022, PANGLAO Company borrowed a Ioan
payable that will mature on December 31, 2027. Included in the loan’s covenants is
the timely payment of monthly interest. As of December 31, 2023, the Company is
5 months behind paying interest. As a result of the breach, the loan and the related
accrued interest became immediately due and demandable even if it will originally
mature on December 31, 2027.
Required: Under each of the following independent scenarios, determine the

classification of the loan (current or noncurrent) as of December 31, 2023:
1. A grace period not to demand payment for the next 18 months was granted on
December 20, 2023.
January 10, 2024.
December 24, 2023. .
Answer - Scenario 1
The loan shall be classified as noncurrent since the grace period was given before
December 31, 2023, and there is a deferral of payment for more than 12 months ajter
the same date.
Answer - Scenario 2
The loan shall still be classified as current since the grace period was only giver
after December 31, 2023, regardless of the period of deferral of payment. However,
the granting of the grace period shall be disclosed in the 2023 financial statements.
Answer - Scenario 3
The loan shall still be classified as current since the length of the grace period wil!
still require payment 6 months after December 31, 2023.
LIABILITIES PAYABLE ON DEMAND

Liabilities, which the creditor can declare as due and demandable anytime, are
always classified as current. This is regardless of the liability's remaining term
until its maturity date,
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IIlustration 8.On December 31, 2023, ASTURIAS Company reported a loan payable
with maturity date of December 31, 2026. The creditor can demand the payment of
the loan anytime, even before the maturity date.
In this case, the loan shall be classified as current, regardless of its remaining term of
3 years.
ACCRUED INTEREST PAYABLE

The computation of accrued interest payable is similar to the computation of
accrued interest receivable from notes receivable. It should be recalled that interest
is earned/incurred by the mere passage of time. The general formula in computing
accrued interest is as follows:
Interest = Principal x Stated Rate x Time
When using this formula, the readers should take note of the following:
a. Principal amount to be used is as of the beginning of the interest period.
b. Time to be used is from the immediately preceding interest payment date
up to the reporting date. The frequency of interest payment (i.e., annually,
semi-annually and quarterly) will affect the amount of accrued interest.
c. Ifone of the interest payment dates is every December 31, accrued interest as of
December 31 of each year will be zero.
d. Assuming all other things are constant, the more frequent that the interest is
paid, the lower the amount of accrued interest as of the reporting date.
Illustration 9. As of December 31, 2023, TUAZON Company had the following

outstanding interest-bearing liabilities:
1. 10-year loan payable dated April 1, 2021 with face amount of P5,000,000 and
interest of 8%. The interest is payable annually every March 31 of each year.
2. 5-year, 12% interest-bearing bond payable dated June 1, 2022 with face amount
of P3,000,000. Interest is payable every May 31 and November 30 of each year.
3. 6-year, 9% interest-bearing loan payable dated January 1, 2021 with face
amount of P2,000,000. Interest is payable every December 31 of each year.
Required: Determine the total accrued interest payable as of December 31, 2023.
Answer:
Latest Interest Accrued int.
PaymentDate Latest IPD to payable,
Liability (IPD) 12/31/23 12/31/23
1 3/31/23 9 months P300,000 (P5Mx 8% x 9/12)
2 11/30/23 1 month 30,000 (P3Mx 12% x 1/12)
3 12/31/23 0 months - (P2Mx9%x 0/12)
Total P330,000
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The readers should take note of the following:

a. Accrued interest payable is normally classified as part of current liabilities.
b. There is no accrued interest payable for Liability 3 since the interest payment
date is every December 31 of each year. For this liability, interest expense for
each year is always fully paid as of each reporting date.
OTHER ITEMS TO BE CONSIDERED

Other concepts that are significant for the overall understanding of the readers
include the following:
a. The accounts payable shall be reported gross of debit balances in the suppliers
accounts. The debit balances shall be separately reported as advances to
suppliers (i.e, an asset account). The following is the pro-forma entry for
reclassification if the accounts payable is net of these amounts:
Advances to suppliers XX
Accounts payable XX
b. The credit balances in the customers’ accounts shall be reported as part of current
liabilities (in the unearned income account). The following is the pro-forma entry
for reclassification if the accounts receivable is net of these amounts:
Accounts receivable XX
Unearned income XX
c. The amount of bank overdraft that cannot be offset with the other bank account
balances shall be classified as part of current liabilities. The following is the pro-
forma entry for reclassification if the cash in bank is already net of this amount:
Cash in bank XX
Bank overdraft (liability) XX
COMPREHENSIVE ILLUSTRATION - CURRENT/NONCURRENT CLASSIFICATION

As of December 31, 2023, TUAZON Company reported the following information
related to some of its account balances:
a. Accounts payable amounted to P900,000 while advances from customers
amounted to P200,000. The accounts payable is net of P120,000 debit balances
in suppliers’ accounts.
b. Deferred tax assets and deferred tax liabilities amounted to P300,000 and
P450,000 respectively. Half of these deferred tax amounts will reverse during
2024. Income tax payable for 2023 amounted to P150,000.
c. Accounts receivable had a balance of P1,200,000, net of credit balances in
customers’ accounts of P75,000.
d. Cash in bank had a balance of P700,000, net of P100,000 overdraft in one bank
account. No other bank accounts are maintained in that bank.
e, Estimated warranty liability amounted to P250,000.
f. The Company has the following information related to its loans payable:
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Face _ Interest Date of

Loan amount Rate issuance Term
1 P4,000,000 6% 9/1/19 5 years
2 6,000,000 8% 4/1/21 4 years
3 5,000,000 9% 7/1/14 10 years
4 2,000,000 12% 10/1/18 6 years
All of the interest are payable annually. The payment of Loan 4's principal
amount can be deferred for at least two years after its maturity based solely on
the Company’s decision. The payment of Loan 3’s principal amount can be
deferred to July 1, 2027 if the lender agrees. The Company breached Loan’s 2
covenants; however, the lender granted grace period on January 10, 2024.
Required: Determine the amounts of current and noncurrent liabilities as of
December 31, 2023.
Answer:
Current Noncurrent
Accounts payable, adjusted (P900,000+P120,000) P1,020,000
Deferred tax liabilities P450,000
Income tax payable 150,000
Advances from customers (P200,000 + P75,000) 275,000
Bank overdraft 100,000
Estimated warranty liability 250,000
Loan 1 (maturity of 9/1/24 or 5 years after 9/1/19) 4,000,000
Loan 1 accrued interest payable from 9/1/23 to
12/31/23 (P4Mx 6% x 4/12) 80,000
12/31/23 (P6Mx 8% x 9/12) 360,000
12/31/23 (P5Mx 9%x 6/12) 225,000
12/31/23 (P2M
x 12% x 3/12) 60,000
Totals P17,520,000 P2,450,000
a. Deferred tax liabilities are always noncurrent regardless of the expected
reversal of their effects.
b. Loan 2 is classified as current since there is a breach of covenants, and the grace
period was granted only on January 10, 2024 or after December 31, 2023.
c. Loan 3 is classified as current since the Company does not have the sole
discretion since the lender’s agreement is necessary for the extension.
d. Loan 4 is classified as noncurrent since the Company has the sole discretion to
extend the maturity date of the loan.
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CHAPTER SUMMARY
1. Fora liability to exist, all of the following criteria shall be met:
a. the entity has an obligation;
b. the obligation is to transfer an economic resource; and
c. the obligation is a present obligation that exists as a result of past events.
2. It is not required to specifically recognize the identity of the counterparty for an
obligation to exist.
3. An obligation exists even if the exact amount of the obligation is unknown, provided
that it can be reliably estimated.
4. Obligations that will be incurred in the future shall not be recognized as there is no
present obligation to account for.
5. For accounting purposes, liabilities are generally classified as financial liabilities and
non-financial liabilities.
6. For financial reporting purposes, liabilities are classified as either current or non-
current. To be classified as current, a liability shall meet any one of the following:
a. it expects to settle the liability within its normal operating cycle;
b. it holds the liability primarily for the purpose of trading;
c. the liability is due to be settled within twelve months after the reporting period; or
d. itdoes not have an unconditional right to defer settlement of the liability for at least
twelve months after the reporting period.
7. The operating cycle of an entity is the time between the acquisition of assets for
processing and their realization in cash or cash equivalents. In the absence of
additional information, the normal operating cycle is assumed to be 12 months.
8. In classifying a non-trade liability as current, its maturity date shall be within 12
months after the reporting date.
9. Deferred tax liabilities are ALWAYS classified as non-current.
10.A liability is classified as non-current if the entity has the sole discretion to extend
the maturity date for at least 12 months after the reporting date.
11. Breach of covenants will generally result to classifying the liability as current, except
when there is a grace period of more than 12 months granted on or before the
reporting date.
12.Even though the grace period is granted after the reporting date, it shall still be
disclosed in the financial statements.
13. Liabilities payable on demand are classified as current, regardless of its remaining
term.
14. Convertibility feature of some liabilities is not relevant in classifying the liabilities as
current or non-current.
15.Accrued interest payable is normally classified as current. It is computed as follows:
Interest = Principal x Stated Rate x Time
Time is from immediately preceding interest payment date until the reporting date.
16.The accounts payable shall be reported gross of debit balances in the suppliers’
accounts.
17.The credit balances in the customers’ accounts and bank overdrafts shall be
reported as part of current liabilities.
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CHAPTER 1: SELF-TEST EXERCISES
True or False
No liability shall be recognized if the counterparty is not specifically identified.
DAAPWNnP
A liability may be recognized even if its amount is based on estimates,

Obligation to be incurred in the future shall be recognized as a liability.
Warranty liability is not considered as a financial liability.
Bonds payable is considered as a financial liability.
On initial recognition, financial liabilities are measured at the total amount of cash
to be paid in the future.
7. Atrade liability that is to be settled within the entity's normal ogenatine cycle shall
be recognized as current.
8. All of the criteria given in the standard shall be met to be able to classify a liability
as current.
9, Portion of deferred tax liability that is expected to be reversed within 12 months is
classified as current.
10. A five-year loan payable maturing in four months shall be reported as a current
liability.
11. A loan payable with remaining term of six months is reported as a noncurrent
liability if the entity has the sole discretion to refinance the loan.
12. Aconvertible bond payable is classified as current or noncurrent, depending on the
expected timing of the actual conversion of the bonds.
13. Accrued interest payable is computed from the beginning of the period until the
interest payment date.
14. A loan with principal that is payable in annual installments is classified as partly
current and partly noncurrent.
15. If a grace period to rectify a breach in loan covenants was granted after the
reporting date, the related loan payable shall be classified as noncurrent.
Multiple Choice - Theories

1. Criteria that should be met for a liability to exist include the following, except
a. the entity has an obligation
b. the obligation is to transfer an economic resource
c. the identity of the counterparty is known
d. there is a present obligation that exists as a result of past events.
2. Obligations to transfer an economic resource include the following, except
a. to exchange economic resources with another party on favorable terms
b. to pay cash
c. to deliver goods or provide services
d. to transfer an economic resource if a specified uncertain future event occurs
3, Which of the following events will give rise to a present obligation?

a. an employment contract was signed with a new employee providing for a
monthly salary of P50,000.
b. purchased inventory items have been shipped FOB shipping point
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c. aconnection with a utility provider has been established

d. allofthe above
4. The following are considered as financial liabilities, except

a. advances from customers
b. bonds payable
c. accounts payable
d. loans payable
5. Non-financial liabilities include all of the following, except
a. income tax payable
b. constructive obligations
c. deferred tax payable
d. note payable
6. Financial liabilities are accounted for differently compared to non-financiaj

liabilities. In relation with this, which of the following is correct?
a. financial liabilities are accounted for using different accounting standards
applicable to the specific liability.
b. non-financial liabilities are initially measured at fair value.
c. financial liabilities may be accounted for at fair value through profit or loss.
d. non-financial liabilities are always classified as noncurrent.
7. To be considered as current, non-trade liabilities shall be payable

a. within 12 months after the reporting period
b. atleast 12 months after the reporting period
c. beyond 12 months after the reporting period
d. any ofthe above
8. All of the following are considered noncurrent liabilities as of December 31, 2023,
except :
a. a five-year loan payable that will mature on July 1, 2025.
b. asix-year bond payable that was issued last April 1, 2018.
c. a one-year loan payable that was borrowed last July 1, 2023 but can be
refinanced for three years based solely on the borrower's intention.
d. aten-year bond payable that was issued last October 1, 2016.
9. Which of these liabilities is considered as current as of December 31, 2023?

a. aloan with remaining term of three years that can be refinanced provided the
lender wil] agree.
b. aconvertible bond payable with remaining term of four years but is expected &
be converted on April 1, 2024.
c. a loan with remaining term of nine years but the lender can claim payment
anytime from the borrower,
d. a loan with the borrower breaching some covenants, but the lender granted 2
grace period on December 31, 2023,
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10. The amount of accrued interest payable shall be determined

a. from the beginning of the period until the latest interest payment date.
b. from the latest interest payment date until the reporting date.
c. from the beginning of the period until the reporting date.
d. from the latest interest payment date until the next interest payment date.
Straight Problems
1. As of December 31, 2023, PUPA Company had the following liabilities:
Accounts payable P1,800,000
Unearned income 200,000
Warranty payable 500,000
Notes payable 800,000
Bonds payable 3,000,000
Lease liability 2,000,000
Pension liability 1,500,000
Required: From the given information, determine the amounts of (a) financial
liabilities and (b) non-financial liabilities.
2. Atthe end of the year 2023, SANSKRIT Company had the following interest-bearing
liabilities:
a. Loan payable with face amount of P5,000,000 that was borrowed last April 1,
2021. Interest is payable every March 31 of each year.
b. Bond payable with face amount of P7,000,000 that was issued last February 1,
2021. Interest is payable very January 31 and July 31 of each year.
Required: From the given information, determine the total amount of accrued
interest payable as of December 31, 2023.
3. On December 31, 2023, DONBURI Company had the following outstanding

borrowings: :
a. Bond payable with face amount of P4,000,000. Interest is payable every
September 30 of each year.
b. Loan payable with original face amount of P10,000,000 and was issued last July
1, 2021. Interest and P2,000,000 principal are payable every June 30 of each
year.
c. Bond payable with face amount of P8,000,000. Interest is payable every March
1 and September 1 of each year,
Required: From the given information, determine the total amount of accrued
interest payable as of December 31, 2023,
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4. In preparing its statement of financial position, DARLING Company accumulated the

following information:
Withholding tax payable P350,000

Accounts payable, net of P50,000 debit balances in
supplier’s accounts 2,500,000
Accounts receivable, net of P100,000 credit balance in
customer’s accounts 3,000,000
Mortgage payable 5,000,000
Advances from customers 200,000
Valued-added tax payable 450,000
Overdraft in Bank A 150,000
Cash in bank balance in Bank B 1,000,000
Share dividends payable 800,000
Salaries payable 300,000
Accrued utilities payable 240,000
Purchase price of machinery ordered but not yet received 2,000,000
Warranty liability 850,000
Deferred tax liability 1,200,000
Dividends payable 750,000
Required: From the given information, determine the total amounts of (a) current
liabilities and (b) non-current liabilities.
5. As of December 31, 2023, MYSTERIOUS Company had the following liabilities:
Accounts payable P1,200,000

Notes payable - trade 900,000
Share dividends payable 600,000
6-year loan payable with maturity date of July 31, 2024. Interest of
12% is payable every July 31 of each year 5,000,000
7-year loan payable that was issued last April 1, 2020. Interest of
9% is payable every March 31 of each year 7,000,000
4-year loan payable that was issued last October 1, 2022. Interest
of 10% and principal amount of P3,000,000 are payable every
September 30 of each year 6,000,000
8-year bond payable that was issued last July 1, 2016, Interest of
8% is payable every June 30 each year 4,000,000
5-year bond payable that was issued last January 1, 2021. Interest
of 12% and P600,000 principal amounts are payable every June
30 and December 31 of each year 3,000,000
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liabilities and (b) non-current liabilities as of December 31, 2023.
6. Last March 1, 2020, VERONICA Company borrowed funds from a bank in a form of
loan payable. The face amount is P5,000,000 and maturity date is set on February
28, 2024.

classification of the loan payable, whether current or noncurrent, as of December 31,
2023:
a. The loan is payable on demand of the bank.
b. The Company has the sole discretion to refinance or roll over the loan for at least
18 months.
c. The Company can refinance or roll over the loan for at least 24 months, provided
the bank will agree.
d. The Company has the sole discretion to refinance or roll over the loan for at most
3 months after the maturity date.
e. The Company has the sole discretion to refinance or roll over the loan for 3
months at a time after the maturity date for such number of times as the
Company sees fit.
f, There were no preexisting refinancing provisions, buton December 15, 2023, the
parties agreed to extend the maturity date to February 28, 2025.
g. There were no preexisting refinancing provisions, but on December 15, 2023, the
parties agreed to extend the maturity date to August 31, 2024.
h. There were no preexisting refinancing provisions, but on January 31, 2024, the
parties agreed to extend the maturity date to February 28, 2025.
7. Last January 1, 2020, MECHANICAL Company borrowed a 10-year, 7% interest-

bearing loan of P8,000,000. One of the covenants included in the loan agreement is
that the current ratio shall be at least 4.0. Failure to comply with this covenant or
any of all other covenants will make the loan immediately due, regardless of the
number of years remaining before the maturity date. Unfortunately, during October
2023, the current ratio decreased to 3.50 for the first time, making the loan
immediately due and demandable.

classification of the loan payable, whether current or noncurrent, as of December 31,
2023:
a. There was no grace period agreed after the breach of the debt ratio covenant.
b. There was a grace period agreed on January 15, 2024 to rectify the breach.
c. There was a grace period agreed on December 27, 2023 to rectify the breach.
d. There was a grace period agreed on December 26, 2023 to rectify the breach.
However, due to the increasing credit risk of the Company, the lender, as a
condition to the given grace period, required that the new maturity date of the
loan is on December 31, 2024.
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8. VOLT Company had the following liability balances as of December 31, 2023;
Accounts payable P 1,900,000

Overdraft in Bank A 260,000
Overdraft in Bank B 160,000
Utilities payable 400,000 °
Loans payable:
Loan 1 - 5-year loan issued last October 1, 2022 5,000,000
Loan 2 - 10-year loan issued last January 1,2017 6,000,000
Loan 3 - 7-year loan issued last June 30, 2017 8,000,000
Loan 4 - 20-year loan issued last April 1, 2015 4,000,000
Additional data regarding these amounts are the following:

a. Accounts payable is net of P70,000 debit balances in suppliers’ accounts.
Similarly, there were also a total of P150,000 credit balances in the customers’
account that were deducted from the accounts receivable.
The Company maintains another bank account with Bank A that had a positive
balance of P800,000. No other bank accounts were maintained with Bank B.
Loan 1 bears 9% interest, payable every April 1 and October 1 of each year.
As part of the Loan 2’s covenants, the Company shall timely pay monthly interest
based on annual rate of 12%. However, the Company’s last interest payment
was on June 30, 2023. On January 12, 2024, the lender agreed to give a grace
period for the Company to rectify the breach.
The Company has the sole discretion to extend Loan 3’s maturity date for at least
two years after the original date. Interest of 10% is payable every June 30 of
each year.
The lender of Loan 4 can claim payment from the Company, regardless of the
loan’s remaining term. Interest of 8% is payable every March 31 of each year.
9. On December 31, 2023, APPLAUSE Company reported the following information:

Share dividends payable P1,300,000
Accounts payable 2,500,000
Bonds payable:
Bond 1 - bears 8% interest 5,000,000
Relevant additional data are the following:
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Bond 1 has an original maturity date of June 30, 2024. However, the Company
has the sole discretion to extend the payment of the 70% of the bond's principal
amount. The bond’s interest is payable every June 30 of each year.
Bond 2 has an original maturity date of April 1, 2024, Nevertheless, the
Company may refinance the bond and extend its maturity date on March 31,
2027, provided the lender will agree. Interest is payable every March 31 and
September 30 of each year.
Bond 3 has a maturity date of December 31, 2029. However, the bond is payable
on the demand of the investors.
Bond 4 has an original maturity date of September 30, 2030 and contains
covenant that the Company shall maintain 40% debt ratio. However, on
December 1, 2023, the Company’s debt ratio increased to 45%, making the bond
due and demandable. The lender granted a grace period on December 15, 2023.
Interest is payable every August 1 of each year.
Multiple Choice - Problems

1. JULIANA Company had the following information related to its liabilities:
Deferred tax liability P2,000,000

Notes payable 900,000
Utilities payable 300,000
From this information, the total amount of financial liabilities shall be

a. P5,650,000 c. P7,250,000
b. P7,100,000 d. P8,100,000
From this information, the total amount of non-financial liabilities shall be

a. P4,200,000 c. P4,350,000
b. P5,800,000 d, P3,350,000
2. As of December 31, 2023, KIMBERLY Company had the following liabilities:

Purchase price of equipment ordered but not yet received P3,000,000
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Salaries payable 320,000

Utilities payable 650,000
10-year loan payable with maturity date of May 1, 2024 2,500,000
7-year loan payable with principal payments of P800,000
every July 1 of each year 5,600,000
From this information, the total amount of current liabilities shall be

a. P4,470,000 c. P7,970,000
b. P6,970,000 d. P9,970,000
From this information, the total amount of non-current liabilities shall be

a. P14,800,000 c. P18,300,000
b. P12,800,000 d. P15,800,000
3. CALM Company had the following information as of December 31, 2023:
Withholding tax payable P250,000

Accrued expenses, including accrued interest payable 900,000
4-year loan payable that was issued last May 1, 2020; interest of 9%
is payable every April 30 of each year 3,000,000
10-year loan payable that was issued last July 1, 2021; interest of
12% is payable every June 30 of each year 5,000,000
5-year loan that is payable P500,000 every April 1 and October 1 of
each year; interest of 10% is payable on the same dates as the
principal installment payments 6,000,000
From the given information, the total amount of current liabilities shall be
a. P7,650,000 c. P6,350,000
b. P4,950,000 d. P5,750,000
From the given information, the total amount of non-current liabilities shall be
a. P17,200,000 c. P14,500,000
b. P16,400,000 d. P15,800,000
4. GENTLE Company had a tough time during the year 2023 because of the decrease in
economic activities in the country in which it operates. As a result, covenants
relating to financial ratios have been breached due to deterioration in the Company's
financials. The Company had the following loans as of December 31, 2023, all of
which have maturity dates beyond the year 2025;
e Loan payable with principal amount of P5,000,000 and interest of 8% payable
every October 1 of each year. The breach relates to non-payment of interest on
October 1, 2023. The lender granted grace period on December 20, 2023. ‘The
interest due October 1, 2023 was actually paid on January 31, 2024,
22
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e Loan payable with principal amount of P4,000,000 and interest of 9% payable

every June 30 of each year. The breach relates to decrease in the current ratio
below 2.50 on November 1, 2023. The lender granted grace period on January 5,
2024.
e Bond payable with principal amount of P6,000,000 and interest of 12% payable
every March 1 and September 1 of each year. The breach relates to debt ratio
being higher than 70%. The lender granted grace period on December 26, 2023.
a. P520,000 c. P5,750,000
b. P4,920,000 d. P7,820,000
a. P6,000,000 c. P10,000,000
b. P9,000,000 d. P11,000,000
5. As of December 31, 2023, TEMPERATURE Company had the following borrowings,

all of which have maturity dates of within the year 2024:
Loan 1 - bears 10% annual interest payable every April 1 P8,000,000

Loan 2 - bears 8% annual interest payable every July 1 4,000,000
Bond 1 - bears 12% annual interest payable every October 1 6,000,000
Bond 2 - bears 9% annual interest payable every December 31 5,000,000
Additional data that may relevant are the following:

a. Loan 1’s original maturity date was March 31, 2024. Maturity date of the half of
the loan is extendible until March 31, 2026, based solely in the Company’s
discretion.
b. Loan 2’s original maturity date is on July 1, 2024. Maturity date of the whole loan
can be extended for additional three months at the Company’s discretion.
c. Bond 1’s original maturity date is on September 30, 2024. This maturity date is
extendible until September 30, 2030, provided the lender will agree.
d. Bond 2’s original maturity date is on December 31, 2025; however, the parties
agreed on December 20, 2023 to extend the loan’s maturity to December 31,
2026.
a. P14,940,000 c. P19,940,000
b. P15,240,000 d. P20,140,000
a. P12,000,000 c. P7,000,000
b. P9,000,000 d. P6,000,000
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6. EGYPT Company had the following information as of December 31, 2023:
Accounts payable, net of P220,000 debit balances P3,500,000

Notes payable - trade 1,600,000
Withholding tax payable - from employee compensation 450,000
Expanded withholding tax payable 300,000
Overdraft - Bank Z 240,000
Overdraft - Bank X 320,000
Share dividends payable 1,200,000
Credit balances in the customers’ accounts that were deducted
from accounts receivable balance 150,000
Dividends payable 1,000,000
Pension liability 2,500,000
Loans payable:
Loan 1 - has original term of five years and 9% interest 4,000,000
Loan 2 - has original term of ten years and 12% interest 5,000,000
Loan 3 - has original term of six years and 10% interest 9,000,000
Loan 4 - has original term of eight years and 7% interest 6,000,000
Additional data related to these liabilities are the following:

a. The Company maintain other bank accounts with positive balance in Bank X. On
the other hand, no other bank accounts are maintained in Bank Z.
b. Loan 1 was originally issued last May 1, 2019. Interest is payable every April 30
of each year. The Company has the sole discretion to extend the maturity date
up until May 1, 2027.
Loan 2 was originally issued last October 1, 2016. Interest is payable every
September 30 of each year. Maturity date may be extended by two years,
provided the lender agrees.
Loan 3 was originally issued last July 1, 2019. Interest is payable every June 30
of each year. The Company has the sole discretion to extend the maturity date
by three months after the original maturity date.
Loan 4 was originally issued last April 1, 2022, with the interest payable every
March 31 of each year. During November 2023, the Company breached some of
the covenants related to debt ratio and current ratio. On January 20, 2024, the
lender granted a grace period not to immediately demand the loan’s payment.
a. P18,725,000 c. P19,815,000
b. P16,655,000 d. P14,615,000
a. P14,000,000 c. P20,500,000
b. P18,000,000 d. P21,300,000
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7, As of December 31, 2023, LIBYA Company generated the following information:

Unearned income P600,000
Purchase price of inventories, the title of which is
yet to be transferred to the Company 1,000,000
Loans payable:
9-year loan payable - 12% 4,000,000
The 12% loan payable has a maturity date of December 31, 2024 but can be extended
to December 31, 2028 if the Company chooses to do so.
The Company has breached some of the covenants in 9% loan payable and 10% loan
payable. On December 20, 2023 and January 5, 2024, the relevant lenders granted
waivers not to immediately collect the loan amounts for 9% loan payable and 10%
loan payable, respectively. Both of these loans had interest payment date of every
December 31 of each year.
The 8% loan payable has an original maturity date of June 30, 2024. On January 31,
2024, half of this loan was refinanced and will now mature on June 30, 2029. Interest
is payable every June 30 of each year.
a. P12,340,000 c, P14,040,000
b. P13,040,000 d. P16,040,000
a. P7,000,000 c. P17,000,000
b. P11,000,000 d. P19,000,000
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Chapter 2 - Accounts Payable and Notes Payable
CHAPTER 2
ACCOUNTS PAYABLE AND NOTES PAYABLE

1. The transactions affecting the accounts payable and the computation of the
accounts payable ending balance.
2. The adjustments to the reported accounts payable balance.
3. The different types of notes payable.
4. The accounting procedures for each different type of notes payable.
ACCOUNTS PAYABLE - INTRODUCTION

Accounts payable is the most common and usually the first type of liability that the
readers may have encountered. This normally arises from the credit purchases of
inventory, equipment, supplies, and other assets from suppliers.
Accounts payable is considered as a short-term financing wherein the entity shall

pay the supplier within a specified period of time, usually ranging from 30 days to -
60 days. To promote prompt payments, the supplier may also include a prompt
payment discount if the account is paid much earlier during the credit period. This
is known as a “purchase discount” in the perspective of the purchasing entity.
Accounting procedures for purchase discount have already been discussed in the
Volume 1 of this Intermediate Accounting series.
ACCOUNTING FOR ACCOUNTS PAYABLE (A/P)

As a financial liability, the accounting for accounts payable is relatively
straightforward. The first thing that the readers should know is what are the
transactions affecting this account and what are the effects of these transactions.
The following transactions affect the accounts payable balance, including the pro-
forma journal entries:
Transactions Effect in A/P Pro-Forma Journal Entries

. Purchases XX
Credit purchases made Increase Accoiiiits payable =a
Payments to suppliers Decrease equal to
beyond the discount the amount of cash Accounts payable ex
; Cash XX
period payment
ss Decrease equal to
Payments to supplier S | theamounteateash Accounts payable XX
within the discount payment plus Cash XX
_. period purchase discount Purchase discount XX
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Chapter 2 —- Accounts Payable and Notes Payable
Transactions Effect in A/P Pro-Forma Journal Entries

Purchase returns or
ee ee Hanksabe Accounts payable XX
ChCGE PUPCHESES Purchase return or allow. xx
(receipt of credit memo
from the supplier)
Issuance of promissory Accounts payable oo
notes for overdue Decrease Nawenavails we
accounts payable apa
a. Cash purchases do not affect the balance of accounts payable.
b. Cash refunds received as a result of purchase returns and allowances do not
affect the balance of accounts payable. To prove this point, the pro-forma journal
entry recording the refunds received is presented as follows:
Cash XX
Purchase returns and allowances XX
Accounts payable account is nowhere to be found in the above entry.
These transactions can be summarized in the following t-account:

Accounts Payable
Payments to credit purchases XX XX Beginning balance
Purchase discount XX XX Gross credit purchases
Purchase return or allowances XX
from unpaid credit purchases
Issuance of promissory note for XX
overdue accounts payable
Ending balance (squeeze) XX
Totals (should be equal) XX =
Transactions on the credit side increase the balance of accounts payable while the
those on the debit side decrease the balance of accounts payable.
The ending balance of accounts payable is the balancing figure between the initially
higher amount of total credits and initially lower amount of total debits to make
these totals equal in amount.
Illustration 1 - Simple. CARPIO Company had a beginning balance of P700,000 in
its accounts payable account. During the year, cash purchases and credit purchases
amounted to P300,000 and P2,800,000, respectively. Credit memos received from
suppliers amounted to P150,000 while cash refunds received amounted to
P100,000. Payments to credit suppliers totaled P2,400,000 which is already net of
P80,000 purchase discounts. Required: Determine the ending balance of accounts
payable.
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The ending balance of the accounts payable is computed as follows:

Accounts Payable
Payments to credit purchases | 2,400,000 | 700,000 | Beginning balance
Purchase discount 80,000 | 2,800,000 | Gross credit purchases |
Purchase return or allowances 150,000
from unpaid credit purchases ital
Ending balance (P3.5M- | 870,000
P2.4M - P80K - P150K) i
Totals (should be equal) | 3,500,000 | 3,500,000 ot |
The readers should take note that the cash purchases and cash refunds received were
not included in the computations as neither of them affects the accounts payable
balance.
Illustration 2 - Comprehensive. On January 1, 2023, CARREON Company had
accounts payable balance of P1,800,000. During 2023, the following transactions
were also provided in aggregate basis:
a. Cash purchases amounted P800,000 which represented 20% of all the
Company’s purchases.
b. Payments to suppliers beyond the credit terms amounted to P2,000,000 while
payments to suppliers within the credit terms amounted to P1,358,000. Credit
terms for all of the suppliers is 3/15, n/45.
c. Credit memos received amounted to P200,000 while refunds received
amounted to P180,000.
d. Due to cash flow issues, the Company issued a note payable for P250,000 of its
overdue accounts payable.
Required: From the given information, determine the balance of accounts payable
as of December 31, 2023.
Solution:
The first step in solving this kind of problem is to determine the amounts relevant
in the computations that were not explicitly provided: ,
a. Credit purchases amounted to P3,200,000 computed based on cash purchases
[(P800,000/20%) x 80%]. Since cash purchases represent 20%, credit purchases
impliedly represent 80% of all purchases.
b. Purchase discounts amounted to P42,000 /(P1,358,000/(1 - 3%)) x 3%,
computed based on grossing up the cash payments to suppliers within the credit
terms then multiplying the grossed-up amount with the cash discount rate. The
1 . S$ )
c. Total payments of credit purchases, both within and beyond the discount period,
amounted to P3,358,000 (P2,000,000 + P1,358,000).
Next, compute for the ending amount of accounts payable using the t-account:
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Accounts Payable
___Payments
to credit purchases | 3,358,000 | 1,800,000 | Beginning balance
Purchase discount | __42,000 | 3,200,000 | Gross credit purchases
Purchase return or allowances 200,000
from unpaid credit purchases . a a el
Issuance of promissory note 250,000
for overdue accounts payable
Ending balance (P5M - | 1,150,000
‘P3,358K - P42K - P200K - P250K)
Totals (should be equal) | 5,000,000 | 5,000,000
ADJUSTMENTS TO ACCOUNTS PAYABLE BALANCE

After determining the ending balance of accounts payable, other items might result
to adjustments, which primarily arise from the following:
a. Unreleased, stale, and postdated checks prepared by the entity.
b. Premature or late recording of suppliers’ invoices.
UNRELEASED, STALE AND POSTDATED CHECKS

Unreleased checks are checks made but not yet given to the payees as of the
reporting date. Stale checks are checks made but not yet encashed by payees within
180 days after the date indicated in the check. Postdated checks are those dated
beyond the reporting date.
The readers should take note that in this Chapter, the concepts on checks are told
in the perspective of the maker.
As mentioned in Volume 1 of this Intermediate Accounting series, once an entity

prepares a check as a payment of its accounts payable, there is a presumption
that the amount has already been deducted from the cash in bank and
accounts payable balances. This is particularly true even if the check is unreleased
or post-dated or becomes stale. The effects of these checks are seen in the following
pro-forma entry to record the payment of the accounts payable:
Accounts payable XX
Cash in bank XX
Because of this, the amount of unreleased, stale, and postdated checks that were
already recorded shall be added back to the accounts payable balance by making
the following journal entry:
Cash in bank XX
Accounts payable XX
Illustration 3. As of December 31, 2023, BALTAZAR Company reported ending

balance of P1,500,000 in accounts payable. Also, as of the same date, the Company
had the following information about the checks it prepared:
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a. Acheck amounting to P120,000 was released only on January 5, 2024.

b. A check amounting to P80,000, dated December 20, 2023, was made last
December 1, 2023.
c. Acheck amounting to P60,000, dated January 6, 2024, was made last December
15, 2023.
Required: Determine the adjusted accounts payable as of December 31, 2023.
Solution:
The adjusted balance of accounts payable is computed as follows:
Particulars Amounts Remarks
Unadjusted P1,500,000
Check A 120,000 Unreleased check as of 12/31/23
Check B - Notpostdated as of 12/31/23
Check C 60,000 Postdated as of 12/31/23
Adjusted P1,680,000
PREMATURE OR LATE RECORDING OF INVOICES FROM SUPPLIERS

Based on the current setup of the accounting information systems of many entities,
increase in the accounts payable will be recorded only upon the receipt of
invoice from supplier of goods and services. As a result, in the absence of contrary
information, the receipt of supplier invoice is presumed to be recorded as an
increase in the accounts payable balance.
Pro-forma journal entry to record the receipt of supplier invoice is as follows:

Purchases or other expense account XX
Accounts payable XX
It should be highlighted that we are talking about accounts payable account

and not the inventory account.
There will be some time lags between the incurrence of liability (i.e, the transfer of
legal title) and the actual receipt of invoice (i.e., the recording of liability). The timing
of transfer of the legal title will still depend on the shipping terms, primarily
FOB shipping point and FOB destination. Again, the rules on the timing of transfer
of legal title based on shipping terms are presented as follows:
a. FOB shipping point - on the date of the supplier's shipment of goods
b. FOB destination - on the date of the entity's receipt of goods
Generally, these time lags are very short and do not really affect the entity’s
reported amounts for a particular reporting period.
For example, the legal title over purchased inventories was transferred to the entity
on November 5, 2023. However, the related invoice was received and recorded only
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on November 10, 2023. In this case, even though there is a delay of a few days, the
whole year ending December 31, 2023 will have no accounting issues since both of
the events were recorded during the same accounting period.
However, as of the reporting date, the amounts reported for accounts payable shall
properly reflect the actual amounts of incurred liability as of that date (i.e., cut-off).
Accounting issues will arise from the following examples of scenarios of in-transit
inventories as of December 31, 2023:
Invoice Date Date of
Receivedand Shippedby Receipt of
Scenario Shipping terms Recorded Supplier Inventory
1 FOB shipping point 1/2/24 12/27/28 1/3/24
Z FOB destination 12/30/23 12/29/23 1/4/24
The following corrections shall be made on the above scenarios:
a. For scenario 1, accounts payable shall be recorded as early as December 27,
2023, which is the date the ownership was transferred to the entity when the
goods were shipped (ie., FOB shipping point terms). As a result, accounts
payable as of December 31, 2023 shall be increased.
b. For scenario 2, accounts payable was prematurely recorded on December 30,
2023 upon the receipt of the invoice. However, it shall be recorded only on
January 4, 2024 when the legal title was transferred to the entity upon actual
receipt of the goods (i.e., FOB destination terms). As a result, accounts payable
as of December 31, 2023 shall be decreased.
Let us know answer a more comprehensive problem.
Illustration 4. PABLO Company reported an unadjusted amount of accounts
payable of P2,260,000 as of December 31, 2023. In addition, the following
additional information was also provided:
Invoice Date Date of
Suppliers’ Shipping Receivedand Shippedby Receiptof
Invoice terms (FOB) Amount Recorded Supplier Inventory
1 shipping point P70,000 1/4/24 12/30/23 1/6/24
2 destination 130,000 1/3/24 12/29/23 1/4/24
3 shipping point 170,000 12/28/23 12/27/23 1/5/24
4 destination 90,000 12/30/23 12/28/23 1/2/24
Required: From the provided information, determine adjusted amount of accounts
payable.
Solution:
The adjusted accounts payable balance is determined by applying the rules on the
timing of transfer of legal title based on shipping terms:
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Chapter 2 — Accounts Payable and Notes Payable
Particulars Amounts Remarks

Unadjusted P2,260,000
Invoice 1 70,000
Should be recorded as early as 12/30/23 when the legal”
title was transferred upon shipment. sini’
Properly recorded during 2024 (1/3/24), during the period
Invoice 2 - when the legal title was transferred to the Company upon
actual receipt on 1/4/24 a
Properly recorded during 2023 (12/28/23), during the
Invoice 3 - period when the legal title was transferred to the Company
upon shipment on 12/27/23 cele
Should be recorded only during 2024, during the period
Invoice 4 (90,000) when the legal title was transferred to the Company upon
actual receipt on 1/2/24
Adjusted — P2,240,000
NOTES PAYABLE - INTRODUCTION
This liability arises from a promissory note, as previously described in Volume 1 of
this Intermediate Accounting series. The classification of a note as a receivable or
payable will depend on whose perspective we are looking at:
a. On the perspective of the payee, it is a note receivable
b. On the perspective of the maker, it is a note payable
To reiterate, the maker is the one who creates and signs the promissory note and
obliges itself to pay a specified amount of money at specified date/s in the future.
On the other hand, the payee is to whom the amount stated in the promissory note
is given. This amount may or may not include interest.
For the rest of the chapter, the focus is on the maker's perspective. The maker’s note
payable arises from the issuance of promissory notes for any of the following
purposes:
a. Purchasing of goods on account beyond normal credit terms
b. Acquiring high-cost long-term assets
c. Borrowing of funds
d. Paying damages
Notes payable can either be payable lump-sum on maturity date (i.e, a term notes
payable) or in installments (i.e., a serial notes payable).
NOTES PAYABLE - INITIAL RECOGNITION AND MEASUREMENT

Since note payable is considered as a financial liability, it shall be initially
measured at fair value asof initial recognition less transaction costs incurred.
Similar to notes receivable, the note payable’s fair value depends on the following:
a. whether the note is interest-bearing or not; and
b. if the note is interest-bearing, whether the stated rate is substantially equal to
market rates.
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Similar to notes receivable, the following decision diagram may be of help to the
readers in determining the note’s fair value on initial recognition:
Is the note interest-bearing?
Yes
Stated Rate = Market Rate?
Yes v
Fair value = present value of cash

Fair value is equal to note’s face
flows using market rate as of
amount
initial recognition
Stated rate means the amount of interest that the maker shall pay in addition to
the face amount of the promissory note. Market rate is the general prevailing rate
of return that the investors expect from the investments with similar characteristics
as the promissory note, regardless of whether the note is interest-bearing or not.
As to the present value calculations, the relevant present value factor will depend
on the timing and amount of the cash flows of notes payable. The computations of
these factors were lengthily discussed in the Notes Receivable chapter in the
Volume 1 of this Intermediate Accounting series:
PV factor of Single PV factor of Ordinary PV factor of

Payment Annuity Annuity Due
Generally, for term notes | Generally, for serial | Generally, for serial
payable. Can be used for | installment notes payable | installment notes payable
some serial notes where | to be received in equal | to be received in equal
the installment | installment amounts in | installment amounts in
payments are unequal | equal interval at the end | equal interval at the
and/or intervals are | of each period. beginning of each
unequal. period.
Cash flow amount is equal
Cash flow amountisequal | to periodic installment | Cash flow amountis equal
to face amount amount to periodic installment
amount
Illustration 5. LOZADA Company issued the following notes payable during the
year 2023, all for the purchase of merchandise inventory:
33
The
The Book
Note Faceamount Statedrate Marketrate Term

1 P2,000,000 10% 10% 4 years
2 5,000,000 None 6% 4 years
3 4,000,000 None 7% 2 year's
4 3,000,000 5% 8% 3 years
Principal amounts for Notes 1, 2 and 4 are all payable on the relevant maturity dates
while Note 3 is payable in two equal annual installments.
Required: Determine the initial fair value of each note and entries to record them
on initial recognition.
Answer - Note 1
Since the note is interest-bearing and the related stated rate is equal to market rate,
the note’s fair value is P2,000,000. The entry to record the transaction is as follows;
Purchases 2,000,000
Notes payable 2,000,000
There is a debit to Purchases account since all of the notes are issued for the
purchase of inventory.
Answer - Note 2
Since the note is noninterest-bearing, its fair value is computed as the present value
of cash flows using the 6% market rate as the discount rate for 4 periods.
PV Cash Flow
PV Factor of Factor onMaturity§ Fair Value
Single payment for 4 periods at6% 0.792094 — P5,000,000 P3,960,470
PV of single payment was used since the note is payable in lump-sum on its
maturity. The entry to record the transaction is as follows:
Purchases 3,960,470
Discount on notes payable 1,039,530
a. Even though the fair value of the note is P3,960,470, the Notes Payable
account is credited equal to its face amount.
b. The amount debited to Discount on notes payable account is equal to the
difference between the note’s face amount and its initial fair value.
Answer - Note 3
The note is noninterest-bearing, so its fair value is computed as the present value
of cash flows using the 7% market rate as the discount rate. However, unlike the
34
The
Note 2, PV of ordinary annuity will be used since the note is payable in two equal
annual installments.
PV Annual
PV Factor of Factor PrincipalPmts. Fair Value
Ordinary annuity for 2 periodsat7% 1.808018 P2,000,000 P3,616,036
The amount of annual principal payment is computed as P4,000,000/2 years.
The entry to record the transaction is as follows:

Purchases 3,616,036
Discount on notes payable 383,964
Answer - Note 4
Even though this note is interest-bearing, its stated rate (5%) is not substantially
equal to the prevailing market rate (8%). As a result, its fair value is computed as
the present value of principal, as well as the interest payments. In this case, PV
factor of single payment will be used for the amount of principal and PV factor
of ordinary annuity will be used for annual interest payment of P150,000
(P3,000,000 x 5%).
PV
PV Factor of Factor Cash Flows Fair Value
Single payment for 3 periods at 8% 0.793832 P3,000,000 P2,381,496
Ordinary annuity for 3 periods at8% 2.577097 150,000 386,565
Total Fair Value P2,768,061
The readers should take note that this is very similar to the computation of the
initial fair value of investment in debt securities.
The entry to record the transaction is as follows:
Purchases 2,768,061
SUBSEQUENT ACCOUNTING FOR PROMISSORY NOTES

Since the initial recognition is different depending on whether the notes payable is
interest-bearing or noninterest-bearing, subsequent accounting will, consequently,
be different depending on the notes payable:
35
The
Interest-Bearing | Interest-Bearing a
Stated Rate = Stated Rate + Noninterest-
Market Rate Market Rate Bearing
Based on market rate on initial
Based on stated recognition (i.e., the effective interest
Interest expense rate applied to rate) applied to beginning-of-the-
face amount period carrying amount
*Carrying amount Based oe The present value amounts appearing
each reporting date nenvainiie jars in the amortization able
amount
Recognition of ‘
accrued interest Based on stated rate Not applicable
payable (no stated rate)
*Generally, the amount of note’s fair value as of the end of each reporting date is not
considered, except when the note payable is measured at fair value through profit or loss. This
subsequent measurement is to be discussed later in the chapter.
Interest-Bearing Note with Stated Rate = Market Rate, Payable Lump-Sum

Illustration 6, On January 1, 2023, GUZMAN Company issued an 8% interest-
bearing promissory note with face amount of P5,000,000 and term of three years.
The note was issued on account of the Company’s purchase ofa land. On the same
date, market yields averaged 8%. Required: Determine the journal entries to be
recorded for 2023 and 2024 in relation to the notes.
The note’s fair value on January 1, 2023 is equal to its face amount. On the same
date, the entry to record the issuance of promissory note is as follows:
Land 5,000,000
Recording of interest will result to the following journal entry, to be made both on
December 31, 2023 and 2024:
Interest expense (P5M x 8%) 400,000
Cash 400,000
Interest-Bearing Note with Stated Rate = Market Rate, Payable in Installments

Illustration 7. CAMACHO Company acquired a building on January 1, 2023 fora
total price of P15,000,000. The Company immediately paid P5,000,000 down
payment and issued a 10% interest-bearing promissory note for the balance. This
note is payable in equal installments of P2,500,000 starting from December 31,
2023 until December 31, 2026. Market rates averaged 10% on the issuance date.
Required: Determine the journal entries to be made during 2023 and 2024.
The note’s fair value on January 1, 2023 is equal to its face amount. On the same
date, the entry to record the issuance of promissory note is as follows:
36
The
CamScanner
Building 15,000,000
Cash ‘ 5,000,000
Since the principal is payable in installment basis (i.e., the note payable has
decreasing balance), the amount of interest expense to be paid each year is also
decreasing, as indicated in the following computations:
Beg. Interest Expense Dec. 31 Bal.
Year Balance (Beg. Bal.x10%) (Beg. Bal. - P2.5M)
2023 P10,000,000 P1,000,000 P7,500,000
2024 7,500,000 750,000 5,000,000
2025 5,000,000 500,000 2,500,000
2026 2,500,000 250,000 =i
Again, the basis of interest expense is the beginning-of-the-period balance of the
principal. The journal entries to record the payment of interest and installment
payment of principal on December 31, 2023 are the following:
Interest expense 1,000,000
Cash 1,000,000
Note payable 2,500,000
Cash 2,500,000
The journal entries to record the payment of interest and installment payment of
principal on December 31, 2024 are the following:
Interest expense 750,000
Cash 750,000
Note payable 2,500,000

Cash 2,500,000
Noninterest-Bearing Note Payable Lump-Sum

Illustration 8. At the beginning of 2023, GUERRERO Company acquired an
equipment by issuing a noninterest-bearing promissory note with face amount of
P3,000,000. The note is payable after three years, on December 31, 2025. On the
date of issuance, market rates averaged 9%. Required: Determine the journal
entries to be recorded for 2023 and 2024.
The note’s fair value as of January 1, 2023 is computed and recorded as follows:
PV Factor of PVFactor CashFlow Fair Value
Equipment 2,316,549
37
The
Moving forward, the amounts of interest expense and carrying amount of the note
payable for each reporting date are determined from this amortization table:
Carrying Discount
Interest Amount/ on Notes
Date Expense Amort. PresentValue Payable
Jan. 1, 2023 2,316,549 683,451
Dec. 31,2023 208,489 208,489 2,925,038 474,962
Dec. 31,2024 227,253 227,253 2,752,291 247,709
Dec. 31,2025 247,709 247,709 3,000,000 -

a. Initial amount of Discount on notes payable account will be the total amount
of interest expense to be recognized over the term of the note payable. Try
totaling the amounts in the Interest Expense column.
b. Carrying amount = Remaining face amount less balance in discount on notes
payable account (e.g., P2,525,038 = P3,000,000 - P474,962). -
The following are the entries to recognize interest expense for 2023 and 2024,
respectively:
Interest expense (2023) 208,489
Interest expense (2024) 227,253
Noninterest-Bearing Note Payable in Installment

Illustration 9. On January 1, 2023, PADUA Company acquired a building by issuing
a noninterest-bearing P4,500,000 promissory note that will mature on December
31, 2025. The note is payable in equal annual installments of P1,500,000 starting
December 31, 2023 and every December 31, thereafter. On the same date, market
yield averaged 7%. Required: Determine the journal entries for 2023 and 2024.
Annual
PV Factor of PV Factor Payment Fair Value
Ordinary annuity for 3 periodsat7% 2.624316 =P 1,500,000 P3,936,474
Building 3,936,474
payable for each year are determined from this amortization table:
38
The
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Prin. Carrying Discount

Pmts_ Interest Amount/ Face on Notes
Date ‘ Expense Amort. Present Value Amt. Payable
Jan. 1, 2023 3,936,474 45M 563,526
Dec. 31,2023 15M 275,553 (1,224,447) 2,712,027 3.0M 287,973
Dec. 31,2024 15M 189,842 (1,310,158) 1,401,869 1.5M 98,131
Dec. 31,2025 15M 98,131 (1,401,869) S = a
The journal entries to record the interest expense and partial payment of note,
respectively, on December 31, 2023, are the following:
Cash 1,500,000
The journal entries to record the interest expense and partial payment of note,
respectively, on December 31, 2024, are the following:

Cash 1,500,000
Interest-Bearing Note with Stated Rate + Market Rate

Illustration 10. SALCEDO Company acquired a transportation vehicle on January
1, 2023 by issuing a 4% interest-bearing promissory note with face amount of
P2,000,000. The principal is payable on December 31, 2026 while the interest is
payable every December 31 of each year. On the same date, market rates averaged
6%. Required: Determine the journal entries for the years 2023 and 2024.
The note’s fair value as of January 1, 2023 is computed using the PV of single
payment for the amount of principal and PV of ordinary annuity for the annual
interest of P80,000 (P2,000,000 x 4%):
PV Factor of PV Factor CashFlows _ Fair Value
Ordinary annuity for 4 periodsat6% 3.465106 80,000 277,208
Journal entry to record the issuance on January 1, 2023 is as follows:
Building 1,861,396
39
The
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payable for each year is determined from this amortization table:
Carrying Discount
Interest Interest Amount/ on Notes
Date Payments Expense Amort. Present Value Payable
Jan. 1, 2023 1,861,396 138,604
Dec. 31, 2023 80,000 111,684 31,684 1,893,080 106,920
Dec. 31, 2024 80,000 113,585 33,585 1,926,665 73,335
Dec. 31, 2025 80,000 115,600 35,600 1,962,265 37,/39
Dec. 31,2026 80,000 117,735 = 37,735 2,000,000 =
Unlike in noninterest-bearing notes, Discount on notes payable is not the sole

source of interest expense for this type of note payable since interest amounts of
P80,000 are also paid each year.
The entry to record the payment of interest and recognition of interest expense on
December 31, 2023 is as follows:
Cash 80,000
The entry to record the payment of interest and recognition of interest expense on
Cash 80,000
PROMISSORY NOTES ISSUED DURING THE YEAR

In the previous illustrations, the promissory notes were all issued on January 1 of
each indicated year. However, in real life, promissory notes may also be issued, for
example, on February 1, March 1, March 31 and so on.
These scenarios have the following accounting consequences:
a. Interest-bearing note payable - accrued interest payable shall be recorded every
December 31 of each year. The amount accrued is from the immediately
preceding interest payment date until the December 31 reporting date.
b. Notes payable subject to present value calculations - the carrying amounts
indicated in the amortization table are not automatically the carrying amount as
of each reporting date. Partial amortization of the discount shall be made, which
will also affect the amount of interest expense during each period.
Illustration 11 - Interest-Bearing. On April 1, 2023, MYLENE Company issued a
five-year, 10% interest-bearing promissory note with face amount of P6,000,000 as
payment for an acquired land. Interest is payable every March 31 of each year.
40
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Required: Determine the journal entries for the years 2023 and 2024.
The entry to record the issuance of promissory note on January 1, 2023 is as

follows:
| Land 6,000,000
To record the accrual of interest on December 31, 2023 covering a period from April
1, 2023 to December 31, 2023 (i.e., 9 months):
Interest expense (P6Mx10%x9/12) 450,000
To record the payment of interest on May 31, 2024:

Interest expense (P6Mx 10%x3/12) 150,000
Cash 600,000
The readers should take note that the three months used in computing the interest
expense amount is from January 1, 2024 to March 31, 2024.
Fast forward to December 31, 2024, the following accrual of interest payable shall
be made (9 months from April 1, 2024 to December 31, 2024):
Interest expense (P6Mx 10%x9/12) 450,000
Illustration 12 - Noninterest-Bearing Note. On October 1, 2023, LAMB Company

issued a four-year, noninterest-bearing note with face amount of P3,000,000 for the
purchase of a machinery. Market rates as of that date averaged 7%. Required:
Determine the journal entries to be made for the years 2023 and 2024.
PV Factor of PVFactor CashFlow Fair Value
Machinery 2,288,685
The relevant amortization table is as follows:
41
The
The Book
Carrying Discount
Interest Amount/ on Notes
Date Expense Amort. PresentValue Payable
Oct. 1, 2023 2,288,685 711,315
Sept.30,2024 160,208 160,208 2,448,893 551,107
Sept. 30,2025 171,423 171,423 2,620,316 379,684
Sept. 30,2026 183,422 183,422 2,803,738 196,262
Sept.30,2027 196,262 196,262 3,000,000 -
The readers should take note that the dates in the amortization table are not as of
December 31 of each year. In addition, the P160,208 interest expense
corresponding to September 30, 2024 is really for the period from October 1, 2023
to September 30, 2024. On the other hand, P171,423 interest corresponding to
September 30, 2025 is from October 1, 2024 to September 20, 2025 and so on.
As such, the carrying amount of the note payable as of December 31, 2023 shall be
determined by recording partial amortization of the discount from October 1, 2023
to December 31, 2023 (i.e., 3 months) as follows:
Interest expense (P160,208 x 3/12) 40,052
After this entry, the carrying amount of the note payable on December 31, 2023
shall be determined as follows:
Note payable - face amount P3,000,00

Less: Discount on note payable (P711,315-P40,052) __ (67 1,263)
Carrying amount, December 31, 2023 2,328,737
Fast forward to September 30, 2024, the amortization from January 1, 2024 to
September 30, 2024 (i.e., 9 months) shall be recorded as follows:
Interest expense (P160,208x 9/12) 120,156
Fast forward yet again to December 31, 2024, the partial amortization from October /
1, 2024 to December 31, 2024 (i.e., 3 months) shall be recorded as follows:
Interest expense (P171,423 x 3/12) 42,856

After this entry, the carrying amount of the note payable on December 31, 2024
shall be determined as follows:
Note payable - face amount P3,000,000
Less: Discount on note payable (P671,263 ~ P120,156 - P42,856) (508,251)
Carrying amount, December 31, 2024 2,491,749
42
The
Lastly, total interest expense for the year 2024 is P163,012 (P120,156 + P42,856).
FINANCIAL LIABILITIES - FAIR VALUE THROUGH PROFIT OR LOSS
Despite the general requirement to subsequently measure a financial liability at
amortized cost, an entity has an option, on initial recognition, to irrevocably
designate a note payable at fair value through profit or loss (FVTPL), meeting
either of the following scenarios:
a. The designation eliminates or significantly reduce a measurement or recognition
inconsistency (“accounting mismatch”); or
b. A group of financial liabilities or financial assets and financial liabilities is
managed and its performance is evaluated on a fair value basis. [PFRS 9.4.41].
For example, there is an accounting mismatch if an entity issued a note, bond, or

loan payable to borrow funds and use the proceeds to acquire financial assets at
FVTPL. In this case, there is a mismatch because the asset financed by the
transaction is measured at FVTPL while the financing transaction is measured at
amortized cost. This mismatch will be eliminated if the related note, bond, or loan
payable is also measured at FVTPL.
The accounting consequences of this FVTPL measurement are the following:
a. The liability’s carrying amount shall now be equal to its fair value as of each
reporting date. The following rules are relevant:
Scenario. Consequence
Fair value > Carrying amount | Unrealized loss
Fair value < Carrying amount | Unrealized gain
These unrealized gains and losses are reported in profit or loss. The readers
should take note that these rules are reverse of the rules in the financial assets
at FVTPL.
b. Interest expense is based the liability’s face amount times the stated rate, if any.
c. Transaction costs on the issuance of the liability shall be expensed outright.
d. The readers should take note that this designation does not automatically make
the financial liability as held for trading.
Illustration 13. BUENO Company borrowed P6,000,000 funds by issuing a 7%

interest-bearing note payable with face amount of P6,000,000 on January 1, 2023.
The note has a maturity date of December 31, 2025 and was issued to acquire an
investment in equity securities at FVTPL. As such, the note is irrevocably designated
to be accounted for at FVTPL. Required: Determine the journal entries for 2023 and
2024 assuming the note has a fair value of P6,500,000 and P6,400,000 as of
December 31, 2023 and 2024, respectively.
To record the borrowing of funds on January 1, 2023:
43
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Cash 6,000,000
The entries to record the payment of interest and change in fair value on December
31, 2023 are the following:
Cash (P6M x 7%) 420,000
Unrealized loss (P6.5M - P6M) 500,000
Note payable 500,000
There is a loss since there is an increase in the note payable’s fair value.
The entries to record the payment of interest and change in fair value on December
31, 2024 are the following:
Cash (P6M x 7%) 420,000
Note payable (P6.4M - P6.5M) 100,000

Unrealized gain 100,000
There is a gain since there is a decrease in the note payable’s fair value.
EXCEPTIONS TO THE RECOGNITION IN PROFIT OR LOSS
Not all changes in the financial liability’s fair value are recognized in profit or loss.
Changes in the fair value from the changes in the entity’s own credit risk shall be
recognized as addition to or deduction from other comprehensive income.
According to PFRS 7, credit risk is the risk that one party to a financial instrument
will cause a financial loss for the other party by failing to discharge an obligation.
The reason for this exception is that recognizing these changes in profit or loss will
not provide useful information. This is because the changes in the financial liability’s
fair value due to the changes in the entity's own credit risk are not really realized,
unless the financial liability is held for trading.
Illustration 14. At the beginning of 2023, EMPIRE Company issued a 10% interest-
bearing financial liability with a face amount of P5,000,000. The Company
irrevocably designated to present the changes in the fair value in profit or loss. Fast
forward to December 31, 2023, this liability had a fair value of P5,500,000. This
increase in fair value has arisen from the following:
Market factors P350,000
Entity’s own credit risk 150,000
In this case, the change in the fair value of the financial liability shall be recorded on
December 31, 2023 as follows:
44
The
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Unrealized loss - P/L 350,000

Unrealized loss - OCI 150,000
Note payable (P5.5M - P5M) 500,000
DETERMINING THE CHANGES IN FAIR VALUE ARISING FROM CHANGES IN THE

ENTITY'S OWN CREDIT RISK
In practice, determining the amount of change in fair value due to changes in the
_ entity’s own credit risk involves complex computations. However, a simple
| approach will be discussed in the chapter to give the readers a high-level idea on
this computational exercise.
The following procedures are relevant in determining the changes in fair value from
changes in the entity’s own credit risk:
1. First, determine the fair value of financial liability as of the end of the period by
discounting the remaining cash flows using the market rate as of that date.
2. Determine the portion of the interest rate of return (i.e., stated rate) that is
instrument-specific using the following formula:
Instrument-specific portion of the rate of return = Total rate of return less

benchmark rate as of the date of issuance
Total rate of return is usually equal to the stated rate.
3. Next, determine the present value of remaining cash flows using a discount rate
equal to instrument-specific portion of the rate of return plus benchmark
rate as of the reporting date.
4. Finally, the difference between the present value amount computed in step 3 and
the fair value of the financial liability in step 1 is the amount of change in fair
value arising from the changes in the entity’s own credit risk.
Graphically, this can be shown as follows:
Carrying amount of the liability as of

the beginning of the period
The difference shall be
recognized in profit or loss
Present value using the instrument-
specific rate plus benchmark rate as
of end of the period (Step 3)
The difference shall be
recognized in OCI
Fair value of the liability as of the
end of the period (Step 1)
45
The
The Book
Illustration 15. On January 1, 2023, HAZE Company issued a P4,000,000 financia

liability with interest rate of 9% (equal to market rates) and maturity date of
December 31, 2027. The liability is to be accounted for at fair value through profit
or loss. Fast forward to December 31, 2023, the market rates averaged 8%
Benchmark rates as of January 1, 2023 and December 31, 2023 were 6% and 5.50%,
respectively. Required: From the given information, determine the journal entry ty
record the change in the liability’s fair value as of December 31, 2023.
In answering this problem, the following procedures are relevant:
1, First, determine the fair value of the financial liability as of December 31, 2023
using the 8% market rate. Remaining cash flows are for the liability’s four-year
remaining term as of that date, using annual interest of P360,000 (P4M x 9%):
PV Factor of PVFactor CashFlows Fair Value
Ordinary annuity for 4 periods at8% 3.312127 360,000 1,192,366
Next, determine the instrument-specific portion of the rate of return as follows:

3% = 9% total rate of return less 6% benchmark rate as of January 1, 2023
Next, determine the present value of the remaining cash flows using 8.50% (3%
instrument-specific portion of the rate of return plus 5.50% benchmark rate as of
December 31, 2023):
PV Cash Present
PV Factor of Factor . Flows Value
Single payment for 4 periods at 8.50% 0.721574 4,000,000 P2,886,296
Ordinary annuity for 4 periods at 8.50% 3.275597 360,000 1,179,215
Total Present Value P4,065,511
4. The amounts to be recognized in profit or loss and other comprehensive income
are determined as follows:
Carrying amount of the liability as of

the beginning of the period - Phe difcronea cal He
P4,000,000 Ser
recognized in profit or loss:
Present value using the instrument- a ange 11-

specific rate plus benchmark rate as muee ee]
of end of the period (Step 3) - —
P4,065,511 The difference shall be
recognized in OCI:
Fair value of the liability as of the P66,975 = P4,132,486 —
end of the period (Step 1) - P4,065,511
P4,132,486
46
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Since there is an increase in the fair value of the financial liability as of December
31, 2023, the following journal entry shall be made:
Unrealized loss - OCI 66,975
Financial liability 132,486
CHAPTER SUMMARY
1. Accounts payable arise from the usual credit purchase of inventory items or services
from supplier.
2. The ending balance of the accounts payable is determined as follows:
Accounts Payable
Payments to credit purchases xX xX Beginning balance
Purchase discount XX XX Gross credit purchases
Purchase return or allowances XX
from unpaid credit purchases
Issuance of promissory note for XX
overdue accounts payable
Totals (should be equal) XX XX
3. Recorded unreleased checks, stale check and post-dated check made by the entity
shall be added to the reported balance of accounts payable.
4, Late or early recording supplier's invoice will also warrant adjustments to the
reported balance of accounts payable.
5. Notes payable are evidenced by a formal document known as promissory note.
Notes payable is told in the perspective of the note’s maker.
6. On initial recognition, notes payable are measured at their fair values, less
transaction costs. The fair value of the note will depend on its cash flows:
a. The fair value of interest-bearing note, with stated rate = market rate is equal to
its principal amount.
b. The fair value of noninterest-bearing note is equal to its cash flows using the
market rate on date of issue as the discount rate.
c. The fair value of interest-bearing note, with stated rate # market rate is equal to
its cash flows using the market rate on date of issue as the discount rate.
7. Interest expense from 6.a above is equal to the remaining principal amount times
the stated rate. Interest expense from 6.b and 6.c above is equal to the beginning
carrying amount times the market rate on initial recognition (i.e., the effective
interest rate).
8. On initial recognition, an entity may irrevocably designate a financial liability at
FVTPL.
9. Increase in the fair value of financial liability at FVTPL is recognized as unrealized
loss, while the decrease is recognized as unrealized gain, both in profit or loss.
10.As an exception, changes in the fair value of financial liability at FVTPL due to the
changes in the entity’s own credit risk shall be recognized in OCI.
47
The
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we
True or False
1. The balance of the accounts payable is affected by the amount of cash refunds
received from the suppliers.
2. Cash purchases do not affect the ending balance of accounts payable.
3. Outstanding checks possessed by the payee shall be added to the accounts payable
balance. ,
4, Unreleased checks shall be added to the accounts payable balance.
5. Notes payable are evidenced by a formal document called promissory note.
6. All notes payable are initially measured at their face amounts.
7. Ifthere is one-time payment of noninterest-bearing note on its maturity date, then
the present value factor of ordinary annuity shall be used in determining its initia]
fair value.
8. Interest expense from a note payable bearing interest with stated rate that is
substantially equal to market rates is based on the remaining face amount times the
stated rate.
9, The carrying amount of noninterest-bearing note payable is also equal to the
present value of the remaining cash flows discounted using the prevailing market
rate on the reporting date.
10. Changes in the fair value of financial liability accounted at FVTPL arising from the
changes in the entity's own credit risk shall be recognized in OCI.

1, The following transactions affect the balance of accounts payable, except
credit purchases
o>
receipt of credit memo from purchase returns

c, receipt of cash refunds from purchase allowance
d. none of the above
2. Apayment of accounts payable within the discount period shall decrease the balance
of accounts payable equal to
a. cash payment only
b. cash payment plus purchase discount
c. purchase discount only
d. none of the above since payment of accounts payable shall increase the balance
of the accounts payable
3, Allofthe following checks shall result to adjustments to the ending accounts payable
balance, except
a. outstanding checks
b. unreleased checks
c. stale checks
d. post-dated checks
48
The
4, Which of the following scenarios will result to adjustments to the ending accounts
payable balance as of December 31, 2023?
a. An invoice was received and recorded on December 30, 2023 for goods that
were purchased FOB shipping point and were shipped on December 25, 2023.
The goods were actually received on January 2, 2024.
An invoice was received and recorded on January 5, 2024 for goods that were
purchased FOB destination and were shipped on December 29, 2023. The goods
were actually received on January 3, 2024.
An invoice was received and recorded on December 29, 2023 for goods that
were purchased FOB shipping point and were shipped on January 2, 2024. The
goods were actually received on January 5, 2024.
purchased FOB destination and were shipped on December 31, 2023. The goods
5. All of the following scenarios will result to adjustments to the ending balance of
accounts payable as of December 31, 2023, except
a. A check dated January 10, 2024 was recorded and given to the payee on
December 20, 2023.
b. An invoice was received and recorded on December 28, 2023 for goods that
were purchased FOB destination and were actually received on January 5, 2024.
purchased FOB shipping point and were shipped on December 29, 2023. Goods
A check dated December 29, 2023 was recorded and given to the payee on
December 22, 2023.
6. On initial recognition, notes payable are measured at their fair values. Which of the
following does not properly describe the fair value of the corresponding note
payable?
a. The fair value of an interest-bearing note payable, in general, is equal to the total
amount of cash to be paid during the note’s term.
b. The fair value of an interest-bearing note payable, with stated rate that is not
substantially equal to market rates, is equal to the present value of cash flows
discounted using the market rate on initial recognition.
c. The fair value of a noninterest-bearing note payable, with one-time payment on
maturity date, is equal to the present value of cash flows discounted using the
market rate on initial recognition.
d. The fair value of a noninterest-bearing note payable, with equal periodic
payment of principal, is equal to the present value of cash flows discounted
using the market rate on initial recognition.
7. Which of the following correctly describe /s the amount of interest expense that shall
be recognized from note payable?
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Chapter 2- Accounts Payable and Notes Payable
a. No interest expense shall be recognized for noninterest-bearing note payable

since there is no related stated rate.
b. Interest expense from interest-bearing note payable, with stated rate
substantially equal to market rate, is equal to beginning face amount multiplied
with stated rate.
c. Bothaandb.
d. Neitheranorb.
8. The following correctly indicates the carrying amount of each type of note payable,
except
a. Interest-bearing note payable with stated rate substantially equal to market rate
- carrying amount is equal to remaining face amount.
b. Interest-bearing note payable with stated rate not substantially equal to market
rate - carrying amount is equal to remaining face amount.
c. Noninterest-bearing note payable that is payable lump-sum on maturity date -
carrying amount is equal to present value of remaining cash flows discounted
using the effective interest rate.
d. Noninterest-bearing note payable that is payable in equal annual installments -
carrying amount is equal to present value of remaining cash flows discounted
using the effective interest rate.
9. Ifa financial liability is accounted for at FVTPL, which of the following accounting
procedures is not correct?
a. The carrying amount of the financial liability is equal to its fair value as of the
reporting date.
b. Increase in the fair value of the financial liability is generally recognized as
unrealized loss in profit or loss.
c. Interest expense is equal to the beginning-of-the-period market rate multiplied
to the liability’s beginning carrying amount.
d. None of the above.
10.All of the following components of the changes in the fair value of the financial
liability shall be recognized in profit or loss, except
a. entity's own credit risk
b. changes in the benchmark rate
c. changes from market conditions
Straight Problems ;
1. On January 1, 2023, CHERRY Company had a beginning accounts payable balance 0!
P900,000. During the year, the Company had credit purchases of P4,500,000, which
represented 75% of the Company’s total purchases. All of the Company’s purchases
have 2/10, n/30 credit terms. Cash payments of P2,450,000 were made within the
discount period while P1,600,000 were paid beyond the discount period. In addition
the Company received total credit memos amounting to P220,000 while cash
refunds from suppliers totaled P90,000,
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Required: Determine the balance of the Company’s accounts payable as of December

31, 2023.
2. During the year 2023, MADONNA Company had the following information involving
its purchases of inventory items:
a. Cash purchases, which are 10% of all purchases, amounted to P600,000.
b. Total cash payments within the discount period amounted P2,328,000 for credit
purchases made under 3/15, n/45 terms.
c. Total cash payments within the discount period amounted P1,980,000 for credit
purchases made under 1/20, n/60 terms.
d. Total cash payments beyond the discount period amounted to P1,400,000.
e. Credit memos received from the supplier amounted to P340,000, while cash
refunds amounted to P110,000.
f. Beginning accounts payable balance amounted to P 1,400,000.
Required: Determine the balance of the Company’s accounts payable as of December

31, 2023.
3. On January 1, 2023, GRAY Company issued a three-year, 12% interest-bearing

promissory note with face amount of P5,000,000 to acquire a building. Market rates
as of that date averaged 12%. Interest is payable every December 31 of each year.
Required; Determine the journal entries for the years 2023 and 2024
4, At the beginning of the year 2023, CROCODILE Company acquired a land by paying
P1,000,000 down payment and issuing a four-year, 10% interest-bearing
promissory note with face amount of P6,000,000. The principal is payable in four
equal annual installments every December 31 ofeach year. Interest is payable on the
same dates as the principal installment payments.
Required: Determine the journal entries for the years 2023 and 2024
5, SAMANTHA Company acquired a transportation equipment on January 1, 2023 by

issuing a noninterest-bearing promissory note with face amount of P4,000,000 and
maturity date of December 31, 2027. Market rates as of January 1, 2023 and
December 31, 2023 averaged 9% and 10%, respectively.
6. On May 1, 2023, ANDREA Company acquired a land for a total price of P8,000,000.
The Company paid a P2,000,000 down payment and issuing a six-year noninterest-
bearing promissory note for the balance. Market rates on January 1, 2023 and
December 31, 2023 averaged 8% and 7%, respectively.
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7. At the beginning of 2023, ROWENA issued a five-year, noninterest-bearing

promissory note with face amount of P5,000,000 for the purchase of an equipment. —
The note is payable in equal annual installments of P1,000,000 starting on Decem ber |
31, 2023. Market rates as of January 1, 2023 and December 31, 2023 averaged 10% —
and 11%, respectively.
8. On October 1, 2023, LESLIE Company acquired a land by issuing a seven-year

noninterest-bearing promissory note with face amount of P8,400,000. The note is
payable in seven equal annual installments every September 30 of each year,
starting in the year 2024. Market rates on the issuance date averaged 8%.
9. On January 1, 2023, JERICHO Company acquired a building by issuing a six-year, 3%

interest-bearing promissory note with face amount of P7,000,000. Market rates as
of that date averaged 9%. Interest is payable every December 31 of each year.
10.0n April 1, 2023, JAMES Company had a financial liability issued for the acquisition
of investments in equity securities. The P6,000,000 face amount financial liability
has a maturity date of March 31, 2028 and interest per annum of 12%. On initial
recognition, this financial liability was irrevocably designated at FVTPL. As of |
December 31, 2023 and 2024, the financial liability had fair values of P5,600,000
and P5,750,000, respectively. There were no changes in the Company’s own credit
risk.
Multiple Choice
1. On December 31, 2023, THOMAS Company reported an unadjusted balance of
P2,500,000. In connection with the review of the accounting manager, the following
data were gathered:
e Acheck dated January 10, 2024 and amounting to P160,000 was given to the
payee on December 20, 2023,
e Acheck dated December 30, 2023 and amounting to P200,000 was given to the
payee only on January 5, 2024.
e Acheck dated December 15, 2023 and amounting to P120,000 was given to the
payee on December 1, 2023. The check is yet to be encashed by the payee.
e An invoice amounting to P170,000 was received and recorded on January 10,
2024, Upon inspection of invoice's details, it was found out that the related goods
were shipped FOB shipping point on December 29, 2023. The goods were
actually received on January 8, 2024.
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From the given information, the adjusted accounts payable balance as of December
31, 2023 shall be
a. P2,870,000 c. P3,030,000
b. P2,830,000 d. P3,150,000
_ As of the end of 2023, SANTORINI Company reported an inventory balance of

P2,000,000 based on physical count and an unadjusted balance in accounts payable
amounting to P1,800,000. The Company’s cut-off procedures generated the
following information on some of the purchase invoices:
e Goods shipped FOB shipping point on December 29, 2023 were actually received
on January 5, 2024. The related invoice amounting to P190,000 was received and
recorded only on January 7, 2024.
e Goods shipped FOB destination on December 28, 2023 were actually received on
January 4, 2024. The related invoice amounting to P120,000 was received and
recorded on December 30, 2023. ;
e Goods shipped FOB shipping point on December 26, 2023 were actually received
on January 2, 2024. The related invoice amounting to P240,000 was received and
recorded on December 29, 2023.
The adjusted accounts payable balance as of December 31, 2023 shall be

a. P1,870,000 c. P2,060,000
b. P1,930,000 d. P2,320,000
The adjusted inventory balance as of December 31, 2023 shall be

a. P2,190,000 c. P2,440,000
b. P2,430,000 d. P2,550,000
. RHODES Company reported an unadjusted accounts payable balance of P3,400,000

as of December 31, 2023. The following additional data were gathered as part of the
Company's purchase cut-off procedures:
Date the goods _ Date the invoice
Invoice Amount Dateshipped werereceived was recorded
1 P210,000 12/28/23 01/03/24 01/03/24
2 150,000 12/30/23 01/06/24 01/07/24
3 280,000 12/27/23 12/31/23 12/30/24
4 180,000 01/03/24 01/09/24 01/10/24
5 300,000 12/24/23 01/05/24 12/28/23
Invoices 1, 3, and 4 were shipped FOB shipping point, while Invoices 2 and 5 were
shipped FOB destination. In addition, there were checks totaling P450,000 that were
unclaimed by the payees as of December 31, 2023.
The adjusted accounts payable balance as of December 31, 2023 shall be

a. P3,830,000 c. P3,610,000
b. P3,990,000 d. P3,310,000
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4. On April 1, 2023, CHARMAINE Company issued a six-year promissory note with a

total face amount of P6,000,000. The note is payable in P1,000,000 annua]
installments every March 31 of each year, starting on March 31, 2024. The
promissory note bears interest of 12% that is payable on the same dates as the
principal installment payments.
Total interest expense for the year 2024 shall be

a. P720,000 c. P600,000
b. P630,000 d. P540,000
a. P660,000 c. P510,000
b. P600,000 d. P480,000
5. October 1, 2023, MAUI Company issued a seven-year, noninterest-bearing
promissory note with face amount of P5,000,000. Market rates as of October 1, 2023
and December 31, 2023 averaged 9% and 11%, respectively.

a. P251,704 c. P246,165
b. 267,903 _ d.P278,904
Carrying amount of the note payable as of December 31, 2024 shall be

a. P2,981,335 c. P3,249,655
b. P3,048,415 d. P3,105,842 ©

a. P268,320 c. P277,892
b. P292,469 d. P274,357

a. P3,249,655 ¢. P3,322,772
b. P3,542,124 d. P3,489,043
6. On July 1, 2023, HILO Company issued a noninterest-bearing promissory note with

face amount of P7,000,000. Maturity date of the note is set on June 30, 2027. In
addition, the principal amounts are payable in equal annual installments every June
30 of each year, starting on June 30, 2024. Market rates on July 1, 2023 averaged
10%.

a. P5,547,264 c, P4,351,990
b. P5,824,627 d. P4,569,590
a. P494,963 c. P435,199
b. P554,726 d. P489,902
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a. P4,351,990 c. P4,569,590
b. P3,037,189 d. P3,524,789

a. P435,199 c. P303,719
b. P369,459 d. P296,793
7. On January 1, 2023, BROOKLYN Company issued a ten-year, 2% interest-bearing

note with face amount of P8,000,000. Market rates as of that date averaged 10%. The
interest is payable every December 31 of each year.
a. P800,000 c. P406,748
b. P160,000 d. P431,422
a. P4,585,645 c. P4,769,032
b. P8,000,000 d. P4,884,210

a. P431,422 c. P431,422
b. P458,565 d. P488,421

a. P4,585,645 c. P4,769,032
b. P8,000,000 d. P4,884,210
8. On April 1, 2023, AMBASSADOR Company issued a six-year, 7% interest-bearing

financial liability with P3,000,000 face amount to finance the acquisition of
investment in debt securities. This investment is to be accounted for at FVTPL. To
reduce the accounting mismatch, the financial liability is to be accounted at FVTPL.
Interest is payable every March 31 of each year.
As of December 31, 2023 and 2024, financial liability’s fair value amounted to
P3,100,000 and P3,190,000, respectively. During 2023, there were no changes in the
Company’s own credit risk. However, during 2024, changes in the Company’s own
credit risk contributed P30,000 to the increase in the financial liability’s fair value.
The net amount to be recognized in the Company’s 2023 profit or loss shall be
a. P210,000 net decrease c. P110,000 net decrease
b. P157,500 net decrease d. P257,500 net decrease
The net amount to be recognized in the Company’s 2024 profit or loss shall be
a. P270,000 net decrease c. P300,000 net decrease
b. P150,000 net decrease d. P240,000 net decrease
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9. At the beginning of 2023, MUMBLE Company issued a financial liability to be |

accounted at FVTPL. This liability has a face amount of P5,000,000, maturity date of
December 31, 2029, and interest of 7% that is payable every December 31 of each
year. Fast forward to December 31, 2023, the market rates averaged 8%. Lastly,
benchmark rates averaged 3% and 3.50% as of January 1, 2023 and December 31, ©
2023, respectively.
The financial liability’s carrying amount as of December 31, 2023 shall be

a. P5,000,000 c. P4,768,858
b. P4,882,656 d. P4,954,903
The net amount to be reported in the Company’s 2023 profit or loss shall be
a. P117,344 gain c. P113,798 gain
b. P117,344 loss d. P113,798 loss
The net amount to be reported in the Company's 2023 OCI shall be
a. P117,344 gain c. P113,798 gain
b. P117,344 loss d. P113,798 loss
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Chapter 3 - Introduction to Provisions
CHAPTER 3
INTRODUCTION TO PROVISIONS

1. The different types of obligations and the related accounting and financial
reporting requirements.
The requirements for the recognition of a provision.
WN
The factors to be considered on measuring provision.

The subsequent accounting for provisions, including changes in estimate.
MN &
The financial reporting requirements for contingent assets.
PROVISIONS AND CONTINGENT LIABILITIES - INTRODUCTION

In the previous chapters, we have discussed liabilities (e.g., accounts payable and
notes payable) from which an entity has a “definite” obligation. Definite in the sense
that the amounts, timing, and identity of the counterparty are all specifically
identifiable without the need of high-level estimates and assumptions.
However, not all liabilities possess these “definiteness” traits and may need
additional analysis and assumptions for their recognition and measurement due to
related uncertainties. These liabilities include, but are not limited to, the following:
a. Liabilities arising from environmental damage caused by entity’s operations.
b. Claims of damages from faulty or hazardous products sold.
c. Customers’ claims from the entity's warranty over the products sold.
d. Premium liability arising from entity's promotional programs.
e. Asset retirement obligation (including restoration and rehabilitation costs).
The relevant standard in this chapter is the PAS 37, Provisions, Contingent Liabilities,
and Contingent Assets.
PROVISIONS vs. CONTINGENT LIABILITIES
First, it is important to know the major differences between provisions and
contingent liabilities:
Provision Contingent Liabilities

How likely to Probable Below probable but
happen? more than remote
Can the amount be
N
measured reliably? Yes a
Recognize as liability in the Disclosure in the notes
Financial reporting balance sheet plus matching only (not recognized as
disclosure in the notes liability)
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Chapter 3 — Introduction to Provisions
“Probable” in this context means more likely than not. If an event has more than
50% chance of happening, it is said to be “probable” since it is understood that
the chance of it not happening is less than 50% (i.e., complement of more than 50%),
“Remote” level of probability in this context shall be determined using judgment
(i.e., no quantitative threshold).
Since provisions involve the recognition and measurement of a liability, this will be
the focus of the chapter.
RECOGNITION OF PROVISIONS
A provision is a liability of uncertain timing or amount. [PAS 37.10]. A provision |
shall be recognized when all of the following conditions are met:
a. an entity has a present obligation (legal or constructive) as a result of a past —
event;
b. itis probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; and
c. areliable estimate can be made of the amount of the obligation.
If any of these conditions is not met, no provision shall be recognized, but

contingent liability may be disclosed in the notes instead. [PAS 37.14]. Each of these
conditions is subsequently discussed in detail in the succeeding sections.
On the other hand, a contingent liability is:

a. a possible obligation that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain
future events not wholly within the control of the entity; or
b. a present obligation that arises from past events but is not recognized because:
i. it is not probable that an outflow of resources embodying economic benefits
will be required to settle the obligation; or
ii. the amount of the obligation cannot be measured with sufficient reliability.
CONDITION 1 - PRESENT OBLIGATION AS A RESULT OF PAST EVENT

Obligations are classified into two kinds as follows:
1. Legal obligation - an obligation that derives from
a. acontract (through its explicit or implicit terms);
b. legislation; or
c. other operation of law
2. Constructive obligation - an obligation that derives from an entity’s actions
where:
a. byan established pattern of past practice, published policies, or a sufficiently
specific current statement, the entity has indicated to other parties that it will
accept certain responsibilities; and
b. asaresult, the entity has created a valid expectation on the part of those othe!
parties that it will discharge those responsibilities. [PAS 37.10].
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The following are examples of legal obligations:

a. obligation to make good any damages covered by an entity's warranty program
stated in the sales contract (i.e., arising from contract).
b. obligation to make good any hidden defects in the sold products (i.e., arising
from legal provisions of Civil Code, a legislation).
c. obligation arising from damages required to be paid as set in a court decision
(i.e., arising from other operation of law).
The following are examples of constructive obligations:

a. Inthe past decades, an entity distributes 5% of its annual net income as bonuses
to its employees, even though such bonuses are not mentioned in the
employment contract.
In this case, the entity has a constructive obligation based on the established
pattern of past practice and this has created a valid expectation on the part of
employees.
b. One of the entity's manufacturing plants accidentally dumped toxic chemicals in
a nearby river. Currently, there is no law that will make the entity liable for
damages, but the entity has a public statement that it will make good any
damages it had caused. In this case, the entity has a constructive obligation
Each of the foregoing examples is the result of obligating event that creates a legal
or constructive obligation that results in an entity having no realistic alternative to
settling that obligation. [PAS 37.10]. In other words, obligating event is the “trigger”
for an entity to incur an obligation from its actions. In addition, the entity shall have
no choice but to settle the obligation.
Illustration 1. VILLAR Company is currently operating a mine in Davao. On a
routine safety inspection, it was found out that there is a very high chance that toxic
chemicals might spill into a nearby river. There is a law requiring mining entities to
clean up any environmental damage.
Based solely on this information, there is no obligating event since there is no actual
environmental damage from the Company’s mining operations (i.e., no actual spilling
of toxic chemicals). Consequently, the Company does not have an obligation.
Illustration 2. SABADO Company operates a domestic fleet of cargo ships. The

ships are periodically maintained due to relevant regulations, where there is a
tough penalty to be imposed in case one of these ships ran aground and cause an oil
spill. During the year, one of the ships sank and caused a major oil spill.
In this case, there is already an obligating event (i.e., the actual happening of oil
spill); thus, the Company has already an obligation.
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Illustration 3. During the year, a new regulation required airline companies,

including LABRADOR Company, to refurbish their aircraft every four years.
Even though there is a legal requirement for the refurbishment, the Company has q
choice not to refurbish its aircraft and buy a new one instead. As a result, the
Company has no obligation for the refurbishment.
However, if the authorities found out that the Company is using its fleet of aircraft
that is not refurbished (i.e., the obligating event), there is now an obligation to pay for
the penalties.
CONDITION 2 - PROBABLE OUTFLOW OF RESOURCES

As previously mentioned, probable means that the likelihood of an event happening
is more likely than the likelihood of it not happening. Quantitatively, to be probable,
the likelihood must be more than 50%.
The level of probability of outflow of economic resources is very much relevant to

court litigations in which the entity is the defendant. The party claiming damages is
called the plaintiff. Compared to our previous examples of obligations, court cases
are not straightforward since they involve the decision of the court judges based on
the evidences presented. As a result, it is necessary to consult with lawyers to
estimate the probability of the entity winning or losing the case since they are the
experts in that field.
Illustration 4. RONQUILLO Company became involved in a court case involving the
alleged health hazards caused by one of its cosmetic products. Lawyers involved in
the same kind of litigation were consulted and gave their estimate of the likelihood
that the Company may win or lose the case. Required: Under each of the following
independent scenarios, determine whether there is a probable outflow of resources
or not:
1. There is a 90% chance that the entity will lose the case.
2. There is a 60% chance that the entity will lose the case
3. There is a 40% chance that the entity will lose the case.
4, There is a 30% chance that the entity will win the case.
The analysis of these scenarios is as follows:
Scenario Likelihood of losing Verdict
1 90% There is a probable outflow of resources
2 60% There is a probable outflow of resources
3 40% There is no probable outflow of resources
4 70% (1 - 30%) There is a probable outflow of resources
Scenarios 1, 2, and 4 will normally result to a recognition of a provision, provided 4

reliable estimate of the obligation can be made. Scenario 3 is a contingent liability
and will just be disclosed in the notes (i.e., not recognized as a liability).
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CONDITION 3 - RELIABLE ESTIMATE CAN BE MADE

The recognition of liability inherently requires that a corresponding amount be
measured. Depending on the liability, measuring it can either be simple or
complicated. In extreme cases that a reliable estimate cannot be made, the
obligation is considered as a contingent liability and will just be disclosed in the
notes. Since the measurement of obligation is crucial, extensive discussions of its
applications are presented.
GENERAL PRINCIPLES IN MEASURING THE OBLIGATION

In a general sense, the amount recognized as a provision shall be the best estimate
of the expenditure required to settle the present obligation at the end of the
reporting period. [PAS 37.36]. The best estimate of the expenditure required to
settle the present obligation is the amount that an entity would rationally pay:
a. to settle the obligation at the end of the reporting period; or
b. to transfer it to a third party at that time. [PAS 37.37].
The judgment of entity’s management is the primary basis for the estimate of
obligation’s outcome and financial effects. This judgment may be supplemented by
advice from independent experts and events after the reporting period. —
Generally, the amount of measurement of liability is based on undiscounted
amounts. However, where the effect of the time value of money is material, the
amount of a provision shall be the present value of the expenditures required to
settle the obligation. [PAS 37.45]. The effect of discounting is normally material if
the obligation will be settled more than 12 months after the measurement date.
The discount rate to be used in computing the present value shall be a pre-tax rate
that reflects the following:
a, current market assessments of the time value of money; and
b. the risks specific to the liability. [PAS 37.47].
Illustration 5. Recently, PANES Company became involved in a lawsuit involving
the alleged Company's maltreatment of its employees. Based on the lawyers’ advice,
the best estimate for the amounts that the entity may be liable to is P2,500,000 and
that it is probable that the Company may be held liable. Relevant discount rate is
8%. Required: Under each of the following independent scenarios, determine the
initial measurement of the provision:
1. The settlement is expected to happen within 8 months.
2. The settlement is expected to happen after 2 years.
Answer - Scenario 1
The provision shall be measured at nominal amount of P2,500,000 since it will be
settled within 12 months from the measurement date.
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Answer- Scenario 2 |
The measurement of the provision shall be based on the present value of cash flows
since it will be settled beyond 12 months after the measurement date:
PV Initial
PV Factor of Factor CashFlows Measurement
Single payment for 2 periods at8% 0.857339 — P2,500,000 P2,143,347
SPECIFIC MEASUREMENT GUIDELINES

Specific circumstances call for specific measurement guidelines. Measurement of
obligation may apply one or a combination of the following guidelines:
Expected value
op
Mid-point of range
Events after the reporting period
Plaintiff's offer of out-of-court settlements
moao
Future events
Expected gain
The details of each of these guidelines are to be discussed in the succeeding

subsections.
EXPECTED VALUE METHOD

This method is used when the provision being measured involves a large population
of items. The procedure is to weight all possible outcome amounts by their
associated probabilities. Therefore, the measurement of provision will depend
on the likelihood of a loss happening.
Illustration 6. During the year, a court case was filed against CRISTOBAL Company.
The case is for the alleged explosions of smartphones that the Company is currently
selling. For this plaintiff, it was alleged that the explosion caused physical injuries.
According to the Company’s lawyers, the amount that may be paid to the plaintiff is
P4,000,000. The court is expected to make a decision within the year. Required:
Under each of the following independent scenarios, determine the initial measure
of provision, if there is any:
1. There is a 70% chance that the Company will lose the case
The amounts to be recognized as provision, if any are determined as follows:

Scenario Amountof Provision Remarks
1 P2,800,000 (P4Mx 70%) + (PO x 30%)
2 2,200,000 (P4Mx 55%) + (PO x 45%)
3 None No probable outflow of resources (<50%)
Note: No present value calculations since the amount is expected to be paid within the yeat-
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It should be noted that if the Company does not lose the case (or have won the case),
it will not be obligated to pay any amount (i.e., zero). That is the reason why the
likelihood that the entity will not lose the case (i.e., 1 less % chance of losing the
case) is shown to be multiplied to zero.
In addition, the readers should be reminded that if the probability is 50% or less as
in Scenario 3, no provision shall be recognized since it is not probable that there will
be an outflow of economic benefits.
Illustration 7. PRADO Company became involved in a litigation as one of its

delivery trucks was involved in a road accident resulting to multiple physical
injuries and damage to properties. According to the lawyers consulted, there is an
80% chance that the Company will become liable. In case that the Company is
ordered by the court to pay damages, the following amounts and their
corresponding probability are estimated:
Amount P2,000,000 P3,000,000 5,000,000
Probability 35% 45% 20%
Answer:
Visually, using the probability tree diagram, the estimated amount of provision of
P2,440,000 is computed as follows:
35% P2,000,000
P3,050,000 =
(P2M x 35%) + 1 53.000.000
80% 71 (P3M x 45%) + sn0i
(P5M x 20%)
P2,440,000 = 20% P5,000,000
(P3,050,000 x 80%)
+ (POx 20%)
20% ait
Since there is an 80% chance that the Company may be held liable, as a complement,
there is a 20% (1 - 80%) chance that the entity may not be held liable; hence a loss
amount of zero was assigned for the 20% probability.
Most of the time, the computed expected value may be further adjusted upwards
using a risk adjustment factor to account for the possible changes in the cash flow
amounts.
Continuing with the illustration, if the risk factor adjustment is estimated to be 6%,
the expected value amount shall be adjusted to P2,586,400 [P2,440,000 x (1 + 6%)].
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MID-POINT OF RANGE
This approach is used when there is a continuous range of possible outcomes, anq
each point in that range is as likely as any other. [PAS 37.39]. The mid-point
amount is computed as follows:
Lower limit amount + Upper limit amount

Mid-point Amount = 5
Illustration 8. During the year, one of GUILLERMO Company's ship capsized ang
caused oil spill. There is no law requiring the Company to clean up the oil spill but
due to international pressure, the Company issued a public statement that it wij
now clean up the oil spill. Based on the Company’s estimate, total clean-up costs can
be anywhere from P6,000,000 up to P9,000,000.
Since all the amounts between P6,000,000 and P9,000,000 have equal probability
of happening, the mid-point amount, at which the provision is initially measured, is
computed as follows:
Mid-point _ _P6,00+ 0,
P9,000
00,00
00_ _ paegg ooo
amount 2
EVENTS AFTER THE REPORTING PERIOD

Generally, events that happened after the reporting period shall not affect the
amounts recorded as of a reporting date. For example, if an inventory was
purchased on January 20, 2024 for cash, the transaction shall not increase the
balance of inventory and shall not decrease the balance of cash, both as of December
31, 2023.
However, there are some events after the reporting period that affect the amounts
recognized as of the reporting date (“adjusting events”). They are considered as
such since they merely confirm existing conditions as of the reporting date.
One of these kinds of events is a provision or contingent liability that was settled
after the reporting date. This settlement affects the recognized amounts as of the
reporting date in the following manner:
a. The amount of actual settlement shall be the measurement of the provision
as of the reporting date.
b. The fact that there is an actual settlement confirms that the entity has, in
reality, an existing and probable obligation as of the reporting date. This
mainly is applicable to obligations not initially recognized because it is not
probable that there is an outflow of economic benefits.
More details on the events after reporting period are discussed in the Volume 3 of
this Intermediate Accounting series.
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Illustration 9. As of December 31, 2023, DULAY Company estimated that its

obligation from a litigation is P4,500,000. On January 15, 2024, the court ordered
the Company to pay P4,200,000 to the plaintiff. The decision is not appealable and
considered as final.
In this case, the provision shall be measured at P4,200,000 as of December 31, 2023.
Illustration 10. As of the end of 2023, APOSTOL Company did not recognize a
provision related to its obligation from a litigation since it is estimated that there is
only a 30% chance that the Company will lose the case. However, on January 10,
2024, the Company is required by the court to pay P3,000,000 to the plaintiff. The
decision is not appealable and considered as final.
As of December 31, 2023, the provision shall be measured at P3,000,000 since the
actual settlement confirmed the existence of probable obligation. This is regardless of
the initial assessment of 30% chance that the Company will lose the case.
PLAINTIFF'S OFFER OF OUT-OF-COURT SETTLEMENT
A court case can be a lengthy and a costly battle. As a result, a plaintiff may offer to
withdraw its filed complaint in exchange for a private settlement with the entity-
defendant.
The amount of the plaintiff's offer for an out-of-court settlement shall not be solely
considered as the measurement of provision. The reason is that other factors
may affect the actual amount such as the final decision of the court which may be
materially different from the amount of plaintiffs offer.
CONSIDERATION OF FUTURE EVENTS

Future events are relevant to provisions that use the information from the future
periods in determining the amount an entity might ultimately be liable for. The
future information includes, but are not limited to, the following:
a. Technological advances that will affect the costs of settling the obligation in the
future.
b. New legislation is taken into consideration when sufficient objective evidence
exists that the legislation is virtually certain to be enacted.
These future events most probably will affect the measurement of asset retirement
obligations.
Illustration 11. OLIVEROS Company has recently started the commercial
production of its gold mine in Leyte. In connection with this, the Company is
estimating the total amount of rehabilitation and restoration costs of the area when
the mining operations has ended after 10 years. Based on the current technology,
total costs are estimated to be P10,000,000. However, by considering the trajectory
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of technological advances, total costs are reliably estimated to be just P6,000,000,

Relevant discount rate is 7%
In this case, the provision shall be computed as the present value of P6,000,000 o;
the cost considering future technological advances:
PV Initial
Single payment for 10 periods at7% 0.508349 = P6,000,000 P3,050,096
EXPECTED GAIN FROM THE DISPOSAL OF AN ASSET

Expected gain from the disposal of an asset shall not be considered in measuring
the amount of provision. The gain shall be recognized only at the time specified
by an accounting standard dealing with the assets concerned. For example, gain on
sale of property, plant and equipment is recognized on the date the control over the
asset has been transferred to the buyer.
INITIAL RECORDING OF PROVISION

Generally, the amount of initially recognized provision is recognized as a loss (i.e,
reported in profit or loss) using the following pro-forma entry:
Loss on provision XX
Provision (estimated liability) _XX
The exceptions to this general rule include, but are not limited to, the following:
a. Asset retirement obligation for wasting assets is included in the measurement of
natural resource asset that will be considered in the computation of depletion.
(Discussed in the Volume 1 Part 2 of this Intermediate Accounting series).
b. Asset retirement obligation that is included in the initial measurement of the
right-of-use assets arising from leases (to be discussed in Chapter 9).
SUBSEQUENT MEASUREMENT OF PROVISIONS
Generally, the amount of initially recognized provision shall not be changed,
except for the following:
a. For provisions measured at present value, the amount of liability is periodically
increased due to the accretion of interest, which is recognized as interest
expense. By analogy, the concept is similar to the accretion of interest in
noninterest-bearing note payable. Pro-forma journal entry to record the
accretion is as follows:
Interest expense XX
Provision (estimated liability) XX
b. Partial settlement that reduces the carrying amount of provision. The pro-forma
journal entry to record the settlement is as follows:
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Provision (estimated liability) XX

Cash XX
c. Changes in the estimated amount of provision

d. Changes in the probability of outflow of economic benefits
Items (c) and (d) are to be discussed in detail in the succeeding sections.
A provision shall be used only for expenditures for which the provision was originally
recognized. [PAS 37.61]. For example, the provision made for environmental
damage shall not debited if an entity settles its obligation related to the damages
that its product caused to its customers.
Illustration 12. As of December 31, 2023, SANTILLAN Company properly

estimated that it will incur P5,000,000 for the restoration and rehabilitation of one
of its oil fields. These restoration costs will be incurred after 4 years. Relevant
discount rate is 9%. The initial amount of provision is computed as follows:
PV Initial
Single payment for 4 periods at9% 0.708425 P5,000,000 P3,542,126
The subsequent carrying amounts of the provision as ofthe end of each year for the
next four years are the following, assuming no changes in the estimate:
Date Interest Expense Carrying Amount
Dec. 31, 2023 3,542,126
Dec. 31, 2024 318,791 3,860,917
Dec, 31, 2025 347,483 4,208,400
Dec. 31, 2026 378,756 4,587,156
Dec, 31, 2027 412,844 5,000,000
The readers should take note of these computations:

a. Interest expense is computed as provision’s beginning-of-the-period
carrying amount x 9% discount rate.
b. Carrying amount is equal to beginning-of-the-period carrying amount plus
interest expense for that period.
CHANGES IN THE ESTIMATED AMOUNT OF PROVISIONS

Provisions shall be reviewed at the end of each reporting period and adjusted to
reflect the current best estimate. [PAS 37.59]. Changes in the estimated amount of
provisions are generally recorded as either a gain or loss in the entity’s profit or
loss during the period of change. In other words, it is considered as a change in
accounting estimate and shall be accounted prospectively (i.e, previously
reported amounts during the prior periods shall not be revised).
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Scenario Gain or Loss

Increase in provision Loss
Decrease in provision Gain
The exception is for asset retirement obligations where the changes affect the
carrying amount of related natural resource asset for wasting asset entities (see
Volume 1 of this Intermediate Accounting series) or the carrying amount of the
right-of-use asset for leases (see Chapter 9).
Illustration 13. At the end of 2022, ABALOS Company recognized a provision at

P6,400,000. As of December 31, 2023, there were changes in the estimates resulting
to changes in the amount of the provision. Accretion of interest for the year 2023
amounted to P100,000. Under each of the following independent ‘scenarios,
determine the journal entry to record the change in the amount of provision:
1. Provision should be P7,000,000 as of December 31, 2023
2. Provision should be P6,250,000 as of December 31, 2023
Answer - Scenario 1
The carrying amount of the provision right before the change in estimate shall be
determined as P6,500,000 (P6,400,000 plus P100,000 accretion of interest). In this
scenario, there is an increase in the provision amounting to P500,000 (P7,000,000 -
P6,500,000). The entry to record the Joss is as follows:
Loss on provision 500,000
Provision (estimated liability) 500,000
Answer - Scenario 2
There is a decrease in the provision amounting to P250,000 (P6,250,000 -
P6,500,000). The entry to record the gain is as follows:
Provision (estimated liability) 250,000
Gain on reduction of provision 250,000
CHANGES IN THE PROBABILITY OF OUTFLOW OF ECONOMIC BENEFITS

It has been established that a provision shall be recognized if it is at least probable
that there is an outflow of economic benefits. If the likelihood is below “probable” 4
contingent liability will only be disclosed. However, in cases where there are
changes in the probability of outflow of economic benefits, these are considered
as changes in accounting estimates and shall be accounted prospectivel¥
(previously reported amounts during prior periods shall not be restated).
There are cases wherein no provision was recognized during the prior periods)
(because probability is <50%), but during the current period, it became probable
that there is an outflow of economic benefits (i.e., possible > probable). In suck,
cases, the following accounting procedures shall be made;
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a. aprovision shall be recognized during the current period

b. a corresponding loss shall be recognized during the current period even
though the obligation arose from prior periods.
The opposite is also true wherein provision may have been recognized during the
prior periods (because probability is more than 50%), but during the current period
it only became possible that there is an outflow of economic benefits (i.e., probable
> possible). In such cases, the following accounting procedures shall be made:
a. the provision shall be reversed during the current period
b. a corresponding gain on reversal of provision shall be recognized during the
current period.
Illustration 14. During 2022, QUINTO Company became involved in a court
litigation alleging that the food it sells is the cause of widespread food poisoning. As
of December 31, 2022, it was reliably assessed that it is only possible that the
Company will be held liable for P4,800,000 damages. However, as of December 31,
2023, it was reliably assessed that it became probable that the Company will be
held liable for P5,200,000 damages.
As of December 31, 2022, the Company shall only disclose a contingent liability.
However, on December 31, 2023, the Company shall recognize a provision based on
the updated estimate of P5,200,000 by making the following journal entry:
Loss on provision 5,200,000
Provision (estimated liability) 5,200,000
Again, a loss on provision shall be recognized in 2023 even though the obligating
event arose from 2022. This is the prospective application of change in estimates.
SPECIFIC APPLICATIONS OF PROVISIONS

Provisions can be applied to the following specific circumstances:
a. future operating losses
b. onerous contracts
c. restructuring
d. warranties and premiums (to be discussed in Chapters 4 and 5)
FUTURE OPERATING LOSSES

Provisions shall not be recognized for future operating losses. [PAS 37.63].
Operating losses are recognized during the period they are incurred.
ONEROUS CONTRACTS
An onerous contract is a contract in which the unavoidable costs of meeting the
obligations under the contract exceed the economic benefits expected to be
received under it. [PAS 37.10].
Provision arising from onerous contracts shall be the lower of the following:
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a. costs of fulfilling the onerous contract; and

b. any compensation or penalties arising from the failure to fulfill the onerous
contract
The Interpretations Committee has clarified that the costs of fulfilling the contract
include both the incremental costs and allocated costs.
Illustration 15. During the earlier part of 2023, MONTERO Company entered into
a noncancelable purchase commitment for the purchase of 100,000 of ABC mode]
computer chips in 2024 at a fixed price of P20/chip. If the Company would cance]
the contract, it should pay P1,100,000 penalty. During the latter parts of 2023, a
new computer chip was discovered rendering the ABC model worthless.
As of December 31, 2023, the contract is considered as onerous. An entity shall
recognize a provision of P1,100,000 (i.e., penalty amount) since this is lower than
the costs of fulfilling the contract amounting to P2,000,000 (100,000 x P20).
RESTRUCTURING - GENERAL CONCEPTS

A restructuring is a program that is planned and controlled by management and
materially changes either:
a. the scope ofa business undertaken by an entity; or
b. the manner in which that business is conducted. [PAS 37.10].
The following are examples of events that may fall under the definition of
restructuring:
a. sale or termination ofa line of business;
b. the closure of business locations in a country or region or the relocation of
business activities from one country or region to another;
c. changes in management structure, for example, eliminating a layer of
management; and
d. fundamental reorganizations that have a material effect on the nature and focus
of the entity’s operations. [PAS 37.70].
A constructive obligation to restructure arises only when an entity:

a. has a detailed formal plan for the restructuring identifying at least:
i. the business or part of a business concerned;
ii. the principal locations affected;
iii. the location, function, and approximate number of employees who will be
compensated for terminating their services;
iv. the expenditures that will be undertaken; and
v. when the plan will be implemented; and
b. has raised a valid expectation for those affected that it will carry out the
restructuring by starting to implement that plan or announcing its mail
features to those affected by it. [PAS 37.72].
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No obligation arises for the sale of an operation until the entity is committed to the
sale, (i.e., there is a binding sale agreement). [PAS 37.78].
Illustration 16. During 2023, the Board of Directors of ALFONSO Company decided
to terminate their operations in a foreign country starting in 2024. There is already
a detailed formal plan for the restructuring, and the plan was already
communicated to the employees in the foreign country.
In this case, as of December 31, 2023, the Company has already incurred a
constructive obligation by announcing the plan to the employees affected. As a
result, a provision for restructuring shall be recognized as of December 31, 2023
even though the restructuring will be actually implemented in 2024.
Illustration 17. On the September 2023 monthly meeting, the Board of Directors
of UMALI Company decided to close down one of its factories in Davao effective July
1, 2024. There is already a detailed formal plan for the restructuring and the plan
was already announced through a press release. The Company is yet to
communicate the plan to the employees affected.
In this case, as of December 31, 2023, the Company has already incurred a
constructive obligation by announcing the plan publicly. For sure, this
announcement has reached the affected employees. As a result, a provision for
restructuring shall be recognized as December 31, 2023.
Illustration 18. During the year 2023, the Board of Directors of CAMPOS Company
decided to terminate its smartphone-making division located in foreign country
effective April 1, 2024. There is already a detailed formal plan for the restructuring
and the plan was already announced to the officers in the corporate headquarters.
In this case, as of December 31, 2023, the Company has not

incurred
yet a
constructive obligation since the plan was announced only to employees in
provision
corporate headquarters and not to the employees affected. As a result, no
for restructuring shall be recognized as December 31, 2023.
RESTRUCTURING- MEASUREMENT OF PROVISION

A restructuring provision shall include only the direct expenditures arising from
the restructuring, which are those that are both:
a. necessarily entailed by the restructuring; and
b. not associated with the ongoing activities of the entity. /PAS 37.80].
A restructuring provision does not include such costs as:
a. retraining or relocating continuing staff;
b. marketing;
c. investment in new systems and distribution networks; or
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d. identifiable future operating losses up to the date of a restructuring [PAS 37.8].}-

82].
Illustration 19. In September 2023, CONSTANTINO Company decided to cease its
commercial operations in Country A effective July 1, 2024. This is the result of the
long-term plan to introduce commercial operations in Country B. In connection
with this, the following amounts were determined:
Estimated payments to be made for immediately terminated
employees (i.e., redundancy payments) P2,400,000
Estimated operating loss from 1/1/24 to 7/1/24 3,000,000
Salaries of employees remaining in Country A from 1/1/24
to 7/1/24 to cater the remaining business transactions 1,200,000
Costs of dismantling equipment that will not be used
subsequently in Country B 400,000
Costs of dismantling equipment that will be transferred to
Country B 500,000
Costs of relocating and installing valuable equipment to
Country B 750,000
Airfare for the transfer of valuable employees to Country B 300,000
Costs of training new employees in Country B 250,000
Estimated capital expenditures to establish commercial
operations in Country B 5,000,000
Salaries of employees in Country B from 1/1/24 to 7/1/24 2,000,000
Marketing costs to promote operationsinCountryB 800,000
Costs of decommissioning the existing factory in Country A 600,000
From the given data, total restructuring provision shall be recognized as follows:
Estimated payments to be made for immediately terminated

employees (i.e., redundancy payments) P2,400,000 :
Costs of dismantling equipment that will not be used
subsequently in Country B 400,000 '
Costs of decommissioning the existing factory in Country A 600,000
ees
Restructuring provision to be recognized, 12/31/23 P3,400,000
Note: All of the other costs are not considered because they are part of the ongoing
activities of the Company, including future operating losses.
CONTINGENT ASSETS
A contingent asset is a possible asset that arises from past events and whose
existence will be confirmed only by the occurrence or non-occurrence of one of
more uncertain future events not wholly within the control of the entity. [ PAS §
37.10]. ,
Contingent assets normally arise from the following: :
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a. Claims of damages/compensation arising from a filed lawsuit (in this case, the
entity is the plaintiff).
b. Insurance claims from the insurer.
c. Reimbursement of amounts paid.
Similar to contingent liabilities, accounting for contingent assets primarily depends
on the likelihood of outcome:
Likelihood Contingent Assets | Contingent Liabilities
Virtually certain Recognize as asset | Recognize as provision
Probable Disclosure only | Recognize as provision
Possible No disclosure permitted Disclosure only
Remote No disclosure permitted | No disclosure required
As the readers may have noted, the required level of likelihood for contingent
assets is one notch higher compared to the contingent liabilities. In other
words, a provision is recognized if the likelihood is at least probable, but an asset is
recognized only when it is virtually certain.
As to reimbursements, the following are the financial reporting requirements:
Financial statement Presentation

Statement of financial Presented as a separate asset and shall not be offset
position (balance sheet) | against the related provision (or liability).
The loss from provision may be presented net of the
Income statement
income amount recognized for the reimbursement asset
The recognition of a contingent asset, whose receipt is virtually certain, has the
following pro-forma entry:
Receivable XX
Other income or gain XX
Illustration 20. BAYLON Company (i.e., plaintiff) filed a lawsuit for an alleged
patent infringement of its competitor (i.e., defendant). Before the end of the current
year, a regional court decided in favor of the Company and initially ordered the
defendant to pay P5,000,000 damages. However, the court decision is currently on
appeal by the defendant.
As of the end of the current year, the Company shall not recognize an asset since the
initial decision in its favor might be later on overturned (i.e., not virtually certain to
be received).
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CHAPTER SUMMARY
1. Provision is a liability of uncertain timing or amount.
2. Aprovision shall be recognized when all of the following conditions are met:
a. an entity has a present obligation (legal or constructive) as a result of a past
event;
b. itis probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; and
c. areliable estimate can be made of the amount of the obligation.
Absence of any of these conditions will result to non-recognition of the liability.
3. An obligation that is not recognized as a provision shall be disclosed only in the

financial statements, except when the likelihood is remote.
4. Obligating event creates a legal or constructive obligation that results in an entity
having no realistic alternative to settling that obligation.
5. There are two types of obligation, legal, and constructive obligation.
6. Probable means more likely than not or more than 50% likelihood. No obligation
shall be recognized if the likelihood is 50% or lower.
7. The amount recognized as a provision shall be the best estimate of the expenditure
required to settle the present obligation at the end of the reporting period. The
management's judgment is the primary basis for the estimate of the obligation.
8. Where the effect of the time value of money is material, the amount of the provision
shall be the present value of the expenditures required to settle the obligation.
9, Expected value method is used when the provision being measured involves a large
population of items. The procedure is to weight all possible outcome amounts by
their associated probabilities.
10.The mid-point approach is used when there is a continuous range of possible
outcomes, and each point in that range is as likely as any other.
11.Events after the reporting period may be used in measuring a provision or
recognizing a provision as of the reporting date.
12, Future events may be considered in estimating the amount of provision.
13. Expected gain from the disposal of an asset shall not be considered in measuring the
amount of provision.
14.Provisions are generally charged to profit or loss, except those related to wasting
asset operations and right-of-use asset.
15.For provisions measured at present value, the amount of liability is periodically
increased due to accretion of interest, which is recognized as interest expense.
16.Changes in the estimate of the provision shall be accounted prospectively (i.e.,
previously reported amounts are not affected). The effects of the change are
generally recognized in the current period’s profit or loss.
17.Changes in the probability of outflow of economic benefits are also accounted
prospectively. The effects of the change are generally recognized in the current
period’s profit or loss.
18, Provisions are not recognized for future operating losses.
19. The amount of the provision to be recognized from onerous contracts shall be the
lower of the following:
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a. costs of fulfilling the onerous contract; and

b. any compensation or penalties arising from failure to fulfill the onerous contract
20.A restructuring is a program that is planned and controlled by management, and
materially changes either:
a. the scope ofa business undertaken by an entity; or
b. the manner in which that business is conducted.
21.Generally, no provision is recognized until the restructuring plan has started to be
implemented or it had been announced to those affected by it
22.A restructuring provision shall include only the direct expenditures arising from the
restructuring, which are those that are both:
a. necessarily entailed by the restructuring; and
b. not associated with the ongoing activities of the entity.
23.A restructuring provision does not include such costs as:
retraining or relocating continuing staff;
op
marketing;
investment in new systems and distribution networks; or
ao
identifiable future operating losses up to the date of a restructuring
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True or False
1, Provisions are recorded as liabilities while contingent liabilities are disclosed only
in the notes to the financial statements.
Z Probable means at most 50% likelihood of happening.
3. If a reliable estimate of the obligation cannot be made, no liability shall be
recognized even if the likelihood is probable.
An obligation arising from contract is considered as a constructive obligation.
U1
The amount recognized for the provision shall be the best estimate of the
expenditure required to settle the present obligation.
Expected value method shall be used when there is a continuous range of possible
outcomes, and each point in that range is as likely as any other.
Mid-point of range method is used when the provision being measured involves a
large population of items.
Actual settlement of a provision after the reporting date may be considered in
determining the carrying amount of the provision as of the reporting date.
Expected proceeds from the disposal of an asset shall be recognized as a receivable,
even though the control is not yet transferred to the buyer.
10. Generally, the amount of provision shall be recognized as loss in the entity’s profit
or loss.
11. Changes in the estimate of provision shall result to the restatement of previously
reported financial information related to prior years.
a2: Restructuring provision shall exclude costs associated with the ongoing activities
of the entity operations.

L The following are correct accounting and reporting for provisions and contingent
liabilities, except
a. Provision is not disclosed in the notes since this has already been recognized in
the balance sheet.
b. Contingent liability is disclosed in the notes to the financial statements.
c. Provision is recognized as liability in the balance sheet.
d. Contingent liability is not recognized as liability in the balance sheet.
Obligations with the following likelihood are required to be disclosed in the notes to
the financial statements, except
a. probable
b. possible
c. remote
d. none of the above since all obligations of an entity shall be disclosed, regardless
of the likelihood of their occurrence,
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3. An obligating event will result to either legal obligation or constructive obligation.

Sources of legal obligation include the following, except
a. operation of law
b. contract
c. legislation
4. Based on the current rules and regulations, an entity engaged in transportation

services shall replace the tires of its vehicles every five years. As of the reporting
period, there is only two years left before the tires are required to be replaced. Based
on this information,
a. the entity shall disclose in the notes to financial statements a contingent liability
the legal requirement to replace the tires.
b. _ the entity shall recognize a provision equal to the present value of the estimated
costs of replacing the tires.
c. the entity shall not recognize a provision nor disclose informaiton’ in the notes
to the financial statements.
d. the entity shall recognize a provision equal to the present value of the estimated
costs of replacing the tires and make a disclosure to the notes.
5. One of the manufacturing entity’s plants has exploded, releasing harmful chemicals
in the air. These released chemicals are considered health hazards and may cause
severe lung issues to the people who inhaled. As to the entity’s obligation, there is a
law requiring it to shoulder the hospitalization costs of the affected people.
However, the entity is not able to reliably estimate the ultimate amount of total
hospitalization costs. In this case,
a. no recognition of provision nor disclosure shall be made.
b. a provision shall be recognized as liability.
c. acorresponding loss shall be recognized in the income statement.
d. only a contingent liability shall be disclosed in the notes.
6. During the current year, one of the entity's ships sank and caused a widespread oil
spill. There is no specific law requiring the entity to clean-up the spill and
rehabilitate the affected area. However, the entity has published a public statement
that it will accept responsibility for the disaster. Costs of cleaning and rehabilitating
the area are reliably measurable. In this case,
a. no recognition of provision nor disclosure shall be made.
b. aprovision shall be recognized as liability.
c. acorresponding increase in goodwill shall be recognized in the balance sheet.
d. only a contingent liability shall be disclosed in the notes.
7. Some customers filed a case against an entity related to the adverse side effects of
its medicine. According to the entity's lawyer, there is a 30% chance that the entity
may lose the case. Damages that may be paid to these customers are measurable
reliably. In this case,
a. aprovision equal to the amount of reliably estimated amount of damages.
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b. a provision equal to the amount of reliably estimated amount of damages times

the 30% likelihood that the entity may be held liable.
c. only acontingent liability shall be disclosed in the notes.
d. no recognition of provision nor disclosure shall be made.
8. The following concepts on measuring the provision are true, except

a. The amount recognized as a provision shall be the best estimate of the
expenditure required to settle the present obligation at the end of the reporting
period.
b. If the effect of the time value is material, the amount of provision shall be the
present value of the estimated expenditures to settle the obligation.
c. Expected value shall be used if the provision being measured involves a large
population of items.
d. Mid-point of range is used when there is a continuous range of possible
outcomes, but some points in that range are more likely than other points.
9. The following are not incorporated in the measurement of a provision, except

a. events after the reporting period
b. plaintiff's offer of out-of-court settlement
c. expected gain from the disposal of an asset
d. expected proceeds from the disposal of an asset
10.Accretion of interest from a provision measured at present value shall be
a. recognized as interest expense
b. added to the related provision
c. added to the entity's goodwill balance
d. bothaandb
11.Which of the following is the correct accounting procedure if there is a change in the
estimate of a provision?
a. The change shall be recognized in the current period's profit or loss
b. The prior periods’ financial statements shall be restated,
c. The beginning retained earnings shall be restated,
d. The provision is debited if there is an increase in estimate and credited if there
is a decrease in estimate.
12.During Year 1, one of the entity’s former employees filed a case against the entity's
labor practices, As of the end of Year 1, it was reliably assessed that itis not probable
that the entity will be held liable. Consequently, no provision was recognized during
Year 1. However, during Year 2, it was reliably assessed that it is now probable that
the entity will be held liable in the labor case. In this case,
a. Financial statements for Year 1 shall be restated by recognizing a provision and
corresponding loss.
b. Financial statements for Year 2 shall reflect the recognition of the provision in
the balance sheet and the corresponding loss in the income statement.
c. Retained earnings balance at the beginning of Year 2 shall be restated,
d. Only a disclosure in the notes shall be made during Year 2,
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13. The amount of provision to be recognized from onerous contracts shall be equal to
a. costs of fulfilling the onerous contract
b. any compensation or penalties arising from failure to fulfill the onerous
contract.
C: higher ofa and b
d. lower of a and b
14. The following are examples of restructuring, except

a. sale or termination of a line of business.
b. the closure of business locations in a country or region or the relocation of
business activities from one country or region to another.
Cc. termination of employees in different departments due to their unreasonable
absences.
d. changes in management structure.
15.An entity transferred its operations from Country X to Country Y. In this case,
restructuring provision shall exclude all of the following, except
a. termination benefits given to retrenched employees
b. marketing and advertising costs in Country Y
c. costs of relocating continuing staff
d. costs of training new staff in Country Y
Straight Problems
1. For each of the give events below, determine the journal entry to recognize the
provision, if any, on December 31, 2023:
a. One of the entity’s tanker leaked hundreds of gallons of oil to the ocean on
October 1, 2023. There is no law requiring the entity to clean-up the spilled oil.
However, the entity is committed to make good of any environmental damage it
previously made during the prior years as part of its corporate social
responsibility. Costs of cleaning and rehabilitating the affected area are reliably
estimated at P6,000,000.
One of the entity’s tanker leaked hundreds of gallons of oil to the ocean on
October 1, 2023. There is a law requiring the entity to clean-up the spilled oil.
However, costs of cleaning and rehabilitating the affected area are not reliably
measurable.
Cc. An entity’s new medicine released to the public during 2023 caused unwanted
side effects that resulted to mental anguish and physical suffering of some of the
users. These users filed a single legal suit against the entity. Based on the reliable
estimate, there is an 80% chance that the entity will be prosecuted and required
to pay a total of P4,000,000 damages.
An entity’s new medicine released to the public in 2023 caused unwanted side
effects that resulted to mental anguish and physical suffering of some of the
users. These users filed a single legal suit against the entity which has a 45%
likelihood that will make the entity liable for P7,000,000 damages.
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e. A common carrier entity is legally required to periodically replace the tires of its
fleet of provincial buses every five years as a precondition for the renewal of its
franchise. As of December 31, 2023, there are still three years before the required
replacement of tires. Costs of tire replacement after three years are estimated at
P2,000,000. Relevant discount rate is 8%.
As of December 31, 2023, based on the current state of an entity's mining
operations, it is probable that an environmental damage will happen in few
months’ time. Local regulation requires the reparation of such damages. In case
there is an actual environmental damage, costs to rehabilitate the affected are
estimated to be P3,000,000.
2. Under each of the following independent scenarios, determine the journal entry to
recognize the provision, if any, on December 31, 2023:
a. On November 1, 2023, the board of directors have agreed to close down its
operations in one of its geographical areas, effective on the 24 quarter of 2024.
The decision is known in the headquarters but is yet to reach the affected
operations. Total costs of restructuring are estimated at P10,000,000.
On October 15, 2023, the board of directors have agreed to close down its
operations in one of its geographical areas, effective on the 2"4 quarter of 2024.
The decision has already been communicated to affected operations. Total costs
of restructuring are estimated at P8,000,000.
An entity is in the process of downsizing its business in one particular area. It
plans to transfer some of its equipment to another area and expects to incur
estimated transportation, handling and deployment costs totaling P1,500,000.
On November 2023, amendments to taxation law introduced a lot of changes
which made the current knowledge of an entity's finance department employees.
Because of this, it plans to conduct a training for the amendments on January
2024 at an estimated cost of P400,000.
As of December 31, 2023, an entity plans to have its factory equipment repaired
in February 2023 at an estimated cost of P600,000.
Some ofan entity’s customers who availed Botox treatment suffered adverse side
effects and decided to file a single case against the entity. The entity’s lawyers
assessed that there is 100% chance that the entity will be held liable and
estimated that the amount of damages to be paid range from P4,000,000 to
P8,000,000. Each amount in that range has an equal likelihood of happening as
the other amounts in the same range.
3. During December 2023, MELANIE Company’s oil tanker ran aground and caused a
major oil spill. The Company is required to clean it up at an estimated total cost of |
P5,000,000. During 2024, the Company made partial clean-up operations incurring
a total cost of P2,700,000. As of December 31, 2024, the estimate of total remaining
clean-up costs amounted to P2,800,000.,
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Required: From this information and ignoring the time value of money, determine
the journal entries to be made for the years 2023 and 2024.
4. During 2023, some of the users of VERONICA Company’s products filed a legal
complaint against the Company because of the skin damage caused by one the
Company’s beauty products. According to the Company’s lawyers, if the lawsuit is
successful against the Company, total damages to be paid will amount to P6,000,000.
There is a 35% likelihood that the Company will lose the case and will be required
to pay the complainants.
Required: Determine the amount of provision to be recognized, if there is any, as of
December 31, 2023 based on the given information.
5. During the latter parts of 2023, one of the PEREZ Company’s mining operations has
inadvertently released harmful chemicals to the major river in the locality. The
mining regulatory body required the Company to clean up the river and restore it to
its condition before the environmental disaster. This is the first time that the
Company is involved in this kind of situation.
Required: Under each of the following independent scenarios, determine the amount
of provision that the Company shall recognize as of December 31, 2023:
1. The following are the possible amounts of clean up and restoration costs and
their related probabilities:
Estimated Cash Outflow Probability
P1,800,000 30%
2,600,000 50%
3,500,000 20%
2. The range of clean up and restoration costs is from P1,800,000 to P3,500,000
and the points between amounts are equally likely to occur as the other points.
6. On December 31, 2023, LAMBDA Company estimates the possible adverse financial
impact of a lawsuit in which it is a defendant. Based on the Company’s best estimate,
it is possible that it may pay the plaintiff P4,500,000.
As of December 31, 2024, the lawsuit has not yet settled, but based on preliminary
hearings, it became probable that the Company will be held liable and pay
P3,800,000, based on best estimate,
Required: From this information, determine the amounts to be recognized as

provision or disclosed as contingent liability as of December 31, 2023 and 2024.
7. On October 31, 2023, DAMSEL Company became a defendant for a lawsuit brought
by its former employee. As of year-end 2023, the Company assessed that it is
probable that it will pay P1,200,000 based on its best and reliable estimate. As of
year-end 2024, the Company assessed that it is still probable to pay the plaintiff but
with revised amount of P1,500,000 based on the its revised best estimate.
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Required: Determine the journal entries to be made for the years 2023 and 2024,
8. SYLVESTER Company became a defendant for a lawsuit brought by its customers
related to the alleged harmful effects of its products. As of year-end 2023, the
Company assessed thatit is possible that it will pay P1,450,000 based on its best and
reliable estimate. As of year-end 2024, the Company reassessed that it is now
probable that it will lose the case and that it will pay P1,600,000 based on its revised
best estimate.
Required: Determine the journal entries to be made for the years 2023 and 2024.
9. In December 2023, DRAGON Company's former CFO filed a lawsuit against the
Company on account of its labor practices that are detrimental to its employees.
Based on the Company’s assessment, there is a 30% chance that it will not be held
liable for damages. In cases the Company will be held liable, there is a 40%
probability that it will pay P8,000,000, 40% probability that it will pay P6,000,000
and 20% probability that it will pay P5,000,000. Due to lengthy legal procedures
involving labor cases, the Company estimates that it will pay the plaintiff after three
years.
In addition, the Company incorporated a 10% upward cash flow adjustment to

account for the possible differences between the estimated cash outflows and the
amount of actual cash outflows. Relevant discount rate is 9%.
Fast forward to December 31, 2024, things became clearer with the Company being
able to make its best estimate of its obligation at P7,000,000, to be incurred after
two years. In addition, there is now a 100% chance that the Company will be held
liable for damages. Relevant discount rate is 8%.
Required: Determine the journal entries to be made for the years 2023 and 2024.

1. During 2023, one of MANDY Company’s trains became derailed causing serious
physical injuries to some of the passengers. In connection with this, the affected
passengers filed a lawsuit claiming P2,300,000 damages. The Company’s lawyers
assessed that the Company is most certainly be held liable for damages from
P1,800,000 up to P3,000,000, with each point within that range have the same
likelihood of occurrence as the other points in the said range. The courts are
expected to have judgment during 2024, so the effect of time value of money is
immaterial.
From the given information, the amount of provision that the Company shall
recognize as of December 31, 2023 shall be
a. P2,300,000 c, P3,000,000
b. P1,800,000 d, P2,400,000
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2. NANCY Company became involved in a litigation involving the accident caused by

one of its transportation trucks during the latter parts of the year 2023. The accident
caused widespread property damage, but luckily, resulting to only slight physical
injuries. In connection with this, the affected entities and individuals filed a lawsuit
claiming P5,000,000 damages. In addition, there was also a one-time offer from the
plaintiffs for an out-of-court settlement amounting to P4,000,000.
On the other hand, the Company reliably estimates that it will be held liable for
damages ranging from P3,500,000 to P4,500,000, with each point in the range is
likely as any other point. In addition, settlement is expected to happen after two
years. Relevant discount rate is 7%.
a. P3,057,036 c. P3,493,755
b. P3,930,474 d. P4,367,194
3. During December 2023, it was alleged that SAMUEL Company’s toys contain
substances that are harmful to the children playing with them. As a result, a group
of parents sued the Company for total damages of P7,000,000. Since, this is the first
time that the Company has become involved in such a case, it consulted with an
outside lawyer. This lawyer estimated that the Company has a 60% chance of losing
the case, and if that is the case, the Company will be required to pay the following
likely amount of damages:
Estimated Cash Outflow Probability

P6,000,000 30%
6,500,000 60%
7,500,000 10%
It was also estimated that the courts will have their final decision in few months.
a. P3,870,000 c. P4,200,000
b. P6,450,000 d. PO
4, In November 2023, VEGETABLE Company became involved ina litigation in which
it was reasonably assessed that there is 30% chance that it will lose the case. In case
the Company has lost the case, there is a 60% chance that it will be required to pay
P4,000,000 damages and 40% chance that it will be required to pay P5,500,000
damages. It was also estimated that the courts will have their final decision in few
months.
a. P1,380,000 c. P4,600,000
b. P4,000,000 d. PO
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5. As of December 31, 2023, CARROT Company is currently a defendant in a lawsuit

involving the health hazards of the chemicals it released in the air. As of the same f
date, the Company reasonably estimated that there is an 80% chance that it may be
held liable for P5,000,000, as the best estimate of its obligation.
On February 1, 2024, the court has made its final and appealable decision requiring
the Company to pay P5,500,000 damages.
From the given information, the amount of provision that the Company shalj
a. P4,000,000 c. P5,500,000
b. P5,000,000 d. PO
6. During the October 2023 meeting of its board of directors, QUEEN Company decided
to close one of its divisions involved in manufacturing micro-chips on April 1, 2024,
The decision was immediately communicated to the affected employees. Estimated
costs that may be relevant are the following:
Estimated redundancy payments _P3,500,000
Costs of transferring some of the equipment used in micro-chip
division to other division 450,000
Estimated payments to employees that will remain until the
actual closure, 20% of their time will be utilized in managing
the closure, while the remaining 80% will be utilized in
managing the existing customers 1,200,000
Costs of dismantling the equipment used in micro-chip division
that will not be used in other divisions 250,000
Costs of airfare for transferring the executives to other divisions 300,000
Costs of tearing down the micro-chip division’s factory 800,000
Purchase of equipment to be used in other divisions 500,000
From the given information, the amount of restructuring provision that shall be
recognized as of December 31, 2023 shall be
a. P1,290,000 c. P5,680,000
b. P4,790,000 d. P6,790,000
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Chapter 4 - Warranties
CHAPTER 4
WARRANTIES

1. The concept of warranty.
2. The different types of warranty for accounting purposes.
3. The recognition and measurement of warranty expense and liability.
4. The analysis of the warranty liability account.
WARRANTIES - INTRODUCTION
To protect their names and reputations, entities spend resources for the quality
control of their products. This is to increase the chance that no defective product
will be sold to the market. However, no quality control process is perfect and some
of the defective (or below the standards) products are sold to the consumers.
To address this, an entity may introduce a warranty program covering the

products it sells. The readers may have heard of this term usually when they are
buying gadgets (e.g., smartphones and laptops). In warranty, the manufacturer of
the product bind itself that it will make good, free of charge, specified defects
that occurred over a specified period of time in the products sold.
The manufacturer may either repair the product or replace it with a new one,
without charging any fees to the customer. This is to lend confidence to customers
that their money will not be put in vain in case the product sold becomes defective.
In addition, there are also cases when some entities deliberately sell defective,
counterfeit, or fake products to earn more profits. To address this, there is this
Article 1561 from the Civil Code of the Philippines, to wit:
“The seller shall be responsible for warranty against the hidden defects which the
thing sold may have, should the defect render it unfit for its intended use, or if the
defect diminishes its fitness for such use to such an extent that, had the buyer been
aware of such defect, he would have purchased it for a lower price, or not have
purchased it at all.”
Lastly, an entity may also offer additional warranty coverage for a fee, which covers
a broader scope compared to the usual warranty it offers voluntarily and/or based
on legal requirements. This form of warranty is called the “service-type” warranty.
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ACCOUNTING CLASSIFICATION OF WARRANTIES

The first step is to identify the type of warranty for accounting purposes which ;,
either of the following:
a. Assurance-type warranty
b. Service-type warranty
The following comparison is helpful in distinguishing these two types of warranty
Assurance-type Service-type =
¥
Provide a customer with Beavide th ith

assurance that the related | ‘°¥! et a ae <
General desccimion product will function as the eee ae a d .
P parties intended because it apples “a EA Sa
complies with agreed-upon eee Pes
specification [PFRS 15.B28] specifications. [PFRS 15.B28]
Does the customer ; =
have the option to YES - in effect, the warranty
purchase warranty NO is a service distinct from the
separately? |, Product sold
YES - the legal requirement
: ? does not give rise to
Recuired Dy law? | cauitiinal performance ne
obligation
Shorter period of time;| Longer period of time;
Length of coverage | usually limited within the | covers a period beyond what|
legally required period only | is legally required
Reena Consistent with providing | Consistent with providing |
ese assurance additional service {
28
4}
Relevant accounting ae 2 Li ae ae PFRS 15, Revenue from ;
standard nore aa Contracts withCustomers |
Contingent Assets
Illustration 1. An entity provides warranty to the gadgets that it is selling. Under

each of the following independent scenarios, determine the classification of the
warranty:
1. The warranty is only provided because it is required by law.
2. The warranty covers a period longer than the usual warranty period in the
industry.
3. Customers do not have the option to separately acquire warranty services
4. The warranty covers a period on par with the industry average.
Answer:
Scenarios 1, 3 and 4 are more likely assurance-type warranties, while Scenario 2
is more likely a service-type warranty.
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Chapter 4 — Warranties
ACCOUNTING FOR ASSURANCE-TYPE WARRANTY

Based on the provisions of PAS 37, assurance-type warranty shall be accounted for
as follows:
a. Expense is recognized during the period of sale for the estimated warranty
costs, regardless of the period when these warranty costs were actually incurred.
b. A corresponding provision (i.e, estimated warranty liability) shall be
recognized for every amount of expense recognized. Together with the
estimated warranty expense amount, the following pro-forma entry shall be
made in initially recognizing the estimated warranty liability:
Estimated warranty expense XX
Estimated warranty liability XX
The amount of liability is reduced by the actual amount of warranty costs incurred
as shown in the pro-forma journal entry below:
Estimated warranty liability XX
Cash XX
Using a t-account, the transactions affecting the estimated warranty liability

account are analyzed as follows:
Warranty Liability
Actual warranty costs XX XX Beginning balance
Ending balance (squeeze) XX XX Estimated warranty expense
Totals (should be equal) XX XX |
In estimating the warranty amounts, the same principles in the measurement of

provisions in the previous chapter shall also be followed (i.e., best estimate, expected
value, midpoint of range, etc.). Specifically, there are a lot of ways to describe the
amount of estimated warranty costs, but these can be classified into any of the
following major categories:
a. Warranty cost per unit
b. Warranty cost as a percentage of revenues or sales
c. Warranty cost as net costs of providing a replacement product. In this case, the
amount of warranty cost per unit is computed as follows:
Cost of replacement product PXxx
Less: Net realizable value of defective product, ifthereisany Xx
“Loss” to be absorbed by the entity Pxx
Add: Handling costs (e.g., shipping) shouldered by the entity XX
Total warranty cost per unit of replacement product PXx
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Chapter 4 —- Warranties
Illustration 2 - Basic Case. MALINAO Company sold 100,000 units of its product
during 2023, its first year of operations. It is expected that 5% of these will have
defects that need to be rectified at an estimated warranty cost of P500/unit. Also,
actual warranty costs of P1,800,000 were incurred during the year.
The estimated warranty expense for 2023 is computed as P2,500,000 (100,000

unitsx 5% x P500).
The entry to record the estimated warranty expense and corresponding liability:
Estimated warranty expense 2,500,000
Estimated warranty liability 2,500,000
The entry to record the actual incurrence of warranty costs:

Estimated warranty liability 1,800,000
Cash 1,800,000
Based on these journal entries, the estimated warranty liability as of December 31,
2023 shall be determined as follows:
Warranty Liability
Actual warranty costs | P1,800,000 P- | Beginning balance
Ending balance (squeeze) 700,000 | 2,500,000 | Warranty expense
Totals (should be equal) | P2,500,000 | P2,500,000
It should be noted that the warranty expense for the period is not
necessarily
equal to the amount of actual warranty costs incurred during the period.
Instead, this estimated warranty expense amount also includes the warranty costs
that are expected to be incurred in the future.
Illustration 3 - Basic Case Based on Revenue. At the beginning of 2023, FRANCO

Company reported estimated warranty liability of P350,000. During the same year,
the Company reported total sales of P15,000,000. Based on the Company’s past
experience, 4% of the related sales amount will be a reliable estimate of actual
warranty costs in the future. Actual warranty costs incurred P650,000.
The estimated warranty expense for 2023 shall be computed as P600,000
(P15,000,000
x 4%):
Estimated warranty expense 600,000
The entry to record the actual incurrence of warranty costs:
Cash 650,000
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Warranty Liability
Actual warranty costs | P650,000 | P350,000 | Beginning balance
Ending balance (squeeze) | 300,000 | 600,000 | Warranty expense
Totals (should be equal) | P950,000 | P950,000
Illustration 4, During 2023, CALDERON Company’s second year of operations, the

Company sold 200,000 units of its product. According to the Company’s estimates,
units that will be repaired under the warranty program is as follows: 4% sold units
within one year from the date of sale and 3% of sold units beyond one year from
the date of sale. Warranty cost per unit is estimated to be P200. Actual warranty
costs incurred during 2023 amounted to P2,550,000, while beginning balance in
warranty liability amounted to P750,000.
The estimated warranty expense for 2023 shall be determined as P2,800,000
[200,000 unitsx (4% + 3%) x P200]:
It should be noted that regardless of the timing of when the warranty costs will
be actually incurred, the related total estimated warranty costs shall be
immediately recognized as expense during the period when the related
products were sold.
Warranty Liability
Actual warranty costs | P2,550,000 | P750,000 | Beginning balance
Ending balance (squeeze) | 1,000,000 | 2,800,000 | Warranty expense
Illustration 5 - Expected Value. QUIJANO Company sold 250,000 units during

2023. The Company expects that 3% of these will have minor defects and that 1%
will have major defects (i.e., 96% of the units are expected to have no defects).
Repair costs are estimated to average P200/unit for minor defects while it is
P700/unit for major defects. Actual warranty costs incurred during the year
amounted to P3,100,000 while beginning warranty liability amounted to P800,000.
The estimated warranty expense for 2023 shall be computed as follows:

Warranty costs from non-defective units (250,000 x 96% x PO) P-
Warranty costs from minor defects (250,000 x 3% x P200) 1,500,000
Warranty costs from major defects (250,000 x 1% x P700) 1,750,000
Total estimated warranty expense for 2023 P3,250,000
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Warran Liability
Actual warranty costs P3,100,000 P800,000 Beginning balance
Ending balance (squeeze) 950,000 _ 3,250,000 Warranty expense
Totals (should be equal) P4,050,000 P4,050,000
Illustration 6 - Provision of Replacement Product. VELASQUEZ Company offers

a replacement product in its warranty program as its products are always beyond
repair when they become defective. Manufacturing costs per unit averaged P300
while net realizable value of defective units from customers averaged P50/unit. In
addition, the Company shoulders the cost of shipment to and from customers which
averages P75/unit.
During 2023, the Company sold 150,000 units, 2% of which are expected to be
replaced. Also, during the year, 2,700 units were replaced. Beginning-of-the-period
warranty liability amounted to P162,500.
The estimated warranty expense per unit is computed as follows:

Cost of replacement product P300
Less: Net realizable value of defective product (50)
“Loss” to be absorbed by the entity P250
Add: Shipping costs shouldered by the entity 1
Total warranty cost per unit of replacement product P325
Based on this warranty cost per unit, the total estimated warranty expense for 2023
shall be determined as P975,000 (150,000 unitsx 2% x P325).
Est. warranty liability 975,000
The entry to record the replacement of 2,700 units and the related shipping costs:
Est. warranty liability (2,700x P325) 877,500
Inventory - defective (2,700x P50) 135,000
Cash (2,700 x P75) 202,500
Inventory ~ new (2,700 x P300) 810,000
Based on these journal entries, the estimated warranty liability as of December 31.
Warranty Liability
Actual warranty costs |__P877,500 | __P162,500 | Beginning balance
Ending balance (squeeze) 260,000 975,000 | Warranty expense
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Chapter 4 —- Warranties
Illustration 7 - Multiple Periods. At the beginning of 2023, ALONZO Company

reported P800,000 in its estimated warranty liability. In addition, the Company
reported the following information for 2023 and 2024:
2023 2024
Sales revenue P25,000,000 P32,000,000
Actual warranty costs incurred 1,400,000 1,450,000
Estimated warranty costs 5%ofsales 5%ofsales
Year 2023
The estimated warranty expense for 2023 shall be computed as P1,250,000
(P25,000,000 x 5%):
The estimated warranty liability as of December 31, 2023 shall be determined as
follows:
Warranty Liability
Actual warranty costs | P1,400,000 P800,000 | Beginning balance
The readers should take note that the P650,000 warranty liability balance as of
December 31, 2023 is the beginning balance for the year 2024.
Year 2024 |
(P32,000,000 x 5%):
follows:
Warranty Liability
Ending balance (squeeze) 800,000 1,600,000 | Warranty expense
WARRANTIES WITH EXPIRATION

So far, the warranties discussed were without corresponding expiration dates.
However, in real life, warranty coverage has their expiration wherein the most
common of which is a one-year warranty coverage. In these cases, the expired
warranty amounts are reported as reduction from both estimate warranty
expense during the period of expiration and estimated warranty liability.
However, to be able to identify the amount of expired warranties, the amount of

actual warranty costs shall indicate the year of sale of the products to which
they relate.
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Illustration 8. LAZARO Company provides two-year warranty for the product jt

sells. The Company started operations in 2022. The following information was
provided:
2022 2023 2024
Sales P28,000,000 38,000,000 P35,000,000
Actual warranty costs from:
2022 sales P750,000 P150,000 P50,000
2023 sales - 900,000 420,000
2024 sales ~ = 880,000
Total actual warranty costs P750,000 P1,050,000 P1,350,000
Estimated warranty costs 4% of sales 4% ofsales 4% ofsales
Year 2022
(P28,000,000 x 4%):
follows:
Warranty Liability
Actual warranty costs P750,000 P- | Beginning balance
Year 2023
(P38,000,000 x 4%):
follows:
Warranty Liability
This P840,000 balance can be broken down as follows:

From 2022 sales (P1,120,000 - P750,000 - P150,000) P220,000
From 2023 sales (P1,520,000 - P900,000) 620,000
Total warranty liability, December 31, 2023 P840,000
It should be noted that the warranty liability from 2022 sales is not yet expired
by December 31, 2023 since some of these may have been sold later that year (e-.8»
December 2022) and so are still covered until December 2024 at the latest.
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Year 2024
The estimated initial warranty expense for 2024 shall be computed as P1,400,000
(P35,000,000x 4%):
Before computing the total warranty liability, itis important to compute first for the
remaining warranty liability from the year 2022:
Estimated warranty expense, 2022 P1,120,000
Less: Actual warranty costs during 2022 from units sold in 2022 (750,000)
Actual warranty costs during 2023 from units sold in 2022 (150,000)
Actual warranty costs during 2024 from units sold in 2022 (50,000)
Remaining warranty liability from units sold in 2022 P170,000
This P170,000 amount is already expired as of December 31, 2024 since after
this date all the sales made in 2022 will be more than two years from the date
they were sold. This amount will be reflected as a reduction of warranty expense
for 2024:
Initial warranty expense, 2024 P1,400,000
Less: Expiration of remaining warranty liability from 2022 (170,000)
Net warranty expense, 2024 P1,230,000
follows:
Warranty Liability
Ending balance (squeeze) 720,000 | 1,230,000 | Warranty expense (net)
This P720,000 balance can also be broken down as follows:

From 2022 sales (expired) P-
From 2023 sales (P1,520,000 - P900,000 - P420,000) 200,000
From 2024 sales (P1,400,000 — P880,000) 520,000
Total warranty liability, December 31, 2024 P720,000
CHANGES IN WARRANTY ESTIMATES

Warranty estimates may change due to many factors which include, but are not
limited to, the following:
a. Changes in entity’s quality control, which can be either of the following:
1. Improvement in quality control will decrease estimated warranty costs.
2. Decline in quality control will increase estimated warranty costs
b. Changes in expected repair costs, which can be either of the following:
1. Increase in repair costs will increase estimated warranty costs.
2. Decrease in repair costs will decrease estimated warranty costs.
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However, it should be noted that regardless of the related reason for change, the
changes in warranty estimates shall be accounted for prospectively and shal]
not affect the previously reported amounts in prior periods.
Illustration 9. GRASSHOPPER Company started its operations in 2023. For the

years 2023 and 2024, it reported the following amounts:
2023 2024
Sales P20,000,000 P28,000,000
Actual warranty costs 850,000 400,000
Estimated warranty costs 5% of sales 2% of sales
The decrease in estimated warranty costs for 2024 is due to the improvement in
the Company’s quality control starting that year.
Year 2023
(P20,000,000 x 5%).
follows:
Warranty Liability
Actual warranty costs | P850,000 P- | Beginning balance
Ending balance (squeeze) 150,000 | 1,000,000 ; Warranty expense
Year 2024
The estimated warranty expense for 2024 shall be computed as P560,000
(P28,000,000x 2%).
follows:
Warranty Liability
Actual warranty costs | P400,000 P150,000 | Beginning balance
Ending balance (squeeze) 310,000 560,000 | Warranty expense
Totals (should be equal) P710,000 P710,000
The readers should take note that amounts previously recorded during 2023
are not restated to reflect the decrease in the estimate of warranty costs made in
2024.
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ACCOUNTING FOR SERVICE-TYPE WARRANTY UNDER PFRS 15

For this type of warranty, the following accounting procedures are relevant:
a. Allocate a portion of the transaction price (i.e., total selling price) for the
warranty. The amount allocated is usually based on the relative stand-alone
selling prices of the product sold and warranty services.
In connection with this allocation, the following formulas may be used:
Allocation to Transaction , __ Stand-alone selling price of goods sold
SoldGoods ~ Price Total of stand-alone selling prices of
goods sold and warranty
Allocation to _ Transaction ¥ Stand-alone selling price of warranty

Warranty Price Total of stand-alone selling prices of
goods sold and warranty
This allocation shall be made since there are two performance obligations: the
selling of goods and the provision of warranty services.
b. The allocated amount to the warranty shall be initially recognized as a contract
liability (i.e., unearned warranty liability).
c. The contract liability is normally recognized as an income on a straight-line
basis over the warranty period.
d. The amounts of actual warranty costs are expensed during the period they
were incurred.
Illustration 10. CINCO Company offers a three-year warranty for the smartphones
it manufactures which is on top of the legally required one-year warranty. On
January 1, 2023, it sold a smartphone for P75,000, including a three-year extended
warranty service. The smartphone has a stand-alone selling price is P74,800 while
the warranty services have stand-alone selling price of P10,200.
During November 2024, the customer presented the product for repair with the
Company incurring repair costs of P2,500.
Year 2023
On January 1, 2023, the following allocation of the P75,000 transaction price is
made:
Allocationto _ P74,800 = P66,000

Smartphone ~ °7%990 * ~p74,800 + P10,200
Allocation to P10,200 = pg9000
Warranty = °/°000 * ~p74,800 + P10,200
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On the same date, the following journal entry shall be made to record the sale:
Cash 75,000
Sales 66,000
Contract liability - warranty 9,000

a. The amountallocated to the sold smartphone is immediately recognized as sales
revenue.
b. From the contract liability, the Company will recognize an annual income from
warranty of P3,000 (P9,000/3 years). The entry to record the annual
recognition of revenue and reduction of contract liability:
Contract liability - warranty 3,000
Income from warranty 3,000
c. No expense is recognized on the date of sale.
Year 2024
During November 2024, the entry to record the incurrence of actual warranty costs
is as follows:
Warranty expense 2,500
Cash 2,500
After considering all the events over the term of the warranty, the following
amounts are reported in the Company’s income statement:
2023 2024 2025
Income from warranty P3,000 P3,000 P3,000
Less: Warranty expense - 2,500
Netincome
from warranty _P3,000 P500 = P3,000
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CHAPTER SUMMARY
1. Warranties are provided by entities to protect their names and reputation.
2. Warranties are differentiated between assurance-type and service-type as follows:
Assurance-type Service-type
Provide a customer with Provide the customer with a
assurance that the related service in addition to the
General product will function as the assurance that the
description parties intended because it product complies with
complies with agreed-upon | agreed-upon specifications.
specification [/PFRS 15.B28] [PFRS 15.B28]
Does the
cust
i one nave YES - in effect, the warranty
e option to 3 Sees
NO is a service distinct from the
purchase duct sold
warranty PFO
separately?
YES - the legal requirement
: ? does not give rise to
Requires bylaw: additional performance NO
obligation
Shorter period of time; Longer period of time;
Length of ae ore :
usually limited within the covers a period beyond what
coverage 5 : : :
legally required period only is legally required
oo Consistent with providing Consistent with providing
y assurance additional service
should perform
Relevant
accounting
FAS 37; Bravislons,
Contingent Liabilities and
PFRS 15, Revenue from
Contrackewith Gidteinexs
standard Contingent Assets
Estimated warranty expense | Allocated transaction price
vi and corresponding liability to the warranty shall be
Initial i : ae :
HOH shall be recognized during initially recognized as
recognt the period when the related contract liability (i.e.,
goods were sold unearned income)
a Recognized using straight-
Recopmoen ot Not applicable line method over the period
nCOME. covered by the warranty
a) rence of Will decrease the estimated Warranty expense is
ac ee warranty liability recognized
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True or False
1. For accounting purposes, warranties are classified as assurance-type or service-
type.
2. Aside from rectifying a damaged product covered by warranty, an entity may also
provide a replacement product if the damage cannot be rectified anymore.
Assurance-type warranties are those that are not required by legislation.
Pim Ww
Service-type warranties provide the customer with a service.

Assurance-type warranties cover periods that are usually shorter than the periods
covered by service-type warranties.
6. Warranty expense from assurance-type warranties shall be recognized during the
period the actual warranty costs were incurred.
7. Actual warranty costs incurred for assurance-type warranties shall increase the
amount of estimated warranty liability.
8. Service-type warranties are accounted under PFRS 15, Revenue from Contracts with
Customers.
9. The transaction price allocated to service-type warranty shall be immediately
recognized as income.
10. Warranty costs incurred related to service-type warranty are recognized during the
period when the related goods were sold.

1. Assurance-type warranties have the following general characteristics, except
a. These are usually required by regulations.
b. These usually cover a shorter period of time.
c. These provide guarantee that the covered product will function as the parties
intended.
d. None of the above
2. Service-type warranties have the following general characteristics, except

a. The entity granting these warranties provides services to the customer.
b. These usually cover a longer period of time.
c. Thereisno option for the customers to separately acquire this type of warranty.
3. Which of the following correctly indicates the applicable accounting standard/s to
the different types of warranties?
a. Assurance-type warranties are accounted under PAS 37 while service-type
warranties are accounted under PFRS 15.
b. Assurance-type warranties are accounted under PFRS 15 while service-type
warranties are accounted under PAS 37.
c. Both assurance-type warranties and service-type warranties are accounted
under PAS 37.
4. Both assurance-type warranties and service-type warranties are accounted
under PFRS 15.
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4. Warranty expense from assurance-type shall be recognized

a. During the period when warranty costs were actually incurred.
b. During the period when the related goods were sold.
c. During the end of the warranty period.
5. What is the effect of incurring actual warranty costs from an assurance-type

warranty?
a. Warranty expense shall be recognized when an entity actually incurs warranty
costs.
b. Warranty liability shall be decreased by the amount of actual warranty costs.
c. Theactual amounts incurred by the entity shall be deferred as prepaid asset and
expensed at the end of the period covered by the warranty.
d. The actual amounts incurred by the entity shall be added to the balance of
warranty liability.
6. The amounts received or allocated as service-type warranty shall be initially

recognized as
a. income
b. expense
c. asset
d. liability
7. Subsequent to initial recognition, the initially recognized amount of service-type
warranty shall be recognized as
a. income using straight-line method
b. expense using straight-line method
c. asset, but expensed at the end of the warranty period
d. liability, but recognized as income at the end of the warranty period
Straight Problems
1. At the beginning of the year 2023, JUMPSTART Company reported a beginning
estimated warranty liability of P1,500,000. During the year, it generated a total sales
revenue of P36,000,000, which are covered by an assurance-type warranty. The
Company expects the warranty costs to be 4.50% of the sales revenue. In addition,
actual warranty costs of P1,430,000 were incurred during the year.
Required: From the given information, determine the following:

a. Journal entries for the year 2023.
b. Estimated warranty liability balance as of December 31, 2023
2. On January 1, 2023, DEMEANOR Company reported estimated warranty liability

amounting to P1,900,000. During the same year, the Company had sold 80,000 units
of its product which are covered by the Company's assurance-type warranty. Out of
these units, the Company expects that 4% will have minor damage with an average
repair cost of P600 per unit, while 1% of these will have major damage with an
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average repair cost of P1,400 per unit. Actual warranty costs incurred during the
year amounted to P3,220,000.

b. Estimated warranty liability balance as of December 31, 2023
3. Atthe beginning of the year 2023, SANCTITY Company reported estimated warranty
liability amounted to P930,000. For the years 2023 and 2024, it reported the
2023 2024
Sales revenue P24,000,000 P29,000,000
Actual warranty costs 860,000 750,000
The Company estimates its warranty costs as 3% of its sales revenue.

a. Journal entries for the years 2023 and 2024.
b. Estimated warranty liability balance as of December 31, 2023 and 2024
4. SANCTUARY Company had sold 90,000 units and 110,000 units of its product during
the years 2023 and 2024, respectively. It was reliably estimated that 2% of sold units
will need to be rectified within one year after the sale, while another 1% of the units
will need to be rectified beyond one year after the sale. Average warranty cost is
estimated at P800 per unit. Actual warranty costs during the years 2023 and 2024
amounted to P2,140,000 and P2,430,000, respectively. Estimated warranty liability
had a balance of P850,000 as of January 1, 2023.

5. MESMERIZING Company maintains a warranty program wherein the covered
defective products are replaceable with a brand-new unit. During the year 2023, the
Company manufactured 100,000 units of its product for a total manufacturing cost
of P35,000,000 and was able to sold 80,000 of these units. It is expected that 2% of
the sold units will be replaced as part of the warranty program. The damaged goods
returned by the customers have net realizable value of P80/unit. In addition, the
Company also shoulders transportation costs related to the replacement units at an
average cost of P30/unit. For the year 2023, 1,050 units were replaced. On January
1, 2023, the Company had an estimated warranty liability balance of P72,000.
a. Journal entries for the year 2023 and 2024.
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6. AMBITIOUS Company offers one-year warranty to its sold products. For the years
2022 to 2024, the Company had the following information:
2022 2023 2024

Sales P24,000,000 P34,000,000 P32,000,000
2022 sales P680,000 P230,000 =
2023 sales - 1,200,000 400,000
2024 sales - - 1,050,000
Total actual warranty costs P680,000 P1,430,000 P1,450,000
Warranty costs are expected to be 5% of the sales amount. The Company started its
operations on January 1, 2022.

a. Journal entries for the years 2022, 2023, and 2024.
b. Estimated warranty liability balance as of December 31, 2022, 2023, and 2024.
7. On January 1, 2023, PROGRESSIVE Company reported an estimated warranty

liability of P1,050,000. Over the next two years, 2023 and 2024, the Company
reported the following financial information:
2023 2024
Sales P26,000,000 P30,000,000
Actual warranty costs 900,000 1,650,000
The Company estimates warranty costs as 3% of its revenue. However, starting

2024, the Company’s quality control became relaxed, prompting the Company to
revise the warranty costs as 5% of its revenue.

8. On July 1, 2023, SAMARITAN Company sold a gaming laptop for a total amount of
P200,000. Included in the price is the extended warranty service for the next four
years. Stand-alone prices of the gaming laptop and warranty services were P198,000
and P22,000, respectively. During the year 2024, warranty repairs were made to this
gaming laptop costing the Company P2,000.

b. Contract liability - warranty balance as of December 31, 2023 and 2024
9, POLARIS Company offers three-year service-type warranty for P15,000 and four-
year warranting for P18,000, both in addition to the assurance-type warranty it
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offers in its kitchen appliances. During the year 2023, it sold the following service.
type warranties:
Date Duration of Warranty No. of Contracts Sold

January 1, 2023 three years 4
January 1, 2023 four years 5
April 1, 2023 three years 3
April 1, 2023 four years 2
October 1, 2023 three years 6
October 1, 2023 four years 4
The Company adjusts its records only every December 31 of each year. In addition,
actual costs incurred for the repairs covered by the service-type warranty amounted
to P15,000 and P20,000 during the years 2023 and 2024, respectively.

b. Contract liability - warranty balance as of December 31, 2023 and 2024
10.SIRIUS Company offers one-year assurance-type warranty for the gadgets it sells
The Company estimates its assurance-type warranty costs to be 3% of its sales
revenue. In addition, during 2023, the Company also started to offer a voluntary
four-year service-type warranty services which covers a broader scope of gadget
care compared to the assurance-type warranty.
During the year 2023, the Company had the following information:
Beginning assurance-type warranty liability P640,000

Sales revenue 35,000,000
Actual warranty costs - assurance-type warranty 1,200,000
Actual warranty costs - service-type warranty 800,000
Service-type warranties sold on January 1, 2023 3,600,000
Service-type warranties sold on July 1, 2023 4,000,000

b, Estimated warranty liability balance from assurance-type warranty as of
December 31, 2023.
c. Contract liability - warranty balance from service-type warranty as of
December 31, 2023.

1, CANOPUS Company estimates its warranty costs to be 6.50% ofits sales revenue. On
January 1, 2023, the Company had an estimated warranty liability balance of
P1,540,000. For the years 2023 and 2024, sales revenue amounted to P45,000,000
and P42,000,000, respectively. In addition, actual warranty costs amounted t0
P3,250,000 and P2,650,000 during 2023 and 2024, respectively.
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Estimated warranty expense for the year 2023 shall be

a. P2,925,000 c. P2,730,000
b. P3,250,000 d. P2,650,000
Estimated warranty liability as of December 31, 2024 shall be
a. P1,278,000 c. P1,295,000
b. P1,185,000 d. P1,215,000
2. On January 1, 2023, CENTAURUS Company reported a beginning estimated
warranty liability balance of P900,000. As to estimated warranty costs, the Company
estimates that 3.50% of the warranty costs will be incurred within one year from the
date of sale, while 2.50% of the warranty costs will be incurred beyond one year
from the date of sale. Actual warranty costs for 2023 and 2024 amounted to
P1,950,000 and P1,520,000, respectively. Total sales revenue for 2023 and 2024
amounted to P30,000,000 and P28,000,000, respectively.
a. P610,000 c. P720,000
b. P750,000 d. P840,000

a. P690,000 c. P860,000
b. P780,000 d. P910,000
3. ARCTURUS Company estimates that 3% of the sold units will have minor defects
while 1% of the sold units will have major defects. Warranty costs of repairing units
with minor defects and major defects are estimated to be P400/unit and
P1,000/unit, respectively. Total number of units sold during 2023 and 2024
numbered 120,000 units and 140,000 units, respectively. Actual warranty costs
incurred during 2023 and 2024 amounted to P2,750,000 and P2,860,000,
respectively. Estimated warranty liability had a balance of P1,100,000 on January 1,
2023.

a. P1,090,000 c. P840,000
b. P990,000 d. P720,000
a. P980,000 c. P1,210,000
b. P1,120,000 d. P1,450,000
4. VEGA Company offers a replacement unit for defective goods covered by its
warranty. Manufacturing costs are P500/unit while the returned and defective units
have net realizable value of P100/unit. In addition, the Company also shoulders the
transportation costs for the return of the defective units and for the transfer of the
replacement units. Average transportation costs are estimated to be PSO/unit.
During 2023 and 2024, the Company has sold 200,000 units and 180,000 units,
respectively. The Company estimates that 3% of the sold units will become defective.
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In addition, the Company replaced 5,400 units and 5,750 units during 2023 angq
2024, respectively. Estimated warranty liability as of January 1, 2023 amounted tf
P1,080,000.

a. P270,000 c, P540,000
b. P360,000 d. P620,000
a. P2,840,000 c. P2,390,000
b. P2,700,000 d. P2,430,000
a. P126,500 c. P124,500
b. P112,500 d. P180,500
. ACAPELLA Company offers two-year warranty covering its sold products. The
Company started its operations on January 1, 2022. The Company estimates its
warranty costs as 5% ofits sales revenues. Estimated warranty liability as of January
1, 2023 amounted to P600,000. For 2023 to 2025, the Company reported the
following financial information:
2023 2024 2025
Sales P30,000,000 28,000,000 P34,000,000
2022 sales P300,000 P120,000 P-
2023 sales 800,000 350,000 150,000
2024 sales ~ 720,000 300,000
2025 sales - 950,000
Total actual warranty costs P1,100,000 P1,190,000 P1,400,000

a. P1,220,000 c. P1,540,000
b. P1,400,000 d. P1,630,000
a. P1,350,000 c. P1,030,000
b. P1,190,000 d. P990,000
a. P1,250,000 c. P1,500,000
b. P1,450,000 d. P1,700,000

a. P1,050,000 c. P1,360,000
b. P1,130,000 d. P1,490,000
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6. Starting January 1, 2023, HADAR Company offered its customers a four-year service
warranty on its sold products on top of the assurance-type warranty that it is
providing. Total price for this warranty is P20,000, On January 1, 2023, 10 service
warranty contracts were sold, while on July 1, 2023, 15 service warranty contracts
were sold. No other service warranty contracts were sold during 2023. Actual
warranty Costs incurred for the damages claimed during 2023 amounted to P35,000.
Net income from this service-type warranty for the year 2023 shall be
a. P62,500 c. P87,500
b. P48,500 d. P52,500
The balance of the contract liability - warranty as of December 31, 2023 shall be
a. P412,500 c. P280,500
b. P372,500 d. P250,500
- ALTAIR Company started its operations on January 1, 2023. Starting on the same
date, the Company offered three-year service warranty for all of the gadgets sold. In
connection with this warranty, the Company had the following financial information
during 2023 and 2024:
Proceeds from service warranties sold on:

January 1, 2023 P432,000
July 1, 2023 720,000
October 1, 2023 900,000
January 1, 2024 648,000
April 1, 2024 1,080,000
August 1, 2024 864,000
Actual repair costs claimed by customers during the:
Year 2023 150,000
Year 2024 220,000
Net income from the service warranty during 2023 shall be
a. P339,000 c. P440,000
b. P189,000 d. P290,000
a. P1,612,000 c. P2,052,000
b. P1,762,000 d. P1,713,000
Net income from the service warranty during 2024 shall be

a. P1,070,000 c. P1,518,000
b. P1,290,000 d. P1,678,000
a. P2,757,000 c. P3,187,000
b. P3,015,000 d. P3,457,000
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Chapter 5 — Premiums, Rebates, Discounts and Other Deferred Income Items
CHAPTER 5
PREMIUMS, REBATES, DISCOUNTS, AND OTHER
DEFERRED INCOME ITEMS

1. The accounting for premiums by applying PAS 37 and PFRS 15.
2. The accounting for rebates, discounts, and gift certificates.
3. The accounting for customer loyalty programs assuming the entity is acting as
the principal or acting as the agent.
PREMIUMS - INTRODUCTION
To boost its sales, an entity may have special offers to its customers in the form of
sales incentives, discount vouchers, and other free items (i.e., premiums).
Depending on the business of the entity, the following are examples of premiums:
a. Special kitchen utensils for a manufacturer of canned goods.
b. Special mugs for a brewery or instant coffee manufacturer.
c. Annual planner for a luxurious brand of coffee.
These items of premiums shall be useful to the customers to entice them to really
do the effort of following the terms and conditions of the promotion. These terms
and conditions contain some or all of the following elements:
a. Inclusion of coupons, vouchers, or their equivalent in every product sold. A
portion of the product sold may also satisfy this element, such as bottle caps.
b. A specified number of coupons or vouchers are presented to redeem the
premiums, free of charge.
c. An amount of cash may also be collected from the customers. In effect, in this
case, the premium is effectively a discount.
ACCOUNTING FOR PREMIUMS - A COMPARISON

Before the effectivity of the accounting standard PFRS 15, Revenue from Contracts
with Customers, premiums are generally accounted for under PAS 37 (i.e., as 2
provision). However, starting January 1, 2018, the date of effectivity of PFRS 15, the
accounting for premiums became such a grey area because of the differing opinions
among academicians.
The different accounting treatments can generally be compared as follows:
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Chapter 5— Premiums, Rebates, Discounts and Other Deferred Income Items
Ree eo PAS OT PERS 15 to

a The net cost of premiums The distribution of premiums is
arson’ in represents an obligation that a distinct performance
favor of using the entity already incurred (i.e.,
= appecach considered as marketing costs) obligation
Initial Recognition of expense and Allocation of a portion of
accounting corresponding provision revenue as a “contract liability”
requirements liability (i.e, deferred revenue)
Subsequent Reduction of liability when the Recognition of revenue and
accountin ; ah corresponding expense when
: 6 premiums are distributed the premiums are distributed
requirements
The author humbly submits that the PFRS 15 approach is more acceptable in
accounting for premiums since this is in line with what is being followed in practice
across different accounting firms, which are the future workplace of the readers.
ACCOUNTING FOR PREMIUMS UNDER PAS 37

Under PAS 37, the following are accounting procedures for premiums:
a. Recognition of expense and corresponding liability (i.e, premium liability)
during the year of sale of the related products as indicated in the following
pro-forma entry:
Estimated premium expense XX
Estimated premium liability XX
Estimated premium expense = “expense or liability per unit” x total

number of premiums expected to be redeemed.
b. The amount of expense or liability per unit of premium is computed as
follows:
o
Unit cost of item to be distributed as premiums Pxx

Add: Handling costs (e.g., shipping and other fees), if any xx
Less: Amounts to be received from redeeming customers, if any XX
Expense or liability per unit of premium Pxx
c. The total number of premiums expected to be redeemed is computed as

follows:
Number of coupon or voucher included per unit of sold product XX
Multiply by: Total number of sold products _XX_
Total number of coupons (or its equivalent) distributed XX
Multiply by: Portion expected to be presented for redemption hh
Total number coupons expected to be redeemed XX
Divide by: Number of coupons needed for one item of premium =_XX_
Total number of premium items expected to be redeemed XX
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d. Premiums purchased are considered as prepaid asset and normally recorded in

an account named as “Premium inventory”. Despite this account name, these
items shall not be included in the entity’s inventory balance.
e, The distribution of premiums reduces the amounts of premium liability
and premium inventory. This also affects other accounts as indicated in the
following pro-forma journal entry:
Estimated premium liability XX
Cash (from customers, if any)
Premium inventory XX
Cash (for handling costs, if any) XX
f. In summary, the transactions affecting the premium liability account are the
following:
Premium Liability
Actual redemption XX XX Beginning balance
Ending balance (squeeze) XX XX Premium expense
Illustration 1. During 2023, GERONIMO Company’s first year of operations, it

offered a sales promotional program wherein it included one coupon for each unit
of its product. Five of these coupons plus P20 shall be presented to redeem a special
wall clock with cost of P120/unit. Handling costs are estimated to be P15 per unit.
For the year, the Company was able to sell 200,000 units of its product (at P190.80
unit selling price) but expects that only 40% of the coupons will be presented for
redemption. A total of 16,500 wall clocks were acquired and by the end of 2023,
12,500 of these were distributed to customers.
In this case, the amount of expense/liability per unit of premium is computed as

follows: °
Unit cost of item to be distributed as premiums P120
Add: Handling costs (e.g., shipping and other fees) 15
Less: Amounts to be received from redeeming customers (20)
Expense/liability per unit of premium P115
Total number of premiums expected to be redeemed is computed as follows:
Number of coupon or voucher included per unit of sold product 1
Multiply by: Total number of sold products _200,000
Total number of coupons distributed — 200,000
Multiply by: Portion expected to be presented for redemption 40% _
Total number coupons expected to be redeemed 80,000
Divide by: Number of coupons needed for one item of premium _
Total number of premium items expected to be redeemed (in units) 16,000
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The amount of estimated premium expense can now be computed as P1,840,000

(P115 x 16,000). journal entry to recognize this is as follows:
Estimated prem. expense 1,840,000
Estimated prem. liability 1,840,000
The purchase of wall clocks is recorded as follows:

Premium inventory 1,980,000
Cash (16,500 x P120) 1,980,000
Journal entry to record the customers’ redemption of 12,500 clocks is as follows:

Estimated prem. liab. (12.5KxP115) 1,437,500
Cash (12,500 x P20) 250,000
Premium invty. (12,500 x P120) 1,500,000
Cash - for handling (12,500 x P15) 187,500
The ending balance of premium liability is computed as follows:

Premium Liability
Actual redemption | P1,437,500 P- | Beginning balance
Ending balance (squeeze) 402,500 | 1,840,000 | Premium expense
Looking at the revenue side, the amount of gross sales revenue that the Company
shall recognize is P38,160,000 (200,000 units x P190.80).
ACCOUNTING FOR PREMIUMS UNDER PFRS 15

Earlier, it was mentioned that under PFRS 15, the distribution of premiums to
customers is a distinct performance obligation. This is primarily because it is an
option to acquire additional goods that provides a material right to the customer that
it would not receive without entering in the related sales contract in the first place.
[PFRS 15.B40].
For premiums, the material right given to the customer can be in either of the
following forms:
a. acquisition of premium items, free of charge, by just presenting a specified
number of coupons; or
b. acquisition of premium items at a relatively low amount, by just presenting a
specified number of coupons plus specified amount of cash.
Without the original sale transaction, customers cannot get hold of any coupons,
which in turn make them unable to redeem the items offered as premiums. Asa result
of this, the following are the relevant accounting procedures for premiums under
PFRS 15:
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a. The transaction price (number of units sold x unit selling price) shall be
allocated between goods sold and contract liability - premiums.
The allocation of transaction price is generally based on the relative stand-
alone selling prices of the goods and the premiums. The amount of stand-
alone selling price of the goods is readily determinable; however, the stand-
alone selling price of the premiums shall be estimated.
b. The estimated stand-alone selling price of premiums is equal to the
amount of discount adjusted by the likelihood that the coupons will be
redeemed. /PFRS 15.B42]. The computation of the stand-alone selling price of
premiums is indicated in the following formula:
Discount per unit of premium Pxx
Multiply by: Expected number of premiums to be redeemed XX
Estimated stand-alone selling price of premiums Pxx
Discount per unit of premium is computed as:

Unit cost of item to be distributed as premiums Pxx
Add: Handling costs (e.g., shipping and other fees), if any XX
Less: Amounts to be received from redeeming customers, if any XX
Discount per unit of premium Pxx
Expected number of premiums to be redeemed is computed as:
Number of coupon or voucher included per unit of sold product

Multiply by: Total number of sold products
Total number of coupons (or its equivalent) distributed
Multiply by: Portion expected to be presented for redemption
Total number coupons expected to be redeemed XX
Divide by: Number of coupons needed for one item ofpremium __XX_
Expected number of premiums to be redeemed XX
As the readers may have noted, the computations above are very similar to the
computations in arriving at premium expense under PAS 37.
c. Theallocation can now be made as follows:

——
Allocationto _ Transaction Stand-alone selling price of sold goods

Sold Goods Price Total of stand-alone selling prices of sold
goods and premiums a]
Allocationto _ Transaction ~ Stand-alone selling price of premiums _

Premium Price Total of stand-alone selling prices of sold
goods and premiums
Pro-forma journal entry to record the transaction on a total basis is as follows:
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Cash/Accounts receivable XX
Sales revenue xX
Contract liability - premiums XX
The rationale of allocation is that a portion of the transaction price initially
received from customers is considered as an “advance payment’ that will be only
earned by the entity upon actual distribution of premiums.
d. Subsequently, as the premiums are distributed, a proportionate amount of the

contract liability is recognized as income:
Contract liability - premiums XX

Income from premiums xX
The proportionate amount to be recognized as income from premiums is

determined using the following formula:
Income _ Amount No. of premiums distributed

from Allocated to Total no. of premiums expected
Premium Premiums to be distributed
The readers should take note that the denominator used is the total number of
premiums expected to be distributed since using this will automatically
incorporate the recognition of breakage income. The concept of breakage will
be discussed later in the chapter under the accounting for gift certificates.
e. Acorresponding entry shall be made for the expense and other accounts affected
(COGS is cost of goods sold):
Expense from premiums (or COGS) XX

Cash (from customers, if any) XX |
Premium inventory XX
Cash (for handling costs, if any) XX
Illustration 2. During 2023, GERONIMO Company’s first year of operations, it

offered a sales promotional program wherein it included one coupon for each unit
of its product. Five of these coupons plus P20 shall be presented to redeem a special
wall clock with cost of P120/unit. Handling costs is estimated to be P15 per unit.
For the year, the Company was able to sell 200,000 units of its product (at P190.80
unit selling price) but expects that only 40% of the coupons will be presented for
redemption. A total of 16,500 wall clocks were acquired and by the end of 2023,
12,500 of these were distributed to customers.
In this case, the total stand-alone selling price of the products sold is
P38,160,000 (200,000 units x P1 90.80), which is also equal to the transaction
price. The stand-alone selling price of the premiums is estimated as follows:
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Chapter 5 - Premiums, Rebates, Discounts and Other Deferred Income Items
Discount per unit of premium P115

Multiply by: Expected number of premiums to be redeemed 16,000
Estimated stand-alone selling price of premiums P1,840,000
The following are supporting computations in arriving to this amount:
Unit cost of premium P120
Add: Handling costs (e.g., shipping and other fees) 15
Less: Amounts to be received from redeeming customers (20)
Discount per unit of premium P115
Number of coupon or voucher included per unit of sold product 1
Multiply by: Total number of sold products 200,000
Total number of coupons distributed 200,000
Multiply by: Portion expected to be presented for redemption 40%
Total number coupons expected to be redeemed 80,000
Divide by: Number of coupons needed for one item of premium 5
Expected number of premiums to be redeemed 16,000
Next, allocate the transaction price of P38,160,000 based on relative stand-alone

selling prices:
Allocationto _ P38,160,000
SoldGoods ~— Ese LOOeees-s P38,160,000 + P1,840,000 a a
Allocationto _ P1,840,000
Premium ~ 38,160,000 x—535760,000+P1,840,000— °4755-360
The entry to record the allocation is as follows:
Cash/Accounts receivable 38,160,000

Contract liability - premiums 1,755,360
The actual distribution of premium during 2023 shall result to the recognition of
income from premium equal to P1,371,375 [P1,755,360 x (12,500/16,000)]. The
entries to recognize the income from premium and other items arising from the
distribution of 12,500 units of premiums are the following:
Contract liability - premiums 1,371,375

Income from premiums 1,371,375
Expense — premiums (P115x12.5K) 1,437,500

Cash (12,500 x P20) 250,000
Premium invty. (12,500 x P120) 1,500,000
Cash (12,500 x P15) 187,500
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Chapter 5 —- Premiums, Rebates, Discounts and Other Deferred Income Items
The ending balance of contract liability - premiums is computed as follows:

Contract Liability
Income recognized | P1,371,375 P- | Beginning balance
Ending balance (squeeze) 383,985 | 1,755,360 | Allocated amount
COMPARISON OF PAS 37 AND PFRS 15 APPROACHES

Based on our concept discussions and the illustrations, the following differences
between the two approaches were noted:
PAS 37 Approach PFRS 15 Approach

Amount of recognized sales Equal to the Transaction price less
revenue transaction price allocation to premiums
sat et During the period the During the period the
Timing of SPAT oF sales revenue is premiums are actually
prea recognized distributed
Neat a During the period the
Timing tee Not applicable premiums are actually
fACOMETOOLP distributed
Ending balance of liability Generally higher Generally lower
CUSTOMER LOYALTY PROGRAMS - INTRODUCTION

Another marketing scheme being implemented by the entities is the granting of so
called “points” to its customers for every sale transaction. The accumulated points
can be used for a variety of purposes, such as, but not limited to, the following:
a. Reduction in the amounts to be paid by customers related to their future
purchases.
b. Additional perks, such as products or services not normally sold by the entity.
Based on these purposes, the customers may increase spending since they feel that
they will be receiving more than what.they are paying for.
This program is best exemplified when you (or your mother) get asked for a
“reward card” before paying in a supermarket, fast-food store, coffee shop,
hardware, or any other store implementing such programs. In this case, the card
stores the information regarding the number of points accumulated by a specific
customer.
ACCOUNTING FOR CUSTOMER LOYALTY PROGRAMS

The accounting will depend on whether the entity is acting as the principal or as an
agent:
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‘Entity is the Principal Entity is an Agent

An entity is a principal if the entity An entity is an agent if the entity’s|
controls a promised good or service performance obligation is to arrange for
before it transfers the good or service to the provision of goods or services by
a customer. [PFRS 15.B35]. another party. [PFRS 15.B36].
This is normally the case if the loyalty This is normally the case if the loyalty
program covers the products or program covers the goods or services
services provided by the entity itself. provided by another entity.
Illustration 3. QUICKGOLD Company, a grocery chain, offers a customer loyalty

program wherein the customers can use their accumulated points to reduce the
amounts to be paid on their future purchases of the Company’s products.
In this case, the Company is considered as the principal since it controls the products
before transferring them to customers (i.e., part of the Company’s inventory).
Illustration 4. BAGMART Company, an operator of a department store, offers a

customer loyalty program wherein the customers can use their accumulated points
to redeem tickets in the cinema operated by MOVIESHACK Company.
In this case, BAGMART Company is considered as an agent since the services to be
provided in the program are coming from another entity, MOVIESHACK Company.
ACCOUNTING IF THE ENTITY IS THE PRINCIPAL

Similar to premiums, customers have a material right that they would not receive
without entering into the loyalty program. That material right is the ability to
acquire, free of charge, the goods and/or services offered by the entity. The
following are the relevant accounting procedures:
a. Portion of the transaction price shall be allocated based on the stand-alone

selling price of the goods or services and stand-alone selling price of “points”.
The stand-alone selling price of “points”, which primarily based on the amount
of discount that the customer can avail, shall be estimated as follows:
Discount amount provided per point XX
Multiply by: Portion expected to be used by customers %
Stand-alone selling price of a point Pxx
Multiply by: Number of points distributed XX
Estimated stand-alone selling price of “points” Pxx
b. The allocation is very similar to the allocation of transaction price in premiums.

This is recorded in a total basis as follows:
Sales revenue XX
Contract liability - points XX
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Initially, the portion allocated to points shall be deferred as a liability.

c. As the “points” are redeemed and the corresponding goods or services have
been provided, the entity shall recognize proportional amounts of contract
liability - points as income from points:
Income _ Amount No. of points distributed
from —_ Allocated to Total no. of points expected to
Points Points be distributed
d. Changes in the estimate of the total number of points to be redeemed shall be

considered as change in accounting estimate and shall be accounted
prospectively. Specifically, the total amount initially allocated to points
shall not be changed. In other words, income from points during the period of
change is equal to a certain amount of catch-up adjustment.
Illustration 5. During 2023, CORDOVA Company instituted a customer loyalty

program wherein for every P150 sales amount the entity will give 1 point. Each
point will reduce the customers’ payments for goods or services in the future by
P1.00: Based on the Company’s reliable estimate, only 80% of these points will be
redeemed. For 2023, the Company reported gross sales of P30,000,000 (before the
allocation).
The stand-alone selling price of initially sold goods or services is P30,000,000,

which is also equal to the transaction price. On the other hand, the estimated stand-
alone selling price of points is computed as:
Discount amount provided per point P1.00
Multiply by: Portion expected to be used by customers 80%
Stand-alone selling price of a point P0.80
Multiply by: Number of points distributed (P30M/P150) 200,000
Estimated stand-alone selling price of “points” P160,000
The total number of points that the entity expects to be redeemed is 160,000 points
(200,000 pointsx 80%).
Next, the P30,000,000 transaction price shall be allocated as follows:
Allocation to P30,000,000 -
SoldGoods ~ 30,000,000 x E2509 000+P160,.000 °29-840,849
Allocation to P160,000 _
Points ~ 30,000,000 x 52009 000+P160000~ «‘>P15%152
The entry to record the transaction and the related allocation is as follows:
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Contract liability - points 159,151
During 2023, the customers have used 90,000 points. In this case, the entity shall
recognize income from points amounting to P89,522 (P159,151 x 90,000/160,000):
Income from points 89,522
As of December 31, 2023, the contract liability - points will have a balance of
P69,629 (P159,151 - P89,522).
During 2024, the customers used 50,000 points. In addition, the Company changed
its estimate of total points to be redeemed at 170,000 points (up from original 160,000
points). Because of the change in estimate, the income from points in 2023 is
Cumulative income to be recognized from 2023 to 2024
{[(90,000 + 50,000)/170,000] x P159,151} P131,066
Less: Income from points already recognized in 2023 (89,522)
Income from points, 2024 (catch-up adjustment) 41,544
The entry to record the income from points in 2024 is as follows:
Income from points 41,544
As of December 31, 2024, contract liability - points will have a balance of P28,085
(P69,629 - P41,544).
ACCOUNTING IF THE ENTITY IS AN AGENT

When an entity that is an agent satisfies a performance obligation, the entity
recognizes revenue in the amount of any fee or commission which it expects to be
entitled to in exchange for arranging for the other party to provide its goods or
services. [PFRS 15.B36].
The entity will normally recognize revenue (e.g., commissions revenue) right upon
the distribution of points to the customers (i.e., not when the points are used by
the customers). The amount of revenue to be recognized is on a net basis.
Illustration 6, EUGENIO Company, an operator of a supermarket, participated in
the customer loyalty program introduced by RUBIO Company, a gasoline station
operator. For each P300 sales, EUGENIO Company will grant 4 points to the
customer. Each point is equivalent to P0.50, which can be used as a partial or full
Payment for RUBIO Company’s products. For every point granted to the customers,
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EUGENIO Company will pay P0.40 to RUBIO Company. It is expected that the
customers will only use 90% of the points. During the year, EUGENIO Company
reported P24,000,000 gross sales.
The stand-alone selling price of initially sold goods is P24,000,000, which is also
equal to the transaction price. On the other hand, the estimated stand-alone selling
price of points is computed as:
Discount amount provided per point P0.50
Multiply by: Number of points distributed [(P24M/P300) x 4 pts.] 320,000
Estimated stand-alone selling price of “points” P144,000
Next, the P24,000,000 transaction price shall now be allocated as follows:

Allocation to 2 P24,000,000
Sold Goods = °24000,000 x 557 p99 000+P144,000 °23-856,859
Allocationto _ P144,000
Points = PERSE ood P24,000,000 + P144,000 nano
Initially, EUGENIO Company shall make the following entry:
Right after the above entry, the Company will make the following entry to record
the amount of income from points (ie, already net of amounts paid to RUBIO
Company):
Cash (320,000 x P0.40) 128,000
Income from points (squeeze) 15,141
PRINCIPAL VS AGENT: CUSTOMER LOYALTY PROGRAM

Based on the discussions, the following are the differences between the scenario
when the entity acts as the principal and the scenario when the entity acts as the
agent:
Entityisthe Principal | Entity is the Agent
Amounts recognized Gross of related Net of amounts paid to other
as income expenditures and costs entity/ies [PFRS 15,B36]
Timing of recognition During the period of During the period of
Gf income actual redemption of distribution of points to
customers customers,
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REBATES, DISCOUNTS, COUPONS, AND FREE PRODUCTS

Other marketing schemes that entities employ include those “buy one, take one for
free”, “buy a certain amount and get a discount in your next purchase”, and similar
promotions. Similar to premiums, the entity has the following performance
obligations in this case:
a. transferring the initial goods acquired by the customers.
b. providing the rebates, discounts, and free products in the future.
For example, a milk tea or coffee shop may provide a coupon that is stamped for
every cup sold to a particular customer. After a certain number of stamps, let us say
10 stamps, a customer may be entitled to a free drink.
In this case, the transaction price received shall be allocated in the same manner as
the allocations made in premiums and customer loyalty programs.
Specifically, the amount initially allocated to the rebates, discounts, or free products
shall be initially recognized as a liability. This deferred amount shall be
proportionately recognized as revenue once the customers have exercised their
rights in the rebate, discounts, and free products.
Illustration 7 - Free Product. To promote its new line of milk tea blend, Taro
Magic, VIRAY Company offered a promotional campaign wherein the customers can
have a free cup for every cumulative purchase of five cups. This is monitored
through a voucher given to the customers where a stamp is punched for every cup
purchased. Each cup of Taro Magic has a selling price P120. For the year 2022,
50,000 cups of this blend were sold and 80% of the stamps distributed are expected
to be used for redemption.
In this case, each stamp will result to a discount of P24 (P120/5). The stand-alone
selling price can now be estimated as follows
Discount amount provided per stamp P24.00
Stand-alone selling price of a point P19,20
Multiply by: Number of stamps distributed (50K cups x 1 stamp per cup) 50,000
Estimated stand-alone selling price of stamps P960,000
Estimated number of stamps to be used in redeeming free cups is 40,000 stamps
(50,000 x 80%).
Transaction price of P6,000,000 (P120x 50,000 cups) shall be allocated as follows:
Allocation to P6,000,000 = P5,172,414
Sold Goods | = P6,000,000 x P6,000,000 + P960,000
Allocation to is P960,000
Stamps ~ 6,000,000 xT) oq9+p960,000 ~ +827,586
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Contract liability - stamps 827,586
During 2023, the customers have used 32,000 stamps. In this case, the entity shall
recognize sales revenue from stamps amounting to P662,069 /[P827,586 x
(32,000/40,000)] as follows:
Contract liability - stamps 662,069
Sales revenue 662,069
On December 31, 2023, contract liability - stamps will have a balance of P165,517
(P827,586 - P662,069).
In case there are changes in the estimate of the total number of stamps to be
presented for redemption, it shall be accounted for prospectively like in customer
loyalty programs (i.e., the initial amount allocated to the stamps shall not be revised).
Illustration 8 - Rebates. On January 1, 2023, ALTAIR Company started to offer its

customers a rebate coupon for every P700 single-receipt sales. Each coupon entitles
the holder P50 off in its future purchase and has a two-year validity. During the year
2023, ALTAIR Company received P9,550,000 from its customers and distributed
10,000 rebate coupons. The Company expects that only 90% of these coupons will
be used before they lapse. During 2023, the customers have used 6,300 of these
coupons.
First, determine the stand-alone selling prices of rebates as follows:
Discount amount provided per rebate coupon P50.00
Multiply by: Number of rebate coupons distributed 10,000
Estimated stand-alone selling price of rebates P450,000
Estimated number of rebates to be used is 9,000 coupons (10,000 x 90%).
Next, allocate the transaction price of P9,550,000 as follows:

Allocation to _ P9,550,000
SoldGoods ~ 9990000 *~59550,000 + P450,000 anne
Allocationto _ P450,000
Rebates = 7590,000 x “bo 555,900 + P450,000 BADE, 700
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Contract liability - rebate coupons 429,750
During 2023, the entity shall recognize sales revenue from rebate coupons
amounting to P300,825 [P429,750 x (6,300/9,000)] as follows:
Contract liability - rebate coupons 300,825
Sales revenue 300,825
On December 31, 2023, contract liability - rebate coupons will have a balance of
P128,925 (P429,750 - P300,825).
INCOME RECEIVED IN ADVANCE

Entities may receive, in advance, amounts from customers for a variety of reasons,
such as, but not limited to, the following:
a. That is just the business model of the entity, such as subscriptions, membership
fees or professional retainers.
b. Due to gift certificates issued.
c. Promotions.
d. Estimated sales returns.
ACCOUNTING FOR INCOME RECEIVED IN ADVANCE

Amounts received in advance shall be initially recorded as a liability until the time
it is earned (goods or services have been provided), where it shall be recognized as
income.
Illustration 9. DELFIN Company, an operator ofa gym, received P120,000 from one
of its customers on March 1, 2023. This amount is good for a one-year gym access
starting April 1, 2023.
In this case, earned membership fees revenue for 2023, from April 1 to December 31
(ie., 9 months), amounted to P90,000 (P120,000 x 9/12). As of December 31, 2023,
unearned income amounted to P30,000 (P120,000 - P90,000).
Illustration 10. CANOY Company provides cleaning services to a variety of entities.

On September 1, 2023, the Company received P500,000 for cleaning services
starting October 1, 2023 until February 28, 2024, The Company expects that
portion of cleaning services to be performed for each month is as follows: 15% each
month for October and November, 25% each month for December and January, and
20% for February.
For the year 2023, the Company shall recognize income from cleaning services
amounting to P275,000 [(15% +15% + 25%) x P500,000]. As of December 31, 2023,
unearned income amounted to P225,000 [(25% + 20%) x P500,000] as composed
of services to be performed in January and February 2024,
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Illustration 11. CRISOSTOMO Company, a magazine publisher, distributes

magazine every July 1 (for January to June issues) and December 31 (for July to
December issues) of each year. Cut-off date for July 1 distribution is on May 31 while
for December 31 distribution is on October 31. Any amount received after the cut-
off date will be applied to the succeeding subscription period. Subscriptions
received from customers are for six-month subscription period. During 2023, its
first year of operations, the following amounts were received from customers:
January P240,000 July P380,000

February 360,000 August 420,000
March 400,000 September 550,000
April 280,000 October 600,000
May 320,000 November 590,000
June 500,000 December 750,000
In this case, the Company shall recognize revenue from subscriptions amounting to
P4,050,000 (from January to October). Unearned income as of December 31,
2023 shall be P1,340,000 (P590,000 received in November + P750,000 received in
December) since these will be delivered to subscribers only on July 1, 2024
(received after the October 31-cut-off date).
GIFT CERTIFICATES
Gift certificates relieve people of the burden of thinking of a good gift that can be
given to a person. For example, instead of buying clothes as gifts, a customer will
instead give a certain amount of gift certificate issued by a department store. In this
case, the recipient of the gift certificate can choose in that department store the
exact design and/or size of the clothes according to his or her liking.
In the Philippines, gift certificates do not expire as required by regulations (R.A.

10962), provided that certificates are not lost. A wide variety of entities issue gift
certificates, such as department stores, cafes, fast food chains, bookstores, and
supermarkets. In addition, gift certificates are on the rise during the holiday season
as a modern way of gift-giving.
ACCOUNTING FOR GIFT CERTIFICATES - BASIC CASE

Generally, gift certificates are accounted for as follows:
a. The proceeds shall initially be recognized as unearned income (i.e., liability).
b. Generally, the related income shall be recognized only upon the transfer of
goods or the provision of services.
Illustration 12, At the beginning of 2023, MEJIA Company reported a P650,000

balance in its unearned income from gift certificates. During the year, a total of
P1,900,000 was received from selling gift certificates, and P1,630,000 of these were
used by customers in buying the Company's products, It is estimated that all of the
gift certificates issued will be used by the customers.
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Upon receipt of the amounts from the customers, the following journal entry will be
made:
Cash 1,900,000
Unearned income - gift certificates 1,900,000
Upon the actual usage of the customers, the following journal entry shall be made;
Considering these journal entries, the ending balance of the unearned income - gift
certificates can now be determined as follows:
Unearned Income a
Actual usage by customers | P1,630,000 P650,000 | Beginning balance
Ending balance (squeeze) 920,000 | 1,900,000 | Amounts received
ACCOUNTING FOR GIFT CERTIFICATES - WITH EXPECTED BREAKAGE

The same accounting procedures as the basic case apply, except for the following:
a. The portion of the initial proceeds received that is not expected to be used by
customers shall be attributed to “breakage”.
Breakage means the unexercised contractual rights of the customers under the
gift certificates. In the Philippines, the main reason for this is the loss of gift
certificates themselves since these certificates do not have expiration dates.
b. The amounts attributed to breakage shall be recognized as income in proportion

to the pattern of rights exercised by customers by using the following formula:
Income from _ Total Expected : Amount of gift certificates used

Breakage Breakage Total amount of gift certificates
expected to be used
Illustration 13. RICO Company sold a total of P4,000,000 gift certificates during
2023. Based on the Company’s estimate, 4% of the face amount of these gift
certificates will never be used by the customers due to the loss of the certificates.
For the whole year 2023, P2,304,000 gift certificates were used.
Initially, the amount that should be attributed to breakage is P160,000 (P4,000,000
x 4%), with the P3,840,000 (P4,000,000x 96%) attributed to the total amount of gilt
certificates expected to be used. The journal entry to record the sale of gift
certificates is as follows:
Cash 4,000,000
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The entry to record the customer’s use of the gift certificates during 2023:
In addition, the amount of income from breakage to be recognized during 2023 is

Income from _ P2,304,000
Breakage ~ [160,000 x—p3 g40,0007 ~ 796,000
*P3,840,000 = P4,000,000 x (1 - 4%)
The entry to record the recognition of corresponding income from breakage:
Unearned income - gift certificates 96,000
Income from breakage 96,000
Considering these journal entries, the ending balance of the unearned income - gift
certificates as of December 31, 2023 can now be determined as follows:
Unearned Income
Actual usage by customers | P2,304,000 P- | Beginning balance
Income from breakage 96,000 | 4,000,000 | Amounts received
Ending balance (squeeze) | 1,600,000
Jt should be noted that the balance of unearned income - gift certificates is reduced
by the following:
a. Amount of gift certificates actually used by the customers.
b. Amount of corresponding income from breakage recognized.
SALES WITH RIGHT OF RETURN

Normally, customers may return the products it purchased from the entity due toa
variety of reasons. In these cases, the following accounting procedures shall be
followed for sales with right of return, as required by PFRS 15:
a. Revenue shall be recognized only to the extent of the estimated amount that will
NOT be refunded to the customers or that will NOT be returned by the customers.
Pro-forma journal entry to record the sale with right of return is as follows:
Sales revenue XX
Refund liability (to be discussed in (b)) XX
b. The portion that is estimated to be refunded or to be returned shall be recognized
as refund liability. Changes in this estimate shall be recognized as either an
addition or deduction from the revenue during the period of change (i.e.,
accounted for prospectively).
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Subsequently, this refund liability shall be debited whenever there is an actua|

refund to customers or returns from customers.
c. Anasset is recognized which represents the entity’s right to recover its products
from customers related to the settlement of the refund liability. This amount
shall be based on the estimated number of products that the customers will return,
This asset is measured at the product’s manufacturing costs less expected
costs to recover those products, including potential decreases in the value of the
returned products.
The recognition of the asset above has a decreasing effect in the amount of the
entity'scost of goods sold. Pro- forma journal entry to record the recognition of
the asset is as follows:
Asset for expected return XX
Cost of goods sold XX
The readers should take note that this asset account is not part of the entity's
inventory balance but as part of other assets.
Illustration 14. During the year 2023, FEMUR Company, a book publisher, sold
10,000 copies of a novel. The Company allows the customer to return the book,
provided these are still salable and in pristine condition. In addition, the Company
will also shoulder the transportation costs for the returned books which average
P30/book. Manufacturing costs and selling price amounted to P200/book and
P450/book, respectively. The Company reasonably expects that 2% of the books
will be returned by the customers. The Company uses the perpetual inventory
system for the recording of its book inventories.
In this case, the journal entries to initially record the receipts from customer and
the cost of goods sold are the following:
Cash (10K x P450) 4,500,000
Sales revenue (10K x 98% x P450) 4,410,000
Refund liability (10K x 2% x P450) 90,000
Cost of goods sold (10K x P200) 2,000,000
Inventory (10Kx P200) 2,000,000
The amount of asset to be recognized from the expected recovery from customers
returns shall be determined as follows: P34,000 [(P200 - P30) x (10,000 x 2%)).
Manufacturing cost per unit P200
Less: Cost per unit to recover the returned products (30)
Recovery asset per unit P170
Multiply by: Expected no, of books to be returned (10,000x2%) ___200__
Total recovery asset to be recognized P34,000
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Journal entry to record this amount is as follows:

Asset for expected return 34,000
Cost of goods sold 34,000
Based on these entries, the Company’s cost of goods sold for the year amounted to
P1,966,000 (P2,000,000 - P34,000).
Assuming that there were 120 books that were returned and refunded during the
year 2023, the following are the relevant journal entries:
Refund liability (120 x P450) ~ 54,000
Cash (120 x P450) 54,000
Inventory (120 x P200) 24,000

Asset for expected return (120x P170) 20,400
Cash (for books’ freight) (120 x P30) 3,600
The readers should take note that P170 = P200 - P30. In addition, in the absence of
damages or obsolescence, the returned inventory shall be debited equal to its cost.
As of December 31, 2023, the refund liability will have a balance of P36,000
(P90,000 - 54,000) while the asset for expected return will have a balance of
P13,600 (P34,000 - P20,400).
CHAPTER SUMMARY
1. Premiums are promotional items offered by an entity to give its customers
additional incentive to purchase its products.
2. There are two conflicting methods of accounting for premiums, one under PAS 37
(the traditional approach) and under PFRS 15 (the contemporary approach).
3. Accounting procedures for premiums under PAS 37 are the same as accounting for
assurance-type warranty:
a. Estimated premium expense and corresponding estimated premium liability
are recognized during the period the related goods were sold.
b. Estimated premium liability shall be reduced (i.e., debited) if the premiums
were actually distributed to claiming customers.
4, The following are the accounting procedures for premiums under PFRS 15:
a. Portion of the selling price of the goods shall be allocated to the sold goods and
premiums based on their relative stand-alone selling prices
Stand-alone selling price.of premiums is equal to discount amount per coupon
times the expected number of coupons to be used in redemption.
b. The amount allocated to the sold goods is immediately recognized as revenue,
while the amount allocated to the premiums are initially recognized as a
deferred liability, This deferred liability will be recognized as income if there is
an actual distribution of premiums.
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5. Customer loyalty programs are accounted for under PFRS 15. As such, the
procedures for premiums accounted under PFRS 15 will be applied, save for the
following modifications:
a. Ifthe entity acts as the principal (it will provide the goods or services when the
customers use the points), the allocated amount to the points shall be initially
recognized as a liability. This amount will be recognized as revenue once the
entity provides the goods and services in exchange of points.
b.Ifthe entity acts as the agent (other entities will provide the goods or services
when the customers use the points), the allocated amount to the points shall be
immediately recognized as income, net of payments to other entities.
6. Rebates, coupons, and free products promotions are all accounted under PFRS 15.
The accounting procedures are similar to customer loyalty program when the entity
acts as the principal.
7. Amounts received in advance from customers shall be recognized as revenue only
when the related performance obligation (i.e., delivering of goods or providing of
services) has been made.
8. Gift certificates are recognized initially as unearned income. This unearned income
will be recognized as revenue when the customers used these to acquire entity's
goods and/or services.
9. However, portion of gift certificates that is expected not to be exercised by the
customers are accounted for as a breakage. Income from breakage is computed as
follows:
Income from . Total Expected 3 Amount of gift certificates used
Breakage Breakage Total amount of gift certificates
expected to be used
10. The t-account of the unearned income - gift certificates can be analyzed as follows:
Unearned Income
Actual usage by customers XX XX Beginning balance
Income from breakage XX XX Amounts received
Ending balance (squeeze) XX XX
11.Sales with right of return are accounted using the following concepts in PFRS 15:
a. The portion of the transaction price that is not expected to be returned or
refunded shall be immediately recognized as revenue.
b. The portion of the transaction price that is expected to be returned or refunded
shall be recognized initially as refund liability, This refund liability will be
debited if actual returns were made.
c. Asset representing the entity's right to recover the products from the expected
return shall be recognized. This recognition will result to reduction from cost of
goods sold.
The amount of asset is equal to the product’s production costs less costs to recover
the product, including potential decreases in the value of the returned products.
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True or False
a Under PFRS 15, premium expense shall be recognized during the period when the
related products were sold.
Z. Under PAS 37, premium liability shall be recognized as an income when there is an
actual distribution of the items of premium.
3 Under PFRS 15, the transaction price shall be allocated to the products sold and to
items of premium based on their relative stand-alone selling prices.
The stand-alone selling price of the items of premium shall be determined by
considering the amount of effective discount that the customers will receive by
exercising their rights under the premium coupons.
In granting loyalty points due to sales to the customers, an entity has two
performance obligations.
An entity acts as a principal if other entities will supply the goods or services
covered by the customer loyalty program.
In customer loyalty program where the entity acts as the agent, the amount of
income it recognizes shall be the net amount to which the entity is entitled.
Changes in the estimate of the number of points to be redeemed shall result to the
restatement of the previously reported income from points.
Under PFRS 15, an entity shall recognize rebate expense and corresponding rebate
liability equal to the estimate of the total amount of rebates that will be used by
customers.
10. The stand-alone selling price of a free product is equal to its supposed selling price
times the probability that the customer will avail the free product.
11. Ifan entity makes a sales promotion where a customer can have one unit of product
in the future for free if it buys four units of the same product now, then the amount
received from this customer shall be allocated to the four units sold and to the free
one unit of product to be given to the customer in the future.
12. The amount initially received as advances from customers shall be recognized as
revenue at the time of receipt.
13, Amounts received from selling gift certificates shall be recognized as revenue only
when the holders used these certificates to avail the entity’s products and/or
services.
14, The total amount received from selling goods which can be returned by the
customers shall be fully recognized as sales revenue when the goods are delivered
to the customers.
15. In case there is an actual return from a customer, the amount refunded to that
customer shall be recognized as an expense.
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1. Under PAS 37, the following accounting procedures related to premiums are Correct,
except
a. During the period when the related goods were sold, estimated premium
expense and corresponding estimated premium liability shall be recognized.
b. During the period when the premiums were actually given to the availing
customers, additional premium expense shall be recorded.
c. The undistributed items of premium shall be recorded as prepaid assets.
2. In determining the amount of estimated premium expense under PAS 37, the
following shall be considered, except
The unit purchase cost of the items of premium.
oD
Number of expected coupons to be redeemed.

Amount of handling costs, if any.
cr aA
Amount to be remitted by customers, if any.

None of the above.
3. Under PFRS 15, the following accounting procedures related to the premiums are
correct, except
a. The transaction price shall be allocated to the products sold and the premium
items to be distributed in the future.
b. The amount initially allocated to the products sold shall be recognized as
revenue when the products are delivered to the customers.
c. The amount initially allocated to the premium items shall be immediately
recognized as income when the main products are delivered to the customers.
4, Theallocation of the transaction price to the products sold and the items of premium
under PFRS 15 shall be
a. basedonthe relative stand-alone selling prices of the product sold and the items
of premium.
b. based on the relative cost of the product sold and the items of premium.
c. based on the relative number of units of the product sold the number of items
of premium expected to be distributed.
d. equally.
5. If an entity acts as the principal in its customer loyalty program, which of the
following accounting procedures is correct?
a. The total transaction price shall be immediately recognized as revenue.
b. The amount allocated to the loyalty points shall be equal to the total amount of
discount that the customers can have assuming all of the points will be
exercised.
c. The amount allocated to the loyalty points shall be recognized as income only
when the products or services were already transferred to the availing
customers,
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d, The amount of revenue to be recognized from exercising the points shall be net
of the costs of providing the goods or services to the availing customers.
6. Ifan entity acts as the agent in its customer loyalty program, which of the following
is/are correct?
a. The goods or services covered by the loyalty program are provided by other
entities.
b. The amount of income to be recognized from points shall be gross of the
amounts paid to the other entities.
c. Bothaandb
d. Neither anor b
7. ABC Company instituted a customer loyalty program where the customers can use
the points they earned for discounts in their future purchases of the Company’s
products. In this case, the following statements are correct, except
a. The Company acts as the principal in the customer loyalty program.
b. The Company shall allocate the transaction price based on the relative stand-
alone selling prices of the goods sold and the points distributed.
c. The amount allocated to the points shall be recognized as income when the
points were distributed to the customers.
d. The amount allocated to the products sold shall be recognized immediately as
sales revenue.
8. XYZ Company inked a memorandum of agreement with ABC Company where the
former will distribute loyalty points to its customers that can be used to purchase
goods sold by the latter. XYZ Company will pay a certain amount to ABC Company
for every point it distributed. In this case, which of the following statements is not
true related to the accounting procedures in XYZ Company’s books?
a. XYZ Company shall recognize income when the customers actually used the
points to purchase goods in ABC Company.
b. XYZ Company is considered as an agent in this customer loyalty program.
Cc. XYZ Company shall recognize income from points equal to the portion of the
transaction price allocated to loyalty points less the amounts paid to ABC
Company.
9. Under PFRS 15, rebates shall be accounted by
a. recognizing estimated rebate expense and corresponding estimated rebate
liability.
b. recognizing estimated rebate income and corresponding estimated rebate
receivable.
allocating the transaction price to the rebates equal to the total amount of
rebates that are expected to be exercised by the customers.
allocating the transaction price between the goods sold and the rebates based
on their relative stand-alone selling prices.
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Chapter 5 - Premiums, Rebates, Discounts and Other Deferred Income Items |
10.An entity recently offered a free product that.can be availed in the future for every|
single purchase of three units of the same product. Which of the following is the |
correct accounting procedure for this promotional program?
a. The entity shall allocate the transaction price between the products sold and the|
free product to be distributed in the future, based on their relative stand-alone |
prices.
The entity shall recognize estimated free product expense and estimated free
product liability equal to the manufacturing cost of the free product.
Cc. The entity shall recognize estimated free product income and estimated free |
product receivable equal to the supposed selling price of this free product.
11. Which of the following is/are correct related to the accounting for advances received
from customers?
a. The advances received shall be initially recognized as liability.
b. The portion related to the advances where the related goods or services were
already provided to the customer shall be recognized as revenue.
Cc. Bothaandb
d. Neither a nor b
12. The following are correct accounting procedures related to gift certificates, except
a. Amounts received shall be initially recorded as liability.
b. Amounts used by the customers in purchasing goods or services from the entity
shall be recognized as revenue.
c. Amounts that are not expected to be redeemed (“breakage”) shall be
immediately recognized as revenue upon receipt of cash from the purchaser of
the certificate.
13.When recording sales with a right of return, an entity shall recognize all of the
following, except |
a. Revenue from the portion of the transaction price that is estimated not to be| |
returned by the customers.
b. Asset representing the right of the entity to recover the goods from the portion
of the transaction price that is expected not to be returned by the customers.
_c. Refund liability from the portion of the transaction price that is estimated to be
returned by the customers in the future. . !
d. None of the above. |
14.Refund liability shall be subsequently accounted using which of the following

accounting procedures?
a. This liability account shall be debited if customers make actual returns to the
entity,
b. Changes in this liability account shall be accounted prospectively by adjusting
the amount of revenue during the period of change.
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c. Bothaandb
d. Neitheranorb
15. The following are true regarding the accounting for the asset for the expected return,
except
a. The initial recognition of this asset has an increasing effect in the amount of the
cost of goods sold.
b. This asset is measured at the production cost of the goods expected to be
returned, less costs to recover, including the potential decreases in the value of
the goods.
c. If there is an actual return of goods from customers, this account shall be
credited.
Straight Problems
1. Starting on January 1, 2023, BULLFROG Company started offering a promotional
program wherein the customers shall present four coupons to be able to receive, for
free, a commemorative spoon and fork set from the Company. A coupon was
included for every bottle of vitamins that the Company is selling.
During the year, the Company sold 100,000 bottles for P75 per bottle. The Company
expects that only 40% of the coupons distributed will ever be used in redemption.
In addition, the Company bought 12,000 sets of premium items amounting to P50
per set. Lastly, 6,600 sets were distributed to the redeeming customers.
Required: Under each of the following independent scenarios, determine the journal
entries for the year 2023:
1. The Company applies PAS 37 in accounting for premiums.
2. The Company applies PFRS 15 in accounting for premiums.
2. During the year 2023, TOAD Company has sold 200,000 boxes of its soap at P47.50
per box. Also, during the year, the Company started to include a coupon in each box
of soap it is selling. Ten of these coupons plus P10 cash will be required from
customers to entitle them to a towel costing P33 per unit. In addition, costs of P8.25
per towel will be shouldered by the Company to transport the towels to the
customers.
The Company expects that only 80% of the coupons will be used in redeeming the
towels. During the year, the Company purchased 15,000 towels, 9,200 of which were
distributed to the customers.
entries for the year 2023;
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3. On January 1, 2023, MONKEY Company, a manufacturer of powdered juice products,

started to offer a special pitcher for every 20 empty packs of its powdered juice
products. The pitcher has a cost of P500 per unit. During 2023 and 2024, the
Company had the following information:
2023 2024
Sales revenue (P150 per pack) P12,000,000 P15,000,000
Number of pitchers bought 1,200 units 1,000 units
Number of pitchers redeemed 800 units 1,100 units
The Company expects that 75% of the packs will not be used in redeeming the special
pitcher.
entries for the years 2023 and 2024:
4. ORANGUTAN Company, an instant coffee manufacturer, started to offer a

promotional program where customers shall mail in 10 empty packs of the
Company’s instant coffee, plus P15 cash, to be entitled to a special mug costing P120
per unit. In addition, the Company will also shoulder the costs handling and shipping
the special mug to the customers which average P20 per mug. Selling price per pack
of the instant coffee is P45.
For the years 2023 and 2024, the Company had the following information:
2023 2024
Number of instant coffee packs sold 200,000 packs 240,000 packs
Number of mugs redeemed 6,400 mugs —- 10,000 mugs
Number of mugs purchased 7,500 mugs 12,000 mugs
The Company expects that only 40% of the packs will be used in redeeming the
special mug.
2. The Company applies PFRS 15 in accounting for premiums,
5. Starting on January 1, 2023, LEMUR Company, an operator of grocery chain,

introduced a customer loyalty program where for every P100 purchase, the
Company will a grant a point with five-year validity. Each point will reduce the
amount to be paid for future purchases by P1.00, During the year, the Company
generated sales revenue of P100,000,000, resulting to the distribution of 1,000,000
total points. The Company expects that only 75% of these points will be used in the
future before they lapse after five years,
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The customers have used the following number of points per year:
Year No. of Points Used
2023 180,000
2024 240,000
2025 120,000
Starting January 1, 2025, the Company now estimates that a total of 80% of the
points will be ultimately redeemed. Round-off the amounts to the nearest peso.
a. Income from points to be recognized from 2023 to 2025.
b. Remaining balance of the contract liability - points as of December 31, 2023,
2024 and 2025.
6. During the year 2023, TARSIER Company, a gasoline station operator, introduced a
customer loyalty program where a loyalty point is granted for every P200 of
petroleum purchases of its customers. Each loyalty point will reduce the customers’
future purchases by P4.00. For the year 2023, the Company reported a total revenue
of P400,000,000. The Company expects that 20% of these points will not be
exercised.
The customers have used the following number of points per year:

2023 200,000
2024 250,000
2025 160,000
2026 220,000
Starting on January 1, 2026, the Company changed its estimate to 25% of the points
are expected that will never be exercised.

a. Income from points to be recognized from 2023 to 2026.
b. Remaining balance of the contract liability - points as of December 31, 2023,
2024, 2025 and 2026,
7. From January 1, 2023 to April 30,2023, GORILLA Company has sold a total of 40,000
t-shirts at P250 unit selling price. Also, during the same period, the Company granted
a promotional program wherein for every purchase of four units of t-shirts, the
Company will grant a coupon for a free shirt (“buy four, get one free”). A total of
10,000 of such coupons were distributed. However, these coupons may be exercised
only from July 1, 2023 to June 30, 2024.
The Company expects that only 70% of these coupons will be redeemed before they
lapse on June 30, 2024, For the years 2023 and 2024, the customers used 4,500
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coupons and 2,000 coupons, respectively. Round-off the amounts to the neares,
peso.
a. Journal entries from 2023 to 2024.
b. Remaining balance of the contract liability - coupons as of December 31, 2023,
and 2024.
8. During the year 2023, BABOON Company, an entity involved in unlimited
samgyupsal business, introduced a marketing program wherein a card will be given
to customers. For every person who ate in the Company’s restaurant, the Company
will puta stamp on the card. After accumulating 5 stamps on the card, the customer's
next visit will be free (i.¢., a free meal pass). The Company normally charges P500
per person.
Allin all, during the year 2023, the Company reported a total samgyupsal revenue of
P10,000,000 and distributed a total of 20,000 stamps. The Company expects that
only 80% of these stamps will be used to avail the free unlimited pass. During 2023,
12,000 of these stamps were used to avail the freebie.

b. Remaining balance of the contract liability - stamps as of December 31, 2023.
9. During the month of January 2023, SAKI Company granted a rebate coupon worth
P187.50 for every customer’s P1,000 single receipt purchase. These rebate coupons
are exercisable starting on February 1, 2023 and have validity until January 31,
2025.
For the month of January 2023, the Company has reported total revenue of
P22,000,000 and granted 20,000 rebate coupons to the customers. However, the
Company expects that only 80% of these coupons will be exercised before their
expiration dates. During 2023 and 2024, the customers have used 8,000 coupons
and 4,500 coupons, respectively.

b. Remaining balance of the contract liability - rebates as of December 31, 2023
and 2024.
10.For the year 2023, VERVET Company introduced a marketing program where for
P1,500 single or multiple receipt purchase, the Company will grant a coupon
containing rebate of P312.50 for future purchases, These coupons have validity
period of one year. The Company expects that only 60% of these coupons will be
used before the expiration date.
During the year, the Company generated a total revenue of P27,000,000 and granted
16,000 rebate coupons to the customers. Actual coupons exercised during the yea!
numbered 5,400 coupons.
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b. Remaining balance of the contract liability - rebates as of December 31, 2023.
11. During the year 2023, BONOBO Company sold gift certificates with total face amount
of P6,000,000. The Company estimates that 2% of these certificates will never be
exercised due to a variety of reasons. During the remainder of the year, the
customers have used certificates with total face amount of P4,116,000.

b. Remaining balance of the unearned income - gift certificates as of December 31,
2023.
12.On October 1, 2023, CHIMPANZEE Company sold gift certificates with total face
amount of P10,000,000. The Company expects that 5% of the face amount of the
certificates will never be redeemed by the customers due to the loss of the certificate
itself. The customers have used gift certificates with total face amounts of
P1,900,000, P2,850,000 and P2,375,000 during the months of October, November
and December, respectively, all during 2023.

b. Remaining balance of the unearned income - gift certificates as of December 31,
2023.
13.For the year 2023, MARMOSET had a total revenue of P7,000,000. The Company
expects that 5% of this amount will be returned. Gross profit rate of 40% have been
consistently applied during the year. On the other hand, the costs to recover the
returned goods are non-existent since the customers will make the return directly
to the Company’s premises. The Company uses the perpetual side method in
recording its inventory transactions.
During the year 2023, goods with total selling price of P200, 000 were returned to
the Company.
Requifed: Determine the journal entriés for the year 2023.
14.COLUGO Company reported the following information during the year 2023:
Total sales (150,000 units) P30,000,000

Total manufacturing costs (200,000 units) 24,000,000
Portion expected to be returned by customers 6%
Estimated costs of recovering the returned units P10 per unit
Units actually returned during the year 6,400 units
Required: Determine the journal entries for the year 2023.
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Multiple Choice - Problems |

1. On January 1, 2023, SHORTHAIR Company, a manufacturer of breakfast cereals
introduced a promotional campaign by providing a free special bowl costing P69
each for every five coupons given by the customers. Consequently, the Company
included one coupon for every box of cereals it sells.
For 2023 and 2024, the Company had the following information:
2023 2024
Number of cereal boxes sold (at P400 unit price) 240,000 units 200,000 unit;
Number of special bowls redeemed 20,000 units 22,000 unit;
The Company expects that only 50% of the distributed coupons will be used in
redeeming the special bowls. Round-off the amounts in the nearest peso.
Under PAS 37, the amount of estimated premium expense for the years 2023 and
2024, respectively shall be
a. P1,440,000; P1,320,000 c. P1,200,000; P1,200,000
b. P1,440,000; P1,200,000 d. P1,200,000; P1,320,000
Under PAS 37, the amount of estimated premium liability as of December 31, 2023
and 2024, respectively shall be
a. P240,000; P120,000 c. P288,000; P120,000
b. P240,000; P228,000 d. P288,000; P228,000
Under PFRS 15, the amount of income from premium for the years 2023 and 2024,
respectively shall be
a. P1,418,719; P1,300,492 c. P1,182,266; P1,300,492
b. P1,418,719; P1,182,266 d. P1,182,266; P1,182,266
Under PFRS 15, the amount of contract liability - premiums as of December 31, 2023
and 2024, respectively shall be
a. P246,783; P118,227 c. P236,783; P118,227
b. P246,783; P135,732 d. P236,453; P118,227
2. During the year 2023, BENGAL Company distributed 500,000 customer loyalty
points that will expire after eight years. Each point used will reduce future purchases
by P2.50. The source of these points is the total sales of P18,875,000. The Company
expects that 90% of these points will be redeemed before they expire. The customers
exercised the following number of loyalty points:
2023 80,000 points
2024 70,000 points
2025 65,000 points
2026 60,000 points
2027 50,000 points
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On January 1, 2025, the Company changed its estimate in the number of points that
will be exercised. The revised estimate is that only 80% of the points will be
redeemed before maturity date.
The amount of income from points during 2024 shall be
a. P154,735 c. P165,156
b. P162,895 d. P172,654
The carrying amount of contract liability - points as of December 31, 2024 shall be
a. P802,823 c. P707,813
b. P723,923 d. P682,363
a. P216,768 c. P153,359
b. P172,529 d. P148,639
a. P184,826 c. P163,925
b. P159,258 d. P176,826
The carrying amount of contract liability - points as of December 31, 2027 shall be
a. P403,567 c. P294,922
b. P348,729 d. P199,072
3. During November 2023, BURMESE Company, an owner of a department store,
introduced a promotional program wherein for every eight pairs of socks sold ina
single receipt, a coupon will be given for a free pair of black shoes that the Company
is also selling. However, the coupons are exercisable from the period December 1,
2023 to March 31, 2024. Each pair of socks has a normal selling price of P50, while
the black shoes have normal selling price of P200 per pair.
The Company generated revenues of socks amounting to P8,000,000 and distributed
15,000 coupons. The Company estimates that only 2/3 of the coupons will be
redeemed in the future. Six thousand five hundred (6,500) coupons were redeemed
during December 2023.
The total amount of revenue from free product during 2023 shall be
a. P560,000 c. P1,040,000
b. P680,000 d. P1,240,000
The carrying amount of contract liability - free product as of December 31, 2023
shall be
a. P560,000 c. P360,000
b. P640,000 d. P920,000
4. For every single receipt purchase of P800, SIAMESE Company will grant P125 rebate
coupon that can be used to reduce the amount to be paid on future purchases. During
the year 2023, the Company generated total revenue of P18,000,000 and granted
20,000 coupons. The Company estimates that only 80% of these coupons will be
used. During 2023, 12,500 of such coupons were exercised.
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The total amount of revenue from rebate during 2023 shall be

a. P1,325,750 c, P1,525,250
b. P1,406,250 d, P1,785,750
The carrying amount of contract liability - rebates as of December 31, 2023 shall be
a. P274,750 c, P474,250
b. P14,250 d. P393,750
5. During November 2023, LION Company, a radio broadcaster, received P12,000,000
from a private entity. Based on this agreement, the Company is required to air the
following number of video ads about the private entity:
No. of Ads No. of Ads
November 2023 3 February 2024 3
December 2023 5 March 2024 2
January 2024 4 April 2024 3
The total amount of advertising revenue during 2023 shall be
a. P4,800,000 c. P4,500,000
b. P4,000,000 d. P4,200,000
The balance of unearned income as of December 31, 2023 shall be
a. P7,000,000 c. P7,200,000
b. P7,400,000 d. P8,000,000
6. On October 1, 2023, LYNX Company sold gift certificates with total face amount of
P8,000,000. Based on the Company's experience, 10% of these certificates will never
be redeemed by the customers. During the remainder of 2023, the customers
redeemed the following face amounts of gift certificates: October, P864,000;
November, P1,080,000; December, P1,440,000.
Total revenue from the exercise of gift certificates during 2023 shall be
a. P3,054,000 c. P3,214,000
b. P3,184,000 d. P3,384,000
Total income from breakage during 2023 shall be
a. P376,000 c. P416,000
b. P424,000 d. P484,000
Total unearned income - gift certificates as of December 31, 2023 shall be
a. P0,000,000 c, P4,362,000
b. P4,240,000 d. P4,332,000
7. For the years 2023 and 2024, WILDCAT Company had the following information:
2023 2024
Gift certificates (GCs) sold P9,000,000 P7,000,000
Amount of GCs redeemed from:
GCs sold during 2023 3,420,000 2,137,500
GCs sold during 2024 - 2,992,500
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The Company expects that 5% of the gift certificates sold will never be redeemed
due to the loss of the certificates
Total income from breakage during 2024 shall be
a. P180,000 c. P270,000
b. P245,000 d. P320,000
The total balance in the unearned income - gift certificates as of December 31, 2024
shall be
a. P7,000,000 c. P7,560,000
b. P7,180,000 d. P7,790,000
8. During 2023, ANDAL Company reported total sales of P6,000,000, of these, 5% are
expected to be returned by customers. All throughout the year, the Company
consistently applied 40% gross profit rate. Costs to recover the returned inventories
are estimated to be 20% of the inventory’s cost. By the end of the year, goods with
total selling price of P120,000 were returned during the year.
From this information, the net amount of cost of goods sold during 2023 shall be
a. P3,600,000 c. P3,744,000
b. 3,456,000 d. P3,532,600
The carrying amount of the asset for expected recoveries as of December 31, 2023
shall be
a. P68,600 c. P72,400
b. P73,600 d. P86,400
9. For the year 2023, DEEP Company sold 300,000 units at P250 unit selling price. On
average, these sold units have total cost of P120 per unit. The Company estimates
that 6% of these goods will be returned and costs to recover will be incurred at P20
per unit. By the end of 2023, a total of 12,000 units were returned to the Company.
The amount of the sales revenue to be recognized immediately during 2023 shall be
a. P72,600,000 c. P70,500,000
b. P68,700,000 d. P66,270,000
From this information, the net amount of cost of goods sold during 2023 shall be
a. P34,200,000 c. P36,000,000
b. P33,840,000 d, P37,800,000
The carrying amount of the asset for expected recoveries as of December 31, 2023
shall be
a. P480,000 c. P600,000
b. P540,000 d. P720,000
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Chapter 6 - Bonds Payable and Loans Payable
CHAPTER 6
BONDS PAYABLE AND LOANS PAYABLE

1. The difference between bonds and loans.
2. The characteristics, elements, and classifications of bonds.
3. The initial measurement of bonds payable.
4. The subsequent measurement of bonds payable, including the different
amortization methods for discount or premium.
5. The initial measurement and subsequent accounting for loans payable.
LONG-TERM FINANCING - INTRODUCTION

To prevent stagnation of its operations, an entity may decide to pursue a business
opportunity or expand its current operations to a bigger market. To finance these
undertakings, an entity may use any or a combination of the following:
a. Savings from results of operations (undistributed net income).
b. Borrowings through bonds and loans.
c. Entering into a finance lease.
d. By issuing additional shares (shareholders’ equity).
In this chapter, the focus will be on the accounting for the borrowings through
bonds and loans. Accounting for leases will be discussed in Chapter 9 while
accounting for undistributed net income and shareholders’ equity will be discussed
in Chapter 15.
BONDS PAYABLE VS. LOANS PAYABLE

Both bonds and loans are sources of long-term financing, but they are very different
from each other. Their salient differences are the following:
~ Bonds Loans
Traded in an Yes - in bond markets No
exchange market?
Contract disclosure Public contract Private contract
Counterparty /ies General public A lender or group of lenders
Determination of Based on prevailing Privately agreed-upon
interest rate market rates
Issuers (Borrowers) Stable and well-known
entities. Also, the Not-so-known entities
government. ae
Let us now focus our attention to the bonds payable first.
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BONDS PAYABLE - INTRODUCTION

Bonds are tradeable securities that represent indebtedness of an entity. The
following are the primary reasons why an entity may choose to issue bonds rather
than borrow from banks in the form of loans:
a. Bonds give more competitive interest rates (i.e., lower than the rates charged by
loans).
b. The borrowing entity can draft the terms and conditions of its bond issuance,
which is up to the investors to accept. Under a loan payable, the lender normally
drafts the terms and conditions of the loan agreement for the borrowing entity
to “take it, or leave it”.
Fundamental Features of a Bond
Generally, all bond issuances have the following elements:
a. Issuer - this is the entity who borrows from the general public. It can be a
government (e.g., the Philippine government) and private or corporate entities
(e.g., Ayala Land Inc. and Union Bank of the Philippines). This the one who
recognizes “bonds payable”.
b. Bondholders - these are persons or entities who lend funds to the issuer. They
“invest” in bonds in the hopes of earning investment income in the form of
interest or trading gains. They recognize “investments in debt securities”.
c. Proceeds - the amount received from the bondholders, which is determined
by the interaction of stated rate and market rates. This amount is what the
issuer can use in its business activities. Lastly, this amount is not required to be
equal to the principal amount.
d. Principal (Face Amount) - the amount that the issuer agrees to pay to the
bondholders on the maturity date. This is not necessarily equal to the amount
of proceeds initially received from bondholders.
e. Maturity date - the date when the principal will be paid to bondholders.
However, there are two exemptions to this general feature:
1. Serial bonds, where portion of principal amounts are paid periodically
(e.g., annually).
2. Perpetual bonds, where the principal is not redeemable (or outstanding
“forever”) but pay periodic interest “forever”.
f. Tenor - this is the total period of time when the bonds are outstanding. This
period of time is usually from the bonds’ issuance date until its maturity date.
g. Interest, Coupon, Stated or Nominal Rate - the amount of annual interest
that the issuer promises to pay to the bondholders. The frequency of interest
payments can be annually, semi-annually, quarterly, or monthly.
Zero-coupon bonds, as the name suggests, do not pay periodic interests but
rather are issued for proceeds that are much lower than the principal amount.
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Chapter 6 — Bonds Payable and Loans Payable
Bond Indenture
Bond indenture or trust deed is the legal contract containing the terms and
conditions of a bond issue. These terms include, but are not limited to,
a. Features of the bond such as principal, nominal interest rate, frequency of
interest payment, maturity date, collateral and covenants. Covenants have been
discussed in Chapter 1.
b. Rights of the bondholders
c. Obligations of the issuer
Classifications of Bonds
Bonds can be classified into different types depending on its characteristics.
a. As to payment of principal amounts:
1. Term bond - principal amount is payable lump-sum on maturity date (i.e,
“balloon” payment on maturity date).
2. Serial bond - principal amount is payable on a periodical basis.
3. Perpetual bond - no payment of principal since it has no maturity date.
b. As to security or collateral:
1. Debenture bond - bond with no security or collateral. Normally issued by
a well-known and established borrower entity who already obtained the
trust of the general public regarding its credit-worthiness.
2. Mortgage bond - bond collateralized with land, building, or other real
properties.
3. Equipment trust certificate - proceeds from the issuance of this certificate
are used in financing the acquisition of equipment (i.e., aircraft). A trustee
normally represents the interest of the investors by leasing out the acquired
equipment to the borrower. The ownership over the equipment will be
transferred to the borrower when all of the lease payment have been paid.
c. As to seniority:
1. Senior bond - bond that has a priority in payments above the other liabilities
of the issuer, except those secured by collaterals.
2. Subordinated bond - bond that will be paid only when all other liabilities
have been fully paid.
d. Other types of bonds:

1. Zero-coupon bond - bond that has no coupon rate and will just pay principal
amounts on maturity date.
2. Income bond - bond that will pay interest only when there are available
earnings. Normally issued by a struggling entity to finance its efforts in
reviving its business operations.
3. Floating-rate bond - bears interest that periodically (i.e., annually, semi-
annually, quarterly, monthly) resets in response to changes in the reference
rate. The amount of interest paid each year is not equal with each other.
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4, Puttable bond - bond that allows the bondholders to claim payment against
the issuer even before the maturity date.
5. Convertible bond - bond that gives the bondholder the option to convert
the bonds into equity securities of the issuer. This will be discussed in
Chapter 7.
INITIAL MEASUREMENT OF BONDS PAYABLE

As a financial liability, by default, bonds payable are initially measured at their fair
values less transaction costs. The exception is when the bonds are accounted at
fair value through profit loss (FVTPL), where transaction costs are expensed outright.
Details on the accounting procedures when a financial liability is accounted at
FVTPL were already discussed in Chapter 3.
The fair value on initial recognition can be derived from either of the following:
a. principal amount multiplied by quoted price (e.g., 98, 102, etc.) as of initial
recognition (i.e. market approach); or
b. future cash flows discounted using the market rates prevailing as of initial
recognition (i.e., present value or income approach).
Unlike notes and loans payable, the bonds payable have quoted prices since they
are traded in an exchange market. Nevertheless, in general, the gross proceeds
from the issuance are equal to the bonds’ fair value on the date of issuance. The
amount of net
proceedsis equal to gross proceeds less transaction costs.
There is a discount if the net proceeds < than face amount while there is a premium
if the net proceeds > than face amount.
When using the income approach, the PV factor of single payment will be used for
the amount of principal and PV factor of ordinary annuity will be used for
periodic interest payment. Also, when using the income approach, the
relationship between the market rate and stated rate has the following pre-
determined results:
Relationship Face Amount vs Proceeds | Discount or Premium?
Market rate > Stated Rate | Face Amount > Proceeds Discount
Market rate < Stated Rate | Face Amount < Proceeds Premium
Market rate = Stated Rate | Face Amount = Proceeds Neither
The readers should take note that these relationships are the same as in the
investments in debt securities. However, the discount has a normal debit balance
(i-e., contra-liability) while premium has a normal credit balance (i.e., adjunct).
Depending on whether there is a discount or premium, the carrying amount (or
amortized cost) of the bonds payable shall be determined as follows:
a. Carrying amount = Face amount less unamortized discount; or
b. Carrying amount = Face amount plus unamortized premium.
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Illustration 1. BLANCO Company issued a 4-year bonds with principal of

P5,000,000. The bonds bear interest of 10% that is payable at the end of each year,
Required: Under each of the following independent scenarios, determine (a) bonds’
fair value on initial recognition; and (b) journal entry to record the issuance:
1. Quoted price is 99.
2. Market rates averaged 8%
3. Market rates averaged 11%
Answer - Scenario 1
The fair value of P4,950,000 (P5,000,000 x 99%). The entry to record the issuance
is as follows:
Cash 4,950,000
Discount on bonds payable 50,000
Bonds payable (at face amount) 5,000,000
The readers should take note that the bonds payable account is always credited
equal to the bonds’ face amount.
Answer - Scenario 2
The fair value of P5,331,214 is computed as follows (P500,000 annual interest =
P5,000,000x 10%):
Ordinary annuity for 4 periodsat8% 3.312127 500,000 1,656,064
Total Initial Fair Value P5,331,214
Cash 5,331,214
Premium on bonds payable 331,214
There is a premium since the market rate of 8% is lower than the stated rate of
10%.
Answer - Scenario 3
The fair value of P4,844,878 is computed as follows (P500,000 annual interest =
P5,000,000 x 10%):
Ordinary annuity for 4 periods at11% 3.102446 500,000 __1,551,223_
Total Initial Fair Value P4,844,878
Cash 4,844,878
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There is a discount since the market rate of 11% is higher than the stated rate of
10%. The P155,122 discount is equal to P5,000,000 face amount less P4,844,878
cash proceeds.
SUBSEQUENT MEASUREMENT
In general, bonds payable are subsequently measured at amortized cost. This
includes the amortization of the initial amount of discount or premium. This
amortization has the following effects to the amount of interest expense relative to
the interest paid and the bond’s amortized cost at the end of each year:
Scenario | Interest Expense vs Interest Paid | Effect in amortized cost

Discount Interest Expense > Interest Paid Increase in amortized cost
Premium Interest Expense < Interest Paid Decrease in amortized cost
Again, on maturity date, the goal is to make the amortized cost (or carrying amount)
of the bond to be equal to its face amount. Needless to say, if the proceeds = face
amount on date of issuance, then the amount of interest expense is equal to
interest paid every year.
METHODS OF AMORTIZING PREMIUM AND DISCOUNT

Similar to investments in debt securities, the following are the three methods of
amortizing the premium or discount on initial recognition:
a. Straight-line method
b. Bond outstanding method
c. Effective interest method
STRAIGHT-LINE METHOD
This method is usually used when the issue price is stated as a quoted price (e.g,
100, 98, 102.50, etc.). In addition, this method has the following characteristics:
a. Simplest among the three methods
b. Equal amounts of amortization are recorded every period. The discount and
premium are amortized from the date of issuance until the maturity date.
c. Equal amounts of increase or decrease in the carrying amount of bonds payable.
Illustration 2. On January 1, 2023, CUEVAS Company issued bonds with total face
amount of P6,000,000 and coupon rate of 10%. The bonds were dated January 1,
2022 and will mature on December 31, 2025. Required: Under each of the following
independent scenarios, determine the amounts of interest expense and carrying
amounts from 2023 to 2025 using the straight-line method:
1. The bonds were issued at 96
Answer - Scenario 1
On the issuance date, the Company will make the following journal entry:
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Cash (P6M x 96%) 5,760,000

Annual amortization of the discount is P80,000 (P240,000/3). Amortization table is
as follows:
Interest Interest Amorti- Carrying Discount on
Date Payments Expense zation Amount Bonds Payable
Jan. 1, 2023 5,760,000 240,000
Dec. 31,2023 600,000 680,000 80,000 5,840,000 160,000
Dec. 31,2024 600,000 680,000 80,000 5,920,000 80,000
Dec. 31,2025 600,000 680,000 80,000 6,000,000 “
a. The 3-year amortization period is from January 1, 2023 issue date until
December 31, 2025 maturity date. The January 1, 2022 date of the bonds
was not considered.
b. The discount amortization made the annual interest expense higher than
interest paid by P80,000.
c. The discount amortization steadily increases the carrying amount of the
bond equal to the annual amortization of P80,000, and decreases the balance of
the discount on bonds payable by the same amount.
For every December 31 of each year, the following journal entry shall be made:

Cash 600,000
Answer - Scenario 2
On the issuance date, the Company will make the following journal entry:
Cash (P6M x 105%) 6,300,000

Annual amortization of premium is P100,000 (P300,000/3). Amortization table is

as follows:
Interest Interest Amorti- Carrying Premium on
Jan. 1, 2023 6,300,000 300,000
Dec. 31,2023 600,000 500,000 (100,000) 6,200,000 200,000
Dec. 31,2024 600,000 500,000 (100,000) 6,100,000 100,000
Dec. 31,2025 600,000 500,000 (100,000) 6,000,000 -
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a. The premium amortization made the annual interest expense Jess than
interest paid by P100,000.
b. The premium amortization steadily decreases the carrying amount of the
bond equal to the annual amortization of P100,000 and decreases the balance
on premium on bonds payable by the same amount.
For every December 31 of each year, the following journal entry shall be made:
Cash 600,000
The readers should take note that straight-line method is applicable to term bonds,
but not to serial bonds, which will be discussed next.
BOND OUTSTANDING METHOD

This method is mainly applied to serial bonds, wherein the outstanding face
amount decreases periodically due to the periodic principal installment payments.
This method addresses the dilemma of using the straight-line method which is the
recording of equal amounts of amortization for each year, without regard to the
bonds’ outstanding face amount. Under the bond outstanding method, there is a
higher amount of amortization during the initial years when the bonds’
outstanding face amount is higher.
When applying this method, the readers may follow these procedures:
1. Understand the payment schedule of the bonds such as periodic amounts of
principal installment payments and the related frequency.
2. Determine the balances of the bonds’ face amount at the beginning of each
year and compute the sum of the balances (will be used as the determinator in
step 3).
3. The amount of amortization in a particular year is equal to the following:
Initial Discount or Beginning-of-the-year face amount
4 X eae
Premium Amount Total of beginning-of-the-year face amounts
The above procedures, by analogy, are very much similar to sum-of-the-years’ digit
(SYD) method of computing depreciation.
Illustration 3, CARLOS Company issued its five-year, 7% interest-bearing bond

with face amount of P10,000,000 on January 1, 2023. The bond is payable in equal
annual installments of P2,000,000 at the end of each year, starting on December 31,
2023 and every December 31, thereafter, Required: Under each of the following
independent scenarios, determine the amounts of interest expense and bonds’
amortized cost for each year using the bond outstanding method:
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Answer - Scenario 1
Initially, there is a premium of P600,000 computed as P10,000,000 x (106% .
100%). Premium amortization for each year is computed as follows:
Year Beg. Bal. Ratio Amortization
2023 10,000,000 10M/30M P200,000 (P600,000
x 10M/30M)
2024 8,000,000 8M/30M 160,000 (P600,000
x 8M/30M)
2025 6,000,000 6M/30M 120,000 (P600,000
x 6M/30M)
2026 4,000,000 4M/30M 80,000 (P600,000
x 4M/30M)
2027 2,000,000 2M/30M 40,000 (P600,000
x 2M/30M)
P30,000,000 P600,000
' The amount of interest paid and expense for each year is determined as follows:
[B] [A] -[B]
[A] Premium Interest
Year Beg. Bal. Interest Paid Amortization Expense
2023 10,000,000 x 7% = P700,000 P200,000 P500,000
2024 8,000,000 x 7% = 560,000 160,000 400,000
2025 6,000,000 x 7% = 420,000 120,000 300,000
2026 4,000,000 x 7% = 280,000 80,000 200,000
2027 2,000,000 .x 7% = 140,000 40,000 100,000
P30,000,000
Similar to the straight-line method, the premium amortization made the amounts
of interest expense Jower than the amounts of interest paid. The related
amortization table can now be made as follows:
Interest+ Premium on
Principal Interest Amorti- Carrying Bonds
Date Payments Expense zation Amount Payable
Jan. 1, 2023 10,600,000 600,000
Dec. 31,2023 2,700,000 500,000 (2,200,000) 8,400,000 400,000
Dec. 31,2024 2,560,000 400,000 (2,160,000) 6,240,000 240,000
Dec. 31,2025 2,420,000 300,000 (2,120,000) 4,120,000 120,000
Dec. 31,2026 2,280,000 200,000 (2,080,000) 2,040,000 40,000
Dec. 31,2027 2,140,000 100,000 (2,040,000) 3 >
The journal entries to be made as of December 31, 2023 and 2024, respectively, are
the following:
Bond payable 2,000,000
Cash (P2M + P700K) 2,700,000
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Cash (P2M + P560K) 2,560,000
Answer - Scenario 2
On the initial recognition, there is a discount of P300,000, computed as P10,000,000
x (100% - 97%). Discount amortization for each year is computed as follows:
Year Beg. Bal. Ratio Amortization
2023 10,000,000 10M/30M P100,000 (P300,000 x 10M/30M)
2024 8,000,000 8M/30M 80,000 (P300,000 x 8M/30M)
2025 6,000,000 6M/30M 60,000 (P300,000 x 6M/30M)
2026 4,000,000 4M/30M 40,000 (P300,000 x 4M/30M)
2027 2,000,000 2M/30M 20,000 (P300,000 x 2M/30M)
P30,000,000 P300,000
The amounts of interest payments and interest expense for each year are
determined as follows:
[B] [A] +[B]
[A] Discount Interest
Year Beg. Bal. Interest Paid Amortization Expense
2023 10,000,000 x 7% P700,000 P100,000 P800,000
a
2024 8,000,000 x 7% 560,000 80,000 640,000

uw
2025 6,000,000 x 7% 420,000 60,000 480,000

2026 4,000,000 x 7% 280,000 40,000 320,000
tou
2027 2,000,000 x 7% 140,000 20,000 160,000

P30,000,000
Similar to the straight-line method, the discount amortization made the amounts
of interest expense higher than the amounts of interest paid. The related
amortization table can now be made as follows:
Interest/ Discount on
Principal Interest Amorti- Carrying Bonds
Jan. 1, 2023 9,700,000 300,000
Dec. 31, 2023 2,700,000 800,000 (1,900,000) 7,800,000 200,000
Dec. 31, 2024 2,560,000 640,000 (1,920,000) 5,880,000 120,000
Dec. 31, 2025 2,420,000 480,000 (1,940,000) 3,940,000 60,000
Dec. 31, 2026 2,280,000 320,000 (1,960,000) 1,980,000 20,000
Dec. 31, 2027 2,140,000 160,000 (1,980,000)
the following:
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Cash (P2M + P700K) 2,700,000

Cash (P2M + P560K) 2,560,000
EFFECTIVE INTEREST RATE METHOD

This is the required method under PFRS 9. [PFRS 9.4.2.1 and PFRS 9.A]. Under this
method, an entity determines effective interest rate (EIR) which exactly discounts
estimated future cash payments through the expected life of the financial liability
to its amortized cost. In other words, this is similar to the effective interest rate
method applied to investments in debt securities and in notes payable.
Generally, the effective interest rate is the market rate on the date of bond
issuance, regardless whether it is higher, lower, or equal to the stated rate. The
exception is when there are bond issue costs, which will be discussed shortly. The
EIR is not changed when market rates change as of each reporting date.
When using the effective interest rate method:

a. The effective interest rate is multiplied to the beginning-of-the-period
carrying amount to obtain the amount of interest expense for the period.
b. The difference between the interest paid and the computed interest expense is
the amount of amortization for the period. The readers may use this guide:
1. Ifthere isa premium, interest paid > interest expense, with the difference
deducted from the bond’s carrying amount.
2. If there is a discount, interest paid < interest expense, with the difference
added to the bond’s carrying amount.
Illustration 4. At the beginning of 2023, ANDAYA Company issued 3,000 of its

P1,000 face value bonds. These bonds pay interest of 9% every December 31 and
has maturity date of December 31, 2026 (i.e., after 4 years). Required: Under each
of the following independent scenarios, determine the related amortization table
and journal entries for the years 2023 to 2024 using the effective interest method:
1, Market rates as of January 1, 2023 averaged 11%.
2. Market rates as of January 1, 2023 averaged 7%.
Answer - Scenario 1
Initial fair value is computed as follows using annual interest of P270,000
(P3,000,000x 9%):
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Ordinary annuity for 4 periods at 11% 3.102446 270,000 837,660
Total Initial Fair Value/Gross Proceeds P2,813,853
The journal entry to record the issuance on January 1, 2023 is as follows:
Cash 2,813,853
The amortization table can now be prepared as follows:

Jan. 1, 2023 2,813,853 186,147
Dec. 31,2023 270,000 309,524 39,524 2,853,377 146,623
Dec. 31,2024 270,000 313,871 43,871 2,897,248 102,752
Dec. 31,2025 270,000 318697 48697 2,945,945 54,055
Dec. 31,2026 270,000 324,055 54,055 3,000,000 7
To obtain the interest expense for 2023, P2,813,853 is multiplied with 11%
effective interest rate, and so on. The journal entries to be made as of December 31,
2023 and 2024, respectively, are the following:
Cash 270,000

Cash 270,000
Answer - Scenario 2
Initial fair value is computed as follows using annual interest of P270,000
(P3,000,000 x 9%):

The journal entry to record the issuance on January 1, 2023 is as follows:
Cash 3,203,232
The amortization table can now be prepared as follows:

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Jan. 1, 2023 3,203,232 203,232
Dec. 31,2023 270,000 224,226 (45,774) 3,157,458 157,458
Dec. 31,2024 270,000 221,022 (48,978) 3,108,480 108,480
Dec.31,2025 270,000 217,594 (52,406) 3,056,074 56,074
Dec.31,2026 270,000 213,926 (56,074) 3,000,000 =
the following:
Premium on bonds payable ' 45,774
Cash 270,000
Cash 270,000
EFFECTS OF BOND ISSUE COSTS - INITIAL RECOGNITION

Bond issue costs are the fees and costs incurred in connection with the issuance of
bonds payable. These include underwriting costs, printing costs, legal costs, and
registration costs. These amounts are paid to any one or a combination of the
following: lawyers, accountants, auditors, investment banks, and bond market
regulator. Lastly, these costs decrease the amount of net proceeds that the issuer
receives from the bond issuance.
Even though bond issue costs purport to be as “expenses”, they are not expensed
outright for bonds measured at amortized cost. Instead, it has a decreasing effect
in the initial measurement of bonds payable. Specifically, it has the following
effects on the initial recognition:
a. Increase in discount on bonds payable; or
b. Decrease in premium on bonds payable
In addition, if bond issue costs > initial amount of premium, the premium will
now become discount that is equal to the amount of excess bond issue costs over
the initial amount of premium.
Illustration 5. On January 1, 2023, LOZANO Company issued 4,000 of its P1,000

face amount bonds that will mature on December 31, 2026. Coupon rate is 8% and
bond issue costs incurred amounted to P250,000.
Assuming that the bonds were issued at their quoted price of 110, the net premium
on bonds payable is computed as follows:
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Initial amount of premium /(110% - 100%) x P4M] P400,000

Less: Bond issue costs 250,000
Premium on bonds payable, net P150,000
Assuming instead that the bonds were issued at their quoted price of 98, the total
discount on payable is computed as follows:
Initial amount of discount [(100% - 98%) x P4M] P80,000
Add: Bond issue costs 250,000
Discount on bonds payable P330,000
EFFECTS OF BOND ISSUE COSTS - SUBSEQUENT MEASUREMENT

Since the bond issue costs affect the initial amounts of discount or premium, the
amounts of subsequent periodic amortization using either the straight-line method
or bond outstanding method will also be affected. However, the manner of
computing the periodic amortization is not affected.
If an entity uses effective interest method, bond issue costs will make EIR > market
yield to be used in amortizing the premium or discount on initial recognition.
Consequently, the following rules can now be formulated:
General rule: | Market rate (yield) on initial recognition is the effective interest rate
When there are bond issue costs, a new effective interest rate will
Exception:
be used, which is higher than the market rate on initial recognition
Illustration 6. AGUIRRE Company issued 6,000 of its P1,000, 10% interest-bearing

bonds on January 1, 2023, when the market yield rates averaged 11%, receiving
P5,853,375 proceeds. The bonds will mature on December 31, 2025. In addition,
the Company also incurred bond issue costs of P141,596. After considering the
bond issue costs, the revised effective interest rate is now 12%.
The initial amount of the discount is computed as P146,625 (P6,000,000 -

P5,853,375); however, this will be increased to P288,221 (P146,625 + P141,596)
because of the bond issue costs. The journal entry to record the issuance, net of
bond issue costs is as follows:
Cash (P5,853,375 - P141,596) 5,711,779

The amortization table will now look like this:
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Jan. 1, 2023 5,711,779 288,221
Dec. 31,2023 600,000 685,413 85,413 5,797,192 202,808
Dec. 31,2024 600,000 695,663 95,663 5,892,855 107,145
Dec. 31,2025 600,000 707,145 107,145 6,000,000 -
It should be highlighted that because of the bond issue costs, the amount of
interest expense per year is computed using the 12% effective rate, rather
than the 11% market rate as of the issuance date.
SEMI-ANNUAL AND QUARTERLY INTEREST PAYMENTS

Interest payments on the bonds may be also made more frequently, such as every
six months (semi-annual) or every three months (quarterly). In both cases, when
computing for the PV factors, the issuer shall make the following adjustments
depending on the interest payment frequency:
Interest Payment Frequency

Semi-annually Quarterly
Number of Periods Years x 2 Years x 4
Periodic Discount Rate Market rate + 2 Market rate + 4
Periodic Interest Payment | AnnualAmount+2 Annual Amount + 4
After these adjustments, the issuer can now proceed to apply the usual amortization
procedures under straight-line and bond outstanding methods. For effective
interest rate method, an example will show the changes to be made in the
computations
Illustration 7. BAGUIO Company issued 2,000 of its 2-year, P1,000 face amount
bonds on January 1, 2023. The bonds pay 10% interest and were issued when the
market rates averaged 9%. Required: Under each of the following independent
scenarios, determine the fair value and subsequent amortization table:
1. Interest is payable semi-annually every June 30 and December 31.
2. Interest is payable every March 31, June 30, September 30, and December 31
Answer - Scenario 1 (Semi-annual Interest Payments)

In computing the bonds’ initial fair value, the following adjustments are to be made:
Number of Periods = 4 (2 yearsx2) Periodic discount rate = 4.50% (9%/2)

Semi-annual interest payment = P100,000 (P2,000,000 x 10% x 6/12)

Single payment for 4 periods at 4.50% 0.838561 2,000,000 P1,677,122
Ordinary annuity for 4 periods at 4.50% 3.587526 100,000 358,753.
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The amortization table can now be made as follows:

Jan. 1, 2023 2,035,875 35,875
Jun. 30,2023 100,000 91,614 (8,386) 2,027,489 27,489
Dec. 31,2023 100,000 91,237 (8,763) 2,018,726 18,726
Jun. 30,2024 100,000 90,843 (9,157) 2,009,569 9,569
Dec. 31,2024 100,000 90,431 (9,569) 2,000,000
The readers shall take note of the following:

a. Periods are split into six-month duration each, instead of the usual one-year
duration when the interest is paid annually.
b. Interest payments are half of the annual amount.
Cs Interest expense is computed as: beginning-of-the-period carrying amount x
9% x 6/12.
d. To compute for the total interest expense for one year, two rows of interest
expense are considered. For example, in 2023, total interest expense is P182,851
(P91,614 + P91,237).
Answer - Scenario 2 (Quarterly Interest Payments)

In computing the bonds’ initial fair value, the following adjustments are to be made:
Number of Periods = 8 (2 yearsx4) Periodic discount rate =_2.25% (9%/4)
Quarterly interest payment = P50,000 (P2,000,000 x 10% x 3/12)
PV Factor of ; PVFactor CashFlows Fair Value

Single payment for 8 periods at 2.25% 0.836938 P2,000,000 P1,673,876
Ordinary annuity for 8 periods at 2.25% 7.247185 50,000 362,359
The amortization table can now be made as follows:

Jan. 1, 2023 2,036,235 36,235
Mar. 31, 2023 50,000 45,815 (4,185) 2,032,050 32,050
Jun. 30,2023 50,000 45,721 (4,279) 2,027,771 27,771
Sept. 30, 2023 50,000 45,625 (4,375) 2,023,396 23,396
Dec. 31, 2023 50,000 45,526 (4,474) 2,018,922 18,922
Mar. 31, 2024 50,000 45,426 (4,574) 2,014,348 14,348
Jun. 30, 2024 50,000 45,323 (4,677) 2,009,671 9,671
Sept. 30, 2024 50,000 45,218 (4,782) 2,004,889 4,889
Dec. 31, 2024 50,000 45,111 (4,889) 2,000,000 -
_ The readers shall take note of the following:
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a. Periods are split into three-month duration each, instead of the usual one-year
duration when the interest is paid annually.
b. Interest payments are one-fourth of the annual amount.
c. Interest expense is computed as: beginning-of-the-period carrying amount
9% x 3/12.
d. To compute for the total interest expense for one year, four rows of interest
expense are considered. For example, in 2023, total interest expense is P182,687
(P45,815 + P45,721 + 45,625 + P45,526).
APPLYING EFFECTIVE INTEREST RATE METHOD ON SERIAL BONDS

Serial bonds payable may also be accounted using the effective interest rate
method. In this case, the amounts and timing of cash flows of principal and interest
shall be estimated. Amounts of interest to be paid are also decreasing due to the
decreasing amount of the bond’s principal or face amount. The present value of
these cash flows will then be determined using a series of PV factors of single
payments.
Illustration 8. On January 1, 2023, AMANDA Company issued a P4,000,000 face
amount bond with a term of four years. The P1,000,000 portion of principal is to be
paid every December 31 of each year, starting in 2023. The bond has stated rate of
10% that will be paid at the same time with principal payments. Market rates
averaged 11% on January 1, 2023.
1. First, determine the amounts and timing of cash flows:
[A] Beg. [B]Interest TotalCash Datetobe No. of
Face Amounts Inflows Received Periods
Year Amount [A]x10% [B]+P1M (Timing) from1/1/23
2023 P4,000,000 P400,000 P1,400,000 12/31/23 1 period
2024 3,000,000 300,000 1,300,000 12/31/24 2 periods
2025 2,000,000 200,000 1,200,000 12/31/25 3 periods
2026 1,000,000 100,000 1,100,000 12/31/26 4 periods
2. Next, determine the PV factors of single payment using the number of periods
determined above and 11% discount rate. After this, PV amounts can now be
Initial Fair
PV Factor of PVFactor Cash Flow Value
Single payment for 1 period at 11% 0.900901 P1,400,000 P1,261,261
Single payment for 2 periods at 11% 0,811622 1,300,000 1,055,109
Single payment for 3 periods at 11% 0.731191 1,200,000 877,429
Single payment for 4 periods at 11% 0,658731 1,100,000 724,604.
Gross proceeds P3,918,403
3. The relevant amortization table is as follows:

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Chapter 6 —- Bonds Payable and Loans Payable
Interest+ Discount
Principal Interest Amorti- Carrying on Bonds
1/1/23 3,918,403 81,597
12/31/23 1,400,000 431,024 (968,976) 2,949,427 50,573
12/31/24 1,300,000 324,437 (975,563) 1,973,864 26,136
12/31/25 1,200,000 217,125 (982,875) 990,989 9,011
12/31/26 1,100,000 109,011 (990,989) - -

a. For serial bonds, annual cash receipts include the relevant principal
installments.
b. The ending balance of premium or discount is equal to the difference
between the bond’s remaining face amount and its carrying amount.
For example, on January 1, 2023, P81,597 = P4,000,000 - 3,918,403; while on
December 31, 2023, P50,573 = P3,000,000 - P2,949,427 and so on.
c. The amount of reduction in the discount on bonds payable is equal to the

difference between the interest paid and interest expense.
For example, the P31,024 (P81,597 - P50,573) decrease during 2023 is also
equal to the difference between P431,024 interest expense and P400,000
interest paid.
4. The journal entry to be made on the date of issuance

is as follows:
Cash 3,918,403
Fast forward to December 31, 2023, the compound journal entry to record the
payment of interest and principal is as follows:

Cash 1,400,000
ISSUANCE DATE NOT ON THE INTEREST PAYMENT DATE OF THE BONDS OR

AFTER THE DATE INDICATED ON THE BONDS
An entity may issue additional bonds in between interest payment dates or after
some time of the date indicated on the bonds, In either of the cases, the issuer
receives accrued interest from the investors/lenders, but this accrued interest will
be subsequently paid back in the immediately succeeding interest payment date.
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In this case, the amount of the accrued interest is computed from the immediately
preceding interest payment date up to the issuance date. Interest payment
frequency also affects the amount of received accrued interest payable,
Nevertheless, the amount of accrued interest does not affect the initial
measurement of the related bond payable.
Illustration 9. On April 1, 2023, CERVANTES Company issued 4,000 of its P1,000

face amount bonds with maturity date of December 31, 2025 at 105.50 plus accrued
interest. The coupon rate is 10% per annum to be paid every December 31 of each
year. The bonds are originally dated January 1, 2022.
In this case, the total amount of cash received can be computed as follows:
Proceeds from face amount (P4M x 105.50%) P4,220,000

Add: Interest from 12/31/22 - 4/1/23 (P4Mx 10% x 3/12) 100,000
Total proceeds from the issuance P4,320,000
It is presumed that the immediately preceding interest payment date is December

31, 2022 since the interest is payable every December 31 of each year. The journal
entry to record the issuance is as follows:
Cash 4,320,000
Premium on bonds payable
[(105.50% - 100%) x P4M] 220,000
Fast forward to December 31, 2023, the following is the journal entry to record the
annual interest payment:
Interest expense (P4M x 10%x9/12) 300,000

Cash 400,000
It should be highlighted that the amount of interest expense recognized in 2023

covers only from April 1, 2023 (date of actual bond issuance) to December 31,
2023 (i.e.,9 months).
In addition, the premium of P220,000 shall be amortized from April 1, 2023 to

December 31, 2025 (or over 33 months or 2.75 years). Using the straight-line
method, monthly amortization of this premium amount is P6,667 (P220,000/33).
Amortization per year is as follows:
Year Amortization
2023 P60,000 (P6,667 x9 months)
2024 80,000 (P6,667 x12 months)
2025 80,000 (P6,667 x 12 months)
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Illustration 10. On October 31, 2023, BERNAL Company issued bonds with total
face amount of P5,000,000 and coupon rate of 12% at P4,900,000, excluding
accrued interest. The bonds will mature on December 31, 2026 and originally dated
on January 1, 2023. In addition, the Company also incurred bond issue costs of
P125,000. Required: Under each of the following independent scenarios, determine
the net proceeds received from the issuance:
1. The interest is payable every June 30 and December 31
2. The interest is payable every March 31, June 30, September 30 and December
31
Answer - Scenario 1
In this scenario, the immediately preceding interest payment date is on June 30,
2023. Using this information, the net proceeds can be computed as follows:
Proceeds from face amount P4,900,000

Add: Interest from 6/30/23 - 10/31/23 (P5M x 12% x 4/12) 200,000
Less: Bond issue costs (125,000)
Net proceeds from the issuance P4,975,000
Answer - Scenario 2
In this scenario, the immediately preceding interest payment date is on September
30, 2023. Net proceeds can be computed as follows:
Proceeds from face amount P4,900,000
Add: Interest from 9/30/23 - 10/31/23 (P5M x 12% x 1/12) 50,000
Less: Bond issue costs (125,000)
Net proceeds from the issuance P4,825,000
REPORTING DATE NOT FALLING ON ONE OF INTEREST PAYMENT DATES

As the readers may have observed, all of the “Dates” columns in previous
amortization tables in this chapter contains December 31 as one of interest
payment dates. These dates indicate the carrying amount of the bond payable as of
each of the indicated dates.
However, there are also cases when the amortization table does not contain
December 31 primarily because there is no scheduled interest payment on that
date. Accounting issues will arise as the December 31 carrying amounts of bonds
payable cannot be directly obtained from these amortization tables. The carrying
amounts as of December 31 of each year are important since they are used in
financial reporting purposes.
The additional accounting procedures will primarily involve “partially

amortizing’ the amounts of discount and premium amortizations:
a. Partial amortization of discount is added to carrying amount.
b. Partial amortization of premium is deducted to carrying amount.
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In addition, there will be accrued interest payable amounts (based on the bonds’
face amount or principal amount, rather than carrying amount) as of each
December 31. This can be best explained through an illustration.
Illustration 11. On October 1, 2023, BUSTAMANTE Company issued bonds with
face amount of P3,000,000 and maturity date of September 30, 2026 when the
market rates averaged 9%. These bonds bear 10% payable every September 30,
starting in 2024, Determine the carrying amounts of the bonds as of December 31,
2023 and 2024.
Answer
The bonds’ fair value as of October 1, 2023 is computed as follows:
PV Factor of PVFactor CashFlows’ Fair Value

Single payment for 3 periods at 9% 0.772183 3,000,000 P2,316,549
Ordinary annuity for 3 periods at9% —_ 2.531295 300,000 © 759,389
Total Fair Value/Gross Proceeds P3,075,938
The amortization table for subsequent measurement is as follows:

Oct. 1, 2023 3,075,938 75,938
Sept 30,2024 300,000 276,834 (23,166) 3,052,772 52,772
Sept. 30,2025 300,000 274,749 (25,251) 3,027,521 27,521
Sept 30,2026 300,000 272,479 (27,521) 3,000,000 :
The following is the computation of the bonds’ carrying amount as of December 31,
2023:
Carrying amount, 9/30/23 P3,075,938
Less: Partial amortization, 10/1/23 - 12/31/23 (P23,166 x 3/12) (5,792)
The readers should take note that when there is a partial discount amortization,
that amount shall be added to the bond’s carrying amount instead.
On the other hand, the following is the computation of the bonds’ carrying amount
_as of December 31, 2024:
Less: Partial amortization, 10/1/24 - 12/31/24 (P25,251 x 3/12) (6,313)
Because of partial amortization, the amounts of interest expense for the first three
years will also be affected as follows:
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2023 2024 2025

Interest Expense (period covered)
P276,834 (10/1/23 - 9/30/24):
P276,834x 3/12 (10/1/23- 12/31/23) P69,208
P276,834 x 9/12 (1/1/24 - 9/30/24) P207,626
P274,749 (10/1/24 - 9/30/25):
P274,749 x 3/12 (10/1/24 - 12/31/24) 68,687
P274,749 x 9/12 (1/1/25 - 9/30/25) P206,062
P272,479 (10/1/25 - 9/30/26):
P272,479 x 3/12 (10/1/25 - 12/31/25) 68,120
Total interest expense P69,208 P276,313 P274,182
Year 2023
To record the partial amortization and interest accrual on December 31, 2023:

Accrued interest payable (3 mos.) 75,000
The accrued interest payable is from October 1, 2023 to December 31, 2023
(P300,000 x 3/12).
Year 2024
To record the payment of interest on September 30, 2024:

Cash 300,000
To record the partial amortization and interest accrual on December 31, 2024:
Accrued interest payable (3 mos.) 75,000
LOANS PAYABLE
Accounting for loans payable is very similar to accounting for bonds payable, except
for the following differences:
a. The initial fair value of interest-bearing loans payable is almost always equal to
the loan’s face amount.
b. Origination fees paid to the lender will decrease the initial carrying
amount of the loan and change the effective interest rate, Its nature is analogous
to bond issue costs.
c. Origination costs incurred by the lender will NOT affect the borrower's
accounting for loan payable since these amounts were incurred by the lender.
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Illustration 12. AREVALO Company borrowed P8,000,000 from a bank on January

1, 2023. The loan bears 10% interest and will mature on December 31, 2025. In
connection with the borrowing, the Company paid P195,500 origination fees to the
lender, while the lender incurred direct origination costs of P244,600 and P60,750
indirect origination costs. Upon considering the relevant amounts, the effective
interest rate will now become 11%.
In this case, the loan payable’s initial measurement on January 1, 2023 is computed
as follows:
Face amount P8,000,000
Less: Origination fees paid to lender (195,500)
Loan payable, initial carrying amount P7,804,500
Again, the direct and indirect origination costs are not considered since these are all
incurred by the lender.
The entry to initially record the borrowing is as follows:

Cash (P8M - P195,500) 7,804,500
Discount on loans payable 195,500
Loans payable 8,000,000
The subsequent amortization table is as follows:

Date Payments Expense ation Amount Loans Payable
Jan. 1, 2023 7,804,500 195,500
Dec. 31,2023 800,000 858495 58,495 7,862,995 137,005
Dec. 31,2024 800,000 864,929 64,929 7,927,924 72,076
Dec. 31,2025 800,000 872,076 72,076 8,000,000 -
Based on the above amortization table, the reader should take note that the interest
expense amounts are based on the 11% effective interest rate.
CHAPTER SUMMARY
1. Bonds payable and loans payable are long-term sources of financing.
2. Bonds are traded in a market while loans are private contracts.
3. The bonds’ face amount is not necessarily equal to the amount of proceeds from
issuance.
4, Bond indenture is the legal contract containing the terms and conditions of a bond
issue.
5. Bonds can be classified as follows:
a. As to payment of principal - term, serial or perpetual.
b. As to security or collateral - debenture, mortgage bond, equipment trust
certificate.
c. As to seniority - senior bond or subordinated bond
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d. Other classifications - zero-coupon bond, income bond, floating-rate bond,

puttable bond, or convertible bond.
6. By default, bonds payable are accounted at amortized cost and initially measured at
fair value less transaction costs.
7. There is a discount if proceeds are less than face amount while there is a premium if
proceeds are more than face amount,
8. Using the present value approach, there is a discount if the EIR is higher than the
stated rate while there is a premium if the EIR is lower than the stated rate.
9. The amount of discount or premium can be amortized using one of the following:
a. Straight-line method - equal amounts of amortization per period; used when
the issue price is stated at quoted price.
b. Bond-outstanding method - decreasing amounts of amortization per period;
used with serial bonds and when the issue price is stated at quoted price.
c. Effective interest method - amortization is equal to the different interest
expense and interest paid; used when the present value approach is used in
determining the issue price of the bond.
10.To determine the amount of interest expense under straight-line and bond-
outstanding methods of amortization, the discount amortization is added to the
interest payment, while the premium amortization is deducted from the interest
payment.
11.Regardless of the method used in amortization, discount will result to a higher
interest expense over interest paid while premium will result to a higher interest
paid over interest expense.
12. Discount amortization will increase the bonds’ amortized cost while premium will
decrease the amortized cost.
13.If the bonds were issued not on an interest payment date, accrued interest shall be
received from the investors.
14. Net proceeds = Fair value of the bonds + accrued interest, if any - transaction costs.
15.Bonds with no interest payment date falling on December 31 shall be partially
amortized from the immediately preceding interest payment date up to December
31 of the current reporting period.
a. Partial amortization of discount is added to the bonds’ carrying amount.
b. Partial amortization of premium is deducted from the bonds’ carrying amount.
16. Similar to investments in debt securities, clean price excludes the accrued interest,
while the dirty price includes the accrued interest.
17.When initial measuring a loan payable, only the origination fees shall be considered
(as a deduction). Origination costs of the lender, whether direct or indirect, are not
considered in the borrower's point-of-view.
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True or False
, Bonds are private contracts not traded in an exchange.
2. The amount of bonds’ principal or face amount is not necessarily the amount of
proceeds that will be received from issuance.
The amount of proceeds received from bond issuance is the amount that will be
repaid to the investors on the bonds’ maturity date.
Term bonds’ principal amounts are payable on lump-sum on maturity date.
A debenture bond is a bond with collateral or security.
OV Ot
For bonds payable measured at amortized cost, initial measurement is equal to fair
value, with transaction costs expensed outright.
There is a discount if the amount of proceeds is lower than the face amount or
principal of the bond.
There is a premium if the market rate is lower than the bonds’ stated rate.
$2 —
In determining the bonds’ carrying amount or amortized cost, any unamortized

discount is added to the bonds’ face amount.
10. Straight-line method of amortizing discount or premium will result to equal
periodic amounts of amortization.
11. Bond-outstanding method of amortizing discount or premium will result to
increasing amounts of amortization.
12. The amortization of premium will result to a higher amount of interest expense
than the amount of interest paid.
13. The amortization of the discount will increase the bond’s carrying amount or
amortized cost.
14. If the bond’s interest payment date is not on the entity's reporting date, partial
amortization shall be made from immediately preceding interest payment date
until the reporting date.
15. Origination costs incurred by the lender are not included in the measurement of the
loan payable in the borrower’s books.

1. Bonds have the following characteristics, except
a. traded in an exchange market
b. interest is privately agreed with the investors
c. public contract
2. Characteristics of loans include the following, except

a. issued by not so known entities
b. lenders include a bank or group of banks
c. private contract
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3. The following are correct descriptions of different classifications of bonds, except

a. Aserial bond’s principal amount is a balloon payment on maturity date.
b. Adebenture bond has no security or collateral.
c. Anincome bond will pay interest only when the issuer has available earnings.
d. Aputtable bond allows the bondholders to claim payment from the issuer even
before the maturity date.
4. Bonds shall be initially measured at
a. fair value less transaction costs (bond issue costs), by default
b. fair value, with transaction costs expensed outright, if the bonds are measured
at FVTPL.
c. bothaandb
d. neitheranorb
5. When using the income approach or the present value of approach of determining
the bond’s fair value, which of the following correctly describes the fair value
consequence of the relationship between the market rate on issuance date and the
stated rate?
a. Nosuch relationship exists between the market rate and stated rate.
b. The fair value of the bond is always lower than its principal or face amount
whenever the market rate is different from the stated rate.
c. Ifthe market rate is higher than the stated rate, then the fair value is higher than
the face amount; if the market rate is lower than stated rate, then the fair value
is lower than the face amount.
d. Ifthe market rate is higher than the stated rate, then the fair value is lower than
the face amount; if the market rate is lower than stated rate, then the fair value
is higher than the face amount.
6. The following statements are true regarding the recording of bond issuance that will
be accounted at amortized cost, except
a. Transaction costs are expensed outright.
b. The bond payable account is always credited equal to the bond’s face amount.
c. The discount on bonds payable account is debited whenever the amount of
proceeds is lower than the face amount.
d. The premium of bonds payable account is credited whenever the amount of
proceeds is higher than the face amount.
7. Inthe absence of transaction costs, effective interest rate is equal to

a. market rate on issuance date and will change depending on the market rates as
of each subsequent reporting dates,
b. market rate on issuance date and will not change, regardless of the market rates
as of each subsequent reporting dates.
c. stated rate and will change depending on the market rates as of each subsequent
reporting dates,
d. stated rate and will not change, regardless of the market rates as of each
subsequent reporting dates,
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8. Which of the following correctly describes the differences between the straight-line
method of amortization and the bond-outstanding method of amortization?
a. Under straight-line method, there is an equal periodic amortization, while under
bond-outstanding method, there is a decreasing amount of periodic
amortization.
Under straight-line method, there is an equal periodic amortization, while under
bond-outstanding method, there is an increasing amount of periodic
amortization.
Under straight-line method, there is an increasing periodic amortization, while
under bond-outstanding method, there is a decreasing amount of periodic
amortization.
Under straight-line method, there is a decreasing periodic amortization, while
under bond-outstanding method, there is an increasing amount of periodic
amortization.
9. When using the effective interest method in amortizing the premium or discount,
the following accounting procedures are correct, except
a. Interest expense is equal to the beginning-of-the-period carrying amount times
the effective interest rate.
b. The amount of amortization is equal to the difference between the computed
interest expense and the amount of interest paid.
c. The carrying amount or amortized cost of the bond is based on the amortization
table.
d. The amount of interest to be paid is equal to the face amount multiplied with the
effective interest rate.
10.In determining the amount of interest expense and interest paid from bonds
payable, which of the following is not correct?
a. Amortization of premium will result to higher interest paid compared to interest
expense.
b. Amortization of discount will result to higher interest expense compared to
interest paid.
c. Both a and b
d. Neither a nor b
11. Which of the following is true regarding the carrying amount or amortized cost of a
serial bonds payable accounted at amortized cost?
a. Initial carrying amount is equal to its fair value as of reporting date
b. Carrying amount is increasing every reporting date
c. Carrying amount is not changing if the initial measurement is equal to its face
amount.
12. Ifa bond was issued not on interest payment date, which of the following statements
is/are correct?
a. Additional amounts will be received in the form of accrued interest payable,
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pter 6 - Bonds Payable and Loans Payable
cha
accrued interest payable is computed from the issue date until the immediately
succeeding interest payment date,
Botha and b
d. Neither a nor b
023, an entity issued its bonds with December 31 interest payment date.
43,0n April 1, 2 the proceeds from issuance shall include
In this case,
a, 12-month accrued interest
», 9-month accrued interest
C 6-month accrued interest
d. 3-month accrued interest
ponding to December 31,
14.1fa bond does not have an interest payment date corres
then
carrying amounts from the amortization table will be used without
a. the
adjustments.
tially amortized
b, the carrying amounts from the amortization table shall be par
ding interest payment date.
from the reporting date until the immediately succee
ll be partially amortized
the carrying amounts from the amortization table sha
e il the reporting date.
from the immediately preceding interest payment dat unt
ll be partially amortized
d. the carrying amounts from the amortization table sha
the current reporting date.
from the immediately preceding reporting date until
in the measurement of loan
15.Which of the following amounts shall be i ncluded
payable?
a. origination fees paid to lender
b. direct origination costs incurred by the lender
Fi indirect origination costs incurred by the lender
all of the above
Straight Problems
CONDOR Company issued a bond originally dated on
1. At the beginning of 2023,
is 97. The bond has face amount of
January 1, 2020 when the bond’s quoted price
2026. Interest of 8% is payable every
P6,000,000 and maturity date of December 31,
ight-line method of amortizing
December 31 of each year, The Company uses the stra
the premium or discount from its bonds payable.
be made for the
Required: From this information, determine the journal entries to
years 2023 and 2024.
4,000 of its P1,000 face amount bonds

On January 1, 2023, EAGLE Company issued on December 31, 2027.
, These bonds will mature
105
a bonds’ quoted price of 31 of each year. The Company use
s the
eve ry De ce mb er
fii est of 10% is payable g the premium or discount from its
bonds payable.
ght -li ne met hod of amo rti zin
Reais for the
this inf orm ati on, determ ine the journal entries to be made
andm 2024,
a'se2023 Fro
ee ,
167
a.
The
3. On July 1, 2023, OSPREY Company issued bonds with total face amount of
P5,000,000 and original date of January 1, 2022 at their quoted price of 94.60,
Maturity date is set on December 31, 2027. Interest of 7% is payable every December
31 of each year. The Company uses the straight-line method of amortizing the
premium or discount from its bonds payable.
Required: From this information, determine the journal entries to be made for the
4. On January 1, 2023, HAWK Company issued five-year, 10% interest-bearing bonds

with P10,000,000 face amount. The bonds were issued at their quoted price of 109.
The bonds’ principal amount is payable in five equal annual installments of
P2,000,000 every December 31 of each year. Interest is payable at the same dates as
the principal installments. The Company uses the bond-outstanding method of
amortizing the premium or discount from its bonds payable.
S. Atthe beginning of the year 2023, OSPREY Company issued a 7,000 ofits P1, 000 face
amount bonds at their quoted price of 90. These bonds have maturity date of
December 31, 2029 and has interest of 9% that is payable every December 31 of
each year. In addition, the bonds’ face amount is payable in seven annual
installments of P1,000,000 every December 31 of each year, starting on December
31, 2023. The Company uses the bond-outstanding method of amortizing the
premium or discount from its bonds payable.
6. On January 1, 2023, BAZA Company issued bonds with total face amount of
P8,000,000 and original date of January 1, 2021 when market rates average 12%.
The bonds have maturity date of December 31, 2028 and interest of 10% that is
payable every December 31 of each year.
7. At the beginning of the year 2023, SWAN Company issued five-year, 9% interest-
bearing bonds with face amount of P9,000,000 when market yields averaged 7%.
Interest is payable every December 31 of each year,
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8. On January 1, 2023, GOOSE Company issued 3,000 bonds with P1,000 face amount
each when the bonds’ quoted price amounted to 94. In addition, bond-issue costs of
P100,000 were also incurred. Interest of 6% is payable every December 31 of each
year until December 31, 2026, the maturity date of the bonds. The Company uses the
straight-line method in amortizing discount and premiums.
9. DUCK Company issued bonds with total face amount of P5,000,000 when the
prevailing market rates averaged 7% on January 1, 2023. These bonds have maturity
date of December 31, 2028 and have 10% interest that is payable every December
31 of each year. In addition, the Company also incurred bond-issue costs amounting
to P252,690, which when considered, will change the effective interest rate to 8%.
10.On January 1, 2023, HUMMINGBIRD Company issued a four-year, 9% interest-

bearing bonds with total of P4,000,000 face amount when the prevailing market
rates averaged 11%.
1. The 9% interest is payable semi-annual every June 30 and December 31.
2. The 9% interest is payable quarterly every March 31, June 30, September 30 and
December 31.
11.At the beginning of the year 2023, KIWI Company issued 8,000 of its P1,000 face
amount bonds when market yields averaged 10%. These bonds have maturity date
of December 31, 2030 and interest of 12% that is payable every December 31 of each
year. In addition, the bonds’ face amount is payable in annual equal installments of
P1,000,000 every December 31 of each year, starting on December 31, 2023.
12.0n April 1, 2023, DODO Company issued six-year, 7% interest-bearing bonds with
face amount of P7,000,000 when market yields averaged 9%. Interest is payable
every December 31 of each year.
Required: From this information, determine the following:
a. Journal entries to be made for the years 2023 and 2024
b. Carrying amounts of the bond payable as of December 31, 2023 and 2024
13.On January 1, 2023, NIGHTJAR Company borrowed a P6,000,000 loan from a bank
with 8% interest and maturity date of December 31, 2026, In addition, origination
fees paid to the bank amounted to P194,384. Direct origination costs incurred by the
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bank amounted to P156,294. Upon considering the relevant fees and costs, the loan’s
effective interest rate is now 9%.
b. Carrying amounts of the loan payable as of December 31, 2023 and 2024
14.On January 1, 2023, ROBIN Company borrowed P10,000,000 from a bank. The loan
is payable in five equal annual installments of P2,000,000 every December 31 of each
year, starting in 2023. Interest of 10% is payable at the same dates as the principal
installment amounts. Origination fees paid amounted to P465,075, while direct
origination costs incurred by the lender amounted to P734,172. After considering
the relevant amounts, the loan has an effective interest rate of 12%.

b. Carrying amounts of the loan payable as of December 31, 2023 and 2024
Multiple Choice
1. On January 1, 2023, FROGMOUTH Company issued a six-year, 9% interest-bearing
bond payable with total face amount of P8,000,000 when market rates averaged 7%.
Interest is payable every December 31 of each year.
Interest expense for the year 2023 shall be

a. P720,000 c. P605,922
b. P613,385 d. P602,397
Carrying amount of the bonds as of December 31, 2024 shall be

a P8,578,312 c. P8,541,952
b, P5/723,575 d. P8,656,030
2. NIGHTINGALE Company issued 2,000 of its P3,000 face amount bonds when market
rates averaged 10% on January 1, 2023. The bonds bear interest of 8%, payable
every December 31 of each year until December 31, 2029, its maturity date.
a. P480,000 c. P547,737
b. P541,579 d, P554,511
a. P5,545,105 c. P5,701,578
b. P5,619,616 d, P5,791,736
3. On October 1, 2023, HERON Company issued bonds with total face amount of
P4,000,000. These bonds have maturity date of September 30, 2029 and interest of
12% that is payable every September 30 of each year, Market rates on the date of
issuance averaged 10%.
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a. P433,713 c. P434,842
b. P431,455 d. P430,326
a. P4,183,922 c. P4,198,948
b. P4,239,929 d. P4,253,589
4. At the beginning of the year 2023, VULTURE Company issued bonds with total face
amount of P9,000,000 when market rates averaged 8%. The bonds are payable in
six equal annual installments starting on December 31, 2023. In addition, interest of
6% is payable on the same dates as the principal installment payments.
a. P459,364 ; c. P569,781
b. P347,313 d. P450,000

a. P5,742,047 c. P1,472,222
b. P4,341,411 d. P2,918,724
5. On July 1,2023, MAYA Company issued four-year, 10% interest-bearing bonds with
total face amount of P10,000,000. The bonds are payable in four equal annual
installments every June 30, starting on June 30, 2024. In addition, interest is also
payable every June 30 of each year. Market rates on the date of issuance averaged
9%.
a. P686,717 c. P1,000,000
b. P802,862 d. P919,007
a. P5,066,911 c. P5,044,922
b. P2,522,933 d. P3,794,922
6. On October 1, 2023, NAZCA Company issued bonds with total face amount of
P5,000,000 and maturity date of December 31, 2027 at the bonds’ quoted dirty price
of 97.72, Interest of 10% is payable every December 31 of each year. The bonds were
originally dated January 1, 2022. Lastly, the Company incurred bond issue costs of
P38,000. The Company uses the straight-line method of amortizing discount or
premium from its bonds payable.
Net amount received from the bond issuance amounted to
a. P5,223,000 c, P5,261,000
b. P4,848,000 d, P4,473,000
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Interest expense during the year 2023 shall be

a. P125,000 c. P148,000
b.. P132,000 d. P156,000
Carrying amount of the bonds payable as of December 31, 2024 shall be

a. P4,484,000 c. P4,628,000
b. P4,556,000 d. P4,752,000
7. On September 1, 2023, BLUEGRASS Company borrowed funds from the genera]

public by issuing 4,000 of its P1,000 face amount bonds at their quoted clean price
of 93.60. In addition, bond issue costs incurred amounted to P108,000. Interest of
12% is payable every June 30 and December 31 of each year until December 31,
2028, the bonds’ maturity date.
Net amount received from the bond issuance amounted to
a. P3,716,000 c. P3,956,000
b. P3,636,000 d. P3,984,000

a. P411,750 c. P432,000
b. P548,250 d. P528,000

a. P3,987,000 c. P3,727,000
b. P3,682,250 d. P3,658,750
8. On April 1, 2023, AKRON Company borrowed a 7% interest-bearing loan with

P6,000,000 face amount. The loan’s maturity date is set on March 31, 2028.
Origination fees paid to the lender amounted to P239,564, while direct origination
costs incurred by the lender amounted to P126,397. After considering the relevant
amounts, the effective interest rate will now become 8%.

a. P460,835 c. P464,102
b. P463,285 d. P466,630
a. P5,845,373 c. P5,857,281
b. P5,893,003 d, P5,881,096
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Chapter 7 — Compound Financial Instruments
CHAPTER 7
COMPOUND FINANCIAL INSTRUMENTS

1. The components of compound financial instruments.
2. The initial allocation of proceeds, including the allocation of transaction costs.
3. The subsequent accounting for the components of compound financial
instruments.
4. The accounting for early retirement.
COMPOUND FINANCIAL INSTRUMENTS

When an entity issues its debt securities (e.g., bonds payable), it may add terms that
may enhance the attractiveness of the issuance (i.e., “sweeteners”). The following
are the most common sweeteners issued together with debt securities:
a. Share warrants - these warrants allow the holder to acquire a certain number
of common or preference shares at a certain price (i.e., exercise price) that might
be lower than the prevailing market price. The shares shall belong to the entity
who issued the debt securities.
b. Convertibility option - the debt securities can be converted, at the option of
the holder or the investor, to a fixed number of common shares belonging to the
entity who issued the debt securities.
ACCOUNTING FOR COMPOUND FINANCIAL INSTRUMENTS

In substance, when an entity issues debt securities with share warrants or
convertibility option, the issuance is actually comprised of the following
components (hence, the name “compound financial instruments”):
a. liability component - corresponding to the debt securities only (i.e., excluding
the “sweeteners”); and
b. equity component - corresponding to the share warrants or convertibility
option (i.e., the “sweeteners”).
It should be reiterated that the share warrants or convertible option shall cover the
equity securities of the entity issuing the debt securities. Otherwise, the
succeeding discussions are not applicable. The standard covering the accounting of
compound financial instruments is PAS 32, Financial Instruments: Presentation.
ALLOCATION OF ISSUANCE PROCEEDS

Since the issuance is, in substance, for the liability and equity components, the
proceeds shall be allocated in the following manner (“split accounting”):
a. first, allocate at an amount equal to the fair value of the liability component.
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b. next, any excess of issuance proceeds over the amount allocated to liability
component shall be allocated to the equity component.
Graphically, this allocation of the proceeds can be presented as follows:
PROCEEDS FROM ISSUANCE
Liability Component Equity Component

Amount allocated is equal to the fair Amount allocated is equal to proceeds
value of the comparable liabilities less amount allocated to liability
without the share warrants or component (i.e., residual amount)
convertibility option.
The allocation procedures above are consistent with the relationship of liabilities
and equity during liquidation, wherein the liability holders will be the first to
receive cash. It is only when all the liabilities have been paid that the equity
holders will receive cash ‘(i.e., residual interest). This allocation shall not be
subsequently revised in cases. where there are changes in the probability of
exercising the share warrants or the convertibility option.
As to the liability component, the difference between the amount allocated to it

(i.e., its fair value) and the related face amount shall be accounted as follows:
Allocated amount > Face amount | Premium on bonds payable

Allocated amount < Face amount | Discount on bonds payable
Pro-forma journal entry to record the allocation is as follows:
Cash (equal to amount of proceeds) XX

Discount on bonds payable (if any) XX
Bonds payable XX
Premium on bonds payable (if any) XX
Share premium - share warrants
or convertibility option (equity
component) XX
Each component will subsequently be accounted for separately from each other.
Depending on the classification of the liability, it can be accounted for either at
amortized cost (by default) or at fair value through profit or loss (if irrevocably
designated as such on initial recognition).
On the other hand, the carrying amount of the equity component will not change,
except during the early retirement of the related bond payable. This equity
component has a normal credit balance.
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Illustration 1. GARCIA Company issued bonds payable with total face amount of
P5,000,000 for 110. The bonds came with share warrants to acquire a total of
50,000 ordinary shares of the Company at P20/share. Comparable vanilla bonds
without share warrants have fair value of 105 while the warrants have a total
P350,000 fair value. Required: Determine the allocation of the proceeds
Answer: The issue price amounted to P5,500,000 (P5,000,000 x 110%) and should
be allocated in the following manner:
Total issue price P5,500,000
Less: Liability component (P5,000,000 x 105%) (5,250,000)
Equity component (residual amount) 250,000
These allocated amounts shall be recorded as follows:
Cash 5,500,000
Premium on bonds payable
(P5,250,000 - P5,000,000) 250,000
Share premium - share warrants 250,000
ALLOCATION OF BOND ISSUE COSTS

Transaction costs related to the issuance of the compound financial instrument
include the following:
a. registration fees
b. bond certificate printing costs
c. underwriting fees
d. accounting, legal and other professional fees
These bond issue costs are allocated to the liability and equity components using
the proportion of the initial allocation of issue price, using the following
formulas:
AllocationtoLiab. _ Bondissue Proceeds allocated to liability component
Component us costs $ Total amount of proceeds
Allocation to _ Bond issue Proceeds allocated to equity component

EquityComponent _ costs Total amount of proceeds
These allocated bond issue costs shall reduce the carrying amounts of the liability
and equity components,
Illustration 2, RAMOS Company issued a four-year, 10% interest-bearing bonds

payable with aggregate face amount of P3,000,000. These bonds were issued at a
total price of 99. Included in the issuance of the bonds is the option to convert them
into 100,000 of the Company’s ordinary shares. Similar bonds without the
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Chapter 7 —- Compound Financial Instruments
convertibility option have market rates averaging 12%. In addition, bond issue
costs incurred totaled P90,079. Required: Determine the allocation of bond issue
costs to the liability and equity components.
Answer:
1. First, allocate the issue price of P2,970,000 (P3,000,000x 99%):
Less: Liability component (fair value computed below) _ (2,817,759)
Equity component (residual amount) P152,241
The fair value of the liability component is computed as follows:

PV Factor of PVFactor Cash Flow Total PV
Ordinary annuity for 4 periods at12% 3.037349 300,000 ‘911,205
FV, liability component P2,817,759
2. Next, allocate the P90,079 bond issue costs as follows:
Allocation to Liability _ P2,817,759

Component = ROOT. ox P2,970,000 — naa 462
Allocationto Equity _ P152,241 |

Component 2. PROT: P2,970,000 — maa
3. The issuance of the bonds shall be recorded as follows:
Cash 2,970,000
Share premium - conv. option 152,241
The discount on bonds payable is equal to P3,000,000 face amount less

P2,817,759 proceeds allocated to the liability component.
On the other hand, the allocation of bond issue costs shall be recorded as follows:

Share premium - conversion 4,617
Cash 90,079
Similar to the accounting made in the previous chapter, the bond issue costs will
either increase the discount on bonds payable or decrease the premium on bonds
payable. In both cases, bond issue costs will decrease the bond's initial carrving
amount.
4. After summarizing these entries, the following are the initial carrying amounts
of the liability component and the equity component:
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Bonds payable P3,000,000

Less: Discount (P182,241 + P85,462) (267,703)
Bonds payable, net P2,732,297
Share premium - conv. option (P152,241 - P4,617) P147,624
By default, the bonds payable shall be measured at amortized cost using an

effective interest rate of 13% (i.e., not the 12% market rate) due to the allocated
bond issue costs.
ACTUAL EXERCISE OF SHARE WARRANTS OR CONVERTIBILITY OPTION

Accounting for the exercise of the share warrants is different from the accounting
for the exercise of the convertibility option. The difference lies primarily with the
computation of total issue price in exchange for issuer’s equity instruments.
The total issue price of equity instruments that were issued due to the exercise of
the share warrants is computed as follows:
Cash received from exercise price of share warrants _ Pxx
Add: Full or proportional amount of share premium - share warrant —_Xx
Issue price of equity instruments Pxx
Less: Total par value of issued shares (xx)
Share premium - issuance : “Pxx|
The related journal entry to record the exercise of share warrants is:
Cash (share warrant exercise price) XX
Share premium - share warrants XX
Share capital XX
Share premium ~ issuance (squeeze) XX
The total issue price of equity instruments that were issued because of the exercise
the of convertibility option is computed as follows:
Updated carrying amount of bonds (full or partial) Pxx
Add: Full or proportional amount of share premium - convertibility xx
Less: Total par value of issued shares (xx)
Share premium — issuance “PXx |
The related journal entry to record conversion of bonds to equity instruments:

Bonds payable, net XX
Share premium - convertibility XX
Share capital XX
Share premium - issuance (squeeze) XX
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Despite the differences between share warrants and convertibility option, the
following similarities are noted:
a. Nogainor loss is recognized from the exercise of share warrants or convertibility
option.
b. Share premium - issuance is the excess of the total issue price over the total par
value of the issued shares.
c. The corresponding carrying amount of the equity component is included in the
issue price of equity instruments. Only a portion of the carrying amount will be
included if there is onlya partial exercise of the share warrants or convertibility
option.
As to their differences, cash is debited if the share warrants were exercised since
the issuing entity will receive cash. Carrying amount of the liability is not relevant in
this case.
On the other hand, the carrying amount of liability is debited when exercising the
convertibility option since the bond payable will now become part of the equity.
Illustration 3 - Share Warrants. On January 1, 2023, REYES Company issued a
five-year, 9% interest-bearing bonds payable with aggregate face amount of
P4,000,000. Together with the bonds, the Company also issued 40,000 share
warrants. Each warrant can be exercised in order to acquire one of the Company’s
P20 par value ordinary shares at P50/share. Total issue price amounted to
P4,300,000 while the fair value of the bonds without the warrants amounted to
P3,900,000. Required: Under each of the following independent scenarios,
determine the journal entry to record the exercise of share warrants:
1. All of the warrants were exercised
2. Only 30,000 share warrants were exercised
Allocation of Bond Issue Price
Before answering the scenarios, it is Hapertantt to first allocate the proceeds to the
liability and equity components:

Less: Liability component (equal to its fair value) (3,900,000)
Answer - Scenario 1
The computations of the issue price of the equity instruments and the amount of
share premium - issuance are the following:
Cash received (40,000 x P50) P2,000,000
Add: Full amount of share premium - share warrant 400,000
Issue price of equity instruments P2,400,000
Less: Total par value of shares issued (40,000 x P20) 800,000
Share premium - issuance P1,600,000
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The
To record the exercise of all of the share warrants:

Cash 2,000,000
Share capital 800,000
Share premium - issuance 1,600,000
Answer - Scenario 2
share premium - issuance are the following:
Cash received (30,000 x P50) P1,500,000
Add: Partial amount of share premium - share warrant
(P400,000x 30,000/40,000) 300,000
Less: Total par value (30,000 x P20) 600,000
To record the exercise of 30,000 of the share warrants:

Cash 1,500,000
Share capital 600,000
Generalizations - Scenarios 1 and 2

The readers should take note that under both scenarios, the net increase in the
shareholders’ equity is equal to the amount of cash received from the exercise
of share warrants. The carrying amount of the bonds is not relevant.
Illustration 4 - Convertible Bonds. At the beginning of 2023, MENDOZA Company
issued 5,000 convertible bonds with P1,000 face amount per bond and term of five
years. These bonds bear interest of 9% that is payable every December 31 of each
year and each of is convertible to 10, P80 par value ordinary shares of the Company.
Issue price is P5,050,000 while the market rates for similar bonds without the
conversion option averaged 11%. Required: Under each of the following
independent scenarios, determine the journal entry to record the conversion of
bonds payable:
1. All of the bonds were converted to ordinary shares on December 31, 2024.
2. 4,000 bonds were converted to ordinary shares on December 31, 2025.
Allocation of Bond Issue Price
Again, before answering the scenarios, it is important to first allocate the proceeds
to the liability and equity components:
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PV Factor of PVFactor CashFlow Total PV

Single payment for 5 periods at 11% 0.593451 5,000,000 P2,967,255
Ordinary annuity for 5 periods at 11% 3.695897 450,000 1,663,154
FV, Liability component P4,630,409
Computation of Carrying Amount of the Bonds Payable
Since the carrying amount of the bonds is relevant in recording the exercise of the
conversion option, the following partial amortization table shall be used:
Interest Carrying Discount
Interest Expense Amorti- Amount/ on Bonds
Date Paid Portion zation Present Value Payable
Jan. 1, 2023 4,630,409 369,591
Dec. 31,2023 450,000 509,345 59,345 4,689,754 310,246
Dec. 31,2024 450,000 515,873 65,873 4,755,627 244,373
Dec. 31,2025 450,000 523,119 73,119 4,828,746 171,254
These carrying amounts will be the basis of each of the foregoing scenarios.
Answer - Scenario 1 - All bonds were converted on December 31, 2024
share premium — issuance are as follows:
Carrying amount of bonds payable, 12/31/24 P4,755,627
Add: Full amount of share premium - convertibility 419,591
Less: Total par value (5,000 bonds x 10 shares x P80) 4,000,000
To record the conversion of all of the bonds payable to ordinary shares:
Bonds payable (5,000 x P1,000) 5,000,000
Share premium - convertibility 419,591
Share capital 4,000,000
Answer - Scenario 2 - 4,000 bonds were converted on December 31, 2025
share premium - issuance are as follows:
Partial carrying amount of bonds payable, 12/31/25
(P4,828,746 x 4,000/5,000) P3,862,997
Add: Partial amount of share premium - convertibility
(P419,591 x 4,000/5,000) 335,673
Less: Total par value (4,000 bonds x 10 shares x P80) 3,200,000
. Share premium - issuance P998,670
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To record the partial conversion of the bonds payable to ordinary shares:

Bonds payable (4,000 x P1,000) 4,000,000
Discount on bonds payable
(P171,254 x 4,000/5,000) 137,003
Share premium - issuance 998,670

Based on the two scenarios, the net increase in the shareholders’ equity is equal
to the carrying amount of the bonds payable converted.
RETIREMENT OF THE BONDS

The issuer of the bonds with share warrants or convertibility option may decide to
retire all or a portion of the bonds before the maturity date by paying the holders a
certain amount.
Consistent with the initial recognition, the retirement amount to be paid to holders
shall also be allocated to the liability and equity components in the following manner:
a. first, allocate to the liability component using its fair value, without the
share warrants or convertibility option, on the date of payment.
b. any excess of the amount to be paid to holders over the amount allocated to
liability component will be allocated to the equity component.
The readers should take note that this is similar to the allocation procedures
involving the allocation of the issue price of the bonds on the initial recognition.
The retirement of the bonds with share warrants or convertibility option has the
following accounting consequences:
a. The difference between the carrying amount of the liability component and the
allocated retirement amount is recognized as gain or loss in profit or loss:
Scenario | Consequences
CA of liability component > allocated retirement price Gain on retirement
CA of liability component < allocated retirement price Loss on retirement
b. The difference between the carrying amount of the equity component and the
allocated retirement amount is recognized directly in equity.
Illustration 5. On January 1, 2023, SANTOS Company issued four-year, 8%
interest-bearing bonds with aggregate par value of P4,000,000 at a total price of
P4,150,000. The bonds are convertible to 100,000 ordinary shares with P30 par
value. Without the conversion option, the bonds can be issued at 10% market yield.
On December 31, 2024, the Company decided to retire the bonds by paying the
bondholders a total amount of P4,050,000. As of the same date, similar bonds
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without conversion option have a 9% market yield. Required: Based on the given
information, determine the journal entry to record the retirement of the bonds.
Answer:
1. First, allocate the issue price of P4,150,000 on January 1, 2023:
The fair value of the liability component is computed as:
PV Factor of PV Factor Cash Flow Total PV
FV, Liability component P3,746,409
2. Next, compute for the carrying amount of the liability as of December 31, 2024
using the following amortization table:
Interest Interest ‘Amorti Carrying Discount on
Date Paid Expense -zation Amount Bonds Payable
Jan. 1, 2023 3,746,409 253,591
Dec. 31,2023 320,000 374,641 54,641 3801,050 198,950
Dec. 31,2024 320,000 - 380,105 60,105 3,861,155 138,845
3. Next, allocate the retirement price of P4,050,000 as follows:
Total retirement price P4,050,000
The fair value of the bond payable as of December 31, 2024 was computed as:
PV Factor of PVFactor CashFlow Total PV
Single payment for 2 periods at 9% 0.841680 P4,000,000 3,366,720
Ordinary annuity for 2 periodsat9% 1.759111 320,000 562,916
FV, Liability Component 3,929,636
Two (2) periods were used since, as of December 31, 2024, there were only two
periods left before the bonds’ maturity date of December 31, 2026. In addition,
market yield of 9% was used to determine the fair value on December 31, 2024.
4. Theallocated retirement price to each componentis compared with the relevant

carrying amounts to determine the amount of gain or loss on retirement:
Carrying amount of bonds payable, 12/31/24 P3,861,155
Less: Retirement price allocated to bonds payable (3,929,636)
Loss on retirement to be recognized in profit or loss P68,481
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The amount allocated to equity component (i.e, P120,364) will simply be

deducted (i.e., debited) from the balance of share premium - convertibility
account (i.e., not recognized in profit or loss, nor in other comprehensive income).
The entry to record the retirement on December 31, 2024 is as follows:
Loss on retirement - P/L 68,481
Cash (equal to retirement price) 4,050,000
NON-EXERCISE OF THE SHARE WARRANTS OR CONVERTIBILITY OPTION

In case some orall of the share warrants or convertibility option were not exercised
before they lapse, an entity may directly transfer the balance in the share premium
— warrants or share premium - convertibility option to other equity accounts (e.g.,
share premium - others). Pro-forma journal to record the direct transfer is as
follows:
Share premium - convertibility XX
Share premium - others XX
Share premium - share warrants XX

Share premium - others xXx
In all cases, this direct transfer has no effect to the amount of the issuer’s total
equity, and no amounts shall be recognized in profit or loss.
Illustration 6. Continuing with SANTOS Company (Illustration 5). Since the related
convertible bonds were already retired, the remaining carrying amount of share
premium —- convertibility of P283,227 (P403,591 - P120,364) shall be directly
transferred to other equity account as follows:

Share premium - others 283,227
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CHAPTER SUMMARY
i A compound financial instrument includes both liability and equity components.
Zi The proceeds from the issuance of compound financial instrument shall be allocated
in the following manner:
a. first, equal to the fair value of the liability component
b. any excess of proceeds from the fair value of the liability component shall be
allocated to the equity component
Subsequent to the initial recognition, each component is accounted for separately.
al ad
In case the share warrants are exercised, the total issue price of the shares is
Cash received from exercise price of share warrants Pxx
Add: Full or proportional amount of share premium - share warrant XX
In case the convertibility option is exercised, the total issue price of the shares is
Updated carrying amount of bonds (full or partial) Pxx
Add: Full or proportional amount of share premium - convertibility XX
Any excess of the issue price over the total par value of the issued shares shall be
credited to share premium - issuance. No gain or loss shall be recognized.
When the share warrants are exercised, the amount of net increase in equity is equal
to the amount of cash received.
When the convertibility option is exercised, the amount of net increase in equity is
equal to the carrying amount of the converted bonds on the date of conversion.
In case the bonds were retired before maturity date, the retirement price shall be
allocated in the same manner as the allocation of the proceeds in (2) above. The
following are the relevant accounting procedures:
a. The difference between the carrying amount of the liability component and the
allocated retirement amount is recognized in gain or loss in profit or loss:
b. The difference between the carrying amount of the equity component and the
allocated retirement amount is recognized directly in equity.
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True or False
1. Compound financial instruments include liability and asset components.
2. Proceeds from the issuance of compound financial instruments shall be allocated
based on the relative fair values of the components.
3. The equity securities to be issued when the holders exercise share warrants or
exercise the convertibility option shall belong to the entity who issued the bonds
payable.
4. To be considered as a compound financial instrument, the option to convert the
bonds shall belong to the bondholders.
5. Total issue price of shares issued for the exercise of share warrants is equal to the
cash received from the holders of such warrants.
6. The amount of net increase in shareholders’ equity from the exercise of share
warrants is equal to the amount of cash received.
7. Total issue price of shares issued for the exercise of the convertibility option is
equal to the full or partial updated carrying amount of the bonds plus the full or
partial carrying amount of share premium - convertibility option.
8. The amount of net increase in shareholders’ equity from the exercise of
convertibility option is equal to the updated carrying amount of the bonds plus the
carrying amount of share premium - convertibility option.
9. Again or loss on conversion shall be recognized if the total par value of the shares
issued is different from their corresponding total fair value.
10. Incase of early retirement, the difference between the retirement price allocated to
the liability component is recognized as gain or loss in profit or loss.
i, Examples of compound financial instruments include which of the following?
a. Bondsissued with attached share warrants
b. Bonds issued that may be converted to other liabilities of the issuer at the
holders’ option.
c. Bothaandb
d. Neitheranorb
The proceeds received from the issuance of compound financial instruments shall
be
allocated based on the relative fair values of the components.
allocated equally to the components.
aaop
allocated solely to the component with a higher fair value.

allocated first to liability component based on its fair value, then the excess
proceeds shall be attributed to the equity component.
Bond issue cost include the following, except
registration fees for the debt security
bond certificate printing costs
a
c. underwriting fees
none of the above
2
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4. Bond issue costs shall be

a. allocated equally to liability and equity components.
b. allocated to liability and equity components in the same proportion as the
allocation of the gross proceeds.
c. allocated to liability and equity components based on their relative fair values,
d. allocated solely to the liability component since these costs relate primarily on
the issue of financial liabilities.
5. Holders of share warrants of a compound financial instruments exercised their
rights contained in those warrants. In this case, which of the following is correct?
a. Included in the issue price is the updated carrying amount of the related
financial liability.
b. The carrying amount of the equity component shall be excluded from the issue
price.
c. The amount of net increase in the shareholders’ equity is equal to the cash
received from the holders.
d. Loss shall be recognized if the total amount received is lower than the prevailing
fair value of the shares.
6. Incase the bondholders exercised the convertibility option, the following statements
are correct, except
a. Share premium - issuance is the excess of the total issue price over the total par
value of the shares issued.
b. Gain or loss shall be recognized as the difference between the total issue price
and the fair value of the shares issued.
c. The total amount ofissue price includes the full or aliquot portion of the updated
carrying amount of the converted liability plus the full or aliquot portion of the
share premium - convertibility option.
d. Noamount of cash will be received upon the actual conversion of the bonds.
7. The share premium - issuance is equal to
a. excess of cash received from the exercise of share warrants over the total par
value of the shares issued.
b. excess of the updated carrying amount of the converted bonds over the total
part value of the shares issued.
c. bothaand bare correct
d. bothaand bare incorrect
8. In cases the bonds payable were retired before maturity date, the early retirement
price paid to the bondholders shall be
a. attributed solely to the liability component.
b. attributed solely to the equity component.
c. allocated to liability and equity components based on their relative fair values.
d. allocated first to the fair value of the liability component as of the date of
retirement, with the excess retirement price allocated to the equity component.
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9. The difference between the updated carrying amount of the liability component and
the proceeds allocated to it shall be recognized
a. inprofitorloss
b. in other comprehensive income
c. asdirect adjustment to retained earnings
d. as direct adjustment to total equity
10. The difference between the updated carrying amount of the equity component and
the proceeds allocated to it shall be recognized
in profit or loss
ao op
in other comprehensive income

as direct adjustment to retained earnings
as direct adjustment to total equity
Straight Problems
1. On January 1, 2023, OWL Company issued a five-year, 10% interest-bearing bonds
with face amount of P6,000,000 at 102 quoted price. Attached to the bonds are share
warrants for the purchase of 80,000 common shares of the Company at an exercise
price of P50 per share. Quoted prices of the similar bonds without the share
warrants averaged 97. On the other hand, the share warrants had fair value of
P900,000 as of the same date.
Required: Determine the journal entry to be made on January 1, 2023.
2. At the beginning of the year 2023, PARROT Company issued six-year, 8% interest-
bearing convertible bonds with face amount of P7,000,000 when market yields
average 6%. The 8% interest is payable every December 31 of each year. Market
yields of comparable plain vanilla bonds averaged 7%. On the other hand, the
convertibility option had fair value of P700,000 as of the same date.
Required: Determine the journal entry to be made on January 1, 2023.
3. On January 1, 2023, BLACKBIRD Company issued P3,000,000 face amount bonds

with attached share warrants for the purchase of 50,000 of the Company’s ordinary
shares. Total issue price is equal to 98 quoted price, while the quoted price of the
bonds without the share warrants is equal to 94. In addition, bond issue costs
incurred amounted to P125,000.
Required: Determine the journal entries to be made on January 1, 2023.
4. During the year, CHICKEN Company issued a three-year, 10% interest-bearing

bonds with P5,000,000 face amount for 109. Attached to the bonds are share
warrants for the purchase of 100,000 of the Company’s P30 par value shares at an
exercise price of P35 per share. The fair value of the bonds without the share
warrants is 105.
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entry to record the actual exercise of the share warrants:
1. All of the warrants were exercised.
2. 40,000 of the warrants were exercised.
3. 70,000 of the warrants were exercised.
5. On January 1, 2023, BLUEBIRD Company issued 9,000 of its P1,000 face amount
bonds at 107. Interest of 10% is payable every December 31 of each year until
December 31, 2028, the bonds’ maturity date. Each of the bonds is convertible to 20
of the Company’s P40 par value ordinary shares. Assuming that there is no
conversion option, the bonds would have been issued at 9% market yield. The
Company accounted the bonds at amortized cost.
entry to record the actual exercise of the convertibility option:
1. All of the bonds were converted on December 31, 2024.
2. 5,000 of the bonds were converted on December 31, 2024.
6. At the beginning of the year 2023, CROW Company issued a seven-year, 10%
interest-bearing, convertible bonds with total face amount of P6,000,000 at a total
issue price of 101. These bonds are divided into 3,000 bond certificates with P2,000
face amount each. Each of these bonds is convertible to 100 of the Company’s P15
par value shares. The interest is payable every December 31 of each year.
Assuming that the bonds is nonconvertible, it could have beenissued at 11% market
yield. The Company accounted the bonds at FVTPL. As such, the following fair values
are relevant:
Date Fair Value Date Fair Value

December 31, 2023 99 December 31, 2025 98
December 31, 2024 102 December 31, 2026 99
entry to record the actual exercise of the convertibility option:
1. Allofthe bonds were converted on December 31, 2024.
4. 2,400 of the bonds were converted on December 31, 2025,
7. On January 1, 2023, PENGUIN Company issued bonds seven-year, 6% interest-

bearing bonds with total face amount of P8,000,000 at an issue price of P7,920,000.
Attached to these bonds are share warrants which allow the bondholders to
purchase a total of 50,000 of the Company's P20 par value shares at P30 exercise
price per share. Assuming that there were no attached share warrants, the bonds
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could have been issued at market yield of 8%. The Company accounted the bonds at
amortized cost.
bondholders P7,840,000. As of the same date, the bonds have market yield of 7%.
Required: Determine the journal entry to record the retirement of the bond on
December 31, 2025.
8. On January 1, 2023, FINCH Company issued four-year, 8% interest-bearing bonds
with aggregate par value of P8,000,000 at a total price of P8,350,000. The bonds are
convertible to 200,000 ordinary shares with P30 par value. Without the conversion
option, the bonds can be issued at 9% market yield.
bondholders a total amount of P8,050,000. As of the same date, similar bonds
without conversion option have 10% market yield.
Required: Determine the journal entry to record the retirement of the bond on
December 31, 2025.

1. On January 1, 2023, SPARROW Company issued 4,000 of its P1,000 face amount
bonds at an issue price of P3,900,000. Interest of 9% is payable every December 31
of each year until December 31, 2029, the bonds’ maturity date. In addition, each
bond gives share warrants to the holder to acquire 100 of the Company’s P40 par
value shares at P50 exercise price. In the absence of the attached share warrants, the
bonds will be issued at market yield of 11%.
Initial measurement of the share premium - warrants on January 1, 2023 shall be

a. P243,839 c. P268,932
b. P254,892 d. P276,976
Assuming that holders of 3,000 bonds exercised their rights under the share
warrants, the amount of share premium - issuance shall be
a. P3,182,879 c. P3,191,169
b. P3,207,732 d. P3,201,699
Assuming that holders of 2,500 bonds exercised their rights under the share
warrants, the amount of share premium - issuance shall be
a. P2,673,110 c. P2,652,399
b. P2,668,083 d. P2,659,308
Assuming that holders of all the bonds exercised their rights under the share
warrants, the amount of net increase in shareholders’ equity shall be
a. P4,243,839 c, P4,254,892
b. P4,276,976 d. P4,268,932
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2. At the beginning of the year 2023, ROBIN Company issued 3,000 of its P3,000 par
value convertible bonds with maturity date of December 31, 2027 at an issue price
of P9,730,000. Interest of 10% is payable every December 31 of each year. Each bond
is convertible to 160 of the Company's P15 par value shares. Without the conversion
option, the bond could have been issued at 9% market yield.
The initial measurement of the share premium - convertibility option on January 1,
2023 shall be
a. P386,821 c, P379,931
b. P393,804 d. P339,843 .
Assuming that on December 31, 2023, 1,000 of the bonds were converted, the
amount of share premium - issuance shall be
a. P697,191 c. P826,131
b. P823,834 d. P828,459
Assuming that on December 31, 2024, all of the bonds were converted, the amount
of share premium - issuance shall be
a. P2,421,616 c. P2,407,743
b. P2,414,633 d. P2,027,812
Assuming that on December 31, 2025, all of the bonds were converted, the amount
of net increase in shareholders’ equity shall be
a. P9,158,315 c. P9,545,136
b. P9,538,246 d. P9,498,158
3. At the beginning of 2023, STARLING Company issued 5,000 of its P1,000 face
amount bonds at an issue price of P5,900,000. Interest of 12% is payable every
December 31 of each year until December 31, 2029, the bonds’ maturity date. The
bonds are convertible to a total of 1,000,000 of the P4 par value ordinary shares of
the Company. In the absence of the convertibility option, the bonds could have been
issued at 10% market yield. Lastly, bond issue costs of P270,152 were incurred,
which when considered, will change the effective interest rate of the liability
component at 11%.
The initial measurement of the share premium - convertibility option on January 1,
2023 after considering the bond issue costs shall be
a. P413,159 c, P438,853
b. P394,241 d. P398,740
The initial measurement of the bond payable on January 1, 2023 after considering
the bond issue costs shall be
a. P5,723,939 c. P5,486,841
b. P5,497,573 d, P5,235,607
a. P459,613 c. P433,206
b. P446,978 d, P471,205
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Assuming all of the bonds were converted on December 31, 2025, the resulting share
premium - issuance shall be
a. P1,356,943 c. P1,429,539
b. P1,207,645 d. P1,632,931
4. On July 1, 2023, GOLDFINCH Company issued its bonds payable with face amount of
P7,000,000 at a total issue price of P7,600,000 (inclusive of accrued interest).
Interest of 6% is payable every December 31 of each year until December 31, 2027.
Attached to the bonds are share warrants for the purchase of the 70,000 of the
Company’s P8 par value ordinary shares at an exercise price of P15 per share.
Without the share warrants, the bonds have clean price of P7,180,000. The Company
is using the straight-line method of amortizing the discount or premium from its
bonds payable. é
Fast forward to December 31, 2025, the Company decided to retire the bonds way
before its maturity date by paying the bondholders a total retirement price of
P7,350,000. As of the same dates, the bonds without attached warrants have fair
value of P7,220,000.
The gain or loss to be recognized in 2025 profit or loss shall be

a. P230,000 gain c. P100,000 gain
b. P230,000 loss d. P100,000 loss
The balance in the share premium - share warrants after recording the early
retirement shall be
a. P210,000 c. P420,000
b. P80,000 d. P290,000
5. On January 1, 2023, CANARY Company issued six-year, 7% interest-bearing

convertible bonds with total face amount of P4,000,000. for an issue price of
P4,100,000. These bonds are convertible to a total of 80,000 ordinary shares of the
Company with P40 par value. Without the convertibility option, the bonds are
issuable at 9% market yield.
Fast forward to December 31, 2026, the Company retired the bonds by paying
retirement price of P3,920,000 to the bondholders. As of the same date, the bonds
have market yield of 10%.
From this information, the gain or loss to be recognized in profit or loss shall be
a. P67,534 gain c. P60,732 gain
b. P67,534 loss d, P60,732 loss
The balance in the share premium - convertibility option after recording the early
retirement shall be
a. P378,932 c. P330,609
b. P497,543 d, P458,875
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Chapter 8 — Extinguishment of Liabilities
CHAPTER 8
EXTINGUISHMENT OF LIABILITIES

The momenta financial liability is extinguished.
The accounting for extinguishment by payment of cash.
ele
The accounting for extinguishment by payment of noncash asset.

The accounting for extinguishment by issuance of own equity securities.
The accounting for modification of terms.
EXTINGUISHMENT OF FINANCIAL LIABILITIES

An entity shall derecognize (i.e., remove from the records) a financial liability from
its statement of financial position when, and only when, it is extinguished (i-e., when
the obligation specified in the contract has been discharged or cancelled or
expired). [PFRS 9.3.3.1].
Examples of events that will extinguish financial liabilities include, but are not
limited, to the following:
a. Payment of cash to holders of financial liability on or before the maturity date.
b. Payment of non-cash assets to holders of financial liability on or before the
maturity date (i.e., dacion en pago).
c. Issuing of an entity’s own equity instruments to settle a financial liability.
d. Substantial modification of the terms of the financial liability
Each of these examples are discussed in the succeeding sections.
PAYMENT OF CASH
This the most common way of extinguishing financial liabilities since the creditors
or lenders will have no objections since obligations are normally payable in cash.
Any difference between the amount of cash paid and the updated carrying
amount of the financial liability shall be recognized in the profit or loss. The
following rules are relevant:
Scenario | Gain or Loss
Cash paid < carrying amount of the liability | Gain on extinguishment
Cash paid > carrying amount of the liability | Loss on extinguishment
Cash paid = carrying amount of the liability No gain or loss
The carrying amount of the financial liability will depend on the accounting method
applied by an entity (i.e., amortized cost or at fair value through profit or loss).
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Illustration 1. GONZALES Company had a financial liability that has a carrying

amount of P4,500,000 as of December 31, 2023. On the same date, the Company
paid cash to the creditors to extinguish the said liability. Required: Under each of
the following independent scenarios, determine the journal entry to record the
payment of the liability:
1. Amount paid was P4,850,000.
2. Amount paid was P4,420,000.
Answer - Scenario 1
The journal entry to record the payment of financial liability is as follows:
Financial liability, net 4,500,000
Loss on extinguishment 350,000
Cash 4,850,000
Answer - Scenario 2
The journal entry to record the payment of financial liability is as follows:
Cash 4,420,000
Gain on extinguishment 80,000
PAYMENT OF NONCASH ASSETS

When an entity does not have enough cash on hand to pay its maturing liability, it
may enter into an agreement with its creditors to pay with noncash assets instead.
The creditors may not easily agree with the arrangement because of the following
factors:
a. The creditor might not be able to use the noncash asset, and it might also incur
unnecessary /additional efforts to convert the received noncash asset to cash.
b. The creditor assumes the risk of decrease in the value of the noncash asset.
Nevertheless, if the creditor agrees to accept the noncash payment, the borrower
entity will now be released from its liability, regardless of the difference between the
value of the noncash asset and the carrying amount of the financial liability. Such
transaction is called “dacion en pago”.
Any difference between the updated carrying amount (CA) of the financial
liability and the carrying amount (CA) of the noncash asset paid is recognized
in profit or loss, The following are the relevant rules:

CA of noncash asset < CA of the liability | Gain on extinguishment
CA of noncash asset > CA of the liability | Loss on extinguishment
The readers should take note that the fair value of the noncash asset is not
relevant in this case.
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Illustration 2. BAUTISTA Company was short on cash when one of its loan payable
with carrying amount of P6,000,000 matured. The Company entered into an
agreement with the creditor to accept noncash asset as payment. Required: Under
each of the following independent cases of noncash asset payments, determine the
journal entry to record the payment of the loan payable:
1. A building with original cost of P15,000,000 and accumulated depreciation of
P9,500,000 is to be transferred to the creditor. The building has a fair value of
P4,800,000.
2. A vacant lot classified as investment property with carrying amount of
P6,450,000 is to be transferred:to the creditor. The land has a fair value of
P7,250,000 and accounted using the cost model.
Answer - Scenario 1
There is a gain on extinguishment since the P5,500,000 (P15M - P9.5) carrying
amount of the building is lower than the carrying amount of the loan payable at
P6,000,000. The journal entry to record the dacion en pago is as follows:
Loan payable 6,000,000
Accumulated depreciation 9,500,000
Building 15,000,000
Answer - Scenario 2
There is a loss on extinguishment since the carrying amount of the land (P6,450,000)
is higher than the carrying amount of the loan payable at P6,000,000. The journal
entry to record the dacion en pago is as follows:
Loan payable 6,000,000
Loss on extinguishment ‘ 450,000
Investment property - land 6,450,000
The readers should take note that under both scenarios, the fair values of the
noncash assets were not considered in computing the total amount of gain or loss
on extinguishment.
ISSUANCE OF AN ENTITY’S OWN EQUITY INSTRUMENTS

An entity may also issue its own equity instruments as payment to its maturing
liability (this transaction can also be called “debt-for-equity swap”). In this kind of
transaction, the entity’s liability will become part of its equity. The creditor's
agreement in this transaction will depend on the balancing of the following factors:
a. There is a chance that the aggregate value of the equity instruments will greatly
exceed the amount of the extinguished liability (ie, advantageous). On the
flipside, there is also a chance that the aggregate value of the equity instruments
will become lower than the amount of: the extinguished liability (i.e.
disadvantageous).
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b. The creditor will now become a part-time owner of the entity and that it will
receive dividends instead of fixed amounts of interest. However, the existence
and amounts of dividends will still depend on the declaration of the entity.
ACCOUNTING FOR ISSUANCE OF AN ENTITY'S OWN EQUITY INSTRUMENTS

Accounting for this kind of transaction is covered by IFRIC 19, Extinguishing
Financial Liabilities with Equity Instruments. The readers should be informed as
early as now the scope limitation of the accounting procedures to be discussed:
a. The equity instruments to be issued by the entity shall be its own equity
instruments. Otherwise, if the equity instruments are from other entities, the
transaction shall be considered as payment of noncash asset (dacion en pago).
b. The issuance of equity instruments shall not be included in the original
terms of the financial liability. As a result, convertible bonds, which in its
original terms allow its conversion to equity instruments, are not covered by
the forthcoming accounting procedures. The actual conversion of convertible
bonds was already covered in Chapter 7.
The following are the steps involving the accounting procedures when an entity
issues its own equity instruments to extinguish its financial liabilities:
1. First, measure the issued equity instruments using the following hierarchy:
a. First Priority: Fair value of issued equity instruments
b. Second Priority: Fair value of extinguished financial liability
c. Third Priority: Carrying amount of extinguished financial liability
2. Next, compare the measurement of issued equity instruments determined in (1)
above and the carrying amount of the extinguished liability. The difference is
recognized in profit or loss. The following are the rules in determining whether
there is a gain or loss on extinguishment:
Measurement of equity instruments < CA of the liability Gain
Measurement of equity instruments > CA of the liability Loss
3. The share premium - issuance is equal to the difference between the

measurement of equity instruments issued and its total par value. This amount
will depend on the measurement of.equity securities issued,
Illustration 3. VILLANUEVA Company had a maturing financial liability with

carrying amount of P3,500,000. However, the Company did not have excess cash
nor unused noncash asset to pay the creditor. As a result, the Company entered into
agreement with the creditor with the Company issuing 200,000 ofits P15 par value
ordinary shares as payment for the maturing financial liability. Required: Under
each of the following independent scenarios, determine the journal entry to record
the Company’s issuance of equity instruments as payment to its maturing liability:
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1. The shares had fair value of P20/share while the financial liability had fair value
of P3,815,000.
2. The shares had fair value of P20/share while the financial liability’s fair value is
not reliably determinable.
3. The shares’ fair value is not reliably determinable while the financial liability
had fair value of P3,365,000.
4. The fair values of both the shares and the financial liability are not reliably
determinable.
Answer - Scenario 1
1. First, determine the measurement of the issued equity instruments. In this case,
the fair value of the issued equity instruments shall be used since it is the first
priority, and it is determinable:
Measurement of equity instruments (P20 x 200,000) 4,000,000
Less: Aggregate par value (P15 x 200,000) (3,000,000)
2. Next, determine the amount of gain or loss on extinguishment as follows:

Measurement of equity instruments (P20 x 200,000) 4,000,000
Less: Carrying amount of liability (3,500,000)
Loss on extinguishment P500,000
3. Lastly, record the issuance transaction as follows:

Answer - Scenario 2
The answer in this scenario is the same with Scenario 1. The absence of the fair
value of the financial liability is not relevant in this case since the fair value of the
issued equity instruments, as the first priority, is available.
Answer- Scenario 3
1. In this case, the issued equity instruments shall be measured equal to the fait
value of the financial liability since the first priority (ie, fair value of equity
instruments) is not available:
Measurement of equity instruments P3,365,000
Share premium - issuance P365,000
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Less: Carrying amount of liability (3,500,000)
Gain on extinguishment P135,000
3. Lastly, record the issuance transaction as follows:

Answer - Scenario 4
1. The issued equity instruments shall be measured equal to the carrying amount
of_the financial liability since the first priority (i.e, fair value of equity
instruments) and second priority (i.e., fair value of financial liability) are both
not available:
Share premium - issuance P500,000

Less: Carrying amount of liability 3,500,000
Gain or loss on extinguishment P-0-
3. Torecord the issuance transaction:

Generalizations - Scenarios 1 to 4
The readers should take note that regardless of the measurement of the equity
instruments and the amount of computed gain or loss on extinguishment, the
amount of net increase in the total equity of the issuing entity is equal to the
carrying amount of the extinguished financial liability.
Illustration 4, FERNANDEZ Company has convertible bonds payable with face
amount and carrying amount of P4,000,000. The bonds are convertible to 250,000
of the Company’s P10 par value ordinary shares, Share premium - convertibility
option account has a balance of P300,000. The shares have fair value of P18/share
while the bonds payable have fair value of P4,350,000. Required: Determine the
journal entry to record the issuance of the shares as a result of the conversion of the
bonds payable.
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The accounting for the actual conversion of the convertible bonds is different from the
concepts discussed in this chapter since the issuance of equity instruments is part of
the original terms of the bonds payable. As a result, the fair values of the shares
and the bonds payable are not relevant and no gain or loss on extinguishment
shall be recognized. This is consistent with the discussion in Chapter 7.
The journal entry to record the conversion of the bonds payable is as follows:
Share capital (P10 x 250,000) 2,500,000
Share premium - issuance (squeeze) 1,800,000
ACCOUNTING FOR PARTIAL EXTINGUISHMENT OF FINANCIAL LIABILITY

So far, the discussions include full extinguishment of financial liabilities. Accounting
procedures for partial extinguishment of the financial liability by payment of cash,
payment of noncash assets and issuance of own equity are substantially the same
with that of full extinguishment.
However, there is an additional step of getting the proportion of the updated
carrying amount corresponding to the partially extinguished portion.
Consequently, there are proportional reductions from the bonds payable account and
premium or discount on bonds payable account. Moving forward, the amounts of
interest expense and carrying amount are all based on the remaining bonds.
Illustration 5. FRANCISCO Company had an outstanding bond payable of

P10,000,000 and balance of P600,000 in its discount on bonds payable account.
Required: Under each of the following independent scenarios of partial
extinguishment, determine the amount of gain or loss on extinguishment:
1. Half of the bonds were redeemed from the bondholders by paying P5,120,000.
2. 60% of the bonds were redeemed by transferring a land with carrying amount
of P5,500,000 and fair value of P5,850,000.
3. 40% of the bonds were paid by issuing 100,000 shares of the Company with
P35/share fair value and P20 par value. The bonds have a total fair value of
P9,800,000.
First, determine the carrying amount of the bonds payable to be used in all of the
succeeding scenarios:
Less: Discount on bonds payable (600,000)
Carrying amount of bonds payable P9,400,000
Answer - Scenario 1
Comparing the portion of the bond’s carrying amount and the amount of cash paid:
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Portion of bonds payable (P9,400,000x 44) P4,700,000

Less: Cash paid (5,120,000)
Loss on extinguishment in profit or loss P420,000
Answer - Scenario 2
Comparing the portion of the bond’s carrying amount and the noncash asset
transferred:
Portion of bonds payable (P9,400,000x 60%) — P5,640,000
Less: Carrying amount of noncash asset (5,500,000)
Gain on extinguishment in profit or loss P140,000
Again, the land’s fair value of P5,850,000 was not used in the computations.
Answer - Scenario 3
Since the fair value of the issued equity shares is available (i.e., first priority), the
fair value of the bonds payable (i.e., second priority) shall be ignored:
Portion of bonds payable (P9,400,000 x 40%) P3,760,000
Less: Fair value of issued equity instruments (100,000 x P35) __ (3,500,000)
Gain on extinguishment in profit or loss P260,000
ACCOUNTING FOR THE EXTINGUISHMENT OF FINANCIAL LIABILITY NOT ON
INTEREST PAYMENT DATE
When accounting for the extinguishment of its financial liabilities, it should be
highlighted that an entity shall determine the updated carrying amount of its
financial liabilities.
This is particularly true when there is a discount or premium and that the
extinguishment happened on a non-interest payment date. In that case, the
discount or premium shall be proportionally amortized up to the date of
liability extinguishment using the following rules on amortization:
a. Add the proportional amortization of discount to the carrying amount of the
liability as of the immediately preceding interest payment date.
b. Less the proportional amortization, of premium from the carrying amount of
the liability as of the immediately preceding interest payment date.
The reason for this is that the amortization of discount or premium is based on
the passage of time. In addition, accrued interest up to the date of
extinguishment shall also be paid.
Illustration 6. RIVERA Company reported the following amortization table of one

of its bonds payable with face amount of P4,000,000, stated rate of 10% and
effective interest rate of 8%:
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Date Paid Expense zation Amount Loan Payable
Dec. 31, 2023 4,264,970 264,970
Dec. 31,2024 400,000 341,198 (58,802) 4,206,168 206,168
Dec. 31,2025 400,000 336,493 (63,507) 4,142,661 142,661
Dec. 31,2026 400,000 331,413 (68,587) 4,074,074 74,074
Dec. 31,2027 400,000 325,926 (74,074) 4,000,000
journal entry to record the extinguishment of the bonds payable:
1. On July 1, 2026, the bonds were retired by paying the bondholders P4,150,000
plus accrued interest.
2. On October 1, 2025, the bonds were retired by paying the bondholders
P4,250,000 including accrued interest.
Scenario 1
First, compute for the updated carrying amount of the bonds as of July 1, 2026:
Less: Partial premium amortization from
1/1/26 to 7/1/26 (P68,587x 6/12) 34,294
Updated carrying amount, 7/1/26 P4,108,367
This partial amortization of premium shall be recorded on July 1, 2026 as follows:
After recording the entry above, the bonds payable will now have the following
balances as of July 1, 2026:

Add: Unamortized premium, 7/1/26 (P142,661 - P34,294) 108,367
Next, compute the gain or loss on extinguishment as follows:
Less: Retirement price (excluding accrued interest) 4,150,000
Loss on extinguishment P41,633
Next, determine the total amount of cash to be paid to the bondholders as follows:
Retirement price P4,150,000
Plus: Payment for accrued interest (P4,000,000x 10% x 6/12) 200,000
Total amount of cash paid to bondholders P4,350,000
Finally, the extinguishment shall be recorded on July 1, 2026 as follows:
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Cash 4,350,000
Based on these journal entries, total interest expense for 2026 is P165,706
(P200,000 - P34,294 or P4,142,661 x 8% x 6/12).
Scenario 2
First, compute for the updated carrying amount of the bonds as of October 1, 2025:
Less: Partial premium amortization from
1/1/25 to 10/1/25 (P63,507x 9/12) 47,630
This partial amortization of premium shall be recorded on October 1, 2025 as

follows:
After recording the entry above, the bonds payable will now have the following
balances as of October 1, 2025:
Add: Unamortized premium, 10/1/25 (P206,168- P47,630) 158,538
Next, compute the gain or loss on extinguishment as follows:
Less: Retirement price less accrued interest
[P4,250,000 - (P4,000,000 x 10% x 9/12)] 3,950,000
Gain on extinguishment P208,538
The readers should take note that the total payment of P4,250,000 to bondholders
already included the accrued interest of P300,000 (P4,000,000 x 10% x 9/12).
Finally, the extinguishment shall be recorded on October 1, 2025 as follows:
Cash 4,250,000
Based on these journal entries, total interest expense for 2025 is P252,370
(P300,000 - P47,630 or P4,206,168 x 8% x 9/12).
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MODIFICATION OF TERMS OF FINANCIAL LIABILITY

Normally, when a borrower entity is having a hard time complying with the original
payment terms and conditions (including the payment schedule) of its liability, it
may enter into an agreement with the creditor to modify the terms of the said
liability. This is particularly relevant during the height of the recent pandemic
wherein many business entities struggled to earn income that can be used in paying
their liabilities and corresponding interest amounts. As a result, many of these
entities made concessions with their creditors which may include one or
combinations of the following:
a. Reduction of principal amount
b. Reduction of interest amounts
c. Extension of the maturity date for the payment of principal
d. Extension of the due date for the payment of interest
Nonetheless, terms may be modified even in the absence of financial difficulty.
Accounting for the modification of terms of financial liability will depend on
whether the modification is substantial or not.
DETERMINING WHETHER THE MODIFICATION IS SUBSTANTIAL OR NOT

The following procedures shall be made in determining whether the modification
is substantial or not:
Step 1. First, determine the following amounts:
1. Amount 1 - Present value of revised cash flows discounted using the original
effective interest rate (not the current market rates) plus the amount of
modification costs and fees incurred, if there are any; and
2. Amount 2 - Carrying amount of the financial liability plus accrued interest, if
there is any. Also equal to the present value of the remaining cash flows of the
original financial liability, discounted using the original effective interest rate.
Step 2. Next, express the absolute difference of the two amounts determined in Step
1 as a percentage of the carrying amount of the financial liability. If the percentage
computed is at least 10%, the modification is considered substantial. If it is less
than 10%, the modification is considered as not substantial. The rules can be
summarized using the following formulas:
There is substantial modification if:
Absolute difference of amounts (1) and (2) determined in the Step 1

: : 2 109
Carrying amount of the liability plus accrued interest, if there is any 6
There is NO substantial modification if:
Absolute difference of amounts (1) and (2) determined in the Step 1 < 10%
Carrying amount of the liability plus accrued interest, if there is any
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The readers should take note that the addition of the modification costs and fees
incurred to the present value of revised cash flows is done only for the purposes of
determining whether the modification is substantial or not. Ultimate
accounting procedures for these costs will be discussed in the succeeding sections.
Illustration 7. CRUZ Company is currently experiencing financial difficulties and is
concerned that it could miss the scheduled payments of the principal and interest
of one of its loan payables with a carrying amount of P8,000,000. As a result, it
entered into an agreement with the creditor to modify the terms of the loan payable.
Required: Under each of the following independent modification of terms scenarios,
determine whether there is a substantial modification of terms or not:
1. Present value of revised cash flows discounted using the original effective
interest rate amounted to P7,500,000.
interest rate amounted to P6,800,000.
interest rate amounted to P6,000,000. Modification costs and fees incurred
Answer - Scenario 1
Applying the formula, the percentage is computed as:
|P8,000,000 - P7,500,000|
Difference (in %) = = 6.25%
P8,000,000
Since the difference is 6.25% (i.e., <10%), the modification is not substantial.
Answer - Scenario 2
Difference (in %) =
|P8,000,000
- P6,800,000|_ _ 4x5
P8,000,000 re eae
Since the difference is 15% (i.e., >10%), the modification is substantial.
Answer - Scenario 3
Difference (in %) =
_|P8,000,000 - (P6,000,000 + P350,000)|_ _ 99 630%
P8.000,000
In this case, the modification costs were added to the PV of the revised cash flows.
Since the difference is 20.63% (i.e., >10%), the modification is substantial.
Generalizations - Scenarios 1 to 3
The carrying amount of the financial liability plus accrued interest, if there is
any, is always used as the denominator in computing the difference in %.
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ACCOUNTING PROCEDURES WHEN THERE IS NO SUBSTANTIAL MODIFICATION

When the modification is not considered as substantial, the following accounting
procedures are relevant:
1. Any difference between the following:
a. carrying amount of the financial liability (plus accrued interest, if there is
any); and
b. present value of revised cash flows discounted using the original effective
interest rate
is recognized in gain or loss on modification in the entity's profit or loss. If
(a) > (b), there is a gain on modification. If (a) < (b), there is a loss on
modification.
2. The amount of modification costs and fees incurred, if there are any, are
deducted from the present value of revised cash flows to determine the
carrying amount of the financial liability after the modification. The
following comparison of the treatment of modification costs and fees is relevant:
Purpose | Treatment of Modification Costs

Determining whether the Added to the present value of the
modification is substantial or not revised cash flows
Determining the initial carrying Deducted from the present value of the
amount of the modified liability revised cash flows
3. If there are modification costs and fees, the effective interest rate (EIR) will
change moving forward; otherwise, the EIR will still be the same. The reason
is that these fees have been included in the computation of the modified carrying
amount of the liability after the modification.
4. Arevised amortization table shall be used moving forward.
Illustration 8. On December 31, 2023, GUZMAN Company has an existing fixed-
interest loan payable bearing 9% interest and with carrying amount and face
amount of P10,000,000. It has a remaining term of five years. On the same date, the
Company and the creditor agreed to reduce the interest rate to 8% over the
remaining term. Market rate as of that date averaged 10%. Required: Determine the
procedures in accounting for the modification.
1. First, compute for the present value of the revised cash flows using the 9%
original effective interest rate:
PV Revised
PV Factor of Factor Cash Flows Total PV
Ordinary annuity for5 periods at9% 3.889651 800,000 3,111,721
PV of revised cash flows using original EIR P9,611,031
Note: P800,000 = P10,000,000 x 8% revised boards.
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The market rate of 10% shall be ignored in the computations.

2. Next, compute the difference (in %) between the carrying amount of the liability
and the present value of revised cash flows in the following manner:
Difference (in %) = |P10,000,000 - P9,611,031|

P10,000,000 = 3.89%
3. Since the modification is not substantial, the carrying amount of the financial
liability is not derecognized but adjusted to reflect the computed present
value of revised cash flows. The gain on modification is computed as follows:
Carrying amount of the financial liability P10,000,000

Present value of revised cash flows (9,611,031)
Gain on modification P388,969
The journal entry to record the modification is as follows:

Discount on loan payable 388,969
After recording the modification, the loan payable’s carrying amount will now
be equal to the present value of revised cash flows:
Loan payable P10,000,000
Less: Discount on loan payable (388,969)
Loan payable, carrying amount after modification P9,611,031
4. Moving forward, the following amortization table shall be used (using the
original effective interest rate of 9%):
Interest Interest Amorti- Carrying Discounton
Dec. 31, 2023 9,611,031 388,969
Dec. 31,2024 800,000 864,993 64,993 9,676,024 323,976
Dec. 31,2025 800,000 870,842 , 70,842 9,746,866 253,134
Dec.31,2026 800,000 877,218 77,218 9,824,084 175,916
Dec. 31,2027 800,000 884,168 84,168 9,908,252 91,748
Dec.31,2028 800,000 891,748 91,748 10,000,000 -
The following journal entry will be recorded on December 31, 2024 related to
the recognition of interest expense and amortization of the discount:
Cash 800,000
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Illustration 9. As of December 31, 2023, LOPEZ Company had a loan payable of

P9,000,000 bearing interest rate of 10%. The remaining term of the loan is two
years. On the same date, the Company informed the creditor that it might fail to pay
the loan on the original scheduled date (i.e, December 31, 2025) because of
financial difficulties. As a result, the following modifications were made:
a. Maturity date is extended to December 31, 2027.
b. Interest rate is reduced to 7% (or P630,000 = P9,000,000x 7%), to be paid during
the remaining revised term of four years.
Modification costs incurred amounted to P261,012, which, when considered, will
change the effective interest rate to 11%. Required: Determine the procedures in
accounting for the modification.
1. First, compute for the present value of the revised cash flows using the 10%
original effective interest rate:
PV Revised
PV Factor of Factor Cash Flow Total PV
Add: Modification costs : 261,012
Amount to be compared to the carrying amount of the liability P8,405,144
Note: 4 periods is from 12/31/23 to revised maturity date of 12/31/27.
and the present value of revised cash flows (including modification costs) in the
following manner:
Difference (in %) = P00 8 P80 Al = 6.61%
3. Again, since the modification is not substantial, the carrying amount of the
financial liability shall only be adjusted to reflect the computed present value of
the revised cash flows. The gain on modification is computed as follows:
Carrying amount of the financial liability P9,000,000
Present value of revised cash flows (8,144,132)
Gain on modification P855,868
The readers should take note that modification costs are not considered in
determining the gain or loss on modification, if there is no substantial
modification. Instead, these costs shall be added to the discount on loan
payable in determining the loan’s carrying amount after the modification.
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The journal entries to record the modification are the following:

Gain on modification 855,868
Cash (modification costs) 261,012
After recording the modification, the loan payable’s carrying amount will now
be equal to the present. value of revised cash flows less the amount of
modification costs (or P7,883,120 = P8,144,132 - P261,012):
Loan payable P9,000,000
Less: Discount on loan payable (P855,868 + P261,012) 1,116,880
Loan payable, carrying amount after modification P7,883,120
4. Moving forward, the following amortization table shall be used (using the
revised effective interest rate of 11% after considering the modification costs):
Interest Interest Amorti- Carrying Discounton
Dec. 31, 2023 _ 7,883,120 1,116,880
Dec. 31,2024 630,000 867,143 237,143 8,120,263 879,737
Dec. 31,2025 630,000 893,229 263,229 8,383,492 616,508
Dec. 31,2026 630,000 922,184 292,184 8,675,676 324,324
Dec. 31,2027 630,000 954,324 324,324 9,000,000 -
Note: P630,000 = P9M x 7% revised stated rate,
The following journal entry will be recorded on December 31, 2024 related to
the recognition of interest expense and amortization of the discount:
Cash 630,000
ACCOUNTING WHEN THERE IS SUBSTANTIAL MODIFICATION

There are two conflicting approaches in recording the substantial modification of
financial liability:
_ Approach ies 42 o ) | Background©:

This approach is prevalent in the acageme and
Traditional
considered as a relic from the old standard, PAS 39.
This is in accordance on what is followed in practice
Contemporary
and the provisions of PFRS 9
Their primary difference arises from the initial measurement of the new liability. In
the author's humble opinion, the contemporary approach is more correct since it is
based on the new standard, and this is the approach followed in practice.
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The following is the detailed comparison of accounting procedures under both

approaches:
Contemporary Traditional
Carrying amount of the ;
original liability (including Derecognized Derecognized
accrued interest)
Since the new liability is | Present value of the
considered as a separate | revised cash flows
Measurement of the new
liability, measure it equal | discounted using the
liability to be recognized
to its fair value. [PFRS 9 | original EIR.
paragraph 5.11].
Recognized in profit or loss using the following
concepts in determining whether it is gain or loss:
Difference between the
a. Old liability > new liability: gain on extinguishment
carrying amount of the
b. Old liability < new liability: loss on extinguishment
original liability and
measurement of the new | Since the measurement of the new liability is different
liability between these approaches, the amount of gain or loss
will also be different.
Accounting for — the | Deducted from gain on extinguishment or added to loss
modification costs on extinguishment
EIR after modification Market rate on the date of | Original EIR used in the
modification old liability
Amortization table Revised moving forward
Despite these differences, the previously discussed concepts in determining

whether there is substantial modification are applicable to both contemporary and
traditional approaches.
Illustration 10. As of December 31, 2023, CASTILLO Company reported loan

payable of P8,000,000 and P640,000 accrued interest based on 8% interest. The
remaining term of the loan is one year. However, the Company is currently
experiencing financial difficulties and asked the creditor to modify the terms of the
liability. They agreed to the following modifications: |
a. Maturity date is extended to December 31, 2026.
b. Principal is reduced to P5,000,000.
c. Interest of 6% will be paid every year but based on the reduced amount of
_ principal (P5Mx 6% = P300,000). Accrued interest of P640,000 shall be waived.
Modification costs amounted to P185,000. Market rates as of the date of

modification averaged 7%, Required: Under each of the following approaches,
determine the journal entry to record the modification:
1. Traditional approach
2. Contemporary approach
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Determining whether there is a substantial modification

The following are the procedures in determining whether there is a substantial
modification of terms:
1. First, compute for the present value of the revised cash flows discounted using
the original effective interest rate of 8%:
PV Revised
PV Factor of Factor Cash Flow Total PV
Add: Modification costs 185,000
Amount to be compared to the carrying amount of the liability P4,927,289
Note: 3 periods is from 12/31/23 to revised maturity date of 12/31/26.
(including accrued interest payable) and the present value of revised cash flows
(including modification costs) in the following manner:
|(P8,000,000 + P640,000) - P4,927,289|_ _=
Difference
j
(inin 9%) =
(P8,000,000 + P640,000) 42.97%0
Since the difference is 42.97% (i.e., >10%), the modification is substantial.

The readers should take note that these computations are relevant to both the
contemporary and traditional approaches.
Answer - Traditional Approach
1. Since the modification is substantial, the carrying amount of the loan payable
and the related accrued interest shall be derecognized. Consequently, under the
traditional approach, a new liability shall be recognized at an amount equal
to the present value of revised cash flows that is discounted using the
original EIR (i.e., P4,742,289 as computed above). The amount of the net gain
from the extinguishment is determined as follows:
Carrying amount of the loan payable and accruedinterest P8,640,000
Less: Present value of revised cash flows (4,742,289)
Initial amount of gain on extinguishment P3,897,711
Less: Modification costs 185,000
Net gain on extinguishment P3;712,7T1
The amount of the discount on the new loan payable is determined as follows:
Gross carrying amount of loan payable - revised P5,000,000
Less: Present value of revised cash flows 4,742,289
Discount on (new) loan payable P257,711
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Loan payable - old 8,000,000
Interest payable 640,000
Discount on loan payable - new 257,711
Gain on extinguishment 3,897,711
Loan payable - new 5,000,000
The journal entry to record the incurrence of modification is as follows:

The readers should take note that the when there is a substantial modification,
modification costs are not included in the carrying amount of the new
financial liability but considered in computing the gain on extinguishment.
2. Moving forward, the following amortization table shall be used using the 8%
original EIR:
Dec. 31, 2023 4,742,289 257,711
Dec. 31,2024 300,000 379,383 79,383 4,821,672 178,328
Dec. 31,2025 300,000 385,734 85,734 4,907,406 92,594
Dec.31,2026 300,000 392,594 92,594 5,000,000 -
Answer - Contemporary Approach
1. The difference between the contemporary and traditional approaches starts in
the measurement of the new liability. Under the contemporary approach of
accounting for substantial modification, the new liability shall be measured at
its fair value. The fair value in the illustration is computed by discounting the
revised cash flows using the market rate of 7% on the date of modification:
Revised
PV Factor of PVFactor Cash Flows Total FV
Ordinary annuity for3 periodsat7% 2.624316 300,000 787,295
FV of the new liability P4,868,785
The amount of net gain from the extinguishment is determined as follows:

Carrying amount of the loan payable and accrued interest P8,640,000
Less: Fair value of the new liability 4,868,785
Initial amount of gain on extinguishment P3,771,215
Less: Modification costs 185,000
Net gain on modification P3,586,215
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The amount of the discount on the new loan payable is determined as follows:
Gross carrying amount of loan payable - revised P5,000,000
Less: Fair value of the new liability 4,868,785
Discount on (new) loan payable P131,215

Loan payable - old 8,000,000
Interest payable 640,000
Discount on loan payable - new 131,215
Gain on extinguishment 3,771,215
Loan payable - new 5,000,000
The journal entry to record the incurrence of modification is as follows:

After recording these entries, the carrying amount of the new financial
liability is equal to its fair value. Again, the modification costs are not
considered in determining the carrying amount of the new financial liability.
Since the initial measurement of the new liability is different from what is used
in the traditional approach, the contemporary approach will yield a different
amount of gain or loss on extinguishment and amortization table moving
forward. f
2. The following amortization table based on 7% EIR (based on market yield on

the date of modification) shall be used moving forward under the contemporary
approach:
Interest Interest Amorti- Carrying Discount on Loan

Date Paid Expense zation Amount Payable
Dec. 31, 2023 . 4,868,785 131,215
Dec. 31,2024 300,000 340,815 40,815 4,909,600 90,400
Dec. 31,2025 300,000 343,672 43,672 4,953,272 46,728
Dec. 31,2026 300,000 346,728 46,728 5,000,000 =
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CHAPTER SUMMARY
di An entity shall derecognize a financial liability from its statement of financial
position when, and only when, it is extinguished (i.e, when the obligation specified
in the contract has been discharged or cancelled or expired).
Examples of transactions which may result to the extinguishment of liabilities:
payment of cash; payment of non-cash assets; issuing of an entity’s own equity
instruments; and substantial modification of the terms of the financial liability
The difference between the cash paid and carrying amount of the liability shall be
recognized in profit or loss.
The difference between the carrying amount of the noncash asset transferred and
carrying amount of the liability shall be recognized in profit or loss.
If the liability is extinguished by an entity issuing its own equity securities, the
difference between the measurement of equity securities and the carrying amount
of the liability shall be recognized in profit or loss.
The measurement of the issued own equity securities shall be based on the following
hierarchy:
a. first, FV of equity securities issued
b. second, FV of extinguished liability
c. lastly, carrying amount of extinguished liability
Of course, the amounts of share premium - issuance and gain or loss on
extinguishment will change depending on which amount in the hierarchy is
available.
If there is only a partial extinguishment of liability, only an aliquot portion of the

carrying amount shall be derecognized and compared with the proceeds received to
determine the gain or loss on extinguishment.
If the extinguishment of liability happened not on an interest payment date, the
following accounting procedures are relevant:
a. Update the carrying amount of the liability. If it is subject to amortization, make
a partial amortization from the immediately preceding interest payment date
until the date of extinguishment.
b. Additional payments shall be made for the accrued interest from the
immediately preceding interest payment date until the date of extinguishment.
c. Gain or loss on extinguishment is the difference between amount paid
(excluding accrued interest) and the updated carrying amount of the liability.
9. As to modification of terms, accounting procedures will depend whether there is a
substantial modification or not.
10.The following are the procedures in determining whether the modification is
substantial or not:
Step 1. First, determine the following amounts:
interest rate plus the amount of modification costs incurred, if there are any
2, Carrying amount of the financial liability plus accrued interest, if there is any.
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Step 2. Next, express the absolute difference of the two amounts determined in Step
1 as a percentage of the carrying amount of the financial liability:
There is substantial modification if:
Absolute difference of amounts (1) and (2) determined in the Step 1 > 109%
Carrying amount of the liability plus accrued interest, if there is any
There is NO substantial modification if:
Absolute difference of amounts (1) and (2) determined in the Step 1 < 10%
Carrying amount of the liability plus accrued interest, if there is any .
11.The following are the relevant accounting procedures depending on the type of
modification:
Not Substantial i Substantial

; Not derecognized, — but
Carrying adjusted to reflect the PV of
amount of the : ;
satin revised cash flows Derecognized
eeu discounted using original
liability FIR
Initial PV of revised cash flows using:

measurement Nat awolicable a. Traditional - original EIR
of the new ouapp b. Contemporary - market rate
liability on the date of modification
Difference between CA of | Difference between CA of
eee! On | existing liability and PV of | existing liability and initial
extinguishment revised cash flows measurement of the new
discounted using orig. EIR liability
Recognized as deduction from
: Will decrease the carrying | gain on extinguishment or
Acoma amount of the modified addition to loss on
ee liability (i.e., not recognized | extinguishment (i.e., no effect in
in profit or loss) the measurement of the new
liability)
Traditional - will not be
Will not be revised, except | revised
EIR after ; ; . :
ae when there are modification | Contemporary- will be revised
modification
costs equal to market rates on the
date of modification
Amortization
table Revised moving forward Revised moving forward
12.Again, modification costs are added to the PV of revised cash flows only for the
purpose of determining whether the modification is substantial or not.
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True or False
1. A financial liability shall be derecognized if the creditor condoned the entity’s debt,
event for without consideration.
2. Ifthe amount paid to the creditors is lower than the carrying amount of the related
liability, then there is a loss on extinguishment.
3. Indacion en pago, the total amount to be recognized in profit or loss is equal to the
difference between the fair value of the noncash asset transferred and the carrying
amount of the related liability.
4. Convertible bonds payable are out of scope of IFRIC 19 since the issuance of equity
instruments is included in the original terms of the liability.
5. The first priority in measuring the issued equity securities as payment for a
financial liability is equal to the fair value of the equity securities issued.
6. The share premium - issuance is equal to the difference between the carrying
amount of the extinguished liability and the total par value of the equity securities
issued.
7. The gain or loss on the extinguishment ofa liability by issuing an entity’s own equity
securities is the difference between the measurement of the issued equity securities
and the total par value of the issued equity securities.
8. Ifa liability was partially extinguished, only a proportional portion of its carrying
amount shall be derecognized.
9. Ifa liability was extinguished not on one of interest payment dates, the carrying
amount of the liability to be used in determining the gain or loss on extinguishment
shall be as of the immediately preceding interest payment date.
10. Additional amounts shall be paid in the form of accrued interest if a liability is
extinguished not on one ofits interest payment dates.
11. There is a substantial modification of terms of the difference between the PV of the
revised cash flows plus modification costs and carrying amount of the liability is
more than 10% of the carrying amount of the liability.
12. Ifthere is no substantial modification, the existing liability will not be derecognized.
13. If there is a substantial modification, the modification costs shall reduce the initial
measurement of the new liability.
14. If there is no substantial modification, the effective interest rate shall not change
after modification, except when there are modification costs.
15. Ifthere is a substantial modification and the entity is using the traditional approach,
the initial liability is equal to the present value of revised cash flows discounted
using the original effective interest rate.

1. All of the following scenarios will result to the extinguishment of a financial liability,
except
a. Breach of loan covenants
b. Payment of cash
c. Transferring of noncash asset
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d. Substantial modification of terms
2. If an entity paid cash to extinguish one of its liabilities, the total amount to be
recognized in profit or loss is equal to the difference between the
a. carrying amount of the liability and the fair value of the liability
b. fair value of the liability and the amount of cash paid
c. carrying amount of the liability and the amount of cash paid
3. In dacion en pago, the total amount to be recognized in profit or loss is equal to the
difference between the
a. fair value of the liability and the fair value of the noncash asset
b. carrying amount of the liability and the carrying amount of the noncash asset
c. fair value of the liability and the carrying amount of the noncash asset
d. carrying amount of the liability and the fair value of the noncash asset
4. The following are the possible measurement bases of issued own equity securities
in extinguishing a liability:
|. Fair value of the liability extinguished
II. Carrying amount of the liability extinguished
Ill. Fair value of the issued equity securities
Whiatis the correct order of the hierarchy in measuring the issued equity securities?
a. I, IL II
b. Il, I, 1
ce. LIM
d. Ill, 1, i
5. In actually converting a convertible bond payable, the gain or loss from the
extinguishment to be recognized in profit or loss is equal to
a. the difference between the measurement of the issued equity securities and
total par value of the issued equity securities.
b. the difference between the carrying amount of the issued equity securities and
total part value of the issued equity securities.
c. the difference between the fair value of the issued equity securities and carrying
amount of the extinguished liability
d. zero
6. Which of the following is not true regarding the amount of gain or loss from the
issuance of equity securities?
a. If the measurement of the issued equity securities is higher than the carrying
amount of the extinguished liability, there is a loss on extinguishment.
b. If the measurement of the issued equity securities is lower than the carrying
amount of the extinguished liability, there is gain on extinguishment.
c. The gain or loss on extinguishment is recognized as direct increase or decrease
in the entity's profit or loss.
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7. There is a substantial modification if the percentage difference between the present

value of the revised cash flows using original effective interest rate and the carrying
amount of the existing liability is
a. more than 10%
b. at least 10%
Cc not more than 10%
d. less than 10%
8. Accounting procedures for substantial modification include the following, except

a. The carrying amount of the original liability shall be derecognized.
b. Gain or loss on extinguishment is the difference between the measurement of
the new liability and the carrying amount of the original liability.
If the entity is using the traditional approach, the new liability is measured at
the present value of the revised cash flows discounted using the market interest
rate on the date of modification.
If the entity is using the contemporary approach, the new liability is measured
at its fair value on the date of modification.
9. Changes in the terms ofa liability which did not result to a substantial modification
shall be accounted as follows, except
a. The carrying amount of the existing liability is not derecognized.
b. After the modification, the carrying amount of the existing liability is equal to
the present value of the original cash flows discounted using the original
effective interest rate.
c. The difference between the carrying amount of the liability before and after the
modification shall be recognized in profit or loss.
10.Which of the following correctly describes the accounting treatment for the
modification costs?
a. Modification costs, whether the modification is substantial or not, shall be
recognized immediately in profit or loss.
b. Modification costs, whether the modification is substantial or not, shall be
deducted from the carrying amount of the modified liability.
c. Modification costs from not substantial modification are recognized
immediately in profit or loss, while modification costs from substantial
modification shall be deducted from the carrying amount of the modified
liability.
d. Modification costs from substantial modification are recognized immediately in
profit or loss, while modification costs from not substantial modification shall
be deducted from the carrying amount of the modified liability.
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Straight Problems
1. On January 1, 2021, WARBLER Company issued six-year, 12% interest-bearing
bonds with total face amount of P4,000,000 when market yields averaged 10%. The
interest is payable every December 31 of each year.
entry to record the retirement of the bonds:
1. On December 31, 2023, all of the bonds were retired by paying P4,300,000.
2. On January 1, 2022, BULLFINCH Company issued 5,000 of its P1,000 face amount
bonds when market rates averaged 7%. These bonds have maturity date of
December 31, 2028. Interest of 9% is payable every December 31 of each year.
Required: Under each of the following independent scenarios, determine the gain or
loss on the retirement of the bonds:
1. On December 31, 2023, half of the bonds were retired by paying P2,600,000.
2. OnDecember 31, 2024, 40% of the bonds were retired by paying P2,250,000.
3. On December 31, 2025, 4,000 of the bonds were retired by paying P4,150,000.
4. On December 31, 2024, 3,000 of the bonds were retired by paying P3,400,000.
3. At the beginning of the year 2023, CRANE Company issued 3,000 of its seven-year,
P2,000 face amount bonds when market rates averaged 14%. Interest of 12% is
payable every December 31 of each year.
Required: Under each of the following independent scenarios, determine the gain or
loss on the retirement of the bonds:
1. On April 1, 2024, all of the bonds were retired by paying P5,480,000, plus
accrued interest.
2. On September 30, 2024, all of the bonds were retired by paying P5,940,000,
including accrued interest.
3. OnJuly 1, 2025, all of the bonds were retired by paying P5,750,000, plus accrued
interest.
4. On February 1, 2025, all of the bonds were retired by paying P5,610,000,
including accrued interest.
5. On September 1, 2026, all of the bonds were retired by paying P6,000,000,
including accrued interest
4, At the beginning of the year 2021, FALCON Company borrowed a five-year, 8%
interest-bearing, P7,000,000 loan from a bank, Origination fees paid amounted to
P272,276, while origination costs incurred by the lender amounted to P212,489.
After considering the relevant amounts, the loan’s effective interest rate is now 9%.
Fast forward to December 31, 2023, the Company issued 200,000 of its P25 par
value ordinary shares to fully pay this loan.
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Required: Under each of the following independent scenarios, determine the journal]
entry to record the extinguishment of the loan payable:
1. The shares have P32 fair value while the bonds have P6,800,000 fair value.
2. The shares have P37 fair value while the bonds’ fair value is not reliably
determinable.
3. The shares’ fair value is not reliably determinable while the bonds have
P6,700,000 fair value.
4. The shares’ fair value is not reliably determinable while the bonds have
5. The shares’ fair value and the bonds’ fair value are both not reliably
determinable.
5. On January i, 2023, OSTRICH Company issued eight-year, 8% interest-bearing

bonds payable with total face amount of P8,000,000 when market yields averaged
9%. Interest is payable every December 31 of each year. In addition, the Company’s
ordinary shares have par value of P10.
During the term of the bonds, the Company experienced financial difficulties and
contemplated to issue a certain number of its ordinary shares.
entry to record the extinguishment of the bonds payable:
1. On December 31, 2024, 650,000 ordinary shares were issued when their fair
value amounted to P11 per share. The bonds were quoted at P7,300,000.
2. On December 31, 2025, 700,000 ordinary shares were issued; however, fair
value of the shares are not reliably determinable. The bonds were quoted at
98.50.
3. On July 1, 2026, 680,000 ordinary shares were issued when their fair value
amounted to P12 per share. The issuance is for the payment of all the Company’s
obligation from the bonds. The bonds have no fair value.
6. On December 31, 2023, CASSOWARY had a loan payable with carrying amount of
P6,000,000 and interest of 10% that will mature in two years. There was no accrued
interest payable as of the same date.
The Company projects that it will be having financial difficulty for the next five years.
As a result, on the same date, it consulted with the bank if the terms can be modified
to give the Company more time to pay the loan. After the lengthy process, the
Company and the bank agreed the following modifications:
a. Extending the maturity date to December 31, 2029.
b. Interest to be paid annually will be reduced to 9%,
Market rates as of that date averaged 11%. Modification costs were immaterial.
a. Journal entry to record the modification on December 31, 2023.
b. Journal entry to record the interest and amortization on December 31, 2024
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chapter g - Extinguishment of Liabilities
ye
on December
a Srantial31,titan
2023, desther
the Company entered j
i: arabe i
modification of terms witha bank
a, Interest for the years 2023 to 2024 will be Waived
. Maturitydate of the loan will be extended
to December 31,2031
Market rates as of that date averaged 7%, while modification
amounted to P437,121. If the modification costs are to be considered costs incurred
amount of the modi in the carryin
fied liability, effective interest rate will change to 6.50%
:
a, Journal entry to record the modification on December 31, 2023.
b. Journal entry to record the interest and amortization on December 31, 2024
g. As of the end of 2023, SWIFT Company had a liability with carrying amount of
P8,000,000 and interest of 7% that will mature on December 31, 2024. For the past
few years, the Company has experienced business reversals and projects that it will
fail to pay the liability unless action will be taken. Consequently, on December 31,
2023, the Company and the creditors agreed to the following modifications in the
terms of the liability:
a. Accrued interest of P560,000 as of December 31, 2023 will be waived.
b. Reduction of the liability’s face amount to P6,000,000.
c. Reduction of interest to 5% based on reduced face amount starting on December
31, 2024.
d. Extending the maturity date to December 31, 2029.
Market rates as of the date of modification averaged 6%. Modification costs incurred
Required: Determine the journal entry to record the modification of the terms, under
each of the following independent scenarios:
1. The Company is using the traditional approach.
2. The Company is using the contemporary approach.
9. On December 31, 2023, the terms of one of PELICAN Company's ability with
were modified as follows:
carrying amount and face amount of P9,000,000
a. Principal will be reduced to P7,000,000.
b. Stated rate based on the modified principa 1 will be
reduced from 9% to 6%.
paid from 2024 to 2025.4 to December 31, 2030.
However, no interest tywilldatbee fro
© Extending the maturi m December 31, 202
d. Modification costs of P320,000 will be paid to the creditor.
Market rates as of the date of modification averaged 8%,
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Required: Determine the journal entry to record the modification of the terms, under
each of the following independent scenarios:
1. The Company is using the traditional approach.
2. The Company is using the contemporary approach.
10.0n December 31, 2023, the maturity date of MAGPIE Company's loan payable of
P20,000,000, the Company agreed the following settlements and modifications with
the lender:
a. P3,000,000 portion will be paid by cash of the same amount.
b. P5,000,000 portion will be paid by a land with carrying amount and fair value
of P4,500,000 and P5,200,000, respectively.
c. P4,000,000 portion will be paid by issuing 100,000 of the Company’s P20 par
value shares. As of the same date, the shares have fair value of P42 per share,
while this portion of the loan has a fair value of P3,900,000. -
d. P8,000,000 portion will be modified as follows (the Company uses the
traditional approach in recording substantial modification):
e Face amount will be reduced to P6,000,000.
Maturity date will be extended to December 31, 2028.
Stated rate based on the reduced amount will be reduced from 8% to 5%.
Modification costs of P300,000 will be paid to the lender.
Market rates as of the date of modification averaged 7%.
Required: Determine all the journal entries related to the settlement and
modification of the loan payable.

1. On January 1, 2023, STORK Company issued 5,000 of its five-year, 8% interest-
bearing bonds with P1,000 face amount when market yields averaged 9%. Interest
is payable every December 31 of each year.
Fast forward to December 31, 2024, 2,000 of the bonds were retired by paying
P2,100,000 to the bondholders. Fast forward yet again to December 31, 2025, 1,500
bonds were retired by paying P1,400,000 to the bondholders.
The gain or loss on retirement on December 31, 2024 shall be
a. P150,627 gain c. P250,832 gain
b. P150,627 loss d, P250,832 loss

a. P435,421 c. P438,609
b. P261,253 d, P263,165
The gain or loss on retirement on December 31, 2025 shall be
a. P231,759 gain c. P73,612 gain
b. P231,759 loss d, P73,612 loss
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a. P132,625 c. P141,782
b. P138,828 d. P147,282
2, OnJanuary 1, 2022, QUAIL Company issued 6,000 of its P1,000 par value bonds with
maturity date of December 31, 2028 when market yields averaged 10%. Interest of
9% is payable every December 31 of each year.
On July 1, 2024, 2,000 of these bonds were retired by paying P2,190,000, inclusive
of accrued interest, to the bondholders. On April 1, 2025, another 1,000 of these
bonds were retired by paying P972,500, inclusive of accrued interest, to the
bondholders.
a. P481,046 c.P577,;255
b. P472,832 d. P573,868
Gain or loss on retirement on July 1, 2024 shall be
a. P169,607 gain c. P259,607 gain
b. P169,607 loss d. P259,607 loss
Gain or loss on retirement on April 1, 2025 shall be
a. P20,009 gain c. P35,632 gain
b. P20,009 loss d. P35,632 loss
3. Atthe beginning of the year 2022, EMU Company issued 10,000 ofits P500 par value
bonds with maturity date of December 31, 2029 when market yields averaged 12%.
Interest of 14% is payable every June 30 and December 31 of each year.
Assumption 1: On December 31, 2024, the Company issued 300,000 of its P10 par
value ordinary shares when the fair value per share amounted to P17. On the other
hand, the bonds have fair value of P5,200,000.
The gain or loss on extinguishment shall be
a. P168,003 gain c. P268,003 gain
b. P168,003 loss d. P268,003 loss
The resulting share premium — issuance shall be
a. P2,100,000 c. P2,300,000
b. P2,200,000 d, P2,450,000
Assumption 2; On December 31, 2025, the Company issued 300,000 of its P10 par
value ordinary shares, the fair value of which is not reliably determinable. On the
other hand, the bonds have fair value of P5,450,000,
The gain or loss on extinguishment shall be

a. P78,953 gain c. P139,512 gain
b. P78,953 loss d, P139,512 loss
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The resulting share premium - issuance shall be

c. P2,100,000 c. P2,300,000
d. P2,200,000 d. P2,450,000
4. On December 31, 2023, CORMORANT Company had an outstanding loan payable

with face amount and carrying amount of P6,000,000 and maturity date of
December 31, 2024. The Company is currently experiencing financial difficulties and
as a result, agreed the following modification of terms with the lender on December
31, 2023:
a. Extending the maturity date on December 31, 2029.
b. Reducing the interest from 12% to 11%.
Market rates on the date of modification averaged 10%, while modification costs
incurred amounted to P118,161. If the modification costs are to be considered in the
carrying amount of the liability, effective interest rate will change to 12.50%.
The amount of net gain on extinguishment shall be
a. P261,316 c. P270,632
b. P246,685 d. P278,532
The initial measurement of the revised liability shall be
a. P5,635,154 c. P5,895,856
b. P5,753,315 d. P5,956,892
The amount of interest expense for the year 2024 shall be

a. P736,982 c. P704,394
b. P744,612 d. P719,164
5. KINGFISHER Company hada liability that has a maturity date of December 31, 2023.
However, due to business reversals that the Company has experienced for the past
few years, it was not able to settle the liability. Consequently, the Company and the
lender agreed with the following modification of terms of the loan:
a. Reduction of the face amount of the loan from P10,000,000 to P6,000,000.
b. Waiving of the P800,000 accrued interest as of December 31, 2023.
c. Reduction of the interest rate to 6%,
d. Extending the maturity date to December 31, 2027.
Market rates as of the date of modification averaged 7%. Modifications amounted to
P200,000.
A . 1: Th Company is using the traditional approach:

a. P5,197,454 c, P5,003,234
b. P4,997,454 d, P4,803,234
The initial measurement of the new liability shall be
a. P5,602,546 c, P5,796,766
b. P5,402,546 d. P5,596,766
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a. P448,204 c. P468,985
b. P405,774 d. P412,789

a. P5,197,454 c. P5,003,234
b. P4,997,454 d. P4,803,234
The initial measurement of the new liability shall be
a. P5,602,546 c. P5,796,766
b. P5,402,546 d. P5,596,766
a. P448,204 c. P468,985
b. P405,774 d. P412,789
6. On December 31, 2023, HAWK Company had a maturing loan payable with face
amount and carrying amount of P10,000,000. Since the Company has no available
cash to pay the loan, the loan was settled in the following manner:
a. The P2,000,000 portion will be paid by an equipment with carrying amount of
P2,400,000 and fair value of P1,900,000.
b. The P3,000,000 portion will be paid by issuing ordinary shares with total par
value of P2,000,000. Total fair values of this portion of the loan and the issued
shares amounted to P3,300,000 and P3,500,000 million.
c. Theremaining P5,000,000 will be modified as follows:
e Stated rate will be reduced to 8% down from 10%,
e The principal amount was reduced to P4,000,000.
e The maturity date was extended to December 31, 2028.
e Modification costs incurred amounted to P180,000. The Company will use
the contemporary approach in recording the modification. Market rates as
of that date averaged 11%.
The amount of net gain or loss on extinguishment shall be

a. P1,243,508 gain c. P543,508 gain
b. P1,243,508 loss d. P543,508 loss
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Chapter 9 —- Lessee Accounting — Basic Considerations
CHAPTER 9
LESSEE ACCOUNTING - BASIC CONSIDERATIONS

The parties in a lease contract.
Pr
The general accounting requirement for leases in the lessee’s perspective.

PWN
The initial measurement and subsequent accounting for right-of-use asset.

The initial measurement and subsequent accounting for lease liability.
The financial reporting for the right-of-use asset and lease liability.
AM
The accounting for the exceptions (i.e., short-term lease and lease of low-value
assets) in the general lessee accounting model.
LEASES - BACKGROUND
Entities usually invest in property development, construction of buildings and
office spaces, and construction of heavy machinery and equipment for the use of
other entities. The technical term for this contract is called a lease. A lease is a
contract, or part ofa contract, that conveys the right to use an asset (the underlying
asset) for a period of time in exchange for consideration. [PFRS 16.A].
Good examples for property leases are those found in Makati Central Business
District, Ortigas Center, and Bonifacio Global City where property developers
construct office spaces in high-rising buildings and shopping malls for other
entities’ use. Other entities, such as aircraft manufacturers, build aircrafts for lease
to airline companies.
The following are the parties in a lease contract:

a. Lessor is the entity who leases out underlying asset and receives consideration.
b. Lessee is the entity who uses the underlying asset and pays consideration.
The lease agreement between the lessor and the lessee is usually documented in a
contract which contains the duration of the lease, asset which is the object of the
lease, lease payments, lease conditions, and other matters concerning the lease.
SOME REASONS WHY LESSEES ENTER INTO LEASE CONTRACTS

The following are some of the reasons why lessees enter into lease contracts:
a. Most leases are structured as financing transactions. Instead of entities
having a large initial outlay of cash when acquiring assets, they can defer its cash
payment into future periods by way of scheduled rental payments.
b. Leases have more flexible terms compared to bank financing. Since the
leased asset can be viewed as the security or the “collateral”, a lease contract is
not subject to strict covenants unlike in a plain bank financing.
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Chapter 9 - Lessee Accounting — Basic Considerations
c. Less exposure to obsolescence. Since the lessee is not the owner of the leased
asset, it can easily get rid of the obsolete asset by the end of the lease term.
d. Lessee’s focus on its main operations. Most of the underlying assets covered
by lease contracts are substantially ready for use at the start of the lease
contract, save for those with some minor retrofitting, if there are any. Because
of this, a lessee can focus on its main operations rather than constructing its own
asset.
LESSEE ACCOUNTING FOR LEASES

PFRS 16, Leases, introduces a general lessee accounting model which requires a
lessee to recognize a right-of-use (ROU) asset and corresponding lease liability,
save for some exceptions.
ROU asset represents the control and the right of the lessee to use the asset during
the lease term but not the legal ownership of the underlying asset. Lease liability
represents the present value of lease payments to be made during the lease term.
ROU asset and lease liability are both recognized on the commencement date. This
is the date on which a lessor makes an underlying asset available for use by a lessee.
The exceptions to this general lessee accounting model, which will be discussed later
in the chapter, are the following:
a. Short-term leases (lease term of not more than 12 months)
b. Leases of low-value assets
RIGHT-OF-USE ASSET - INITIAL MEASUREMENT

The lessee should initially measure the right-of-use of asset at cost. The cost of the
right-of-use asset consists of:
a. initial measurement of lease liability;
b. any lease payments made at or before the commencement date less any lease
incentives received;
c. any initial direct costs incurred by the lessee; and
d. asset retirement obligation that is to be incurred by the lessee in dismantling
and removing the underlying asset, restoring the site, on which it is located, or
restoring the underlying asset to the condition required by the terms and
conditions of the lease, unless those costs are incurred in producing inventories.
Security deposit paid shall be recognized as a separate asset and shall be excluded
from the cost of ROU asset since it can be recovered later on from the lessor.
LEASE LIABILITY - INITIAL MEASUREMENT

The measurement of lease liability will be discussed first since this is the major
component in the initial measurement of ROU asset. The following aspects about
the initial measurement of the lease liability are to be discussed in this section:
a. Discount rate to be used in computing the present value of lease payments
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b. Amounts and number of lease payments to be included in the lease liability

c. Extension and termination options on the lease term
Depending on the circumstances, the initial amount of lease liability can be
either equal to or lower (but not higher) than the initial amount of ROU asset.
DISCOUNT RATE
Since the lease liability is a present value amount, the future cash flows included in
its measurement shall be discounted. The rate to be used is determined using the
following hierarchy:
a. First, the implicit rate on the lease, if known by the lessee.
b. Otherwise, the lessee shall use its own incremental borrowing rate.
For example, in a lease contract, the implicit rate is 10% and lessee’s incremental
borrowing rate is 12%. If the lessee knows the implicit rate, it shall use 10% in
discounting the lease payments; otherwise, it shall use 12%.
In practice, this implicit rate is seldom known by the lessee as this represents the
rate that the lessor is earning from the lease.
Incremental borrowing rate is the interest that a lessee would have to pay to
borrow over a similar term, and with a similar security, the funds necessary to
obtain an asset of a similar value to the right-of-use asset in a similar economic
environment. [PFRS 16.A].
LEASE LIABILITY - LEASE PAYMENTS

The following shall be included in the present value of lease payments as of
commencement date for the right to use the underlying asset to the extent that they
were not paid as of commencement date:
a. fixed payments less any lease incentives to be received;
b. variable lease payments that depend on an index, initially measured using the
index or rate as at the commencement date;
c. amounts expected to be payable by the lessee under residual value guarantees;
d. exercise price of a purchase option if the lessee is reasonably certain to exercise
that option; and
e. payments of penalties for terminating the lease, if the lease term reflects the
lessee exercising an option to terminate the lease.
These inclusions in the lease liability amount are to be discussed bit-by-bit in the
succeeding sections. Item e will be discussed much later in the chapter.
On the other hand, the following amounts, which are otherwise considered as
payments connected with a lease, are excluded from the initial measurement of
lease liability:
a. non-lease payments such as payments related to utilities, service fees, security
fees, maintenance fees, association dues, and other related expenses; and
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b. variable lease payments as percentage of the lessee’s revenue, output or

future performance. However, the minimum amount of lease payments and
variable lease payments based on an index (e.g., consumer price index, general
price index, etc.), if there are any, shall still be included in the initial
measurement of lease liability as fixed payments.
These exclusions from lease liability are recognized as expenses when incurred.
FIXED LEASE PAYMENTS
At the minimum, a lease contract normally contains the usual periodic lease
payments (e.g., annual, semi-annual, quarterly, or monthly lease payments). “Fixed”
lease payments in this context means “determinable” lease payments, rather than
“equal” lease payments per period. A good example of this is the monthly rentals
for the apartments or dormitories rented out by the students.
Depending on the characteristics of cash flows, the following present value factors
are to be applied, as previously encountered in earlier chapters:
PV Factors es » Applicable to
PV of ordinary annuity Lease payments are made at the end of each period
PV of annuity due Lease payments are made at the beginning of each period
Series of PV of single | Lease payments are not equal with each other and/or the
payment length of time between each payment is not uniform
The readers should take note that PV of annuity due = PV of ordinary annuity x (1 +
r%). Usually, lease contracts require payments at the beginning of each period,
hence, expect the heavy use of PV of annuity due in the chapters involving leases.
Illustration 1. RICO Company leased a vehicle from a lessor by paying P400,000
annually for the next five years. Implicit rate on the lease, which is not known by the
Company is 6%. The Company’s incremental borrowing rate is 7%. Required: Under
each of the following independent scenarios, determine the initial amount of lease
liability and ROU asset:
1. Lease payments are made at the end of each period.
2. Lease payments are made at the beginning of each period.
Scenario 1 - Lease payments are made at the end of each period
Lease Liab./
PV Factor of PVFactor Cash Flows ROU Asset
Ordinary annuity for 5 periods at 7% 4.100197 P400,000 P1,640,079
The following shall be noted: .

a. Since the lease payments are to be made at the end of each period, the PV factor
of ordinary annuity was used. oo.
b. Since the implicit rate of 6% is not known by the Company, its incremental
borrowing rate of 7% shall be used instead.
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c. Since there were no other information given, the initial measurements of lease
liability and ROU asset are equal. This will be the same case as in Scenario 2.
Journal entry to record the transaction on commencement date:
Right-of-use asset 1,640,079
Scenario 2 - Lease payments are made at the beginning of each period
Lease Liab./
Annuity due for 5 periods at 7% 4.387211 P400,000 P1,754,884
Since the lease payments are to be made at the beginning of each period, the PV
factor of annuity due was used.
Illustration 2. At the beginning of 2023, PUNZALAN Company leased a commercial
space from a lessor for four years. The following are the relevant provisions:
a. Annual payments of P1,400,000 are due every January 1 of each year, starting in
2023. This is inclusive of P200,000 annual security and maintenance fee.
b. Additional rent of 3% of revenues are to be paid to the lessor. Company’s
revenue for 2023 amounted to P8,000,000. The Company also incurred initial
direct costs of P300,000.
c. Security deposit of P800,000 is required to be paid on January 1, 2023.
Company’s incremental borrowing rate as of January 1, 2023 was 8%.
In this case, the initial amount of lease liability shall be computed as follows:
PV Factor of PVFactor Cash Flows Lease Liab.
Annuity due for 4 periods at 8% 3.577097 P1,200,000 P4,292,516
The following points should be noted:

a. The P200,000 security and maintenance fee is a non-lease payment, hence,
deducted from the total annual payment to arrive at P1,200,000 (P1,400,000 -
P200,000) annual lease payment.
b. Variable lease payments of 3% of revenues are excluded in the measurement of
lease liability. These will be recorded as additional expense during the period they
were incurred. Rental expense based on this for 2023 is P240,000 (P8M x 3%).
c. Security deposit is recognized as a separate asset. However, there are initial
direct costs of P300,000, making the initial amount of ROU asset different
from initial amount of lease liability, as follows:
Initial measurement of lease liability P4,292,516
Add: Initial direct costs incurred by lessee 300,000
Initial measurement, ROU asset P4,592,516
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d. Journal entry to be made on commencement date, January 1, 2023, is as follows:

~ Lease liability 4,292,516
Cash (for initial direct costs) 300,000
VARIABLE PAYMENTS BASED ON INDEX OR RATE

Lease contracts normally run for a fixed period of time wherein the purchasing
power of money may drastically decrease or increase because of inflation or
deflation, respectively. To address this, some lease contracts contain provisions to
adjust the periodic lease payments prospectively in response to changes in the
relevant index or rate. This is to be discussed in the succeeding chapter.
RESIDUAL VALUE GUARANTEES
Underlying assets of lease contracts normally diminish in value at the end of the
related lease term. As a result, lessees may guarantee a minimum value of the
underlying asset at the end of the lease term to create an incentive for the lessor to
enter into a lease contract. Lessees shall pay any shortfall from this minimum value.
Note: Shortfall = Guaranteed amount less expected value at the end of the lease.
For example, a lessee made a residual value guarantee of P1,000,000. If the

underlying asset’s value at the end of the lease term is at least P1,000,000, no
additional amounts shall be paid. However, if the underlying asset’s value go below
P1,000,000 at the end of lease term, say at P800,000, the lessee shall pay the shortfall,
in this case P200,000 (P1,000,000 less P800,000).
In computing the lease liability, the identity of the entity guaranteeing the residual
value is relevant. Particularly, the residual value guarantee shall only be included
in the lease liability if the guarantor is either of the following:
a. lessee; or
b. an entity related to lessee.
If the entity guaranteeing the residual value is an entity related to the lessor, it
will be considered as unguaranteed residual value and will be excluded from the
lease liability.
The readers should take note that the amount to be included in the lease liability is
the present value of expected amount of the shortfall, which is not necessarily the
amount of residual value guarantee.
There is an expected shortfall only if guaranteed residual value > expected value
of the leased asset as of the end of lease term. For this expected amount of
shortfall, we will be using the PV of single payment.
Illustration 3.0On January 1, 2023, BENITEZ Company entered into a five-year lease
contract covering a vehicle. Annual lease payments of P600,000 are due at the start
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of each year, starting on January 1, 2023. In addition, the Company also made a
residual value guarantee that the asset’s value at the end of lease term is at least
P800,000. Unguaranteed residual value amounted to P950,000. Company’s
incremental borrowing rate is 6%. Required: Under each of the following
independent scenarios, determine the initial measurement of lease liability and
ROU asset:
1. Expected value of the asset is P300,000 at the end of the lease term.
2. Expected value of the asset is P1,000,000 at the end of the lease term.
Scenario 1 - Expected value of the asset is P300,000

In this scenario, the amount of expected shortfall to be paid at the end of lease term
is P500,000 (P800,000 - P300,000). Initial measurement of lease liability and ROU
asset are computed as follows:
Lease Liab./
PV Factor of PV Factor Cash Flows ROU Asset
Single payment for 5 periods at 6% 0.747258 P500,000 P373,629
Annuity due for 5 periods at 6% 4.465106 600,000 2,679,064
Initial Measurement, Lease Liability/ROU Asset P3,052,693
Scenario 2 - Expected value of the asset is P1,000,000

In this scenario, there is no expected shortfall to be paid at the end of lease term
since the expected value is more than the residual value guarantee. Initial
measurement of lease liability and ROU asset are computed as follows:
Lease Liab./
Single payment for 5 periods at 6% 0.747258 P- px
Scenarios 1 and 2 - Generalizations

1. The amount of unguaranteed residual value will never be included in the
lease liability.
2. The amount to be included in the measurement of the lease liability is not
necessarily the amount of guaranteed residual value. Instead, the amount of
expected shortfall, if any, shall be included.
3. Expected shortfall will be included in the lease liability only if expected value <
residual value guarantee.
PURCHASE OPTIONS
Generally, the lessee shall return the underlying asset to the lessor at the end of the
lease term. However, some lease contracts may provide an option to the lessee to
purchase the underlying asset at a specified purchase price at the end of lease term.
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Chapter 9 - Lessee Accounting - Basic Considerations
In this case, the present value of the purchase price shall be included in the
lease liability only when the lessee is reasonably expected to exercise it. There
are many factors to consider whether or not to exercise the purchase option, such
as, but not limited to, the following:
a. contractual terms and conditions for the optional periods compared with
market rates
b. significant leasehold improvements undertaken
c. costs relating to the termination of the lease
d. the importance of that underlying asset to the lessee’s operations
e. conditionality associated with exercising the option /PFRS 16.B37].
As a result, even though there is a bargain purchase option (expected asset value >
purchase option price) at the end of the lease term, it is not automatic that the lessee
will exercise the option; consideration of other factors may still result to its non-
exercise.
Conversely, even if there is no bargain purchase option at the end of the lease term,
it is possible that the lessee can still reasonably expect to exercise the purchase
option.
Illustration 4. BERNABE Company entered into a six-year lease contract on

January 1, 2023. Annual lease payments of P1,500,000 are due at the start of each
year, starting on January 1, 2023. In addition, the lease contract gives the Company
the option to purchase the underlying asset for P900,000 at the end of the lease
term. Incremental borrowing rate is 9%. Required: Under each of the following
independent scenarios, determine the initial measurement of lease liability and
ROU asset:
1. Expected value of the asset is P900,000 at the end of the lease term and the
lessee is reasonably certain to exercise the purchase option.
2. Expected value of the asset is P1,200,000 at the end of the lease term but the
lessee is not reasonably certain to exercise the purchase option.
Scenario 1 - Reasonably certain to exercise the purchase option
Since it is reasonably certain that the lessee will exercise the purchase option, it will
be included in the computation of the lease liability and ROU asset as follows:
Lease Liab./
PV Factor of PV Factor CashFlows ROU Asset
Annuity due for 6 periods at 9% 4.889651 1,500,000 7,334,477
Initial Measurement, Lease Liability/ROU Asset 7,871,117
Even though there is no bargain purchase option, the amount of purchase option is
still included in the lease liability computation since the lessee is reasonably certain
to exercise the purchase option.
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Scenario 2 - Not reasonably certain to exercise the purchase option

Since it is not reasonably certain that the lessee will exercise the purchase option,
it will be excluded in the computation of lease liability and ROU asset as follows:
Lease Liab./
PV Factor of PVFactor CashFlows ROU Asset
Single payment for 6 periods at 9% 0.596267 P- P-
Even though there is a bargain purchase option (P1,200,000 > P900,000), the
amount of purchase option was still excluded in the lease liability computation since
the lessee is NOT reasonably certain to exercise the purchase option.
Scenarios 1 and 2 - Generalizations and Comparison
1. Similar to residual value guarantee, the amount to be paid for the purchase
option is presumed to be made at the end of the lease term, hence the use of PV
of single payment.
2. The amounts to be included in the lease liability computations from residual
value guarantee and purchase option are compared as follows:
Amounts included in lease liability
Residual Value Guarantee Expected shortfall, if there is any
Purchase option price, if reasonably
Purchase Option
certain to be exercised
SUBSEQUENT MEASUREMENT OF RIGHT-OF-USE ASSET

Generally, ROU asset is subsequently measured using the cost model which is cost:
a. less accumulated depreciation and accumulated impairment losses; and
b. add or less the adjustments to the lease liability (to be discussed in the next
chapter).
Depending on the lease contract, the following are the relevant guidelines in
depreciating ROU assets:
Ref Scenario Depreciation period | Depreciable amount
A Basic lease contract Shorter of: Initial measurement
B With residual value a. lease term; or of ROU asset (i.e., no
guarantee b. useful life of ROU deduction for
C With purchase option not asset residual value
expected to be exercised (“general rule”) guarantee)
D With purchase option Initial measurement
expected to be exercised Guar did hecoPensenil nes _ a
F Transfer of ownership at life end of useful life, if
the end of the lease term .
thereisany
*Also known as salvage value.
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The following are the rationale for the abovementioned rules:

a. Under scenarios A, B and C, the lease term limits the lessee’s use of the
underlying asset since that asset is required to be returned to the lessor at the
end of the lease term. As a result, the lease term is considered in determining
the depreciation period.
Under scenarios D and E, the lease term does not limit the lessee’s use of the
underlying asset, thus, the lease term is not considered in determining
depreciation period. In addition, the lessee is entitled to the residual value of the
Cc The residual value guarantee is the residual value to be received by the

lessor (i.e., not by the lessee since the underlying asset will be returned to the
lessor at the end of the lease term). As a result, this shall never be deducted to
arrive at the depreciable amount of the ROU asset in the lessee’s perspective.
Aside from the cost model, the ROU asset can also be subsequently measured under
the following models:
a. revaluation model - if the underlying asset of the ROU asset belongs to a class
of property, plant and equipment to which lessee applies the revaluation model.
[PFRS 16.35].
fair value model - if the lessee uses fair value model for its investment
properties and the ROU asset meets the definition of investment property. [PFRS
16.34].
SUBSEQUENT MEASUREMENT - LEASE LIABILITY
Regardless of the subsequent measurement of the corresponding ROU asset, the
lease liability shall subsequently be measured as follows:
a. increasing the carrying amount to reflect interest on the lease liability (i.e.,
accretion of interest);
b. reducing the carrying amount to reflect the lease payments made; and
Cc remeasuring the carrying amount to reflect any reassessment or lease
modifications (to be discussed in the next chapter). [PFRS 16.36].
In short, since we are dealing with present values, we will be using the amortization
table when subsequently measuring the lease liability. The relevant amortization
table will vary depending on the amounts of cash flows included in its initial
measurement (e.g., expected shortfall, purchase option, etc.) The following are the
pro-forma journal entries for the accretion of interest expense at the end of each
year and the periodic payment of lease liability, respectively:
Interest expense XX
Lease liability XX
Lease liability xx
Cash x
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In addition, if the lease payments are made at the start of each period, additional
procedures are to be made to properly determine the ending balance of the lease
liability at the end of each year. No such additional procedures are made if the lease
payments are paid at the end of each period.
Illustration 5. On January 1, 2023, BUENAVENTURA Company entered into a four-
year lease contract covering an equipment. The Company is required to pay annual
lease payments of P1,800,000 every January 1 starting in 2023. Incremental
borrowing rate is 7%. Ignoring the lease term, the equipment supposedly can be
used for seven years after which it can be sold for P300,000. Required: Under each
of the following independent scenarios, determine the initial and subsequent
accounting for the ROU asset and lease liability:
1. There were no additional lease provisions (i.e., basic lease contract)
2. There is a residual value guarantee of P1,500,000, with the expected value of the
asset at the end of the lease term set at P700,000.
3. There is a purchase option for P900,000 that is reasonably expected to be
exercised.
4. There is a purchase option for P900,000 that is not reasonably expected to be
exercised.
5. There is a transfer of ownership at the end of the lease term.
Scenario 1 - Basic Lease Contract
The initial measurement of ROU asset and lease liability, and annual depreciation
of ROU asset are computed as follows:
Lease Liab./
Less: Residual value -
Depreciable amount of ROU asset P6,523,769
Divide by: Shorter of lease term (4 yrs) and useful life (7 yrs) 4
Annual depreciation, ROU asset 1,630,942
The following is the amortization table for the lease liability:
Lease Interest Amorti- Carrying

Date Payments Expense zation Amount
Jan. 1, 2023 6,523,769
Jan.1,2023 1,800,000 - (1,800,000) 4,723,769
Jan.1,2024 1,800,000 330,664 (1,469,336) 3,254,433
Jan.1,2025 1,800,000 227,810 (1,572,190) 1,682,243
Jan.1,2026 1,800,000 117,757 (1,682,243) “i
Year 2023
On the commencement date, January 1, 2023, the following journal entry is made:
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Cash 1,800,000
On December 31, 2023, the following entries are to be made:

Depreciation expense 1,630,942

Lease liability 330,664
It should be noted that the interest expense of P330,664 corresponding on January

1, 2024 in the amortization table really covers the period from January 1, 2023 to
January 1, 2024. As a result, this interest amount has already accreted as of
December 31, 2023.
In addition, neither P4,723,769 nor P3,254,433 is usable as carrying amounts as of
December 31, 2023 since they are both as of January 1 of each corresponding years.
As a result, the carrying amount of the lease liability shall be computed separately
as follows (based on journal entries):
Lease Liability
Payment 1/1/23 | P1,800,000 | P6,523,769 | Initial balance
Balance, 12/31/23 (squeeze) | 5,054,433 330,664 | Interest accretion
Year 2024
On January 1, 2024, the following journal entry shall be made:
Cash 1,800,000
Fast forward on December 31, 2024, the following journal entry shall be made:
Depreciation expense 1,630,942

Carrying amount of lease liability as of December 31, 2024 is computed as (again,
based on the beginning balance and journal entries):
Lease Liability
Payment 1/1/24 | P1,800,000 P5,054,433 | 1/1/24 balance
Balance, 12/31/24 (squeeze) | 3,482,243 227,810 | Interest accretion
Totals (should be equal) | P5,282,243 P5,282,243
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These are the additional procedures that were mentioned earlier and shall be
applied to subsequent periods and to other scenarios, whenever the lease payments
are made at the beginning of each period.
In summary, the following amounts are reported in the income statement and
balance sheet for each year:
Income Statement | Balance Sheet, 12/31
Year Depre- Interest ROU Lease
ciation Expense Asset, Liab.,
6,523,769
2023 1,630,942 330,664 4,892,827 5,054,433 (4,723,769+330,664)
2024 1,630,942 227,810 3,261,885 3,482,243 (3,254,433+227,810)
2025 1,630,942 117,757 1,630,943 1,800,000 (1,682,243+117,757)
2026 1,630,943
Note that the carrying amount of ROU asset is periodically reduced by the annual
depreciation (for example, P4,892,827 = P6,523,769 - P1,630,942). At the end of the
lease term, ROU asset and lease liability have zero carrying amounts since the
underlying asset is to be returned to the lessor.
Scenario 2 - Residual Value Guarantee of P1,500,000
In this case, there is an expected shortfall of P800,000 (P1,500,000 - P700,000). This
is included in the initial measurement of ROU asset and lease liability, and annual
depreciation of ROU asset as follows:
Lease Liab./
Initial measurement, Lease liability/ROU asset P7,134,085 ©
Less: Residual value of ROU asset
Depreciable amount P7,134,085
Divide by: Shorter of lease term (4 yrs) and useful life (7 yrs) 4
Annual depreciation, ROU asset P1,783,521
Again, the amount of residual value guarantee was not deducted since this will
be received by the lessor, not by the Company.The following is the amortization
table for the lease liability:
Jan. 1, 2023 7,134,085
Jan. 1, 2023 1,800,000 (1,800,000) 5,334,085
Jan. 1, 2024 1,800,000 373,386 (1,426,614) 3,907,471
Jan. 1, 2025 1,800,000 273,523 (1,526,477) * 2,380,994
Jan. 1, 2026 1,800,000 166,670 (1,633,330) 747,664
Dec. 13, 2026 800,000 52,336 (747,664)
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The following amounts are reported in the income statement and balance sheet for
each year:
Depre- _ Interest ROU Lease
Year ciation Expense | Asset, Liab.,
7,134,085
2023 1,783,521 373,386 | 5,350,564 5,707,471 (5,334,085+373,386)
2024 1,783,521 273,523 | 3,567,043 4,180,994 (3,907,471+273,523)
2025 1,783,521 166,670 | 1,783,522 2,547,664 (2,380,994+166,670)
2026 1,783,522 52,336 # 800,000 (747,664+52,336)
At the end of the lease term, upon the return of the underlying asset to the lessor,
the following guidelines are relevant:
scenariog:e53745 _ Consequence
Actual shortfall > expected shortfall | Loss on guarantee
Actual shortfall < expected shortfall | Gain on guarantee
Actual shortfall = expected shortfall No gain or loss
In this scenario, the balance of the lease liability on December 31, 2026 is equal to
the initial amount of P800,000 expected shortfall (i.e, P1,500,000 residual value
guarantee less P700,000 expected value of the underlying asset at the end of lease
term).
Subcase 1 - On December 31, 2026, the value of the equipment is P700,000. This
will result to P800,000 actual shortfall to be paid in cash (P1.5M - P700K), which is
equal to P800,000 initially estimated amount of shortfall. In this case, the following
entry shall be made on that date:
Cash 800,000
Subcase 2 - On December 31, 2026, the value of the equipment is P400,000. This
will result to P1,100,000 actual shortfall to be paid in cash (P1.5M - P400K). In this
case, the following entry shall be made on that date:
Loss on guarantee (P1.1M-P800K) 300,000
Cash (P1,500,000 - P400,000) 1,100,000
Subcase 3 - On December 31, 2026, the value of the equipment is P1,200,000. This
will result to P300,000 actual shortfall to be paid in cash (P1.5M - P1,.2M). \n this case,
the following entry shall be made on that date:
Cash (P1.5M - P1.2M) 300,000
Gain on guarantee (P800K - P300K) 500,000
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Scenario 3 - P900,000 Purchase Option Reasonably Expected to be Exercised

Since the purchase option is reasonably expected to be exercised, the purchase
option price is included in the initial measurement of ROU asset and lease liability,
and annual depreciation of ROU asset as follows:
Lease Liab./
Annuity due for 4 periods at 7% 3.624316 — P1,800,000 P6,523,769
Initial measurement, Lease liability/ROU asset P7,210,375
Less: Residual value at the end of useful life 300,000
Divide by: Useful life (7 yrs) 7
Annual depreciation, ROU asset P987,196

a. Since the underlying asset is usable beyond the end of the four-year lease term,
it shall be depreciated over its own useful life.
b. Relevant residual value at the end of the useful life is deducted in arriving at the
depreciable amount since the lessee is entitled to receive this amount later on.
The following is the amortization table for the lease liability:

Jan. 1, 2023 7,210,375
Jan.1,2023 1,800,000 - (1,800,000) 5,410,375
Jan.1,2024 1,800,000 378,726 (1,421,274) 3,989,101
Jan.1,2025 1,800,000 279,237 (1,520,763) 2,468,338
Jan.1,2026 1,800,000 172,784 (1,627,216) 841,122
Dec. 13,2026 900,000 58,878 (841,122) -
each year (assuming the purchase option will be actually exercised at the end of the
lease term):
Year Depre- _ Interest ROU Lease
7,210,375
2023. 987,196 378,726 | 6,223,179 5,789,101 (5,410,375+378,726)
2024 987,196 279,237 | 5,235,983 4,268,338 (3,989,101+279,237)
2025 987,196 172,784 | 4,248,787 2,641,122 (2,468338+172,784)
2026 987,196 58,878 | 3,261,591 900,000 (841,122+58,878)
2027 987,196 - 2,274,395 ~
2028 987,196 - 1,287,199 -
2029 987,199 - 300,000 | -
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Since the lessee (i.e., the Company) can still use the underlying asset after the end
of the lease term, its carrying amount and depreciation expense traverse
beyond the end of the lease term. On the other hand, interest expense and lease
liability are limited at the end of the lease term.
On December 31, 2026, the exercise of the purchase option shall be recorded as
follows:
Cash 900,000
As of the same date, since the Company now owns the underlying asset, the
following entry may be made to reclassify the carrying amount of the ROU asset:
Equipment 3,261,591
ROU asset 3,261,591
Query: What if, despite the initial assumption that the purchase option will be
exercised, the lessee did not actually exercised the purchase option at the end of the
lease term?
In this case, the underlying asset shall be returned to the lessor and a loss shall be
recognized equal to the difference between the carrying amounts of the ROU asset
and lease liability at the end of the lease term.
For this scenario, the following entry shall be made on December 31, 2026:
Loss on purchase option 2,361,591
ROU asset 3,261,591
Scenario 4 - P900,000 Purchase Option NOT Reasonably Expected to Exercise

Initial and subsequent accounting for ROU asset and lease liability are the same as
in Scenario 1 (i.e., purchase option price is excluded).
Scenario 5 - Transfer of Ownership at the End of Lease Term
The initial measurement of ROU asset and lease liability, and annual depreciation
are computed as follows:
Lease Liab./
Less: Residual value at the end of the useful life 300,000
Divide by: Useful life (7 yrs) 7

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a. Since the underlying asset is usable beyond the end of the four-year lease term,
it shall be depreciated over its own useful life.
b. Relevant residual value at the end of the useful life is deducted in arriving at the
depreciable amount since the lessee is entitled to receive this amount.
The following is the amortization table for the lease liability (similar to Scenario 1):
Lease Interest Carrying
Date Payments Expense Amort. Amount
Jan. 1, 2023 6,523,769
Jan.1,2023 1,800,000 - (1,800,000) 4,723,769
Jan.1,2024 1,800,000 330,664 (1,469,336) 3,254,433
Jan.1,2025 1,800,000 227,810 (1,572,190) 1,682,243
Jan.1,2026 1,800,000 117,757 (1,682,243) -
each year:
Year Depre- _ Interest ROU Lease
6,523,769
2023 889,110 330,664 | 5,634,659 5,054,433 (4,723,769+330,664)
2024 889,110 227,810 | 4,745,549 3,482;243 (3,254,433+227,810)
2025 889,110 117,757 | 3,856,439 1,800,000 (1,682,243+117,757)
2026 889,110 - 2,967,329
2027 ~=889,110 2,078,219
2028 889,110 1,189,109
2029 889,109 300,000
On December 31, 2026, since the Company now owns the underlying asset, the
following entry may be made to reclassify the carrying amount of the ROU asset:
Equipment 2,967,329
ROU asset 2,967,329
CONSIDERATION OF EXTENSION AND TERMINATION OPTION

In the previous illustrations, the lease contracts have non-cancellable lease terms.
However, in reality, some lease contracts contain provisions giving the lessee the
option to extend the lease term and/or pre-terminate the lease term.
In these cases, the total lease term is determined as the non-cancellable lease term,
together with both
a. periods covered by an option to extend the lease if the lessee is reasonably
certain to exercise that option; and
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b. periods covered by an option to terminate the lease if the lessee is reasonably

certain not to exercise that option. [PFRS 16,4].
In assessing whether or not to exercise the given option, the lessee may use similar
factors mentioned in the discussions about purchase option. The initial and
subsequent measurement of ROU asset and lease liability shall follow the lessee’s
assumption about exercising the extension or termination options or not.
Illustration 6 - Extension Option. BALLESTEROS Company entered into a lease

contract with a non-cancellable period of 4 years. In addition, the Company also has
the option to extend the lease term for an additional 3 years. Annual lease payments
of P750,000 are due at the beginning of each year. Incremental borrowing rate is
9%, Required: Under each of the following independent scenarios, determine the
initial amounts of ROU asset and lease liability:
1. Extension option is reasonably expected to be exercised.
2. Extension option is not reasonably expected to be exercised.
Scenario 1 - Extension option is reasonably expected to be exercised
Since the extension option will be exercised, the total lease term to be considered is
7 years (4 years plus 3-year extension period). The initial measurement of ROU asset
and lease liability is determined as follows:
Lease Liab./
Less: Residual value
Divide by: Expected lease term (7 yrs) 7
The lease liability of P4,114,439 shall be amortized for the next 7 years.
Scenario 2 - Extension option is NOT reasonably expected to be exercised

Total lease term to be considered is 4 years only. The initial measurements of ROU
asset and lease liability are determined as follows:
Lease Liab./
Depreciable amount of the ROU asset P2,648,471
Divide by: Expected lease term (4 yrs) +
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Illustration 7 - Termination Option. ANDALUCIA Company entered into a six-

year lease agreement. The lease requires annual lease payments of P600,000 to be
made every January 1 of each year, starting in 2023. In addition, the Company also
has the option whether to terminate the lease on December 31, 2026 (i.e., at the end
of the 4% year), but it is required to pay a P400,000 termination penalty.
Incremental borrowing rate is 8%. Required: Under each of the following
independent scenarios, determine the initial measurement of the ROU asset and the
lease liability:
1. The Company expects not to exercise the termination option.
2. The Company expects to exercise the termination option.
Scenario 1 - Termination option will not be exercised
In this illustration, the noncancellable portion of the lease term is four years and the
period subject to termination period is two years. For this scenario, since the
termination option will not be exercised, the lease is set to run for six years (4 years
+ 2 years covered by the termination option), which then be used in determining
the initial measurement of ROU asset and lease liability:
Lease Liab./
Less: Residual value =
Depreciable amount of the ROU asset P2,995,626
Divide by: Expectedleaseterm(6yrs)
Scenario 2 - Termination option will not be exercised
The initial measurement of ROU asset and lease liability shall be determined as:
Lease Liab./
Single payment for 4 periods at 8% 0.735030 400,000 294,012
Scenarios 1 and 2 - Generalization
The readers should take of the following:
a. The number of periods used in the computation is based on the expectations of
exercising the termination option.
b. No termination penalty shall be included in the computations if the lease term
reflects the entity's expectation of not exercising the termination option.
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c. The amount of termination penalty shall be included only when the lease term
reflects the entity’s expectation of exercising the termination option.
EXCEPTIONS TO THE GENERAL LESSEE ACCOUNTING MODEL
Earlier, it was mentioned that there are leases exempt from the requirement of
recognizing lease liability and ROU asset. These leases arise from the following:
a. Short-term lease
b. Lease of low-value assets
Instead, the lease payments are recognized as rent expense on a straight-line
basis over the lease term unless another systematic basis applies.
If the amount of lease payments increases periodically, there will be initial
amounts of accrued rent payable which will be fully reversed by the end of the
lease term. On the other hand, if the amount of lease payments decreases
periodically, there will be initial amounts of prepaid rent (i.e., an asset) which will
also be fully reversed by the end of the lease term.
SHORT-TERM LEASES
Leases with lease term of 12 months or less are considered as short-term leases,
provided there is no related purchase option. The exception can be applied on a
- per class of underlying asset basis. Class is similar to the classes mentioned in
property, plant and equipment and intangible assets.
Illustration 8. On July 1, 2023, TOMAS Company entered into twelve-month lease

ofa commercial space. The following is the schedule of semi-annual lease payments:
Date of payment Lease payment
December 31, 2023 P500,000
June 30, 2024 700,000
In this case, the amount of rent expense to be recognize per month is computed as:
Date of payment Lease payment
December 31, 2023 P500,000
June 30, 2024 700,000
Total lease payments over the lease term P1,200,000
Divide by: Lease term (in months) 12
Monthly rent expense P100,000
Journal entry to record the payment and the recognition of rent expense on
Rent expense (P100,000 x 6 mo.) 600,000
Cash 500,000
Accrued rent payable 100,000
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It should be noted that since lease payments are increasing, there will be an initial
amount of accrued rent payable. In addition, the amount of rental expense is not
necessarily equal to the amount of rentals paid.
Journal entry to record the payment and the recognition of rent expense on June 30,
2024 is as follows:
Rent expense (P100,000 x 6 mo.) 600,000
Accrued rent payable 100,000
Cash 700,000
It should be noted that the balance of accrued rent payable or prepaid rent will be
reversed by the end of the lease term.
LEASE OF LOW-VALUE ASSETS

The assessment of whether an underlying asset is low-value or not shall be based
on its value when it is brand new (i.e., not necessarily equal to its current value).
PFRS 16 does not mention the use of quantitative thresholds, but according to the
related Basis for Conclusions, the standard-setting body ‘has in mind’ that low value
assets are those with value of USD5,000 or less (roughly PHP250,000 or less).
Further, to be qualified as a lease of low-value asset, the underlying asset shall not
be subleased. Sublease is to be discussed on Chapter 11.
For example, a lease of a second-hand vehicle with current value of P200,000 but
with brand new value of P1,000,000 will not be considered as a lease of low-value
asset. The reason is that its P1,000,000 value when brand new shall be considered,
not its current value of P200,000.
In addition, the assessment is not affected by the size, nature, or circumstances

of the lessee (i.e., the assessment shall be in absolute basis). Accordingly, different
lessees are expected to reach the same conclusions about whether a particular
underlying asset is of Jow value. Lastly, the application of this exemption can be
made on a lease-by-lease basis.
Examples of low-value assets include, but are not limited to, laptops, tables, phones,
small vehicles (e.g., tricycles), and small items of furniture and equipment.
Illustration 9. Due to work-from-home setup given as an option to its employees,

MATIAS Company rented 100 laptops for the next three years, starting January 1,
2023. Annual lease payments are due to be paid on the following dates:
December 31,2023 —P1,400,000

December 31, 2024 1,000,000
December 31, 2025 810,000
P3,210,000
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In this case, the annual rent expense is computed as P1,070,000 (P3,210,000/3).

Journal entry to record the lease payment and rent expense on December 31, 2023;
Rent expense 1,070,000
Prepaid rent 330,000
Cash 1,400,000
It should be noted that since the amount of lease payments are decreasing each
year, there will be an initial amount of prepaid rent.
Journal entry to record the lease payment and rent expense on December 31, 2024:
Cash 1,000,000
Prepaid rent 70,000
After making the above entry, the balance of prepaid rent will be P260,000
(P330,000 - P70,000) as of December 31, 2024.
Journal entry to record the lease payment and rent expense on December 31, 2025:
Cash 810,000
Prepaid rent 260,000
As of December 31, 2025, the end of the lease term, the balance for the prepaid rent
will be zero.
ANNEX 1 - LEASE CONTRACTS IN PRACTICE

So far, the illustrations showed the amounts of lease payments that are equal each
year and that the lease payments are made annually. However, in practice, the
amounts of lease payments usually increase periodically (due to rental escalations)
and that they are usually payable more frequently (e.g., quarterly, monthly).
As such, the following accounting procedures shall be made:
a. Inthe case of increasing periodic lease payments, these shall be discounted using
a series of PV factors of single payments (i.e., similar to the computation of
present value of cash flows from serial bonds and serial notes).
b. For more frequent lease payments, the PV factor shall be determined in the same
manner as in the bonds payable with interest that is payable quarterly or semi-
annually, to wit:
Lease Payment Frequency
Semi-annually Quarterly
Number of periods Years x2 Years x 4
Periodic discount rate Discount rate + 2 Discount rate + 4
Periodic lease payment Annual Amount + 2 Annual Amount + 4
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Illustration 10 - Increasing Lease Payments. On January 1, 2023, PLANKTON

Company entered into a five-year lease contract covering a land. Annual lease
payments are due every January 1 of each year, starting on January 1, 2023. Lease
payment due for 2023 is P1,000,000 and shall be increased by 10% every year
starting with January 1, 2025 lease payment. Incremental borrowing rate of the
Company is 6%. Initial direct costs incurred by the Company amounted to P450,000
Required: Determine the initial measurement of ROU asset and lease liability.
From the given information, the following procedures shall be performed:
a. First, determine the lease payments that shall be made each year and the
corresponding timing of payments:
Lease Datetobe No.of Periods
Year Payments Received from 1/1/23
2023 1,000,000 01/01/23 0 period
2024 1,000,000 01/01/24 1 period
2025 1,100,000 /1Mx(1+10%)] 01/01/25 2 periods
2026 1,210,000 [1.1Mx(1+10%)] 01/01/26 3 periods
2027 1,331,000 [1.21Mx(1+10%)] 01/01/27 4 periods
b. Next, determine the present value of lease payments to determine the amount
of lease liability:
Present
PV Factor of PVFactor Cash Flow Value
Single payment for 0 period at 6% 1.000000 P1,000,000 P1,000,000
Single. payment for 1 period at 6% 0.943396 1,000,000 943,396
Single payment for 2 periods at 6% 0.889996 1,100,000 978,996
Single payment for 3 periods at 6% 0.839619 1,210,000 1,015,939
Single payment for 4 periods at 6% 0.792094 1,331,000 1,054,277
Initial amount of lease liability P4,992,608
c. From the initial amount of lease liability, the ROU asset has initial amount of
P5,442,608 (P4,992,608 + P450,000).
Illustration 11 - More Frequent Lease Payments. On January 1, 2023,

PREAMBLE Company entered into a four-year lease agreement covering an office
space. Annual lease payment is P800,000 per year. Incremental borrowing rate is
8%. Required: Under each of the following independent scenarios, determine the
initial amount of lease liability and ROU asset:
1. Lease payments are split and payable every January 1 and July 1 of each year
(semi-annually), starting on January 1, 2023.
2. Lease payments are split and payable every January 1, April 1, July 1 and October
1 (quarterly) of each year, starting on January 1, 2023.
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Scenario 1 - Semi-annual Lease Payments

In computing the lease liability’s present value (in this case, also equal to initial
amount of ROU asset), the following adjustments are to be made:

Semi-annual lease payments = P400,000 (P800,000/2)
Lease liab/
PV Factor of PVFactor Cash Flow ROU asset
Scenario 2 - Quarterly Lease Payments

In computing the lease liability’s present value (in this case, also equal to initial
amount of ROU asset), the following adjustments are to be made:
Quarterly lease payments = P200,000 (P800,000/4)
Lease liab/
PV Factor of PVFactor Cash Flow ROU asset
CHAPTER SUMMARY
1. Alease isa contract, or a part of a contract, that conveys the right to use an asset (the
underlying asset) for a period of time in exchange for consideration.
2. Lessor is the entity who leases out an underlying asset and receives consideration.
Lessee is the entity who uses the underlying asset and exchanges consideration.
3. The general lessee accounting model requires the recognition of right-of-use (ROU)
asset and lease liability on commencement date. This date is the date on which a
lessor makes an underlying asset available for use by a lessee.
4. ROU asset represents the control and the right of the lessee to use the asset during
the lease term, not the legal ownership of the underlying asset. It shall be initially
measured at cost, which is composed of the following:’
a. initial measurement of lease liability;
b. any lease payments made at or before the commencement date, less any lease
incentives received;
c. any initial direct costs incurred by the lessee; and
d. asset retirement obligation
9. Lease liability represents the present value of lease payments to be made during the
lease term. Amounts to be included in the present value are the following:
a. fixed payments, less any lease incentives to be received;
b. variable lease payments that depend on an index or a rate, initially measured
using the index or rate as at the commencement date;
c. amounts expected to be payable by the lessee under residual value guarantees;
d. exercise price of a purchase option if the lessee is reasonably certain to exercise
that option; and
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e. payments of penalties for terminating the lease, if the lease term reflects the
6. The discount rate to be used shall be determined by the following hierarchy:
a. First, the implicit rate on the lease, if known by the lessee.
b. Otherwise, the lessee shall use its own incremental borrowing rate.
7. Ifthe fixed lease payments are paid at the end of each period, PV of ordinary annuity
shall be used while PV of annuity due shall be used if these are paid at the beginning
of each period.
§. As to guaranteed residual value, the amount to be included in the lease liability shall
be the expected shortfall and not necessarily the amount of the guarantee.
9. Expected shortfall is the difference between the higher guaranteed residual value
less the lower expected value of the asset at the end of the leased term.
10.Purchase option price shall be included in the lease liability only if the-entity is
reasonably certain to exercise the option.
11.Subsequent to the initial recognition, the carrying amount of the lease liability shall
be measured using an amortization table. Interest expense is also based on the
amortization table.
12.Subsequent to initial recognition, depending on the circumstances, ROU asset may
be accounted using either the cost model (default), revaluation model or the fair
value model.
13.Under the cost model, depending on the terms and conditions of the lease, the ROU
asset shall be accounted as follows: .
Ref Scenario | Depreciation period | Depreciable amount

A Basic lease contract Shorter of: Initial measurement of
4 With residual value a. lease term; or ROU asset (i.e., no
guarantee b. useful life of ROU deduction for
c With purchase option not asset residual value
_expected to be exercised (“general rule”) guarantee)
D With purchase option Initial measurement of
expected to be exercised Civkirthbaecaes ROU asset less residual
E Transfer of ownership at useful life me Genes
the end of the lease term at :
14.No ROU asset nor lease liability are required to be recognized for the following leases
(i.e., exception to the general lessee accounting):
a. Short-term leases (lease term of not more than 12 months)
b. Leases of low-value assets (roughly PHP250,000 or less)
In these cases, the lease payments are recognized as rent expense ona straight-line
basis over the lease term, unless another systematic basis applies.
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True or False
1. Lessor is the entity who is using the property and paying rental payments to the
lessee.
2. Under the general lessee accounting requirements, an entity shall recognize ROU
asset and lease liability on commencement date.
ROU asset represents the lessee’s right to use the underlying asset but not the
ownership over the underlying asset.
Lease liability represents the lessor’s right to receive the lease payments from the
lessee.
The cost of the ROU asset shall exclude the amount paid for lease transaction costs.
nu
Variable lease payments based on revenue or output shall be excluded from the
measurement of lease liability.
Periodic payments for the utilities billed by the lessor shall be included in the
measurement of lease liability.
Security deposits are included in the cost of ROU asset.
© %
If the lessee knows the implicit rate, it shall be used in determining the present
value of lease liability; otherwise, the lessee’s incremental borrowing rate shall be
used.
10. The amount to be included in the lease liability is the present value of the expected
shortfall to be paid, which exists only if the residual value guarantee is higher than
the expected value of the underlying asset at the end of the lease term.
ad. The present value of the purchase option price shall be included in the lease liability
only if the purchase option price is much lower than the expected value of the
underlying asset at the end of the lease term.
12. ROU asset is subsequently measured using cost model by default.
13. Generally, lease liability is subsequently measured using the amounts in the related
amortization table.
14. Short-term leases are those with lease terms of at least 12 months.
15. The value of the underlying asset in assessing whether it is low-value shall be based
on when it is brand new, regardless of the underlying asset's current condition.

1. In a lease contract,
The lessee uses the leased asset, while the lessor receives the lease payments.
aa op
The lessor uses the leased asset, while the lessee received the lease payments.
The lessee receives the lease payments from the lessor.
The lessor uses the leased asset.
2. ROU asset and lease liability shall be recognized on

inception date of the lease
aoa op
commencement date of the lease

commencement date or inception date, whichever is earlier
commencement date or inception date, whichever is later
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3. All of the following amounts are excluded in the cost of ROU asset, except
a. initial measurement of the lease liability
b. cash payments for security deposit
c. initial direct costs incurred by the lessor
4. The cash flows to be included in the present value of the lease liability include the
following, except
fixed lease payments
variable lease payments based on revenue
canoe
portion of payments representing security services

minimum lease amount portion of variable lease payments
both b andc
5. Discount rate to be used in determining the present value of lease liability shall be
a. theimplicit rate
b. the lessee’s incremental borrowing rate
c. the implicit rate, if known by the lessee, otherwise, the lessee’s incremental
borrowing rate.
d. the lessee’s incremental borrowing rate, if known by the lessee, otherwise, the
implicit rate.
6. To be considered in the initial measurement of lease liability, the residual value

guarantee shall be guaranteed by the following, except
a. the lessee
b. aparty related to the lessee
c. aparty related to the lessor
d. bothaandb
7. The amount of residual value guarantee to be included in the measurement of lease

liability shall be the present value of
a. the amount of guaranteed residual value
b. the difference between the higher residual value guarantee and the lower
expected value of the asset at the end of the lease term.
c. the difference between the higher expected value of the asset at the end of the
lease term and the lower residual value guarantee.
d. the expected value of the asset at the end of the lease term.
8. The present value of the purchase option price shall be included in the initial
measurement of liability
a. only when the lessee is reasonably certain to exercise the option.
b. only when the purchase option price is way below the expected value of the
asset of the lease term.
c. only when the purchase option price is way above the expected value of the
asset of the lease term.
d. only when the lessee is not reasonably certain to exercise the option.
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| Chapter 9 - Lessee Accounting - Basic Considerations
9, Depending on the circumstances and subsequent to initial recognition, ROU asset

shall be accounted under which of the following models?
a. cost model
b. fair value model
c. revaluation model
d. any of the above models
10.If an entity is using the cost model in subsequently accounting for its ROU asset,
which of the following incorrectly describes the length of the relevant depreciation
period that shall be used?
a. Inalease agreement wherein the ownership over the underlying asset will be
transferred at the end of the lease term, the depreciation period to be used shall
be over the useful life of the underlying asset.
b. Ina lease agreement with purchase option, where the lessee is not certain to
exercise, the depreciation period to be used shall be over the useful life of the
underlying asset.
c. Ina basic lease agreement, the depreciation period to be used shall be the
shorter of the lease term and the useful life of the underlying asset.
d. Inalease agreement with guaranteed residual value, the depreciation period to
be used shall be the shorter of the lease term and the useful life of the underlying
asset.
11. Which of the following transactions affect the carrying amount of the ROU asset?
a. depreciation
b. remeasurement of the lease liability
c. bothaandb
d. neitheranorb
12. The following transactions have the correct corresponding effects to the carrying
amount of the lease liability, except
a. interest expense increases the carrying amount of the lease liability.
b. lease payment decreases the carrying amount of the lease liability.
c. reassessment and lease modifications have either an increasing or decreasing
effect to the carrying amount of the lease liability.
13. Which of the following circumstances will not require the recognition of ROU asset
and Jease liability?
a. short-term lease
b. lease involving real properties
c. lease involving movable properties
d. lease of high-value assets
14.Which of the following correctly describes the accounting for the exceptions to the
general lessee accounting?
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a. NoROUasset shall be recognized, buta lease liability shall be recognized for the
present value of future lease payments.
b. No lease liability shall be recognized, but ROU asset shall be recognized to
indicate that the entity controls the underlying asset.
c. NoROQUassetand lease liability shall be recognized, but the rental expense to be
recognized is equal to the amount of lease payment made.
d. NoROUassetand lease liability shall be recognized, but the lease payments shall
be recognized as rental expense using the straight-line method.
15. The following leases are exceptions to the general lessee accounting model under
PFRS 16, except
a. Alease for eight months that cannot be extended.
b. Alease involving a land.
c. Alease involving a laptop computer.
d. Alease for 12 months that cannot be extended.
Straight Problems
1. On January 1, 2023, PIGEON Company leased a transportation vehicle from a lessor
by paying annual lease payments of P900,000 for the next seven years, starting on
December 31, 2023. Based on the equipment’s current condition, the Company can
use it for next eight years. However, the vehicle is required to be returned at the end
of the lease term. Implicit interest rate and lessee’s incremental borrowing rate were
8% and 11%, respectively. The Company knew of the implicit interest rate.
Required: From these data, determine the following:

a. Journal entries for 2023 and 2024.
b. Carrying amounts of the lease liability and ROU asset as of December 31, 2023
and 2024.
2. Using the same information as in PIGEON Company, except that the Company does
not know the implicit interest rate. Required: From the revised information,
determine the following:
and 2024.
3. On January 1, 2023, BISHOP Company entered into a five-year lease of office space,
requiring the Company to pay annual rental of P 1,800,000, starting immediately.
That amount is inclusive of P200,000 building security costs, P70,000 housekeeping
costs, and P30,000 real property taxes. Security deposit of P700,000 were also paid.
In addition, the Company incurred initial direct costs of P100,000. The Company’s
incremental borrowing rate is 7%.
and 2024.
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4. At the start of 2023, DOVE Company leased a commercial space for four years for
P1,200,000 per year, This amount is payable every January 1 of each year, starting
on January 1, 2023. In addition, the Company is also required to paid additional rent
of 5% of the Company’s commercial space’s revenue, to be paid every February 1 of
the succeeding year. Revenue from the commercial space amounted toP12,000,000
and P15,000,000 for the years 2023 and 2024, respectively. The Company's

and 2024.
5. FLATBILL Company entered into a five-year lease agreement for its use of a
commercial space starting on January 1, 2023. The lease payments are equal to 8%
of the Company’s revenues for each year and are payable every December 31 of each
year, starting in 2023. The Company reported the following amounts of revenues for
the following years:
2023 2024 2025 2026 2027

P10,000,000 12,000,000 7,500,000 P8,000,000 P9,000,000
Despite of the variability in the amount of lease payments, the Company shall pay a
minimum rental of P600,000. Incremental borrowing of the Company is 9%.

and 2024.
6. BABBLER Company leased, for five years, a vehicle from a lessor on January 1, 2023.
Annual rental payments of P1,200,000 are payable every January 1 of each year,
starting in 2023. To induce the lessor to enter to the lease agreement, the Company
guaranteed that the fair value of the vehicle will be at least P800,000 at the end of
the lease term. The Company reasonably expects that the value of the vehicle will be
nil at the end of the lease term. Unguaranteed residual value, according to the lessor
amounted to P400,000, Additionally, rental deposit of P300,000 was paid under the
lease agreement. Incremental borrowing rates of the Company and the lessor were
10% and 8%, respectively.

and 2024.
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Chapter 9 — Lessee Accounting —- Basic Considerations
7. On January 1, 2023, CRIMSON Company leased a machinery through a six-year lease

with annual lease payments of P1,000,000 to be made starting on that date and every
January 1 thereafter, Under the lease agreement, the Company guarantees that the
fair value of the machinery at the end of the lease term is at least P900,000. Based
on the Company's reasonable estimates, the machinery will have fair value of
P500,000 at the end of the lease term. Company’s incremental borrowing rate is 6%.
a. Journal entries for 2023 and 2024,
and 2024.
8. MADDER Company leased from a lessor a production line machinery starting on

January 1, 2023. The lease term runs for seven years and requires annual payments
of P1,400,000 every January 1 of each year starting in 2023. The Company has an
option to purchase the machinery at the end of the lease term for P500,000. It
expects that the machinery will have a fair value of P950,000 at the end of the lease
term. The Company expects to exercise this purchase option because of the huge
bargain on purchase that it can realize in the future. The Company can use the
machinery for ten years, if not being limited by the lease term, after which it can be
sold for P200,000. The Company’s and lessor’s incremental borrowing rates were
7% and 9%, respectively.
and 2024.
9. Going back to MADDER Company, except that it decided not to exercise the purchase
option despite of the estimated bargain purchase. Instead, it will lease a more
technologically advanced machinery after the end of the lease term.
Required: From the revised information, determine the following:.

and 2024.
10.0n January 1, 2023, SALMON Company entered into a five-year lease of an
equipment, requiring the Company to pay annual rental of P1,500,000, starting on
that same date. The ownership over the equipment will be transferred to the
Company at the end of lease term. On its own, the equipment has a useful life of eight
years, after which it can be sold for P300,000. The Company's incremental
borrowing rate is 6%,
and 2024.
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11.0n January 1, 2023, EXTROVERT Company entered into a lease contract with a non-
cancellable period of 6 years, In addition, the Company has also the option to extend
the lease term for additional 4 years. Annual lease payments of P900,000 are due at
the end of each year. Incremental borrowing rate is 8%.
Required: Under each of the following independent scenarios, determine the initial
amounts of ROU asset and lease liability:
a. Extension option is reasonably expected to be exercised.
b. Extension option is not reasonably expected to be exercised.
12. At the beginning of the year 2023, INTROVERT Company entered into a ten-year
lease agreement. The lease requires annual lease payments of P400,000 to be made
every January 1 of each year. In addition, the Company has also the option whether
to terminate the lease on December 31, 2027 (i.e., at the end of the 5th year), but it
is required to pay a P1,000,000 termination penalty. Incremental borrowing rate is
6%.
measurement of the ROU asset and the lease liability:
a. The Company expects not to exercise the termination option.
b. The Company expects to exercise the termination option.
13.Due to implementation of work-from-home setup, on January 1, 2023, CARDINAL

Company leased 200 laptops over a three-year period for the use of its employees.
Lease payment is P16,000 per laptop on the first year, P11,000 for the second year,
and P9,000 for the third year. Lease payments are due every first day of each year.
The laptops are valued at P40,000 each. Incremental borrowing rate is 9%.
Required: Determine the journal entries for the years 2023 to 2025.
14.0n January 1, 2023, CARMINE Company entered into a three-year lease contract
involving 30 brand new tricycles to be used in its public transportation business.
Each tricycle has a value of P40,000. Lease costs for 2023 that was paid on the same
date amounted to P9,000 per tricycle. The lease payments are payable at the start of
each year and will increase by 10% each year. Incremental borrowing rate is 7%.
Required: Determine the journal entries for the years 2023 to 2025.
15.ACUPUNCTURE Company entered into a four-year lease agreement covering an

office equipment. Annual lease payments are due every January 1 of each year,
starting on January 1, 2023, Lease payment due for 2023 amounted to P800,000 and
will increase by 5% each year, starting on January 1, 2024 lease payment. Initial
direct costs incurred by the Company amounted to P250,000. Incremental
borrowing rate is 8%.
Required: Determine the initial measurement of lease liability and ROU asset.
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16. At the beginning of the year 2023, DRAGON Company entered into a three-year lease
agreement covering a machinery. Annual lease payment is fixed at P1,000,000.
Incremental borrowing rate is 10%. Initial direct costs amounted to P150,000.
measurement of lease liability and ROU asset:
1. Lease payments are split and due every January 1 and July 1 of each year,
starting on January 1, 2023,
2. Lease payments are split and due every January 1, April 1, July 1 and October 1
of each year, starting on January 1, 2023.

1. On January 1, 2023, POPPY Company entered into a six-year lease contract covering
a vehicle which requires annual lease payments of P900,000. These payments shall
be made every January 1 of each year, starting in 2023. In addition, the Company
also incurred initial direct costs of P200,000. Implicit interest rate, which is not
known to the Company, was 8%. The Company’s incremental borrowing rate, on the
other hand, was 9%. On its own, the vehicle has a useful life of 10 years and residual
value of P300,000 after such useful life.
The initial carrying amount of the ROU asset shall be

a. P4,600,686 c. P4,693,439
b. P4,400,686 d. P4,493,439
The initial carrying amount of the lease liability shall be
a. P4,600,686 c. P4,693,439
b. P4,400,686 d. P4,493,439
Annual depreciation expense from the ROU asset shall be
a. P430,069 c. P766,781
b. P716,781 d. P460,069
The carrying amount of the ROU asset on December 31, 2024 shall be
a. P3,680,549 c. P3,740,549
b. P3,167,124 d. P3,067,124
The carrying amount of the lease liability on December 31, 2025 shall be
a. P2,278,165 c. P2,915,748
b. P3,178,165 d. P2,483,200
2. At the beginning of the year 2023, RUSTY Company entered into a lease contract
covering a machinery:
Annual lease payments to be paid every January 1 ~ P1,200,000
Lease term 8 years
Useful life of the machinery 12 years
Guaranteed residual value P1,000,000
Residual value of the machinery after useful life 200,000
256
The
Implicit rate known to the Company 79

Incremental borrowing rate of the Company 8%
Assumption 1: The machinery’s expected value at the end of the lease term is P400,000.
a. P8,249,156 c, P8,016,352
b. P7,987,913 d. P7,771,805
a. P6,012,264 c. P6,680,294
b. P6,713,627 d. P6,062,265
a. P5,692,445 c. P5,320,042
b. P4,086,916 d. P4,492,445
Total amount of expense to be recognized during the year 2025 shall be
a. P1,428,589 c. P1,254,528
b. P1,374,447 d. P1,316,515
Assumption 2: The machinery’s expected value at the end of the lease term is
P1,100,000.

a. P7,725,348 c. P6,467,147
b. P6,525,348 d. P7,667,147
a. P5,750,360 c. P5,800,360
b. P6,133,718 d. P6,173,718
a. P4,920,236 c. P5,264,653
b. P4,064,653 d. P4,349,179
a. P1,302,810 c. P1,242,919
b. P1,358,782 d, P1,382,782
3. On January 1, 2023, MAROON Company entered into a lease contract involving a

building. This lease had the following pertinent information
Initial direct costs incurred by the lessee P500,000
Initial direct costs incurred by the lessor 400,000
Annual lease payments to be paid every December 31 1,800,000
Purchase option price 3,000,000
Residual value of the building after its useful life 800,000
Lease term 10 years
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Useful life of the building 15 years

Implicit rate not known to the Company 11%
Incremental borrowing rate of the Company 9%
Assumption 1: The Company is reasonably certain to exercise the purchase option.

a. P12,819,017 c, P13,219,017
b. P13,319,017 d, P13,719,017
a. P12,067,115 c. P12,431,083
b. P11,987,115 d. P12,484,416
a. P12,500,420 c. P11,468,275
b. P11,663,458 d. P10,700,420

a. P1,930,147 c. P1,331,902
b. P1,866,746 d. P2,294,940
Assumption 2: The Company is NOT reasonably certain to exercise the purchase option.
a. P12,451,784 c. P12,051,784
b. P11,951,784 d. P11,551,784
a. P11,301,665 c. P10,396,606
b. P10,846,606 d. P11,206,606
a. P10,859,316 c. P9,059,316
b. P9,874,654 d. P9,962,675
a. P2,096,408 c, P2,176,408
b. P2,021,819 d. P2,101,819
4. On January 1, 2023, VERMILION Company entered into a five-year lease contract
involving an equipment. Annual lease payments of P1,100,000 are due every January
1 of each year, starting in 2023, Initial direct costs of P400,000 were incurred by the
Company. The ownership over the equipment will be transferred to the Company at
the end of the lease term. On its own, the equipment has a useful life of 12 years and
residual value of P200,000. The Company's incremental borrowing rate was 6%.
a. P5,311,617 c, P4,211,617
b. P4,911,617 d. P3,811,617
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a. P3,266,970 c. P3,186,970
b. P4,426,348 d. P4,459,681
a. P2,137,737 c. P3,116,733
b. P2,016,733 d. P2,940,314
a. P1,062,323 c. P602,387
b. P1,238,742 d. P546,972
5. On January 1, 2023, CINNABAR Company leased an office space for five years
requiring P2,000,000 annual lease payments to be made every January 1 of each
year, starting in 2023. Annual lease payments will increase by 8% starting on the
lease payment on January 1, 2024. Relevant incremental borrowing rate was 5%.
The initial carrying amount of the lease liability shall be
a. P10,587,988 c. P10,893,593
b. P9,091,900 d. P9,832,740
a. P2,161,249 c. P2,521,588
b. P2,460,467 d. P2,309,417
6. At the beginning of the year 2023, REDWOOD Company entered into a four-year
lease contract involving an office space. Annual lease payments are set at
P1,200,000. In addition, initial direct costs incurred by the lessee amounted to
P500,000. Estimated residual value of the office space after its 20-year useful life
amounted to P400,000. The Company’s and lessor’s incremental borrowing rates
were 9% and 10%, respectively.
If the annual lease payment is split and payable every January 1 and July 1 of each
year, starting on January 1, 2023, the initial measurement of lease liability shall be
a. P3,957,532 c. P3,993,789
b. P4,135,621 d. P4,083,650
If the annual lease payment is split and payable every January 1, April 1, July 1 and
October 1 of each year, starting on January 1, 2023, the initial measurement of lease
liability shall be
a. P3,957,532 c. P3,993,789
b. P4,135,621 d. P4,083,650
7. FLORAL Company started-to operate its “bazaar” on April 1, 2023 by signing a one-
year lease contract covering a commercial space. Lease payments of P400,000 and
P600,000 are due on April 1, 2023 and October 1, 2023, respectively. The Company's
incremental borrowing rate was 8%.
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The total amount of expense to be recognized for the year 2023 shall be
a. P400,000 c. P750,000
b. P600,000 d. P500,000
8. On January 1, 2023, SCARLET Company entered into a four-year lease contract
involving an old sport utility vehicle (SUV) to be used in its business. Currently, the
SUV is valued at P180,000 but similar SUVs have fair value of P1,000,000 when
brand new. The annual lease payments of P90,000 are payable at the beginning of
each year. Relevant incremental borrowing rate was 9%.
The total amount of expense to be recognized for the year 2023 shall be
a. P90,000 c. P102,793
b. P99,958 d. P110,586
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Chapter 9A — Lessee Accounting — Other Matters
CHAPTER 9A
LESSEE ACCOUNTING - OTHER MATTERS

1. The difference between the reassessment of a lease and a lease modification.
2. The accounting for reassessment of lease.
3. The accounting for lease modification.
4, The financial reporting for the right-of-use asset and lease liability.
REASSESSMENT VS MODIFICATION
In the previous chapter, there were no changes made when subsequently
accounting for ROU asset and lease liability, aside from those arising from
depreciation, accretion of interest, and lease payments. However, in real life, it is
possible that during the lease term, changes in the measurement of lease liability
and ROU asset may happen as arising from the reassessment of lease liability or
from lease modification.
These two terms may appear to be the same but for lessee accounting, they are
different. Before getting into the details, it is the best to know, in a general sense,
their major differences:
Reassessment Lease Modification
Change/s in the assumptions
Change/s in the lease
General description or estimates that were
agreement itself
initially made
Involvement of the Novinvolved Involved (i.e., need to agree
lessor to the modification/s)
Scenarios covered Four specific scenarios Wide variety of scenarios
Discount rate used in Can be the original or e gts
c : : Always a revised discount
computing the PV of revised, depending on the y nes
rate
revised cash flows reason for the reassessment
The major accounting difference arises from the discount rate to be used in
determining the present value of revised cash flows. Nevertheless, both of these
changes will affect the lease liability and the ROU asset.
REASSESSMENT OF LEASE LIABILITY

In the previous chapter, there were assumptions and estimates made when initially
measuring the lease liability (and consequently the ROU asset). These include the
following:
a. Assumptions pertaining to the lease term because of the existence of the option
to extend and/or terminate the lease term.
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The
b. Assumptions about the exercise of purchase option.

c. Estimate of the expected value of the underlying asset to compute the expected
shortfall under residual value guarantee.
d. Variable payments based on index or rate.
These assumptions and estimates are susceptible to changes, especially if the

circumstances on which they are based also change.
ACCOUNTING FOR REASSESSMENT OF LEASE LIABILITY

The following are the accounting procedures to be followed:
a. Determine the revised amount, number, and/or timing of lease payments based
on the reassessment.
b. Determine whether the circumstance triggering the reassessment of the lease
liability requires the use of an original or revised discount rate. The following
guidelines are relevant:
Ref | Circumstance Discount Rate

A Changes in the estimated Jease term Revised discount rate
B Changes in the decision whether or not to determined on
exercise purchase option reassessment date
Changes in wee :
C g 5 the expected shortfall from Original discount rate
residual value guarantee
; ; : used on commencement
D Changes in the index or rate for variable dite
lease payments based on index or rate
The reason for the use of a revised discount rate based on circumstances A and
B above is that the economics of the lease have drastically changed compared
to circumstances C and D.
. Determine the revised carrying amount of the lease liability at the time of the
reassessment by getting the present value of lease payments in (a) using the
discount rate determined in (b).
. Compare the revised carrying amount of the /ease liability computed in (c) with
its carrying amount before reassessment. Any change will also have a
corresponding direct and same effect to the ROU asset. The following guidelines
are relevant:
Result of comparison of lease liability Consequence

Revised carrying amount > carrying Increase in lease liability and
amount before reassessment ROU asset by the same amount
Revised carrying amount < carrying Decrease in lease liability and
amount before reassessment ROU asset by the same amount
Further, if the amount of decrease in the lease liability > carrying amount of
ROU asset, the difference is recorded as gain in the lessee’s profit or loss.
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Chapter 9A - Lessee Accounting - Other Matters
These consequences can be better seen in the following pro-forma journal

entries, starting with the increase in lease liability:
Right-of-use asset XX
Lease liability XX
Decrease in lease liability is recorded as follows:
Lease liability XX
Right-of-use asset XX
Gain on reassessment (if any) XX
e. Because of the changes, the annual depreciation of the ROU asset and the
amortization table of lease liability will be revised moving forward.
REASSESSMENT OF LEASE TERM

Generally, the lease term may increase or decrease from the changes in the
assumption regarding extension or termination options. Increase in lease term
normally results to increase in lease liability while decrease in lease term
decreases the lease liability. These scenarios will be discussed in the foregoing
illustrations:
Illustration - Increase in Lease Term. On January 1, 2023, CLEMENTE Company

entered into a five-year lease contract covering an office space. Annual lease
payments of P900,000 are due every January 1 of each year. The lease contract gives
the Company the option to extend the lease term for an additional 3 years.
Incremental borrowing rate is 7%. As of the commencement date, the Company
assessed that it is not reasonably certain that it will exercise the extension option.
However, on January 1, 2024, after the lease payment for that year, the Company
reassessed that it will now exercise the extension option. Incremental borrowing
rate as of this date is 9%.
As of the commencement date, the initial measurements of lease liability and ROU
asset plus the annual depreciation of ROU asset are computed as follows (i.e.,
excluding the three-year extension period):
Lease Liab./
As of January 1, 2024, the reassessment date, the ROU asset has carrying amount of
P3,158,792 (P3,948,490 less P789,698 one-year depreciation for 2023).
Amortization of the lease liability up to this same date is computed as follows:
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Chapter 9A — Lessee Accounting - Other Matters

Jan. 1, 2023 3,948,490
Jan. 1, 2023 900,000 - (900,000) 3,048,490
Jan. 1, 2024 900,000 213,394 (686,606) 2,361,884
In accounting for the reassessment on January 1, 2024, the following procedures

are relevant:
a. There are now six annual lease payments of P900,000 (three remaining
payments from the original lease term plus the three-year extension period) to
be paid starting January 1, 2025. The end of the revised lease term is on
December 31, 2030.
b. Discount rate to be used is the incremental borrowing rate of 9% as of the
reassessment date (i.e., revised) since the trigger is the change in lease term.
c. The revised amount of lease liability after reassessment is computed and
compared with the related carrying amount before reassessment as follows:
Revised
Less: Lease liability balance before reassessment 2,361,884
Increase in lease liability P1,675,443
Note: 6 periods stand for the remaining lease payments as of January 1, 2024.
It should be noted that the PV of ordinary annuity was used since as of January
1, 2024, the next cash payment will made only after one year on January 1, 2025.
d. This increase is recorded on January 1, 2024 as follows:

The annual depreciation of ROU asset starting 2024 shall be revised as follows:
ROU asset, carrying amount before reassessment P3,158,792

Add: Increase in lease liability 1,675,443
ROU asset, carrying amount after reassessment P4,834,235
Divide by: Remaining lease term (1/1/24 - 12/31/30) 7 years
ROU asset, annual depreciation starting 2024 P690,605
The lease liability shall now be amortized moving forward as follows (using
9%):
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Jan. 1, 2024 4,037,327
Jan. 1, 2025 900,000 363,359 (536,641) 3,500,686
Jan. 1, 2026 900,000 315,062 (584,938) 2,915,748
Jan. 1, 2027 900,000 262,417 (637,583) 2,278,165
Jan. 1, 2028 900,000 205,035 (694,965) 1,583,200
Jan. 1, 2029 900,000 142,488 (757,512) 825,688
Jan. 1, 2030 900,000 74,312 (825,688)
Illustration 2 - Decrease in Lease Term. On January 1, 2023, JACINTO Company

entered into a four-year lease contract involving a vehicle, where annual payments
of P600,000 are due every January 1 starting on that date. In addition, the Company
has the option to extend the lease term for an additional three years, which was
reasonably expected to be exercised. Incremental borrowing rate is 8%. However, on
January 1, 2025, the Company reassessed that it will not exercise the extension
option since it decided to look instead for a more updated version of the vehicle at
the end of the lease term. Incremental borrowing rate as of this date is 6%.
As of the commencement date, the initial measurements of lease liability and ROU
asset plus the annual depreciation of ROU asset are computed as follows (based on
total lease term of seven years or four years plus three-year extension period):
Lease Liab./
Annuity due for 7 periods at8% 5.622880 P600,000 P3,373,728
Depreciable amount~P3,373,728
P2,409,806 (P3,373,728 less P963,922 two years depreciation for 2023 and 2024).

Jan. 1, 2023 3,373,728
Jan. 1, 2023 600,000 (600,000) 2,773,728
Jan. 1, 2024 600,000 221,898 (378,102) 2,395,626
Jan. 1, 2025 600,000 191,650 (408,350) 1,987,276

are relevant:
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There will be only one annual lease payment of P600,000 left (four remaining
payments from the original seven-year lease term less the three-year extension
period that will not be exercised anymore) to be paid on January 1, 2026. The
end of the revised lease term is on December 31, 2026.
reassessment date (i.e., revised) since the trigger is the change in lease term.
Revised
PV Factor of PV Factor Cash Flows Lease Liab.
Single payment for 1 period at 6% 0.943396 P600,000 P566,038
Decrease in lease liability (P1,421,238)
It should be noted that the PV of single payment was used since as of January 1,
2025, there is only one cash payment left to be made on January 1, 2026.
d. This decrease is recorded on January 1, 2025 as follows:

The annual depreciation of ROU asset starting 2025 is revised as follows:

Less: Decrease in lease liability (1,421,238)
ROU asset, carrying amount after reassessment P988,568
The lease liability will now be amortized moving forward as follows (using 6%
revised discount rate): .
Jan. 1,2025 566,038
Jan. 1, 2026 600,000 33,962 (566,038) -
REASSESSMENT OF DECISION TO EXERCISE OR NOT THE PURCHASE OPTION

Changes in the expectations whether to exercise the purchase option or not have
the following general effects in the lease liability and ROU asset:
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Scenario Lease liability ROU Asset

ae satoatueaner* Will result to being amortized
veatsesstnent: dectded not tb Decrease over the remaining lease term
exercise it anymore with zero residual value
Initially expected not to Will result to being amortized over
exercise the option but after Theven the remaining useful life of the
reassessment, decided to per underlying asset, less any residual
exercise it value at the end of useful life
Illustration 3 - Subsequent Decision Not to Exercise the Option. VIDAL
Company entered into a lease contract on January 1, 2023 with the following terms:
Annual lease payments payable in advance P1,000,000
Purchase option price 700,000
Lease term 4 years
Useful life of underlying asset 6 years
Residual value after useful life P350,000
Incremental borrowing rate 5%
It is reasonably certain that the Company will exercise the option. However, on
January 1, 2024, after making the lease payment for that year, it was reassessed that
the purchase option will not be exercised anymore. Incremental borrowing rate as
of that date is 7%.
As of the commencement date, the initial measurements of the lease liability, ROU
asset, and annual depreciation of ROU asset are computed as follows:
Lease Liab./
Initial measurement of lease liability and ROU asset P4,299,139
Less: Residual value 350,000
Divide by: Useful life 6 years
Jan. 1, 2023 4,299,139
Jan. 1,2023 1,000,000 - (1,000,000) 3,299,139
Jan.1,2024 1,000,000 164,957 (835,043) 2,464,096
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are relevant:
a. There are still two lease payments left to be made starting January 1, 2025.
However, the purchase option price will not be included in the lease
payments anymore.
reassessment date (i.e., revised) since the trigger is the change in assumptions
about purchase option.
Revised
PV Factor of PV Factor CashFlows Lease Liab.
Ordinary annuity for 2 periods at 7% 1.808018 P1,000,000 P1,808,018
Less: Lease liability balance before reassessment (2,464,096)
Decrease in lease liability P656,078
Again, the PV of ordinary annuity was used since as of January 1, 2024 the next
cash payment will made only after one year on January 1, 2025.
Right-of-use asset 656,078
Less: Decrease in lease liability (656,078)
Since the usage of the underlying asset will now be limited by the lease term, it
shall now be depreciated over the remaining lease term and no residual value shall
now be deducted in arriving at the depreciable amount. The lease liability will
now be amortized moving forward as follows (using 7% revised discount rate):
Jan. 1, 2024 1,808,018
Jan.1,2025 1,000,000 126,561 (873,439) 934,579
Jan.1,2026 1,000,000 65,421 (934,579) =
Illustration 4 - Subsequent Decision to Exercise the Option. At the beginning of

2023, SALAS Company entered into a lease with the following information:
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Annual lease payments payable in advance —_—P1,500,000

Purchase option price 900,000
Lease term 5 years
Useful life of underlying asset 8 years
Residual value after useful life P500,000
As of the commencement date, the Company is not reasonably certain to exercise the
purchase option. However, on January 1, 2025, the Company reassessed that it is
now reasonably certain that it will exercise the purchase option. Incremental
borrowing rate on the date of reassessment is 10%.
As of the commencement date, the initial measurements of lease liability, ROU asset,
(excluding purchase option price) and annual depreciation of ROU asset are
Lease Liab./
Less: Residual value ~
Divide by: Lease term 5 years
P3,880,914 (P6,468,190 less P2,587,276 two-year depreciation for 2023 and 2024).

Jan. 1, 2023 6,468,190
Jan.1,2023 1,500,000 = (1,500,000) 4,968,190
Jan.1,2024 1,500,000 397,455 (1,102,545) 3,865,645
_Jan.1,2025 1,500,000 309,252 (1,190,748) 2,674,897

are relevant:
However, the purchase option price will now be included in the lease
payments. This is to be paid on December 31, 2027 at the end of the lease term
(i.e., after 3 periods).
reassessment date (i.e, revised) since the trigger is the change in assumptions
about purchase option.
c..The revised amount of lease liability after reassessment is computed and
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Chapter 9A - Lessee Accounting — Other Matters
Revised
PV Factor of PVFactor CashFlows Lease Liab.
Ordinary annuity for 2 periods at 10% 1.735537 1,500,000 2,603,306
Revised lease liability P3,279,490
Increase in lease liability P604,593

Less: Increase in lease liability 604,593
Less: Residual value (500,000)
Depreciable amount 3,985,507
Divide by: Remaining useful life (1/1/25 - 12/31/30) 6 years
Underlying asset’s useful life is. until] December 31, 2030 or 8 years from the
January 1, 2023 start of the lease term. Remaining useful life was used and
residual value at the end of useful life was considered since the lease term will
not anymore limit the usability of the underlying asset to the Company after the
reassessment.
The lease liability will now be amortized moving forward as follows (using 10%
revised discount rate):
Jan. 1, 2025 3,279,490
Jan.1,2026 1,500,000 327,949 (1,172,051) 2,107,439
Jan.1,2027 1,500,000 210,744 (1,289,256) 818,183
Dec. 31,2027 900,000 81,817 (818,183) =
REASSESSMENT OF THE RESIDUAL VALUE GUARANTEE

Reassessment of the expected value of the underlying asset at the end of the lease
term has the following consequences:
Effect in expected Effect in lease
Scenarios shortfall liability/ROU asset
Decrease in expected value Increase Increase
Increase in expected value Decrease Decrease:
Note: Expected shortfall = residual value guarantee less expected value.
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Illustration 5, ANDRADE Company entered into a four-year lease contract covering

a vehicle. Annual lease payments of P1,200,000 are due at the beginning of each
year starting on January 1, 2023. In addition, residual value guarantee of
P 1,000,000 was made, even though the expected value of the vehicle at the end of
the lease term is P700,000. Incremental borrowing rate at this date is 9%.
On January 1, 2024, the expected value was reassessed due to drastic changes in the
economy. Incremental borrowing rate as of that date was 11%. Required: Under
each of the following independent scenarios, determine the procedures to account
for the reassessment:
1. Expected value increased to P1,100,000.
2. Expected value decreased to P200,000.
Before anything else, it is necessary to compute for the unadjusted carrying

amounts of the lease liability and ROU asset as of January 1, 2024. Initial
measurements of lease liability, ROU asset, and annual depreciation of ROU asset
are computed as (using expected shortfall of P300,000 or P1,000,000 - P700,000):
Lease Liab./
Initial measurement of lease liability and ROU asset P4,450,082
Divided by: Lease term (in years) 4 years
P3,337,561 (P4,450,082 less P1,112,521 one-year depreciation for 2023).
Jan. 1, 2023 4,450,082
Jan.1,2023 1,200,000 ~ (1,200,000) 3,250,082
Jan.1,2024 1,200,000 292,507 (907,493) 2,342,589
Scenario 1 - Expected value increased to P1,100,000

are relevant:
However, there will be no expected shortfall to be included since the expected
value of P1,100,000 is now higher than the P1,000,000 residual value guarantee.
b. Discount rate to be used is still the incremental borrowing rate of 9% as of the
commencement date (i.e., original) since the trigger is the change in the estimate
of expected shortfall.
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The

Revised
Ordinary annuity for 2 periods at 9% 1.759111 =P 1,200,000 2,110,933
Decrease in lease liability (P231,656)


Less: Decrease in lease liability (231,656)
Divide by: Remaining lease term, (1/1/24 - 12/31/26) 3 years
ROU asset, annual depreciation starting 2024 P1,035,302
Revised amortization table for the lease liability is intentionally omitted.

Scenario 2 - Expected value decreased to P200,000
arerelevant: .
However, the amount of expected shortfall will increase to P800,000
(P1,000,000 - P200,000).
b. Discount rate to be used is still the incremental borrowing rate of 9% as of the
commencement date (i.e. original) since the trigger is the change in the
estimate of expected shortfall.
Revised
Ordinary annuity for 2 periods at 9% 1.759111 1,200,000 2,110,933
Increase in lease liability P386,091
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Add: Increase in lease liability 386,091
Revised amortization table for the lease liability is intentionally omitted.
REASSESSMENT OF VARIABLE LEASE PAYMENTS BASED ON RATE OR INDEX

On the commencement date, the variable lease payments based on rate or index
that are included in the computation of lease liability are still unadjusted by the
changes in the rate or index. At the time of adjustment, the amount of lease payments
will change as well as the present value of lease liability. Using indices, the following
formula will be used to compute for the revised lease payments:
Revised Lease _ Unrevised Lease Index as of revision date
Payments > Payments x Index as of commencement date
or as of immediately preceding
revision date
The changes in lease payments have the following profound effects in the lease
liability and ROU asset:
Scenario Effect on lease liability Effect on ROU asset

Increase in lease payments Increase Increase
Decrease in lease payments Decrease Decrease
Illustration 6. On January 1, 2023, MAGALLANES Company entered into a six-year

lease contract covering an office space. Annual lease payments of P2,100,000 are
due at the beginning of each year. These lease payments will be adjusted starting
January 1, 2026 using the change in consumer price index (CPI) from January 1,
2023 to January 1, 2025. Incremental borrowing rate as of this date was 6%. CPIs
as of January 1, 2023 and 2025 were 120 and 150, respectively. Incremental
borrowing rate as of January 1, 2025 was 8%.
As of the commencement date, the computation of lease liability and ROU asset will
be based on the P2,100,000 unadjusted lease payments:
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The
Lease Liab./
Depreciableamount P10,945,964
P7,297,310 (P10,945,964 less P3,648,654 two years depreciation for 2023 and
2024). Amortization of the lease liability up to this same date is computed as
follows:
Jan. 1, 2023 10,945,964
Jan.1,2023 2,100,000 = (2,100,000) 8,845,964
Jan.1,2024 2,100,000 530,758 (1,569,242) 7,276,722
Jan.1,2025 2,100,000 436,603 (1,663,397) 5,613,325

are relevant:
a. The revised annual lease payment is computed as follows:
Revised Lease. _ 150,
Payments = P2,100,000 x mat P2,625,000
There were three remaining lease payment dates, starting on January 1, 2026,
to which this revised annual lease payment shall be applied.
commencement date (i.e., original) since the trigger is the change in variable
lease payments based on index or rate.
Revised
Ordinary annuity for 3 periods at6% 2.673012 2,625,000 P7,016,656
Increase in lease liability | P1,403,331

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Amortization table for the lease liability is intentionally omitted.
LEASE MODIFICATIONS
Lease modification arises when the lessor and lessee agreed to amendments in the
original lease contract. These amendments cover a wider spectrum of changes
compared to simple reassessment of lease liability. For accounting purposes, lease
modifications can be categorized into the following major categories:
a. Increase in scope of the lease by adding the right to use one or more underlying
assets.
b. Decrease in the scope of the lease.
c. All other lease modifications.
It should be also recalled that in discounting the revised lease payments arising
from lease modifications, a revised discount rate shall always be used.
INCREASE IN THE SCOPE OF THE LEASE

A lease modification shall be accounted for as a separate lease if both of the
following conditions were met:
a. the modification increases the scope of the lease by adding the right to use
one or more underlying assets; AND
b. the consideration for the lease increases by an amount commensurate with
the stand-alone price for the increase in scope and any appropriate
adjustments to that stand-alone price to reflect the circumstances of the
particular contract.
In assessing the criterion (b) the rate of lease payment on the original lease shall be
presumed as equivalent to stand-alone price.
Accounting for as a separate lease means that the original lease will not be
affected (i.e., depreciation of original ROU asset and amortization of the original
lease liability will not be affected),
If any one or both of the conditions mentioned were not met, the lease modification
shall be accounted for similar to reassessment of lease liability (i.e. the original
lease will be affected). In this case, the combined lease payments from the
original lease and from the modification shall be discounted using a revised
discount rate.
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The
Illustration 7. On January 1, 2023, ROLDAN Company entered into a five-year lease

of 4,000 square meters of office space for annual lease payment of P800,000 (or
P200 per square meter), due immediately. Incremental borrowing rate as of this
date is 5%. On January 1, 2024, after paying the lease due for the year, the Company
and the lessor modified the lease contract by including an additional 3,000 square
meters of office space over the remaining four-year lease term, with the additional
lease payment due immediately. Incremental borrowing rate is 7% as of this date.
accounting procedures for the lease modification:
1. The annual lease payment for additional 3,000 square meters was set at
P600,000.
2. The annual lease payment for additional 3,000 square meters was set at
P360,000.
Before anything else, the following is the computation of the initial measurement of
lease liability and ROU asset:
Lease Liab./
Less: Residual value ~
Amortization of the lease liability over the lease term is computed as follows:
Jan. 1, 2023 3,636,761
Jan. 1, 2023 800,000 rm (800,000) 2,836,761
Jan. 1, 2024 800,000 141,838 (658,162) 2,178,599
Jan. 1, 2025 800,000 108,930 (691,070) 1,487,529
Jan. 1, 2026 800,000 74,376 (725,624) 761,905
Jan. 1, 2027 800,000 38,095 (761,905) ss
Scenario 1 - Annual lease payments for increase in scope is P600,000

Under this scenario, the modification shall be accounted for as a separate lease
since the additional P600,000 annual lease payment commensurate with the
stand-alone selling price of the office space (ie, P200 per square meter or
P600,000/3,000 square meters, which is also equal to the lease amount of P200
per square meter computed in the original lease of 4,000 square meters).
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Chapter 9A - Lessee Accounting — Other Matters
As a result, the original lease will not be affected and shall be accounted for
separately. The amount of lease liability and ROU asset arising from the increase in
scope are computed as follows (using 7% revised discount rate):
Lease Liab./
PV Factor of _ PV Factor Cash Flows ROU Asset
Less: Residual value *
Divide by: Remaining lease term 4 years
The amortization table of the related lease liability from the increase in scope is as
follows:
Jan. 1, 2024 2,174,590
Jan. 1, 2024 600,000 - (600,000) 1,574,590
Jan. 1, 2025 600,000 110,221 (489,779) 1,084,811
Jan. 1, 2026 600,000 75,937 (524,063) 560,748
Jan. 1, 2027 600,000 39,252 (560,748) =
Combining the information with the lease of 4,000 square meters and 3,000 square
meters, the following are the total amounts reported in income statement:
Depreciation Exp. From Total Interest Expense From Total
the Lease of (in sq. m. Depreciation |_ the Lease of (in sq. m.) Interest
Year 4,000 3,000 Expense 4,000 3,000 Expense
2023 727,352 - 727,352 141,838 - 141,838
2024 | 727,352 543,648 1,271,000 108,930 110,221 219,151
2025 | 727,352 543,648 1,271,000 74,376 75,937 150,313
2026 | 727,352 543,648 1,271,000 38,095 39,252 77,347
2027 727,351 543,646 1,270,997 = = =
It should be highlighted in the above table that the original lease of 4,000 square
meters will be co-existing with the lease of 3,000 square meters.
Scenario 2 - Annual lease payments for increase in scope is P360,000
Under this scenario, the modification shall not be accounted for as a separate
lease since the additional P360,000 annual lease payment does not
commensurate with the stand-alone selling price of the office space (i.e., P120
per square meter or P360,000/3,000 square meters, which is less than the lease
amount of P200 per square meter computed in the original lease of 4,000 square
meters).
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In this case, the following accounting procedures will be made:

a. The increase of P360,000 will be combined with P600,000 original annual lease
payment. In computing for the revised amount of lease liability, the P360,000
shall be discounted for four periods using annuity due (four remaining lease
payments, with the first one due immediately). For the original P800,000
lease payment, it is discounted using ordinary annuity for three periods
because the remaining lease payments based on original terms are to be
received starting only on January 1, 2025.
modification date (i.e., revised) since the trigger is a lease modification.
c. The revised amount of lease liability after modification is computed and
compared with the related carrying amount as of January 1, 2024 as follows:
Revised
Less: Lease liability balance before modification (2,178,599)
Increase in lease liability P1,225,608


ROU asset, carrying amount before modification P2,909,409
ROU asset, carrying amount after modification P4,135,017
ROU asset (combined), annual depreciation starting 2024 P1,033,754
The amortization table of the lease liability (combined) is as follows:

Jan. 1, 2024 3,404,207
Jan. 1, 2024 360,000 - (360,000) 3,044,207
Jan. 1, 2025 1,160,000 213,094 (946,906) 2,097,301
Jan. 1, 2026 1,160,000 146,811 (1,013,189) 1,084,112
Jan. 1, 2027 1,160,000 75,888 (1,084,112)
Note: P1,160,000 = P800,000 + P360,000
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The
DECREASE IN THE SCOPE OF THE LEASE

A decrease in the scope of the lease normally arises from decrease in right to use
one or more of the underlying assets. The accounting for this lease modification is
a little complicated compared to the other categories:
a. Determine the updated carrying amount of the lease liability and ROU asset as
of the date of lease modification.
b. Proportionately reduce the updated carrying amounts of the lease liability and
ROU asset with their difference recognized in profit or loss:
Proportional _ Carrying i Decrease in Scope
Reduction Amount Total Scope Before Modification
c. Determine the amount of revised lease liability for the remaining lease payments
by discounting the remaining cash flows using the revised discount rate.
d. The balance of lease liability after effecting the proportional reduction on (b)
above is adjusted to reflect the revised lease liability amount determined in (c).
This further adjustment has a corresponding effect to ROU asset as follows:
Result of comparison for lease liability | | Accounting consequence

Revised carrying amount > Increase in lease liability and
proportionately reduced carrying amount | ROU asset by the same amount
Revised carrying amount < Decrease in lease liability and
proportionately reduced carrying amount | ROU asset by the same amount
Illustration 8. On January 1, 2023, ASIS Company entered into a six-year lease

contract covering 5,000 square meters of office space. Annual lease payments of
P900,000 are due at the end of each year starting on December 31, 2023. Relevant
On January 1, 2024, due to the introduction of work-from-home setup for the
Company’s employees, the scope of the lease was reduced by 2,000 square meters.
Revised annual lease payment for the remaining 3,000 square meters was set at
P500,000 for the five-year remaining lease term, payable starting on December 31,
2024. Incremental borrowing date as of date is 9%.
As of January 1, 2023, the initial measurement of lease liability and ROU asset are
Lease Liab./
Less: Residual value =
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Accounting for Decrease in Scope

a. ROU asset had a balance of P3,467,160 (P4,160,592 - P693,432) as of January 1,
2024. As of the same date, the balance of lease liability is computed as follows:
Jan. 1, 2023 4,160,592
Dec. 31,2023 900,000 332,847 (567,153) 3,593,439
b. Proportionately reduce the computed updated balances of ROU asset and lease
liability as of January 1, 2024, with the difference recognized in profit or loss:
Reductionof _ 2,000 square meters
ROU Asset PROT ok 5,000 square meters = aes
Reductionof _ 2,000 square meters 7
Leasetiak,, “Ree? oF 5,000 square meters “hn RAE TATS
The proportional reduction shall be recorded as follows:
Right-of-use asset | 1,386,864
Gain on lease modification - P/L 50,512
The gain on lease modification is equal to the difference between the
proportionate reduction in ROU asset and lease liability.
c. Next, discount the revised annual lease payments of P500,000 using the revised
discount rate of 9% over the remaining lease term of five years to determine the
revised lease liability:
Revised
d. Compare the revised lease liability computed in (c) above with the carrying
amount of the lease liability after proportional reduction:
Lease liability right after the proportional
reduction (P3,593,439 — P1,437,376) P2,156,063
Less: Revised lease liability (1,944,826)
Further decrease in lease liability P211,237
This further decrease is recorded as follows:

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After considering all the journal entries, ROU asset and lease liability will have
the following balances after the lease modification:
Lease Liability ROU Asset
Balances before modification, 1/1/24 P3,593,439 P3,467,160
Less: Proportional reduction (1,437,376) (1,386,864)
Balances after proportional reduction P2,156,063 P2,080,296
Less: Further decrease in lease liability (211,237) (211,237)
Balances after modification, 1/1/24 P1,944,826 1,869,059
Moving forward, the ROU asset will have annual depreciation of P373,812
(P1,869,059/S-year remaining lease term from 1/1/24 to 12/31/28). The lease
liability will be subsequently measured as follows (using 9% effective interest
rate):

Date Payments Expense ‘zation Amount
Jan. 1, 2024 1,944,826
Dec. 31,2024 500,000 175,034 (324,966) 1,619,860
Dec. 31,2025 500,000 145,787 (354,213) 1,265,647
Dec.31,2026 500,000 113,908 (386,092) 879,555
Dec. 31,2027 500,000 79,160 (420,840) 458,715
Dec. 31,2028 500,000 41,285 (458,715) :
ALL OTHER LEASE MODIFICATIONS
Accounting for these modifications, such as changes in the amounts of lease
payments, will utilize the same previously discussed concepts on the reassessment
of lease liability, except for the discount rate. The discount rate to be used in
discounting the revised cash flows from all lease modifications shall always be a
revised rate.
PRESENTATION OF R.0.U. ASSET AND LEASE LIABILITY

Generally, ROU asset is presented separately from other assets in the statement of
financial position. Otherwise, the lessee shall:
a. include right-of-use assets within the same line item as that within which the
corresponding underlying assets would be presented if they were owned; and
b. disclose which line items in the statement of financial position include those
right-of-use assets.
For example, if an underlying asset in a lease contract is an office building, the
related carrying amount of the ROU asset shall be included in the Property, Plant
and Equipment line item. Ifan underlying asset in a lease contract involves the lease
of a trademark, the carrying amount of the ROU asset shall be included in the
Intangibles line item.
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The
As to lease liabilities, these are generally presented separately from other liabilities
in the statement of financial position. Otherwise, the lessee shall disclose which line
items in the statement of financial position include those liabilities,
CURRENT AND NONCURRENT PRESENTATION

ROU assets are generally presented as part of noncurrent assets. On the other hand,
lease liabilities are partly classified as current and partly as noncurrent, with
the exact amounts depending on whether the lease payments are made at the start
or end of each period:
Annual lease payments are Annual lease payments are
made at the end ofeach period | made at the start of each period
Immediately succeeding amount
Current
of amortization. in _ the | Amountof annual lease payment
portion
amortization table.
Updated carrying amount less
Non- Immediately succeeding carrying amount
em of annual lease
: payment.
ere amount in the amortization table ais see edna eo panes atey
portion succeeding carrying amount in the
amortization table
Illustration 9. On January 1, 2023, ANGELES Company entered into a five-year

lease contract involving an office space. Annual lease payments were P600,000.
Incremental borrowing rate was 7%. Required: Under each of the following
independent scenarios, determine the current and noncurrent portions of the lease
liability as of December 31, 2023 and 2024:
1. Lease payments are made in arrears every December 31 of each year.
2. Lease payments are made in advance every January 1 of each year.
Scenario 1 - Lease payments are made every December 31

The initial measurement of the lease liability on January 1, 2023 is as follows:


Jan. 1, 2023 2,460,118
Dec. 31,2023 600,000 172,208 (427,792) _2,032,326
Dec. 31,2024 600,000 142,263 (457,737) 1,574,589
Dec. 31,2025 600,000 110,221 (489,779) —_1,084,810
Dec.31,2026 600,000 75,937 (524,063) 560,747
Dec. 31,2027 600,000 39,253. ~—- (560,747) -
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From this amortization table, the current and noncurrent portions of the lease
liability as of December 31, 2023 and 2024 are determined as follows:
Amorti- Carrying Current Noncurrent
Date zation Amount Portion Portion
Dec.31,2023 (427,792) 2,032,326.--» P457,737.-» P1,574,589
Dec. 31,2024 (457,737)---" 1,574,589-"- "5 489,7 79__..-»1,084,810
Dec.31,2025 (489,779)---'1,084,810------
Scenario 1 - Lease payments are made every January 1

The initial measurement of the lease liability on January 1, 2023 is as follows:


Jan. 1, 2023 2,632,326
Jan. 1, 2023 600,000 - (600,000) 2,032,326
Jan. 1, 2024 600,000 142,263 = (457,737) 1,574,589
Jan. 1, 2025 600,000 110,221 (489,779) 1,084,810
Jan. 1, 2026 600,000 75,937 (524,063) 560,747
Jan. 1, 2027 600,000 39,253 (560,747) -
As discussed in the previous chapter, if the annual lease payments are made at the
beginning of each year, the carrying amounts in the amortization table above do
not correspond to December 31 carrying amounts. As a result, accretion of interest
shall be recorded to get the true carrying amounts as of December 31, 2023 and
2024:
2023 2024
January 1 balance P2,032,326 P1,574,589
Add: Accretion of interest 142,263 110,221
December 31 balances P2,174,589 P1,684,810
From these carrying amounts, the current and noncurrent portions are determined
as follows:
Carrying Current Noncurrent
Date Amount Portion Portion
Dec. 31,2023 P2,174,589 P600,000 P1,574,589 (P2,174,589 - P600K)
Dec. 31, 2024 1,684,810 600,000 1,084,810 (P1,684,810 - P600K)
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PRESENTATION IN THE STATEMENT OF CASH FLOWS

In the statement of cash flows, the lessee shall classify:
a. cash payments for the principal portion (amortization portion) of the lease
liability within financing activities;
b. cash payments for the interest portion of the lease liability generally within
operating activities; and
c. short-term lease payments, payments for leases of low-value assets and variable
lease payments not included in the measurement of the lease liability within
operating activities.
DISCLOSURES IN THE NOTES TO THE FINANCIAL STATEMENTS

A lessee shall disclose the following amounts for the reporting period:
a. depreciation charge for right-of-use assets by class of underlying asset;
b. interest expense on lease liabilities;
c. the expense relating to short-term leases and leases of low-value assets. This
expense need not include the expense relating to leases with a lease term of one
month or less;
d. the expense relating to variable lease payments not included in the
measurement of lease liabilities;
e. income from subleasing right-of-use assets (sublease is discussed in Chapter
Td);
f. total cash outflow for leases;
g. additions to right-of-use assets;
h. gains or losses arising from sale and leaseback transactions; and
i. the carrying amount of right-of-use assets at the end of the reporting period by
class of underlying asset.
CHAPTER SUMMARY
1. Reassessment of lease liability and lease modification are differentiated as follows:
Reassessment Lease Modification

Change/s in the Change/s in the lease
General description assumptions or estimates
that were initially made agreement itself
Involved (i.e., need to
I :
nee of the Not involved agree to the
modification/s)
Scenarios covered Four specific scenarios Wide variety of scenarios
Discount rate used in Can be the original or

; revised, depending on the Always a revised
computing the PV of :
: reason for the discount rate
revised cash flows
reassessment
2. The discount rate to be used in determining the revised lease liability if there is a
reassessment of lease liability shall be determined as follows:
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Circumstance 5s Discount Rate

Changes in the estimated lease term Revised discount rate
Changes in the decision whether or not to determined on reassessment
exercise purchase option date
Changes in the expected shortfall from residual
ia value guarantee Original discount rate used
Changes in the index or rate for variable lease on commencement date
payments based on index or rate
3. Both reassessment of lease liability and lease modifications have the following
accounting consequences in the lease liability and ROU asset:
Lease liability ROU asset

Revised lease liability
> carrying amount of Increase Increase
lease liability
‘ gaa? Decrease. However, if the amount of
d lease liabil t
a ng am canter Decrease decrease exceeds the balance in ROU
iat ats st asset, the excess is recorded as gain in
ease liability
profit or loss
4. Generally, ROU asset and lease liability are presented separately from other assets
and other liabilities, respectively.
5. Generally, ROU asset is classified as noncurrent while lease liability is partly current
and partly noncurrent.
6. The current and noncurrent portions of lease liability are determined as follows:
Annual lease payments are Annual lease payments are
made at the end of each period | made at the start of each period
Immediately succeeding amount
Current | of — amortization in the | Amount of annual lease payment
amortization table.
Non- | Immediately succeeding carrying | Updated carrying amount less

current | amountin the amortization table | amount of annual lease payment.
7. In the statement of cash flows, the following are classified within operating
activities:
a. interest portion of lease payment.
b. lease payments for short-term leases, lease of low-value asset, and variable lease
amounts based on revenue or output.
8. The principal portion of lease payment is classified within financing activities.
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CHAPTER 9A: SELF-TEST EXERCISES

True or False
As Reassessment of lease liability involves the changes in the initial assumptions or
estimates made.
2. Lease modification involves changes in the lease agreement itself.
3 The discount rate to be used for the reassessment of lease liability is always a
revised discount rate determined on the date of reassessment.
When there is a lease modification, the discount rate to be used in the determining
the revised lease payments may be the original or the revised one, depending on
the type of modification.
If, as a result of lease modification or reassessment, there is an increase in lease
liability, then the carrying amount of the related ROU asset shall also increase.
Any excess of the amount of decrease in lease liability over the carrying amount of
the related ROU asset shall be recognized in other comprehensive income.
If the change in lease liability arises from the change in the expected shortfall from
guaranteed residual value, then the discount rate to be used in determining the
revised lease liability shall be the original discount rate.
If the lessee and lessor agreed to increase the amounts of lease payments, the
discount rate to be used shall be the original discount rate.
The current portion of a lease liability, where the annual lease payments are paid
at the start of each period, is equal to the amount of annual lease payments.
10. The principal or the amortization portion of the lease payment shall be reported
within the operating activities in the statement of cash flows.

i. The following are the characteristics of reassessment, except
a. limited to a certain number of scenarios only
b. the lessor is involved in the changes in the carrying amount of the lease liability.
c. reassessment means changes in the initially made assumptions when
determining the initial measurement of lease liability.
d. none of the above.
Which of the following is not the characteristic of lease modifications?
a. Discount rate to be used in determining the present value of the revised lease
payments is always the original discount rate.
b. Lease modification involves changes in the lease agreement itself.
c. Lease modification covers a wide range of scenarios.
If there is a reassessment, the discount rate to be used in determining the revised

carrying amount of lease liability shall be
a. equal to original discount rate at all times
b. equal to revised discount rate at all times
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c. either the original discount rate or the revised discount rate, depending on the
entity’s accounting policy.
d. either the original discount rate or the revised discount rate, depending on the
reason for the changes.
4. [there is a lease modification, the discount rate to be used in determining the

revised carrying amount of lease liability shall be
a. equal to original discount rate at all times
b. equal to revised discount rate at all times
Cc. either the original discount rate or the revised discount rate, depending on the
reason for the changes.
d. either the original discount rate or the revised discount rate, depending on the
entity’s accounting policy.
5. A revised discount rate will be used to which of the following scenarios of
reassessment of lease liability?
a. Changes in the lease term
b. Changes in the decision regarding the exercise of the purchase option
Cc Both a and b
d. Neither a nor b
6. The original discount rate will be used to which of the following scenarios of
reassessment of lease liability?
a. Changes in the lease payments based on the changes in the index or rate on
which these payments are based.
b. Changes in the amount of expected shortfall from residual value guarantee
Cc. Botha and b
d. Neither a nor b
7. Changes in the carrying amount of the lease liability, either from reassessment or
lease modification, have the following accounting consequences, except
a. Decrease in the carrying amount of the lease liability will result to a
corresponding decrease in the carrying amount of the related ROU asset.
b. Any excess of the amount of decrease in lease liability over the carrying amount
of the related ROU asset shall be recognized as direct increase to retained
earnings.
Cc. Increase in the carrying amount of the lease liability will result to a
corresponding increase in the carrying amount of the related ROU asset.
d, There will be changes in the annual amount of depreciation of the ROU asset.
8. The lease modification shall be accounted as a separate lease if
a. the modification increases the scope of the lease by adding the right to use one
or more underlying assets
b. the consideration for the lease increases by an amount commensurate with the
stand-alone price for the increase in scope
either a orb
both aandb
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9. Which of the following is the correct accounting procedure for a lease modification
that increased the scope of the lease?
a. If the increase is accounted separately, the carrying amount of ROU asset from
the original lease will increase.
b. If the increase is not accounted separately, the carrying amount of ROU asset
from the original lease will not be affected.
Cc. If the increase is not accounted separately, there will be two amortization tables
that will be used moving forward.
d. If the increase is accounted separately, the carrying amount of lease liability
from the original lease will not be affected.
10.If the lease modification resulted to decrease in the scope of the lease, it shall have
the following accounting consequences, except
a. The revised cash flows shall be discounted using the original discount rate to
determine the revised lease liability.
b. Proportionately reduce the carrying amounts of the lease liability and’ ROU
asset.
c. Any difference between the proportional reduction from the carrying amount of
the lease liability and ROU asset shall be recognized in profit or loss.
d. There is a corresponding increase in the carrying amount of the ROU asset if the
revised lease liability is higher than the proportionately reduced carrying
amount of lease liability.
11.Which of the following cash flows from the lease are not recognized as within the
operating activities?
a. Interest portion of the lease payments
b. Lease payments related to short-term lease
c. Lease payments related to variable lease amounts based on revenue
12. The following presentation requirements related to ROU asset and lease liability are
true, except
a. Thenoncurrent portion of the lease liability is equal to the amount of gross lease
payments that will be paid beyond 12 months after the reporting date.
b. Generally, lease liabilities and ROU asset shall be presented separately from
other liabilities and other assets, respectively.
c. ROU assets are generally reported as part of noncurrent assets.
d. The current portion of the lease liability, where the annual lease payments are
made at the beginning of each period, is equal to the amount of annual lease
payments.
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Straight Problems
1. Yn January 1, 2023, LION Company entered into a five-year lease contract involving
aa office space. Annual lease payments of P1,400,000 are payable every January 1,
starting in 2023, Under the lease contract, the Company may extend the lease term
for additional four years while paying the same amount of annual lease payments
during the extended term.
It has been estimated that the Company will not extend the lease term after the
expiration of the initial lease term as it plans to construct its own office building.
Relevant incremental borrowing rate was 9% as of January 1, 2023.
Immediately after paying the rent on January 1, 2025, the Company decided to
extend the lease term as there is a current economic downturn which adversely
affected its operations. Relevant incremental borrowing rate as of this date was
10%.
a. Journal entry to record the reassessment on January 1, 2025.
b. Carrying amount of the lease liability and ROU asset as of December 31, 2025.
2. CHEETAH Company entered into a six-year lease contract involving a production

equipment on January 1, 2023. Annual lease payments of P1,200,000 are payable
every January 1, starting in 2023. Under the lease contract, the Company may extend
the lease term for additional four years while paying the same amount of annual
lease payments during the extended term. It has been estimated that the Company
will extend the lease after the expiration of the initial lease term. Relevant
incremental borrowing rate was 8% as of January 1, 2023.
Fast forward to January 1, 2026, after making the lease payment for that year, the
leased production equipment became incompatible and less efficient when the
Company reorganized its production line. As a result, the Company decided that it
will not exercise the extension option. Relevant incremental borrowing rate as of
this date is 9%.
3. On January 1, 2023, ELEPHANT Company leased from a lessor a warehouse for seven
years. Annual payments of P1,000,000 are payable every January 1 of each year
starting in 2023. The Company has an option to purchase the warehouse at
P2,000,000 at the end of the lease term. The Company does not expect to exercise
this purchase option because it reasonably projects that after the lease term, its
business activities will increase, prompting it to use a larger warehouse. As of the
commencement date, the warehouse has a remaining useful life of 12 years and
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residual value of P1,200,000 at the end ofits useful life. Relevant discount rate as of
January 1, 2023 is 6%.
On January 1, 2026, the Company assessed that the demand for its product has not
picked up yet for it to expand the size of its warehouse. As a result, the Company
expects that itis very likely that it will now exercise the purchase option. There were
no changes in the estimated remaining useful life and residual value of the
warehouse. Relevant discount rate as of this date is 7%.

4. GIRAFFE Company leased from a lessor a production machinery on January 1, 2023.

The initial lease term runs for six years and requires annual payments of P1,500,000
every January 1 of each year starting in 2023. There is an option to purchase the
machinery at P1,000,000 at the end of the lease term. The Company expects that it
will exercise the purchase option as it plans to fully integrate the machinery into its
manufacturing operations. As of the commencement date, the machinery has a
remaining useful life of ten years and residual value of P600,000 at the end of its
useful life. Relevant discount rate as of January 1, 2023 was 8%.
On January 1, 2025, after paying the rent for that year, the Company discovered a
more technologically advanced and efficient version of the machinery. As a result,
the Company expects that it is very likely that it will not exercise the purchase
option. Relevant discount rate as of this date is 7%.
5. On January 1, 2023, BUFFALO Company leased an office equipment for eight years.
Annual lease payment of P1,400,000 is payable every first day of each year, starting
in 2023. To induce the lessor to agree to enter to the contract, the Company
guarantees that the value of the equipment is P1,000,00 at the end of the lease term.
Concurrently, the expected value of the equipment by that time is P400,000.
Relevant incremental cost was 7% as of January 1, 2023.
On January 1, 2026, after payment of the lease for that year, the Company reasonably
expected that the value of equipment at the end of the lease term increased to
P800,000. Relevant incremental borrowing rate as of this day was 6%.

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6 Using the same information as in BUFFALO Company, except that, on January 1,

2026, the expected value of the equipment decreased to P100,000.
Required: From the revised information, determine the following:
7. Onjanuary 1, 2023, HIPPO Company entered into a six-year lease contract covering
a commercial space. Annual lease payments for the years 2023 and 2024 amounted
to P1,800,000 to be paid at the start of each year, starting in 2023. Rent starting 2026
will be P1,800,000, adjusted for the cumulative changes in the consumer price index
(CPI) from January 1, 2023 to January 1, 2025. CPIs for January 1, 2023 and 2025
were 120 and 180, respectively. Incremental borrowing rates were 9% and 8% as of
January 1, 2023 and 2025, respectively.

8. LEOPARD Company entered into a six-year lease agreement involving 3,000 square
meters of office space. Annual lease payment of P2,400,000 is due every January 1
of each year, starting in 2023. Relevant incremental borrowing rate as of this date
was 8%.
On January 1, 2025, the Company agreed with the lessor to expand the scope of the
lease by including additional 2,000 square meters of office space. Relevant
incremental borrowing rate as of this date was is 7%.
Required: Under each of the following independent scenarios, determine the (a)
journal entry to record the increase in scope of the lease; and (b) carrying amounts
of ROU asset and lease liability as of December 31, 2025: .
1. There is an increase of P1,600,000 in the annual lease payments on account of
the additional 2,000 square meters.
the additional 2,000 square meters.
the additional 2,000 square meters. However, the Company saved P300,000
costs of broker’s commission.
9, At the start of 2023, BABOON Company entered into a six-year lease contract
involving 5,000 square meters of office space. Annual lease payment amounted to
P1,800,000 payable every December 31 of each year, starting in 2023, Incremental
borrowing rate was 6%.
On January 1, 2025, because of non-full occupancy of original office space, the lease
parties agreed to exclude the 2,000 square meters portion from the scope of the
lease. As a result, as of this date, the Company occupies only 3,000 square meters of
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office space for annual lease payments of P1,100,000 to be paid starting on

December 31, 2025. Incremental borrowing rate as of this date was 7%.
Required: Based on these data, determine the following items:
a. Carrying amounts of the lease liability and ROU asset as of January 1, 2025 before
the lease modification.
b. Journal entries to record the lease modification on January 1, 2025.
c. Revised carrying amounts of the lease liability and ROU asset as of January 1,
2025.
10.On January 1, 2023, HYENA Company entered into a five-year lease of a vehicle by
paying P800,000 every January 1 of each year starting in 2023. The Company’s
incremental borrowing rate as of this date is 6%. On January 1, 2025, after paying
the rentals for that year, the Company signed an agreement with the lessor to extend
the lease term for additional four years. The same amount of rent will be paid during
that extended lease term. Incremental borrowing rate as of this date rate was 7%.

1. On January 1, 2023, RHINO Company entered into a lease contract with the following
information:
Annual lease payments to be made every January1 —P1,700,000

Lease term 6 years
Optional extension period 4 years
On the commencement date, the Company is certain to exercise the extension option.
However, right after paying the rent due on January 1, 2025, the Company is now
certain that it will not exercise the extension option. Incremental borrowing rate as
of this date was 6%.
From this information, the amount of decrease in lease liability on January 1, 2025
shall be
a. P4,205,820 c. P4,456,983
b. P4,306,710 d, P4,789,056
The revised annual depreciation of the ROU asset after reassessment shall be
a. P1,349,696 c. P1,387,265
b. P1,266,678 d, P1,412,487
2. KUDU Company rented a vehicle starting on January 1, 2023. Relevant data about
the lease are the following:
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Lease term 7 years

Useful life of the vehicle 10 years
Residual value of the vehicle at the end of useful life P400,000
Annual lease payments to be paid every January 1 1,200,000
Purchase option price at the end of lease term 800,000
On the commencement date, the Company is certain that it will exercise the purchase
option at the end of the lease term. However, on January 1, 2026, after paying the
rent for that year, the Company changed its mind and it now expects that it will not
exercise the purchase option at the end of the lease term. Incremental borrowing
rate as of this date was 9%
The carrying amount of the ROU asset right before the reassessment shall be
a. P5,312,634 c. P4,238,885
b. P5,192,634 d. P4,410,313
The carrying amount of the lease liability right after the reassessment shall be
a. P3,149,179 c. P3,459,982
b. P3,037,554 d. P3,890,953
From this information, the amount of annual depreciation starting 2026 shall be
a. P879,236 c. P1,117,673
b. P922,093 d. P1,147,673
At the beginning of the year 2023, ZEBRA Company rented the vacant office building
ofa lessor. The related lease had the following information:
Annual lease payments to be made every January 1 P2,000,000

Guaranteed residual value 4,000,000
Unguaranteed residual value 1,000,000
Estimated value of the building atthe end ofthe leaseterm 2,500,000
Lease term 6 years
Useful life of the office building 15 years
Assumption 1: The estimated value of the building at the end of lease term decreased
to P1,500,000 based on the reassessment made on January 2, 2025. Incremental
borrowing rate as of this date was 8%.
From this information, the amount of increase or decrease in the lease liability on
January 2, 2025 shall be
a. P708,427 increase c. P458,676 increase
b. P708,427 decrease d. P458,676 decrease
a. P1,458,934 c, P1,956,057
b. P1,756,903 d, P2,059,678
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Assumption 2: The estimated value of the building at the end of lease term increased
to P3,000,000 based on the reassessment made on January 2, 2025. Incremental
borrowing rate as of this date was 8%,
From this information, the amount of increase or decrease in the lease liability on
January 2, 2025 shall be
a. P354,211 increase c. P790,832 increase
b. P354,211 decrease d. P790,832 decrease
a. P1,976,659 c. P1,867,503
b. P1,581,243 d. P1,690,398
4, On January 1, 2023, IMPALA Company leased a certain office space for eight years
by paying P2,000,000 annual lease payment on the same date. Incremental
borrowing rate as of that date was 6%.
Fast forward to January 2, 2025, the Company rented the adjacent office space for
the remaining period of the original lease term. Annual lease payments for this
additional space amounted to P1,500,000 and are payable immediately. These
annual amounts commensurate with the stand-alone rental price of the additional
space. Incremental borrowing rate as of this date was 7%.
The total amount of depreciation expense of ROU assets for the year 2025 shall be
a. P2,920,645 c. P3,369,759
b. P3,179,721 d. P3,575,846
The total amount of interest expense from lease liabilities for the year 2025 shall be
a. P1,164,107 c. P989,841
b. P936,005 d. P890,023
5. At the beginning of the year 2023, HONEYBADGER Company leased an 8,000 square
meter office space for an annual rental of P2,400,000, to be paid every December 31
of each year, starting in 2023. The lease is to run for the next nine years. Incremental
Fast forward to January 1, 2026, the Company and the lessor agreed to reduce the
occupied space by 3,000 square meters. The annual lease payments will also be
reduced to P1,600,000 starting on December 31, 2026 payment. Incremental
The proportional reduction from the carrying amount of the ROU asset on January
1, 2026 shall be
a. P3,258,941 c. P3,604,562
b. P3,489,309 d. P3,748,133
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The amount of gain or loss to be recognized in 2026 profit or loss due to the
proportional reduction of the ROU asset and lease liability shall be
a. P256,732 gain c, P412,459 gain
b. P256,732 loss d. P412,459 loss
The final carrying amount of the ROU asset right after the modification shall be
a. P7,180,287 c. P7,659,308
b. P6,246,888 d. P7,890,632
The final carrying amount of the lease liability right after the modification shall be
a. P7,683,092 c. P7,867,718
b. P7,789,025_ d. P7,904,329
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Chapter 10 - Lessor Accounting — Finance Lease
CHAPTER 10
LESSOR ACCOUNTING - FINANCE LEASE

1. The classifications of leases in the perspective of the lessor.
2. The bases in classifying the lease as financing or operating.
3. The different classifications of finance lease.
LESSORS
In the previous two chapters, the story of a lease was told in the perspective of the
lessee. In this chapter, concepts are discussed in the perspective of the lessor. As
previously mentioned, a lessor is an entity that provides the right to use an
underlying asset to a lessee for a period of time in exchange for consideration.
Lessors can be classified into the following general categories:
a. Property developers - lease out buildings as office spaces, mall spaces, and
rent-to-own condominiums. At an entity level, the largest property developers
in the country are the Ayala Land, Megaworld Corporation, SM Prime Holdings,
and Filinvest Land.
b. Banks - banks in the country usually structure their leasing business in. leasing
and financing subsidiaries. Banks’ leasing business mainly focus on the financing
aspect, meaning they will buy the asset to be leased out with the hopes of earning
interest income from the lease payments.
c. Captive leasing companies - these are the subsidiaries whose primary
operations involve catering the leasing and financing operations of their parent
company. The primary purpose of this arrangement is to facilitate the sale of the
products of the parent company through credit or installment basis since this
will result to higher revenues for the parent company.
d. Independents - the final catch-all category of lessors which are not covered by
the previously discussed lessor groups.
ADVANTAGES OF BEING A LESSOR

In leasing out assets, lessors can realize the following benefits:
a. Cash inflows generation from properties. An idle and vacant land, on its own,
cannot generate cash flows. Property developers invest money on the
development of idle lands to office spaces, malls, and condominiums in the hopes
of realizing cash flows in the form of rentals which will exceed the total cost of
development.
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Chapter 10 — Lessor Accounting - Finance Lease
b. Generation of rewarding interest margin. The implicit interest charged by the

lessors is normally much higher than the cost of funds used to finance the
transaction, For example, a bank issues bonds payable bearing interest of 5% to
be used in financing its leasing transactions, which the bank normally charges
12% rate of return. Based these facts, the bank earns 7% interest margin (12%
- 5%).
c. Stimulation of sales. Structuring a sale transaction as a lease transaction
increases the number of units sold since individuals and businesses are more
willing and more able to purchase assets in credit or installment basis.
d. Underlying asset’s residual value. Lessors can sell the returned underlying
assets at the end of the lease term.
e. Increased loan security. The underlying asset serves as the security which can
be easily clawed back from the lessee in cases lease payments were not made.
LESSORS’ ACCOUNTING FOR LEASES

The lessor shall classify each of its leases as either an operating lease or a finance
lease. So how shall the lessor classify its leases? The following graphical
presentation has the answer:
Does the lessor transfer

substantially all the risks and Classify the lease as
rewards incidental to ownership an operating lease
of an underlying asset?
Classify the lease as a finance lease
Risks include the possibilities of losses from idle capacity or technological

obsolescence and of variations in return because of changing economic conditions.
Rewards may be represented by the expectation of profitable operation over the
underlying asset’s economic life and of gain from appreciation in value or
realization of a residual value.
There is a need for classification as accounting procedures differ between a
finance lease and an operating lease. Finance leases are discussed in this chapter
while operating leases will be discussed in the next chapter. In practice, in the
lessor’s perspective, most of the leases are classified as operating lease.
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Chapter 10 —- Lessor Accounting — Finance Lease
Lease classification is made on inception date and reassessed only if there is a lease
modification. Inception date is the earlier of the date of a lease agreement and the
date of commitment by the parties to the principal terms and conditions of the lease.
WHEN ARE RISKS AND REWARDS SUBSTANTIALLY TRANSFERRED?
The classification of a lease as a finance or operating lease depends on the|
substance of the transaction rather the legal form of the contract. Examples of
situations that individually or in combination would normally lead to a lease
being classified as a finance lease are the following:
a. the lease transfers ownership of the underlying asset to the lessee by the
end of the lease term (e.g,, rent-to-own arrangements); _
b. the lease contains an option for the lessee to purchase the underlying asset
which the lessee is reasonably certain to exercise because the expected fair
value at the time of the option’s exercisability is sufficiently lower than the
purchase option price (i.e., bargain purchase option);
c. the lease term is for a major part of the economic life of the underlying asset
even if title is not transferred (at least 75% of economic life);
d. at the inception date, the present value of the lease payments amounts to at
least substantially all of the fair value of the underlying asset (at least 90%
of the fair value of the underlying asset); and
e. the underlying asset is of such a specialized nature that only the lessee can
use it without major modifications.
(Note: The 75% in (c) and 90% (d) were borrowed from US GAAP so as to have a clear-cut
distinction and to reduce subjectivity involved in the judgement used in the classification
of the lease.)
Other indicators of situations that individually or in combination could also lead to

a lease being classified as a finance lease are:
a. if the lessee can cancel the lease, the lessor’s losses associated with the
cancellation are borne by the lessee;
b. gains or losses from the fluctuation in the fair value of the residual accrue to the
lessee (for example, in the form of a rent rebate equaling most of the sales
proceeds at the end of the lease); and
c. the lessee has the ability to continue the lease for a secondary period at a rent
that is substantially lower than market rent.
Illustration 1 - Transfer of Ownership. LEDESMA Company leased out its

machinery for three years with the ownership transferred to the lessee at the end
of the lease term. This machinery has a useful life of six years.
The lease shall be classified as a finance lease because of the transfer of ownership,
regardless of the fact that the lease term is only 50% of the useful life (i.e, 3 years/6
years).
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Illustration 2 - Purchase Option. CORTES Company recently acquired a vehicle

which was immediately leased out for four years even though its useful life is ten
years. The lessee has an option to purchase the vehicle at the end of lease term for
a price of P300,000.
If the expected value of the vehicle is P500,000 at the end of the lease term, then
the lease can be classified as a finance lease since the purchase option price is
sufficiently lower (i.e., bargain purchase option). This is regardless of the fact that the
lease term is only 40% (4 years/10 years) of the vehicle's useful life.
If the expected value of the vehicle is P300,000 at the end of the lease term, then
the lease shall be classified as an operating lease since the purchase option price is
not sufficiently lower than this expected value (i.e., not a bargain purchase option).
The lease term that is just 40% of the useful life is not helpful either.
Illustration 3 - Major Portion of Useful Life. During the year, FELICIANO

Company leased out one of its buildings for a specified period of time. This building
has a useful life of 20 years and shall be returned at the end of the lease term.
If the lease term is at least 15 years, then the lease shall be considered as a finance
lease since it is at least 75% (15 years/20 years) of the building’s useful life. This is
still true even if there is no transfer of ownership at the end of the lease term
(application of accounting substance over legal form).
Illustration 4 - PV of Lease Payments is Substantially Equal of the Fair Value

of the Underlying Asset. At the beginning of the current year, SAYSON Company
leased out one of its office buildings for 10 years, even though the building has a
useful life of 18 years. After the lease term, the possession of the building shall be
transferred back to the Company. Annual lease payments of P1,400,000 are due at
the beginning of each year. Relevant discount rate is 7%. Required: Under each of
the following independent scenarios, determine the classification of the lease in the
perspective of the Company as the lessor:
1. The building has a value of P11,600,000.
2. The building has a value of P14,000,000
Scenario 1 - Building value of P11,600,000

The present value of the lease payments is computed as:
PV Factor of PV Factor Cash Flows Total PV

Divide by: Value of building 11,600,000
PV of lease payments expressed as % of asset’s value 90.70%
Since the percentage is at least 90% of the asset’s value, the lease is considered
as a finance lease in the perspective of the Company. This is regardless of the fact
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that there is no transfer of ownership at the end of the lease term and the fact that the
lease term is just 55.56% (10 years/18 years) of the asset's useful life.
Scenario 2 - Building value of P14,000,000
The same present value in Scenario 1 shall be used in the following computation:
75.15%
_ _P10,521,325
~~ P14,000,000
Since the percentage is less than 90% of the asset's value, the lease is considered
as an operating lease in the perspective of the Company. There are no other factors
that will make the lease be classified as a finance lease (i.e., there is no transfer of
ownership and the lease term is just 55.56% of the asset’s useful life).
INITIAL RECOGNITION AND MEASUREMENT - FINANCE LEASE

Since the risks and rewards were substantially transferred to the lessee, the lessor
shall do the following on commencement date:
a. derecognize the underlying asset; and
b. recognize a lease receivable from the lessee.
The abovementioned lease receivable is technically called the net investment in
the lease, which is the gross investment in the lease discounted at the interest
rate implicit in the lease (or net investment in the lease = gross investment in the
lease less unearned finance income).
Gross investment in the lease is the sum of undiscounted amounts of:
a. the lease payments receivable by a lessor under a finance lease; and
b. any unguaranteed residual value accruing to the lessor.
Details on the components of the gross investment in the lease and the interest rate
implicit in the lease will be discussed shortly.
The difference between the gross investment in the lease and net investment in the
lease is the unearned finance income (contra-asset account with normal credit
balance), which is equal to the total finance income that the lessor will earn
throughout the lease term. On the other hand, pro-forma entry to be made on the
commencement date will depend on the classification of the finance lease,
which will be covered later in the chapter.
For the readers to have an initial grasp on these new concepts about net investment
and gross investment in the lease, a basic illustration will be provided.
Illustration 5. LUNA Company leased out its vehicle for a five-year lease term,
which is equal to its useful life. The first annual lease payment of P1,000,000 is due
immediately. Unguaranteed residual value is estimated to be P600,000. Implicit
interest rate is 9%, Incremental borrowing rates of the lessor and lessee were 6%
and 8%, respectively.
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For this illustration, the lease shall be classified as a finance lease since the lease term
is 100% of the useful life of the underlying asset. As a result, the gross investment in
the lease is determined as follows:
Total annual lease payments (P1,000,000 x 5 years) P5,000,000
Add: Unguaranteed residual value 600,000
Gross investment in the lease P5,600,000
Using the implicit rate of 9%, the net investment in the lease is computed as follows:
Net investment in the lease P4,629,679
Less: Gross investment in the lease 5,600,000
Unearned finance income P970,321

a. For lessor’s accounting of the lease, implicit rate shall always be used.
Incremental borrowing rates of the lessor and lessee are totally ignored.
b. Unlike in the lessee’s accounting of the lease, unguaranteed residual value is
included in the lessor’s accounting for the net investment in the lease.
COMPONENTS OF LEASE PAYMENTS RECEIVABLE BY THE LESSOR
At the commencement date, the lease payments included in the measurement of the
net investment in the lease comprise the following payments:
a. fixed payments less any lease incentives payable;
b. variable lease payments that depend on an index or a rate, initially measured
using the index or rate as at the commencement date;
c. residual value guarantees provided to the lessor;
d. the exercise price of a purchase option if the lessee is reasonably certain to
exercise that option; and
€. payments of penalties for terminating the lease, if the lease term reflects the
Security deposit received from lessee is accounted as a separate liability.
By analogy to the lessee’s accounting, the following are excluded from the lessor’s
net investment in the lease:
a. non-lease payments such as receipts related to utilities, service fees, security
fees, maintenance fees and other related services to the lessee (these are to be
accounted for under PFRS 15, Revenue from Contracts with Customers); and
b. variable lease payments as percentage or portion of the lessee’s revenue,
output or future performance. However, the variable lease payments based
on index and minimum amount of variable lease payments, if there is any,
shall still be included in the net investment in the lease.
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Chapter 10 - Lessor Accounting - Finance Lease
These exclusions from net investment in the lease are recognized as income when
earned.
These aforementioned inclusions and exclusions in net investment in the lease are,
by analogy, generally similar to the perspective of the lessee, except for the residual
value guarantees, which will be discussed next.
GUARANTEED AND UNGUARANTEED RESIDUAL VALUE

Residual value is the amount that the lessor may receive on account of the
underlying asset at the end of the lease term. This is comprised of the following
portions:
Total Residual Value = Guaranteed Portion + Unguaranteed Portion
For a portion of residual value to be considered as guaranteed in the lessor’s
perspective, any of the following entities shall be making the guarantee over that
portion:
a. lessee;
b. a party related to the lessee; or
c. any third party not related to the lessor that is financially capable of discharging
the obligations under the guarantee.
The portion of residual value is considered as unguaranteed:
a. if that portion’s realization in cash is not assured; or
b. ifthe guarantee was made solely by a party related to the /essor
Lessor’s accounting for these portions of residual value is as follows (with
comparison to lessee’s accounting):
-— Lessor’s Accounting _ Lessee’s Accounting
Guaranteed PV of this portion is included in | PV of expected shortfall is
portion the net investment in the lease | included in the lease liability
Unguaranteed | PVofthis portionisincludedin | Excluded from the lease
portion the net investment in the lease liability
Based on the table above, the present value of residual value, whether guaranteed
or unguaranteed, is included in the /essor’s net investment in the lease.
Needless to say, if the ownership over the underlying asset will be transferred
to the lessee at the end of the lease term, no residual value shall be included in
the lessor’s gross and net investment in the lease, be it guaranteed or
unguaranteed. The reason is that, in this case, the lessor is not entitled to the value
of the underlying asset.
Illustration 6. PEPITO Company leased out its equipment for four years under a
finance lease. Annual lease payments of P700,000 are due at the beginning of each
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Chapter 10 — Lessor Accounting - Finance Lease
year starting on the current year. Total residual value of the equipment at the end
of the lease term is estimated to be P500,000, P300,000 of which is guaranteed by
the lessee. Implicit interest rate is 6%. Required: Under each of the following
independent scenarios, determine the amounts of gross investment in the lease, net
investment in the lease, and unearned finance income:
1. The equipment will revert back to the Company at the end of lease term
2. The ownership will be transferred to the lessee at the end of lease term.
Scenario 1 - Equipment to revert back to the Company

The gross investment in the lease is determined as follows:
Total annual lease payments (P700,000 x 4 years) P2,800,000
Add: Guaranteed residual value 300,000
Unguaranteed residual value (P500,000 - P300,000) 200,000
Single payment for 4 periods at 6% 0.792094 200,000 158,419
The readers should take note that both the P300,000 guaranteed residual value and
P200,000 unguaranteed residual value shall be included both in the gross investment
‘and net investment (at present values) since the Company, as the lessor, will be
entitled to these amounts as the equipment will revert back to it.
Scenario 2 - Ownership will be Transferred to the Lessee
The gross investment in the lease is determined as follows:
Total annual lease payments (P700,000 x 4 years) P2,800,000
No residual value was included in both the gross and net investment in the lease
since the ownership will be transferred to the lessee and the Company, as the
lessor, will not be entitled to these amounts.
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TYPES OF FINANCE LEASES

Depending on the type of lessor’s operations, finance lease can be classified as
either direct financing lease or dealer’s/manufacturer’s lease. Any reference to
manufacturer's lease also include the dealer’s lease. Direct financing lease and
manufacturer's lease are compared as follows:
Direct Financing Lease Manufacturer's Lease

Typically, property
Typically, banks and
Lessors involved developers and captive
independent lessors
leasing companies
General goal of To sell more inventory
To finance another
through credit or
EASE OU ntity’s purchase of as et
underlying assets enthy SP epee installment terms
Income earned Interest income only aaa Brn ane SS:

Initial measurement Generally equal to Generally equal to the cash
of net investment in purchase cost of the selling price of the
the lease underlying asset underlying asset
PV of unguaranteed RV
will be deducted from:
Effects of Generally, still included in li _ ac d
unguaranteed gross and netinvestment | 2 ©0St of goods so
residual value (RV) in the lease
However, it is still included
in the gross and net
investment in the lease
On commencement date, the following pro-forma journal entry shall be made for
direct financing lease:
Lease receivable XX
Unearned finance income XX
Asset [Asset for lease] XX
On commencement date, the following pro-forma journal entry shall be made for
manufacturer's lease:
Lease receivable XX
Cost of goods sold XX
Unearned finance income XX
Sales revenue (generally equal to net invest.) XX
Inventory XX
It should be noted that the amount debited to the “Lease receivable” account
under both types of finance lease is equal to the amount of the gross investment
in the lease.
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Illustration 7 - Direct Financing Lease. At the beginning of 2023, SOLIS Bank

financed another entity’s purchase of a specialized machinery with cost of
P7,151,206. Annual lease payments of P1,500,000 are due at the beginning of each
year for the next five years equal to the useful life of the machinery. Residual value
is P800,000. Implicit interest rate is 7%. Required: Under each of the following
independent scenarios, determine the journal entry to record the transaction on the
commencement date:
1. Residual Value is Guaranteed by Lessee
2. Residual Value is Unguaranteed
Scenario 1 - Residual Value is Guaranteed by the Lessee
Gross investment in the lease is computed as follows:
Total annual lease payments (P1,500,000x 5 years) P7,500,000
Discounting these amounts using 7% discount rate will result to the following
amounts of net investment in the lease and unearned finance income:

Unearned finance income P1,148,794
Journal entry to record the transaction on commencement date: -

Lease receivable 8,300,000
Unearned finance income 1,148,794
Equipment for lease 7,151,206
Scenario 2 - Residual Value is Unguaranteed

Despite the fact that the residual value is unguaranteed, the amounts of gross and
net investment in the lease, unearned finance income, and journal entry on
commencement date are the same with Scenario 1.
Illustration 8 - Manufacturer’s Lease. On January 1, 2023, ALVAREZ Company
leased out for four years one of its manufactured machineries, which is normally
sold to other entities. Useful life for this machinery is estimated to be five years (i.e.,
lease term is 80% of useful life), while total cost to manufacture the machinery is
P2,500,000. Annual lease payments of P1,200,000 are due at the beginning of each
year starting in 2023 while the residual value is estimated to be P600,000. Implicit
interest rate is 9%. Required: Under each of the following independent scenarios,
determine the journal entry to be recorded on commencement date:
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1. Residual Value is Guaranteed by Lessee

2. Residual Value is Unguaranteed
Scenario 1 - Residual Value is Guaranteed by Lessee
Gross investment in the lease is computed as follows:
Total annual lease payments (P1,200,000 x 4 years) P4,800,000
Discounting these amounts using 9% will result to the following amounts of net
investment in the lease and unearned finance income:
PV Factor of PVFactor Cash Flows Total PV

Cost of goods sold 2,500,000
Unearned finance income 737,391
Inventory 2,500,000
Scenario 2 - Residual Value is Unguaranteed

Despite the fact that the residual value is unguaranteed, the amounts of gross and net
investment in the lease and unearned finance income are the same with Scenario 1,
when the residual value is guaranteed. However, the amounts of sales revenue and
cost of goods sold will be revised as follows:
[A] [A] - [B]
Amounts in Less: PVof Amounts assuming
Scenario 1 unguaranteedRV RVis unguaranteed
Salesrevenue 4,662,609 P425,055 P4,237,554
Less: COGS 2,500,000 425,055 2,074,945
Gross profit P2,162,609 P2,162,609
Inventory 2,500,000
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It should be noted that the gross profit is always the same for manufacturer’s
lease, whether the residual value is guaranteed or unguaranteed.
LIMIT ON THE REVENUE TO BE REPORTED ON MANUFACTURER'S LEASE

The amount of revenue to be recognized is the lower between:
a. fair value of the underlying asset; and
b. the present value of the lease payments accruing to the lessor, discounted using
a market rate of interest.
In addition, if the rate charged by the lessor is substantially lower than the
market rate, the amount of revenue shall be limited by the present value of the
cash flows discounted using the market rate.
Illustration 9, On January 1, 2023, CONQUER Company, a manufacturer of aircraft,

entered into a lease agreement to lease out an aircraft for ten years, which is its
remaining economic life. Annual lease payments amounted to P1,700,000 with the
first payment due on January 1, 2023. Ownership over the aircraft will be
transferred to the lessee at the end of the lease term. The current fair value of the
aircraft is P12,319,709. Implicit interest rate is 8%. The lease qualifies as a finance
lease since the lease term is 100% of the remaining economic life.

amount of revenue to be recognized by the Company:
1. Market rate of interest is 7%
2. Market rate ofinterestis 10% -
Scenario 1 - 7% Market Rate of Interest

The present value of the lease payments using the 7% market rate is computed as
follows:

Annuity due for 10 periods at 7% 7.515232 1,700,000 P12,775,895
PV of lease payments discounted using market rate 12,775,895
Fair value of the underlying asset 12,319,709
Amount to be recognized as revenue (lower) P12,319,709
Scenario 2 - 10% Market Rate of Interest

The present value of the lease payments using the 10% market rate is computed as
follows:

PV of lease payments discounted using market rate 11,490,341
Fair value of the underlying asset 12,319,709
Amount to be recognized as revenue (lower) P11,490,341
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The reason for this limitation is to prevent an entity from immediately recognizing
unnecessarily high amounts of revenue (and gross profit) by quoting a lower-than-
market rates of return.
IMPLICIT RATE ON THE LEASE

The interest rate implicit in the lease or the implicit rate is the rate of interest
that causes the:
a. sum of the present value of lease payments and present value of unguaranteed
residual value to equal the net investment in the lessor, which is the sum of the
following:
i. the fair value of the underlying asset; and
ii. any initial direct costs of the lessor (for direct financing lease only).
This can be simplified by the following equation:
a. PV of lease payments; plus Net Investmentin the lease |

b. PV of unguaranteed residual i| a. FVofunderlying asset; plus
value b. Lessor’s initial direct costs (for
direct financing lease only)
Stated otherwise, the implicit rate is the return that a lessor would like to realize
in leasing out assets under finance lease.
The fair value of the underlying asset above may refer to the purchase price of the
direct financing lessor or the cash selling price of the manufacturer lessor.
Initial direct costs are the incremental costs of obtaining a lease that would not
have been incurred if the lease had not been obtained, except for such costs
incurred by a manufacturer or dealer lessor in connection with a finance lease.
Examples of initial direct costs are finder’s fees, agent's commissions, and up-front
fees.
The following are the effects of initial direct costs to direct financing lease and
manufacturer's lease:
Direct Financing Lease Manufacturer's Lease

Added to net investment in the lease; | Expensed outright (i.e., no effect in net
Decrease in unearned finance income; | investment in the lease and implicit rate
Decrease in implicit rate on the lease on the lease)
Initial direct costs related to for manufacturer's lease are expensed since it is
considered as selling costs. In addition, the income (i.e. sales revenue) which these
costs are related to has already been recognized in full.
Illustration 10. A direct financing lessor provided the following information:
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Annual lease payments for three years

(to be received at the end of each year) P10,000
Unguaranteed residual value 3,000
Purchase cost of underlying asset 26,000
Initial direct costs 2,152
Required: Determine the implicit rate from the given facts.
Solution:
The first step is to plug the numbers in the equation:
Annual lease payments for 3 years PV amt FV of asset P26,000

Unguaranteed residual value PV amt Initial direct costs 2,152
Should be PV P28,152 Net investment P28,152
Based on the total of the fair value of the underlying asset and the initial direct costs,
the present value of annual lease payments plus the unguaranteed residual value
should be P28,152, which is also equal to the net investment in the lease. In nominal
terms, the total cash flow will be P33,000 ((P10,000 x 3) + 3,000).
Finding the implicit rate involves finding the interest rate that, when used to
discount this P33,000 cash flows, will give a PV of P28,152. This will involve trial
and error.
Trial 1-5%
First, let us try 5%, the relevant computations are the following:
Total PV amount P29,824
Since the computed PV of P29,824 is higher than the target PV of P28,152, a higher
rate, say 9% will be used in the trial-and-error computation to arrive at a lower PV
amount.
Trial 2 -9%
Using 9%, the present value shall be computed as follows:
In this case, the computed PV of P27,630 is now lower than the target P28,152. As
a result, a lower rate than 9% shall be used, say 8%, to arrive at a slightly higher PV
amount
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Trial 3 - 8%
Using 8%, the present value shall be computed as follows:
PV Factor of PV Factor CashFlows Total PV

Ordinary annuity for 3 periods at8% 2.577097 10,000 25,771
The PV computed above is P28,152 which is now equal to the total of fair value of
the underlying asset plus the lessor’s initial direct cost. In conclusion, the implicit
rate in this example is 8%.
It may appear that the computation of the implicit rate is quite tedious, but in
practice computer software is widely used to easily compute the implicit rate.
APPLICATIONS OF IMPLICIT RATE CALCULATIONS

The previous equation can also be used if one component of the equation is missing,
provided that the other three components plus the implicit rate, if relevant, are
known.
Illustration 11 - Computation of Annual Lease Payments on Direct Financing

Lease. On January 1, 2023, ROSA Financing Company financed a lessee’s acquisition
of a building worth P5,000,000. Initial direct costs amounted to P240,000. Annual
lease payments are due at the start of each year for the next eight years, after which,
the ownership will be transferred to the lessee. The Company would like to earn a 6%
return from this lease.
The amount of annual lease payments and gross investment in the lease are
Cost of building P5,000,000

Add: Initial direct costs 240,000
Divide by: PV factor of annuity due for 8 periods at 6% 6.582381
Annual lease payments at the beginning of each year P796,065
Multiply: Number of lease payments 8
Journal entry to record the transaction is as follows:

Unearned finance income (squeeze) 1,128,520
Building for lease (total cost) 5,240,000
For this illustration, in case there is a given amount of residual value, it shall not be
considered in the computation of annual lease payment since the ownership over
the building will be transferred to the lessee.
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Illustration 12 - Computation of Annual Lease Payments on Manufacturer's

Lease. At the beginning of 2023, DURAN Company leased out one of its
manufactured vehicles to another entity for ten years, equal to the vehicle’s useful
life. Cash selling price is P7,000,000 while the manufacturing costs is P4,500,000.
Residual value of P800,000 is guaranteed by the lessee. In addition, initial direct
costs incurred amounted to P190,000. Implicit interest rate is 7%.
The amount of annual lease payments and gross investment in the lease are
Cash selling price (also net investment in the lease) P7,000,000
Less: PV of guaranteed residual value for 10 periods at
7% (P800,000 x 0.508349) 406,679
PV of annual lease payments P6,593,321
Divide by: PV factor of annuity due for 10 periods at-7% 7.515232
Annual lease payments at the beginning of each year P877,328
Multiply: Number of lease payments 10
Total lease payments P8,773,280
Add: Amount of guaranteed residual value 800,000
Journal entry to record the transaction is as follows:
Selling expenses (initial direct costs). 190,000
Unearned finance income 2,573,280
Inventory 4,500,000
Cash (for initial direct costs) 190,000
Again, the initial direct costs are not considered in determining the net investment
in the lease and the amount of annual lease payments. In addition, the residual value
(whether guaranteed or unguaranteed) was considered in the computations since
there is no transfer of ownership to the lessee. Lastly, l income i.
P9,573,280 gros in 7,000,000 net i
SUBSEQUENT MEASUREMENT OF NET INVESTMENT IN THE LEASE
By analogy, subsequent accounting for net investment in the lease is sort of similar
to the subsequent accounting for lease liability, albeit the change in point-of-view:
a. Interest income increases the net investment in the lease (by decreasing the
unearned finance income account equal to the amount of interest income
recognized).
b. Lease payments received from lessee decrease the net investment in the
lease (by decreasing the lease receivable account equal to the amount of
amounts received).
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The effects of these amounts are better seen in an amortization table. These
procedures are applicable to both direct financing and manufacturer's leases.
Generally, interest income is determined using the implicit interest rate on the
lease (i.e., beginning net investmentx implicit rate), except for the following:
a. For manufacturer’s lease, when there is a quotation of artificially low rates of
interest in order to attract customers.
b. For manufacturer's lease, if the PV of lease payments, using market rate of
interest, is lower than the fair value of the underlying asset.
For these exceptions, interest income is determined using the market rate of interest
on commencement date.
At the end of each year, the amounts of net investment and gross investment in the
lease (i.e., lease receivable aveount) and unearned finance income are equal to the
following:
_Amounts Ending balance equal to

Gross investment Undiscounted amounts to be received in
(i.e., lease receivable) the future, including unguaranteed RV
Amounts to be recognized as interest
Unearned finance income
income in future periods
Difference between the balance of gross
Net investment in the lease
investment and unearned finance income
Illustration 13 - Direct Financing Lease. For this illustration, we will be using the
information previously provided for SOLIS Company (Illustration 7). To reiterate,
the net investment in the lease is P7,151,206, gross investment is P8,300,000,
annual lease payment is P1,500,000, and implicit rate of 7%. Residual value is
P800,000. There is no transfer of ownership over the underlying asset.
The relevant amortization table for the subsequent measurement of net investment
in the lease is as follows, nteed or
Gross Unearned
Lease _ Interest Net Investment/ Finance
Date Pmts. Income Amort. Investment _—_ Lease Rec. Inc.
Jan. 1, 2023 7,151,206 8,300,000 1,148,794
Jan. 1, 2023 1.5M - (1,500,000) 5,651,206 6,800,000 1,148,794
Jan.1,2024 15M 395,584 (1,104,416) 4,546,790 5,300,000 753,210
Jan.1,2025 15M 318,275 (1,181,725) 3,365,065 3,800,000 434,935
Jan.1,2026 15M 235,555 (1,264,445) 2,100,620 2,300,000 199,380
Jan.1,2027, 15M 147,043 (1,352,957) 747,663 800,000 52,337
Dec. 31,2027 800K 52,337 (747,663) - s -
Year 2023
On January 1, 2023, the entry to record the receipt of lease payments from lessee:
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Cash 1,500,000
On December 31, 2023, the entry to record the recognition of interest income for
the year:
Interest income 395,584
Even though the interest income of P395,584 corresponds to January 1, 2024 in the
amortization table, this interest income is actually earned from January 1, 2023 to
December 31, 2023.
In addition, the net investment amounts in the amortization table do not
correspond to their supposed balances at the end of each year mainly due to the
fact that the lease payments are made at the beginning of each year.
The gross and net investment in the lease as of December 31, 2023 shall be
Remaining lease payments (01/01/24 - 12/31/27) (P1.5Mx4pmts) _P6,000,000
Add: Residual value (whether guaranteed or unguaranteed) 800,000
Gross investment in the lease/Lease receivable P6,800,000
Less: Unearned finance income (P1,148,794 - P395,584) (753,210)
Net investment in the lease, 12/31/23 (or P5,651,206 + P395,584) P6,046,790
Year 2024
Cash 1,500,000
the year:

Remaining lease payments (01/01/25 - 12/31/27) (P1.5Mx3pmts) —P 4,500,000
Less: Unearned finance income (P753,210 - P318,275) (434,935)
The computation of ending balance of the net investment in the lease is similar to
the computation of the lease liability’s carrying amount every December 31 (i.e.,
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accretion of interest income will be added to the beginning balance of the net
investment):
[c] = [D]
[A] [B] [A]+[B] 12/31 Gross - [C]
[D]
Beg. Net Interest 12/31Net Investment/ 12/31 Unearned
Year Investment Income Investment Lease Rec. Finance Income
2023 = 5,651,206 395,584 6,046,790 6,800,000 753,210
2024 4,546,790 318,275 4,865,065 5,300,000 434,935
2025 3,365,065 235,555 3,600,620 3,800,000 199,380
2026 2,100,620 147,043 2,247,663 2,300,000 52,337
2027 747,663 52,337 800,000 800,000 -
Illustration 14 - Manufacturer’s Lease. For this illustration, we will be using the
information previously provided for ALVAREZ Company (Illustration 8). To
reiterate, the net investment in the lease is P4,662,609, gross investment is
P5,400,000, annual lease payment is P1,200,000, and implicit rate of 9%. Residual
value is P600,000. There is no transfer of ownership over the underlying asset.
The relevant amortization table for the subsequent measurement of net investment
in the lease is as follows, whether the residual value is guaranteed or not:
Gross Unearned
Lease Interest Net Investment/ Finance
Date Pmts. Income Amort. Investment Lease Rec. Inc.
Jan. 1, 2023 4,662,609 5,400,000 737,391
Jan. 1, 2023 1.2M ~ (1,200,000) 3,462,609 4,200,000 737,391
Jan.1,2024 12M 311,635 (888,365) — 2,574,244 3,000,000 425,756
Jan. 1,2025 1.2M 231,682 (968,318) 1,605,926 1,800,000 194,074
Jan. 1, 2026 1.2M 144,533 (1,055,467) 550,459 600,000 49,541
Dec. 31,2026 600K 49,541 (550,459) - = -
Year 2023
Cash 1,200,000
the year:
Even though the interest income of P311,635 corresponds to January 1, 2024 in the
amortization table, this interest income is actually earned from January 1, 2023 to
December 31, 2023. In addition, the net investment amounts in the amortization
table do not correspond to their supposed balances at the end of each year mainly
due to the fact that the lease payments are made at the beginning of each year.
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Remaining lease payments (01/01/24 - 12/31/26) (P1.2Mx3 pmts) — P3,600,000
Gross investment in the lease/Lease receivable ~P4,200,000
Net investment in the lease, 12/31/23 (or P3,462,609 + 311,635) P3,774,244
Net income for 2023 is P2,474,244 (P2,162,609 gross profit + P311,635 interest).
Year 2024
Cash 1,200,000
the year:
Remaining lease payments (01/01/25 - 12/31/26) (P1.2Mx2pmts) 2,400,000
The carrying amounts of net investment in the lease over the lease term are
summarized as follows:
[C] = [D]
[A] [B] [A] + [B] 12/31 Gross [D] - [C]
Beg. Net Interest 12/31Net Investment/ 12/31 Unearned
Year investment Income’ Investment Lease Rec. Finance Income
2023 3,462,609 311,635 3,774,244 4,200,000 425,756
2024 2,574,244 231,682 2,805,926 3,000,000 194,074
2025 1,605,926 144,533 1,750,459 1,800,000 49,541
2026 550,459 49,541 600,000 600,000 -
RETURN OF ASSET TO THE LESSOR AT THE END OF THE LEASE TERM

If there is no transfer of ownership nor bargain purchase option on an underlying
asset in a finance lease, the underlying asset will be returned to the lessor at the
end of the lease term. At that time:
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Chapter 10 —- Lessor Accounting - Finance Lease
a. Net investmentin the lease is equal to the undiscounted amount of residual value,
whether guaranteed or unguaranteed, as can be seen in the previous
amortization table (i.e., zero balance for unearned finance income).
b. When received, the underlying asset shall be recognized equal to its fair value.
Of course, these two amounts are rarely equal so accounting for their difference
becomes necessary. Accounting procedures will depend on whether the residual
value is guaranteed or not and whether the fair value of underlying asset is higher or
lower than the remaining balance of net investment in the lease:
Scenario Accounting for difference
Residual value is guaranteed:
Net investment < FV ofasset | Difference is recognized as gain in profit or loss
Net investment > FV of asset | Difference is to be received as cash from lessee
Residual value is unguaranteed:
Net investment < FV ofasset__| Difference is recognized as gain in profit or loss
Netinvestment>FVofasset | Difference is recognized as loss in profit or loss
Needless to say, in rare circumstances where the carrying amount of the net
investment in the lease is equal to the residual value (or fair value), then no
gain or loss will be recognized nor amounts will be received from the lessee.
Illustration 15. On December 31, 2023, ABELLA Company’s lease with a lessee
involving a vehicle has come to an end. On the same date, the underlying asset shall
be returned to the Company. The balance of net investment in the lease is equal to
the undiscounted residual value of P1,000,000. Required: Under each of the
following independent scenarios, determine the journal entry to record the return
of the vehicle to the Company:
1. Residual value is guaranteed; fair value of vehicle is P1,200,000
2. Residual value is guaranteed; fair value of vehicle is P750,000
3. Residual value is unguaranteed; fair value of vehicle is P1,200,000
4. Residual value is unguaranteed; fair value of vehicle is P750,000
Scenario 1 - RV is guaranteed; FV of vehicle is P1,200,000
The journal entry to record the receipt of the vehicle:
Vehicle for lease (at fair value) 1,200,000
Gain on residual value (squeeze) 200,000
Scenario 2 - RV is guaranteed; FV of vehicle is P750,000
Vehicle for lease (at fair value) 750,000
Cash 250,000
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Chapter 10 —- Lessor Accounting — Finance’ Lease
No gain or loss shall be recognized in this case since the supposed loss was
shouldered by the lessee (i.e., cash will be received from the lessee).
Scenario 3 - RV is unguaranteed; FV of vehicle is P1,200,000
The journal entry is the same with Scenario 1
Scenario 4 - RV is unguaranteed; FV of vehicle is P750,000
Vehicle for lease (at fair value) 750,000
Loss on residual value (squeeze) 250,000
A loss was recognized since the difference is not shouldered by the lessee.
CHAPTER SUMMARY
1. Alessor is an entity that provides the right to use an underlying asset to a lessee for
a period of time in exchange for consideration.
2. Generally, lessors are classified into the following large groups: property developers,
banks, captive leasing companies, and independents.
3. For accounting purposes, leases in the perspective of the lessor are classified as
either finance lease or operating lease.
4. Aleaseis classified as finance lease if the lessor transferred substantially all the risks
and rewards incidental to ownership of an underlying asset. Otherwise, the lease is
classified as operating lease.
5. The classification shall be made on the inception date.
6. Examples of situations that individually or in combination would normally lead toa
lease being classified as a finance lease are:
a. the lease transfers ownership of the underlying asset to the lessee by the end of
the lease term (e.g., rent-to-own arrangements);
b. the lease contains a bargain purchase option;
c. the lease term is for a major part of the economic life of the underlying asset even
if title is not transferred (at least 75% of economic life);
d. at the inception date, the present value of the lease payments amounts to at least
substantially all of the fair value of the underlying asset (at least 90% of the fair
value of the underlying asset); and
e. the underlying asset is of such a specialized nature that only the lessee can use it
without major modifications.
7. Onthe commencement date, the lessor shall account for the finance lease as follows:
a. Recognize a net investment in the lease.
b. Derecognize the underlying asset.
8, Net investment in the lease is the present value of gross investment in the lease,
discounted using the implicit interest rate.
9. Gross investment in the lease is equal to lease payments plus unguaranteed residual
value. The balance in the lease receivable account is equal to the gross investment in
the lease.
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Chapter 10 — Lessor Accounting ~ Finance Lease
10.Unearned finance income represents the total amount of interest income to be

recognized over the lease term (Unearned finance income = Gross investment in the
lease - net investment in the lease).
11.The present value of residual value shall be included in the net investment in the
lease, whether it is guaranteed or unguaranteed. On the other hand, any residual
value guarantee shall be excluded if the underlying asset will not revert back to the
lessor (e.g., there is a transfer of ownership or purchase option).
12. The following are the classifications of finance leases:
Direct Financing Lease Manufacturer’s Lease
Typically, property
Typically, banks and
Lessors involved : developers and captive
independent lessors leasing companies
General goal of To finance another To sell more inventory
leasing out underlying | _ entity's purchase of through credit or
assets asset installment terms
Interest income and gross
Income earned Interest income only
profit
Initial measurement Generally equal to Generally.equal to the cash
of net investment in purchase cost of the selling price of the
the lease underlying asset underlying asset
PV of unguaranteed RV
will be deducted from:
Generally, still 3. Sales revenue
ee efi included in gross and 4. Cost of goods sold
residual value (RV) net investment in the However, itis still
lease included in the gross and
net investment in the
lease
Initial direct costs Included in net Expensed outright

investment
13.The amount of revenue to be recognized from manufacturer's lease is the lower

between:
a. fair value of the underlying asset; and
14.In subsequently accounting for the finance leases, whether direct financing or
manufacturer's, the amounts of interest income and carrying amount are
determined based on the amortization table.
15. However, if the periodic lease payments are made at the beginning of each period,
the carrying amount of net investment in the lease is equal to net investment in the
lease at the beginning of the period plus interest income during the period.
16. The returned underlying asset shall be measured at its fair value at the end of the
lease term.
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Chapter 10 —--Lessor Accounting - Finance Lease
True or False
1. Through leasing assets, a lessor entity may increase the sales of its assets.
2. Alessor bank focuses on selling the inventory items of its parent company or its
other affiliates.
3. In the lessor’s perspective, a lease is classified as either finance lease or an
operating lease.
4. Alease is classified based solely on the lessor’s judgment.
5. A lease is classified as a finance lease if the present value of the lease payments
amounts to at least majority of all the fair value of the underlying asset.
6. Alease is classified as a finance lease if the ownership over the underlying asset will
be transferred to the lessee at the end of the lease term.
7. If there is no transfer of ownership at the end of the lease term, a lease is
automatically classified as an operating lease.
8. Under a finance lease, the carrying amount of the underlying asset shall be
derecognized from the books of the lessor.
9. Residual value, whether guaranteed or not, shall be included in the gross
investment in the lease, except when the asset will not revert back to the lessor.
10. Inadirect financing lease, the lessor will earn both gross profit and interest income
during the lease term.
11. Initial direct costs are included in thes net investment in the lease in a
manufacturer's lease.
12. The present value of the unguaranteed residual value shall be deducted both from
the sales revenue and the cost of goods sold.

Ai In classifying leases as finance lease or operating lease, the substantial transfer of
which of the following shall be considered?
a. Risks
b. Rewards
c. Bothaandb
d. Eitheraorb
The following circumstances will normally result to a lease being classified as a

finance lease, except
a. There isa transfer of ownership over the underlying asset at the end of the lease
term.
b. There is a bargain purchase option
c. The lease term is for the major part of the economic life of the underlying asset,
even if there is no transfer of ownership at the end of the lease term.
d. Atthe inception date, the present value of the lease payments amounts to at least
half of all of the fair value of the underlying asset.
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The
3. Other indicators of situations that individually or in combination could also lead to

a lease being classified as a finance include the following, except
a. If the lessee can cancel the lease, the lessor’s losses associated with the
cancellation are borne by the lessee.
b. Gains or losses from the fluctuation in the fair value of the residual accrue to the
lessee.
c. The lessee has the ability to continue the lease for a secondary period at a rent
that is substantially higher than market rent.
4. Leases shall be classified as finance lease or operating lease on
a. _ inception date of the lease
b. commencement date of the lease
c. aorb, whichever is earlier
d. aorb, whichever is later
5. The finance lease shall be recorded on
a. inception date of the lease
b. commencement date of the lease
c. aorb, whichever is earlier
d. aorb, whichever is later
6. On initial recognition, the lessor in a finance lease shall
a. Recognize a receivable in the form of net investment in the lease.
b. Derecognize the underlying asset.
c. Bothaandb
d. Neitheranorb
7. The gross investment in the lease shall exclude which of the following?
a. A guaranteed residual value.
b. Anunguaranteed residual value.
c. Fixed periodic lease payments.
d. Variable lease payments based on the lessee’s revenue.
8. Which of the following statements is/are correct?
a. The present value of the guaranteed residual value is included both in the
lessee’s lease liability and lessor’s net investment in the lease.
b. The present value of the unguaranteed residual value is included in the lessor’s
net investment in the lease but excluded from the lessee’s lease liability.
c. Bothaandb
d. Neitheranorb
9. The following statements are true regarding direct financing lease, except
Net investment in the lease excludes the unguaranteed residual value
2 oT}
This type of lease is usually offered by banks,

This type of lease is used to finance the lessee’s purchase of an asset.
Net investment in the lease is usually equal to the purchase cost of the
underlying asset.
320
The
to be reported in profit or loss from a direct financing lease include/s

amount/sincome
10. The Interest
g.
b. Gross profit
c. Bothaandb
d. Neither anor b
11. The following statements are true related to a manufacturer's lease, except
a. This type of lease is usually offered by captive leasing companies.
b. Net investment in the lease is equal to the cost of production of the underlying
asset.
c. Through this type of lease, the lessor has an objective of increasing the sales of
its inventory items.
d. Net investment in the lease includes the present value of the unguaranteed
residual value.
12. The amount sales revenue that a lessor shall recognize from a manufacturer's lease
is equal to
a. fair value of the underlying asset
c. eitheraor b, whichever is higher
d. eithera orb, whichever is lower
13. The amount/s to be reported in profit or loss from a direct financing lease include/s
a. Interest income
b. Gross profit
c. Bothaandb
d. Neitheranorb
14. The following are the effects of the present value of the unguaranteed residual value
ina manufacturer’s lease, except
a. Net decrease in the gross profit
b. Reduction in the sales revenue
c. Reduction in the cost of goods sold
15.Which of the following correctly describes the accounting for initial direct costs?
a. Initial direct costs are expensed outright under both direct financing lease and
manufacturer’s lease.
b. Initial direct costs are included in the net investment in the lease under both
direct financing lease and manufacturer's lease.
¢. Initial direct costs are expensed outright under direct financing lease and
included in the measurement of net investment in the lease under
manufacturer’s lease.
d. Initial direct costs are expensed outright under manufacturer's lease and
included in the measurement of net investment in the lease under direct
financing lease.
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The
Straight Problems
1. Given the following scenarios, determine the classification of each lease contract as
either financing lease or operating lease in the lessor’s perspective:
a. A five-year lease involving an underlying asset with 20-year economic life. The
ownership over the asset will be transferred to the lessee at the end of the lease
term.
b. A six-year lease involving an underlying asset with eight-year economic life.
There is no transfer of ownership over the asset at the end of the lease term.
c. Asix-year lease involving an underlying asset with 12-year economic life. There
is no transfer of ownership over the asset at the end of the lease term.
d. A four-year lease involving an underlying asset with ten-year economic life, The
lessee has an option to purchase the asset for P300,000 at the end of the lease
term. Expected value of the asset by that time is P800,000.
e. Aseven-year lease involving an underlying asset with nine-year economic life.
The lessee has an option purchase the asset for P500,000 at the end of the lease
term. Expected value of the asset by that time is P490,000.
f. A four-year lease involving an underlying asset with ten-year economic life. The
underlying asset had a fair value of P4,000,000. Lease payments of P1,000,000
are payable in advance. Relevant discount rate as of that date was 7%.
g. Asix-year lease involving an underlying asset with eight-year economic life. The
are payable at the end of each period. Relevant discount rate as of that date was
8%.
h. A six-year lease involving an underlying asset with 12-year economic life. The
are payable in advance. Relevant discount rate as of that date was 5%.
2. At the start of 2023, INDIGO Company, a financing a company, entered into a six-
year lease contract involving a machinery. Annual lease payment of P1,400,000 is to
be received every January 1 of each year, starting in 2023. Total cost and fair value
of the machinery amounted to P6,989,794. The machinery has estimated remaining
economic life of seven years. Implicit interest rate was 8%.

b. Amounts of gross investment in the lease and net investment in the lease as of
December 31, 2023 and 2024
3. On January 1, 2023, SPRUCE Financing Company leased out a vehicle for five years
by receiving annual lease payment of P1,800,000 every December 31 of each year,
starting in 2023. In addition, total residual value amounted to P1,500,000, of which,
P800,000 is guaranteed by the lessee. The vehicle has total cost of P8,703,142 and
estimated economic life of six years. Expected value of the underlying asset by the
end of the lease term is P300,000. Interest rate implicit in the lease was 6%.
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a, Journal entries for the year's 2023 and 2024,
4, On January 1, 2023, LARA Company, a manufacturer of production machineries,
leased out one of its manufactured machineries for five years by receiving annual
lease payment of P2,200,000 every January 1 of each year, starting in 2023.
Guaranteed residual value amounted to P1,000,000. The machinery had economic
life of ten years and has total production costs of P7,000,000. The fair value of the
machinery as of that date was P11,200,000. Implicit interest rate is 7%.
5. At the start of 2023, DENIM donnie: a dealer of vehicles, rented out, for six-year
term, one of its sports utility vehicles (SUV) in its inventory. Annual lease payment
of P1,200,000 will be received every December 31 of each year, starting in 2023.
Estimated economic life was eight years and production costs amounted to
P4,200,000. The relevant residual value amounted to P800,000. Implicit interest
rate was 9% while the fair value amounted P6,500,000.
Assumption 1: The residual value is guaranteed by the lessee.
Required: Determine the following:
Assumption 2: The residual value is guaranteed by a party related to the lessor.
6. At the beginning of the year 2023, SLATE Company, a manufacturer of
transportation vehicle, entered into a lease agreement to lease out one of the
vehicles in its inventory for five years, even though the remaining economic life is
six years. Annual lease payments amounted to P1,400,000 with the first payment
due on December 31, 2023. The current fair value of the asset is P5,740,276. Implicit
interest rate was 7%.
Required: Under each of the following independent scenarios, determine the amount
of revenue to be recognized by the Company:
a. Market rate of interest is 6%
b. Market rate of interest is 8%
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7. OnDecember 31, 2023, the end of the lease term of one the COBALT Compa ny’s lease
contracts, the Company reported a net investment in the lease amounting to
P2,000,000. This amount represents the residual value of the underlying asset to be
returned to the Company.
entry to be made upon the return of the underlying asset:
1. The residual value is guaranteed; fair value of the vehicle is P1,800,000.
2. The residual value is guaranteed; fair value of the vehicle is P950,000.
3. The residual value is unguaranteed; fair value of the vehicle is P1,700,000.
4. The residual value is unguaranteed; fair value of the vehicle is P850,000.
1. On January 1, 2023, AZURE Financing Company leased out a building to another
entity for a lease term of ten years, even though the building’s economic life is 20
years. Annual lease payments of P2,500,000 are due to be paid every December 31
of each year, starting in 2023. Ownership over the building will be transferred to the
lessee by the end of the lease term. The Company acquired the building for
P17,558,954 shortly before the start of the lease. In addition, initial direct costs of
P841,264 were incurred. When considered, these costs will change the implicit rate
from 7% to 6%.
The initial amount of gross investment in the lease on January 1, 2023 shall be
a. P25,000,000 c. P25,841,264
b. P27,500,000 d. P28,341,264
The amount of interest income to be recognized for the year 2024 shall be
a. P1,140,166 c. P1,104,013
b. P1,229,127 d. P1,020,254
The amount of net investment in the lease as of December 31, 2024 shall be
a. P17,004,231 c. P16,288,082
b. P15,524,485 d. P14,928,248
2. Atthe beginning of the year 2023, ADMIRAL Company leased out one ofits inventory
items for eight years, which is equal to that item’s economic life. Lease payments of
P1,600,000 are due every January 1 of each year, starting in 2023. Production costs
for each item amounted to P6,500,000. Initial implicit rate was 9%. In addition,
initial direct costs amounted to P277,468, which when considered, will decrease the
implicit rate to 8%
The amount of net income for the year 2023 shall be
a. P3,152,725 c. P3,887,470
b. P3,600,002 d. P4,096,607
The amount of the lease receivable as of December 31, 2024 shall be
a. P12,800,000 c. P9,600,000
b. P11,200,000 d, P8,000,000
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The balance in the net investment in the lease as of December 31, 2024 shall be
a. P8,777,470 c. P7,823,442
b. P8,052,725 d. P7,177,470
3. SAPPHIRE Company leased out one of its manufactured equipment for seven years.
Annual lease payments of P1,500,000 are due on the first day of each year, starting
in 2023. The equipment has a total useful life of nine years. Estimated residual value
of the equipment at the end of the lease term is P1,000,000, of which P600,000 is
guaranteed by the lessee. Implicit interest rate is 7% while the production costs
totaled P6,000,000.
The amount of sales revenue to be recognized during 2023 shall be
a. P9,272,560 c. P9,472,498
b. P9,023,460 _ d. P9,127,834
The amount of cost of goods sold to be recognized shall be
a. P5,689,700 c. P6,000,000
b. P5,479,400 d. P5,750,900
Net investment in the lease as of December 31, 2024 shall be
a. P8,316,639 c. P7,293,804
b. P6,816,639 d. P7,772,560
4. On January 1, 2023, NAVY Financing Company entered into a five-year direct
financing lease of a transportation vehicle with cost of P6,000,000. Unknown
amount of annual lease payment is due to be paid every January 1 of each year,
starting in 2023. Unguaranteed residual value is estimated to be P800,000. In
addition, initial direct costs of P300,000 were also incurred. Implicit interest rate
was 8%.
The amount of annual lease payments shall be

a. P1,391,425 c. P1,460,996
b. P1,334,732 d. P1,265,161
The initial balance of lease receivable, before any lease payments, shall be
a. P7,304,980 c. P6,673,660
b. P8,104,980 d. P7,473,660
The net investment in the lease as of December 31, 2024 shall be
a P4,349,978 c. P4,965,268
b. P5,362,489 d. P4,027,757
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Chapter 10A - Lessor Accounting — Operating Lease and Other Lessor Matters
CHAPTER 10A
LESSOR ACCOUNTING - OPERATING LEASE AND
OTHER LESSOR MATTERS

1. The accounting for operating leases.
2. The accounting for lease of land and building together.
3, Theaccounting for lease modifications and changes in lease classification in the
lessor’s perspective.
4. The simultaneous accounting procedures in the books of the lessee and lessor.
OPERATING LEASES
In the previous chapter, it was discussed that if there is a substantial transfer of
risks and rewards, the lessor shall account for the lease as a finance lease.
Otherwise, it will be accounted for as an operating lease.
In practice, lease contracts that normally result to an operating lease in the
perspective of the lessor are those involving commercial and office spaces.
However, all other lease contracts are not precluded to be classified as eperseing
lease, as long as there is no substantial transfer of risks and rewards.
GENERAL ACCOUNTING FOR OPERATING LEASES
Lessor’s accounting for operating leases is very straightforward relative to the
accounting for finance lease primarily because there are no present value
calculations. Instead, the following primary procedures will be relevant:
a. Generally, rental income shall be recognized ona straight-line basis (i.e., equal
amounts per period), regardless of the actual amounts of rentals received.
b. The underlying asset is not derecognized, instead it will continue to be
accounted for by the lessor. As such, if the underlying asset is depreciable and
the entity is using the cost model, the lessor shall record depreciation.
If the underlying asset is a land and/or a building, it is generally classified as
investment property (as discussed in the Volume 1 of this Intermediate
Accounting series); otherwise, it is considered as PPE or intangible asset,
whichever is relevant. In addition, the underlying asset is also subject to
impairment under PAS 36, except when it is accounted for using the fair value
model under PAS 40.
The amounts included in the straight-line calculation of rental income are
those lease payments that will be received from the lessee, but excluding the
following:
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Chapter 10A — Lessor Accounting - Operating Lease and Other Lessor Matters
a. Security deposit which will be recognized as a separate liability.

b. Variable lease payments based on performance, such as based on sales or
output. These will be recognized as rental income during the period these were
earned. However, the minimum portion of these variable lease payments shall be
included in the straight-line calculation of rental income.
c. Non-lease payments received such as those related to security and
maintenance. This will be recognized as a separate income when earned.
In cases the amount of rent received is not equal to the rental income
recognized, the difference will have the following consequences:
Scenario > Consequences (depending on circumstances)
: ‘ Increase in accrued rent receivable or
Rent received < Rent income : s
Decrease in unearned rent income
< ‘ Increase in unearned rent income or
Rent received > Rent income : i
Decrease in accrued rent receivable
On a cumulative basis, the following are the relevant guidelines:

Scenario Amount of cumulative difference
Cumulative rent received < .
; RENE Accrued rent receivable (asset)
Cumulative rent income
Cumulative rent recei > : Snatltgs
; ve Unearned rent income (liability)
Cumulative rent income
The amounts of accrued rent receivable and unearned rent income shall be zero by
the end of the lease term. By analogy, these rules are similar to the rules applied to
the lessee’s accounting for short-term leases and lease of low-value assets.
Illustration 1 - Increasing Amount of Rent. On January 1, 2023, MAHINAY
Company entered into a four-year lease contract involving its office space due at the
beginning of each year. Lease payment for 2023 is set at P1,000,000 while lease
payments for succeeding years will increase by 10% annually and payable every
December 31. Security deposit of P400,000 was received from the lessee. Implicit
interest rate is 7%. The lease is properly accounted for as an operating lease.
The total amount of rentals to be received over the lease term is determined as
follows:
Year Rentals
2023 P1,000,000
2024 (P1,000,000 x 110%) 1,100,000
2025 (P1,100,000x 110%) 1,210,000
2026 (P1,210,000 x 110%) 1,331,000
Total rental payments P4,641,000
Rental income per year P1,160,250
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The
The readers should take note that the security deposit was excluded from the total
rental payments that will be recognized as rental income.
Year 2023
Journal entry to record the receipt of security deposit on January 1, 2023:
Cash : 400,000
Liability for security deposit 400,000
Journal entry to record the recognition of rental income and the receipt of lease
payments on December 31, 2023:
Cash - 1,000,000
Accrued rent receivable 160,250
Rental income 1,160,250
Since the amount of rental income is higher than the amount of rental received, the
difference is recognized as accrued rent receivable.
Year 2024
Cash 1,100,000
Year 2025
Cash 1,210,000
Starting this year, the amount of rent received is now higher than the rental income
resulting to the decrease in previously recognized accrued rent receivable.
Year 2026
Cash 1,331,000
The Company will report the following balances every year for this lease:
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[A] [B]
Cumulative Cumulative [B] - [A]
Rent Rental Rent Rental Accrued Rent
Year Received Income Received Income Receivable
2023 1,000,000 P1,160,250 P1,000,000 P1,160,250 P160,250
2024 1,100,000 1,160,250 2,100,000 2,320,500 220,500
2025 1,210,000 1,160,250 3,310,000 3,480,750 170,750
2026 = 1,331,000 = 1,160,250 4,641,000 4,641,000
a. If the periodic rental payments are increasing, the amount of accrued rent
receivable builds up during the first few years and will be gradually decreased
during the latter years. Again, this will zeroed out at the end of the lease term.
b. Implicit interest rate is ignored.
Illustration 2 - With Rent-Free Periods. At the beginning of 2023, ESGUERRA
Company entered into a four-year lease contract covering a commercial space by
agreeing to receive annual lease payments of P3,000,000 every December 31 of
each year. In addition to this annual lease payment, the lessee is also required to
pay, every December 31, 2% of its annual sales.
The Company will also charge additional P200,000 per year for the security services
it will provide in the premises. Lastly, the Company agreed to slash 50% off from
the annual lease payments for 2025 and 2026 (however, not reducing the 2%
variable lease payments) as part of its promotional campaign. The amounts of
revenue for 2023, 2024, 2025, and 2026 were P20,000,000, P22,000,000,
P18,000,000, and P23,000,000, respectively. The lease is properly accounted for as
an operating lease.
The total amount of fixed lease payments to be received over the lease term is
Year Rentals
2023 P3,000,000
2024 3,000,000
2025 (P3,000,000x 50%) 1,500,000
2026 (P3,000,000 x 50%) 1,500,000
Total rental payments (fixed portion) P9,000,000
Rental income per year (fixed portion) P2,250,000
The readers should take note that the following were excluded from the total rental
payments:
a. Variable lease payments of 2% of annual sales will be recognized as rental
income when earned and will result to annual amounts of rental income not
equal with each other.
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Chapter 10A - Lessor Accounting — Operating Lease and Other Lessor Matters
b. P200,000 annual receipts for security services will be recognized as other

income as the services are provided.
Year 2023
Cash 3,000,000
Rental income (from fixed lease pmts.) 2,250,000
Unearned rent income (squeeze) 750,000
Cash (P20M x 2%) 400,000
. Rental income (P20M x 2%) 400,000
There is an unearned rent income since the total amount of P3,400,000 rental
received (P3,000,000 + P400,000) is higher than the total rental income of
P2,650,000 (P2,250,000 + P400,000). However, the variable lease component has no
contribution to the unearned rent income since the amount of variable lease received
is fully recognized as rental income.
Year 2024
Cash 3,000,000
- Unearned rent income(squeeze) 750,000
Cash (P22M x 2%) 440,000
Rental income (P22M x 2%) 440,000
Year 2025
Cash 1,500,000
Rental income (from fixed lease pmts) 2,250,000
Cash (P18M
x 2%) 360,000
Year 2026
Cash 1,500,000
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Chapter 10A - Lessor Accounting - Operating Lease and Other Lessor Matters
Cash (P23M x 2%) 460,000

The Company will report the following balances for every year for this lease:
[A] [B] [B]-[A]
Total Total Cumulative Cumulative Unearned
Rent Rental Rent Rent Rent
Year Received Income Received Income Income
2023 3,400,000 P2,650,000 P3,400,000 2,650,000 750,000
2024 3,440,000 2,690,000 6,840,000 5,340,000 1,500,000
2025 1,860,000 2,610,000 8,700,000 7,950,000 750,000
2026 1,960,000 2,710,000 10,660,000 10,660,000 -

a. Ifthe periodic lease payments are decreasing, the amount of unearned rent
income (a liability account) builds up during the first few years and will
gradually decrease during the latter years.
b. Amounts of rental income per year are not equal to each other solely because of
the variable lease payments received, which is based on the lessee’s fluctuating
revenue.
c. Annually, P200,000 service revenue will be recognized upon provision of
security services to the lessee.
OTHER MATTERS AFFECTING OPERATING LEASES

For all operating leases, the following are the accounting piseaiires for initial
direct costs incurred by the lessor:
a. These are amortized over the /ease term.
b. Any unamortized amount shall be added to the carrying amount of the
underlying asset.
In addition, depreciation of underlying asset starts when it is ready for use, thus,
depreciation is still recorded even though the underlying asset is not leased out to a
lessee.
Lastly, lease incentives provided to the lessee shall reduce the total amount of
rental income to be recognized over the lease term. Lease incentives are payments
made by a lessor to a lessee associated with a lease or the reimbursement or
assumption by a lessor of costs of a lessee.
Illustration 3. On January 1, 2023, ENDURE Company, with a business of leasing
out commercial spaces, leased out one of its commercial spaces for four years by
receiving P1,300,000 on each of the first two years and P1,500,000 on each of the
last two years, payable at the end of each year. The commercial space was built and
ready to be used starting on January 1, 2022. The Company incurred P15,000,000
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Chapter 10A — Lessor Accounting — Operating Lease and Other Lessor Matters
for the construction and expects to use the same for 15 years, Initial direct costs
incurred related to lease amounted to P300,000. As a way to induce the lessee to
enter into the lease, the Company waived P300,000 of the lease payment for the
first year as a form of lease incentive.
The total amount of rentals to be received over the lease term shall be determined
as follows:
Year Rentals
2023 (P1.3M - P300,000) _P 1,000,000
2024 1,300,000
2025 1,500,000
2026 1,500,000
Rentalincome peryear P1,325,000
Annual depreciation of commercial space and amortization of initial direct costs are
Annual depreciation _ P15,000,000 a
ofcommercialspace 15-yearusefullife — Pi000,000
Annual amortization _ P300,000

ofinitialdirectcosts ~ 4-yearleaseterm — B7S,000
The Company will report the following balances for every year for this lease:
[A] [B] [B] - [A]

Cumulative Cumulative Accrued
Rent Rental Rent Rental Rent
2023 P1,000,000 P1,325,000 P1,000,000 P1,325,000 P325,000
2024 1,300,000 1,325,000 2,300,000 2,650,000 350,000
2025 ~- 1,500,000 1,325,000 3,800,000 3,975,000 175,000
2026 =1,500,000 1,325,000 5,300,000 5,300,000 =
Carrying amounts of the commercial space at the end of each year are computed as:
2022 2023 2024 2025 2026
Beg. Carrying Amt. P15,000,000 P14,000,000 P13,225,000 P12,150,000 P11,075,000
Add: Initial direct
costs (IDC) - 300,000 = - -
Less: Depreciation (1,000,000) (1,000,000) (1,000,000) (1,000,000) (1,000,000)
Amortization of
IDC os (75,000) (75,000) (75,000) (75,000)_
End. Carrying Amt P14,000,000 P13,225,000 = P12,150,000 + —~P11,075,000 P10,000,000
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Chapter 10A — Lessor Accounting —- Operating Lease and Other Lessor Matters
a. Depreciation will be recognized starting in 2022, which is the year when it is

ready for use, whether the commercial space is occupied by a lessee or not.
b. The unamortized balance of the initial direct costs is effectively included in the
ending carrying amount of the commercial space at the end of each year.
c. By the end of 2026, the P300,000 balance of initial direct costs has been fully
amortized (i.e., reduced to zero).
Net income for each year from this lease is computed as follows:
‘2023 ° 2024 2025 2026
Rental income P1,325,000 P1,325,000 P1,325,000 P1,325,000
Less: Depreciation (1,000,000) (1,000,000) ~—_ (1,000,000) (1,000,000)
Amortization of IDC (75,000) (75,000) (75,000) (75,000)
Net income from this lease P250,000 P250,000 P250,000 P250,000
LEASE OF LAND AND BUILDING TOGETHER

A lessor may lease outa whole building to a single lessee in one lease contract. Since
a building needs land on which it will stand, a lease of a whole building impliedly
also includes the lease of the land on which it sits.
So how should the lease of land and building be classified in the lessor’s
perspective? The answer is that the lessor shall separately classify the lease of
the land apart from the lease of the building by using the following guidelines:
a. Land has indefinite useful life, so it will most likely be classified as an operating
lease. However, the leased land is not precluded to be classified as a finance
lease, if the risks and rewards were substantially transferred to the lessee.
b. Building has definite useful life, so it will be classified as either a finance or an
operating lease, depending on the circumstances.
Periodic lease payments are allocated based on the relative fair values of the
leasehold interests in the land and building components. However, if the lease
payments cannot be reliably allocated between these two elements, the entire
lease contract is generally classified as a finance lease. (Note: leasehold interest is
different from the property itself).
Lastly, if the land element is immaterial to the lease, a lessor may treat the lease of
land and building as a single unit for classification purposes.
Illustration 4, On January 1, 2023, a lessor leased out for five years one of its office
buildings, together with the land on which the building sits, to a single lessee in a
single lease contract. The carrying amount of land is P1,800,000 while the building
has carrying amount of P2,700,000. Advance annual lease payment for this lease
amounted to P1,007,815. Leasehold interests over the land and building have fair
values of P2,000,000 and P3,000,000, respectively. Implicit interest rate was 6%.
accounting for the annual lease payments of P1,007,815:
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1. The lease of building component is classified as finance lease, while the lease of
land component is operating lease.
2. Both the lease of building and the lease of land are classified as finance lease,
3. Both the lease of building and the lease of land are classified as operating lease.
Scenario 1 - The lease of the building component is classified as .a finance
lease while the lease of the land componentis an operatinglease
In this case, the first step is to allocate the annual lease payment of P1,007,815 into
the lease of building and the lease of land based on the relative fair values of their
leasehold interest:
Allocation to P3,000,000
Lease of Building P1,007,815 xX —Fou4p3m.~ £604,689
Allocation to P2,000,000_
Lease of Land P1,007,815 xX poy p3q.- ~—«~P403,126
The P403,126 allocation to the lease of land shall be recognized as rental income
each year. The carrying of the land is not derecognized.
On the other hand, the P604,689 allocated to the lease of building shall form part of
the net investment in the lease initially measured as follows:
PV Factor of PVFactor CashFlows Total PV

Annuity due for 5 periods at 6% 4.465106 604,689 P2,700,000
The journal entry to record the recognition of the net investment in the lease and
the derecognition of the building is as follows:
Lease receivable (604,689 x Syrs) 3,023,445
Building, net 2,700,000
Unearned finance income(squeeze) 323,445
This net investment in the lease shall be subsequently accounted using the
following amortization table:
Lease Interest Amorti- Net
Date Pmts. Income zation Investment
Jan. 1, 2023 2,700,000
Jan.1,2023 604,689 - (604,689) 2,095,311
Jan.1,2024 604,689 125,719 (478,970) 1,616,341
Jan.1,2025 604,689 96,980 (507,709) 1,108,632
Jan.1,2026 604,689 66,518 (538,171) 570,461
Jan.1,2027 604,689 34,228 (570,461) -
To summarize, the following amounts will be recorded in the Company’s profit or

loss for the first three years of the lease term:
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2023 2024 2025

Rental income from lease of land P403,126 P403,126 P403,126
Add: Interest income from lease of building 125,719 96,980 66,518
Total amount to be recognized in profitorloss P528,845 PS00,106 P469,644
Scenario 2 - Both the lease of the building and the lease of the land are
classified as FINANCE leases
In this case, no allocation is needed since both of the leases are classified as finance
leases. As such, the net investment in the lease is computed as follows:
The journal entry to recognize the net investment in the lease and the derecognition
of both the land and building is as follows:
Lease receivable (1,007,815x5yrs) 5,039,075
Land 1,800,000
Unearned finance income(squeeze) 539,075
This net investment in the lease shall be subsequently accounted for using the
following amortization table:
Lease Interest Amorti- Net
Date Pmts. Income zation Investment
Jan. 1, 2023 4,500,000
Jan.1,2023 1,007,815 - (1,007,815) 3,492,185
Jan.1,2024 1,007,815 209,531 (798,284) 2,693,901
Jan.1,2025 1,007,815 161,634 (846,181) 1,847,720
Jan.1,2026 1,007,815 110,863 (896,952) 950,768
Jan.1,2027 1,007,815 57,047 (950,768) -
In this scenario, the total amount to be recognized in profit or loss is limited to the
interest income based on the above amortization table (e.g., P209,531 interest
income for 2023, P161,634 interest income for 2024, P110,863 for 2025).
Scenario 3 - Both the lease of the building and the lease of the land are
classified as OPERATING leases
In this case, no allocation is needed since both of the leases are classified as
operating leases. As such, the carrying amounts of the land and building are not
derecognized.
In addition, annual rental income of P1,007,815 are recognized each year in the
Company’s profit or loss over the duration of the lease term less the depreciation
expense from the building over its useful life.
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CHANGES IN LEASE CLASSIFICATION

As previously mentioned in the preceding chapter, the lease classification, whether
operating or finance lease, is determined on inception date. This initial
classification shall not be changed from events arising from any of the following:
a. Changes in estimates (such as economic life or residual value of underlying
asset)
b. Changes in circumstances (such as default of the lessee)
Instead, lease classification shall be reassessed only when there is a lease
modification, which will be discussed in the next section.
Illustration 5. At the beginning of 2023, ROQUE Company leased out for five years
an equipment with useful life of 10 years. As of the same date, the lease was
properly classified as an operating lease. Fast forward to January 1, 2024, the total
useful life of the equipment was reassessed to be only six years.
Despite the decrease in useful life and corresponding increase in percentage of lease
term over the equipment’s useful life (i.e., 83.33% or 5-year lease term/6-year revised
total useful life), the classification of the lease shall not be changed to a finance
lease. The reason is that there is no lease modification that is the supposed trigger
in reassessing the lease classification (i.e. only a change in estimate in this case).
Illustration 6. On January 1, 2023, ANDRES Company entered into a four-year lease

contract involving its machinery with useful life of five years. As of this date, the
lease was properly classified as a finance lease. Fast forward to January 1, 2024, the
total useful life of this machinery was revised upwards to eight years.
Despite of the increase in useful life and corresponding decrease in percentage of lease
term over the machinery’s useful life (i.e, 50% or 4-year lease term/8-year revised
total useful life), the classification of the lease will not be changed to an operating
lease because of the lack of lease modification.
LEASE MODIFICATION OF FINANCE LEASE

Similar to lessee’s perspective, lease modification on the perspective of lessor
involves change/s in the original terms of the lease contract.
For accounting purposes, lease modifications of finance lease are classified as
follows:
a. Those that will change the classification from finance lease to operating lease
b. Those that will not change finance lease classification
1. Modifications that will result to a separate lease.
2. All other modifications that will not change the lease classification.
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Chapter 10A - Lessor Accounting —- Operating Lease and Other Lessor Matters
LEASE MODIFICATION - FROM FINANCE LEASE TO OPERATING LEASE

Modifications that will normally make a finance lease turn into an operating lease
include, but are not limited to, the following scenarios:
a. Shortening of the lease term relative to the useful life of the underlying asset.
b. Decrease in the present value of the lease payments relative to the fair value.
c. Removal of the provision transferring the ownership over the underlying asset
to the lessee at the end of the lease term.
d. Removal of the provision involving a bargain purchase option.
Because of these modifications, the lease would have been classified as an operating
lease assuming that the modification had been in effect at the inception date.
Accounting for this kind of lease modification involves the following procedures:
a. Calculate the updated balance of net investment in the lease (i.e., lease receivable
less balance of unearned finance income) as of the date of lease modification.
b. Derecognize the updated net investment in the lease and recognize the
underlying asset equal to the derecognized amount of net investment in
the lease.
No gain or loss will be recognized in recording the journal entry in letter (b).
aA
Moving forward, the lessor shall recognize depreciation expense on the

underlying asset and recognize rental income, instead of interest income.
Illustration 7. On January 1, 2023, JOSE Company leased out its building with
carrying amount of P2,985,650 for eight years, over the building’s useful life. Annual
lease payments of P500,000 are due at the end of each year starting in 2023. Implicit
rate is 7%. The lease of the building was properly classified and accounted for as
finance lease. On December 31, 2024, after the lease payment for that year, the lease
agreement was amended by shortening the total lease term to just four years (i.e.,
shortened until December 31, 2026).
In this case, the initial measurement of net investment in the lease is computed as
follows:

Less: Gross investment in the lease (P500,000 x 8) 4,000,000
Unearned finance income P1,014,350
Based on the amortization table, the net investment in the lease is subsequently
accounted as follows:
Gross Unearned
Lease _— Interest Net Investment/ Finance
Jan. 1, 2023 2,985,650 4,000,000 1,014,350
Dec. 31,2023 500,000 208,996 (291,004) 2,694,646 3,500,000 805,354
Dec. 31,2024 500,000 188,625 (311,375) 2,383,271 3,000,000 616,729
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After considering the modification made, the total revised lease term, expressed as
percentage of the useful life, has gone down to 50% (4-year shortened total lease
term/8-year total useful life) (i.e., less than 75%). As a result, the lease shall be
reclassified as an operating lease. To account for this change in classification, the
Company shall make the following journal entry on December 31, 2024:
Building 2,383,271
The entry derecognizes the net investment in the lease and recognizes the underlying
asset for the same amount. The reason for this is that under the concepts of
operating lease, it is the Company that, as the lessor, should record the underlying
asset. In addition, no gain or loss was recognized in the reclassification.
Moving forward, the Company will record the following amounts every year:
a. Rental income of P500,000.
b. Depreciation on building of P397,212 (P2,383,271/6 years remaining useful life).
The six-year remaining useful life is equal to eight-year useful life less two-year
period that has elapsed.
LEASE MODIFICATION - NO CHANGE IN FINANCE LEASE CLASSIFICATION

Accounting for this kind of modification will depend whether it will result to a
separate lease or not. The modification will result to a separate lease if both of
the following conditions are met:
a. the modification increases the scope of the lease by adding the right to use
one or more underlying assets; and
b. the consideration for the lease increases by an amount commensurate with
the stand-alone price for the increase in scope and any appropriate
adjustments to that stand-alone price to reflect the circumstances of the
particular contract.
In assessing the criterion (b) the rate of lease payment on the original lease shall be
presumed as equivalent to stand-alone price.
Accounting When the Modification Resulted to a Separate Lease

In this case, the following accounting procedures are relevant:
a. The original lease shall not be affected.
' b. Two leases (i.e. original and modified) shall be accounted for separately.
Consequently, two amortization tables will be maintained moving forward,
Accounting When the Modification Did Not Result to a Separate Lease - PFRS 9
In this case, the provisions in PFRS 9 shall be followed, Specific accounting
procedures will depend on whether there is a substantial modification or not.
Judgment will be applied in this assessment.
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If the lease modification is considered as “not substantial”:

a. The revised net investment in the lease shall be measured equal to the present
value of the revised lease payments discounted using the original implicit rate.
b. Any difference between the carrying amount of the net investment in the lease
shall be recognized in profit or loss.
If the lease modification is considered “substantial”:

a. The previous net investment in the lease shall be derecognized.
b. Anewinvestment in the lease shall be recognized and measured equal to its fair
value (using market rate on that date), with the difference between this amount
and the amount of previous net investment in the lease reported in profit or loss.
Illustration 8. On January 1, 2023, TEA Financing Company rented out an

equipment for annual lease payments of P700,000 due immediately. The equipment
was purchased shortly before the lease at cost of P3,936,016. The lease is to run for
seven years, which is the equipment’s economic life. Implicit rate is 8%.
Fast forward to January 3, 2025, the Company and the lessee agreed to increase the
lease payments to P800,000 starting with the January 1, 2026 lease payment.
Market rates as of that date averaged 9%. The Company properly assessed that this
modification shall be accounted under PFRS 9.
accounting for the modification:
1. The modification is considered as not substantial.
2. The modification is considered as substantial
Scenario 1 - The modification is considered as not substantial

In this case, the first step is to determine the initial net investment in the lease on
January 1, 2023:

Less: Gross investment in the lease (P700,000x 7) 4,900,000
Next, determine the net investment in the lease as of the date of modification on
January 3, 2025:
Gross Unearned
Lease _ Interest Net Investment/ Finance
Jan. 1, 2023 3,936,016 4,900,000 963,984
Jan.1,2023 700,000 - (700,000) 3,236,016 4,200,000 963,984
Jan.1,2024 700,000 258,881 (441,119) 2,794,897 3,500,000 705,103
Jan.1,2025 700,000 223,592 (476,408) 2,318,489 2,800,000 481,511
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The modified net investment in the lease on January 3, 2025, using the original
discount rate of 8% is determined as follows:

Less: Gross investment in the lease (P800,000 x 4) 3,200,000
The readers should take note that 4 periods represent the remaining four lease
payments (7 total lease payments less 3 lease payments already made). In addition,
ordinary annuity was used since the cash flow will happen starting on January 1,
2026 or one period after January 3, 2025.
The journal entry to record the modification on January 3, 2025 is as follows:
Lease receivable (P3.2M - P2.8M) 400,000
Gain on modification - P/L
(P2,649,702 - P2,318,489) 331,213
Unearned finance income
(P550,298 - P481,51 1) 68,787
Scenario 2 - The modification is considered as substantial

In this scenario, the same amounts in Scenario 1 for net investment, gross
investment, and unearned finance income as of January 3, 2025 will be used.
However, the fair value of the new net investment in the lease shall be determined
as follows, using the revised 9% market rate:
Less: Gross investment in the lease (P800,000x 4) 3,200,000
The following journal entry shall be made to derecognize the previous net
investment in the lease and to recognize the new net investment in the lease:
Unearned finance income - old 481,511
Lease receivable - new 3,200,000
Loan receivable - old 2,800,000
Unearned finance income - new 608,224
Gain on modification - P/L
(P2,591,776 - P2,318,489) 273,287
LEASE MODIFICATION OF OPERATING LEASE

A lessor shall account for a modification to an operating lease as a new lease from
the effective date of the modification, considering any prepaid or accrued lease
payments relating to the original lease as part of the lease payments for the new
lease.
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LEASE MODIFICATION - NO CHANGE IN OPERATING LEASE CLASSIFICATION

In this case, there will be no journal entries made in accounting for the
modification, but the amount of periodic rental income will be affected moving
forward. The amount of revised periodic net income is computed as follows:
Total revised lease payments (excluding variable lease payments
and non-lease components) Pxx
Add: Balance of unearned rent income (if any) XX
Less: Balance of accrued rent receivable (if any) (xx)
Net revised lease payments Pxx
Divided by: Remaining lease term (revised, if relevant) [in years]
Revised periodic rental income (excluding variable lease payments) Pxx
Illustration 9. SEVILLA Company currently has a balance of unearned rent income

of P45,000 from one of its operating leases. On December 31, 2022, annual lease
payment for this lease has been modified to be fixed at P700,000 starting for the
year 2023. Remaining lease term is five years.
Starting in 2023, the annual rental income to be recognized is computed as follows:
Total revised lease payments (P700,000 x 5) P3,500,000
Add: Balance of unearned rent income 45,000
Net revised lease payments P3,545,000
Divided by: Remaining lease term 5 years
Revised periodic rental income P709,000
Moving forward, the Company will report the following amounts:

Rent Rental Unearned
Year Received Income’ _ Rent Inc.
2023 P45,000
2024 700,000 709,000 36,000
2025 700,000 709,000 27,000
2026 700,000 709,000 18,000
2027 700,000 709,000 9,000
2028 700,000 709,000 -
Illustration 10. On January 1, 2023, BELTRAN Company entered into a six-year

lease contract involving its warehouse which has a useful life of ten years. Annual
lease payments of P1,000,000 are due at the start of each year and will increase by
P100,000 starting in 2024. The lease was properly classified as an operating lease.
On December 31, 2024, the lease agreement was modified to adjust the annual lease
payments at a fixed amount of P1,300,000 for the next four years.
Before considering the modification, the annual rental income is computed as
follows:
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Year Rentals
2023 P1,000,000
2024 (P1,000,000 +P100,000) 1,100,000
2025 (P1,100,000 +P100,000) 1,200,000
2026 (P1,200,000 +P100,000) — 1,300,000
2027 (P1,300,000 +P100,000) — 1,400,000
2028 (P1,400,000 +P100,000) __ 1,500,000
Rental income per year 1,250,000
Accrued rent receivable as of December 31, 2024 is computed as follows:
[A] [B] [B]-[A]
Rent Rental Cumulative Cumulative Accrued
Year Received Income Rent Rec. RentInc. Rent Rec..
2023 P1,000,000 P1,250,000 1,000,000 1,250,000 P250,000
2024 1,100,000 1,250,000 2,100,000 2,500,000 400,000
Because of the lease modification on December 31, 2024, the revised amount of
annual rental income is computed as follows:
Total revised lease payments (P1,300,000 x 4) P5,200,000
Less: Balance of accrued rent receivable, 12/31/24 (400,000)
Net revised lease payments P4,800,000
Divided by: Remaining lease term 4 years
Revised periodic rental income P1,200,000
Moving forward, the following amounts are to be reported:
[A] [B] [B]-[A]
Cumulative Cumulative Accrued
Rent Rental Rent Rent Rent
2023 P1,000,000 P1,250,000 P1,000,000 P1,250,000 P250,000
2024 1,100,000 1,250,000 2,100,000 2,500,000 400,000
2025 1,300,000 1,200,000 3,400,000 3,700,000 300,000
2026 1,300,000 1,200,000 4,700,000 4,900,000 200,000
2027 ~=1,300,000 1,200,000 6,000,000 6,100,000 100,000:
2028 1,300,000 1,200,000 7,300,000 7,300,000 3
LEASE MODIFICATION - OPERATING LEASE TO FINANCE LEASE
In this case, the lease modification will involve journal entries to account for the
following:
a. Derecognition of underlying asset and recognition of net investment in the lease.
b. Adding the balance of accrued rent receivable to the net investment in the lease
or deducting the balance of unearned rent income from the net investment in the
lease.
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LEASES IN THE LESSEE’S AND LESSOR’S PERSPECTIVES

One may have in mind that the lease liability recognized by the lessee is a mirror of
the net investment recognized by the lessor. In addition, it may also appear that the
derecognized asset of the lessor is recognized as a ROU asset by the lessee.
Despite these, it cannot be expected that the lease liability in the lessee’s books is
equal to the net investment in the lessor’s books, and the ROU asset in the lessee’s
books is the carrying amount of the asset derecognized by the lessor. Consequently,
interest income of the lessor from the net investment is also not necessarily equal to
the interest expense of the lessee from the lease liability.
The reason/s for these differences may include one or a combination of the
following:
a. The implicit rate used by the lessor may not be known by the lessee (which in
turn, will use its incremental borrowing rate).
b. Unguaranteed residual value is included in the net investment in the lease in the
lessor’s books, while it is excluded from the lease liability in the lessee’s books.
c. Theamount of guaranteed residual value is included in the net investment in the
lease, but only the amount of expected shortfall is included in the lease liability.
d. The lease is accounted as operating lease in the books of the lessor, but the lessee
is still required to recognize ROU asset and lease liability.
Illustration 11 - Differences in Discount Rates. On January 1, 2023, PISTACHIO
Financing Company leased a machinery to LAUREL Company for three years. The
ownership over the machinery will be transferred to LAUREL Company at the end
of the lease term. Annual lease payments of P400,000 are due every December 31
of each year starting in 2023. Implicit rate of 8% is not known by LAUREL.
Incremental borrowing rate of LAUREL is 6%. Required: Determine the (a) initial
measurement of the net investment in the lease in PISTACHIO’s books; and (b)
initial measurement of the lease liability in LAUREL’s books.
PISTACHIO Company’s Books (Lessor)
The initial measurement of the net investment in the lease is determined follows:
Ordinary annuity for 3 periods at8% 2.577097 P400,000 P1,030,839
LAUREL Company’s Books (Lessee)

The initial measurement of the lease liability (and ROU asset) is determined as
follows:
Ordinary annuity for 3 periods at6% 2.673012 P400,000 P 1,069,205
Since the initial measurement of the net investment in the lease and the lease
liability are different, the amount of interest income in PISTACHIO’s books is
different from the interest expense in LAUREL's books.
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Illustration 12 - Unguaranteed Residual Value. At the beginning of the year

2023, SEAFOAM Company leased an asset from FERN Company for six years. The
asset’s useful life is seven years. The contract calls for an annual lease payment of
P500,000 to be made every January 1 of each year starting in 2023. In addition, the
asset has an unguaranteed residual value of P700,000. Implicit interest rate in the
lease is 7%, which is also known by SEAFOAM Company. Required: Determine the
(a) initial measurement of the net investment in the lease in FERN’s books; and (b)
initial measurement of the lease liability in SEAFOAM’s books.
FERN Company’s Books (Lessor)

TotalPV P3,016,538
SEAFOAM Company's Books (Lessee)

follows:
In this case, the difference arises from the fact that the lessee did not include the
unguaranteed residual value in the measurement of its lease liability.
Illustration 13 - Guaranteed Residual Value. At the beginning of the year 2023,

MINT Company leased out an asset for five years by receiving annual lease payment
of P600,000 due immediately from LIME Company. The asset has an estimated
useful life of six years. In addition, LIME guaranteed a residual value of P800,000
for the asset, even though its expected value by that time is just P300,000. Implicit
rate is 9%, which is not known by LIME. LIME’s incremental borrowing rate is 10%.
Required: Determine the (a) initial measurement of the net investment in the lease
in MINT’s books; and (b) initial measurement of the lease liability in LIME’s books.
MINT Company’s Books (Lessor)

TotalPV P3,063,777
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LIME Company’s Books (Lessee)

follows (using expected shortfall of P500,000 = P800,000 - P300,000):

Total PV P2,812,380
Aside from the difference in the discount rate, the amount to be included in the
lessor’s books is equal to the guaranteed residual value while the amount to be
included in the lessee’s books is equal to the expected shortfall.
Illustration 14 - Operating Lease. On January 1, 2023, JADE Company leased out
one of its office buildings to SAGE Company for four years, even though the
remaining economic life is 20 years. Annual lease payments of P1,000,000 are due
every December 31 of each year. Implicit interest rate of 7% is known by SAGE
Company. Required: Determine the (a) initial measurement of the net investment
in the lease in JADE’s books; and (b) initial measurement of the lease liability in
SAGE's books.
JADE Company’s Books (Lessor)

Since the lease does not qualify as a finance lease, JADE Company, as the lessor, shall
not recognize net investment in the lease. Instead, it shall recognize the P1,000,000
lease payments as annual rental income.
SAGE Company’s Books (Lessee)

Regardless of the classification of the lease in the books of the lessor (and the lessor’s
non-recognition of net investment in the lease), the lessee shall still recognize ROU
asset and lease liability, unless the exception of the short-term lease or lease of low-
value asset applies.
Consequently, the initial measurement of the lease liability (and ROU asset) is
PV Factor of PVFactor Cash Flows Total PV
Ordinary annuity for4 periods at 7% 3.387211 P1,000,000 P3,387,211
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Chapter 10A—Lessor Accounting — Operating Lease and Other Lessor Matters
CHAPTER SUMMARY
1. A lease is classified as an operating lease if there is no substantial transfer of all the
risks and rewards of ownership over the underlying asset.
2. The following are the accounting procedures for operating leases:
a. Rental income shall be recognized on a straight-line-basis, regardless of the
actual amounts of rentals received. In line with this, unearned rental income or
accrued rental income shall be recognized as follows:
i. Cumulative rent received < Cumulative rent income: accrued rent receivable
ii. Cumulative rent received > Cumulative rent income: unearned rent income
b. Variable lease payments based on revenue are not included in the lease
payments that will be recognized on a straight-line basis. These lease payments
shall be recognized as rental income when earned.
c. Underlying asset is not derecognized. Depreciation, if relevant, shall start when
it is ready for use.
d. Initial direct costs are amortized over the related lease term. Unamortized
amounts are added to the carrying amount of the underlying asset.
e. Security deposits are accounted separately.
3. Inalease of land and building together, the lease of the land componentis most likely
classified as an operating lease while the lease of the building component is either a
finance or an operating lease.
4. Changes in the lease classification are made only when there is a lease modification
(ie., not when there are changes in estimate).
5. If a lease modification resulted to reclassification of a lease from finance lease to
operating lease, the lessor shall derecognize the net investment in the lease and
simultaneously recognize the underlying asset for the same amount. No gain or loss
shall be recognized in this reclassification.
6. Ifalease modification only changed the cash flows of a finance lease:
a. Ifcertain conditions are met, account the modification separately as a new lease.
b. Otherwise, apply the provisions under PFRS 9.
7. Ina lease modification of an operating lease, the balance in accrued rental income
or unearned rental income shall be considered in determining the lease payments.
8. It cannot be expected that the lease liability in the lessee’s books is equal to the net
investment in the lessor’s books, and the ROU asset in the lessee’s books is the
carrying amount of the asset derecognized by the lessor.
9. Even though the lessor accounted the lease as operating lease, the lessee is still
required to recognize lease liability and ROU asset in its books, except when the
short-term lease or the lease of low-value assets applies.
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True or False
1. Alease is classified as operating lease if there is a transfer of ownership over the
underlying asset at the end of the lease term.
2. The amount of rental income recognized from operating lease is equal to the
amount lease payments received.
3. Non-lease payments received are recognized as other income apart from rental
income.
4. Ifthe cumulative amount of rent received is higher than the cumulative rent income
recognized, there is a balance in the unearned rent income account.
5. If, during the year, the rent received is lower than the rent income, there is either
an increase in unearned rent income or a decrease in accrued rent receivable.
6. Initial direct costs shall be amortized over the underlying asset’s remaining useful
life.
7. Depreciation of an underlying asset shall start when it is ready for intended use.
g. Ina lease of land and building together, if the lease payments cannot be reliably
allocated between the land and building elements, the entire lease contract is
generally classified as finance lease.
9. Change in the estimate of an underlying asset’s useful life shall trigger a change in
the lease classification.
10. Ifthere is a lease modification from finance lease to operating lease, the lessor shall
recognize the underlying asset at its fair value and derecognize the net investment
in the lease.
11. Lease modification of finance lease that did not result to a separate lease shall be
accounted using the provisions under PFRS 9.
12. Unguaranteed residual values will result to differences in the net investment in the
lease in the lessor’s books and lease liability in the lessee’s books.

i The amount of rental income to be recognized from operating lease is
a. equal to the amount of rent received.
b. equal to total lease payments divided by lease term.
c. equal toaand b, whichever is shorter.
d. equal toaand b, whichever is higher.
The following amounts are excluded in determining the straight-line amount of rent
income, except
a, non-lease payments
b. variable lease payments based on revenue
c. security deposits
Which of the following are the accounting consequences if the amount of rental
received is higher than rental income recognized?
347
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I. Increase in accrued rent receivable

Il. Increase in unearned rent income
Ill. Decrease in accrued rent receivable
IV. Decrease in unearned rent income
a. IlorIll
b. TorIV
c. IlorIV
d. lorlll
4, Which of the following statements is/are true?

I. There is an unearned rent income if the cumulative amount of rent received is
higher than the cumulative rent income recognized.
II. There is an accrued rent receivable if the cumulative amount of rent received
is lower than the cumulative rent income recognized.
a. lIonly
b. Ilonly
c. BothlandII
d. Neither! nor II
5. The underlying asset in an operating lease
a. Shall be revalued to its fair value on the commencement date
b. shall be subjected to impairment on the commencement date
c. shall be depreciated only during the period when it is leased out to a lessee
d. shall not be derecognized
6. The initial direct costs incurred shall be amortized over
a. the period of lease term
b. the remaining useful life of the underlying asset
c. the simple average of lease term and remaining useful life of the underlying
asset
d. initial direct costs are not amortized but fully expensed during the period these
were incurred.
7. The unamortized balance of initial direct costs shall be presented
a. asSaseparate assetinthe balance sheet _
b. asan addition to the carrying amount of the underlying asset
c. asan addition to the other assets
d. based on the lessor’s accounting policy
8. When there is a single lease contract covering a building and a land on which it sits,
a. the lessor shall separately classify the lease of the land apart from the lease of
the building.
b. the classification of the lease of the building component shall be followed for the
whole lease contract
c. _ the classification of the lease of the land component shall be followed for the
whole lease contract
d. the whole lease shall be automatically classified as a finance lease.
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chapter 10A — Lessor Accounting — Operating Lease and Other Lessor Matters
9, Change in lease classification shall be made when there is

a a Se in the estimate of the underlying asset's useful life
p.c. alease in circu
achangemodif mstance, such as the defaul
ication
6 t of th e lessee
d. allofthe above
10.1f the classification of a lease changed from finance lease to operating lease, the
following accounting procedures are correct, except
a. Update the carrying amount of the net investment in the lease.
b. Measure the returned underlying asset equal to the carrying amount of the net
investment in the lease as of that date.
c. Derecognize the net investment in the lease.
d. Again or loss shall be recognized from the reclassification.
11.If there is a modification in an operating lease contract, but without changing its
classification as such, which of the following accounting procedures is correct?
a. The balance in the unearned rent income shall be immediately recognized as
rent income.
b. The balance in the accrued rent receivable shall be immediately written-off as a
loss.
Cc. The revised lease payments shall be adjusted with the balance in the unearned
rent income account or in accrued rent receivable account.
d. Allofthe above accounting procedures are correct.
in the amounts recognized
12. The following are the reasons/sources of the differences
by the lessor and lessee, except
a. Variable lease payments based on revenue.
st rate in the lease.
b. The lessee does not know the implicit intere |
value.
c. The existence of unguaranteed residual
is classified as an operating lease in the
d. A five-year lease of a high-value asset
lessor’s perspective.
.
Straight Problems e for
y rented out a portion of its office spac
1. At the start of 2023, EMERALD Compan 15 years and has a carrying amount of
five years. The office space has a useful life of
,000 (inclusive of P50,000 for security
P8,000,000. Annual rental payment of P600
y December 31 of each year, starting In
services provided to the lessee) is due ever
2023. Incremental borrowing rate is 8%.
2023.
Required: Determin e the journal entries to be mad e for the year
r lease contract
Company entered into a four-yea
2. On January 1, 2023, SHAMROCK annual lease
the land s it owns . The lease contract states that
covering one of 2023. The
0 are due at the beginning of each year, starting in
payments of P2,000,00 1, 2024
by 10% each year starting on January
amount of annual rent will increase
lease payment. m.
entr ies to be mad e eac h year over the lease ter
Required: Determine the journal
349
The
3. At the beginning of the year 2023, PARAKEET Company entered into a five-year
lease contract covering one of its vehicles with remaining useful life of eight years.
The following is the schedule pf the lease payments to be made at the end of each
year: 2023, P2,000,000; 2024, P1,800,000; 2025, P1,600,000; 2026, P1,400,000; and
2027, P1,200,000.
Required: Determine the journal entries to be made from 2023 to 2025.
4. Starting in January 2023, OLIVE Company leased out its commercial space for eight
years with annual lease payment of P900,000, to be made at the end of each year.
Additionally, as an incentive for the lessee, the Company waived half of the rent for
the first three years.
a. Annual amount of rent income to be recognized over the lease term
b. Journal entries to be made from 2023 to 2025
5. On January 1, 2023, MOSS Company leased out its machinery for four years. The
machinery has an original cost of P7,200,000, was acquired last July 1, 2022 and
available for use on the same date. The Company estimates that the machinery has
a useful life of nine years.
Annual lease payments of P1,075,000 are due immediately and inclusive of P50,000
charge for annual machinery maintenance services and P25,000 marketing charge.
Lease portion of annual payments will increase by 8% each year, starting on the
January 1, 2025 payment. Initial direct costs incurred by the Company and the lessee
amounted to P240,000 and P140,000, respectively.
Additional lease payment equal to 3% of the lessee’s revenues are due to be paid
every December 31 of each year. This variable lease payment is not affected by the
8% increase in the fixed lease payments above. The lessee reported revenues of
P20,000,000 and P18,000,000 for the years 2023 and 2024, respectively.
Lastly, the Company also incurred initial direct costs amounting to P180,000 and
required the lessee to pay a security deposit of P600,000.
a. Annual amount of rent income (fixed portion) to be recognized
b. Journal entries for the years 2023 and 2024
c. Carrying amount of the machinery as of December 31, 2023 and 2024
6. At the beginning of the year 2023, VILLA Company purchased a land with a vacant
office building on it for P10,000,000. Of the total price, P4,000,000 can be attributed
to the land and P6,000,000 can be attributed to the building. This allocation is based
on the relative fair values of the land and the building of P5,200,000 and P7,800,000,
respectively. At the time of purchase, the building has a remaining useful life of ten
years. Right after the purchase, the assets were leased out to a lessee for eight years.
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Annual lease payments of P1,565,120 are due every January 1 of each year, starting
in 2023. Implicit interest rate us 7%.
Required: Determine the net amount to be recognized in profit or loss for the years
2023 and 2024.
7. Onfanuary 1, 2023, PICKLE Company entered into a seven-year lease agreement
covering its newly-acquired vehicle by receiving P600,000 annual lease payments
every December 31 of each year, starting in 2023. The lessee also guaranteed that
the vehicle will have at least a residual value of P800,000 at the end of the lease term.
The vehicle has cost of P3,881,475 and useful life of nine years. Implicit interest rate
on the lease is 6%.
On December 31, 2024, the parties agreed that the lease term be shortened and that
the revised end of the lease term is on December 31, 2027. In addition, lease
payments for 2025, 2026, and 2027 will be P900,000, P800,000, and P700,000,
respectively.
Required: Determine the journal entry to record the lease modification.
8. At the beginning of 2023, FOREST Company leased out an office space for five years.
The office space has useful life of twenty years and has a carrying amount of
P12,000,000. Annual lease payments are due during the first day of each year,
starting in 2023 in the following schedule: 2023, P1,200,000; 2024, P1,400,000;
2025, P1,600,000; 2026, P1,800,000; and 2027, P2,000,000.
On December 31, 2025, the Company and the lessee agreed to extend the lease up to
December 31, 2028, and fixing the annual lease payments at P1,600,000, starting on
January 1, 2026.

a. Amount of rental income to be recognized for each year after modification.
b. Balance of accrued rent receivable or unearned rent income, whichever is
applicable, at the end of each year.
9. OnJanuary 1, 2023, SACRAMENTO Financing Company entered into a five-year lease

agreement with UNIFORM Company covering a vehicle with cost of P4,838,735 and
six-year useful life. Annual lease payments of P1,000,000 are due to be paid every
January 1 of each year, starting in 2023. In addition, there is an unguaranteed
residual value of P500,000. Implicit interest rate of the lease is 6%, which is not
known by UNIFORM. Incremental borrowing rates of SACRAMENTO and UNIFORM
are 7% and 6.50%, respectively.
a. Journal entries in the books of SACRAMENTO Company for 2023.
b. Journal entries in the books of UNIFORM Company for 2023.
10. At the beginning of the year 2023, CANARY Company leased out one of its vehicles
to DAFFODIL Company. The lease term is for five years even though the vehicle's
351
The
useful life is 10 years. The following is the schedule of the lease payments to be made
at the end of each year: 2023, P1,000,000; 2024, P900,000; 2025, P800,000; 2026,
P700,000; and 2027, P600,000. Implicit rate on the lease, which is not Known by
DAFFODIL, is 10%, while DAFFODIL’s incremental borrowing rate is 9%.
a. Journal entries in the books of CANARY Company for 2023.
b. Journal entries in the books of DAFFODIL Company for 2023.

1. Startingin January 2023, DALISAY Company leased out its commercial space for four
years by receiving annual lease payment of P1,000,000 to be made at the end of each
year. The annual lease payment will increase by P300,000 every year starting with
the December 31, 2025 lease payment. The lessee is also required to pay additional
rent equal to 10% of its revenues. Revenues reported by the lessee amounted to
P9,900,000 and P9,600,000 for the years 2023 and 2024, respectively.
From the given information, the total amount of rent income to be recognized for the
year 2023 shall be
a. P1,225,000 ; c. P1,000,000
b. P2,215,000 d. P1,990,000
From the given information, the total amount of rent income to be recognized for the
year 2024 shall be
a. P1,960,000 c. P2,185,000
b. P1,000,000 d. P1,225,000
The balance of the accrued rent receivable as of December 31, 2024 shall be
a. PO c. P225,000
b. P145,000 d. P450,000
The balance of the accrued rent receivable as of December 31, 2025 shall be
a. P375,000 c. P225,000
b. P450,000 d. P175,000
2. On January 1,2023, FLAXEN Company signed the first ever lease contract underlying
a portion of its newly constructed office building with useful life of 20 years. Annual
lease payment of P1,500,000 is due every December 31 of each year for the next five
years. As this lessee is the first occupant in the building, the lease payment related
to first twelve months of the lease term was waived in the form of lease incentive. In
addition, the lessor incurred initial direct costs of P600,000. The building was
completed last October 1, 2022 for total construction costs of P10,000,000.
The net amount of income from the lease for the year 2023 shall be
a. P620,000 c. P580,000
b. P880,000 d. P980,000
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The
The balance in the accrued rent receivable or unearned rent income as of December
31, 2024 shall be
a. P900,000 rent receivable c. P600,000 rent receivable
b. P900,000 unearned rent — d. P600,000 unearned rent
The carrying amount of the building as of December 31, 2024 shall be

a. P8,875,000 c. P9,369,000
b. P9,000,000 d. P9,235,000
3. On January 1, 2023, BUTTER Company owns an idle land and building with carrying
amounts of P2,000,000 and P4,000,000, respectively. The building has remaining
useful life of ten years. On the same date, the Company decided to lease out both of
the properties in a single ten-year lease agreement by receiving advanced annual
lease payments of P740,026. As of that date, leasehold interests on the land and
building have fair values of P1,200,000 and P2,400,000, respectively. Implicit
interest rate on the lease is 5%.
The total amount to be reported in 2023 profit or loss from this lease shall be
a. P740,026 c. P422,008
b. P340,026 d. P562,092
The carrying amount of the net investment in the lease, if any, as of December 31,
2023 shall be
a. PO c. P3,681,982
b. P3,506,649 d. P3,348,063
4. At the beginning of the year 2023, LEMON Company, leased out one of its equipment
with cost of P10,535,372 for ten years, which is equal to its useful life. Annual lease
payment of P1,500,000 is due every December 31 of each year starting in 2023.
Implicit interest rate was 7%.
On December 31, 2024, when the asset’s fair value amounted to P9,250,000, the
parties agreed to shorten the lease term and to end it on December 31, 2026. Annual
lease payments during the shortened lease term will remain the same. In addition,
there are no changes in the total estimated useful life of the equipment. Implicit rate
as of this date was 8%.
The initial measurement of the underlying asset on December 31, 2024 shall be
a. P9,250,000 c. P8,083,934
b. P8,956,947 d. P7,863,293
The net amount of income to be recognized from the lease for the year 2025 shall be
a. P380,382 c. P636,803
b. P343,750 d. P673,435
The carrying amount of the underlying asset as of December 31, 2025 shall be
a. P7,073,442 c. P8,093,750
b. P6,880,381 d. P7,837,329
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5. OnJanuary 1, 2023, MUSTARD Company leased out its machinery for four years. The
machinery has a useful life of 15 years and carrying amount of P9,000,000. Annual
lease amount to be received during the first year, on January 1, 2023, is P2,400,000
and will be reduced by P400,000 in the succeeding years.
On December 31, 2024, the parties agreed to extend the original lease term by
additional three years and that the annual lease payments starting on January 1,
2025 are fixed at P1,200,000 per year.
The balance in the accrued rent receivable or unearned rent income as of December
31, 2024 shall be
a. P800,000 rent receivable c, P700,000 rent receivable
b. P800,000 unearned rent d. P700,000 unearned rent
The revised annual rent income starting in the year 2025 shall be
a. P1,040,000 c. P1,200,000
b. P1,060,000 d. P1,360,000
6. At the beginning of the year 2023, MEDALLION Financing Company leased out its
vehicle to DANDELION Company for 10 years, even though the vehicle’s useful is 12
years. Annual lease payment of P1,200,000 is due to be paid every January 1, 2023.
In addition, estimated residual value of the vehicle is P1,000,000, of which, P600,000
was guaranteed by DANDELION Company, even though the expected value of the
vehicle at the end of the lease term is P200,000. Implicit interest rate, which is not
known by DANDELION, was 7%. Incremental borrowing rates of MEDALLION and
DANDELION were 8% and 9%, respectively.
Interest income for 2023 in the lessor’s books shall be

a. P582,864 c. P568,630
b. P539,664 d. P524,434
Interest expense for 2023 in the lessee’s books shall be
a. P567,685 c. P614,336
b. P614,523 d. P662,693
The balance of the net investment in the lease as of December 31, 2023 shall be
a. P8,249,155 Cc. P8,326,627
b. P8,909,491 d, P7,709,491
The balance of the lease liability as of December 31, 2023 shall be
a. P7,363,260 c, P8,025,953
b. P6,825,953 d. P7,440,289
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Chapter 11 — Sublease, and Sale and Leaseback
CHAPTER 11
SUBLEASE, AND SALE AND LEASEBACK
ttt errr rrr itt tet

1. The parties in a sublease contract.
2. Theaccounting for the sublease in the books of the intermediate lessor.
3. The parties ina sale and leaseback transaction.
4. Theaccounting fora sale and leaseback transaction assuming there is a transfer
of control over the underlying asset.
5. The accounting for a sale and leaseback transaction assuming there is no
transfer of control over the underlying asset.
SUBLEASES
In the previous chapters covering lease accounting, there were only two parties
involved namely the lessor and the lessee. However, there are some circumstances
wherein the original lessee leases out the underlying asset to another lessee while
maintaining the original lease. This kind of setup is called the sublease. Graphically,
this can be shown as follows:
Lessor
Head lease |
Original lessee /intermediate lessor
Sublease |
Sublessee
As early as now, readers are oriented that in this chapter, there will be a lot of
references to the previous chapters involving accounting for leases in the
perspective of both the lessor and the lessee.
ACCOUNTING FOR SUBLEASES - LESSOR AND SUBLESSEE

Subleases do not affect the accounting by the lessor (classifying the lease as either
finance or operating lease in accordance with Chapter 10), neither the accounting
by the sublessee (applying the general lessee requirements in Chapter 9). However,
additional accounting procedures are made in the perspective of the original lessee
(also known as the intermediate lessor).
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The
ACCOUNTING FOR SUBLEASES - ORIGINAL LESSEE/INTERMEDIATE LESSOR

Accounting for subleases in the point-of-view of the original lessee/intermediate
lessor will depend on its accounting for the head lease, which is either of the
following:
a. Used the general lessee accounting model (i.e., recognition of ROU asset and
lease liability); or
b. Applied the short-term lease exception, if applicable.
(Note: The original lessee/intermediate lessor cannot apply the low-value underlying
asset exception since the existence of such sublease disqualifies the use of this exception.)
Details on the accounting for the sublease are the following:
Used the general lessee Applied the short-term

_ accounting model in the lease exception, if
head lease applicable -
Can be either finance or
poh operating with reference to
aap = tte the ROU asset, rather than the Operating lease only
underlying asset itself
ACCOUNTING FOR SUBLEASE IF THE GENERAL LESSEE ACCOUNTING MODEL

WAS USED IN THE HEAD LEASE
As an intermediate lessor, the original lessee shall use the indicators discussed in
Chapter 10 to determine whether the sublease is classified as finance or operating
lease. The accounting procedures for the sublease will depend on its classification:
Sublease classified as Sublease classified as

finance lease |_operatinglease |
Treatment of ROU Hodated canine anioulikis Not derecognized;
asset from the P ee ie d depreciation will still be
head lease én recognized moving forward
Net investment in Recognized equal to the PV of
N/A
the lease sublease payments
Discount rate used | /mplicit rate on the sublease; if
in arriving atnet | notavailable, use the discount N/A
investmentinthe | rate used on the lease liability
lease from the head lease
Gain or loss on sublease
(derecognized ROU asset vs net Rental income,
Amounts reported investment in the lease), depreciation of underlying
; interest income from net ROU asset, and interest
in profit or loss i > ies
investment in the sublease, and expense on lease liability
interest expense on lease from the head lease
liability from the head lease
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Chapter 11 - Sublease, and Sale and Leaseback
- Sublease classified as ~ Sublease classified as —

| finance lease operatinglease
Journalentryon | Journal entry derecognizing the
the ROU asset from the head lease None
commencement and recognizing net investment
date of sublease in the sublease
Lease liability on
iA Lend lease Not affected by the sublease Not affected by the sublease
The readers should take note that in the intermediate lessor’s books, both the head
lease (as represented by the lease liability) and the sublease (as represented by the
net investment in the lease or rental income) are recorded and accounted.
Illustration 1 - Sublease is Classified as Finance Lease. GABRIEL Company has
a business strategy of leasing property from a lessor at a “wholesale” lease
payments (i.e., the head lease) and subsequently leasing out the same property to
other lessees at a “retail” lease payments (i.e., the sublease).
At the beginning of 2023, GABRIEL leased for five years, a warehouse from MATEO
Properties by paying annual lease payments of P1,000,000 at the beginning of each
year, starting on that date. Incremental borrowing rate of GABRIEL is 7%.
One day after the original lease has been consummated, on January 2, 2023,
GABRIEL leased out the warehouse to NICOLAS Logistics for five years. GABRIEL
will receive annual lease payments of P1,200,000 on this lease due at the beginning
of each year. Implicit rate on the sublease is 8%. The sublease is properly classified
as finance lease.
In this case, the following are the relationships among the parties:
MATEO Properties (Lessor)
Head lease |
GABRIEL Company
(Original lessee/intermediate lessor)
Sublease 1
NICOLAS Logistics
(Sublessee)
Accounting by MATEO Properties (the Lessor in the Head Lease)

MATEO will classify and account for the head lease of its warehouse as either
finance lease (Chapter 10) or operating lease (Chapter 10A). MATEO’s accounting
will not be affected by the existence of sublease to NICOLAS.
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Accounting by NICOLAS Logistics (the Sublessee)

NICOLAS will account for the sublease, as a lessee, by recognizing ROU asset and
lease liability (using the concepts in Chapter 9). NICOLAS’ accounting will not be
affected by the fact that this is just a sublease.
Accounting by GABRIEL Company (the Original Lessee/Intermediate Lessor) -
Initial Accounting for the Head Lease and the Sublease
The initial amounts of ROU asset and lease liability from the head lease as of
January 1, 2023 are computed as follows:
Lease Liab./
Annuity due for 5 periods at7% 4.387211 P1,000,000 P4,387,211
These amounts are recorded as follows:

On the other hand, the net investment in the sublease as of January 1, 2023 is
Annuity due for 5 periods at8% 4.312127 P1,200,000 P5,174,552
Less: Gross investment (P1,200,000 x 5) 6,000,000
The sublease is recorded on January 2, 2023 as follows:

Lease receivable (from sublease) 6,000,000
Right-of-use asset (from head lease) 4,387,211
Gain on sublease (squeeze) 787,341

a. Since the underlying asset was leased out immediately, the amount of ROU asset
to be derecognized is equal to its initial measurement.
b. There is a gain on sublease since the net investment in the lease (i.e.,
P5,174,552) is higher than the carrying amount of the ROU asset (i.e.,
P4,387,211).
Accounting by GABRIEL Company (the Original Lessee/Intermediate Lessor) —
Subsequent Accounting for the Head Lease and the Sublease
Subsequent accounting in the records of GABRIEL will include the following:
a. Lease liability from the head lease shall be amortized separately using the
concepts from Chapter 9. Interest expense will arise from this amortization
process using 7% interest rate.
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The
Lease Interest Amorti- Lease

Date Payments Expense zation Liability
Jan. 1, 2023 4,387,211
Jan.1,2023 1,000,000 - (1,000,000) 3,387,211
Jan.1,2024 1,000,000 237,105 (762,895) 2,624,316
Jan.1,2025 1,000,000 183,702 (816,298) 1,808,018
Jan.1,2026 1,000,000 126,561 (873,439) 934,579
Jan.1,2027 1,000,000 65,421 (934,579) -
b. Net investment in the sublease shall be amortized separately using the
concepts from Chapter 10. Interest income will arise from this amortization
process using 8% discount rate.
Gross Unearned
Lease _ Interest Amorti- Net Investment/ Finance
Date Pmts. Income zation Investment Lease Rec. Inc.
Jan. 1, 2023 5,174,552 6,000,000 825,448
Jan. 1, 2023 1.2M - (1,200,000) 3,974,552 4,800,000 825,448
Jan. 1, 2024 1.2M 317,964 (882,036) 3,092,516 3,600,000 507,484
Jan. 1, 2025 1.2M 247,401 (952,599) 2,139,917 2,400,000 260,083
Jan. 1, 2026 1.2M 171,193 (1,028,807) 1,111,110 1,200,000 88,890
Jan. 1, 2027 1.2M 88,890 (1,111,110) - - , -
Net income for 2023 from the head lease and sublease in GABRIEL Company’s
books is P868,200 (P787,341 gain + P317,964 interest inc. - P237,105 interest exp.).
Illustration 2 - Sublease Classified as Operating Lease. On January 1, 2023,

MENDEZ Company leased for six years an office space from CUNANAN Company.
Annual lease payments of P600,000 are due at the beginning of each year, starting
in 2023. Incremental borrowing rate of MENDEZ is 9%.
Due to the expected temporary non-utilization of the office space, MENDEZ leased
out the office space for P750,000 for two years to VASQUEZ Company. Lease
payments are due at the beginning of each year starting in 2023. Implicit interest
rate on the sublease is 10%. The sublease is properly classified as operating lease.
The relationships among the parties are graphically presented as follows:
CUNANAN Company (Lessor)
Head lease |
MENDEZ Company
(Original lessee/intermediate lessor)
Sublease ‘
VASQUEZ Company (Sublessee)
359
The
Chapter it- Sublease, and Sale and Leaseback
Accounting by CUNANAN Company (the Lessor)

CUNANAN will classify and account for the head lease of its warehouse as either
finance lease (using the concepts in Chapter 10) or operating lease (using the
concepts in Chapter 10A). CUNANAN’s accounting will not be affected by the
sublease to VASQUEZ.
Accounting by VASQUEZ Company (the Sublessee)
VASQUEZ will account for the sublease, as a lessee, by recognizing ROU asset and
lease liability (using the concepts in Chapter 9). VASQUEZ’s accounting will not be
affected by the fact that this is just a sublease.
Accounting by MENDEZ Company (the Original Lessee/Intermediate Lessor) -
Initial Accounting for the Head Lease and the Sublease
The initial amounts of ROU asset and lease liability from the head lease as of
January 1, 2023 are computed as follows:
Lease Liab./
Annuity due for 6 periodsat9% 4.889651 P600,000 P2,933,791

Since the sublease is classified as an operating lease, the ROU asset in the head
lease will not be derecognized and no net investment in the lease will be recognized.
Hence, there will be no gain or loss on sublease.
Accounting by MENDEZ Company (the Original Lessee/Intermediate Lessor) —
Subsequent Accounting for the Head Lease and the Sublease
a. Lease liability from the head lease shall be amortized separately using the
concepts from Chapter 9. Interest expense will arise from this amortization
process using 9%.
Jan. 1, 2023 2,933,791
Jan.1,2023 600,000 “ (600,000) 2,333,791
Jan.1,2024 600,000 210,041 (389,959) _— 1,943,832
Jan.1,2025 600,000 174,945 (425,055) _—«-1,518,777
Jan.1,2026 600,000 136,690 (463,310) 1,055,467
Jan.1,2027 600,000 94,992 (505,008) 550,459
Jan.1,2028 600,000 49,541 (550,459) -
In addition, since the ROU asset is not derecognized, depreciation expense of
P488,965 shall be recorded for each year for the next six years.
360
The
CamScanner
b. As to the sublease, there is no amortization table to be used since there is no

recognized net investment in the lease. Instead, rental income of P750,000 will
be recognized for each year for the next two years.
Net income for 2023 from the head lease and sublease is P50,994 (P750,000 rental
income - P210,041 interest expense - P488,965 depreciation expense).
SALE AND LEASEBACK TRANSACTIONS
A sale and leaseback transaction actually involves the following two events:
a. The sale of an asset by an entity (i.e., the seller) to another entity (i.e., the buyer)
b. The immediate leaseback of the sold asset by the seller (i.e., the lessee) from the
buyer (i.e., lessor).
The seller on the sale transaction will become the lessee on the leaseback
transaction, hence the seller-lessee designation. On the other hand, the buyer on
the sale transaction will become the lessor on the leaseback transaction, hence the
buyer-lessor designation.
These relationships are best depicted in the following graphical presentation:
Seller-lessee
‘i Immediately leases
Sells an back the same asset
asset that was sold
Buyer-lessor
ACCOUNTING FOR SALE AND LEASEBACK

Due to the inherent link between these two transactions, the accounting for the sale
is affected by the leaseback, and the accounting for leaseback is affected by the sale.
Specific accounting procedures will depend on whether the transfer of the asset,
from the seller-lessee to buyer-lessor, is considered as sale or not (i.e., whether
there is a transfer of control or not).
In making this assessment, the requirements on determining when a performance

obligation is satisfied under PFRS 15 are applied. These indicators are as follows:
the seller-lessee has a present right to payment for the asset;
ao op
the buyer-lessor has legal title to the asset;

the seller-lessee has transferred physical possession of the asset;
the buyer-lessor has the significant risks and rewards of ownership of the asset;
and
e. the buyer-lessor has accepted the asset
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The
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ACCOUNTING IF THE TRANSFER AS SALE

OF THE ASSET IS CONSIDERED ~
SELLING PRICE IS EQUAL TO THE FAIR VALUE OF THE ASSET
In this scenario, accounting for the sale and leaseback is complicated, mainly
because of the complex computations involved.
Accounting in the Perspective of Seller-Lessee
The seller-lessee shall account for the sale and leaseback as follows:
a. First, compute for the lease liability arising from the leaseback by applying
general lessee accounting model (i.e., PV of lease payments discounted using
either implicit rate or incremental borrowing rate).
b. Compute for the ROU asset arising from the leaseback by applying this formula:
Carryingamt. , _ Computed lease liability
ROU Asset
of sold asset Fair value of sold asset
This is a deviation from the general rule that the initial amount of ROU asset is
based on the initial amount of lease liability.
c. Compute for the initial amount of gain or loss on sale using the following rules:
Scenario Difference will Result to
FV of asset > carrying amount of asset Gain on sale
FV of asset < carrying amount of asset Loss on sale
However, the amount of gain or loss on sale that will be actually recognized
by the seller-lessee shall be computed as follows:
Fair value of sold asset less
Recognized Initial Amount
x computed lease liability
GainorLoss = _ of Gain or Loss
Fair value of sold asset
The amount of recognized gain or loss on sale corresponds to the portion of the
rights transferred to the buyer-lessor. Recognized gain or loss can also be
computed as a balancing figure in the journal entry.
Alternatively, the following formula can also be used in computing for the
recognized gain or loss on sale:
Selling price less lease liability and loan payable, if any Pxx
Less: Carrying amount of asset less ROU asset recognized XX
Recognized gain (loss) on sale and leaseback PXxx
d. Derecognize the carrying amount of the transferred asset.
Accounting in the Perspective of Buyer-Lessor

The buyer-lessor shall account for the sale and leaseback as follows:
a. Recognize the transferred asset from seller-lessee equal to its fair value.
b. Classify the lease as either finance lease or operating lease.
362
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1. If the lease is classified as finance lease, apply the concepts from Chapter 10
(derecognition of asset and recognition of net investment in the lease).
2. If the lease is classified as operating lease, apply the concepts from Chapter
10A (recognition of rental income over the lease term).
Illustration 3. On January 1, 2023, ANCHETA Company sold its land with carrying
amount of P2,400,000 for P3,000,000 (equal to its fair value) to VENTURA
Company. The sale transferred the control of the land to VENTURA. Subsequently,
ANCHETA leased back the land from VENTURA Company by paying annual lease
payments of P400,000 at the beginning of each year for the next five years.
Incremental borrowing rate of ANCHETA is 6%. The lease is properly classified as
operating lease in the perspective of VENTURA.
Accounting in the Perspective of ANCHETA Company (Seller-Lessee)
First, compute for the lease liability to be recognized as follows (using the
incremental borrowing rate of seller-lessee):
Next, compute the amount of ROU asset to be recognized:
ROU Asset = P2,400,000 x P1,428,834

P3,000,000
There is an initial amount of gain on sale of P600,000 (P3,000,000 less P2,400,000),

however the actual amount of gain on sale to be recognized is computed as follows:
Recognized P3,000,000 - P1,786,042

P600,000 P242,792
Gain on Sale P3,000,000
The entry to recognize the sale and leaseback transaction is as follows:
Cash 3,000,000
Land 2,400,000
Gain on sale and leaseback (squeeze) 242,792
Alternatively, the recognized gain on sale and leaseback can also be determined as:
Selling price less lease liability (P3M - P1,786,042) P1,213,958
Less: CA of asset less ROU asset recognized (P2.4M - P1,428,834) __ (971,166)
Recognized gain on sale and leaseback P242,792
Accounting in the Perspective of VENTURA Company (Buyer-Lessor)

VENTURA Company will make the following journal entry to record the purchase
of the asset on January 1, 2023:
363
The
Land 3,000,000
Cash 3,000,000
Since the lease is considered as an operating lease, the Company will just recognize
annual rental income of P400,000 for the next five years. No depreciation will be
recognized since the land is not depreciable.
ACCOUNTING IF THE TRANSFER OF THE ASSET IS CONSIDER ED -—
AS SALE
SELLING PRICE NOT EQUAL TO THE FAIR VALUE OF THE ASSET (OFF-MARKET)
The differences in the asset’s selling price and its fair value will further complicate
the accounting procedures.
Accounting in the Seller-Lessee’s Perspective
The following comparison is relevant in accounting for the off-market terms
(compared with the benchmark scenario wherein the selling price is equal to fair
value) in the perspective of seller-lessee:
SP =FV SP > FV SP <FV
G Pure sale and | With assumed With assumed
eneral :
. leaseback | financing from prepayment of lease
assumption .
transaction buyer-lessor payments
PV of lease PV of lease payments.
Amount of lease PV of lease payments less | However, for the purposes
liability the amount of | of computing ROU asset,
recognized payee assumed prepayment is added to
financing the PV of lease payments
lea Both to lease ;
ee chai liability and To lease liability only
Sedes only loan payable
Manner of
computing ROU Same
asset
Initial gain or Same amounts computed by comparing FV and carrying
loss (selling price is ignored)
Actual amount of ‘
recognized gain | Benchmark Higher pian se Lower than SP = FV
or loss =i
*FV is fair value while SP is selling price; both pertaining to the transferred asset
Accounting in the Buyer-Lessor’s Perspective

The following comparison is relevant in accounting for the off-market terms
(compared with the benchmark scenario wherein selling price is equal to fair value)
in the perspective of buyer-lessor:
364
The
The Book
SP=FV | SP>FV |... SPeRV

Measurement of Always equal to the asset's fair value, regardless of the
asset purchased amount of purchase price paid to the seller-lessee
Additional
Loan :
amounts None receivable Unearned rental income
recognized
Application of Rental Rental income c a oa cae a

lease payments- | . 1 and loan De Oe aerent
ne ee cgi re:as
iF operating lease income only peoeitaeie unearned income
rental income
Application of Net Net investment ,
lease payments - | investment in and loan ee esHnent ey pare
iffinancelease | theleaseonly | _ receivable only
Iilustration 4 - SELLING PRICE > FAIR VALUE. Using the same information as in
ANCHETA, except that the selling price is now P3,300,000 (i.e., P300,000 higher
than the asset’s fair value).

In this case, the present value of lease payments computed in the original scenario
shall be used in computing for the total amount of lease liability:
PV of lease payments P1,786,042
Less: Excess of asset’s selling price over its fair value (financing) (300,000)
Lease liability from the leaseback P1,486,042
Next, compute the amount of ROU asset to be recognized in this scenario:
P1,486,042
ROU Asset = P2,400,000 x P3,000,000 P1,188,834
There is an initial amount of gain on sale of P600,000 (P3,000,000 FV less

P2,400,000, again ignoring the P3,300,000 selling price). However, the actual amount
of gain on sale to be recognized is computed as follows:
Recognized _ P3,000,000
- P1,486,042 _
Gainvon'Sate = *990.000 x P3,000,000 = aaNARe
Cash 3,300,000
Loan payable (the assumed financing) 300,000
Land 2,400,000
365
The
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Subsequently, the annual lease payment of P400,000 is split between the lease
liability and loan payable as follows:
Alloc. (Prop.
Balances Proportion xP400,000)
Lease liab. 1,486,042 (P1,486,042/P1,786,042) P332,812
Loan pay. 300,000 (P300,000/P1,786,042) 67,188
Total P1,786,042 P400,000
In the lease liability’s amortization table, P332,812 will be used in the lease
payments column while in the loan payable’s amortization table, P67,188 will
be used in the principal payments column. Both amortization tables will use 6%
effective interest rate:
Jan. 1, 2023 1,486,042
Jan. 1, 2023 332,812 “ (332,812) 1,153,230
Jan. 1, 2024 332,812 69,194 (263,618) 889,612
Jan. 1, 2025 332,812 53,377 (279,435) 610,177
Jan. 1, 2026 332,812 36,611 (296,201) 313,976
Jan. 1, 2027 332,812 18,836 (313,976) -
Loan Interest Amorti- Loan

Date Payments Expense zation Payable
Jan. 1, 2023 300,000
Jan. 1, 2023 67,188 - (67,188) 232,812
Jan. 1, 2024 67,188 13,969 (53,219) 179,593
Jan. 1, 2025 67,188 10,776 (56,412) 123,181
Jan. 1, 2026 67,188 7,391 (59,797) 63,384
Jan. 1, 2027 67,188 3,804 (63,384) -

Land 3,000,000
Loan receivable 300,000
Cash 3,300,000
Since the lease is considered as an operating lease, the Company will just recognize
rental income for the next five years. However, the annual rental income will
decrease to P332,812 since the P67,188 portion is considered as annual payment for
the loan receivable.
The amounts in the amortization of loan receivable are the same as the amortization
of loan payable albeit changing the interest expense amounts to interest income.
366
The
The Book
] i = < . Using the same information as in

ANCHETA, except that the selling price decreased to P2,800,000 (i.e., P200,000
lower than the asset's fair value of P3,000,000).
In this case, the P1,786,042 present value of lease payments computed in the
original scenario shall be recognized as the amount of lease liability. However, the
amount of lease liability to be used for the purpose of computing for the ROU asset and
gain or loss on sale is determined as follows:
PV of lease payments (equal to lease liability to be recognized) P1,786,042
Add: Excess of asset’s fair value over its selling price (prepayment) 200,000
Lease liability for ROU asset and gain or loss on sale computations 1,986,042
ROU Asset = P2,400,000

P1,986,042 _ P1,588,834
P3,000,000 _
There is an initial amount of gain on sale of P600,000 (P3,000,000 FV less
P2,400,000). However, the actual amount of gain on sale to be recognized is
Recognized _ P3,000,000 - P1,986,042
Gainon Sale =P OPOONO % P3,000,000 P202,792
Cash 2,800,000
Land 2,400,000
Note that the amount recognized for lease liability does not include the amount of
assumed P200,000 prepayment.
Land 3,000,000
Cash 2,800,000
Unearned rent income 200,000
Since the lease is considered as operating lease, the Company will just recognize
rental income for the next five years. However, the annual rental income will
increase to P440,000 {P400,000 + (P200,000/5 years)], due to the straight-line
recognition of unearned rent income as rent income.
367
The
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To summarize, the following amounts are determined in the books of the seller-
lessee under each of the scenarios:
SP =FV SP > FV SP <FV
ROU Asset P1,428,834 P1,188,834 P1,588,834
Lease liability 1,786,042 1,486,042 1,786,042
Gain 242,792 302,792 202,792
Loan payable None 300,000 None
SALE AND LEASEBACK TRANSACTION INVOLVING LOSS

Illustration 6. At the beginning of 2023, LORENZO Company sold its building with
carrying amount of P5,000,000 and fair value of P4,000,000 to CORDERO Company.
At the same date, this building was leased back by LORENZO by paying P600,000
annual lease payments at the beginning of each year, starting in 2023, for four years.
Incremental borrowing rate is 8%. Required: Under each of the following
independent scenarios of selling price amounts, determine the journal entry to
record the sale and leaseback in the books of LORENZO and CORDERO:
1. Selling price is P4,000,000
= ing Pri 4.0 = Fair Valu 000,0
Accounting in the Perspective of LORENZO Company (Seller-Lessee)
The lease liability to be recognized is computed as follows:
Annuity due for 4 periods at8% 3.577097 P600,000 P2,146,258
P2,146,258
ROU Asset = P5,000,000 X —4:000,000 > P2,682,823
There is an initial amount of loss on sale of P1,000,000 (P4,000,000 FV less

P5,000,000 carrying amount). However, the actual amount of loss on sale to be
recognized is computed as follows:
Recognized _ P4,000,000 - P2,146,258
Losson'Sale ~ 74900000 x P4,000,000 = Eee
Cash 4,000,000
Loss on sale and Jeaseback (squeeze) 463,435
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The
The Book
Accounting in the Perspective of CORDERO Company (Buyer-Lessor)

The entry to record the purchase of asset is as follows:
Building 4,000,000
Cash 4,000,000
ario 2 - ing Pri < Fai 4,

The amount of lease liability to be recognized is equal to P2,146,258, the amount
computed in Scenario 1. However, in computing for the ROU asset and realized loss,
the lease liability to be used is P2,546,258 (P2,146,258 plus P400,000 excess of
asset’s fair value of P4,000,000 over its selling price of P3,600,000).
ROU Asset
_= P5,000,000 x
P2,546,258_
P4,000,000
_= P3,182,823

P5,000,000 carrying amount). However, the amount of loss on sale to be recognized
is computed as follows:
Recognized P4,000,000 - P2,546,258
P1,000,000 P363,435
Loss on Sale P4,000,000
Cash 3,600,000
Loss on sale and leaseback 363,435

Building 4,000,000
Cash 3,600,000
= >
The amount of lease liability is computed as P1,646,258 (P2,146,258 PV of lease
payments computed in Scenario 1 less P500,000 assumed financing equal to the
excess of P4,500,000 selling price over the P4,000,000 fair value).
369
The
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P 1,646,258
ROUAsset = P5,000,000 x 4,000,000. ~ P2,057,823

P5,000,000 carrying amount). However, oi amount
of gain on sale to be recognized
Recognized _ P4,000,000 - P1,646,258 _
LossonSale ~ 000,000 x P4,000,000 he Renee
Cash 4,500,000
Loss on sale and leaseback 588,435
Loan payable 500,000

Building 4,000,000
Loan receivable 500,000
Cash 4,500,000
ACCOUNTING IF THE TRANSFER OF THE ASSET IS NOT CONSIDERED AS SALE

In cases that the transfer of the asset is not considered as sale (i.e., failed sale and
leaseback transaction), the transaction is recognized as a pure financing
transaction, regardless of the relationship of the selling price to the asset's
fair value. Accounting procedures in this case are much simpler.
The following accounting procedures are relevant for the seller-lessee:
a. Recognition ofa financial liability equal to the amount of proceeds received from
the buyer-lessor. This liability is to be accounted for under PFRS 9.
b. The “lease payments” made are applied as amortization of the financial liability.
c. No derecognition of the transferred asset and no recognition of ROU asset nor
gain or loss on sale.
The following accounting procedures are relevant for the buyer-lessor:
a. Recognition of a financial asset equal to the amount of paid to the seller-lessee.
This asset is to be accounted for under PFRS 9. No recognition of “purchased”
asset.
b. The “lease payments” received are applied as amortization of the financial asset.
c. No subsequent classification as either operating or finance lease.
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The
CHAPTER SUMMARY
1. There is a sublease if the original lessee (intermediate lessor) leases out the
underlying asset to another lessee (the sublessee) while maintaining the original
lease.
2. The sublease will not affect the accounting by the original lessor nor it will affect the
accounting of the sublessee. Instead, accounting for subleases primarily affect the
books of the intermediate lessor.
3. Inthe intermediate lessor’s books, both the head lease and the sublease are recorded
and accounted.
4. Ifthe intermediate lessor applied the general lessee accounting for the head lease,
the sublease can be accounted as either finance or operating lease, depending on the
circumstances. In this case, the following accounting procedures are relevant:
Sublease classified as _ |. Sublease classified as
finance lease
Treatment of ROU Not derecognized;
x Updated carrying amount depreciation will still be
asset recognized from : 3 : ;
the head lease is derecognized recognized moving
forward
Netinvestmentin the | Recognized equal to the PV
N/A
lease of sublease payments
Discount rate used in Implicit rate on the
arriving at net sublease; if not available, N/A
investment in the discount rate used on the
lease head lease
Gain or loss on sublease, Rental income,
interest income from net depreciation of
Amounts reportedin | investment.in the sublease, underlying asset, and
profit or loss and interest expense on | interest expense on lease
lease liability from the liability from the head
head lease lease
Journalentry on the a ROU

commencement date 6 Be None
asset and recognizing net
of sublease ;
investment
If the intermediate lessor applied the short-term lease exception, the sublease is
automatically considered as operating lease. Accounting procedures are the same as
in the operating lease column in the above table.
In a sale and leaseback transaction, the seller-lessee sells an asset and immediately
leases it back from the buyer-lessor.
The accounting for a sale and leaseback will depend whether the control over the
sold asset has been transferred from the seller-lessee to the buyer-lessor.
If there is a transfer of control, the following are the accounting procedures in
determining the amounts to be recorded in the books of the seller-lessee and buyer-
lessor as a result of the sale and leaseback (if selling price = fair value):
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CamScanner
a. First, compute for the lease liability arising from the leaseback by applying
general lessee accounting model (i.e., PV of lease payments discounted using
either implicit rate or incremental borrowing rate).
b. Compute for the ROU asset arising from the leaseback by applying this formula:
Carryingamt. , _ Computed lease liability
ROU Asset =
of sold asset Fair value of sold asset
c. Compute for the initial amount of gain or loss on sale using the following rules:
Scenario. —_- Difference will Result to
FV of asset > carrying amount of asset Gain on sale
FV of asset < carrying amount of asset Loss on sale
However, the amount of gain or loss on sale that will be actually recognized by
the seller-lessee shall be computed as follows:
Fair value of sold asset less
Recognized Initial Amount
x ___ computed lease liability
GainorLoss =_ of Gainor Loss
Fair value of sold asset
d. Derecognize the carrying amount of the transferred asset.
9. The following procedures are relevant in case the selling price of the underlying
asset is not equal to its fair value:
Seller-lessee SP=FV- SP>FV SP <FV

Pure saleand | With assumed ;
General : With assumed prepayment
: leaseback financing from
assumption ianeartian aperieete of lease payments
PV of lease PV of lease payments.
Amount of PV of lease payments less | However, for the purposes
lease liability -| the amount of of computing ROU asset,
recognized Payee assumed prepayment is added to the
financing PV of lease payments
Application of Both to lease
lease nia liability and To lease liability only
payments y loan payable
Manner of
computing Same
ROU asset
Recognized Benchmark | Lower than the Higher than the SP = FV
ROU Asset scenario SP = FV scenario scenario
Initial gainor | Same amounts computed by comparing FV and carrying amount
loss of asset (selling price is ignored)
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Chapter 11- Sublease, and Sale and Leaseback
Buyer-lessor SP=FV «|. SP>FV 2 )() 0 SP<FV

Measurement Always equal to the asset’s fair value, regardless of the
of asset amount of purchase price paid to the seller-lessee
Additional toan
amounts None ; Unearned rental income
; receivable
recognized
eam of Rental'incoms Rental income, increased

. ts -if Rental sand ipa by periodic recognition of
gene income only ééelvalil unearned rent income as
operating eceivable eu inegiie
lease
Application of }
lease ; Ne f Nee seams Net investment in the lease
ayments=it investment in and loan only
P the lease only receivable
finance lease
10.If there is no transfer of control (i.e., failed sale and leaseback transaction), the
transaction is recognized as a pure financing transaction.
373
The
True or False
i There is a sublease if the original lessor terminated its existing lease with a lessee
and leased out the property to another lessee.
2. The sublessee shall not recognize ROU asset and lease liability since the underlying
asset is not really owned by the intermediate lessor.
Ss The original lessor’s accounting for the lease will not be affected by the sublease.
4. The intermediate lessor accounts for both the head lease and the sublease.
5 If the intermediate lessor accounted the head lease by recognizing ROU asset and
lease liability, the sublease is automatically accounted as operating lease.
If the sublease is accounted as finance lease, the carrying amount of the ROU asset
from the head lease shall be derecognized and a net investment in the lease shall be
recognized.
The seller in a sale and leaseback transaction will become lessor of the sold asset.
~
The amount of gain or loss to be recognized on sale and leaseback is equal to the
difference between the carrying amount of the asset sold and its related fair value.
If the fair value of the sold asset in the sale and leaseback transaction is lower than
the selling price, the amount of difference is considered as a financing from the
buyer-lessor.
10. The amount of ROU asset to be recognized from a sale and leaseback transaction is
not necessarily equal to the amount of the recognized lease liability.

1, The following statements regarding the roles of parties in a sublease contract are
correct, except
a. Intermediate lessor is actually the middle person in the sublease contract.
b. Sublessee leases an underlying asset from the intermediate lessor.
c. The original lessor initially leased out the underlying asset to the intermediate
lessor.
If the intermediate lessor accounted for the head lease using the general lessee
accounting model, the sublease can be classified as
a. operating lease only
b. finance lease only
c. either operating or finance lease
d. neither operating and finance lease
If the intermediate lessor accounted for the head lease using the short-term lease
exception, the sublease can be classified as
operating lease only
finance lease only
aoop
both operating and finance lease

neither operating and finance lease
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4, Ifthe sublease is classified as a finance lease, the following are the correct accounting
procedures in the books of intermediate lessor, except
a. A net investment in the lease shall be recognized as the present value of the
sublease payments.
b. The carrying amount of the ROU asset from the head lease shall be derecognized.
c. Subsequent to the initial recognition, the intermediate lessor shall recognize
both interest expense from lease liability in the head lease and interest income
from the net investment in the sublease.
d. Any difference between the recognized net investment in the lease and carrying
amount of the derecognized ROU asset shall be recognized in equity.
5. If the sublease is classified as an operating lease, all of the following amounts are
recognized in the intermediate lessor’s profit or loss, except
a. interestincome from the net investment in the sublease
b. interest expense from the lease liability from the head lease
c. depreciation of the ROU asset
d. none ofthe above
6. Inasale and leaseback,
a. The seller-lessee transfers an asset to another entity (the buyer-lessor) and
leases that asset back from the buyer-lessor.
b. The seller-lessor transfers an asset to another entity (the buyer-lessee) and
leases that asset back from the buyer-lessee.
c. The buyer-lessee transfers an asset to another entity (the seller-lessor) and
leases that asset back from the seller-lessor.
d. The buyer-lessor transfers an asset to another entity (the seller-lessee) and
leases that asset back from the seller-lessee.
7. Ifasale and leaseback is accounted as a sale and the amount of selling price is equal
to the fair value of the sold asset, the amount of ROU asset is equal to
a. the amount of lease liability
b. the carrying amount of the asset sold
c. the carrying amount of the asset sold times the initial amount of lease liability
over the fair value of the sold asset
d. the fair value of the sold asset times the initial amount of lease liability over the
carrying amount of the sold asset
8. Ina sale and leaseback transaction, where the amount of selling price is lower than
the asset’ fair value, the difference is
presumed to be financing from the buyer-lessor
op
presumed to be prepayment to the buyer-lessor

a not meaningful amount
ao
deducted from the lease liability in determining the amount of ROU asset.
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9. Ifthe selling price of the asset is higher than its fair value and the sale and leaseback
transaction has transferred the control over the asset, the following statements are
correct, except
a. The difference between the selling price of the asset and its fair value is
presumed to be additional financing (i.e., loan payable) from the buyer-lessor in
the seller-lessee’s books.
b. The lease liability in the seller-lessee’s books is equal to the present value of the
periodic payments.
c.- The buyer-lessor shall record the asset at its fair value, regardless of the
purchase price paid for it.
d. The periodic payments shall be split in the seller-lessee’s books into amounts
applied to the amortization of lease liability and amounts applied to the
amortization of the loan payable.
10. The amount of gain or loss recognized on sale and leaseback is equal to
a. the difference between the selling price and carrying amount of the asset
b. the difference between the selling price and fair value of the asset
c. the difference between the fair value and carrying amount of the asset
Straight Problems
1. On January 1, 2023, BEIGE Financing Company rented out its factory building with
carrying amount of P10,521,325 and useful life of ten years to GRANOLA Company.
The lease term spans the whole useful life and requires advanced annual lease
payments of P1,400,000. Implicit rate for the lease, which is not known by
GRANOLA, is 7%. Incremental borrowing rate of GRANOLA as of this date is 8%.
On the same date, GRANOLA Company leased out this factory building to OYSTER
Company over the whole duration of the head lease by receiving P1,600,000
advanced annual lease payments starting in 2023. OYSTER Company had
incremental borrowing rate of 6% at that date.

a. Journal entries in GRANOLA’s books for the year 2023.
b. Netincome from the head lease and sublease for the year 2023.
2. At the beginning of the year 2023, HONEY Company leased out its commercial space
to BUMBLEBEE Company for five years by receiving P700,000 every January 1 of
each year, starting in 2023. The commercial space has a useful life of ten years and
original cost of P5,000,000. Implicit interest for the lease is 9%, while incremental
borrowing rates of HONEY Company and BUMBLEBEE Company as of the same date
were 8% and 7%, respectively.
However, BUMBLEBEE Company changed its plans and decided to lease out the
space starting on January 1, 2024 to PINEAPPLE Company. Annual lease payments
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of P900,000 are due immediately starting on the same date. PINEAPPLE Company
has an incremental borrowing rate of 9%,

a. Journal entries in BUMBLEBEE’s books for the year 2024.
b. Netincome from the head lease and sublease for the year 2024.
3. On January 1, 2023, ORANGE Company sold its land with P5,500,000 fair value to
AMBER Company for a certain price. The land is carried in ORANGE’s books at an
amount of P4,800,000. On the same date, the parties entered into a four-year lease
contract covering the same land and with ORANGE as the lessee and AMBER as the
lessor. Annual lease payments of P1,000,000 are due every January 1 of each year,
starting in 2023. ORANGE and AMBER had incremental borrowing rate of 5% and
6%, respectively.
Required: Under each of the following scenarios, determine the journal entry to
record the sale and leaseback transaction in the books of ORANGE and AMBER:
1. The selling price of the land is P5,500,000
4. BRONZE Company acquired a building with P8,000,000 fair value from APRICOT
Company on January 1, 2023. APRICOT reported that the building had a carrying
amount of P10,000,000 and estimated remaining useful life of 20 years. On the same
date as the sale, BRONZE entered into a five-year lease contract with APRICOT
covering the building sold by the latter. Annual lease payments of P900,000 are due
every January 1 of each year, starting in 2023. Incremental borrowing costs as of the
same date for BRONZE and APRICOT were 7% and 8%, respectively.
Required: Under each of the following scenarios, determine the journal entry to
record the sale and leaseback transaction in the books of BRONZE and APRICOT:
1. The selling price of the building is P8,000,000

1. On January 3, 2023, GINGER Company leased an equipment for four years from CLAY
Company by paying P900,000 every year, starting on the same date. Incremental
borrowing rate of GINGER Company is 9% on the same date. CLAY Company
properly accounted for this lease as an operating lease.
As a way of background, CLAY Company leased the equipment from BLONDE
Company starting January 1, 2021 by paying annual lease payments of P750,000 for
the next ten years. The equipment has a useful life of ten years and cost of
P5,636,424 to BLONDE. As of the same date, the incremental borrowing rate of CLAY
Company was 8% and the implicit interest rate of the lease is 7%, CLAY Company
does not know of this implicit interest of the lease.
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The gain on sublease in the books of CLAY shall be

a. PO c. P759,513
b. P673,691 d. P809,561
The net amount to be recognized in CLAY Company's 2023 profit or loss shall be
a. P11,685 c. P79,110
b. P44,101 d. P116,920
2. At the beginning of 2023, LAVENDER Company leased a vehicle to THISTLE

Company for four years by receiving P1,050,000 annual lease payment on the same
date. Implicit rate on the sublease is 8%. On this date, incremental borrowing rates
of LAVENDER Company and THISTLE Company were 5% and 6%, respectively.
LAVENDER appropriately recorded this lease as a finance lease.
LAVENDER Company originally leased the vehicle from PLUM Company for five
years starting on January 1, 2022. PLUM carries this vehicle at an amount of
P3,880,914. Annual lease payments required to be paid under that lease agreement
is P900,000, starting on the commencement date. Implicit interest rate of the lessor
for the lease, which LAVENDER does not know, was 6% at the time. As of the same
date, LAVENDER Company had incremental borrowing rate of 7%.
The gain or loss on sublease in the books of LAVENDER shall be

a. P617,832 gain c. P597,160 gain
b. P617,832 loss d. P597,160 loss
Net amount to be recognized in LAVENDER Company's 2023 profit or loss shall be

a. P648,304 c. P729,821
b. P699,731 d. P791,845
3. PLUM Company acquired a warehouse for P7,400,000 from MAGENTA Company on
January 1, 2023. MAGENTA reported that the warehouse has a carrying amount of
P5,000,000 and accumulated depreciation of P2,000,000. The warehouse has a fair
value of P7,000,000 at the date of sale. On the same date as the sale, PLUM entered
into a six-year lease contract with MAGENTA covering the warehouse sold by the
latter. Annual lease payments of P900,000 are due every January 1 of each year,
starting in 2023. Incremental borrowing costs as of the same date for PLUM and
MAGENTA were 6% and 7%, respectively.
The amount of lease Jiability to be initially recognized in the books of MAGENTA
Company shall be
a. P4,590,177 c. P4,691,128
b. P4,190,177 d. P4,291,128
The amount of ROU asset to be initially recognized in the books of MAGENTA
Company shall be
a. P3,350,806 c. P3,278,698
b. P3,065,091 d. P2,992,984
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The amount of gain on sale and leaseback to be recognized in the books of MAGENTA
on January 1, 2023 shall be
a. P2,000,000 c. P688,521
b. P802,807 d. P954,732
4, WINE Company purchased a machinery from ORCHID Company for P10,000,000 on

January 1, 2023. ORCHID carried the machinery on its books at P9,000,000 but has
an original cost of P12,000,000 and fair value of P10,500,000. Immediately after the
sale, ORCHID signed a five-year lease contract with WINE covering the same
machinery. Annual lease payments of P1,400,000 are due every January 1, starting
in 2023. WINE and ORCHID had incremental borrowing costs of 7% and 8%,
respectively.
The amount of lease liability to be initially recognized in the books of ORCHID

Company shall be
a. P6,642,095 c. P6,536,978
b. P6,142,095 d. P6,036,978
The amount of ROU asset to be initially recognized in the books of ORCHID Company
shall be
a. P5,174,553 c. P5,264,653
b. P5,603,124 d. P5,693,224
The amount of gain on sale and leaseback to be recognized in the books of ORCHID
Company on January 1, 2023 shall be
a. P566,146 c. P551,129
b. P637,575 d. P622,558
5. MULBERRY Company owns a land with carrying amount of P10,200,000. On January

1, 2023, this was sold to IRIS Company for a certain price, even though its fair value
at that time was P8,000,000 only. Immediately after the sale, MULBERRY entered
into an eight-year lease agreement with IRIS covering the land just sold. Annual lease
payments of P1,100,000 are due every January 1 of each year, starting in 2023.
MULBERRY Company had an incremental borrowing rate of 6%.
Assumption 1: Selling Price is P8,000,000.

The amount of lease liability to be initially recognized in the books of MULBERRY
Company shall be
a P6,967,301 c. P7,240,619
b. P7,152,906 d, P7,832,956
The amount of ROU asset to be initially recognized in the books of MULBERRY
Company shall be
a. P9,231,789 c. P9,850,396
b. P7,240,619 d. P7,493,298
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The amount of loss on sale and leaseback to be recognized in the books of

MULBERRY Company on January 1, 2023 shall be
a. P2,200,000 c. P1,911,170
b. P208,830 d. P325,835
Company shall be
a. P7,340,619 c. P7,740,619
b. P6,740,619 d. P7,240,619
Company shall be
a. P7,240,619 c. P9,869,289
b. P7,740,619 d. P9,231,789
The amount of loss on sale and leaseback to be recognized in the books of
MULBERRY Company on January 1, 2023 shall be
a. P71,330 c. P208,830
b. P2,200,000 d. P2,128,670
Company shall be
a. P7,240,619 c. P6,982,782
b. P6,240,619 d. P5,982,782

Company shall be
a. P7,240,619 c. P7,956,789
b. P6,240,619 d. P9,231,789
The amount of gain on sale and leaseback to be recognized in the books of

MULBERRY Company on January 1, 2023 shallbe -
a P483,830 c. P689,317
b. P2,200,000 d. P892,831
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Chapter 12 —- Employee Benefits — Part 1
CHAPTER 12
EMPLOYEE BENEFITS- PART 1

1. The introductory concepts on employee benefits.
2. The classifications of employee benefits.
3. The accounting for short-term employee benefits.
4. Theaccounting for other long-term benefits.
5. The accounting for termination benefits.
EMPLOYEE BENEFITS
On their own, business and corporate entities cannot undertake operations without
the intellect and physical labor of a natural person (i.e., a human being). This need
is met by establishing a senior management team wherein they create short-term
to long-term strategies and steer the whole organization to a specific direction.
However, each member of this team cannot do all of the tasks under his/her
responsibility. For example, the chief marketing officer cannot do all the marketing
tasks.
Because of the aforementioned limitations, additional natural persons are hired to
whom the tasks that cannot be performed by the senior management are delegated.
Of course, these natural persons have mouth/s to feed and will not spend their time,
effort, energy, and life to work for an entity without corresponding compensation.
In this setup, the entity is considered as the “employer” and natural persons are
considered as the “employees”.
The specific amount of compensation may vary from employee to employee
depending on the specific function being performed and will also vary across each
employer. However, it has the following fundamental components:
a. Basic hourly, daily, weekly, or monthly pay
b. Additional benefits such as de minimis benefits, profit-sharing, additional
month/s of salary, pension benefits, etc. These benefits also include amounts
provided for the benefit of employee’s dependents and beneficiaries, such as
scholarships, insurance coverage, etc.
ACCOUNTING FOR EMPLOYEE BENEFITS

The accounting standard covering employee benefits is PAS 19 (or also known as
PAS19R), Employee Benefits. This standard is applied regardless of the classification
of employee whether full-time, part-time, casual or temporary basis. Employees
also include directors and other management personnel.
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Chapter 12 — Employee Benefits — Part 1
PAS 19 defines employee benefits as all forms of consideration given by an entity

in exchange for service rendered by employees or for the termination of
employment. [PAS 19.8]. These benefits may be given directly to the employees or to
their spouses, children, dependents, or other entities (e.g. insurance entities for
health insurance premiums).
Under PAS 19, the accounting for an employee benefit will depend on its
classification, which can be one of the following [PAS 19.8):
Classification Description
Benefits (other than termination benefits) that are expected to
Short-term be settled wholly before twelve months after the end of the
employee benefits | annual reporting period in which the employees render the
related service.
Benefits (other than termination benefits and short-term
ee see employee benefits) that are payable after the completion of
employment.
Termination Benefits provided in exchange for the termination of an
benefits employee's employment.
Otherlong-term | Benefits other than short-term employee _ benefits,
employee benefits | post-employment benefits, and termination benefits.
Post-employment benefits will be discussed in the next chapter due to its

complexity.
SHORT-TERM EMPLOYEE BENEFITS

These benefits normally include the following amounts:
wages, Salaries, and social security contributions;
oe Be
paid annual leave and paid sick leave;

profit-sharing and bonuses; and
Pa
non-monetary benefits (such as medical care, housing, cars, and free or

subsidized goods or services) for current employees. [PAS 19.5].
These amounts are considered as such because of the corresponding reasons:

a. Under the labor code, wages, and salaries are required to be paid at least twice
a month (Art. 103, Chapter III, Title II of Labor Code of the Philippines).
b. Paid annual leave and paid sick leave are effectively paid at the same time when
wages and salaries are paid.
c. Profit-sharing and bonuses are normally paid within few months after the end
of the reporting period to which they are based. For example, bonuses for the
year 2023 will be paid either in March or April 2024 when the 2023 financial
statements have been finalized.
d. Non-monetary benefits are normally paid on a monthly basis.
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Chapter 12 - Employee Benefits — Part 1
ACCOUNTING FOR SHORT-TERM EMPLOYEE BENEFITS

When an employee has rendered service to an entity during an accounting period,
the entity shall recognize the undiscounted amount of short-term employee
benefits expected to be paid in exchange for that service:
a. adebit to expense, unless another accounting standard requires or permits the
inclusion of the benefits in the cost of an asset.
For example, employee benefits given to employees involved in the
manufacturing of inventories or construction of an item of PPE will be
capitalized as part of cost inventories and PPE, respectively.
b. Asa liability (accrued expense) or as an asset (prepaid expense or advances to

employees), depending on the amount paid and the amount of benefits:
Scenario | Accounting Consequence
Amount paid > undiscounted amount of benefits Prepaid asset
Amount paid < undiscounted amount of benefits Accrued liability
Illustration 1. During the year 2023, SANTIAGO Company incurred short-term

employee benefits of P4,800,000 for office employees.
journal entry to record the transaction:
1. The Company paid P4,500,000
Answer - Scenario 1
The journal entry to record the transaction is as follows:
Employee benefit expense - short-term 4,800,000
Cash 4,500,000
Accrued liability (squeeze) 300,000
Answer - Scenario 2
The journal entry to record the transaction:
Employee benefit expense - short-term 4,800,000
Advances to employees (squeeze) 150,000
Cash 4,950,000
Generally, the amount of short-term employee benefits is recognized in profit or
loss, regardless of the amount of payments to employees. If these benefits are
incurred in connection with the manufacturing of inventories, the debit of
P4,800,000 would be to Inventories account. If the benefits are incurred in
connection with the construction of an item of PPE, the debit of P4,800,000 would
be to a PPE account (e.g., Building, Equipment, and Machinery accounts).
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SPECIAL CONSIDERATIONS FOR SHORT-TERM EMPLOYEE BENEFITS

Special accounting considerations will be discussed regarding the following short-
term employee benefits:
13t month pay
Profit-sharing plans
epaasp
Paid absences (vacation leaves and sick leaves)

Statutory contributions
Bonus plans
13™ MONTH PAY

This employee benefit is required to be paid to almost every employee not later
than every December 24 of each year (Presidential Decree No. 851). This is to
coincide with the increase in the consumption during the holiday season (i.e.,
during the last days of each year). Generally, this additional benefit is equal to one
month of basic pay (not including the amount of monthly additional benefits).
For example, an employee that receives a basic pay of P30,000 per month
(excluding additional compensation), will receive a total amount of P390,000
(P30,000 x 13 months) for one year, instead of just P360,000 (P30,000x 12 months).
DETERMINING THE AMOUNT OF 1374 MONTH PAY

The exact amount of 13 month pay to be received will depend on how long an
employee is employed in the entity during the current year (i.e., pro-rated if
relevant). This can be summarized as follows (using calendar reporting year):
Scenarios Amount of 13" Month Pay
Employee is still employed as of
December 31 of the current year:
Start of employment is on or before
The whole amount of basic pay
January 1 of the current year
; : No. of months from date of"
Start of employment is during the Basic employment until Dec. 31
current year pay Xx 12
Employee resigned or quit during

the current year:
Start of employmentis on or No. of months from Jan 1. until
before January 1 of the current boy X date of resignation
year pay 12
No, of mos. from date of
Start of employment is during the ‘ employment until date of
current year nose x resignation
pay 12
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Chapter 12 —- Employee Benefits - Part 1
jllustration 2. An employee currently receives a monthly basic pay of P60,000 for

the current year 2023. Required: Under each of the following independent
scenarios, determine the amount of 13th month pay to be received by the employee:
1. The employee was hired last March 1, 2022.
2. The employee was hired last April 1, 2023.
3. The employee was hired last September 1, 2023.
Scenario 1 :
Since the employee is employed with the entity starting on January 1, 2023, the
amount of 13 month pay is equal to the whole amount of basic pay of P60,000.
Scenario 2
The employee is employed for nine months only (from April 1, 2023 to December 31,
2023). Consequently, the amount of 13 month pay for this employee is P45,000
(P60,000 x 9/12).
Scenario3
The employee is employed for four months only (from September 1, 2023 to
December 31, 2023). Consequently, the amount of 13 month pay for this employee
is P20,000 (P60,000 x 4/12).
Illustration 3 - Resignation. On October 1, 2023, an employee earning a monthly
basic salary of P90,000 resigned in search for better job opportunities. Required:
Under each of the following independent scenarios, determine the amount of 13th
month pay to be received by the employee on the date of his or her resignation:
1. The employee was hired last March 1, 2020.
2. The employee was hired last May 1, 2023.
3. The employee was hired last July 1, 2023.
Scenario 1
For the current year, the employee is employed from January 1, 2023 to October 1,
2023 or for nine months. Consequently, the amount of 13" month pay is equal to
P67,500 (P90,000x 9/12).
Scenario 2
For the current year, the employee is employed from May 1, 2023 to October 1,
2023 or for five months. Consequently, the amount of 13 month pay is equal to
P37,500 (P90,000x 5/12).
Scenario 3
For the current year, the employee is employed from July 1, 2023 to October 1, 2023
or for three months. Consequently, the amount of 13 month pay is equal to
P22,500 (P90,000 x 3/12).
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ACCOUNTING FOR 13™ MONTH PAY

The readers may have noted that as the period of employment for the current year
becomes longer, the amount of 13% month pay that an employee will receive increases.
In addition, the employees are also entitled to a proportional amount of 13th month
pay even if they resigned or quit during the current year.
Because of these, in practice, entities make a monthly accrual of 1/12 of the basic
pay of all of its employees who are still employed. This accrual is generally recorded
using the following pro-forma entry:
13% month pay expense XX
Accrued liability for 13‘ month pay XX
No additional issues will arise for entities using the calendar year reporting
(reporting date ending every December 31 of each year) as the 13" month pay will
be already paid by December 24 of each year. As a result, no accrued liability for
13% month pay will be recognized as of December 31.
However, for entities using the fiscal year reporting (reporting date is other than
December 31), amounts of accrued liability for 13 month pay shall be
recognized. The amount of accrued liability shall be based on the period from
January 1 until the fiscal reporting date.
Illustration 4. SORIANO Company’s accountant is unsure of how to account for the

13 month pay of one of its employees earning P120,000 basic pay each month.
This employee has been employed in the Company for the last five years. The
Company's policy is to pay 13 month pay every December 15 of each year.
Required: Under each of the following scenarios, determine the amount of accrued
liability for 13 month pay to be recognized for this particular employee as of each
of the indicated reporting date:
1, The Company’s reporting date is December 31, 2023
2. The Company's reporting date is March 31, 2024
3. The Company’s reporting date is June 30, 2024
Scenario 1
No accrued liability will be recognized as the 13% month pay for the year 2023 has
already been paid last December 15, 2023.
Scenario 2
Accrued liability for three months (January 1, 2024 to March 31, 2024) shall be
recognized. This will amount to P30,000 (P120,000 x 3/12).
Scenario 3
Accrued liability for six months (January 1, 2024 to June 30, 2024) shall be
recognized. This will amount to P60,000 (P120,000 x 6/12).
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PAID ABSENCES
These benefits are given to employees to acknowledge that they are just human
beings that need some time-out for work without affecting the amount of their
benefits. The most common type of paid absences are the vacation leaves and the
sick leaves. However, the employer entity may grant other types of paid absences.
Paid vacation leaves are granted to promote the general well-being of employees,
especially their mental health. Paid sick leaves are granted because it is expected
that every employee will catch sickness during the year.
Paid absences can be classified into the following general types:
Accumulating _..Non-accumulating
These paid absences are carried forward | These are paid absences that cannot be
and can be used in future periods if the | carried forward, and they lapse if the
current period’s entitlement is not used in | current period’s entitlement is not
full. Accumulating paid absences can | used in fulland do not entitle employees
either be: to a cash payment for unused
a. Vesting - employees are entitled to a | entitlement on leaving the entity (i.e,
cash payment for unused paid absences | non-vesting). [PAS 19.18].
upon leaving the entity. ;
b. Non-vesting - employees are not | Most of the time, sick leaves, paternity
entitled to a cash payment for unused | °F maternity leaves, and study leaves
paid absences upon leaving the entity, | 4"¢ all non-accumulating
[PAS 19.15]
Most of the time, paid vacation leaves are
accumulating.
Illustration 5. MABEL, an accounting manager employed last January 1, 2023, is

receiving 12 days of paid vacation leaves each year. For the year 2023, she used 5
days of vacation leave. Required: Under each of the following independent
scenarios, determine the total number of vacation leaves available to MABEL for the
subsequent year, 2024:
a. The vacation leave is accumulating
b. The vacation leave is not accumulating
Scenario 1 - Accumulating
Since the vacation leave is accumulating, MABEL can carry over to 2024 her unused
7 days (12 days less 5 days) of paid vacation leave in 2023. For 2024, she is entitled
to a total of 19 days (12 days annual entitlement plus 7 days carried over from 2203)
of paid vacation leave. In addition, any unutilized paid vacation leaves during 2024,
out of these 19 days, can be carried further over to year 2025.
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Scenario 2 - Not Accumulating

Since the vacation leave is non-accumulating, MABEL cannot carry over to 2024 her
unused 7 days of paid vacation leave in 2023. As a result, she is entitled to just 12
days of paid vacation leave in 2024 (equal to annual entitlement), In addition, any
unutilized paid vacation leaves for 2024 cannot be carried over in 2025.
ACCOUNTING FOR PAID ABSENCES

An entity shall recognize the expected cost of paid absences as follows:
a. in the case of accumulating paid absences, when the employees render
service that increases their entitlement to future paid absences (i.e., expense is
recognized whether the paid absences were used or not).
b. in the case of non-accumulating paid absences, when the absences occur (i.e.,
when the paid absences were used). [PAS 19.13].
An entity shall measure the expected cost of accumulating paid absences as the
additional amount that the entity expects to pay as a result of the unused
entitlement that has accumulated at the end of the reporting period. [PAS 19.16].
The following accounting procedures are relevant in accounting for each type of
paid absences:
is AmountofAccrued | Totalamountof Benefit
Types — Liability : (Expense)
Accumulating:
Unused paid absences
Vesting measured at the expected
future salary rates Used paid absences measured
Unused paid absences | at current salary rates plus
measured at the expected| the amount of accrued
Non-vesting future salary rates, reduced | liability.
' by the estimate related to
resigning employees
Used paid absences measured
Non-accumulating None at current salary rates
Illustration 6 - Accumulating vs. Non-accumulating. HERNANDEZ Company

started its operations in 2023. It grants 15 days of vacation leaves (VL) each year to
each of its three employees. These employees have the following pertinent details:
Currentsalary Salary starting 2024 Utilized VLs
Employee A P1,000/day P1,100/day 5 days
Employee B 2,500/day 2,750/day 9 days
Employee C 3,000/day 3,300/day 4 days
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Chapter 12 - Employee Benefits - Part 1

amounts of (a) expense for 2023 and (b) accrued liability, if there is any, as of
December 31, 2023:
a. The paid vacation leaves are accumulating
b. The paid vacation leaves are non-accumulating
Scenario 1
The total amount of expense for 2023 shall be determined as follows:
Salary base [A] Utilized VLs[B] [A] x [B]
Employee A P1,000/day 5 days P5,000
Employee B 2,500/day 9 days 22,500
Employee C 3,000/day 4 days 12,000
Expense from used vacation leaves P39,500
Salary base[A] _ Unutilized VLs [B]
Employee A P1,100/day 10 days (15 - 5) 11,000
Employee B 2,7 50/ day 6 days (15 - 9) 16,500
Employee C 3,300/day 11 days (15 - 4) 36,300
Expense from unused vacation leaves P63,800
Total Expense (P39,500 + P63,800) P103,300
The amount of accrued liability as of December 31, 2023 is P63,800, which is

equal to the expense for unused vacation leaves. The readers should take note of
the following:
a. Expense arising from used vacation leaves is based on current salary rates.
b. Expense arising from unused vacation leaves is based on future salary rates.
Scenario 2
If the vacation leave is non-accumulating, the amount of expense to be recognized
is pertaining only to the paid absences that has been used or utilized. In this case,
the expense to be recognized is P39,500 (equal to the computed expense from
used vacation leaves in Scenario 1). There is no accrued liability to be recognized
as of December 31, 2023 for unused vacation leaves.
Illustration 7 - Vesting vs. Non-vesting. TOLENTINO Company’s employees have
a combined unutilized vacation leaves (accumulating) of 300 days as of December
31, 2023. The Company’s employees have an average salary of P2,000/day, and this
average is not expected to increase materially. There is a reasonable expectation
that some employees with a total 30 days of unutilized or unused paid vacation
leaves will resign early next year. Required: Under each of the following
independent scenarios, determine the amount of accrued liability to be recognized
as of December 31, 2023:
1. The vacation leaves are vesting
2. The vacation leaves are non-vesting
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Scenario 1
Accrued liability to be recognized shall be P600,000 (300 daysx P2,000/day). The
number used was 300 days (i.e., without regard to resigning employees) since the
employees will receive this benefit whether they stay employed or resign.
Scenario 2
Accrued liability to be recognized shall be P540,000 (270 daysx P2,000/day). The
number used 270 days (300 days - 30 days) since the entity has no obligation to
pay in cash the 30 days of unutilized vacation leave credits when the
corresponding employees resign.
PROFIT-SHARING AND BONUS PLANS
This benefit to employees to boost their morale to feel that they can “share” in the
amount of the net income earned by their employers, instead of just receiving a
fixed amount of monthly salary. This benefit is also given to acknowledge the fact
that without the combined efforts of an entity’s employees, then it may have not
earned a certain amount of net income.
The amount of this benefit depends on what is indicated in the employment
contract and the succeeding guidelines released by the entity. However, this benefit
is most likely based on the following factors:
a. Performance appraisal of employees (i.e., how well the employee performed his
or her job during the year).
b. Turnover of employees (if the benefit requires an employee to be still employed)
c. Level of audited net income earned.
ACCOUNTING FOR PROFIT-SHARING AND BONUS PLANS
An entity shall recognize the expected cost of profit-sharing and bonus payments
when, and only when:
a. theentityhasa present legal or constructive obligation to make such payments
as a result of past events; and
b. areliable estimate of the obligation can be made.
A present obligation exists when, and only when, the entity has no realistic
alternative but to make the payments. [PAS 19.19].
There is a legal obligation if the payment of profit-sharing to employees is included
in the employment contract or agreement with the employee’s labor union. There
is a constructive obligation if, for example, the entity does not promise to pay
profit-sharing, but it had a past practice of paying discretionary profit-sharing
amounts.
The amounts of benefit from profit-sharing and bonus plans are recognized as
accrued liability as of the reporting date since they are normally paid after the
finalization of the entity’s financial statements, normally March or April of the
succeeding year.
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There is a corresponding amount of expense since the transaction is not with

owners of the entity but rather a transaction with employees.
Illustration 8, DIAZ Company has a published profit-sharing plan to its employees
containing the following provisions:
a. If the net income is at least P20,000,000, total profit-sharing to all employees is
5% of net income.
b. If the net income is at least P30,000,000, total profit-sharing to all employees is
7% of net income.
No employees are expected to leave before receiving the profit-sharing amounts.
amount of profit-sharing to be accrued as of December 31, 2023:
1. Net income is P23,000,000
2. Netincome is P32,000,000
Scenario 1
The amount of accrued liability for profit-sharing to be recognized is P1,150,000
(P23,000,000 x 5%) since the amount of net income is more than P20,000,000 but
less than P30,000,000.
Scenario 2
The amount of accrued liability for profit-sharing to be recognized is P2,240,000
(P32,000,000x 7%) since the amount of net income is more than P30,000,000.
DIFFERENT BASES OF BONUS

The previous illustration showed the fundamental computation of bonus amount. ©
However, the bonus amounts to be paid may also be based after considering the
bonus itself and/or the amount of income tax. As such, the following are the possible
scenarios of bonus computations:
1. Bonus is based on net income before bonus and income tax
2. Bonus is based on net income after bonus but before income tax
3. Bonus is based on net income before bonus but after income tax
4. Bonus is based on net income after bonus and income tax.
Scenarios 1 and 2 above are much easier to compute relative to scenarios 3 and 4.
The following are the relevant formulas in determining the amount of bonus for
each scenario:
Scenarios ; _. Corresponding Formula

Based on net income before bonus B=NIxB%
and income tax
Based on net income after bonus but B=. B% xX ene NDEs
aire before income tax (1 + B%)
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Based on net income before bonus = RO _ pre rs

but after income tax BOHM Lee UM = BU
Based on net Snmictde
income after bonus and ~ na ny pra ic
B= B%x {[NI - B] - [T%x (NI - B)}}
Where:
B = Bonus B% = Bonus percentage
NI = Net Income T% = Income tax rate
It should be noted that the algebraic concepts will be applied in solving the amount
of bonus under scenarios 3 and 4. In addition, the expression [T% x (NI - B)] in some
of the above formulas pertains to the amount of income tax.
Illustration 9. During the year 2023, COSMOS Company reported P5,250,000 net
income before income tax of 25%. As an incentive, the Company pays 5% bonus to
its management team.

amount of bonus to be paid to the management team:
Scenario 1 - Before bonus and income tax

This scenario is the easiest among the different bases of bonus computation. In this
case, the bonus to be computed is P262,500 (P5,250,000 x 5%).
Scenario 2 - After bonus but before income tax
In this case, computation of the bonus is as follows:
B = [NI/(1+B%)]
x B%
B = [5,250,000/(1+5%)]x5%
B = [5,250,000/1.05] x 5%
B = [5,000,000] x 5%
B = P250,000
The following is the proof of the above computations:

Net income before bonus and income tax P5,250,000
Less: Amount of bonus (since after bonus) (250,000)
Net income after bonus but before income tax P5,000,000
Multiply by: Bonus rate 5%
Amount of bonus P250,000
Scenario 3 - Before bonus but after income tax

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=B B%x {NI-[T% x (NI -B)]}}

=B 5% x {5,250,000 ~ [25% x (5,250,000 - B)]}
=B 5% x {5,250,000 - [1,312,500 - 0.25B]}
=B 5% x {5,250,000 - 1,312,500 + 0.25B}
=B 5% x {3,937,500 + 0.25B}
=B 196,875 + 0.0125B
B-0.0125B = 196,875
0.9875B = 196,875
0.9875 0.9875
B = P199,367

Less: Amount of tax [(P5,250,000 - P199,367) x 25%] (1,262,658)
Net income before bonus but after income tax P3,987,342
Scenario 4 - After bonus and income tax

B = B%x{[NI-B] -[T% x (NI - B)]}
B = 5% x {[5,250,000 - B] - [25% x (5,250,000 - B)]}
B = 5%x {5,250,000 - B] - [1,312,500 - 0.25B]}
B = 5% x {5,250,000 - B - 1,312,500 + 0.25B}
B = 5% x {3,937,500 - 0.75B}
B = 196,875 - 0.0375B
B +0.0375B = 196,875
1.0375B = 196,875
1.0375 1.0375
B = P189,759

Less: Bonus (189,759)
Less: Amount of tax [(P5,250,000 - P189,759) x 25%] (1,265,060)
Net income after bonus and income tax P3,795,181
EMPLOYEE AND EMPLOYER STATUTORY CONTRIBUTIONS

In the Philippine setting, laws require the contribution of certain amounts to
Philhealth, Social Security System (or SSS for private sector employees),
Government Service Insurance System (or GSIS for government sector employees),
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and Home Development Mutual Fund (or HDMF). The amounts of the contributions
are determined using tables, which are already out of scope of this chapter.
In each of these contributions, a certain portion shall be deducted from employees’
gross pay (i.e., the employee share) to arrive at the amount of net pay while the
other portion is shouldered by the employer as its out-of-pocket costs (i.e.,
employer share). However, the employer is required to remit both the employee and
employer shares to the relevant government agencies.
Consequently, the following are the relevant accounting procedures:
Employee Share _ Employer Share

These amounts are already included in An additional and separate expense
the amount of compensation expense. account shall be recognized for each type
These amounts decrease the employees’ of statutory contribution. These amounts
net pay. do not affect the employees’ net pay.
A liability is recognized for unremitted A liability is recognized for unremitted

contributions contributions
In addition to the statutory contributions, the employer is also required to withhold

the tax on its employees’ compensation income. As such, the whole amount of
withholding tax will decrease the employee's net pay (i.e., pure employee share and
no employer share). Consequently, the amount of withholding tax is accounted in a
similar manner as the employee’s share in statutory contributions.
To summarize, the following is the computation of employees’ net take home pay:
Gross compensation or gross pay (basic pay plus allowances) Pxx
Less: Employee's share in statutory contributions (xx)
Withholding tax on compensation (xx)
Net pay Pxx
Illustration 10. During the month of December 2023, CANOPY Company had the
following financial information related to the compensation of all of its employees:
Total gross pay P6,000,000
Philhealth contributions:
Employee share 400,000
Employer share 600,000
SSS contributions:
HDMF contributions:
Withholding tax onemployee’s compensation 1,400,000
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Required: From the given information, determine the amount of total net pay and
journal entries to record the transactions.
The amount of total net pay shall be determined as follows:
Gross compensation or gross pay P6,000,000
Less: Employee's share in statutory contributions
(P400,000 + P500,000 + P100,000) (1,000,000)
Withholding tax on compensation (1,400,000)
Net pay P3,600,000
The readers should take note that only the employees’ share in the statutory
contributions will decrease the amount of the net pay. The journal entry to record the
payment to employees and the withholding of employee share in statutory
contributions and tax on compensation is as follows:
Compensation expense 6,000,000

Cash (equal to net pay) 3,600,000
Withholding tax payable 1,400,000
Philhealth contributions payable 400,000
SSS contributions payable 500,000
HDMF contributions payable 100,000
The journal entry to record the accrual of the Company’s shares to statutory
contributions (i.e., employer share) is as follows:
Philhealth contributions expense 600,000
SSS contributions expense 550,000
HDMF contributions expense 200,000
Philhealth contributions payable 600,000
SSS contributions payable 550,000
HDMF contributions payable 200,000
As of December 31, 2023, the Company will have the following liabilities:
Philhealth contributions payable (P400,000 + P600,000) P1,000,000

SSS contributions payable (P500,000 + P550,000) 1,050,000
HDMF contributions payable (P100,000 + P200,000) 300,000
Withholding tax payable 1,400,000
For the month of December 2023, the Company will have the following short-term
employee benefit expense from the information given:
Compensation expense (inclusive of employee share and tax) 6,000,000
Philhealth contributions expense (employer share only) 600,000
SSS contributions expense (employer share only) 550,000
HDMF contributions expense (employer share only) 200,000
Total short-term employee benefit expense P7,350,000
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recog
The readers should take note that a separate expense is nized only for the
while the expense related to the
employees’ share are already included in the amount of compensation expense.
OTHER LONG-TERM EMPLOYEE BENEFITS
This category covers all other benefits that are not classified as either short-term,
post-employment, or termination benefits. These benefits are expected to be settled
beyond twelve months after the end of the annual reporting period in which the
employees render the related service. As such, these are subject to present value
‘calculations. These benefits include, but are not limited to, the following long-term
employee benefits:
a. long-term paid absences such as long-service or sabbatical leave;
b. jubilee or other long-service benefits;
c. long-term disability benefits;
d. profit-sharing and bonuses (long-term); and
e. deferred remuneration.
Other long-term employee benefits are not usually subject to the same degree of
uncertainty as the measurement of post-employment benefits. As such, PAS 19
requires much simpler accounting for other long-term employee benefits where all
amounts are recognized in profit or loss (except when these are allowed to be
included in the carrying amount of an asset).
OTHER LONG-TERM EMPLOYEE BENEFITS - LONG-TERM DISABILITY BENEFIT

One of the specific types of other long-term benefits that was mentioned is PAS 19R,
which is the long-term disability benefit where benefits are given to employees
when they became disabled. This is usually applicable to industrial workplace
where debilitating accidents can happen to employees.
The recognition of obligation for this employee benefit will depend on the following
scenarios:
1. If the level of benefit depends on the length of service (i.e., the longer the
employee service, the higher the benefit), an obligation arises when the service
is rendered.
The amount of the obligation reflects the probability that payment will be
required and the length of time for which payment is expected to be made.
2. Ifthe level of benefit is the same, regardless of the years of service, the expected
cost of this benefit is recognized when an event resulting to rong -term disability
occurs.
TERMINATION BENEFITS
Termination benefits result from either of the following:
a. an entity's decision to terminate the employment (ie, lay-off of employees); or
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b. an employee's decision to accept an entity’s offer of benefits in exchange for the

termination of employment. /PAS 19.159].
Termination benefits are typically lump sum payments but sometimes also include:
a. enhancement of post-employment benefits, either indirectly through an
employee benefit plan or directly,
b. salary until the end of a specified notice period if the employee renders no
further service that provides economic benefits to the entity. [PAS 19.161].
The event that gives rise to an obligation for termination benefits is the employee
Indicators that an employee benefit is provided in exchange for services (which will
not be classified as termination benefits) include the following:
a. the benefit is conditional on future service being provided (including benefits that
increase if further service is provided).
b. the benefit is provided in accordance with the terms of an employee benefit plan.
Termination benefits also exclude employee benefits resulting from termination of
employment at the request of the employee without an entity’s offer (ie.,
resignation) or as a result of mandatory retirement requirements.
However, the difference between the benefit provided for termination of
employment at the request of the employee and a higher benefit provided at the
request of the entity is a termination benefit.
Illustration 11. During the year 2023, FOSSIL Company paid the following amounts
to its employees:
1. Payments to employees who were laid off amounted to P800,000.
2. Payments to employees who accepted the Company’s offer of termination
benefits amounted to P1,200,000.
3. Payments to employees who resigned without the Company’s offer amounted to
P500,000.
4. Payments to retiring employees amounted to P600,000.
Required: Determine the total amount of termination benefits.
The amounts paid to employees are classified as follows:

Termination Not Termination
Benefits Benefits
1 P800,000
2 1,200,000
3 P500,000
4 600,000
Totals P2,000,000 P1,100,000
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Payment 3 is not classified as termination benefits since the Company has not made
any offer to the employee while Payment 4 is considered as post-employment
benefit, a separate category of employee benefits.
RECOGNITION AND MEASUREMENT OF TERMINATION BENEFITS

An entity shall recognize both a liability and expense for termination benefits at the
earlier of the following dates:
a. when the entity can no longer withdraw the offer of those benefits; and
b. when the entity recognizes costs for a restructuring that is within the scope of
PAS 37 (see Chapter 3) and involves the payment of termination benefits.
If the termination benefits arise from the employee's decision to accept an entity’s
offer, the entity can no longer withdraw the offer of termination benefits at earlier
of the following:
a. when the employee accepts the offer; and
b. when a restriction (e.g., a legal, regulatory or contractual requirement or other
restriction) on the entity's ability to withdraw the offer takes effect.
If termination benefits arise from the entity’s decision to terminate an employee’s
employment, the entity can no longer withdraw the offer that it has communicated
to the affected employees if all of the following criteria have been met:
a. Actions required to complete the plan indicate that it is unlikely that significant
changes to the plan will be made.
b. The plan identifies the number of employees whose employment is to be
terminated, their job classifications or functions and their locations, and the
expected completion date.
c. The plan establishes the termination benefits that employees will receive in
sufficient detail that employees can determine the type and amount of benefits
they will receive when their employment is terminated.
Termination benefits are measured in accordance with the following concepts:
Termination benefits are expected to | Termination benefits are expected to
be settled wholly within 12 months be settled wholly beyond 12 months
after the current reporting date after the current reporting date
Apply the concepts of short-term | Apply the concepts of other long-term
employee benefits (i.e., not discounted) employee benefits (i.e., discounted)
Illustration 12 - Closure. Near the end of the year 2023, SAMSON Company
announced the closure of one of its factories effective on March 31, 2024. The
Company offered an immediate payment of P80,000 per employee to those who will
immediately leave the Company. Of the Company's total of 200 employees, 50 are
expected to leave immediately. The employees who will remain until the date of
closure will receive a total of P170,000 each on March 31, 2024. Required: From
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this information, determine the amount of termination benefits to be recognized

during the year 2023.
The amount of termination benefits is equal to P16,000,000 (200 x P80,000). The

reason for this is that the Company will give P80,000 to each of its 200 employees
whether they immediately leave or render additional service to the Company.
The excess of P90,000 (P170,000 - P80,000) for each of the remaining 150
employees or a total of P13,500,000 (P90,000 x 150) are recognized as short-term
employee benefits over the three-month period from January 1, 2024 to March 31,
2024. The reason is that these amounts are paid to employees in exchange for their
services during the said three-month period.
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CHAPTER SUMMARY
1. Employee benefits may be given to employees themselves, or to their spouses,
children or dependents, or to other entities.
2. General classifications of employee benefits are the following:
Classification . Description
Benefits (other than termination benefits) that are expected
Short-term to be settled wholly before twelve months after the end of the
employee benefits | annual reporting period in which the employees render the
related service.
Benefits (other than termination benefits and short-term
Post-employment
employee benefits) that are payable after the completion of
benefits
employment.
Termination Benefits provided in exchange for the termination of an
benefits employee’s employment.
Otherlong-term | Benefits other than short-term employee benefits,
employee benefits | post-employment benefits and termination benefits.
3. Short-term employee benefits are recognized as expense, except when other
standards permit their capitalization in the cost of an asset.
4. Any difference between the amounts of payments and short-term employee benefits
are recognized as either prepaid asset or liability.
Short-term employee benefits are not normally discounted.
oy in
Paid absences can be either accumulating (those that can be carried forward next
year) or non-accumulating (those that cannot be carried forward next year).
7. Accumulating paid absences can either be vesting (where employees are entitled to
a cash payment for unused absences) or non-vesting (where employees are not
entitled to a cash payment for unused absences).
8. 13% month pay is a form of additional benefit. Proportional amounts are given to
employees who rendered less than one year of service to the entity.
9. Bonuses can be computed in different ways: before bonus and tax, after bonus but
before tax, before bonus but after tax, or after bonus and tax.
10. Bonuses are recognized at the time the entity has the legal or constructive obligation
to distribute such amounts.
11.Employee’s share in the statutory contributions and withholding taxes reduce the
net take home pay of the employee. These amounts are already part of compensation
expense.
12. Employer's share in the statutory contributions is recorded as additional expenses.
These amounts do not affect the net take home pay of the employee.
13.0ther long-term benefits are the catch-all category of employee benefits. No
amounts are recognized in other comprehensive income.
14. Termination benefits result from the employee termination rather than employee
service.
15.If termination benefits are payable within 12 months after the reporting period,
apply concepts on short-term employee benefits. Otherwise, the concepts on other
long-term benefits shall be applied.
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True or False
1. Short-term employee benefits given to factory workers are capitalized as inventory
cost.
2. Benefits given to the employee's dependents on account of its employment cannot
be considered employee benefits and shall be out of scope of PAS 19.
3. If the actual payment is higher than the amount of short-term employee benefits,
an entity shall recognize a prepaid asset.
Short-term employee benefits are discounted if they are not yet paid as of the end
of the current reporting period.
If an entity resigned during the current year, he or she is not entitled to receive a
proportional amount of 13 month pay.
The accrued liability for vesting paid absences is not reduced by the expected
unused paid absences for resigning employees.
If an employee was hired during the year, he or she is entitled to a proportional
amount of 13“ month pay.
Non-accumulating paid absences expire at the end of the period they were granted.
An accrued liability based on the current salary rates are recognized for unused
accumulating paid absences.
10. The amount of bonus is generally higher if it is based on net income before bonus
compared when it is based on net income after bonus.
11. The amount of withholding tax is recognized as a separate expense in the
employer's books.
az. Employer's share in statutory contributions does not reduce the employee’s take
home pay.
13. Portion of other long-term employee benefits may be recognized in other
comprehensive income.
14. Benefits paid to a resigning employee is considered as a termination benefit.
15. Benefits paid to a retiring employee is considered as post-employment benefit.

1. Which of the following is not a category of employee benefits covered by PAS 19?
a. Share-based employee benefits
b. Termination benefits
c. Post-employment benefits
d. Short-term employee benefits
2. All of the following are considered as employee benefits, except
a. Payments made to other entities
b. Payments made to employee's spouse
c, Payments made to employee's children
3. Which of the following is excluded from the short-term employee benefits?
a. Profit-sharing and bonuses that are payable during the next period
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b. Medical care benefits

c. Jubilee service benefits
d. Free periodic gift certificates for groceries
4. The following accounting procedures are correct for short-term employee benefits,
except
a. The amount of benefits is not discounted.
b. The amount of benefits cannot be capitalized in any case.
c. A prepaid asset shall be recognized if the amount of actual payment is higher
than the amount of short-term employee benefits
5. Ifan employee was hired on May 1 of the current period and stayed with the entity
as of the end of the current period, it shall
a. receive a proportional amount of 13" month pay from January 1 to May 1.
b. receive a proportional amount of 13 month pay from May 1 to December 31.
c. receive the full amount of the 13% month pay
d. notreceive any amount on account of the 13‘ month pay
6. An employee that was hired few years ago has resigned on October 1 of the current
period. In this case, the employee is entitled to
a. a proportional amount of 13th month pay from January 1 to October 1.
b. a proportional amount of 13th month pay from October 1 to December 31.
c. receive the full amount of the 13th month pay
d. notreceive any amount on account of the 13th month pay
7. Paid absences can be classified as either
a. Vesting and non-vesting
b. Accumulating and vesting
c. Accumulating and non-accumulating
d. Non-accumulating and non-vesting
8. The following statements are true regarding accumulating paid absences, except
a. Unused paid absences can be carried forward to be used in the succeeding
periods.
b. For used paid absences, the amount of benefit is based on the current salary
levels of employees.
c. For unused paid absences that are vesting, accrued liability shall be recognized
based on the future salary rates of employees.
9. Which of the following is true regarding non-accumulating paid absences?
a. Unused paid absences can be carried forward in the succeeding periods.
b. For used paid absences, the amount of benefit is based on future salary levels of
employees.
c. For unused paid absences, no accrued liability shall be recognized.
d. The total amount of benefit is based both from used and unused paid absences.
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10.Statutory contributions have corresponding portions that are shouldered by

employees and employer. In this case, which of the following statements is correct?
a. Both the amounts of employee share and employer share will reduce the
amount of net pay of employees.
b. Both the amounts of employee share and employer share will result to
additional expense.
c. Employer share will reduce the net pay of employees, while the employee share
will have no effect in the net pay of employees.
d. Employer share will result to the recognition of additional expense, while the
employee share will not result to additional amounts of expenses
11. Other long-term employee benefits include the following, except

a. Health maintenance insurance premiums
b. Long-service leaves
c. Sabbatical leaves
d. Long-term disability benefits
12. Which of the following is not considered as termination benefits?
a. Payments to employees with redundant positions.
b. Payments to retiring employees
c. Bothaandb
d. Neitheranorb
Straight Problems
1. During the month of December 2023, CUYO Company’s salary to its employees
amounted to P4,500,000.
entry to record the payment:
1. The Company paid P4,300,000.
2. During November 2023, AGUTAYA Company wants to compute the amounts of 13%
month pay that it will distribute in December 2023. The following is a partial listing
of relevant information for some of its employees:
. Employee Monthly Basic Pay Date Hired
Employee A P100,000 September 30, 2022
Employee B 60,000 June 1, 2023
Employee C 70,000 January 1, 2023
Employee D 80,000 October 1, 2023
a.. Total 13 month pay to be paid to these employees,
b. Total short-term employee benefits for the year 2023.
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Chapter 12 — Employee Benefits - Part 1
3. MAGSAYSAY Company had the following employees who resigned during the year:
Monthly Date of
Employee Basic Pay Date Hired Resignation
Employee A P90,000 September 30, 2022 April 1, 2023
Employee B 120,000 July 1, 2022 June 30, 2023
Employee C 50,000 June 1, 2023 November 1, 2023
Employee D 90,000 March 31, 2023 August 1, 2023
a. Total 13 month pay to be paid to these employees.
b. Total short-term employee benefits for the year 2023.
4. BATANES Company pay bonus to its management team equal to 6% of its net
income. For the year 2023, the Company earned net income before tax of
P4,770,000. Relevant income tax rate is 25%.
Required: Under each of the following independent scenarios of basis of bonus

computation, determine the amount of bonus to be distributed:
5. CAGAYAN Company started its operations during the year 2023. In addition, it also
grants 20 paid absences to each of its employees every year.
As of December 31, 2023, the Company had the following information:

Daily Salary Daily Salary Used Paid
Employee (Current) (Future) Absences
A P2,000 P2,200 14
B 1,800 1,980 16
C 2,500 2,750 12
D 1,500 1,650 8
total expense for the paid absences and (b) accrued liability, if any, as of December
31, 2023: .
1. The paid absences are accumulating
2. The paid absences are non-accumulating
6. On January 1, 2023, ISABELA Company started its operations. In addition, it also

grants 15 paid absences to each of its employees every year.
_ As of December 31, 2023, the Company had the following information:
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Employee No. of Average Total of Used

Category Employees DailySalary Paid Absences
Managers 100 P3,000 1,200
Supervisors 250 2,000 2,900
Staffs 500 1,200 6,200
The Company plans to increase the salary of its employees by 5% starting in the year
2024. In addition, the Company expects that 40 vacation days of managers, 90
vacation days of supervisors, and 140 vacation days of staffs will not be exercised
until the resignation of the relevant employee.
total expense for the paid absences and (b) accrued liability, if any, as of December
31, 2023:
1. The paid absences are accumulating and vesting
2. The paid absences are accumulating but non-vesting
3. The paid absences are non-accumulating
7. During the month of October 2023, QUIRINO Company is preparing the payroll
computations for its employees. Relevant data were provided as follows:
EmployerShare Employee Share

SSS contributions P300,000 P450,000
Philhealth contributions 260,000 320,000
HDMF contributions 90,000 120,000
Gross compensation for the month amounted to P4,000,000, while withholding

taxes on compensation amounted to P700,000.

a. Journal entries to record the recognition and settlement of compensation and
statutory contributions.
b. Total employee benefit expense for the month of October 2023.
8. VIZCAYA Company operates in multiple locations, Area A, B and C. During the year
2023, the Company decided to close down its operations in Area C effective on June
30, 2024 and terminate some employees in Areas A and B.
There were 50 employees in Area A and each of them are offered with P40,000
separation benefit. Of these employees, 20 immediately accepted the offer and
ceased their employment with the Company, while the remaining 30 employees will
stay with the Company until closure. They are still entitled to their average normal
salary of P30,000 per month from January 1, 2024 to June 30, 2024, plus the P40,000
termination benefit to be given to them on June 30, 2024.
The Company also terminated their contract with employees with redundant
functions, giving them a total of P1,200,000 separation benefit. Some employees,
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fearing that they will be laid off, voluntarily resigned and was given a total of
P200,000 separation pay.
Lastly, employees who reached mandatory retirement age were paid a total of
P1,500,000 retirement benefits.
Required: From the given information, determine the total amount of termination
benefit to be recognized during the year 2023.

1. On January 1, 2023, ILOCOS Company started its operations. It has a policy of giving
20 days paid vacation leaves (VLs) and 15 days of paid sick leaves (SLs). The vacation
leaves are accumulating and vesting, while the sick leaves are non-accumulating.
For the year 2023, the Company had the following information regarding to its
employees:
Current Future Total Total
Employee No. of Daily Daily Used Used
Category Employees Salary Salary VLs SLs
Staffs 200 P1,000 P1,060 3,000 1,200
Supervisors 80 1,500 1,590 1,000 500
Managers 30 2,500 2,650 350 150
From the given information, the total accrued liability from the paid absences as of
December 31, 2023 shall be
a. P6,492,500 c. P2,525,000
b. P2,676,500 d. P6,125,000
From the given information, the total short-term employee benefit expense for the
year 2023 from the paid absences shall be
a. P13,825,000 c. P10,376,500
b. P14,192,500 d. P10,225,000
2. For the year 2023, APAYAO Company earned net income before tax of P8,640,000,
while relevant tax rate is 25%. The Company has a policy of giving 8% bonus to its
employees.
The bonus based on net income before bonus and income tax shall be
a. P691,200 c. P640,000
b. P528,980 d. P489,057
The bonus based on net income after bonus but before income tax shall be
a. P691,200 c. P640,000
b. P528,980 d, P489,057
The bonus based on net income before bonus but after income tax shall be
a. P691,200 c. P640,000
b. P528,980 d. P489,057
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The bonus based on net income after bonus and income tax shall be
a. P691,200 c. P640,000
b. P528,980 d. P489,057
3. KALINGA Company pays bonus of 12% to its management team. For the year 2023,
it earned a net income before 25% income tax of P5,600,000.
The bonus based on net income before bonus but after income tax shall be
a. P600,000 c, P519,588
b. P462,385 d, P672,000
The bonus based on net income after bonus and income tax shall be
a. P600,000 c. P519,588
b. P462,385 d, P672,000
The bonus based on net income before bonus and income tax shall be
a. P600,000 c. P519,588
b. P462,385 d. P672,000
The bonus based on net income after bonus but before income tax shall be
a. P600,000 c. P519,588
b. P462,385 d. P672,000
4. OnJanuary 1, 2023, ABRA Company started its operations on January 1, 2023. As to
its employee’s welfare, it grants 15 paid vacation leaves to each of its employees
every year.
As of December 31, 2023, the Company had the following employees:
Current Used Vacation

Employee Daily Salary Leaves
A P1,900 10
B 2,100 12
C 3,000 7
D 2,400 6
E 1,600 8
The Company plans to increase the employee’s salaries by 6%, starting on January
1, 2024.
If the vacation leaves are accumulating, total benefit expense for 2023 shall be
a. P92,400 c, P169,356
b. P97,944 d, P174,900
If the vacation leaves are non-accumulating, total benefit expense for 2023 shall be
a. P92,400 c. P169,356
b. P97,944 d. P174,900
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5. At the beginning of the year 2023, IFUGAO Company had to the following
composition of its manpower:
Employee No. of Monthly
Category Employees Salary
Staffs 30 P30,000
Supervisors 1 42,000
Managers 5 72,000
The following employees were hired during the year: March 31 - three staffs; April
30 — two supervisors; August 1 - one manager; and October 1 - two staffs. There
were no employee resignations during the year.
From the given information, the total expense for 13 month pay during the year
2023 shall be
a. P1,764,000 c. P2,070,000
b. P1,932,500 d. P2,212,500
6. During its October 2023 monthly meeting, the board of directors of BENGUET
Company decided and immediately announced its intention to restructure its
operations by closing down its operations in one geographical area (Location B) and
downsizing its remaining operations in its remaining geographical areas of
operations (Locations A and C).
The Company immediately terminated 30 employees in Location B by paying them

P20,000 termination pay. The remaining 20 employees will still work in winding
down the operations in Location B until its closure on March 31, 2024. These
employees will still earn their P10,000 monthly salaries until the date of closure and
they will also receive the P20,000 termination pay on the same date.
In addition, there were a total of 25 employees that were laid off in Locations A and
C. These employees received severance pay of P25,000 each. On the other hand, 10
employees, that were not optimistic on their future with the Company, voluntarily
resigned and received P10,000 separation pay.
The total termination benefits to be recognized for the year 2023 shall be
a P1,325,000 c. P1,225,000
b. P1,725,000 d. P1,625,000
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Chapter 12A — Post-Employment Benefits
CHAPTER 12A
POST-EMPLOYMENT BENEFITS

1. The minimum amount of post-employment benefits.
2. The different types of post-employment benefit plans and their characteristics.
3. The accounting for defined contribution plan.
4. The accounting for defined benefit plan, including the amounts to be reported
in the statement of financial position, income statement, and other
POST-EMPLOYMENT BENEFITS
These benefits are given to employees after their employment with an entity has
been completed (other than short-term benefits and termination benefits). In
practice, this is normally given to retiring employees from ages 50 years old (early
retirement age) to 65 years old (mandatory retirement age), depending on the
entity’s retirement plan. These benefits are given to retiring employees in a lump-
sum basis or in a periodical basis.
So, why continue giving benefits to the retired employees even if they are not
working for the entity anymore?
It is because they have devoted their time, effort, loyalty, life, and aspirations to the
entity, and it is imperative for the entity to support them in their old age where they
cannot work further and earn money for themselves.
MINIMUM AMOUNT OF RETIREMENT BENEFITS
Retirement plan provided by an employer entity varies from other employer
entities, depending on what is the agreed level of benefits with the employees.
However, minimum amount of retirement benefit is defined in Republic Act No.
7641, amending the Article 287 of the Labor Code of the Philippines.
The minimum amount is one-half (1/2) month salary for every year of service,
with a fraction of at least 6 months being considered as one whole year. One-half
month salary includes the following amounts:
a. 15 days salary based on salary rate at the time of retirement;
b. Cash equivalent of not more than 5 days of service incentive leaves; and
c. 1/12 of 13 month pay. This is equivalent to 2.5 days (30 days times 1/12).
In other words, one-half month salary is equivalent to 22.5 days of compensation

(15 days + 5 days + 2.5 days). Retirement benefits to be given shall not go below one-
half month salary x number of year of service to the last employer.
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This amount shall be given to a retiring employee meeting the following

requirements:
a. Age ofat least 60 years old at the time of retirement; and
b. Atleast 5 years of service to the employer in which the employee retires from.
Illustration 1. A 62-year-old employee retired from his last employer when his
daily salary is P5,000/day. He was employed for the last 42 years, of which 10 years
were with his last employer. From this information, the minimum amount of
retirement benefits that this employee should receive shall be determined as:
Daily salary P5,000
Multiply by: No. of days 22.90 days
One-half month salary P112,500
Multiply by: No. of years in service in the last employer 10 years
Minimum amount of total retirement benefits P1,125,000
DIFFERENT TYPES OF POST-EMPLOYMENT BENEFIT (RETIREMENT) PLANS
Post-employment benefit plans are formal or informal arrangements under which
an entity provides post-employment benefits for one or more employees. [PAS
19.8]. For accounting purposes, these plans are classified as follows:
1. Defined contribution plan
2. Defined benefit plan
Their major differences are compared as follows:
Defined Contribution Plan Defined Benefit Plan

Fixed contributions into a Provide the agreed (i.e., pre-
separate entity (a fund) and no determined) benefits to
Entity’s obligation legal or constructive obligation current and former
to pay further contributions if employees, regardless of the
the fund becomes insufficient performance of the fund.
Actual contribution plus the Pre-determined amounts of
returns from the investing of benefits, regardless of the
Amounts to be
paid redress actual contributions £(i.e., | contributions and returns
dependent on the fund’s | earned from contributions to
performance) the fund
Who assumes the
actuarial risk and Employees Employer entity
investment risk?
ieee tS Less common More common
Actuarial risk is the risk that the amounts of retirement benefits are less than
anticipated. Investment risk is the risk that the amount of contributions and
returns are not sufficient to pay the expected benefits.
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Defined benefit plans are more common in practice primarily due to the minimum
amount of retirement benefits required by Republic Act No. 7641.
Examples of cases where an entity’s obligation is not limited to the amount that
it agrees to contribute to the fund are when the entity has a legal or constructive
obligation through:
a. a plan benefit formula that is not linked solely to the amount of contributions
and requires the entity to provide further contributions if assets are insufficient
to meet the benefits in the plan benefit formula;
b. a guarantee, either indirectly through a plan or directly, of a specified return on
contributions; or
c. those informal practices that give rise to a constructive obligation. [PAS 19.29].
By considering these examples, a retirement plan may be assessed to be as defined

benefit plan for accounting purposes, even if it is legal form is a defined
contribution plan (i.e., accounting substance over legal form).
ACCOUNTING FOR DEFINED CONTRIBUTION PLANS

Accounting for this kind of retirement plan is simple and relatively straightforward
since the liability of an entity is limited to the amounts of its required
contributions.
When an employee has rendered service to an entity during a period, the entity
shall recognize the contribution payable to a defined contribution plan in exchange
for that service:
a. a debit to expense, unless another accounting standard requires or permits the
inclusion of the benefits in the cost of an asset.
For example, employee benefits given to employees involved in the

manufacturing of inventories or construction of an item of PPE will be
capitalized as part of cost of the inventories and PPE, respectively.
b. asa liability (accrued expense) or as an asset (prepaid expense or advances to
employees), depending on the amounts of incurred benefit and benefits paid:
Scenario 255 Accounting Consequence
Amount paid > undiscounted amount of benefits Prepaid asset
Amount paid < undiscounted amount of benefits Accrued liability
Unless the amount is to be paid after 12 months, the entity shall measure the
required contributions on an undiscounted basis.
Illustration 2, MORALES Company maintains a defined contribution plan for its

office workers that requires the Company to pay 5% of its net income before tax,
due on December 31 of each year. For the year 2023, the Company reported
P24,000,000 net income before tax.
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Required: Under each of the following scenarios, determine the single journal entry
to record the payment of the required contribution:
Scenario 1
The journal entry to record the transaction is:
Retirement expense (P24M x 5%) 1,200,000
Cash 1,000,000
Accrued liability - retirement 200,000
Scenario 2
The journal entry to record the transaction is:
Retirement expense (P24M x 5%) 1,200,000
Prepaid expense — retirement 150,000
Cash 1,350,000
Generalizations - Both Scenarios
The amount recognized as the defined contribution expense (P1,200,000) is not
affected by the amount of actual contributions. In addition, the amounts are not
discounted since these are paid on or shortly after December 31 of each year.
ACCOUNTING FOR DEFINED BENEFIT PLANS
Accounting for this kind of retirement plan is somewhat complicated since the
actuarial and investment risks are both assumed by the entity. In addition, in actual
practice, almost all employer entities maintain a separate retirement fund (i.e., plan
assets from which the benefits are paid from). If there is a corresponding retirement
fund, then the defined benefit obligation is said to be “funded”.
Accounting for defined benefit plans also means accounting for the following:
1. Defined benefit obligation (or projected benefit obligation) - this is the
present value of the estimate of the entity's retirement obligation in the future.
This is connected to actuarial risk.
2. Retirement fund or plan assets -fund to which contributions are made to earn
returns that can be used to reduce the amount of retirement costs and from
which the retirement benefits are paid. This is connected to investment risk.
ACCOUNTING FOR DEFINED BENEFIT OBLIGATION
The accounting for defined benefit obligation has the following characteristics:
a. An entity shall make actuarial assumptions and estimates related to the amount
of obligation it has regarding the retirement benefits (i.e, retirement obligation).
b. The computations are primarily discounted in nature as the amounts are
expected to be settled far into the future.
c. Since the computations utilize actuarial assumptions, these assumptions might
change in the future, which results to the recognition of actuarial gains and losses.
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The
Chapter 12A - Post-Employment Benefits
To be able to compute the present value of defined benefit obligation, an entity shall
follow these procedures as the “three-step approach”:
a. Apply actuarial valuation method
b. Attribute benefit to periods of service
c. Make actuarial assumptions
Actuarial Valuation Method
An entity shall use the projected unit credit method in determining the present
value ofits defined benefit obligation and other amounts that will be discussed later
on. This method is also known as “accrued method pro-rated on service” or
“benefit/years of service method”. [PAS 19.68].
This method sees each period of service as giving rise to an additional unit of benefit
entitlement and measures each unit separately to build up the final obligation. [PAS
19.68].
Attribute the Benefit to Periods of Service
In determining the present value of its defined benefit obligations and the related
amounts to be discussed later on, an entity shall allocate the benefit to periods of
service under the plan’s formula.
For example, an entity grants P50,000 retirement benefit for every year of service,
from the time of employment up to expected retirement date of an employee. Based
on this plan, an entity attributes P50,000 for every year of service of the employee.
The present value of P50,000 will increase the amount of defined benefit obligation
each year as the employee renders additional one year of service.
Making Actuarial Assumptions
These are the entity’s best estimates of the variables that will determine the
ultimate cost of providing post-employment benefits. These assumptions include
the following [PAS 19.76]:
- Demographic assumptions- _. Financial assumptions —_
Include, but are not limited to, the | Include, but not limited to, the following:
following: mortality, employee turnover, | discount rate, benefit levels, future
disability, early retirement, and claim | salary, future benefit costs, and claim
rates under medical plans (ie, | handling costs (i.e, financial inputs)
nonfinancial inputs)
Actuarial assumptions shall be unbiased and mutually compatible. [PAS 19.75].

On the other hand, the discount rate used in discounting the retirement benefits
shall be determined by the following hierarchy:
a. First, reference to the market yields of high-quality corporate bonds as at the
end of reporting period.
b. Otherwise, reference to the market yields on government bonds as at the end
of the reporting period.
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The
Resulting Amounts After Applying the Three-Step Approach

The following amounts are the results from the estimation of defined benef
obligation using the “three-step approach”:
Amounts Description © pie Set i q
.
a. Current service cost - the increase in the present value of the defingy-
benefit obligation resulting from employee service in the ‘veh
period.
b. Past service cost - is the change in the present value of the define
benefit obligation for employee service in prior periods resulting from
a plan amendment or a curtailment. This excludes the changes in
actuarial assumptions.
Plan amendment is the introduction or withdrawal of, or changes to
a defined benefit plan. Plan curtailment is the significant reduction
by the entity in the number of employees covered by a plan.
Service
costs Both current service cost and past service cost are measured on a
discounted basis. ,
c.any gain or loss on settlement. [PAS 19.8]. Settlement can be
considered as immediate and/or premature payment of retirement
benefits. Loss is added to the amount of retirement cost, while gain is
deducted from retirement cost. fib
Gain or loss on settlement is determined using the following rules:
Scenario Result
Settlement price > present value of settled benefit Loss
Settlement price < present value of settled benefit Gain
Interest expense is the change during the period in the net defined
benefit liability (asset) that arises from the passage of time. [PAS 19.8].
This is recognized since the current service and past service costs are
Interest measured on a discounted basis (i.e., unwinding of discount).
expense The interest rate used in computing the amount of interest expense is
the discount rate at the beginning of the current annual reporting
period. This is similar to the discount rate determined at the end of the
previous annual reporting period. My
Actuarial gains and losses are changes in the present value of the
defined benefit obligation-resulting from:
a. experience adjustments (the effects of differences between the
Actuarial previous actuarial assumptions and what has actually occurred)
gains and b. the effects of changes in actuarial assumptions. [PAS 19.8].
losses
The existence of actuarial gain or loss is determined as follows:
a. Loss -if the change/s resulted to an increase in liability.
b. Gain - ifthe change/s resulted to a decrease in liability.
—§
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4
an!
ates
The
ent Benefits
chapter 12A - Post-Employm
Beginning defined benefit obligation (DBO)

add: Interest expense (beginning disco unt rate x beginning DBO) Pxx
Current and past service costs XX
Actuarial losses XX
Less: Benefits paid to retirees in accordan ce with retirement plan
: *
(xx)
a
Settled benefits at present value (pre mature settleme

nts) (xx)
Actuarial gains
ending defined benefit obligation ed
The amounts deducted on account of payment to retirees and settled benefits should
peequal to the present value of the settled liability and not necessarily the actual
amount of payment.
Inaddition, for simplicity’s sake, the basis of interest expense is the beginning
balance. However, in actual practice, the readers should not be surprised if the
present value of paid or settled benefits are considered in the computations.
On the other hand, the following amounts are recognized in the entity’s total
comprehensive income:
As net expense in profit or loss:
Current and past service costs — Pxx
Interest expense. XX
Loss on settlement (if loss) XX
Less: Gain on settlement (if gain) : (xx)
Net expense recognized in profit or loss Pxx
As net deduction from other comprehensive income:

Actuarial losses, if any Pxx
Less: Actuarial gains, if any __(xx)|
Net retirement cost recognized in OCI Pxx
The readers should take note that the amounts of payments to retirees and
settlement amounts are excluded from the retirement cost as they have already
expense, OF actuarial
£0 previously recognized as part of service costs, interest
als or losses,
The
Cumulative a mounts of etirement cost recognizi ed in OCI is mainta‘ ined ina
‘
r fashion as unrealized gains
t in a similar
. .
Shareholders’ equity accoun

:
me
urities at FVTOCI.
;
losses from investments in equity sec

D 1, 2023,
nn BENEFIT OBLIGATION ~- INDIVIDUAL euros eore anuary
3, BELINDA,
se, setion earning
i“Urrently a 55-year-old newly hired employe
P8,000 per month. Her employer provides a retirement benefit
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The
of one month salary for every year of employment, using the monthly salary at the
time of retirement. It is expected that she will be retiring at the age of 60 years old
on January 1, 2028 and that her monthly salary will be at P9,000 per month at that
time. Relevant discount rate is 7%. Required: From this information, determine the
amounts of current service cost, interest expense, and defined benefit obligation for
each year from 2023 to 2027.
Identification of Actuarial Assumptions
Before directly answering the requirements of the problem, it is interesting to note
the following actuarial assumptions contained in the problem:
a. Demographic assumption- the estimated retirement at the age of 60 years old
b. Financial assumptions- future salary of P9,000 and discount rate of 7%. The
discount rate in this problem was assumed to be fixed, but in actual practice, this
is subject to changes.
Computations:
1, First, attribute the amount of benefits to the period from which they arise:
2023 2024 2025 2026 $2027
Attributedamount P9,000 P9,000 P9,000 P9,000 P9,000
Based on the previous table, BELINDA will be entitled to P9,000 retirement

benefitfor every year
of service. If she will continue her service up to her expected
retirement date after 5 years, she will be entitled to P45,000 (P9,000 x 5 years)
retirement benefit. The P8,000 current salary is not relevant in this case.
On the other hand, if BELINDA works for only four years, she will be entitled to
retirement benefit of just P36,000 (P9,000 x 4 years of service).
2. Next, compute for the amount of present value of the attributed benefits for each
year. The starting date for the number of periods computation to be used in
present value calculation is every December 31 of each year until January 1,
2028.
December 31 2023 2024 2025 2026 #$£=‘2027
Attributed amount P9,000 P9,000 P9,000 P9,000 P9,000
Periods until 1/1/28 4 3 2 1 ~
Present value/current
service cost 6,866 7,347 ~=7,861 8,411 9,000
There are four (4) periods used in 2023 since it is four years from December 31,
2023 to January 1, 2028, There are three (3) periods used in 2024 since it is
three years from December 31, 2024 to January 1, 2028 and so on.
The computations of present value of attributed benefit or the amount of current
service cost for each year are the following:
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The
Current
PV Attributed Service
Year PV Factor of Factor Benefit Cost
2023 Single payment for 4 periods at 7% 0.762895 P9,000 P6,866
2024 Single payment for 3 periods at 7% 0.816298 9,000 P7,347
2025 Single payment for 2 periods at 7% 0.873439 9,000 P7,861
2026 Single payment for 1 period at 7% 0.934579 9,000 P8411
No present value calculations are necessary for the year 2027.

3. Next, compute for the amounts of interest expense and ending balance of defined
benefit obligation for each year. These amounts can be computed as follows:
2023 2024 2025 2026 2027
Beg. defined benefit obligation P- P6866 P14,694 P23,584 P33,646
Add: Interest expense ms 481 1,029 1,651 2,354
Current service cost 6,866 7,347 7,861 8,411 9,000
End. defined benefit obligation P6,866 P14,694 P23,584 P33,646 P45,000
The interest expense per year is computed as the beginning defined benefit
obligation multiplied by the 7% discount rate (e.g., P481 = P6,866x 7%). Current
service costs are those determined in Step 2. The ending balance of defined
benefit obligation last year is the beginning balance for the current year.
It should be noted that the previous present value calculations are different
from the usual way of computing present values because every year of
BELINDA’s service, additional amounts of current service cost are added to the
present value of the obligation.
DEFINED BENEFIT OBLIGATION - ENTITY LEVEL BASIS

Illustration 4. As of December 31, 2022, the actuarial valuation report of
MERCADO Company reported a balance of P3,400,000 in its defined benefit
obligation. This amount is computed using the discount rate of 8%. During the year
2023, current service cost and past service cost amounted to P600,000 and
P110,000, respectively. Actuarial losses due to a decrease in employee turnover
amounted to P450,000 while actuarial gains from the increase in discount rate to
9% as of December 31, 2023 amounted to P270,000. Also, during 2023, payments
to retirees amounted to P850,000. Lastly, the Company settled a retirement
obligation with present value of P320,000 by paying the concerned employee
P350,000 cash. Required: From the given information, determine the following:
1. Defined benefit obligation as of December 31, 2023
2. Retirement cost to be recognized in 2023 profit or loss
3. Retirement cost to be recognized in 2023 other comprehensive income
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Answer:
1. Defined benefit obligation as of December 31, 2023 is computed as follows:
Defined benefit obligation, 1/1/23 P3,400,000
Add; Interest expense (P3,400,000 x 8%) 272,000
Current service cost 600,000
Past service cost 110,000
Actuarial losses 450,000
Less: Paid benefits to retirees (850,000)
Settled benefits (at present value) (320,000)
Actuarial gains (270,000)
The readers should take note that the rate used (i.e, 8%) is as of the beginning
of 2023 and not the 9% as of December 31, 2023. The 9% rate will be used in
computing the interest expense for the year 2024.
In addition, the amount deducted from defined benefit obligation on account of

settled benefits is equal to its present value of P320,000, rather than the
P350,000 amount of settlement.
2. The amount of retirement cost to be recognized in 2023 profit or loss is
Interest expense P272,000
Loss on settlement (P350,000 - P320,000) 30,000
Total amount recognized in 2023 profitorloss P1,012,000
There is a loss on settlement since the amount paid (i.e., P350,000) is higher than
the present value of settled retirement obligation (i.e., P320,000).
3. The amount of retirement cost to be recognized in other comprehensive income

(OCI) is computed as follows:
Actuarial losses P450,000
Less: Actuarial gains (270,000)
Net retirement cost to be recognized in OCI P180,000
Net amount of retirement cost to be recognized in total comprehensive income
is P1,192,000 (P1,012,000 + P180,000).
-ACCOUNTING FOR PLAN ASSETS

Plan assets are assets that:
a. are held by an entity (a fund) that is legally separate from the reporting entity
and exists solely to pay or fund employee benefits; and
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The
b. are available to be used only to pay or fund employee benefits, are not available to
the reporting entity’s own creditors (even in bankruptcy), and cannot be returned
to the reporting entity, unless either:
i. the remaining assets of the fund are sufficient to meet all the related
employee benefit obligations of the plan or the reporting entity; or
ii, the assets are returned to the reporting entity to reimburse it for employee
benefits already paid. [PAS 19.8].
The plan assets are measured equal at their fair value and reduced by liabilities
that are unrelated to employee benefits (i.e., the net asset value of the fund).
Examples of these liabilities include the trade payables, derivative liabilities, unpaid
fund management fees, and income tax payable of the fund. [PAS 19.114].
The composition of plan assets does not include the following:
a. Unpaid contributions due from the reporting entity.
b. Any non-transferable financial instruments issued by the entity and held by the
fund. [PAS 19.114].
Query: What are the reasons for establishing a separate fund from which
retirement benefits will be paid?
Answer: The primary reason is the reduction in the retirement costs because the
returns earned by the fund can be used as payments to the retirees. In addition,
certain amounts have already been segregated for the payment of retirement
benefits, regardless of the financial performance of the reporting entity.
TRANSACTIONS AND AMOUNTS AFFECTING PLAN ASSETS
The following affect the balance of plan assets:
1. Contributions of the entity - the entity's additional funding to the plan assets.
When the balance in the fund is used to acquire investments, the amount of
plan assets is not affected (i.e., similar to accounting for bond sinking funds).
Payments to retirees
wn
Settlement price paid for the immediately or prematurely settled retirement

benefits (not the present value of retirement obligation settled)
4. Actual return (loss) on plan assets - amounts earned by the fund from dividends,
interest, net unrealized and realized gains, reduced by related plan assets’
expenses. Actual return has increasing effect while actual loss has
decreasing effect on the balance of plan assets.
5. Withdrawals from the plan assets (very rare).
The accounting for actual return on plan assets is a little bit complicated so a
separate section will discuss the related concepts.
These transactions and amounts have the following effects in determining the
ending balance of plan assets:
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Beginning plan assets Pxx

Add: Actual return (fund income > fund expenses) XX
Contributions to the plan assets XX
Less: Actual loss (fund income < fund expenses) (xx)
Amount of benefits paid to retirees (xx)
Withdrawals from the fund (very rare) (xx)
Settlement price of settled benefits (not the PV of benefits) (xx)
Ending plan assets Pxx
ACCOUNTING FOR ACTUAL RETURNS

Reporting-wise, the amount of actual returns (loss) is split into the following:
a. Interest income, which is reported as deduction from interest expense in
defined benefit obligation in profit or loss; and
b. Remeasurement gain or loss, which is reported in other comprehensive
income, together with actuarial gains and losses from defined benefit liability.
The amount of remeasurement gain or loss depends on the difference between the
amount of actual returns and the amount of computed interest income.
COMPUTATION OF INTEREST INCOME AND REMEASUREMENT GAIN OR LOSS
The amount of interest income is generally computed as follows:
|___Interest Income = Beg. Bal. of Plan Assets x Discount Rate _|
The discount rate is the same interest rate used to compute the interest
expense from defined benefit obligation (i.e., determined at the beginning of the
current annual period).
From the given amount of actual return and computed amount of interest income,
the gain or loss on remeasurement is determined by applying the following rules:
Scenarios Remeasurement Gain or Loss? ©
Actual return is positive (or income):
Actual return > interest income Gain
Actual return < interest income Loss
Actual return is negative (or loss): Always loss equal to the amount of
Actual return > interest income actual loss plus the amount of
Actual return < interest income interest income
Illustration 5, At the beginning of 2023, AGUILAR Company reported a beginning

balance in its plan assets amounting to P5,600,000. The relevant discount rate used
to compute the present value of defined benefit obligation as of January 1, 2023 is
6%. The relevant discount rate used to compute the present value of defined benefit
obligation as of December 31, 2023 is 7%. Required: Under each of the following
independent scenarios, determine the amounts of interest income and
remeasurement gain or loss:
1. Actual return is P500,000
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2. Actual return is P200,000

3. Actual loss is P100,000
Answer - Interest Income (All Scenarios)
The interest income is computed as P336,000 (P5,600,000x 6%). The interest rate
used is as of the beginning of 2023 (i.e.,6%) and not as of the end of 2023 (i.e., 7%).
Nevertheless, this 7% will be used in computing for the amount of interest income
for 2024.
Answer - Remeasurement Gain or Loss
Applying the previously mentioned rules, remeasurement gain or loss is computed
in each scenario as follows:
Scenario 1 Scenario 2 Scenario 3
Actual return (loss) P500,000 P200,000 (P100,000)
Less: Interest income (336,000) (336,000) (336,000)
Remeasurement gain (loss) P164,000 (P136,000) (P436,000)
EFFECTS OF CONTRIBUTIONS AND PAYMENTS FROM THE PLAN ASSETS IN

INTEREST INCOME COMPUTATION
The previous computations of interest income assumes either or both of the
following:
a. there are no additional contributions or payment from the fund during the year.
b. contributions or payment from the fund are made at the end of the year in the
absence of information on when the transactions happened during the year.
However, in actual practice, contributions and/or retirement payments from the
fund can happen at any time during the year. Their effects shall be included in the
computation of interest income. The following accounting procedures are
relevant:
a. Contributions have increasing effect while payments have decreasing effect.
b. The effects shall be time-weighted and will depend on the length of time from
the date these contributions and payments occur up to the reporting date.
This is somewhat similar to the computation of the weighted average capital of
a partner,
c. The weighted average plan assets shall be multiplied with the discount rate at
the beginning of the period to obtain the interest income during the current
period.
The above procedures are also applicable in determining interest expense from
defined benefit obligation.
Illustration 6, At the beginning of 2023, NAVARRO Company reported beginning
balance of P3,200,000 in its plan assets. On April 1, 2023, it contributed P800,000
and on September 1, 2023 paid P1,200,000 to retirees. In addition, the plan assets
reported actual return of P320,000. Discount rate at the beginning of 2023 is 8%.
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Required: From this information, determine the amount of interest income and
remeasurement gain or loss for 2023.
Answer:
1. First, determine the weighted average of plan assets by including the time-
weighted effects of contributions and payments from fund:
[B] [A] x [B]
[A] Timeto Weighting Weighted
Date Amounts 12/31 Factor Amounts
1/1 P3,200,000 12 months 12/12 P3,200,000
4/1 800,000 . 9months 9/12 600,000
9/1 (1,200,000) 4months 4/12 (400,000)
Weighted average plan assets P3,400,000
The readers should take note that the amount of actual return is not included in
the computations as it is determined only at the end of each year.
2. Next, multiply the 8% discount rate to the computed weighted average plan
assets of P3,400,000 to get the interest income for 2023 of P272,000.
3. Lastly, since the amount of the actual return of P320,000 is higher than the
computed amount of interest income (i.e., P272,000), their difference is
considered as remeasurement gain of P48,000.
COMPREHENSIVE ACCOUNTING FOR PLAN ASSETS
Illustration 7. MANALO Company reported a beginning balance of P8,000,000 for
2023 for its plan assets. These plan assets are expected to earn 10% return, even
though the discount rate used to compute the present value of the related
retirement liability as of December 31, 2022 is 9%. During the year, additional
contributions of P2,200,000 were made to the fund and P1,200,000 were paid to
retirees. In addition, retirement liability with present value of P200,000 was settled
by paying P170,000 from the fund. For the year 2023, the plan assets earned
P600,000 return. From this given information, determine the following amounts:
a. Balance of plan assets as of December 31, 2023
b. Interest income to be deducted from interest expense.
c. Remeasurement gain or loss
Answer:
a. The balance of plan assets as of December 31, 2023 is computed as follows:
Plan assets, 1/1/23 P8,000,000
Add: Actual return 600,000
Contributions to the plan assets 2,200,000
Less: Settlement price of retirement liability (not the PV) (170,000)
Amount of benefits paid to retirees (1,200,000)
Plan assets, 12/31/23 P9,430,000
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It should be noted that the amount of settlement price was used instead of the
present value of settled liability since the amount paid from the plan assets is
equal to the settlement price. Here, the focus is accounting for plan assets,
and not the defined benefit obligation.
b. The amount of interest income is P720,000 (P8,000,000 beginning balance
times 9% discount rate). It should be noted that the interest rate to be used is
always the discount rate and not the expected rate of return.
In addition, the beginning balance of plan assets was used since there is no
information given regarding the exact dates on when the contributions,
payments to retirees, and settlement were made. As a result, it was assumed that
they took place at the end of 2023.
c. Actual return of P600,000 is less than the amount of interest income of
P720,000. As a result, their difference is considered as remeasurement loss of
P120,000.
ACCOUNTING FOR BOTH DEFINED BENEFIT OBLIGATION AND PLAN ASSETS
In practice, almost every entity consults with an actuary to calculate its retirement
obligation and maintains plan assets primarily with banks and other financial
institutions. As a result, in practice, an entity simultaneously accounts for defined
benefit obligation and plan assets.
PRESENTATION OF NET RETIREMENT ASSET OR LIABILITY
It is a common misconception that the amount of defined benefit obligation and
plan assets will be separately reported as liability and asset, respectively, in the
statement of financial position. However, the correct way of presenting them is by
obtaining their net amount as follows:
Defined benefit obligation Pxx
Less: Plan assets (xx)
Net retirement liability (asset) Pxx
The following rules summarize the reporting requirements:

Scenario -.. | Net retirement liability or asset?
Defined benefit obligation > Plan assets Net retirement liability
Defined benefit obligation < Plan assets Net retirement asset
Generally, net retirement liability is reported within the noncurrent liabilities
section of the balance sheet, while net retirement asset is reported within the
noncurrent assets section of the balance sheet.
Illustration 8. GOMEZ Company hasan ending balance of defined benefit obligation
amounting to P4,800,000. Required: Under each of the following independent
scenarios, determine the amount of net retirement liability or asset:
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1. The plan assets amounted to P4,500,000

2. The plan assets amounted to P5,200,000
Answer - Scenario 1
There is anetretirement liability of P300,000 since the defined benefit obligation
of P4,800,000 is higher than the amount of plan assets of P4,500,000. This net
retirement liability is reported in the liabilities section of the balance sheet.
Answer - Scenario 2
There is a net retirement asset of P400,000 since the defined benefit obligation
of P4,800,000 is lower than the amount of plan assets of P5,200,000. This net
retirement asset is reported in the assets section of the balance sheet.
ACCOUNTING FOR TOTAL RETIREMENT COSTS
This is now the right time to put into test the concepts that the readers have learned
in accounting for both the defined benefit obligation and plan asset. In practice, all
of the relevant amounts can be found on the actuarial valuation report given by
an actuary whom the entity has consulted. °
Computing for the ending balances of obligation and asset is the same as previously
discussed, but the amounts recognized in profit or loss and other comprehensive
income will now be merged in the following manner:
As expense in profit or loss:
Current and past service costs Pxx
Interest expense on defined benefit obligation XX
Less: Gain on settlement (if gain) (xx)
Interest income on plan assets (xx)
Net retirement cost recognized in profit or loss Pxx
As reduction from other comprehensive income:
Actuarial /osses on defined benefit obligation Pxx
Remeasurement loss on plan assets (if loss) XX
Less: Actuarial gains on defined benefit obligation (xx)
_Remeasurement gains on plan assets (if gain) (xx)
Net retirement cost recognized in OCI PXX
Total retirement costs in comprehensive income (net expense
recognized in profit or loss and OCI) PXX
Illustration 9, At the end of 2022, DIZON Company’s actuarial valuation report

(AVR) showed balances of P7,300,000 and P6,200,000 for its defined benefit
obligation and plan assets, respectively. During the year 2023, the following
transactions transpired:
a. Current service cost and past service cost amounted to P700,000 and P240,000,
respectively.
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b. Contributions to the fund amounted to P500,000 while actual return amounted

to P750,000.
c. Actuarial losses due to changes in financial assumptions amounted to P900,000.
d. Actuarial gains due to changes in demographic assumptions amounted to
P100,000 while actuarial losses due to experience adjustments amounted to
P300,000.
Payments to retirees amounted to P1,000,000 while retirement liability with
present value of P420,000 was settled for P370,000.
f. Discount rate based on the 2022 AVR is 7% while it is 9% as of December 31,
2023 AVR. In addition, the plan assets are expected to earn 12% return.
From the given information, determine the following amounts:
1. Defined benefit obligation as of December 31, 2023
2. Plan assets as of December 31, 2023
3. Amount to be presented in balance sheet as of December 31, 2023
4. Net retirement expense in profit or loss for 2023
5. Net retirement cost to be reported in other comprehensive income for 2023
Answer:
1. Defined benefit obligation as of December 31, 2023 is computed as follows:
Add: Interest expense (P7,300,000 x 7%) 511,000
Actuarial losses - financial assumptions 900,000
Actuarial losses - experience adjustments 300,000
Less: Paid benefits to retirees (1,000,000)
Settled benefits (present value) (420,000)
Actuarial gains - demographic assumptions (100,000)
The amount deducted on account of settled benefits is the present value of such
benefits. In addition, the readers should not forget the computation of interest
expense. This is based on the discount rate at the beginning of 2023 (or based
on 2022 AVR), rather than at the end of 2023.
2. Balance of plan assets as of December 31, 2023 is computed as follows:
Plan assets, 1/1/23 P6,200,000
Add: Actual return 750,000
Contributions to the plan assets 500,000
Less; Settlement price of retirement liability (not at PV) (370,000)
Amount of benefits paid to retirees (1,000,000)
Plan assets, 12/31/23 P6,080,000
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It should be noted that unlike in defined benefit obligation, the amount deducted
from the plan assets on account of settled benefits is the settlement price. In
addition, the amount deducted from defined benefit obligation and plan assets on
account of payments to retirees are equal (both P1,000,000 in this illustration).
3. Next, determine the net retirement liability or asset as of December 31, 2023 by
netting the computed balances of defined benefit obligation and plan assets:
Defined benefit obligation P8,431,000
Less: Plan assets (6,080,000)
Net retirement liability, 12/31/23 P2,351,000
There is a net retirement liability since the amount of defined benefit obligation
is higher than the amount of plan assets. Therefore, this is presented in the
liabilities section of balance sheet as of December 31, 2023.
4. The net amount to be recognized in profit or loss in 2023 is as follows:
Current service cost P700,000
Interest expense on defined benefit obligation 511,000
Less: Gain on settlement (P420,000 - P370,000) (50,000)
Interest income on plan assets (P6,200,000x 7%) (434,000)
Net expense recognized in profit or loss, 2023 P967,000
The computation of interest income is based on the beginning balance of plan
assets as there are no information on the exact dates on when the contribution,
payment to retirees, and settlement. As a result, they are assumed to have
happened at the end of 2023.
In addition, if we group these amounts, we can compute for net service cost of
P890,000 (P700,000 current service cost + P240,000 past service cost - P50,000
gain on settlement) and net interest expense of P77,000 (P511,000 interest
expense — P434,000 interest income).
5. Net retirement costs to be reported in other comprehensive for 2023 is
Actuarial losses on financial assumptions P900,000
Actuarial losses on experience adjustments 300,000
Less: Actuarial gains on demographic assumptions (100,000)
Remeasurement gain on plan assets (P750,000
actual return less P434,000 interest income) (316,000)
Net retirement cost recognized in OCI P784,000
There is a remeasurement gain on plan assets since the amount of actual return
is higher than the amount of interest income.
6. The compound journal entry to record the transaction is as follows:

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Retirement cost - OCI 784,000

Retirement cost - profit or loss 967,000
Cash (equal to contributions) 500,000
Net retirement liability 1,251,000
The amounts in the journal entry are explained below:

a. The credit to cash is equal to the amount of contributions during the year.
b. Payments to retirees have no effect in the net retirement liability since
it was deducted from both the defined benefit obligation and plan asset.
c. Settlement of benefits also has the same effect as payments to retirees, except
for the gain or loss on settlement that was already included in the retirement
cost - profit or loss amounting to P967,000.
In addition, the P1,251,000 net credit to the retirement liability is also equal to
the increase in net retirement liability which is determined as follows:
Net retirement liability, ending (P8,431,000 - P6,080,000) —P2,351,000
Less: Net retirement liability, beginning (P7.3M - P6.2M) (1,100,000)
Net increase in net retirement liability, 2023 P1,251,000
ACCOUNTING FOR ASSET CEILING
It has been previously discussed that any excess of plan assets over the defined
benefit obligation (or surplus of plan assets) is reported as a net retirement asset.
However, there might be a limit, legally or otherwise, on the amount of net
retirement asset that an entity shall recognize. This is due to the fact that the entity
might not be able to fully utilize the economic benefits from this asset as the excess
belongs to the retirement beneficiaries.
Because of these limitations, the concept of asset ceiling will now become relevant.
The asset ceiling is the present value of any economic benefits available in the form
of refunds from the plan or reductions in future contributions to the plan. [PAS
19.8].
The net retirement asset that shall be reported is lower of the following:
a. excess of plan assets over defined benefit obligation (hereinafter referred to as
“surplus of plan assets”); and
b. amount of asset ceiling.
The readers should take note that the asset ceiling does not affect the separate
balances of plan assets and defined benefit obligation; instead, only their net amount
is affected. The resulting accounting procedures are summarized by the following
rules:
Hear: Scenario 4 it eae Accounting consequences
Surplus of plan assets < Asset ceiling No consequences
Surplus of plan assets > Asset ceiling | Accounting for effect of asset ceilin
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The “effect of asset ceiling” is the amount of excess of surplus of plan assets over the
amount of asset ceiling. This is accounted for as follows:
a. Changes in this amount, is recognized in other comprehensive income as
remeasurement gain or loss.
b. The amount to be recognized in other comprehensive income is reduced by the
amount of interest. This interest is reported in profit or loss.
c. The interest is computed as discount rate applied to beginning amount of
effect of asset ceiling. This discount rate is the same as the one used in
computing the amount of net interest expense (income) in defined benefit
obligation and plan assets.
These rules are summarized as follows:
Gain or loss, netof | Interest Income or

Scenario related interest Expense _
Increase in effect of asset ceiling | Remeasurement loss Interest expense
Decrease in effect of asset ceiling | Remeasurement gain Interest income
It should be noted that the amount of interest income or expense is included in the
computation of net interest expense (income) on net retirement liability
(asset). Incorporating these new amounts, the revised computation to be
recognized in profit or loss and other comprehensive income is as follows:

Interest expense on asset ceiling (if any) XX
Interest income on asset ceiling (if any) ___ (xx)

Actuarial losses on defined benefit obligation Pxx
Remeasurement loss on plan assets XX
Remeasurement loss on asset ceiling (if any) XX

Remeasurement gains on plan assets (xx)
Remeasurement gains on asset ceiling (if any) (xx
Illustration 10. DIVINA Company reported the following partial information for
the last three years:
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2022 2023 2024

Defined benefit obligation, 12/31 P7,500,000 8,200,000 P9,700,000
Plan assets, 12/31 8,000,000 9,200,000 11,000,000
Service costs 700,000 400,000 500,000
Netinterest income before asset ceiling 50,000 100,000 130,000
Net actuarial losses before asset ceiling 350,000 250,000 420,000
Remeasurement gains (losses) on plan
assets 120,000 150,000 (180,000)
The asset ceiling is P600,000. Assume a steady discount rate of 10% for three years.
Required: Determine the amounts to be recognized as interest and remeasurement
gains or losses for each year using only the concepts on the effect of asset ceiling.
Answer:
4. First, compute for the amount of the surplus of plan assets over the defined
benefit obligation for each year:
2022 2023 2024
Plan assets P8,000,000 P9,200,000 P11,000,000
Less: Defined benefit obligation (7,500,000) (8,200,000) (9,700,000)
Surplus P500,000 1,000,000 P1,300,000
2. Next, compare these surplus amounts with the asset ceiling of P600,000 to
compute the effect of asset ceiling as of December 31 of each year:
2022 2023 2024
[A] Surplus P500,000 P1,000,000 P1,300,000
Asset ceiling 600,000 600,000 600,000
[B] Lower 500,000 600,000 600,000
Effect of asset ceiling [A] - [B] None P400,000 P700,000
There is no effect of asset ceiling for 2022 since the surplus of plan assets does
not exceed the asset ceiling. As a result, there will be no accounting
consequences for asset ceiling during this year.
3. Next, compute for the change in the effect of asset ceiling by comparing the
previous year’s amount with the current year’s amount. After this, the amounts of
interest and remeasurement gains or losses for the asset ceiling can now be
2022 2023 2024
Effect of asset ceiling, end P- P400,000 P700,000
Less: Effect of asset ceiling, beg - - _ (400,000)
Increase in the effect of asset ceiling — P- P400,000 300,000
Less: Interest expense on asset ceiling - - __*(40,000)
Remeasurement loss in OCI — P400,000 P260,000
*P40,000 = P400,000 beginning effect of asset ceiling x 10%.
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For the years 2023 and 2024, there are increases in the effect of asset ceiling.
However, interest expense is recognized only for 2024 since there is no
beginning balance on the effect of asset ceiling during 2023.
4, Incorporating the amounts computed in step (3), the total amounts to be
reported in profit or loss and in other comprehensive income are the following:
2022 2023
Service costs P700,000 P400,000
Net interest income (before
asset ceiling) (50,000) (100,000)
Interest expense on asset ceiling ~ is
Net retirement cost recognized
in profit or loss P650,000 P300,000
On the other hand, net amounts recognized in other comprehensive income are
the following:
2022 2023
Net actuarial losses P350,000 P250,000
Add: Remeasurement losses on
plan assets
Remeasurement losses on
asset ceiling 400,000
Less: Remeasurement gain on
plan assets (120,000) (150,000)
Net retirement cost recognized
in other compre. income P230,000 P500,000
The readers should take note that the asset ceiling does not affect the
computation of the individual ending balances of defined benefit obligation and
plan assets. However, as previously mentioned, it limits the reported amount of net
retirement asset.
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CHAPTER SUMMARY
1. Post-employment benefits are given to employees after their employment with an
entity has been completed.
2. According to Republic Act No. 7641, the minimum amount of retirement benefit is
equivalent to 22.50 days of compensation.
3. Post-employment benefit plans are classified to defined contribution plan and
defined benefit plan.
4. Accounting for defined contribution plan is fairly simple since the employer entity's
obligation is limited to its contributions to the retirement fund. As such, both the
actuarial risk and the investment risk are shouldered by the employees.
5. Accounting for defined benefit plans is complicated since the employer entity is
required to provide the promised benefit to its employees, regardless of the fund’s
performance. As such, both the actuarial risk and investment risk are shouldered by
the employer entity.
6. Accounting for defined benefit plans involve the simultaneous accounting for
defined benefit obligation and plan assets.
7. In determining its defined benefit obligation, the employer entity shall use the
projected unit credit method.
8. Actuarial assumptions are classified into demographic assumptions and financial
assumptions. These assumptions shall be unbiased and mutually compatible.
9. The discount rate used in discounting the retirement benefits shall be determined
by the following hierarchy (both as at the end of the reporting period):
a. First, reference to the market yields of high-quality corporate bonds.
b. Otherwise, reference to the market yields on government bonds.
10. The following transactions affect the balance of defined benefit obligation:
Beginning defined benefit obligation Pxx
Add: Interest expense (discount rate x beg. defined benefit obligation) XX
Current and past service costs XX
Actuarial losses XX
Less: Benefits paid to retirees in accordance with retirement plan (xx)
Settled benefits (immediate or premature settlements) (xx)
Actuarial gains (xx)
Ending defined benefit obligation Pxx
11.Current service cost represents the increase in the present value of defined benefit
obligation resulting from employee service in the current year, while past service
cost arise from employee service from prior periods.
12. Interest expense is based on the discount rate determined as of the beginning of the
current period (equivalent to the end of the previous period),
13.Actuarial gains and losses arise from both the experience adjustments and changes
in actuarial assumptions.
14. The plan assets are measured at their fair values. The transactions affecting the plan
assets’ ending balance are the following:
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Beginning plan assets Pxx

Add: Actual return (fund income > fund expenses) XX
Contributions to the plan assets XX
Less: Actual loss (fund incame < fund expenses) (xx)
Amount of benefits paid to retirees (xx)
Settlement price of settled benefits (xx)
Ending plan assets Pxx
15.The amount to be reported in the statement of financial position is the net amount
between the defined benefit obligation and plan assets.
16. There is a net retirement liability if defined benefit obligation > plan assets while
there is a net retirement asset if defined benefit obligation < plan assets.
17. If the economic benefits from the plan assets are subject to an asset ceiling, it shall
be measured at the lower of the surplus of plan assets and the amount of asset
ceiling.
18. After considering the defined benefit obligation and plan assets, the total retirement
cost is comprised of the following:
Interest expense on asset ceiling (if any) xx
Loss on settlement (if loss) xX
Interest income on asset ceiling (if any) (xx)
Actuarial losses on defined benefit obligation Pxx
Remeasurement loss on plan assets XX
Remeasurement loss on asset ceiling (if any) XX
Remeasurement gains on plan assets (xx)
Remeasurement gains on asset ceiling (if any) (xx)
19.The remeasurement gain or loss on plan assets is equal to the difference between
the amount of actual return and interest income.
20.Interest income is based on the same discount rate as used in the computation of
interest expense.
21. Interest income or expense on asset ceiling is equal to the beginning effect of the asset
ceiling x the discount rate as used in the computation of interest expense.
22. Effect of the asset ceiling is the difference between the higher surplus of plan assets
and the asset ceiling.
23.Remeasurement gain or loss on asset ceiling is the difference between the change in
effect of asset ceiling and the interest income or expense on asset ceiling.
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True or False
i. According to Republic Act No. 7641, the minimum amount of retirement benefits is
equal to one-half month salary for every month of service.
2 One-half month salary is equivalent to 15 days of compensation.
3. In a defined contribution plan, the amounts to be paid to retirees shall be at least
equal to the amount of the pre-determined level of benefits.
The actuarial risk and investment risk are both shouldered by the employer entity
in a defined benefit plan.
Defined benefit plan is more common than defined contribution plan.
no
In a defined contribution plan, if the amount paid is lower than the required
contributions, the employer entity shall recognize a prepaid asset.
The total retirement cost in a defined benefit plan is equal to the amount of actual
contributions to the plan asset.
Service costs have an increasing effect to the balance of the defined benefit
obligation.
The defined benefit obligation shall be based on the future amounts of employees’
salaries.
10. Interest expense shall be determined based on the discount rate determined as of
the end of the previous period.
11. Actuarial gains have increasing effect to the balance of the defined benefit
obligation.
12. Actuarial assumptions shall be both unbiased and mutually incompatible.
13. The present value of settled retirement benefits shall be deducted from the balance
of plan assets, while the settlement price shall be deducted from the balance of
defined benefit obligation.
14. There is a remeasurement gain from plan assets if the amount of actual return is
higher than the amount of interest income.
15. Contributions to the plan assets shall be recognized as part of total retirement cost.

1. The following are the components of the minimum retirement benefit under
Republic Act No. 7641, except
a. 15 days salary based on salary rate at the time the employee was hired.
b. Cash equivalent of not more than 5 days of service incentive leaves
c. 1/12 of 13" month pay
2. Defined contribution plans and defined benefit plans have the following correct
differences, except
Under the defined contribution plan, the entity is only required to contribute
fixed amounts to the retirement fund, while under the defined benefit plan, the
entity is required to provide the promised benefits, no matter what happens.
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b. Under the defined contribution plan, investment risk and actuarial risk are both
shouldered by the employer entity, while in defined benefit plan, these risks are
shouldered by employees.
c. Defined contribution plan is less common than the defined benefit plan.
d. Under the defined contribution plan, the amount of benefit that the employees
will receive depends on the fund’s performance, while under the defined benefit
plan, the promised benefits shall be given, regardless of the fund's performance.
3. This is the risk that the amounts of retirement benefits are less than anticipated
a. Investment risk
b. Retirement benefit risk
c. Creditrisk
d. Actuarial risk
4. This is the risk that the amounts of contributions and returns are not sufficient to
pay the expected benefits
a. Investment risk
b. Retirement benefit risk
c. Expected benefit risk
d. Actuarial risk
5. The following are the correct accounting procedures for defined contribution plan,
except
a. The amount of retirement cost is generally recognized as expense.
b. If the amount of actual contributions is higher than the retirement cost, the
employer entity shall recognize a prepaid asset.
c. The amount of retirement cost is equal to the amount of actual contributions.
6. Accounting for defined benefit obligation have the following characteristics, except
a. The defined benefit obligation is based on the present value of estimated future
post-employment payments to employees.
b. Actuarial assumptions and estimates shall be made to be able to measure the
defined benefit obligation amid the uncertainties.
c. Changes in assumptions and estimates will result to the recognition of actuarial
gains and losses.
d. The amount of retirement cost is equal to the payment to retirees or the
settlement price paid in immediately settling post-employment benefits.
7. The actuarial valuation method to be used in estimating the defined benefit
obligation is called the
a. Expected unit credit method
b. Projected unit credit method
c. Incurred unit credit method
d. Actual unit credit method
8. Demographic assumptions include the following, except
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Early retirement
eof Claim rates under medical plans
Employee turnover
Discount rate
9, Financial assumptions include the following, except

a. Employee mortality
b. Future salary amounts
c Future benefit costs
d. Claim handling costs
10. Discount rate to be used in discounting the retirement benefits shall be equal to
a. by reference to the market yields of high-quality corporate bonds as at the end
of the reporting period.
b. by reference to the market yields on government bonds as at the end of the
reporting period. ,
c. first, by reference to market yields on government bonds; otherwise, by
reference to market yields of high-quality corporate bonds, both as at the end of
the reporting period.
first, by reference to market yields of high-quality corporate bonds; otherwise,
by reference to market yields on government bonds, both as at the end of the
reporting period.
11. Service costs are comprised of the following, except

a. Gain or loss on settlement
b. Actuarial losses
Cc. Past service cost
d. Current service cost
12. Interest expense from the defined benefit obligation shall be equal to
a. Beginning defined benefit obligation multiplied by the discount rate determined
as of the end of the current period.
b. Ending defined benefit obligation multiplied by the discount rate determined as
of the end of the current period.
Beginning defined benefit obligation multiplied by the discount rate determined
as of the beginning of the current period.
Ending defined benefit obligation multiplied by the discount rate determined as
of the beginning of the current period.
13. The following statements are true regarding actuarial gains and losses, except
a. These arise from changes in actuarial assumptions
b. These arise from the effects of differences between the previous actuarial
assumptions and what has actually occurred.
There is an actuarial gain if it resulted to an increase in defined benefit
obligation.
Both actuarial gain and loss are recognized in the employer entity’s other
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14. The following correctly indicate the effect of each transaction to the balance of plan
assets, except
a. Actual return increases the plan assets equal to the excess of fund income over
the fund expenses.
b. The settlement of benefits decreases the plan assets equal to the present value
of the settled benefits.
c. Contributions to the plan assets increase the plan assets equal to the amount of
contributions
d. Gain or loss on settlement has no effect to the balance of plan assets.
15. Remeasurement gains and losses from plan assets are determined as follows, except
a. There isa remeasurement gain if the amount of actual return is higher than the
amount of interest income.
b. There is a remeasurement loss if the amount of actual return is lower than the
c. Interest income from plan assets shall be based on the same discount rate used
in determining the interest expense on the related defined benefit obligation.
d. There is a remeasurement gain if the amount of actual loss is higher than the
16. The following components of total:retirement cost are recognized in profit or loss,
except
a. Payments to retirees
b. Interest expense from defined benefit obligation
c. Gainon settlement
d. Current service cost
17.Amounts recognized in employer entity’s OCI are the following, except

a. Remeasurement gain or loss from plan assets
b. Contributions or withdrawals from plan assets
c. Actuarial gain or loss from defined benefit obligation
d. Remeasurement gain or loss from the effect of the asset ceiling
Straight Problems
1. On January 1, 2023, at the age of 45 years old, SONIA was hired as one of the
department managers in ABC Company. SONIA’s starting salary with the Company
was P100,000 per month and it is expected that this will increase to P180,000 by the
time of her retirement at 65 years old. As part of the Company's policy, retirees will
receive on their retirement date one month salary based on their final salary for
every year of service to the Company. Relevant discount rate is 7% for all of the years
involved.

a. Current service cost from 2023 to 2025
b. Interest expense from 2023 to 2025
c. Ending defined benefit liability as of the end of 2023 to 2025 for SONIA
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The
ter 12A - Post-Employment Benefits
cha
_ BERNARDO was hired last January 1, 2023 wh n he was 50 years old. His starting
2 salary with XYZ Company amounted to P200,00 0 and is expected to increase by
every year, Starting in 2024. He is expected to retire upon 2%
reaching the age of 65
ears. As part of the Company’s policy, retirees will receive
on their retirement date
one month salary based on their final salary for ever i
Relevant discount rate is 8% for all of the years ievalveal Caer ee
Required: From the given informat ion, determine the following:

3, current serv ice cost from to 2025
2023to 2025
expense from
Interest 2023
pb.
c. Ending defined benefit liability as of the end of 2023 to 2025 for BERNARDO
’ On January 1, 2023, PANGASINAN Company had a beginning projected benefit
obligation of P6,000,000. As of the same date, the relevant discount rate is 9%.
During the year, current service cost and past service cost amounted to P800,000
and P200,000, respectively. In addition, the Company paid P700,000 to retirees and
paid settlement price of P360,000 for a retirement obligation with present value of
345,000.
Fast forward to December 31, 2023, actuarial gain from experience adjustments
amounted to P120,000, actuarial loss from changes in demographic assumptions
amounted to P200,000, and actuarial gain from changes in financial assumptions
amounted to P270,000. Relevant discount rate as of the same date is 8%.

a. Interest expense for the year 2023.
2023
b. Balance of the projected benefit obligation as of December 31,
c. Total retirement costs to be recognized in 2023 profit or loss
e income
d. Total retirement costs to be recognized in 2023 other comprehensiv
reported its defined benefit obligation with balance of
. ZAMBALES Company
provided:
P5,400,000. In addition, the following data were also
7%
Discount rate, January 1, 2023
8%
Discount rate, December 31, 2023
P1,200,000
Payments to retirees, April 1, 2023
Settlement price paid, July 1, 2023 840,000
900,000
Carrying amount of settled benefits, July 1, 2023
330,000
Past service cost
500,000
Current service cost
Sy
Actuarial loss from experience adjustments aerate
Actuarial gain from changes in demographic assumptions
ptions
Actuarial loss from changes in financial a ssum
rmine th e following:
Required: From the given information, dete
a. Interest expense for the year 2023.
cember 31, 2023
Balance of the projected benefit obliga tion as of De
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c. Total retirement costs to be recognized in 2023 profit or loss

d. Total retirement costs to be recognized in 2023 other comprehensive income
5. On January 1, 2023, TARLAC Company had plan assets with total fair value of
P4,500,000. During the year, the Company contributed P1,400,000 to the fund and
paid P800,000 to the retirees. In addition, the Company settled benefits with
carrying amount of P500,000 by paying P420,000 to the relevant employees. Fund
income amounted to P1,000,000, while fund expenses amounted to P400,000.
Discount rate and expected rate of return for the year were 6% and 8%, respectively.
a. Interestincome for the year 2023.
b. Balance of the plan assets as of December 31, 2023
c. Remeasurement gain or loss for the year 2023
6. During the year 2023, PAMPANGA Company had the following information:
Discount rate 6%
Expected rate of return 7%
Plan assets, beginning balance P7,500,000
Actual return 210,000
Contributions, July 1, 2023 1,000,000
Payments to retirees, October 1, 2023 400,000
Price paid in settling benefits with carrying
amount of P800,000, March 31, 2023 900,000

a. Interest income for the year 2023.
b. Balance of the plan assets as of December 31, 2023
c. Remeasurement gain or loss for the year 2023
7. ECIJA Company, on January 1, 2023 had defined benefit obligation of P7,000,000 and
plan assets of P6,000,000. During the year 2023, the following events occurred
which may be relevant in accounting for the Company's post-employment benefits:
Current service cost P1,000,000
Payments to retirees 900,000
Amount paid to settled benefits 450,000
Carrying amount of settled benefits ‘500,000
Contributions to the fund 800,000
Actual return from plan assets 420,000
Net actuarial loss 600,000
Discount rate, January 1, 2023 5%
Discount rate, December 31, 2023 6%
Expected rate of return from plan assets 7%
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The

a. Balances of defined benefit obligation and plan assets as of December 31, 2023.
b. Total retirement cost to be recognized in 2023 profit or loss.
Cc Total retirement cost to be recognized in 2023 other comprehensive income.
d, Journal entry to recognize the relevant transactions on December 31, 2023.
g. BULACAN Company had the following information related to its post-employment

benefit plan:
Plan assets, January 1, 2023 P7,900,000

Defined benefit obligation, January 1, 2023 9,400,000
Contribution to plan assets 1,000,000
Payment to retirees 1,200,000
Contribution to plan assets 800,000
Current service cost 1,500,000
Actuarial loss from experience adjustments 300,000
Actuarial loss from changes in financial assumptions 500,000
Actuarial gain from changes in demographic assumptions 250,000
Discount rate, January 1, 2023 6%
Discount rate, December 31, 2023 8%
Expected return from plan assets 7%
a. Balances of defined benefit obligation and plan assets as of December 31, 2023.
b. Total retirement cost to be recognized in 2023 profit or loss.
G. Total retirement cost to be recognized in 2023 other comprehensive income.
d. Journal entry to recognize the relevant transactions
on December 31, 2023.
9. On January 1, 2023, AURORA Company had plan assets and defined benefit
obligation of P8,000,000 and P10,000,000, respectively.
During the year 2023, the following transactions have occurred:

Contributions to the plan assets P1,600,000
Current service cost 1,300,000
Payments to settled benefits 430,000
Carrying amount of settled benefits 400,000
During the year 2024, the following transactions have occurred:
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The
Chapter 12A —- Post-Employment Benefits

Past service cost
Actual return from plan assets
Payments toretirees _
Payments to settled benefits
Carrying amount of settled benefits
Net actuarial gain
Discount rates were 7%, 8% and 9% as of January 1, 2023, December 31, 2023, and
December 31, 2024

a. Balances of defined benefit obligation and plan assets as of December 31, 2023
and 2024.
b. Total retirement cost to be recognized in 2023 and 2024 profit or loss.
c. Total retirement cost to be recognized in 2023 and 2024 OCI.
d. Journal entries to recognize the relevant transactions on December 31, 2023
and 2024.
10. At the beginning of the year 2023, BENGUET Company had plan assets and defined
benefit obligation if P8,000,000 and P6,000,000, respectively. The Company is
always subject to P1,200,000 asset ceiling. During the year 2023, the following
transactions related to the Company’s post-employment benefit plan have occurred:
Payments to retirees
Actual return from plan assets
Past service cost
Contributions to the plan assets
Payments to settled benefits
Carrying amount of settled benefits
Net actuarial loss
Discount rate and expected rate of return were 10% and 9%, respectively.
Net interest income or expense for the year 2023.
op
Balances of defined benefit obligation and plan assets as of December 31, 2023.
Total retirement cost to be recognized in 2023 profit or loss.
Total retirement cost to be recognized in 2023 other comprehensive income.
pao
Journal entry to recognize the relevant transactions on December 31, 2023.
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1. BATAAN Company’s retirement benefit plan had the following information for the
year 2023:
The defined benefit obligation had a beginning balance of P5,600,000. Discount rate
as of the beginning of the period was 7%. During the year, payments to retirees
amounted to P600,000, while payments to settle retirement benefit with carrying
amount of P200,000 amounted to P300,000. Current service cost and past service
costamounted to P470,000 and P180,000, respectively. Net actuarial loss amounted
to P350,000. Discount rate as of the end of the period was 8%.
Plan assets had a beginning balance of P4,000,000. Contributions to the plan
amounted to P700,000, while actual return amounted to P560,000, even though
expected rate of return from plan assets was only 10%.
The ending balance of defined benefit obligation as of December 31, 2023 shall be
a. P5,800,000 c. P6,248,000
b. P6,192,000 d. P6,148,000
The ending balance of plan assets as of December 31, 2023 shall be
a. P5,260,000 c. P4,360,000
b. P4,660,000 d. P4,460,000
Net retirement cost to be recognized for the 2023 profit or loss shall be
a. P878,000 c. P762,000
b. P662,000 d. P862,000
Net retirement cost to be recognized for the 2023 OCI shall be

a. P350,000 c. P190,000
b. P70,000 d. P110,000
2. On January 1, 2023, RIZAL Company reported balances in its defined benefit

obligation and plan assets of P7,000,000 and P5,000,000, respectively. For the year
2023, the following transactions affecting the Company’s retirement plan are the
following:
Past service cost P480,000
Actuarial gain from experience adjustments 180,000
Actuarial loss from changes in actuarial assumptions 650,000
Contributions to plan assets, May 1, 2023 1,200,000
Payment to a retiree, July 1, 2023 500,000
Payment to a retiree, November 1, 2023 600,000
Actual return from the plan assets 720,000
Discount rate 10%
Expected return on plan assets 12%
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Interest expense from defined benefit obligation for the year 2023 shall be
a. P700,000 c. P840,000
b. P665,000 d. P798,000
Interest income from plan assets for the year 2023 shall be
a. P654,000 c. P545,000
b. P500,000 d. P600,000
Balance of the defined benefit obligation as of December 31, 2023 shall be
a. P8,450,000 c, P8,365,000
b. P8,145,000 d. P8,400,000
Balance of the plan assets as of December 31, 2023 shall be

a. P5,820,000 c. P5,970,000
b. P6,365,000 d. P6,585,000
Total retirement cost to be recognized in the Company's total comprehensive income

for the year 2023 shall be
a. P1,780,000 c. P1,790,000
b. P1,745,000 d. P1,755,000
3. LAGUNA Company had the following transactions from 2023 to 2024 elated to its
retirement benefit plan:
2023 2024
Plan assets, January 1 P7,000,000 22?
Defined benefit obligation, January 1 9,500,000 22?
Discount rate, January 1 7% 6%
Current service cost 1,200,000 1,100,000
Past service cost 250,000 350,000
Contributions to the fund 1,600,000 1,800,000
Payments to retirees 960,000 750,000
Payment to settled benefits 380,000 420,000
Carrying amount of settled benefits 320,000 470,000
Actuarial gain (loss) from experience adjustments (750,000) 220,000
Actuarial gain (loss) from changes in assumptions 160,000 (550,000)
Actual return from plan assets 680,000 320,000
Net retirement cost to be recognized in 2023 profit or loss shall be
a. P1,685,000 c. P2,125,000
b. P1,565,000 . d. P2,425,000
Net retirement cost to be recognized in 2023 OCI shall be

a. P590,000 net gain c. P400,000 net gain
b. P590,000 net loss d. P400,000 net loss
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a. P10,565,000 c. P10,865,000
b. P10,485,000 d. P10,925,000

a. 7,940,000 c. P7,860,000
b. P8,000,000 d. P7,750,000
Total retirement cost to be recognized in 2024 profit or loss shall be

a. P1,759,100 c. P1,579,100
b. P1,859,100 d. P1,679,100
Total retirement cost to be recognized in 2024 OCI shall be

b. P486,400 net loss d. P173,600 net loss

a. P12,076,900 c. P11,674,100
b. P12,140,500 d. P12,190,500

a. P8,890,000 c. P8,950,000
b. P8,810,000 d. P8,840,000
4. On January 1, 2023, CAVITE Company had plan assets with balance of P9,000,000
and defined benefit obligation of P8,200,000. As of the same date, asset ceiling
amounted to P500,000. During the year 2023, the Company had the following
transactions:

Actual return from plan assets 1,200,000
Payments to settled benefits 150,000
Carrying amount of settled benefits 200,000
At the end of 2023, asset ceiling has increased to P800,000. Relevant discount rate
is 9%,
Total retirement cost to be recognized in 2023 profit or loss shall be
a. P1,055,000 c. P1,028,000
b. P1,155,000 d. P1,128,000
Total retirement cost to be recognized in 2023 OCI shall be
b. P211,000 net loss d, P145,000 net loss
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The

a. P8,896,000 ; c. P8,762,000
b. P9,550,000 d. P9,500,000
a. P11,000,000 c. P11,540,000
b. P11,120,000 d. P10,950,000
5. On January 1, 2023, BATANGAS Company had plan assets with balance of
P6,400,000. During the year 2023, the Company paid P800,000 to retirees and paid
P300,000 to settled benefits with carrying amount of P360,000. Actual return from
the plan assets amounted to P500,000. By the end of 2023, the plan assets had
balance of P6,700,000.
From the given information, determine the amount of contributions made

a. P1,020,000 c. P840,000
b. P960,000 d. P900,000
6. QUEZON Company had a beginning defined benefit obligation of P7,500,000. During

the year, current and past service costs amounted to P870,000 and P210,000,
respectively. Payments to retirees amounted to P500,000, while settlement of some
benefits resulted to a loss on settlement of P75,000. Actuarial loss amounted to
P330,000. Relevant discount rate is 8%. At the end of the current year, the defined
benefit obligation had a balance of P8,610,000.
From the given information, determine the carrying amount of settled benefits
a. P400,000 c. P1,060,000
b. P1,000,000 d. P1,420,000
From the given information, determine the amount paid to the settled benefits
a. P325,000 c. P925,000
b. P1,075,000 d. P475,000
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Chapter 13 — Accounting for Income Taxes
CHAPTER 13
ACCOUNTING FOR INCOME TAXES

1. The difference between the accounting income and taxable income including
how they are determined.
2. The high-level idea on the taxation system in the Philippines.
3. The types of differences between the amount of accounting income and taxable
income.
4. The computation of total tax expense and its components.
5. The subsequent accounting for deferred taxes using the balance sheet approach
and the income statement approach.
6. The recognition of income taxes outside profit or loss.
7. The accounting for net operating loss carryover and changes in tax rates.
ACCOUNTING FOR INCOME TAX

Income taxes are one of the costs of doing business in almost all jurisdictions. As its
namesake, these are taxes based on the level of income earned by an entity. These
amounts are “enforced contributions” (i.e., involuntary) used for the functioning of
the government in providing public services.
So, how to compute for the amount of income tax due on the net income of an entity?
First, it is important to distinguish the following terminologies:

a. Accounting income - net income before tax for financial reporting purposes,
and determined using the rules in accounting (i.e., revenues are recognized when
earned and expenses are recognized when incurred).
b. Taxable income - determined using the rules laid down by the taxation
authority (i.e., from the legislative branch of the government).
In a perfect world, where the rules in determining accounting income and the
taxable income are the same (i.e., equal amounts of accounting income and
taxable income), the amount of income tax expense = ACCOUNTING INCOME times
the INCOME TAX RATE.
For example, an entity has a net income before tax of P1,500,000 in its accounting
records, while the relevant income tax rate is 25%. In this case, income tax expense
is P375,000 (P1,500,000 x 25% income tax rate).
As ideal this scenario might be, this is not always the case. The amounts of
accounting income and taxable income are rarely equal in this actual and
imperfect world. The changes in the accounting rules are not necessarily at the
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The
Chapter 13 - Accounting for Income Taxes
same pace as the changes in taxation rules. There are times that drastic changes
were made in the accounting rules by issuing new accounting standards, but no
similar changes were made to taxation rules, and vice versa.
To understand the sources of these differences, it is important to know first the
details of determining the amounts of accounting income and taxable income.
DETERMINING THE ACCOUNTING INCOME

The amount of accounting income is determined by applying the concepts discussed
in the accounting subjects encountered in college such as, but are not limited to,
Financial Accounting and Reporting, Intermediate Accounting, Advanced
’ Accounting and Cost Accounting. These subjects utilize the rules provided by the
following:
a. Philippine Financial Reporting Standards or PFRSs (based on International
Financial Reporting Standards or IFRSs, including interpretations from
International Financial Reporting Interpretations Committee or IFRIC);
PFRSs for Small and Medium Enterprises;
reals
PFRSs for Small Entities;

Philippine Interpretations Committee (PIC) Q&As; and
Any other generally accepted accounting principles in the country.
The accounting standard covering the accounting for income taxes is PAS 12,
Income Taxes.
DETERMINING THE TAXABLE INCOME

In the Philippines, determining the amount of taxable income will utilize the
provisions set by the following:
a. the National Internal Revenue Code (NIRC), as amended
b. issuances by the Bureau of Internal Revenue (BIR) (e.g., revenue regulations,
revenue memorandum circulars, etc.); and
c. provisions of other relevant laws and regulations
As the readers may have noted, the sources of rules in determining the amount of
accounting income are different from the sources of rules in determining the amount
of taxable income. Consequently, the amounts of accounting income and taxable
income cannot be expected to be equal to each other.
PRIMER ON PHILIPPINE INCOME TAXATION

An item of income is either exempt from taxation (non-taxable) or subject to
taxation (taxable). In the Philippines, items of taxable income are subject to one of
the following: final withholding income tax, capital gains tax, or the regular income
tax. More details on this topic will be discussed in the Income Taxation subject.
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Item of Income.
Yes
' No
Taxable?
Income is subject to only one of the ff.: Income is not subject

a. Final withholding income tax to tax (has no current
b. Capital gains tax or future tax
c. Regular income tax consequences)
The above tax schemes can be summarized as follows:
Schemes Description
Generally, items of passive income are subject to this kind of tax. Items of
passive income include, but are not limited to, interest income from bank
deposits, interest income from government securities, dividend income,
prizes and royalties.
Final
with- The entity who earned these items of income will receive amounts that are
holding net of the related final tax since the income payor has already withheld the
tax related amount of tax. As a result, the readers are advised to ascertain
(FWT) whether the given amount of income is still the gross amount or already
net of tax.
Depending on the circumstances, the rate of the final tax is from 4.50%
and up to 25%.
There are two items of income that are subject to this kind of income tax:
e Difference between the (a) net proceeds from the sale of investment
Capital
in domestic equity securities directly to the buyer and (b) the original
gains tax
cost of the investment. Related tax rate is 15%.
(CGT) e Selling price of real property (land and/or building) classified as
capital asset for taxation purposes. Related tax rate is 6%.
Items of taxable income that are not subjected to either the final
withholding tax or capital gains tax. This is the “catch all” income tax
Regular applied to all other income. Current tax rates are 20% or 25%.
income
tax In the absence of items of income subject to either final withholding tax
or capital gains tax, the amount of “income subject to regular income tax”
is synonymous to “taxable income”.
For the rest of the chapter, a considerable amount of discussions will revolve
around regular income tax.
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The computation of regular income tax has the following general form:
Gross income (excluding those subjected to FWT and CGT) Pxx
Less: Allowable deductions (analogous to operating expenses) XX
Taxable income Pxx
Multiply by: Regular income tax rate %
Regular income tax expense Pxx
The amount of gross income is normally the amount of net revenue less the amount
of direct costs (e.g., cost of goods sold for merchandising or manufacturing entities),
However, the amount of gross taxable income is not necessarily the same with the
amount of accounting gross profit because there might be differences between the
accounting rules and the taxation rules.
Similarly, the amount of allowable deductions is somewhat analogous to operating
expenses in accounting. However, there are also differences between accounting
rules and taxation rules with regards to the computations of operating expenses and
allowable deductions, respectively.
As to the regular income tax rate, currently, a tax table is used for individual
taxpayers, while for corporate taxpayers, a single flat rate of either 20% or 25% is
used. For the rest of the chapter, the focus will be on the corporate taxpayers.
DIFFERENCES BETWEEN ACCOUNTING INCOME AND TAXABLE INCOME

These differences can be generally categorized into the following:
1. Permanent differences - differences that do not have any current and/or future
tax consequences. Examples of these include, but are not limited to the following:
a. Income not subject and will never be subject to income tax.
b. Recognized operating expenses as per accounting rules that can never be
considered as allowable deductions in computing taxable income.
2. Temporary differences - these differences normally arise from timing

differences that will have future tax consequences. Examples of these differences
include, but are not limited to, the following:
a. An item of income that was accrued in accounting but will only be taxable
when actually received.
b. Unearned income amounts received from customers are taxable during the
period of receipt but will be recognized as income in accounting only when
earned,
c. An item of expense that was already accrued and included in the operating
expenses to determine the accounting income but will be allowed as a
deduction in determining taxable income only when actually paid.
d. An item of expense that was prepaid (i.e, not recognized as expense in
determining accounting income) but will be tax-deductible at the time of
payment.
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e. Differences in the amount of depreciation expense used in computing

accounting income and taxable income.
Details on the temporary differences will be discussed later in the chapter.
RECONCILING ACCOUNTING INCOME TO TAXABLE INCOME

The following is the general format in reconciling accounting income to taxable
income:
Accounting income Pxx
Add: Non-tax-deductible expenses (permanent difference) XX
Less: Non-taxable income (permanent difference) (xx)
Income subject to income tax Pxx
Less: Income subject to final withholding tax orcapita) gains tax (xx)
Income subject to regular income tax Pxx
Add or less: Temporary differences XX
Taxable income subject to regular income tax for thes current period | Pxx
The amount of “Income subject to regular tax” also includes the amounts that will
be subject to regular tax in the future periods.
Illustration 1. RIVERA Company reported net income before tax of P5,500,000 in

its income statement for the year 2023. Upon inspection, the Company recognized
income of P800,000 that is exempt from tax and included P1,200,000 non-
deductible expenses in its operating expenses. The Company also noted the
following temporary differences:
a. Advances received from customers amounting to P400,000 were recognized as
liability but taxable upon receipt.
b. Accrued income amounting to P600,000 will be taxable only upon actual receipt.
c. Prepaid insurance of P300,000 was paid on December 27, 2023. This insurance
covers the year 2024. According to taxation rules, the expenses are tax-
deductible when actually paid.
d. Depreciation expense deducted to arrive to accounting income amounted to
P1,250,000. However, tax-deductible depreciation expense amounted to
P1,500,000.
There were no items of income subject to final withholding tax nor capital gains tax.
Required: Determine the amount taxable income subject to regular income tax for
the year 2023.
In this case, the following reconciliation of accounting income to taxable income is
relevant:
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Net income in income statement (accounting income) P5,500,000

Add: Non-tax-deductible expenses (permanent difference) 1,200,000
Less: Non-taxable income (permanent difference) (800,000)_
___
Income subject to income tax P5,900,000
Temporary differences:
Add: Taxable advances from customers 400,000
Less: Accrued income that will be taxable only upon receipt (600,000)
Prepaid insurance that is tax-deductible when paid (300,000)
Excess tax depreciation (P1,500,000 - P1,250,000) (250,000)
Taxable income subject to regular income tax for 2023 P5,150,000
The readers should take note that in order to arrive at the amount of taxable
income, the accounting income shall be adjusted by following the taxation
rules. The tax treatments of temporary differences are explained as follows:
a. Advances from customers are not yet included in the accounting income but
these are already taxable; hence, they are added to arrive at the taxable income.
b. Accrued income is already included in the accounting income, but this will be
taxable only in the future periods; hence, it is deducted to arrive at the taxable
income. When this accrued income is received, then that is the time that it should
be included in the determination of taxable income.
c. Prepaid insurance is recorded as an asset of the Company (i.e., no expense was
recognized in accounting income from this transaction). However, this is
already tax-deductible; hence, it should be deducted as expense to arrive at the
taxable income.
d. Since the amount of depreciation expense already deducted from accounting
income is lower than the amount of tax depreciation, additional depreciation
expense shall be further deducted to arrive at the taxable income.
COMPONENTS OF TOTAL TAX EXPENSE

Total tax expense is composed current income tax and deferred income tax.
Details of their components and their corresponding basis are the following:
Current Basis
Final tax Pxx Income subject to final tax
Capital gains tax xx Income subject to capital gains tax
Regular income tax xx Taxable income for the current period
subject to regular tax
Deferred
Deferred tax expense xx Temporary differences
Deferred tax benefit (xx) Temporary differences
Total tax expense Pxx
The readers should take note that permanent differences do not have corresponding
tax expense since they do not have tax consequences.
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At the bottom portion of the income statement of an entity, the total tax expense is
presented as follows:
Net income before tax Pxx
Less: Total tax expense (xx)
Net income after tax Pxx
CURRENT INCOME TAX

Current income tax expense is named as such since this amount is related to items
of taxable income for the current period. In practice, this is also called the “income
tax expense”
Current tax is simply computed as the amount of taxable income times the
corresponding tax rate. However, for final withholding taxes, caution should be
given if the amount of income is already net of final tax. In those cases, the income
should be grossed-up before multiplying the corresponding tax rate.
To the extent that the current income tax is not yet paid, a corresponding income
tax payable shall be recognized. However, for final withholding taxes, no
liability shall be recognized as the amount received is already net of the
corresponding final tax (i.e., the tax has already been paid by the counterparty).
The following are the pro-forma entries related to current income tax:
a. To recognize current income tax:
Income tax expense XX
Income tax liability XX
b. To record the payment of current income tax:

Income tax liability XX
Cash XX
Illustration 2. For the year 2023, CASTRO Company reported P4,000,000 net
income before tax in its accounting records. Included in this amount is interest
received amounting to P160,000, net of 20% final tax. Non-taxable gain from the
proceeds of life insurance amounting to P1,000,000 was included in the accounting
income. Recognized operating expenses amounting to P450,000 are not tax
deductible. There were no other differences noted. Relevant regular income tax rate
is 25%. During the year, the Company paid P300,000 for its regular income tax,
Required: Determine the amount of (a) current income tax expense for 2023 and
(b) income tax payable as of December 31, 2023.
Answer:
a. First, reconcile the amount of accounting income to taxable income.
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Accounting income before tax P4,000,000

Add: Non-tax-deductible expenses 450,000
Less: Non-taxable gain on life insurance (1,000,000)
Income subject to income tax P3,450,000
Less: Income subject to final tax (160,000)
Taxable income subject to regular income tax P3,290,000
b. Next, apply the corresponding tax rates to the corresponding amount of income
to compute for the amount of current income tax:
Final tax expense P40,000 (P160,000/80%) x 20%
Regular income tax expense 822,500 P3,290,000x25%
Total current income tax expense P862,500
The readers should take note that P160,000 interest income is already net of
20% tax, so it was first grossed-up to P200,000 (i.e. the gross amount of
interest) before multiplying the 20% final tax.
c. Finally, compute for the income tax payable in the following manner:
Regular income tax P822,500
Less: Regular income tax paid (300,000)
Income tax payable P522,500
It should be highlighted that any amount of final tax is already remitted by the
income payor to the tax collection agency; hence, no amount of tax liability is
recognized for final tax.
TEMPORARY DIFFERENCES
According to PAS 12, temporary differences are differences between the carrying
amount of an asset or liability in the statement of financial position and its tax base.
Temporary differences may be either:
a. taxable temporary differences - will result in taxable amounts in
determining taxable profit (tax loss) of future periods when the carrying amount
of the asset or liability is recovered or settled; or
b. deductible temporary differences - will result in deductible amounts in
of the asset or liability is recovered or settled.
These temporary differences will result to the following amounts:
Temporary Corresponding Corresponding Income

differences Balance Sheet Amount Statement Amount
Taxable temporary Deferred tax liability
diffarentes (DTL) D eferred tax expense
Deductible temporary Deferred tax asset Deferred tax
differences (DTA) benefit/income
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These deferred tax amounts are named as such (“deferred”) as their tax
consequences wil happen in the ene and not ee the current perion
DETERMINING THE AMOUNT OF DEFERRED TAXES

When computing for the amount of deferred taxes, an entity can either use the
income statement approach or the balance sheet approach. However, PAS 12
prefers the use of the balance sheet approach. Nevertheless, in general (save for very
few exceptions), both approaches will result to the same deferred amounts.
Deferred taxes are measured by multiplying the amount of temporary
difference by the relevant tax rate (normally the regular income tax rate). The tax
rate is not necessarily the currently enacted rate but should be the tax rate that is
estimated to be applied during the period the deferred taxes are expected to
“reverse”, provided the new tax rate is substantially enacted as of the reporting
date. Changes in the tax rates are discussed later in the chapter.
However, the readers should take note that the full recognition of DTL is required,
but the DTA shall be recognized only up to the portion of the temporary differences
that are recoverable in the future (see the NOLCO section).
In addition, DTAs and DTLs shall never be discounted (i.e., shall be measured at
their gross amounts and not at present value amounts).
The usual practice in the Philippines is to present a net amount of DTL or DTA since
the income taxes are payable to only one taxation authority, the Bureau of Internal
Revenue (BIR). |1f DTL > DTA, it is said to be “net DTL”. If DTL < DTA, it is said to be
“net DTA”. Lastly, both the DTL and DTA are always considered non-current.
INCOME STATEMENT APPROACH

This approach is applicable only if the amounts of taxable income and accounting
income are provided. As such, the following accounting procedures are followed:
1. First, an entity shall compare the following amounts:
a. Accounting income subject to regular income tax; and
b. Taxable income for the current period
The amount of accounting income above excludes the effects of permanent
differences and the income subject to final tax or capital gains tax.
When comparing these amounts, the following can be summarized
Scenario ; Resulting Deferred Tax
Accounting income subject to regular income tax> | Not deferred tax expense
Taxable income for the current period
Accounting income subject to regular income tax<! Not deferred tax benefit
Taxable income for the current period
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In other words, any temporary difference that has the effect of increasing the
accounting income relative to the taxable income will result to deferred tax
liability and a corresponding deferred tax expense. On the other hand,
temporary difference that has the effect of decreasing the accounting income
relative to the taxable income will result to deferred tax asset and a
corresponding deferred tax benefit.
Next, the resulting deferred tax expense or benefit in the first step has the
following effects in the beginning balance of net DTL or net DTA to arrive at the
corresponding ending net DTL or net DTA.
Effectin Beg. Net DTL_ | Effectin Beg. Net DTA
Net deferred tax expense Added Deducted
Net deferred tax benefit _ Deducted Added
These can also be manifested in the following pro-forma journal entries:

a. If there is a net deferred tax expense: .
Deferred tax expense — net XX
Deferred tax liability - net XX
or
Deferred tax expense — net XX
Deferred tax asset — net XX
b. If there is a net deferred tax benefit:

Deferred tax liability - net XX
Deferred tax benefit - net XX
or
Deferred tax asset - net XX
Deferred tax benefit - net XX
Illustration 3. At the beginning of 2023, SANCHEZ Company reported a net DTL of

P400,000. During 2023, accounting income of P7,000,000 were reported. In
addition, the following differences between the accounting rules and tax rules were
noted:
a. Income of P750,000 is non-taxable.
b. Operating expenses of P450,000 are not deductible for tax purposes.
C. Recorded depreciation expense for the building amounted to P1,800,000.
However, related tax depreciation should be P1,500,000.
d. Accounting depreciation for the equipment amounted to P900,000,. However,
the related tax depreciation should be P1,150,000.
Estimated warranty expense amounted to P600,000. Actual warranty costs
amounted to P400,000. Warranty costs are tax-deductible when actually paid.
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f. Income of P1,000,000 were accrued in accounting records but will be taxable

only when actually received.
g. Advances from customers amounting to P350,000 were recorded as liability
but taxable upon receipt.
h. There were no items of income that are subject to final tax or capital gains tax.
Relevant regular income tax rate is 25%,
Required: From this information, determine the following amounts:
a. Current income tax expense
b. Net deferred tax expense or benefit
c. Ending net DTL or DTA
d. Breakdown of net deferred tax expense or benefit
e. Presentation of total tax expense
Answer:
1. First, reconcile the amount of accounting income to taxable income:
Add: Non-tax-deductible expenses (permanent difference) 450,000
Less: Non-taxable income (permanent difference) (750,000)
Income subject to [regular] income tax P6,700,000
Add: Excess accounting depreciation — building (P1.8M - P1.5M) 300,000
Excess accounting warranty expense (P600K - P400K) 200,000
Taxable advances from customers 350,000
Less: Excess tax depreciation - equipment (P1.15M - P900K) (250,000)
Accrued income not yet taxable in 2023 (1,000,000)
Taxable income for 2023 P6,300,000
From the computed taxable income of P6,300,000, the current income tax
expense can now be determined as P1,575,000 (P6,300,000
x 25%).
2. Since the amount of accounting income subject to income tax (P6,700,000) is

higher than the computed taxable income (P6,300,000), their net difference of
P400,000 is a “taxable temporary difference”. This will result to net deferred
tax expense of P100,000 (P400,000x 25%).
This can be recorded as follows:
Deferred tax expense, net 100,000

Deferred tax liability, net 100,000
After recording this entry, ending balance of net DTL is P500,000 (P400,000
beginning net DTL balance plus net deferred tax expense of P100,000).
3. The source (i.e., breakdown) of P100,000 net deferred tax expense is as follows:
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Deferred tax expense computation:

Excess tax depreciation - equipment (P1.15M - P900,000) 250,000
Accrued income not yet taxable in 2023 1,000,000
Taxable temporary difference P1,250,000
Multiply by: Regular income tax rate 25%
Deferred tax expense (increase in DTL) P312,500
The readers should take note that the temporary differences included in the
computation of deferred tax expense are those deducted from the accounting
income to arrive at the taxable income. These have the effect of increasing the
accounting income relative to taxable income.
Deferred tax benefit computation:
Excess accounting depreciation — building (P1.8M - P1.5M) 300,000
Excess accounting warranty expense (P600,000 - P400,000) 200,000
Taxable advances from customers 350,000
Deductible temporary difference P850,000
Deferred tax benefit (increase in DTA) P212,500
The readers should take note that the temporary differences included in the
computation of deferred tax benefit are those added to the accounting income
to arrive at the taxable income. These have the effect of increasing the taxable
income relative to accounting income.
The net deferred tax expense of P100,000 can now be computed as follows:
Deferred tax expense P312,500
Less: Deferred tax benefit (212,500)
Net deferred tax expense (netincreaseinDTL) P100,000
4, In the income statement of the Company, the following portion is presented:
Net income before tax (accounting income) P7,000,000

Less: Current income tax expense 1,575,000
Net deferred tax expense 100,000
Total tax expense (1,675,000)
Net income after tax P5,325,000
The readers should take note that the amount of total tax expense is equal to
the amount of income subject to regular income tax (i.e. excluding
permanent differences) multiplied by the regular income tax rate. In the
example, total tax expense of P5,325,000 can also be computed as follows:
P6,700,000 x 25%. Again, permanent differences do not have any tax
consequences.
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BALANCE SHEET APPROACH

To reiterate, this approach is followed in PAS 12. It has a big advantage over the
income statement approach that will be discussed later in this section. This is also
applicable if the tax base and the carrying amounts of the assets and liabilities are
determinable.
Under the balance sheet approach, the tax base of an asset or liability is
compared with the corresponding carrying amounts. According to PAS 12, tax
base is the amount attributed to that asset or liability for tax purposes.
Tax Base of an Asset
The tax base of an asset is the amount that will be deductible for tax purposes
against any taxable economic benefits that will flow to an entity when it recovers
the carrying amount of the asset. If those economic benefits will not be taxable,
the tax base of the asset is equal to its carrying amount. These principles can be
exemplified as follows:
a. Abuilding has a cost of P10,000,000 and carrying amount of P7,000,000. For tax
purposes, the cumulative amount of depreciation deducted from income totaled
P4,000,000. The tax base of the building is P6,000,000 (P10,000,000 - P4,000,000).
b. Aland has an original cost of P8,000,000, however, during the year, impairment
loss of P2,000,000 was recorded. In taxation, the amount of loss is deductible
only when realized (i.e., related asset has been sold). The tax base of the land is
P8,000,000.
c. Accrued interest receivable has carrying amount of P500,000. This amount is
taxable only upon receipt. The tax base of this asset is zero.
d. A note receivable has a carrying amount of P800,000. The receipt of repayment
from the debtor is not taxable. The tax base of the note receivable is P800,000.
Tax Base of a Liability
The tax base of a liability is its carrying amount less any amount that will be
deductible for tax purposes with respect to that liability in the future periods.
In the case of revenue received in advance, the tax base of the resulting liability is
its carrying amount less any amount of the revenue that will not be taxable in
future periods. These principles can be exemplified as follows:
a. Interest payable has a carrying amount of P600,000. This can only be deducted
for taxation purposes only when actually paid. The tax base of the liability is zero.
b. Estimated warranty expense is P700,000, while the actual warranty costs
amounted to P300,000. For tax purposes, warranty costs are deductible when
actually paid. The tax base of the liability is zero.
c. Accrued utilities has a carrying amount of P700,000. This has already been
deducted for tax purposes. The tax base of the liability is P700,000.
d. Advances from customers, a liability account, has a carrying amount of
P1,200,000. The receipt of these amounts is already taxable. The tax base of the
liability is zero.
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Application of Balance Sheet Approach

When applying this approach, an entity may use the following steps:
1. First, determine and compare the carrying amounts and tax bases of the assets
and liabilities. The results of this comparison are summarized as follows:
Scenarios | Resulting deferred tax amount.
Assets
Carrying amount > Tax base Deferred tax liability
Carrying amount < Tax base Deferred tax asset
Liabilities
Carrying amount > Tax base Deferred tax asset
Carrying amount < Tax base Deferred tax liability
Again, the amount of the difference between the carrying amount and the
tax base are multiplied with the regular income tax rate to obtain the
amounts of deferred tax liability or asset. The readers should take note that the
resulting deferred tax liabilities and assets are already the ending balances.
2. Next, compare the determined ending deferred tax liability or asset with the
corresponding beginning balances of deferred tax liability or asset. These changes
in the balances have the following effects in deferred tax expense or deferred tax
benefit/income:
Change. Deferred Tax Expense or Benefit
Increase in DTL Deferred tax expense
Decrease in DTL Deferred tax benefit
Increase in DTA Deferred tax benefit
Decrease in DTA Deferred tax expense
Based on the above table, the reader should take note that deferred tax liability
has a direct relationship with deferred tax expense and an inverse
relationship with deferred tax benefit.
On the other hand, deferred tax asset has a direct relationship with deferred
tax benefit and an inverse relationship with deferred tax asset.
Illustration 4. As of December 31, 2023, the carrying amounts of TORRES

Company's assets and liabilities equal their corresponding tax bases, except for the
following:
Carryingamount Tax base
FVTPL investments - debt securities P1,600,000 P1,100,000
Equipment 2,000,000 2,400,000
Building 5,000,000 4,000,000
Advances from customers 800,000 600,000
Estimated warranty liability 250,000 400,000
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Relevant tax rate is 25%. Beginning balances of deferred tax liability and asset
amounted to P300,000 and P90,000, respectively (net liability of P210,000).
Required: Determine the total amounts of deferred tax liability and deferred tax
asset as of December 31, 2023, and deferred tax expense and deferred tax benefit
for the year.
Answer:
1. First, determine the difference between the carrying amount and tax base of
each asset and liability:
Carrying
amount Tax base Differences
FVTPL investments - debt P1,600,000 P1,100,000 P500,000
Equipment 2,000,000 2,400,000 (400,000)
Building 5,000,000 4,000,000 1,000,000
Advances from customers 800,000 600,000 200,000
Estimated warranty liability 250,000 400,000 (150,000)
Based on the computations above, if the amount of difference is positive, carrying
amount> tax base. If the amount of difference is negative, carrying amount < tax base.
2. Next, determine which of the differences will give rise to taxable temporary
difference (deferred tax liability) or deductible temporary difference (deferred
tax asset), in absolute amounts:
Will Result To
Deferred Tax Deferred Tax
Differences Liability Asset
Assets:
FVTPL investments — debt P500,000 P500,000
Equipment (400,000) P400,000
Building 1,000,000 1,000,000
Liabilities:
Advances from customers 200,000 200,000
Estimated warranty liability (150,000) 150,000
P1,650,000 P600,000
Note: In the “Differences” column, if the amount is positive, carrying amount> tax base.
If the amount of difference is negative, carrying amount < tax base.
3. The amounts of deferred tax liability and asset are computed as follows:
Taxable temporary differences P 1,650,000

Multiply by: Tax rate 25%
Deferred tax liability, 12/31/23 P412,500
Less: Deferred tax liability, 1/1/23 300,000
Deferred tax expense, 2023 P112,500
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Deductible temporary differences P600,000

Multiply by: Tax rate 25%
Deferred tax asset, 12/31/23 P150,000
Less: Deferred tax asset, 1/1/23 90,000
Deferred tax benefit, 2023 P60,000
These changes in deferred taxes are recorded as follows:

Deferred tax expense 112,500
Deferred tax liability 112,500
Deferred tax asset 60,000

Deferred tax benefit 60,000
These deferred tax amounts can also be presented in the following net basis:
a. Net deferred tax liability of P262,500 (P412,500 - P150,000) as of
December 31, 2023.
b. Net deferred expense of P52,500 (P112,500 - P60,000) for the year 2023.
This can also be computed as the amount of increase in net deferred tax
liability (i.e., P262,500 - P210,000).
COMPARISON OF INCOME STATEMENT AND BALANCE SHEET METHODS
Generally, the use of either methods will yield the same results as to the amount
of deferred tax expense (benefit) and deferred tax liability (asset). Their difference
lies on the calculation methodology.
Under the income statement approach, the amount of net deferred tax expense
(benefit) is determined first. This amount is either added to or deducted from the
amount of net deferred tax liabilities or assets at the beginning of the period to
determine the ending balance of net deferred tax liabilities or assets.
Under the balance sheet approach, the ending balances of net deferred tax
liabilities (assets) are determined first. These ending balances are compared
with the corresponding beginning balances to determine the amounts of net deferred
tax expense (benefit) during the current year.
In actual practice, elements of these approaches are applied as they are relevant
and all data needed are normally available. For example, it is much easier to compute
for the amount of current income tax expense using the income statement approach,
However, the use of balance sheet approach enables the entity to know the gross
amounts of deferred tax liabilities and assets, rather than the net amounts under the
income statement approach.
Illustration 5. LEON Company reported accounting income before tax for 2023
amounting to P8,500,000. The following were the differences noted between the
accounting rules and the tax rules:
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. Income of P1,100,000 is non-taxable. Operating expenses of P850,000 are not

tax-deductible.
. Depreciation expense recorded for machinery amounted to P950,000, however
tax depreciation should be P600,000.
. Depreciation expense recorded for vehicles amounted to P1,200,000, however
tax depreciation should be P1,400,000.
. Estimated warranty expense of P750,000 was recorded and P500,000 was paid
for the warranty claims. Warranty costs are tax-deductible only when actually
paid.
. Research costs of P2,000,000 were expensed during 2023. However, for tax
purposes, these costs are tax-deductible in equal amounts for five years
including the current year.
Relevant regular income tax rate for the current and future years is 25%. At the
beginning of the year 2023, the following assets and liability have different tax
bases compared to their carrying amounts:
Carrying amount Tax base
Machinery, net P4,550,000 P5,200,000
Vehicles, net 3,500,000 3,100,000
Warranty liability 1,000,000 0
Based on the given amounts for the year 2023, the carrying amounts and tax bases
of the assets and liability as of December 31, 2023 are the following:
Carrying amount Tax base
Machinery, net P3,600,000!! P4,600,00018)
Vehicles, net 2,300,000! 1,700,0001!
Warranty liability 1,250,000! “
Research costs - 1,600,000IF1
Note: [A] = P4,550,000 - P950,000; [B] = P5,200,000 - P600,000; [C] =
P3,500,000 - P1,200,000; [D] = P3,100,000 - P1,400,000; [E] =
P1,000,000 + P750,000 - P500,000; [F] = P2,000,000 - (P2,000,000/5
years)
Note: There is an assigned tax base for research costs as it is considered an asset for
tax purposes since it is not tax deductible outright and need to be “amortized” in
determining the tax-deductible amount.
Required: From the given information, determine the following amounts using both
the income statement approach and balance sheet approach:
a. Net deferred tax liability or asset, 1/1/23
b. Current income tax expense for 2023
c. Net deferred tax expense or benefit for 2023
d. Net deferred tax liability or asset, 12/31/23
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Answer - Net Deferred Tax Liability or Asset, 1/1/23

For this requirement, only the balance sheet approach is applicable.
1, First, compute the difference between the carrying amount and the tax base:
[A] [B] [A] - [B]
Carrying amount Tax base Difference
Machinery P4,550,000 P5,200,000 (P650,000)
Vehicles 3,500,000 3,100,000 400,000
Warranty liability 1,000,000 - 1,000,000
2. Next, classify each difference if they will result to deferred tax liability or asset
(in absolute amounts):
Will Result to
Differences DTL DTA
Machinery (P650,000) P650,000
Vehicles 400,000 P400,000
Warranty liability 1,000,000 1,000,000
P400,000 = P1,650,000
Multiply by: Regular income tax rate 25% 25%
DTLand DTA, respectively P100,000 P412,500
Note: In the “Differences” column, if the amount is positive, carrying amount > tax base.
If the amount of difference is negative, carrying amount < tax base.
At the beginning of 2023, there is a net deferred tax asset of P312,500

(P412,500 - P100,000).
Answer - Income Statement Approach

1. First reconcile the amount of accounting income to the amount of taxable
income:
Add: Non-tax-deductible expenses (permanent difference) 850,000
Less: Non-taxable income (permanent difference) (1,100,000)
Income subject to [regular] income tax P8,250,000
Add: Excess accounting depre. - machinery (P950K - P600K) 350,000
Excess warranty expense (P750,000 - P500,000) 250,000
Research costs that are tax-deductible in the future
[P2,000,000 - (P2,000,000/5 years)] 1,600,000
Less: Excess tax depreciation - vehicle (P1.4M - P1.2M) (200,000)
The effect of research costs in computing for the taxable income for the year
2023 can also be stated as follows:
a. The whole amount of P2,000,000 is added back to the accounting income.
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b. Annual amount of P400,000 (P2,000,000/5 years) is deducted from

accounting income. Both of these amounts will result to net addition of
P 1,600,000 (P2,000,000 - P400,000) in determining the 2023 taxable income,
This is also a great time to compute the amount of current income tax using the
taxable income for 2023. The amount of current income tax is P2,562,500
(P10,250,000x 25%).
2. Next, the amount of income subject to regular income tax (i.e., P8,250,000) is
lower than the amount of taxable income for the year (i.e., P10,250,000); hence,
their difference of P2,000,000 will result to a net deferred tax benefit and
corresponding increase in net deferred tax asset.
Consequently, the amount of net deferred tax benefit for 2023 is P500,000,
[(P10.25M - P8.25M) x 25%]. These shall be recorded as follows:
Deferred tax asset - net 500,000
Deferred tax benefit - net 500,000
After recording this entry, the amount of net deferred tax asset, 12/31/23 is
P812,500 (P312,500 beginning balance plus P500,000 deferred tax benefit).
3. The Company’s income statement will show the following portion:

Less: Current income tax expense 2,562,500
Net deferred tax benefit . (500,000)
Total tax expense (2,062,500)
Alternatively, the total tax expense of P2,062,500 can also be computed by
multiplying the P8,250,000 income subject to regular income tax by 25% tax rate.
Answer - Balance Sheet Approach
1. First, determine the differences between carrying amount and the tax bases as
of December 31, 2023:
[A] [B] [A] - [B]

Carrying amount Tax base Difference
Machinery P3,600,000 4,600,000 (P1,000,000)
Vehicles 2,300,000 1,700,000 600,000
Warranty liability 1,250,000 . - 1,250,000
Research costs - *1,600,000 (1,600,000)
*Research costs are considered as asset for tax purposes in applying the balance
sheet approach.
2. Next, classify each difference if they will result to deferred tax liability or asset
(in absolute amounts):
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Will Result to
Difference DTL DTA
Machinery (asset) (P1,000,000) P1,000,000
Vehicles (asset) 600,000 600,000
Warranty liability 1,250,000 1,250,000
Research costs (asset) (1,600,000) 1,600,000
P600,000 P3,850,000
Multiply by: Regular income tax rate 25% 25%
Ending DTLand DTA, respectively _ P150,000 P962,500
Note: In the Differences” column, if the amount is positive, carrying amount > tax
base. If the amount of difference is negative, carrying amount < tax base.
Again, when using the balance sheet approach, the amounts of computed deferred
tax liability and asset are already the ending balances. At the end of 2023, there
is a net deferred tax asset of P812,500 (P962,500 - P150,000). This is the same
with what is computed using the income statement approach.
. Next, compute for the amount of change in the deferred tax liability and asset to
compute for the amounts of deferred tax expense and benefit:
Deferred tax expense (increase in DTL), 2023 P50,000

Deferred tax benefit (increase in DTA), 2023 P550,000
These can be recorded as follows:


Netting the amounts of deferred tax expense and benefit will result to net
deferred tax benefit of P500,000 for 2023. This is the same with the amount
computed under the income statement approach.
. As an additional note, the implied amount of current income tax expense can
also be determined by using the following relationships:
Current income tax expense Pxx
Add: Net deferred tax expense XX
Less: Net deferred tax benefit or income
Total income tax expense
_(x)
Pxx
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The total income tax expense can be determined by excluding the effects of the
permanent differences in computing! for the amount of accounting income subject
to income tax as follows:
Less: Non-taxable income (1,100,000)
Accounting income subject to income tax P8,250,000
Total income tax expense P2,062,500
Using the total income tax expense of P2,062,500 and net deferred tax benefit of
P500,000, the current income tax expense is the squeeze amount as follows:
Current income tax expense (squeeze) (P2,062,500 + eee: P2,562,500
Less: Net deferred tax benefit (500,000)
Total income tax expense P2,062,500
The amount of current income tax expense above is the same as computed when
using the direct reconciliation under the income statement approach. In other
words, the current income tax expense can still be determined impliedly by using
he relationship between th eferred ta nse for benefit) a alincome
tax expense.
RECOGNITION OF INCOME TAXES OUTSIDE PROFIT OR LOSS

So far, the illustrations deducted the amount of deferred taxes from the amount of
accounting income (i.e., profit or loss). However, there are items of temporary
differences that are recognized in other comprehensive income (OCI) or directly in
equity.
The following are some temporary differences that are recognized in the OCI:
a. Revaluation of property, plant and equipment or intangible assets
b. Unrealized gains and losses from financial assets at FVTOCI
c. Remeasurement losses from retirement plan
The following are some temporary differences that are recognized in equity:
a. Withholding taxes from payment of dividends to shareholders.
b. The equity portion of compound financial instrument
Consequently, the amounts recognized in OCI or in equity are already net of the
related deferred tax amount.
Illustration 6. As of December 31, 2023, DOMINGO Company revalued its land with
original cost of P10,000,000 and fair value of P12,000,000. The revaluation is not
taxable at the revaluation date but will be taxable when the land is actually sold.
Relevant tax rate is 25%. The revaluation can be recorded as follows:
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Land 2,000,000
Revaluation surplus 1,500,000
There is a deferred tax liability because the carrying amount of P12,000,000 after
revaluation is higher than the tax base of P10,000,000. The gross amount of
revaluation surplus is P2,000,000 (P12,000,000 - P10,000,000). However, the
amount recognized is net of deferred tax [P2,000,000 x (1 - 25%)].
NET OPERATING LOSS CARRY-OVER (NOLCO)
In periods of business decline, reversals, or difficulties, an entity may incur net loss
before tax. In addition, a small amount of accounting income before tax may result
to negative amount of taxable income (i.e., taxable loss) after reconciling it with the
tax rules.
No income tax is due for taxable loss; however, these loss amounts from the previous
periods are deductible against the amounts of taxable income in the future (i.e.,
NOLCO). Because of this, the following accounting procedures shall be considered:
a. An amount of deferred tax asset is recognized equal to taxable loss times the
regular income tax, assuming all of the taxable loss is recoverable.
b. However, the amount of recognized deferred tax asset is limited to the portion of
NOLCO that is expected to be claimed before it expires. In the Philippines, NOLCO
will generally expire three years after it was sustained.
In other words, deferred tax asset is recognized only up to the NOLCO’s
recoverable portion. Consequently, no deferred tax asset is recognized for the
portion of the NOLCO that cannot be recovered in the future.
Illustration 7. MARTINEZ Company reported accounting income before tax of

P1,000,000. Proceeds from life insurance amounting to P2,000,000 is not subject to
tax while P350,000 expenses are non-deductible for tax purposes. There were no
other temporary differences during the year. Relevant tax rate is 25%.
The amount of taxable loss is computed as follows:

Less: Non-taxable income (2,000,000)
Taxable loss for 2023 (P650,000)
Assuming that this taxable loss can be claimed in full as deduction before it expires,
deferred tax asset of P162,500 (P650,000 x 25%) is recognized. This is recorded
as follows: ,
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In the income statement of the Company, the following portion can be found:
Netincome before tax (accountingincome) —_ P 1,000,000
Add: Deferred tax benefit 162,500
The readers should take note that the amount of net deferred tax benefit is added
to the accounting income.
Illustration 8. During 2023, an entity reported net income before tax of P600,000.
Depreciation of P1,250,000 was recorded for the year but the tax depreciation
should be P2,100,000. Relevant tax rate is 25%. Based solely on this information,
the amount of taxable loss is computed as follows:
Accounting income before tax P600,000
Less: Excess tax depreciation (P2,100,000 - P1,250,000) (850,000)
Taxable loss for 2023 j (P250,000) |
The amount of deferred tax asset to be recognized is P62,500 (P250,000 x 25%),

assuming that this taxable loss is fully recoverable. This is recorded as follows:
In addition, deferred tax liability of P212,500 (P850,000 x 25%) shall be

recognized for the difference in depreciation since the effect of the temporary
difference is decreasing the amount of taxable income relative to accounting income.
This is recorded as follows:

In the income statement of the entity, the following portion can be found:
Net income before tax (accounting income) P600,000
Less: Deferred tax expense P212,500
Deferred tax benefit (62,500)
Total tax expense (150,000)
Net income after tax P450,000
Again, total tax expense of P150,000 is equal to the amount of accounting income
(i.e., since there were no permanent differences) multiplied by the tax rate (or
P600,000
x 25%).
CHANGES IN INCOME TAX RATES
The income tax rates are not necessarily the same rate all throughout the existence
of an entity. These tax rates change because of fiscal policies adopted by the
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government to attract foreign investors or to change the disposable income of

consumers.
Regardless of the reason of the change, it will definitely impact the amounts of
recognized deferred tax liability and asset, even if there are no changes in the
temporary differences. The changes in these deferred amounts are recorded either
in profit or loss, other comprehensive income or equity, depending on where the
initial deferred amounts were recorded.
In accounting for changes in tax rates, it is much better to use the balance sheet
approach as it readily accounts for the corresponding changes in the deferred tax
amounts, including those coming from changes in tax rates.
Illustration 9. At the beginning of 2023, RODRIGUEZ Company reported P300,000
deferred tax liability and P180,000 deferred tax asset (net deferred tax liability of
P120,000). These are all based on 30% tax rate. At the end of 2023, cumulative
taxable temporary differences amounted to P1,500,000 and cumulative deductible
temporary differences amounted to P950,000. Required: Under each of the
following independent scenarios, determine the amount of net deferred tax
expense or benefit:
1. The enacted tax rate increased to 32%
2. The enacted tax rate decreased to 25%
Answer - Scenario 1
1. First, compute for the amounts of deferred tax liability and asset as of December
31, 2023 using the enacted new tax rate, 32%:
Cumulative taxable temporary differences, 12/31/23 P1,500,000
Multiply by: Enacted new tax rate 32%
Cumulative deductible temporary differences, 12/31/23 P950,000
Since the amounts of temporary differences given are cumulative, they also
include the amounts of temporary differences not just from 2023 but also from
previous periods.
2. Next, compare these amounts to the corresponding balances as of January 1,
2023:
Increase in DTL/Deferred tax expense, 2023 P180,000
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Increase in DTA/Deferred tax benefit, 2023 P124,000
The amounts of deferred tax expense and benefit already included the increase
in the deferred tax amounts as of January 1, 2023 due to increase in enacted tax
rate. For 2023, there is a net deferred tax expense of P56,000 (P180,000 -
P124,000).
The portion of net deferred tax expense of P56,000 related to the increase in
net deferred tax liability as of January 1, 2023 is P8,000 net expense
(P120,000/30% multiplied by the 2% increase in the tax rate).
Answer - Scenario 2
1. First, same with Scenario 1, compute for the amounts of deferred tax liability
and asset as of December 31, 2023 using the enacted new tax rate, 25%:
Cumulative taxable temporary differences, 12/31/23 P1,500,000
Cumulative deductible temporary differences, 12/31/23 P950,000

2. Next, compare these amounts to the corresponding balances as of January 1,

2023:

Increase in DTL/Deferred tax expense, 2023 P75,000

Increase in DTA/Deferred tax benefit, 2023 P57,500
The amounts of deferred tax expense and benefit already included the decrease
in the deferred tax amounts as of January 1, 2023 due to decrease in enacted tax
rate. For 2023, there is a net deferred tax expense of P17,500 (P75,000 -
P57,500).
The portion of net deferred tax expense of P17,500 related to the decrease in
net deferred tax liability as of January 1, 2023 is P20,000 net benefit
(P120,000/30% multiplied by the 5% decrease in the tax rate).
Illustration 10. MACAROONS Company started its operations on January 1, 2023.

During the year, the Company reported accounting income before tax of
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P4,000,000. There were no differences in accounting rules and taxation rules,

except for the following:
a. Accounting depreciation amounted to P2,000,000, while tax depreciation
b. Warranty expense recognized amounted to P900,000, while actual warranty
costs amounted to P600,000.
Income tax rate is 30% for 2023. However, starting on January 1, 2024, the income
tax rate was lowered to 25%. Required: From the given information, determine the
total tax expense for the year 2023.
The following is the relevant reconciliation from accounting income to taxable

income and the computation of the current tax expense:
Add: Excess warranty expense (P900,000 - P600,000) 300,000
Less: Excess tax depreciation (P2,000,000 - P2,800,000) (800,000)
Multiply by: Tax rate for the year 30%
Current tax expense P1,050,000
The readers should take note that the current tax rate is used in determining the
current tax expense. However, in determining the deferred tax amounts, the
revised tax rate shall be used.
Consequently, the deferred tax expense and deferred tax income shall be
Taxable temporary differences, 12/31/23 P800,000
Deferred tax expense (increase in DTL), 12/31/23 P200,000
Deductible temporary differences, 12/31/23 P300,000
Deferred tax income (increase in DTA), 12/31/23 P75,000
Net deferred tax expense for the year 2023 is P125,000 (P200,000 - P75,000)
which is consistent with the fact that accounting income is higher than taxable
income. Consequently, net deferred tax liability of P125,000 shall also be
recognized as of December 31, 2023 since there are no beginning balances.
In the income statement of the entity, the following portion can be found:
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Less: Current income tax expense P1,050,000
Deferred tax benefit (75,000)
Totaltaxexpense | (1,175,000)
As an exception to the general rule, if there are changes in tax rate in the future, the
total tax expense is NOT equal to the amount of accounting income subject to income
tax multiplied by the tax rate.
EFFECTS OF SCHEDULED CHANGES IN TAX RATES
Sometimes, scheduled changes in tax rates and their corresponding effectivity dates
are enacted and announced during the current period. For example, a law was
enacted setting tax rate of 28% for the years 2024 to 2025, tax rate of 26% for the
years 2026 to 2027, and tax rate of 24% for the years 2028 and 2029.
In these cases, these scheduled changes in tax rates will change the amounts to be
recognized for the deferred tax liabilities and deferred tax assets, based on the
expected timing of the reversal of the temporary differences.
Illustration 11. During the last days of the year 2023, PRESENT Company incurred
research costs totaling P4,000,000. Since the costs were incurred during the
research phase, these amounts were expensed outright in determining the
accounting income. However, for taxation purposes, these amounts shall be
amortized annually for P800,000 (P4M/5) for five years starting in 2024. In
addition, a new law was announced that will gradually decrease the income tax rate
to 27% in 2024 and 2025, 24% in 2026 and 2027, and 20% moving forward.
In this case, the initial measurement of deferred tax asset shall be determined as:
Expected reversal during 2024 (P800,000x27%) 216,000

Expected reversal during 2025 (P800,000x27%) 216,000
Expected reversal during 2026 (P800,000 x 24%) 192,000
Expected reversal during 2027 (P800,000 x 24%) 192,000
Expected reversal during 2028 (P800,000 x 20%) __ 160,000
SUBSEQUENT REVERSAL OF DEFERRED TAXES

Subsequent to initial recognition, when the effects of temporary differences have
been reversed, the related deferred tax assets (DTA) and liabilities (DTL) will
correspondingly be decreased. Depending on the temporary differences, the
reversal may be one-time or gradual. Consequently, the reversal of deferred taxes
and liabilities have the following accounting consequences:
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Scenario | Accounting consequence

Reversal of deferred tax liability | Deducted (credited) from total tax expense
Reversal of deferred tax asset Added (debited) to total tax expense
Illustration 12 - Reversal of DTL. On December 24, 2023, FUTURE Company
acquired a three-year property insurance by paying P450,000. This insurance
covers the period from January 1, 2024 to December 31, 2026. The taxation rules
require this amount to be immediately deducted in determining the taxable income.
In addition, the Company reported accounting income of P2,000,000 and
P2,300,000 in 2023 and 2024, respectively. There were no other temporary
differences. The Company is subject to 25% income tax.
In this case, the carrying amounts and tax bases of the prepaid insurance as of
December 31, 2023 and 2024 are the following:
12/31/23 12/31/24
Carrying amount P450,000 P300,000
Less: Tax basis = -
Temporary difference P450,000 P300,000
Multiply by: tax rate 25% 25%
Deferred tax liability P112,500 P75,000
The readers should take note that the carrying amount is reduced by P150,000 per
year (P450,000/3-year coverage). There is a zero tax base since the whole P450,000
was already expensed during 2023.
For the year 2023, there is a debit of P112,500 in deferred tax expense due to the
initial recognition of deferred tax liability. On the other hand, in 2024, there is credit
of P37,500 (P112,500 - P75,000) in deferred tax expense due to the partial reversal
of temporary difference. The effects of these deferred tax expense amounts can be
further analyzed as follows:
2023 2024
Accounting income P2,000,000 P2,300,000
Less: Outright expensing of P450,000 premiums
under taxation rules (450,000)
Add: Annual insurance expense recognized in
accounting income but not in taxable income 150,000
Taxable income P1,550,000 P2,450,000
The total tax expense for each year is determined as follows:
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2023 2024
Taxable income P1,550,000 P2,450,000
Multiply by: Income tax rate 25% 25%
Current income tax expense P387,500 P612,500
Add: Deferred tax expense in recognizing DTL 112,500
Less: Credit to deferred tax expense in reversing DTL (37,500)
Total tax expense P500,000 P575,000
To double check, the total tax expense can also be determined by multiplying the
accounting income subject to income tax by the income tax rate:
: 2023 2024
Accounting income P2,000,000 P2,300,000
Multiply by: Income tax rate 25% 25%
Total tax expense P500,000 P575,000
EFFECTIVE INCOME TAX RATE

PAS 12 requires the presentation of the reconciliation of the statutory tax rate to
the effective tax rate. Generally, the effective tax rate is determined as follows:
Effective _ Total tax expense
taxrate Accounting income before income tax
Illustration 13. Using the same information as in LEON Company in Illustration 5,

the effective tax rate for the year 2023 is determined as follows:
Total tax expense P2,062,500
Divide by: Accounting income before tax 8,500,000
Effective income tax rate 24.26%
Generally, effective tax rate will differ from the statutory tax rate due to one or a
combination of the following scenarios (non-exhaustive list):
a. Existence of permanent differences
b. Existence of unrecognized deferred tax assets due to recoverability issues
c. Existence of income subject to final tax or capital gains tax due to the differences
between final tax rates or capital gains tax rates and the regular income tax rate.
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ANNEX 1 - USUAL DIFFERENCES BETWEEN ACCOUNTING RULES AND TAXATION

RULES IN DETERMINING NET INCOME
In this section, the most common differences between the accounting and taxation
treatments are summarized, including the resulting deferred tax amounts. These
are the following:
Differences _ Treatment and resulting deferred tax amounts

Bad debts expense Bad debts expense isi deducted inj determining
ini acco untin 1g
oe pialante income while the accounts written off is deducted in
Zz determining taxable income. This will result to DTA equal to
written-off ;
allowance for bad debts x income tax rate.
; Deducted in determining accounting income but not deducted
Loss on invento
: Y | in5 determining
oe 3
taxable income. This willk result to DTA equal to
write-down ; : : \
allowance for inventory write-down x income tax rate.
Unrealized gain is added to accounting income while the
Unrealized gain or unrealiz = loss isi deducted from accounting
‘ ‘ ing income
i , No
loss- FVTPL unrea a gain or-loss is considered in determining taxable
t: ectiierits income. T ese amounts willj result to the following
ing:
a. DTA= cumulative unrealized loss x income tax rate
b._DTL= cumulative unrealized gain x income tax rate
Unrealized gain or Similar to the treatment of FVTPL securities, except deferred
loss - FVTOCI taxes are recognized in other comprehensive income
investments
BECOURIINE The difference will result to DTL. The amount of DTL is equal
depreciation < tax to income tax rate
x (tax depreciation — accounting depreciation)
depreciation P ons 9 2eP
ACCOUNNE The difference will result to DTA. The amount of DTA is equal
depreciation > tax ; ; Re ies
e to income tax ratex (accounting depreciation - tax depreciation)
depreciation
The revaluation is considered as unrealized gain; as such, it is
Ravahiatan not considered in taxable income. This will result to DTL equal
to amount of revaluation x income tax rate. However, deferred
taxes are recognized in other comprehensive income.
Deducted in determining accounting income but not deducted
Impairment in determining taxable income. This will result to DTA equal to
allowance for impairment x income tax rate.
Immediately expensed in determining accounting income but
required to be amortized for a particular number of years in
Research costs quired to b tized f P ber of
determining taxable income. This will result to DTA equal to
unamortized research costs x income tax rate.
Amortized over the periods benefitted in determining
accounting income but immediately expensed when paid in
Prepaid expenses
determining taxable income. This will result to DTL equal to
carrying amount of prepaid expenses x income tax rate
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Recognized immediately as expense in determining accounting

income but will be expensed only when actually paid in
Accrued expenses
determining taxable income. This will result to DTA equal to
carrying amount of accrued expenses x income tax rate
Estimated warranty expense is deducted in determining
Estimated accounting income while the actual warranty costs is deducted
warranty in determining taxable income. This will result to DTA equal to
amount of estimated warranty liability x income tax rate.
Includes deferred amounts from premiums, vouchers,
Contract liabilities
coupons, rebates, etc. This will result to DTA equal to amount
PERSP of contract liabilityx income tax rate.
Advances from | Recognized as liability and excluded in determining the
customers accounting income but already included as income upon
(including gift receipt in determining taxable income. This will result to DTA
certificates) equal to carrying amount of advances x income tax rate.
a Refer to the treatment of unrealized gain or loss - FVTPL

liabiliti investments
iabilities
Compound This will result to DTL equal to the amount allocated to the
financial equity component x income tax rate. However, the deferred
instrument taxes are recognized directly in equity.
In taxation, ROU asset and lease liability are not recognized.
Instead, the actual amounts of lease payments are considered
as deductible expenses.
As such, these amounts will result to the following:

Leases — lessee a. DTL= carrying amount of ROU asset x income tax rate
accounting b. DTA = carrying amount of lease liability x income tax rate
Consequently, the net DTL or net DTA from lease contracts are
not expected to be significant in comparison to other sources of
temporary differences due to the not-so-large difference
between the carrying amounts of ROU asset and lease liability.
Employee Benefits The accrued liability for paid absences will result to DTA equal
— Paid Absences to the amount of accrued liabilityx income tax rate.
Employee Benefits The accrued liability for other employee benefits will result to
~ Other Accruals DTA equal to the amount of accrued liability x income tax rate.
Retirement benefit costs recognized in profit or loss are
deducted in arriving at accounting income. However, the
Employee Benefits amount of contributions to plan assets are the deductible
~ Retirement amounts in determining taxable income.
Benefits As such, the amountofDTA or DTL will depend on the cumulative
differences from the total retirement benefit costs and amount of
contributions to plan assets.
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Chapter 13— Accounting for Income Taxes
Do not have tax consequences. Income with permanent

differences include the following examples:
a. Tax-exempt interest income
b. Proceeds from the settlement of life insurance policy
c. Other income from donations from non-shareholder
Permanent d. Tax-exempt gains from selling long-term debt securities
differences Expenses with permanent differences include the following:

a. Undocumented and/or out-of-period expenses
b. Expenses in excess of allowable amount (e.g,,
representation expense, interest expense, etc.)
c. Expenses related to items of income subject to final tax or
capital gains tax.
CHAPTER SUMMARY
L Income taxes are one of the costs in conducting business. In paying income taxes, an
entity does not really receive goods or services from the government but pays taxes
since these amounts are enforced contributions (i.e., required contributions).
Total income tax expense = current income tax expense + deferred tax expense -
deferred tax benefit.
Current income tax expense = taxable income x income tax rate. Currently, the
regular income tax rates for corporations, depending on the circumstances is either
20% or 25%. Current income tax expense also includes final withholding taxes and
capital gains taxes.
Due to the different bases, accounting income and taxable income cannot be
expected to be equal in amounts. This can be attributed to permanent differences
and temporary differences.
Permanent differences will not have current and future tax consequences.
wi
Temporary differences normally arise from timing differences that will have future
tax consequences. These are classified as follows:
a. taxable temporary differences - will result in taxable amounts in determining
taxable profit (tax loss) of future periods when the carrying amount of the asset
or liability is recovered or settled. These will give rise to DTL and an increase in
deferred tax expense,
b. deductible temporary differences - will result in deductible amounts in
of the asset or liability is recovered or settled. These will give rise to DTA and an
increase in deferred tax income/benefit.
Deferred taxes are not discounted but considered as non-current assets or liabilities.
‘
When using the income statement approach, the net amount of deferred tax expense
or deferred tax benefitis determined first with corresponding effects as follows:
Effect in Beg. Net DTL Effect in Beg. Net DTA
Net deferred tax expense Added Deducted
Net deferred tax benefit Deducted Added
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9. When using the balance sheet approach, the ending balances of DTL and DTA are
determined first based on the differences between the tax base and carrying
amounts of assets and liabilities:
Scenarios Resulting deferred tax amount

Assets
Carrying amount > Tax base Deferred tax liability
Carrying amount < Tax base Deferred tax asset
Liabilities
Carrying amount > Tax base Deferred tax asset
Carrying amount < Tax base Deferred tax liability
These ending balances are compared with beginning DTL and DTA:
Change Deferred Tax Expense of Benefit
Increase in DTL Deferred tax expense
Decrease in DTL Deferred tax benefit
Increase in DTA Deferred tax benefit
Decrease in DTA Deferred tax expense
10.Same amounts of deferred taxes will be computed whether using the income
statement approach or the balance sheet approach.
11. Full recognition of DTL is required, but the DTA shall be recognized only up to the
portion of the temporary differences that are recoverable.
12. By default, deferred taxes are recognized in profit or loss. However, some deferred
taxes are recognized in OCI (e.g., revaluation of PPE) or directly in equity (e.g.,
compound financial instruments).
13. Taxable loss may be carried over to subsequent taxable periods (NOLCO) up to three
years based on current rules. As such, DTA shall be recognized only for the portion
of the NOLCO that are expected to be applied in reducing the future taxable income
before it expires.
14. Effectively, in general and in the absence of final taxes and capital gains tax, the total
income tax expense = accounting income subject to tax x income tax rate.
15.Changes in tax rates effective in the future periods affect the measurement of
deferred taxes, but it shall not affect the measurement of current tax expense which
is still based on the unchanged current tax rate.
16.Subsequent to initial recognition, as the temporary differences are reversed, the
amounts of the DTL and DTA will have corresponding decrease and effects as
follows;
Scenario Accounting consequence

Reversal of deferred tax liability | Deducted (credited) from total tax expense
Reversal of deferred tax asset Added (debited) to total tax expense
17. Effective income tax rate = Total tax expense/Accounting income before tax.
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True or False
1. Accounting income is determined using the rules under the PFRSs and related
standards.
2. The amount tax payable for the current period is based on the amount of accounting
income.
3. Ifan income is already subject to final tax or capital gains tax, it is not anymore
subject to the regular income tax.
4. In the Philippine setting, the tax rates for individual taxpayers are either 20% or
25%, while the tax rates for corporate taxpayers are based ona tax table.
5. Tax-exemptincome will result to temporary difference between accounting income
and taxable income.
6. Temporary differences will result to deferred tax amounts.
7. Current tax expense from regular income tax is based on the taxable income applied
with current income tax rate.
8. Deductible temporary differences will give rise to deferred tax liability, while
taxable temporary differences will give rise to deferred tax asset.
9. Theincrease in deferred tax liability corresponds to deferred tax expense, while the
increase in deferred tax asset corresponds to deferred tax benefit.
10. If the temporary differences are expected to reverse beyond 12 months after the
reporting period, such amounts shall be discounted to reflect the time value of
money. :
11. The tax base of an asset with non-taxable economic benefits is equal to zero.
12. If the tax base of an asset is higher than its carrying amount, the difference will give
rise to deferred tax asset.
13. If the carrying amount of the liability is higher than its tax base, the difference will
give rise to deferred tax liability.
14. Scheduled changes in tax rates in the future affect the initial measurement of
deferred tax asset or deferred tax liability.
15. All of the corresponding deferred tax asset arising from net operating loss carry-
over shall be recognized.

1. The following are the sources of rules and procedures in determining the amount of
accounting income, except
a. Philippine Financial Reporting Standards or PFRSs
b. Philippine Interpretations Committee (PIC) Q&As
c. interpretations from International Financial Reporting Interpretations
Committee or IFRIC
2. In determining the entity’s taxable income, the following are considered, except
a. the provisions of The National Internal Revenue Code
b. Revenue Regulations issued by the BIR
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Cc Revenue Memorandum Circulars issued by the BIR

3. Under the Philippine taxation rules, taxation schemes include the following, except
a. Value-added income tax
b. Final income tax
G Capital gains tax
d. Regular income tax
4. The total income tax expense is composed of which of the following?
a. final income tax and capital gains tax
b. current income tax and deferred income tax
c. final income tax and deferred income tax
d. capital gains tax and current income tax
5. Current income tax expense is composed of the following, except
a. deferred tax expense
b. final income tax expense
c. capital gainstax expense ©
d. regular income tax expense
6. Differences between accounting income and taxable income are composed of
permanent differences and temporary differences. Which of the following correctly
describes the tax consequences of these differences?
a. Permanent differences have future tax consequences, while temporary
differences have no future tax consequences.
b. Permanent differences have no future tax consequences, while temporary
differences have future tax consequences.
Both permanent differences and temporary differences have future tax
consequences,
Both permanent differences and temporary differences have no future tax
consequences.
7. Temporary differences will give rise to what types of deferred taxes?
a. Both the taxable temporary differences and deductible temporary differences
will result to deferred tax assets.
b. Both the taxable temporary differences and deductible temporary differences
will result to deferred tax liabilities.
Taxable temporary differences will result to deferred tax liabilities, while
deductible temporary differences will result to deferred tax assets.
Taxable temporary differences will result to deferred tax assets, while
deductible temporary differences will result to deferred tax liabilities.
8. Permanent differences include the following, except
a, Expenses in excess of allowable deductions under taxation rules.
b. Undocumented expenses.
c, Unrealized gains and losses from investments
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d. Tax-exempt interest income
9. Deferred taxes are measured

a. asthe amount of temporary difference times the relevant income tax rate.
b. asthe amount of temporary differences times the relevant income tax rate and
discounted using the current market rates.
c. asthe amount of temporary differences times the relevant income tax rate and
discounting, using the current market rates, the portion that is expected to be
realized beyond 12 months after the reporting date.
10.Which of the following is true regarding the recognition of deferred tax assets and
liabilities?
a. The amounts initially determined for both deferred tax asset and deferred tax
liability are required to be recognized in the entity’s books.
b. The amounts initially determined for both deferred tax asset and deferred tax
liability are not required to be recognized in the entity’s books.
c. The amount initially determined for deferred tax asset is required to be
recognized in the entity’s books, while the amount initially determined for
deferred tax liability is not required to be recognized in the entity’s books.
d. The amount initially determined for deferred tax asset is not required to be
recognized in the entity’s books, while the amount initially determined for
deferred tax liability is required to be recognized in the entity's books.
11. The following circumstances will result to deferred tax asset, except
a. Theamountofbad debts expense is higher than the amount of accounts actually
written off.
b. The unamortized portion of research costs that are required to be amortized in
determining the taxable income.
c. Ahigher tax depreciation compared to accounting depreciation.
d. Impairment loss on property, plant and equipment
12. The following circumstances will result to deferred tax liability, except
a. Unrealized gain on investments in equity securities at FVTPL.
b. A higher amount of estimated warranty expense than the amount of actual
warranty costs incurred.
c. Revaluation increase on property, plant and equipment
d. Prepaid expenses that were already expensed in determining taxable income.
13.When applying the income statement method, the following accounting procedures
are correct, except
a. The amount of total income tax expense is also equal to taxable income
multiplied by the relevant income tax rate.
b. There is a net deferred tax expense if accounting income subject to income tax
is higher than the taxable income.
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c. The amount of net deferred tax benefit for the period is added to the beginning
net deferred tax asset or deducted from beginning net deferred tax liability.
d. Permanent differences will not give rise to deferred tax expense nor benefit.
14.The balance sheet method of determining the deferred tax amounts include the
following procedures, except
a. The tax base of assets and liabilities are compared with the corresponding tax
bases.
b. If the carrying amount of an asset is higher than its tax base, the difference is
considered as taxable temporary difference.
c. If the carrying amount of a liability is lower than its tax base, the difference will
give rise to deferred tax liability.
15. The following correctly describe the tax base of the relevant asset, except
a. The tax base of an asset is the deductible amount for tax purposes against
taxable income in the future.
b. The tax base of an asset is equal to its carrying amount if the receipt of the
economic benefits is not subject to tax.
Cc. The tax base of an accrued receivable, where the income is taxable only upon
receipt, is equal to its carrying amount.
d. The tax base of an impaired land is equal to its original cost.
16. Which of the following tax bases of liabilities is correct?
a. The tax base of a liability in general is its carrying amount, less any amount that
will not be deductible for tax purposes in future periods.
b. The tax base of advances from customers is its carrying amount, less any amount
that will be taxable in future periods.
G The tax base of estimated warranty liability is equal to its carrying amount.
d. The tax base of accounts payable is equal to its carrying amount.
17.If there is a change in income tax rate in the succeeding period, which of the
following correctly describe its effects in the amounts of current income tax expense
and deferred taxes?
a. The current income tax expense shall be based on the original income tax rate,
but the deferred taxes shall be based on the revised income tax rate.
b. The current income tax expense shall be based on the revised income tax rate,
but the deferred taxes shall be based on the original income tax rate.
Both the current income tax expense and deferred taxes are based on the
original income tax rate,
Both the current income tax expense and deferred taxes are based on the
revised income tax rate.
18. Effective income tax rate is equal to
a. Total tax expense divided by taxable income
b. Current tax expense divided by taxable income
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c. Deferred tax expense or benefit divided by accounting income

d. Total tax expense divided by accounting income
Straight Problems
1. During the year 2023, PORAC Company reported accounting income of P5,000,000.
Based on the taxation rules, interest income of P700,000 is tax-exempt, while
expenses of P900,000 is not deductible in determining the taxable income. There
were no other differences noted between the accounting rules and taxation rules.
Relevant tax rate is 25%. During the year, the Company made total quarterly income
tax remittance of P750,000.
Required: Determine the amounts of (a) current income tax expense for 2023 and
the (b) balance of current income tax payable as of December 31, 2023.
2. APALIT Company, an entity subject to 25% regular income tax, reported the
following information during the year 2023:
Sales revenue P8,000,000
Operating expenses, including P400,000 non-deductible expenses 2,000,000
Interest income from deposits, net of 20% final tax 400,000
Proceeds from life insurance policy on the Company’s president 5,000,000
Gain on sale of investmentin equity securities at FVTPL subject to
15% capital gains tax that was already paid 800,000
Accounting depreciation included in operating expenses 500,000
Tax depreciation 300,000
Quarterly remittance of the regular income tax totaled P240,000 during the year.

a. Accounting income before any income tax.
b. Total current income tax expense for the year 2023.
c. Current income tax payable as of December 31, 2023.
During the year 2023, SASMUAN Company’s first year of operations, it had an
accounting income of P7,000,000. The Company is subject to 25% income tax. The
following differences between the accounting rules and taxations rules were
identified:
Tax depreciation P1,800,000
Accounting depreciation 1,200,000
Interest income that is tax-exempt 1,000,000
Actual warranty costs 600,000
Expense items that are not tax-deductible 800,000
Periodic interim payments of regular income tax amounted to P800,000.
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a. Current income tax expense for the year 2023,
b. Current income tax payable as of December 31, 2023.
c. Deferred tax expense and deferred tax benefit for the year 2023.
d. Deferred tax liability and deferred tax asset as of December 31, 2023.
4, On January 1, 2023, TOMAS Company had a net deferred tax liability of P540,000.
During the year 2023, the Company reported the following information:
Accounting income (audited) P12,000,000

Interest income from tax-exempt securities 1,000,000
Unearned advances received from customers 700,000
Impairment loss on the Company’s land 1,500,000
Tax depreciation 1,900,000
Bad debts expense 500,000
Accounts written-off 800,000
Representation expense in excess of tax-
deductible amount 300,000

a. Current income tax expense for the year 2023.
b. Deferred tax expense and deferred tax benefit for the year 2023.
c. Effective interest rate for the year 2023.
d. Netdeferred tax asset or liability as of December 31, 2023.
5. BACOLOR Company reported deferred tax asset of P900,000 and deferred tax
liability of P500,000 as of January 1, 2023. During the year 2023, it had accounting
income of P6,000,000 and the following information:
Accounting income (audited) P10,000,000
Gain from the settlement of life insurance on Company's president 2,000,000
Expense items with no proper documents as required by tax rules 400,000
Tax depreciation 1,300,000
Loss on inventory write-down 200,000
Unrealized gain from FVTPL debt investments 1,200,000
Impairment of the Company’s office building 1,000,000
Research costs in 2023 required to be amortized for five years,
starting in 2023,.in determining the tax-deductible amount 1,500,000
Amounts paid for prepaid insurance 1,100,000
Insurance expense during the year 450,000
Actual warranty costs , 650,000
Gain on sale of tax-exempt debt security 950,000
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* Chapter 13 — Accounting for Income Taxes
Applicable income tax rate for the Company is 25%. Assume that the amounts of
deferred tax expense and benefit do not contain reversals of the beginning deferred
tax asset and liability.
c. Effective interest rate for the year 2023,
d. Net deferred tax asset or liability as of December 31, 2023.
6. On January 1, 2023, RITA Company started its operations. During the year, it
reported net income before tax of P6,000,000 in its income statement. As of
December 31, 2023, the Company has compiled the following information:
Carrying amount of equipment P4,500,000
Tax base of equipment 3,500,000
Research costs - tax-deductible in equal amounts for the
next five years, starting in 2023 1,000,000
Estimated warranty liability - tax-deductible only when the
related warranty costs were actually incurred 600,000
Carrying amount of FVTPL debt investments 1,800,000
Original cost of FVTPL debt investments 1,250,000
Prepaid insurance — tax-deductible at the time of payment 500,000
Tax-exempt income items 900,000
Non-tax-deductible expense items 400,000
The Company is subject to 25% income tax.
c. Effective interest rate for the year 2023.
d. Deferred tax asset and deferred tax liability as of December 31, 2023.
7. At the beginning of the year 2023, MINALIN Company had deferred tax liability and
deferred tax asset amounting to P180,000 and P1,000,000, respectively. Net income
before tax for the year 2023 amounted to P8,000,000. As of December 31, 2023, the
Company’s assets and liabilities with different carrying amounts and tax bases are
the following:
’ Carrying Amount Tax Base
Accounts receivable P4,500,000 P4,800,000
Property, plant and equipment 9,000,000 7,800,000
Unamortized research costs - 2,000,000
FVTPL debt investments 6,000,000 5,400,000
Inventory : 5,000,000 5,500,000
Estimated warranty liability 1,200,000 =
Unearned income 800,000 os
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"%
Tax-exempt income earned amounted to P1,400,000, while expenses that are non-
deductible amounted to P800,000. The Company is subject to 25% income tax rate.
¢ Effective interest rate for the year 2023.
d. Deferred tax asset and deferred tax liability as of December 31, 2023.
On January 1, 2023, MASANTOL Company had the following information:
Carrying Amount Tax Base
Allowance for bad debts P500,000 =
FVTPL debt investments 3,500,000 3,100,000
Inventory 2,800,000 3,000,000
Estimated warranty liability 700,000 -
Unearned income 300,000 -
During the year 2023, the Company reported accounting income of P7,000,000. The
differences between the accounting rules and taxation rules are the following:
a. Non-taxable income earned during the year amounted to P700,000, while non-
deductible expenses amounted to P950,000.
b. During the year, the Company recognized bad debts expense of P900,000 and
written-off P750,000 worthless accounts.
Tax depreciation amounted to P1,800,000, while accounting depreciation
Unearned loss on FVTPL debt securities amounted to P200,000.
Additional loss on inventory write-down amounting to P180,000 was
recognized, ;
Estimated warranty expense amounted to P800,000, while the actual warranty
costs incurred amounted to P1,000,000.
Advances received from the customers amounted to P400,000. On the other
hand, income recognized in accounting income arising from advances amounted
to P250,000.
Required: From the given information, determine the following using (a) income
statement approach and (b) balance sheet approach:
Deferred tax asset and deferred tax liability as of January 1, 2023.
Current income tax expense for the year 2023.
Shap
Deferred tax expense and deferred tax benefit for the year 2023.
Effective interest rate for the year 2023.
Deferred tax asset and deferred tax liability as of December 31, 2023.
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9. SIMON Company started its operations on January 1, 2023, During the year 2023,
the Company reported accounting income of P4,000,000.
Upon comparing the accounting rules and taxation rules, the Company noted the
following differences:
a. Tax depreciation amounted to P1,600,000, while accounting depreciation
b. Amounts paid for insurance amounted to P800,000, while the insurance
expense for the year is P200,000.
c. Loss on inventory write-down amounted to P150,000.
d. Tax-exempt income for 2023 amounted to P700,000, while non-tax-deductible
expenses amounted to P600,000.
The entity is subject to 30% income tax. However, a new law was passed later during
2023 where the income tax rate has been reduced to 25% effective on January 1,
2024.

b. Deferred tax expense and deferred tax benefit for the year 2023. _
c. Deferred tax asset and deferred tax liability as of December 31, 2023.
1. At the beginning of the year 2023, MACABEBE Company, an entity that is subject to
25% income tax rate, had a beginning deferred tax asset of P450,000 and deferred
tax liability of P600,000. For the year 2023, the Company had an accounting income
of P8,000,000.
Upon comparing the taxation rules and accounting rules, it noted the following
differences:
e Accounting depreciation amounted to P2,000,000, while the tax depreciation is
P2,700,000.
e Unrealized loss on FVTL debt investments amounting to P400,000 is not tax-
deductible until! the related investments have been sold.
e Gain on the settlement of life insurance proceeds amounting P1,200,000 is tax
exempt, while expenses amounting to P900,000 are not tax-deductible.
The amount of current income tax expense for the year 2023 shall be
a. P1,615,000 c. P1,925,000
b. P1,850,000 d. P2,055,000
The amount of net deferred tax expense or benefit for the year 2023 shall be
a. P75,000 expense c. P90,000 expense
b. P75,000 benefit d. P90,000 benefit
The amount of net deferred tax asset or liability as of December 31, 2023 shall be
a. P240,000 net DTL c. P225,000 net DTL
b. P240,000 net DTA d. P225,000 net DTA
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2. CANDABA Company reported deferred tax asset and liability amounting to P200,000
and P350,000, respectively on January 1, 2023. Accounting income for the year 2023
amounted to P4,000,000. Tax-exempt income of P800,000 and P1,000,000 expenses
that are not tax-deductible were considered in determining this amount of
accounting income. The Company is subject to 25% income tax rate.
Fast forward to December 31, 2023, the following assets and liabilities had carrying
amounts different from the relevant tax bases:
Carrying Amount Tax Base
Accounts receivable P2,500,000 P2,800,000
Unearned income 800,000 -
Bonds payable at FVTPL 4,600,000 5,000,000
The amount of net deferred tax liability or asset as of December 31, 2023 shall be
a. P325,000 net DTA c. P200,000 net DTA
b. P325,000 net DTL d. P200,000 net DTL
The amount of net deferred tax expense or benefit for the year 2023 shall be
a. P200,000 expense c. P50,000 expense
b. P200,000 benefit d. P50,000 benefit
a. P1,050,000 c. P1,100,000
b. P1,000,000 d. P850,000
The amount of taxable income for the year 2023 shall be
a. P4,400,000 c. P4,000,000
b. P3,400,000 d. P4,200,000
3. For the year 2023, MAGALANG Company had taxable income of P6,500,000. In
addition, the Company reported the following are the balances of deferred tax assets
and liabilities as of the beginning and ending of the year 2023:
January 1,2023 December 31, 2023
Deferred tax asset P600,000 P520,000
Deferred tax liability 750,000 1,150,000
The Company is subject to 25% income tax. There were no permanent differences
during the year.
The amount of accounting income for the year 2023 shall be
a. P8,420,000 c. P8,740,000
b. P4,580,000 d. P5,070,000
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4. GUAGUA Company had current income tax expense of P 1,700,000. In addition, the
Company reported the following cumulative amounts of temporary differences as of
the beginning and ending of the year 2023:
January 1,2023 December 31,2023
Taxable temporary differences P3,200,000 P4,400,000
Deductible temporary differences 4,200,000 5,850,000
The Company is subject to 25% income tax. In addition, tax-exempt income items
amounted to P1,400,000, while expenses that are not tax-deductible totaled
P1,000,000.
The amount of accounting income for the year 2023 shall be
a. P6,350,000 c. P7,250,000
b. P6,750,000 d. P7,650,000
5. During the year 2023, FLORIDABLANCA Company’s first year of operations, it

reported accounting income of P1,400,000. Upon comparing the relevant tax rules
and accounting rules, the following differences were noted:
e Tax-exempt income earned amounted to P1,200,000, while expenses that are not
properly documented based on the tax rules amounted to P300,000.
e Unrealized gain on FVTPL debt investments for the year 2023 amounted to
P1,000,000.
e Loss on inventory write-down amounted to P200,000.
The Company reasonably expects that it can earn sizable amounts of taxable income
for the next three years. Relevant income tax rate is 25%.
The total tax expense for the year 2023 shall be

a. P125,000 c. P185,000
b. P155,000 d. P215,000
The total amount of gross deferred tax asset as of December 31, 2023 shall be
a. P50,000 c. P125,000
b. P75,000 d. P175,000
6. ARAYAT Company reported accounting income of P600,000 for the year 2023, its
first year of operations. The Company is subject to 25% income tax. The following
differences between accounting rules and taxation rules were noted:
e Tax depreciation amounted to P2,000,000, while accounting depreciation
e Prepaid expenses had carrying amount of P800,000, while accrued expenses
amounted to P450,000. The tax rules require the full deduction of expense
amounts during the year the related payments were made.
Unrealized gain on FVTPL debt securities amounted to P900,000.
Expected warranty costs amounted to P1,000,000, while actual warranty costs
incurred amounted to P850,000.
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Assumption: The Company expects that all of the taxable loss for 2023 is recoverable.
a. PO c. P225,000
b. P150,000 d. P375,000
a. P120,000 c. P365,000
b. P150,000 d. P475,000
Assumption: The Company expects that only 70% of the taxable loss for 2023 is
recoverable.

a. PO c. P247,500
b. P212,500 d, P337,500
a. P174,500 c. P377,500
b. P287,500 d. P412,500
7. During the year 2023, MERMAID Company’s first year of operations, it reported
accounting income of P5,500,000, which when compared with taxation rules will
give rise to the following differences:
a. Bad debts expense for the year amounted to P1,400,000, while accounts actually
written-off amounted to P1,200,000.
b. Tax depreciation for the year amounted to P1,800,000, while accounting
depreciation amounted to P2,050,000.
c. Unrealized gain on financial assets at FVTPL for 2023 amounted to P300,000.
d. Estimated warranty expense amounted to P950,000, while actual warranty
costs incurred amounted to P600,000.
e. Tax-exempt income amounted to P1,100,000, while expenses that are not tax-
deductible amounted to P850,000.
Originally, the Company is subject to 30% income tax; however, starting in 2024, the
applicable income tax rate has changed to 32%.
a. P1,840,000 c. P1,800,000
b. P1,725,000 d, P1,920,000
The amount of deferred tax liability as of December 31, 2023 shall be
a. P96,000 c. P90,000
b. P176,000 d. P165,000
The amount of deferred tax asset as of December 31, 2023 shall be
a. P176,000 c. P165,000
b. P240,000 d, P256,000
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Chapter 13 —- Accounting for Income Taxes
The net amount of total tax expense for the year 2023 shall be’
a. P1i,885,000 c. P1,680,000
b. P1,675,000 d. P1,565,000
8. For the year 2023, ARIEL Company had the following differences in its accounting
income and taxable:
a. Research costs of P3,000,000 were expensed outright during the year, but
required to be amortized for five years for tax purposes, starting in the
succeeding year.
b. Advances received from the customers amounting to P2,000,000 will be earned
in the following manner: P1,200,000 in 2024 and P800,000 in 2025.
c. Three-year insurance premiums of P600,000 paid July 1, 2023 were tax-
deductible upon payment.
Applicable income tax rate for 2023 is 30%, however, the income tax rate will
decrease by 1% every year starting in 2024 (e.g., income tax rate for 2024 will be
29%, while income tax rate for 2025 will be 28%).
The amount of deferred tax liability as of December 31, 2023 shall be
a. P145,000 c. P141,000
b. P140,000 d. P150,000
The amount of deferred tax asset as of December 31, 2023 shall be
a. P810,000 c. P1,212,000
b. P972,000 d. P1,382,000
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Chapter 14 - Accounting for Derivatives
CHAPTER 14
ACCOUNTING FOR DERIVATIVES

The different types and purposes of derivatives.
WN pe
The different reasons why entities enter into derivative contracts.

The amounts of pay-off or obligation from each type of derivatives.
The initial and subsequent accounting for each type of derivatives.
Due
The classification of liabilities into current and noncurrent amounts.

The computation of accrued interest payable.
DERIVATIVES - INTRODUCTION
In conducting their operations, entities are exposed to a lot of business risks,
financial risks, and non-financial risks. As part of these risks, the selling price of an
entity’s products and the amounts of the entity's expenses may be subject to huge
fluctuations in amounts (i.e., high volatility in the amounts).
As such, an entity may use derivatives to manage the level of volatility through the
process of “hedging”. Hedging is the primary purpose of derivatives where the risks
can be transferred to other entities; however, accounting for hedging will be
discussed in a higher accounting subject.
On the other hand, some entities may also use derivatives for speculative purposes
(i.e., undesignated hedging instruments) where they bet on the future movements
in the price of financial assets or commodities. If the future events are favorable to
an entity’s bet, this can generate additional income to the entity. Accounting for
these speculative purposes is the focus of this chapter.
DEFINITION AND CHARACTERISTICS OF DERIVATIVE PRODUCTS
Before anything else, it is important for the readers to know the definition and
characteristics of derivatives under PFRS 9, to wit:
A derivative is a financial instrument or other contract within the scope of PFRS 9

with ALL three of the following characteristics:
a. its value changes in response to the change in one of the following (also called
“underlying”):
® specified interest rate e foreign exchange rate
e financial instrument price e index of prices or rates
* commodity price e credit rating or credit index
© other variable, provided in the case of a non-financial variable, the variable is
not specific to a party to the contract
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Chapter 14 — Accounting for Derivatives
b. it requires no initial net investment or an initial net investment that is smaller

compared to what normally would be required for other types of contracts that
would be expected to have a similar response to changes in market factors.
c. itis settled at a future date.
In other words, the short-hand definition for derivatives is as follows: derivative is
a contract, whose value is “derived” from the changes in the performance of the
underlying that will be settled in a future date.
DIFFERENT DERIVATIVE PRODUCTS

Based on the previous definition of a derivative, the following are the most common
examples of derivative contracts:
Contract Description
A contract that requires the entity to purchase or sell a certain number,
amount, or quantity of underlying. This contract arises from an exchange
market where the terms and conditions of the contract are made public.
Future | Generally, no initial amount is paid in entering in this contract.
An entity that is a party to a future or forward contract is required to
abide by the contract's terms and conditions, whether its position in the
contract is advantageous or disadvantageous.
Similar to future contracts, except forward contracts are privately
Forward
agreed-upon (i.e., over-the-counter contract)
A contract that gives right but not an obligation to purchase or sell a
certain number, amount, or quantity of underlying. In other words, the
holder of the options may choose not to exercise the option if it is in a
Options disadvantageous position.
However, unlike the future and forward contracts, the holder of the option
will pay a small amount in acquiring an option contract. It can be said that
generally, options are less risky compared to forwards/futures.
ELEMENTS OF A DERIVATIVE CONTRACT

The following are the primary elements of a derivative contract:
Elements Description ;
The asset, index, or rate covered in a derivative contract. Changes in th
Underlying
value of underlying determine the value of the derivative contract.
Exercise | The fixed amount at which the entity shall pay or receive in buying or
price selling the underlying, respectively,
This represents the nominal amount over which the derivative contract
Notional | is based but not necessarily the contract's value. This is determined as
the quantity of underlying x exercise price,
The date that the derivative contract is settled. In practice, there are
Maturity
multiple maturity dates for each derivative cash flows.
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Illustration 1. On November 15, 2023, an entity, a speculator, entered into a

forward contract for the purchase of 100,000 kilograms of a commodity for P50 per
kilogram. The parties will settle the contract on January 15, 2024.
Based on the information provided, the elements of the forward contract are
dissected as follows:
a. The underlying is the value of 100,000 kilograms of the commodity. Changes in
the value of the commodity will determine the value of the forward contract.
b. Exercise price is the P50 fixed purchase price (e.g., original forward price).
c. Notional = P5,000,000 (100,000 kilograms x P50 purchase price per kilogram)
d. Maturity date is on January 15, 2024.
MANNERS OF SETTLING DERIVATIVE CONTRACTS
Derivative contracts may be settled through either of the following:
Manner Description
; The selling party delivers the underlying and receives the exercise
Physical ; : : : ;
<ehienent price while the buying party receives the underlying asset and pays
for the exercise price.
Generally, the party at the disadvantaged position pays cash to the
party at the advantaged position (except in option contracts). In other
words, there will be no delivery of the underlying asset. This mode of
Netcash | settlement is mainly applicable for speculative purposes.
settlement y
The amount of net cash settlement is equal to the difference between
he total exercise price (i.e., notional) a ! h lyi
ofthe maturity date.
GENERAL ACCOUNTING MODEL FOR DERIVATIVE PRODUCTS
The following decision tree is relevant in determining whether PFRS 9 is applicable
to derivative contracts:
Does the derivative contract have

financial asset as underlying?
Can the contract be settled net in

cash or by exchanging financial
instruments?
Yes
The contract is out-of-scope of PFRS 9 The PFRS 9 applies
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Based on the previous diagram, the following non-exhaustive list of derivative

contracts are accounted for under PFRS 9:
a. Derivative contract with foreign currency underlying.
b. Derivative contract to purchase or sell equity securities of other entities.
c. Derivative contract to purchase or sell debt securities of other entities.
On the other hand, a derivative contract covering a certain number of barrels of
crude oil (i.e., non-financial asset) that can be settled net in cash is within the scope
of PFRS 9. However, this derivative contract is out of scope of PFRS 9 if the entity
intends to take delivery of the underlying (i.e., not through net cash settlement).
Derivative contracts within the scope of PFRS 9 shall be accounted as follows:
Is the derivative contract held for

speculation?
Is the derivative contract

designated for hedging?
v
Apply the hedge accounting procedures Account for the contract
depending on the hedge classification (e.g., as at fair value through
fair value hedge, cash flow hedge) profit or loss (FVTPL)
The focus of this chapter is the accounting under the FVTPL model. Hedge
accounting is discussed in higher accounting subjects.
The accounting for derivatives at FVTPL is sort of similar to accounting for equity
or debt securities at FVTPL as follows:
a. The derivative asset or derivative liability is recognized at their fair values as of
each reporting date.
b. Changes in the fair value of the derivative asset or derivative liability are
recognized in the current year’s profit or loss.
DETERMINING THE PAY-OFF FROM FORWARDS/FUTURES
Before determining the amount to be recognized for forward/futures asset or
forward/futures liability, it is important to understand the: (a) role of the entity
(whether buying or selling); and (b) the relationship between the current
forward/futures price and the exercise price (i.e., original forward/future price) of the
underlying.
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For simplicity, many accounting problems in Intermediate Accounting replace

forward/future price with the current price (i.e., spot price) of the underlying. The
readers should take note that the forward/futures price is still the better amount to
be used since it reflects all other risks in the contract.
It should be noted that forward/future price pertains to buying or selling amount
in the future while spot price pertains to immediate buying or selling. However, on
settlement date, forward/future price will be equal to spot price.
Again, for forwards and futures, the entity is required to abide by the terms and
conditions; so, it is possible that the entity will either be at advantageous or
disadvantageous positions as follows:
Scenarios E ai Rw EON is Position

Buying entity:
Forward or future price or spot price > Exercise price | _Advantageous
Forward or future price or spot price < Exercise price | Disadvantageous
Selling entity:
Forward or future price or spot price > Exercise price | Disadvantageous
Forward or future price or spot price < Exercise price | Advantageous
Note: Exercise price above pertains to the original forward or future price.
Based on the above scenarios, it can be said that the positions of the buying entity
and the selling entity in a derivative contract are “mirrors” of each other. In other
words, if the forward/future contract is advantageous to the buying entity, then it
is disadvantageous for the selling entity and vice versa.
Illustration 2. On December 1, 2023, ABC Company and XYZ Company entered into
forward contract where the former will buy from the latter 10,000 ordinary shares
of another entity at a forward price of P30 per share. Required: Under each of the
following independent scenarios, determine the position of each of the entities
involved as of December 31, 2023:
1. The current forward price is P35 per share as of December 31, 2023.
2. The current forward price is P27 per share as of December 31, 2024.
Scenario 1 - Forward price has increased to P35 per share
In this case, the entities have the following positions:
ABC Company | The Company is in an advantageous position since it will be able
(the buying | to purchase the ordinary shares at a lower price of P30 per share
entity) rather than at a higher amount of P35 per share in the future.
XYZ Company | The Company is in a disadvantageous position since it is required
(the selling | to sell the shares at a lower price of P30 per share, even though the
| entity) selling prices in the future have increased to P35 per share
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Scenario 2 - Forward price has decreased to P27 share

In this case, the entities have the following positions:
ABC Company | The Company is in a disadvantageous position since it is required
(the buying | to pay P30 per share even though the value of the shares in the
entity) future is only P27 per share.
XYZ Company | The Company is in an advantageous position since it will receive
(the selling P30 per share, which is above the value of the shares in the future
entity) at P27 per share.
ACCOUNTING FOR DERIVATIVE PRODUCTS - FORWARDS/FUTURES

In the previous section, it was mentioned that a party in a forward/future contract
can have advantageous or disadvantageous position. Based on the entity’s position,
it shall recognize the following:
Position Amount to be recognized
Advantageous Forward /future asset
Disadvantageous Forward/future liability
Due to the mirror nature of the parties’ position in the forward/future contract, if
one of them recognizes a forward/future asset, then the other one recognizes
forward/future liability for the same amount and vice versa.
Depending on the given information, the amount of forward/future asset or liability
is measured as follows:
Scenarios Measurement of Forward/Future Asset or Liabili
Forward/future price is (current forward or future price less original forward
given or future price) x quantity of underlying
e ts (spot price less original forward or future price) x
Only spot price is given quantity ofunderlying
Note: The amounts determined shall be stated at their absolute values (disregarding the negative
sign, if any) since the advantageous or disadvantageous position is the determining factor whether
an entity recognizes an asset or liability, respectively.
Changes in the fair value of forward/future asset or liability have the following
consequences in an entity's profit or loss:
Changes Amount in profit or loss
Increase in forward/future asset Unrealized gain
Decrease in forward /future asset Unrealized loss
Increase in forward/future liability Unrealized loss
Decrease in forward /future liability Unrealized gain
On the date of settlement, for aprivalives entered into for speculative purpeses, the
at the advantageous position (i. e,, net ah sadoment)
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Illustration 3. On November 10, 2023, ALPHA Company entered in a forward

contract with BETA Company for speculative purposes involving ALPHA’s purchase
of 15,000 barrels of petroleum gas at a forward price of P80 per barrel. The
settlement date is set on January 20, 2024. By December 31, 2023, the prevailing
forward price amounted to P90 per barrel. Fast forward to settlement date, the
forward and spot price are equal to P93 per barrel. The parties intend to ultimately
make a net cash settlement. Time value of money is deemed immaterial.
Required: Determine the journal entries to be recorded in the books of ALPHA and
BETA during 2023 and 2024.
In this case, the following journal entries shall be made:
Date ALPHA Company (the buyer) | - BETA Company (the seller)
11/10/23 No entry since there were no changes yet in the forward price and there
are no amounts paid for the forward contract.
12/31/23 Forward asset 150,000 Unrealized loss - P/L 150,000
Unrealized gain - P/L 150,000 Forward liability 150,000
There is unrealized gain since the There is unrealized loss since the
Company, as the buyer, is in an Company, as the seller, is in a
advantageous position (P90 disadvantageous position (P90
forward price > P80 exercise price). forward price > P80 exercise price).
The amount of asset is computed The amount of liability is computed
as: (P90 - P80) x 15,000 barrels. as: (P90 - P80) x 15,000 barrels.
01/20/24 The Company, as the buyer, is still The Company, as the seller, is still in
in an advantageous position (P93 a disadvantageous position (P93
forward price > P80 exercise price). forward price > P80 exercise price).
The cumulative amount of asset is The cumulative amount of liability
computed as P195,000 /(P93 - P80) is computed as P195,000 /[(P93 -
x 15,000 barrels]. P80) x 15,000 barrels].
Consequently, a further unrealized Consequently, a further unrealized
gain of P45,000 (P195K ~ P150K) loss of P45,000 (P195K - P150K)
shall be recognized: shall be recognized as follows:
Forward asset 45,000 Unrealized loss-P/L 45,000
Unrealized gain- P/L 45,000 Forward liability 45,000
Finally, the receipt of settlement Finally, the payment of settlement

price from BETA Company shall be price to ALPHA Company shall be
recorded as follows: recorded as follows:
Cash 195,000 Forward liability 195,000

Forward asset 195,000 Cash 195,000
Note: Ultimately, the total amount of unrealized gain of P195,000 (P150,000 + P45,000) is
equal to the amount of cash received. On the other hand, the total amount of unrealized loss
is equal to the amount of cash paid.
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Illustration 4. On October 1, 2023, speculating the decline in the price of copper

ore, DELTA Company entered into a forward contract to sell 20,000 tons of copper
with GAMMA Company ata P40 forward price. Settlement date is set on January 31,
2025. Forward prices and spot prices are the following:
Forward prices Spot prices
December 31, 2023 P32.00/ton P30.00/ton
December 31, 2024 36.50/ton 34.00/ton
January 31, 2025 35.00/ton 35.00/ton
The parties plan to have a net cash settlement on maturity date. Required:
Determine the journal entries to be recorded in the books of DELTA and GAMMA
during 2023 to 2025. The effect of time value of money is immaterial.
In this case, the following journal entries shall be made:
Date DELTA Company (the seller) |. GAMMA Company (the buyer)
10/01/23 No entry since there were no changes yet in the forward price and there
are no amounts paid for the forward contract.
12/31/23 | Forward asset 160,000 Unrealized loss - P/L 160,000
Unrealized gain- P/L 160,000 Forward liability 160,000
There is unrealized gain since the There is unrealized loss since the
Company, as the seller, is in an Company, as the buyer, is in a
advantageous position (P32 disadvantageous position (P32
forward price < P40 exercise price). forward price < P40 exercise price).
The amount of asset is computed The amount of liability is computed
as: (P32 - P40) x 20,000 tons. as: (P32 - P40) x 20,000 tons.
12/31/24 | The Company, as the seller, is still in The Company, as the buyer, is still
an advantageous position (P36.50 in a disadvantageous position
forward price > P40 exercise price). (P36.50 forward price > P40 exercise
The cumulative amount of asset is price). The cumulative amount of
computed as P70,000 /(P36.50 - liability is computed as P70,000
P40) x 20,000 tons]. [(P36.50 - P40) x 20,000 tons].
Consequently, an unrealized loss of Consequently, an unrealized gain of
P90,000 (P70K - P160K) shall be P90,000 (P70K - P160K) shall be
recognized due to the decrease in recognized due to the decrease in
FV of the asset: the FV of the liability:
Unrealized loss-P/L 90,000 Forward liability 90,000
Forward asset 90,000 Unrealized gain-P/L 90,000
01/31/25 | The Company, as the seller, is still in The Company, as the buyer, is still
an advantageous position (P35 in. a disadvantageous position
forward price > P40 exercise price). (P35 forward price > P40 exercise
The cumulative amount of asset is price). The cumulative amount of
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computed as P100,000 /(P35 - liability is computed as P100,000

P40) x 20,000 tons]. [(P35 - P40) x 20,000 tons].
Consequently, an unrealized gain of Consequently, an unrealized loss of
P30,000 (P100K - P70K) shall be P30,000 (P100K - P70K) shall be
recognized due to the increase in FV recognized due to the increase in FV
of the asset: of the liability:
Forward asset 30,000 Unrealized loss - P/L 30,000
Unrealized gain-P/L 30,000 Forward liability 30,000
Finally, the receipt of settlement Finally, the payment of settlement
price from GAMMA Company shall price to DELTA Company shall be
be recorded as follows: recorded as follows:
Cash 100,000 Forward liability 100,000

Forward asset 100,000 Cash 100,000
The readers should take note that over the life of the derivative, DELTA Company
has reported net unrealized gain of P100,000 (P160,000 - P90,000 + P30,000),
which is equal to the amount of cash it received from GAMMA Company.
DETERMINING THE POSITION IN OPTION CONTRACTS

ALL of the following factors affect the pay-off from option contracts:
a. Whether the entity is the holder or the writer of the option contract.
e Holder (or investor) - the entity who bought the option contract by initially
paying the option premium amount.
e Writer -the entity who created the option contract and sold it to holder. This
entity initially received the option premium amount but can have potential
liabilities in the future.
For simplicity in this chapter, the accounting procedures are told in the
perspective of the holder entity.
b. Whether the entity is the potential buyer or the seller in the option contract. The
following terminologies are relevant for the holder entity:
Role in the option contract | Name of the option contract

Potential buyer Call option
Potential seller Put option
The basic trading strategy using options is as follows: An entity purchases a call
option if it expects that the price of the underlying will increase while it purchases
put option if it expects that the price of the underlying will decrease.
C. The amount of option’s “strike price” (i.e, exercise price) relative to the current
value of the underlying (i.e., spot price).
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After considering all of these factors, the following are the positions of the holder
entity in an option contract (ignoring the amount of option premium paid):
Scenarios Position
The entity is a potential buyer (call option):
Spot price > Exercise or strike price Advantageous
Spot price < Exercise or strike price Disadvantageous
The entity is a potential seller (put option):
Spot price > Exercise or strike price Disadvantageous
Spot price < Exercise or strike price Advantageous
The other terminologies for the holder entity’s position are the following:
Position Option Terminology Probability of Exercise

Advantageous IN-the-money Most likely to be exercised
Disadvantageous OUT-of-the-money Least likely to be exercised
Spot price = Strike price AT-the-money Neutral
The readers should take note that the “moneyness” of an option contract is
dependent on BOTH of the following:
a. whether the option is a call option or put option; and
b. the relationship of the spot price and strike price
The probability of exercising the option is relevant since the option is a right, but
not an obligation unlike in the future and forward contracts. In other words, option
contracts are not required to be exercised, especially if the holder entity is in a
disadvantageous position.
Illustration 5. On December 1, 2023, EPSILON Company acquired a call option for
the purchase ofa certain number of shares of another entity ata strike price of P100
per share. Required: Under each of the following independent scenarios, determine
the Company’s position as of December 31, 2023:
1. The underlying shares had fair value of P110 per share as of December 31, 2023.
Scenario 1 - The share’s fair value is P110 per share
In this case, the Company is in an advantageous position since it has the right to
purchase the shares for just P100 per share, even though the prevailing market
price is P110 per share. As such, the option is said to be in-the-money and will most
likely exercised by the Company.

In this case, the Company is in a disadvantageous position since it has the right to
purchase the shares for P100 per share, even though the prevailing market price is
just P92 per share. As such, the option is said to be out-of-the-money and the
Company will most likely not exercise the call option.
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Illustration 6. Use the same information as in EPSILON Company, except that the
contract is a put option for the purchase of a certain number of shares of another
entity at a strike price of P100 per share. Required: Under each of the following
independent scenarios, determine the Company's position as of December 31,
2023:

In this case, the Company is in a disadvantageous position since it has the right to
sell the shares at P100 per share, even though the prevailing market price is higher
at P110 per share. As such, the option is said to be out-of-the-money and will most
likely not exercised by the Company.

In this case, the Company is in an advantageous position since it has the right to
sell the shares for a higher amount of P100 per share, even though the prevailing
market price is just P92 per share. As such, the option is said to be in-the-money and
the Company will most likely exercise the call option.
NET AMOUNT OF PAY-OFF FROM OPTION CONTRACTS

For option contracts that are currently IN-the-money, the following are the gross
amounts of pay-off in the perspective of the holder entity assuming their exercise:
Option Gross amount of pay-off

Gross pay-off = (Spot price - Strike price) x No. of units of underlying
Call As the spot price increases, the gross pay-off amount increases. As to the
option | maximum amount, the sky is the limit since the spot price can go to much
higher amounts relative to strike price.
Gross pay-off = (Strike price - Spot price) x No. of units of underlying
Put As the spot price decreases, the gross pay-off amount increases. As to the
option | maximum amount, the strike price is the limit since the spot price of the
underlying will most likely never go below zero.
The gross pay-off is the amount that can be received by the holder from the writer of
the option. After considering the initial amount of option premium, the net pay-off
= gross pay-off less amount initially paid as option premium.
For option contracts that are currently OUT-of-the-money, there will be no
negative amounts of pay-off. Instead, the maximum
amount of loss in an option
contract is equal to the amount initially paid as option premium.
Illustration 7. During the year 2023, for speculative purposes, ZETA Company
acquired a call option covering 50,000 kilograms of wheat at a strike price of P70
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per kilogram by paying P15,000 initial option premium. Required: Under each of
the following independent scenarios, determine the net amount of pay-off or loss
from the call option contract:
1. Spot price on the date of exercise is P90 per kilogram.
The net amount of pay-off or loss in each scenario is determined as follows:
Scenarios Gross pay-off Net pay-off
1 P1,000,000 = (P90 - P70) x 50,000 | P985,000 = P1,000,000 - P15,000
2 P400,000 = (P78-P70)x 50,000 | P385,000 = P400,000 - P15,000
3 None (spot price < strike price) Loss of P15,000
Illustration 8. During the year 2023, for speculative purposes, KAPPA Company
acquired a put option covering 30,000 ounces of nickel at a strike price of P50 per
kilogram by paying P10,000 initial option premium. Required: Under each of the
following independent scenarios, determine the net amount of pay-off or loss from
the put option contract:
1. Spot price on the date of exercise is P45 per ounce.
The net amount of pay-off or loss in each scenario is determined as follows:
Scenarios Gross pay-off Net pay-off
1 P150,000 = (P50 - P45) x 30,000 | 140,000 = P150,000 - P10,000
Z P360,000 = (P50 - P38) x 30,000 | P350,000 = P360,000 - P10,000
3 None (spot price > strike price) Loss of P10,000
Note: The amount of net pay-off is equal to the net amount of gain or loss over the life of the option.
FAIR VALUE OF OPTION CONTRACTS

The fair value of option contracts is determined using the option pricing models
(e.g., binomial tree, Black-Scholes-Merton), which are already out of scope of this
book. However, the general components of the fair value of the options are the
following:
Fair Value of Option = Intrinsic Value + Time Value
An option that is in-the-money has both
intri valuensic
and time value. However,
out-of-the-money option has time value only but not intrinsic value. Consequently,
the fair value of in-the-money option is considerably higher compared to out-of-
the-money option.
Intrinsic value is the difference between the spot price and strike price, provided
that the option is in-the-money. On the other hand, time value represents the
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amount that a holder would pay after considering the likelihood that the amount of
pay-off from the option will increase in the future.
As such, an out-of-the-money option does not necessarily have a zero value, but it
could still have value in the form of time value.
Illustration 9. As of December 31, 2023, one of PLANETARY Company’s call

options had fair value of P1,500,000. This call option covers 5,000 ounces of gold at
a strike price of P1,000 per ounce. As of the same date, the spot price for the gold
amounted to P1,280 per ounce.
In this case, there is an intrinsic value for the call option since spot price of P1,280
is higher than strike price of P1,000. The P1,500,000 fair value can now be split into
following components:
Intrinsic value [(P1,280 - P1,000) x 5,000] P1,400,000

Add: Time value (P1,500,000 - P1,400,000) 100,000
Total fair value of the option P1,500,000
ACCOUNTING FOR DERIVATIVE PRODUCTS - OPTIONS

Accounting for options is very similar to financial assets at FVTPL, where changes
in the option’s fair value are recognized in profit or loss. Since an option represents
a right, but not an obligation, an asset shall be recognized if the holder is in an
advantageous position, but no liability shall be recognized if it is in a
disadvantageous position.
Generally, the option’s fair values are already given, and no computations are
necessary. However, i. ofagi r intrinsic valu
i hall ion’s fair value (i.e., time ' ime
On the date of settlement, the option’s fair value is equal to its intrinsic value (i.e.,
time value will become zero on this date). Changes in the fair value of option asset
have the following consequences:
'. Changes .—_ | Amount in profit or loss
Increase in option asset Unrealized gain
Decrease in option asset Unrealized loss
As to exercisability date/s, options can be classified as either of the following:

a. American option - exercisable anytime until the option’s expiration date.
b. European option - exercisable only on the option’s expiration date. For the rest
of the chapter, the options are presumed to be European options.
If, on the date of settlement, the option is out-of-the-money, the amount of net loss
over the option’s life is equal to the amount of initial option premium.
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Illustration 10. On October 1, 2023, speculating the decrease in the price of silver,
an entity acquired a put option to sell 12,000 ounces of silver for P500 per ounce
by paying option premium of P30,000. The option will be settled on February 1,
2024. Fair value of the option and spot price of silver are the following:
Option SpotPrice - Silver
December 31, 2023 P300,000 P480
February 1, 2023 480,000 460
On October 1, 2023, the journal entry to record the payment of option premium:
Option asset 30,000
Cash 30,000
On December 31, 2023, the journal entry to recognize the change in the fair value
of the option in profit or loss:
Option asset 270,000
Unrealized gain - P/L (P300K- P30K) 270,000
On February 1, 2024, the journal entry to recognize the change in the fair value of
the option in profit or loss and receipt of net cash settlement from the option’s
writer:
Option asset (P480K- P300K) 180,000
Unrealized gain - P/L 180,000
Cash 480,000
After considering all of the entries, the net gain from the option contract is P450,000
(P270,000 + P180,000) or the amount of net increase from initial premium payment
(P480,000 - P30,000) or the net pay-off {[(P500 - P460) x 12,000] - P30,000}.
Query: What if the spot price of the silver increased to P515 per ounce on February
1, 2023?
In this case, the option will be worthless (i.e., zero fair value) and the P300,000
carrying amount of the option asset as of that date shall be derecognized as a loss
as follows:

After considering this entry, the net loss from the option contract is P30,000
(P270,000 unrealized gain less P300,000 unrealized loss - P/L), which is also equal
to the P30,000 option premium that was initially paid to the writer. Again, no
liability shall be recognized for options.
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Illustration 11. On October 15, 2023, speculating the increase in price of

microchips, an entity acquired a call option to. purchase 40,000 chips at a strike
price of P60 per chip by paying P45,000 initial option premium. The time value of
the option is deemed to be very immaterial. Spot prices of the chips were P68 per
chip and P65 per chip as of December 31, 2023 and March 1, 2024 (date of
settlement), respectively.
In this case, the fair values of the option contract are equal to intrinsic values
Date Intrinsic Values Unrealized Gain (Loss)
P320,000 P275,000 unrealized gain
December 31,2023 | pee _ p6q) x 40,000] (P320,000 - P45,000)
March 1, 2024 P200,000 _ P120,000 unrealized loss
i [(P65 - P60) x 40,000] (P200,000 - P320,000)
OTHER FORMS OF DERIVATIVES

The following are the other forms of derivatives:
1. Credit default swaps (CDS) - provide guarantee against the credit risk or the
chance that the counterparty will default on its obligation in a contract.
Specifically, ina CDS agreement:
e anentity exposed to credit risk pays periodic premiums to the guaranteeing
entity.
e in case of default, the guaranteeing entity is required to purchase that
financial asset at a fixed price from the entity who is originally exposed to the
credit risk.
For example, ABC Company has a loan receivable from another entity. To protect
against credit risk, ABC Company entered into a CDS agreement with XYZ
Company. Before the loan receivable defaults, the parties have the following
obligations:
ABC periodically pays the CDS premiums xyz

Company |¢ Compa
ey provides guarantee against credit risk tree
Incase the borrower of the loan receivable defaults, the parties will now have
the following obligations:
ABC sells the loan receivable 4 XYZ
Com hs Compan
scent pays the amount of the loan receivable pany
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2. Interest rate swaps - in this form of swap, the parties change their exposure
from a variable interest rate to a fixed interest rate or vice versa.
For example, Entity A and Entity B, both speculators, entered into an interest
rate swap agreement with a notional principal of P100 million. Under the terms
of the swap, Entity A will pay 7% fixed rate (i.e., fixed-rate payer) while Entity B
will pay variable rate (i.e., variable-rate payer), both based on the P100 million
notional. Settlement is scheduled every December 31 of each year.
If, on December 31, 2023, the variable rate averaged 9%, the parties are required
to pay the following amounts:
will pay 7%)

>|
Entity A Entity B
will pay 9%
In this case, the parties may just agree to have a net cash settlement wherein
Entity B will pay 2% (9% - 7%) to Entity A.
3. Cross-currency swap - in this form of swap, the parties agree to exchange
principal (and interest payments) denominated in one currency for principal
(and interest payments) denominated in another currency. In hedging, this swap
is used to manage the foreign currency risk.
For example, ABC Company and XYZ Company entered into a speculative cross-
currency swap wherein ABC Company will pay 12% interest based on PHP50
million while XYZ Company will pay 10% interest based on US$1 million. The
settlement is every December 31 of each year.
- In this case, the parties have the following obligations every December 31:
: a a
ABC will pay 12% based on PHPSO million=> XYZ
c P
ompany will pay 10% based on US$1 million Compan
ie
4. Interest rate caps and floors - Interest rate caps are used to limit variable
interest from going up beyond a certain level (i.e., cap rate) while interest rate
floors are used to limit variable interest from going down beyond a certain level
(i.e., floor rate). In short, these derivatives are used in managing interest rate
fluctuations.
Interest rate caps are normally used for a liability with variable interest rate to
reduce the risk that the borrower will pay a very high amount of interest.
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Interest rate floors are normally used for an asset with variable interest rate to
reduce the risk that the investor entity will receive a very low amount of interest.
Illustration 12 - Interest Rate Cap. Entity A has a P10,000,000 face amount

bonds payable, owed to Entity C, bearing variable interest rate payable every
December 31 of each year. To protect itself from sudden increase in variable
interest rate, it entered in an interest rate cap agreement with Entity B at cap
rate of 8%.
Scenario 1: If, on December 31, 2023, the variable interest increases to 10% (i.e.,
above cap rate), then Entity A will receive a pay-off from Entity B equal to
P200,000 [P10,000,000x (10% - 8%)]. Entity A shall pay Entity C 10% interest.
Scenario 2: If, on December 31, 2023, the variable interest increases to 7% (i.e.,
still below cap rate), then there will be no pay-off between Entities A and B.
However, Entity A shall pay Entity C 7% interest.
Illustration 13 - Interest Rate Floor. ABC Company has an investment in bonds
with P5,000,000 face amount and bear variable interest. To protect itself against
the sudden decrease in variable interests, ABC Company entered into an interest
rate floor agreement with XYZ Company at a floor rate of 5%.
Scenario 1: If, on December 31, 2023, the variable interest decreases to 4% (i.e.,
below floor rate), then ABC Company will receive pay-off from XYZ Company
equal to P50,000 /P5,000,000 x (5% - 4%)].
Scenario 2: If, on December 31, 2023, the variable interest decreases to 6.50%
(i.e., still above floor rate), then there will be no pay-off between the parties.
To summarize, the following are the amounts of pay-offs from interest rate caps
and floors:
Scenarios - Amount of Pay-Off to be Received

Interest Rate Caps
Pay-off = Principal Amount of Liability x
Current rate > Cap Rate (Current rate - Cap rate)
Current rate < Cap Rate None
Interest Rate Floors
Current rate 2 Floor Rate None
Pay-off = Principal Amount of Assetx
Current rate < Floor Rate (Floor rate - Current rate)
A combination of interest rate cap floor is called interest rate collar.
5. Swaptions - combination of option and swap, wherein it is an option to enter
into a swap contract in the future.
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CHAPTER SUMMARY
1. Derivatives have the following characteristics:
a. its value changes in response to the change in underlying.
b. itrequires no initial net investment or a very small initial net investment
c. itis settled ata future date.
The following are the most common types of derivative contracts: futures, forwards,
and options.
Primary elements ofa derivative contract include the following: underlying, exercise
price, notional, and maturity. Notional = Quantity of underlying x exercise price.
Settlement of derivatives can be either of the following:
a. Physical settlement - with actual delivery of underlying asset.
b. Netcash settlement between counterparties.
Derivatives for speculative purposes are accounted under at FVTPL.
uw
Forwards and futures are very similar wherein they require an entity to purchase or
sell a certain amount of quantity of underlying. However, futures contracts are
traded in an exchange while forward contracts are private contracts.
Forward or future asset will be recognized if the entity is in an advantageous
position while a forward or future liability will be recognized if it is in a
disadvantageous position:
Scenarios se see Position
Buying entity:
Forward or future price or spot price > Exercise price Advantageous
Forward or future price or spot price < Exercise price Disadvantageous
Selling entity:
Forward or future price or spot price > Exercise price Disadvantageous
Forward or future price or spot price < Exercise price Advantageous
8. Option gives right but not an obligation, to purchase or sell a certain number,
amount, or quantity of underlying
9. Options can be either call option (i.e., option to buy) or put option (i.e., option to sell).
10.An option asset will be recognized if the entity is in an advantageous position, but
no liability will be recognized if it is in a disadvantageous position:
Scenarios Position
The entity is a potential buyer (call option):
Spot price > Exercise or strike price Advantageous
Spot price < Exercise or strike price Disadvantageous
The entity is a potential seller (put option):
Spot price > Exercise or strike price Disadvantageous
Spot price < Exercise or strike price Advantageous
11.An option is in-the-money if the holder is at an advantageous position while it is
out-of-the money if the holder is at an disadvantageous position.
12. The fair value of an option is composed of intrinsic value and time value. Out-of-the-
money options have only the time value.
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True or False
1. Derivatives may be used for hedging or for speculative purposes.
2. The price of the underlying is dependent on the changes in the value of the
derivative.
3. Commodity price can be considered as an underlying in a derivative contract.
4. Non-financial variable can never be considered as underlying in a derivative
contract.
5. Underlying represents the nominal amount over which the derivative contract is
based and not necessarily the value of the derivative contract.
6. Inaphysical settlement, there is an actual delivery of the underlying asset.
7. Aderivative with financial asset underlying and is held for speculation is accounted
at fair value through profit or loss.
8. Aderivative that can be net settled in cash, regardless of the underlying, and is held
for speculation can be accounted at fair value through profit or loss.
9. Forward contracts represent a right, but not an obligation to buy or to sell a certain
quantity of underlying.
10. Futures contracts are over-the-counter contracts.
11. Ina forward contract to buy, an entity shall recognize a forward asset if the forward
price has increased over the exercise price.
12. In a forward contract to sell, an entity shall recognize a forward liability if the
forward price has decreased under the exercise price.
13. Acall option is an option to purchase, while a put option is an option to sell.
14. A call option or a put option is considered out-of-the-money if the exercise price is
higher than the strike price.
15. In an in-the-money option, the fair value of the option is composed of time value
and intrinsic value components, while the fair value of the out-of-the-money option
is composed of intrinsic value only.

1. All of the following are the characteristics of derivative contracts, except
a. These are settled ona future date.
b. The values of the underlying of these contracts respond to the changes in the
value of the relevant derivative contracts.
c. Noorvery minimal initial investment
2. Underlying of a derivative contract can be any of the following, except
a. Number of units produced by one of the parties,
b. Price of petroleum products
c. Credit rating of a group of borrowers
d. Exchange rate between Philippine peso and US dollars
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Chapter 14 = Accounting for Derivatives
3. Which of the following derivatives is/are accounted at fair value through profit or
loss?
a. Derivatives with financial asset underlying but will be physically settled.
b. Derivatives with nonfinancial asset underlying but will be net cash settled.
c. Derivatives designated for hedging.
d. Bothaandb
4. Elements of a derivative are properly described as follows, except
a. The underlying is the basis of the value of the derivative.
b. Exercise price is the fixed purchase price or selling price in the contract.
c. Notional is the current value of the derivative contract.
d. Maturity is the date that the contract will be settled.
5. Which of the following correctly describe the difference between forwards and
futures?
a. Forwards involve obligation to purchase, while futures involve obligation to sell
underlying assets.
b. Forwards will always result to forward asset, while futures will always result to
forward liability.
c. Forwards are traded in an exchange market, while futures are not traded.
d. Forwards are private contracts, while futures are public contracts.
6. Depending on the position of the entity in a forward contract,

a. A forward asset is recognized if the entity is in advantageous position, while a
forward liability is recognized if the entity is in disadvantageous position.
b. A forward asset is recognized if the entity is in advantageous position, but no
liability is recognized if the entity is in disadvantageous position.
c. A forward asset is not recognized if the entity is in advantageous position, but a
forward liability is recognized if the entity is in disadvantageous position.
d. A forward asset is recognized if the entity is in disadvantageous position, while
a forward liability is recognized if the entity is in advantageous position.
7. Ina forward or future contract to buy, a forward asset is recognized if
a. Current relevant forward prices are lower than exercise price.
b. Current relevant forward prices are higher than exercise price.
c. Current relevant forward prices are equal to exercise price.
8. Ina forward or future contract to sell, a forward liability is recognized if
a. Current relevant forward prices are lower than exercise price.
b. Current relevant forward prices are higher than exercise price.
c. Current relevant forward prices are equal to exercise price.
9. Changes in the fair value of forward/futures held for speculation are recognized in
a. Profit or loss
b. Other comprehensive income
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c. Retained earnings
d. Equity
10.There are two types of options as to the role of the holder, namely call option and
put option. Which of the following correctly describes each of these types?
a. Both call and put options are options to buy.
b. Both call and put options are options to sell.
c. Call option is an option to buy, while put option is an option to sell.
d. Call option is an option to sell, while put option is an option to buy.
11. Depending on the position of the entity in an option contract,
a. An option asset is recognized if the entity is in advantageous position, while an
option liability is recognized if the entity is in disadvantageous position.
b. An option asset is recognized if the entity is in advantageous position, but no
liability is recognized if the entity is in disadvantageous position.
c. An option asset is not recognized if the entity is in advantageous position, but
an option liability is recognized
if the entity is in disadvantageous position.
d. An option asset is recognized if the entity is in disadvantageous position, while
an option liability is recognized if the entity is in advantageous position.
12.In a call option contract, which of the following scenarios will make it an in-the-
money option?
a. Spot price = Exercise price
b. Spot price < Exercise price
c. Spot price > Exercise price
13.In a put option contract, which of the following scenarios will make it an in-the-
money option?
a. Spot price = Exercise price
b. Spot price < Exercise price
c. Spot price > Exercise price
14. Given the following different statuses of options, rank them from the most likely to
be exercised to the least likely to be exercised:
I. At-the-money option
I], In-the-money option
III, Out-of-the-money option
II, J, Wl
of
II, 1, I
c. I, Ill, I
d. II, Il,1
15.The maximum net amount of loss of a holder over the life of an option contract is
equal to
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a. its carrying amountas of the immediately preceding reporting date.

b. its maximum fair value less the amount initially paid for the option.
c. the amount initially paid for the option.
d. the present value of expected payments to be made to the writer of the option.
Straight Problems
1, On October 10, 2023, SHADOW Company, as a speculator, entered into a forward
contract to buy 80,000 units of raw materials for P200 per unit from another
speculator, GRAPHITE Company. The settlement date is set on March 1, 2024. On
December 31, 2023 and March 31, 2024, the forward price is P220 per unit and spot
price is P215 per unit, respectively.
Required: From the given information, determine the journal entries to be made for
2023 and 2024 in the books of SHADOW Company and GRAPHITE Company
On October 20, 2023, FOSSIL Company committed to a forward contract to sell

60,000 grams of gold at a fixed price of P500 per gram to COIN Company, to be
settled on March 15, 2024. Both of the counterparties are speculators. Forward price
as of December 31, 2023 and spot price on March 15, 2024 were P483 per gram and
P474 per gram, respectively.
2023 and 2024 in the books of FOSSIL Company and COIN Company
PEBBLE Company, on September 1, 2023, entered into a forward agreement to buy

100,000 shares of ABC Company for P40 per share for speculative purposes. The
counterparty in this agreement is LEAD Company, a fellow speculator. Settlement
date is set on January 31, 2024. ABC Company’s shares had forward price of P37 per
share and spot price of P33 per share on December 31, 2023 and January 31, 2024,
respectively.
2023 and 2024 in the books of PEBBLE Company and LEAD Company.
Speculating on the expected decline in the fair value of petroleum products, on

November 10, 2023, CHARCOAL Company entered into a forward contract to sell
30,000 barrels of crude oil at P200 per barrel. The counterparty entity is FLINT
Company, another speculator. Settlement date is set on February 14, 2024. Each
barrel of the crude oil had forward price of P220 per barrel and spot price of P216
per barrel, as of December 31, 2023 and February 14, 2024, respectively.
2023 and 2024 in the books of CHARCOAL Company and FLINT Company.
Expecting an increase in the price of silver, DOVE Company, a speculator, entered
into a call option covering 10,000 ounces of silver ata strike price of P600 per ounce
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by paying an initial option premium of P40,000. The fair values of the option and
silver as of each relevant dates are the following: '
Silver Spot
Date FV ofOption Price per Ounce
September 30, 2023 (contract date) P40,000 P598
December 31, 2023 230,000 620
January 28, 2024 (settlement date) 800,000 680
Required: From the given information, determine the journal entries to be recorded
in the books of DOVE Company.
. On October 1, 2023, FOG Company, speculating on the expected decrease in the price
of microchips, entered into a put option covering 30,000 units at a strike price of P80
per unit. Initial option premium paid amounted to P25,000. Settlement date is set on
March 10, 2024. The fair values of the option and microchips as of each relevant
dates are the following:
Microchips
Date FV of Option per Unit
October 1, 2023 P25,000 P80
December 31, 2023 250,000 73
March 10, 2024 360,000 68
in the books of FOG Company.
. On September 30, 2023, ANCHOR Company, a speculator, entered into a call option
covering 100,000 shares of another entity at a strike price of P50 by paying P50,000
to the writer of the option. Spot prices for the shares amounted to P52 per share and
P44 per share on December 31, 2023 and April 1, 2024 (the settlement date),
respectively. Time value of the option is deemed to be immaterial.
in the books of ANCHOR Company.
. SLATE Company, a speculator, acquired a put option by paying P10,000 on

September 1, 2023. The put option covers 200,000 shares of another entity and
strike price of P100. Settlement date is set on February 20, 2024. Spot prices for the
shares amounted to P97 and P104 as of December 31, 2023 and February 20, 2024,
respectively.
Required; From the given information, determine the journal entries to be recorded
in the books of SLATE Company.
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Chapter 14 —- Accounting for Derivatives

1. On September 30, 2023, SMOKE Company entered into a forward contract to buy
60,000 kilograms of wheat from GRAY Company at an exercise price of P90 per
kilogram. Settlement date is set on April 1, 2024. Both of the parties are speculators.
Forward prices and spot prices are the following:
Date Forward Price SpotPrice
December 31, 2023 P94 P92
April 1, 2024 88 88
As of December 31, 2023, SMOKE Company shall report ;

a. P120,000 forward asset c. P240,000 forward asset
b. P120,000 forward liability d. P240,000 forward liability
For the year 2023, the amount unrealized gain or loss in GRAY Company’s books
shall be
a. P240,000 unrealized gain c. P120,000 unrealized gain
b. P240,000 unrealized loss d P120,000 unrealized loss
For the year 2024, the amount unrealized gain or loss in SMOKE Company’s books
shall be
b. P240,000 unrealized loss d. P360,000 unrealized loss
On April 1, 2024, the settlement shall include

a. SMOKE Company paying P240,000 to GRAY Company.
b. SMOKE Company receiving P240,000 from GRAY Company.
c. SMOKE Company paying P120,000 to GRAY Company.
d. SMOKE Company receiving P120,000 from GRAY Company.
2. On October 5, 2023, DEL MONTE Company, speculating a decrease in the price of a

particular commodity, entered into a forward contract to sell 50,000 units of this
commodity for P80 per unit. The contract is with PAOMBONG Company, a fellow
speculator. Settlement date is set on March 20, 2024. Forward prices amounted to
P84 and P78 as of December 31, 2023 and March 20, 2024, respectively. On the other
hand, spot prices amounted to P81 and P78 as of December 31, 2023 and March 20,
2024, respectively.
As of December 31, 2023, PAOMBONG Company shall report

For the year 2023, the amount unrealized gain or loss in DEL MONTE Company’s
books shall be
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For the year 2023, the amount unrealized gain or loss in PAOMBONG Company’s
books shall be
On March 20, 2024, the settlement shall include

a. PAOMBONG Company paying P100,000 to DEL MONTE Company.
b. PAOMBONG Company receiving P100,000 from DEL MONTE Company.
c. PAOMBONG Company paying P300,000 to DEL MONTE Company.
d. PAOMBONG Company receiving P300,000 from DEL MONTE Company.
3. On August 31, 2023, OBANDO Company entered into a forward contract to buy
90,000 kilograms of barley from BALAGTAS Company at an exercise price of P120
per kilogram. Settlement date is set on March 1, 2024. Both of the parties are
speculators. Forward prices and spot prices are the following:
Date Forward Price Spot Price
December 31, 2023 P129 P127
March 1, 2024 132 132
As of December 31, 2023, OBANDO Company shall report

For the year 2023, the amount unrealized gain or loss in BALAGTAS Company’s
books shall be
For the year 2023, the amount unrealized gain or loss in OBANDO Company's books
shall be
On March 1, 2024, the settlement shall include
a. OBANDO Company paying P1,080,000 to BALAGTAS Company.
b. OBANDO Company receiving P1,080,000 from BALAGTAS Company.
c. OBANDO Company paying P270,000 to BALAGTAS Company.
d. OBANDO Company receiving P270,000 from BALAGTAS Company.
4, On November 5, 2023, speculating the increase in the fair value of the shares of
another entity, BUSTOS Company acquired a call option covering 50,000 shares of
other entity at a strike price of P150 per share. The Company made an initial
payment of P45,000 to the writer of the option. The settlement date is set on January
20, 2025. The fair values of the option and the shares are the following:
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Date FVofOption SpotPrice

November 5, 2023 P45,000 P147
December 31, 2023 480,000 158
December 31, 2024 30,000 148
January 28, 2025 150,000 153
The amount of unrealized gain or loss to be recognized in the Company’s 2023 profit
or loss shall be
b. P480,000 unrealized loss d,.P435,000 unrealized loss
or loss shall be
or loss shall be
5. On November 12, 2023, speculating the decrease in the value of copper, RAFAEL
Company acquired a put option covering 80,000 kilograms of copper ata strike price
of P100 per kilogram by paying P15,000 to the writer of the option. Settlement date
is on February 1, 2025. The fair values of the option and the shares are the following:
Time Value Spot
Date ofOption _ Price
November 12, 2023 P15,000 P98
December 31, 2023 20,000 95
December 31, 2024 12,000 103
February 1, 2025 - 97
or loss shall be
or loss shall be
The net amount of unrealized gain or loss to be recognized in the Company’s profit
or loss over the life of the put option shall be
b. P240,000 net loss d, P225,000 net loss
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Chapter 15 — Shareholders’ Equity - Contributed Capital
CHAPTER 15
SHAREHOLDERS’ EQUITY - CONTRIBUTED CAPITAL

The differences between equity and liability.
The components of shareholders’ equity.
She gee
The components of legal capital and contributed capital.

The accounting for contributed capital components.
The differences among authorized, issued, subscribed, and outstanding number
of shares and transactions affecting these number of shares.
EQUITY INSTRUMENTS
An equity instrument is any contract that evidences a residual interest in the
assets of an entity after deducting all of its liabilities. [PAS 32.11]. That residual
claim represents rights to receive some or all of the following:
a. Dividends, when there is declaration;
b. Proceeds from satisfying the equity claims either from liquidation or in part at
other times; and
c. Any other claims established by contract, legislation, or similar means.
Examples of equity instruments include, but are not limited to, the entity’s own
common (or ordinary) shares, preference shares, and share rights.
EQUITY COMPARED TO LIABILITY

Both the equity and liability instruments are claims against an entity's assets as
illustrated in the basic accounting equation (Assets = Liabilities + Equity). In
layman’s terms, a claim of a creditor is considered as liability while the claim of the
owner is considered as equity. However, there are other things to be considered
when classifying claims as equity or liability.
The classification of instruments into liability or equity will depend on the
substance of the transaction rather than the legal form. Under PAS 32, features
of liability compared to equity are the following:
Liability fe. Equity

Is there a contractual obligation to Yes No
|___ pay cash or noncash asset?
Is there a contractual obligation to
exchange financial assets or financial
liability with another entity under Yes No
conditions that are potentially
unfavorable to the issuer?
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Liability |. Equity |
Other than
exchange of fixed Exchange of fixed
Derivative that can be settled by the amount of cash or
; ar : amount of cash or ;
issuance of entity’s own equity anothonfhandal another financial
instruments ascot fora heed asset for a fixed
sumer oEeHalteY number of shares
Will receive
Bari Ma otal ay aes amounts only when
Priority in liquidation Priority all ltabilities have
been paid
: May be recognized :
Changes in value (ie, FVTPL) Not recognized
Reporting of returns paid to holders : 2 ;
(eg, interest, dividends etc) In profit or loss Directly in equity
The main distinguishing feature of equity instruments is the absence of an entity’s

obligation to pay cash or other financial asset to its shareholders. For example,
redeemable preference shares are legally considered as equity of an entity.
However, since there is a contractual obligation for the issuer to pay cash to the
holder, it will be considered as a liability for accounting purposes.
In addition, transactions involving the equity holders in their capacity as such

do not affect the profit or loss or other comprehensive income of an entity.
INTRODUCTION TO SHAREHOLDERS’ EQUITY

Most of the entities that are using full PFRSs are large enough for them to be legally
structured as corporations. Compared to sole proprietorship and partnership, the
corporation’s equity (called shareholders’ equity) has a lot more components
wherein each account provides different financial information.
The ownership over a corporation is normally divided into shares of stock, which is
evidenced by share certificates. The more shares thata shareholder owns, the more
ownership interest it has over the corporation. The components of shareholders’
equity are discussed in detail as follows:
Component Description
Represents the total par value or stated value of issued shares.
This can be classified as either pertaining to ordinary shares or
preference shares. Issued shares are shares that were fully paid
Share capital | by shareholders.
Ordinary shares are those with general shareholder rights and
are entitled to vote in important corporate matters.
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Chapter 15 - Shareholders’ Equity — Contributed Capital
Preference shares contain “preferences” such as priority in

receiving dividends. However, preference shares normally cannot
vote on corporate matters,
Par value of a share is the nominal minimum value assigned to
each share. Par value shares cannot be issued for a
consideration below the issued shares’ total par value.
Stated value of a share is the nominal value assigned to no-par
value shares. No-par value shares shall be paid immediately (i.e.,
not allowed to be paid in installments). Legally, the minimum
stated value is set at P5.00 per share.
aecorentan This is primarily the excess of the consideration over the
Gr ndditional shares total par value or stated value. This can also include the
+5 ital equity component on compound financial instruments and special
paid in capita assessments from shareholders.
Subscribed Represents the total par value of shares that were subscribed but
share capital | not yet fully paid. The related share certificate is yet to be issued.
Represents the amount of subscription price not yet paid by the
= subscribers. This is normally presented as a deduction from
Subscription | shareholders’ equity.
receivable
However, if the balance of this account is collectible within 12
months, this will be presented as part of current assets.
Retained Total earnings of the entity less total dividends declared,
earnings cumulatively from the entity’s inception.
——_ Issued shares that were subsequently bought back from
shareholders. Presented as deduction from shareholders’
shares ;
equity.
Represent the cumulative amounts of unrealized gains and
losses recognized in other comprehensive income (OCI) that
Cumulative | are yet to be transferred to retained earnings.
other Separate accounts are normally maintained for each type of OCI
comprehensive | such as revaluation surplus, unrealized gains or losses on FVTOCI
income investments, etc,
amounts ‘ ‘ ‘ ae
If there is a cumulative loss or debit balance, it is presented as a
deduction from equity, while if there is a cumulative gain or
credit balance, it is presented as an addition to equity.
CONTRIBUTED CAPITAL
From the term itself, contributed capital represents the amounts contributed by
the shareholders to the entity. This is computed by using the following
shareholders’ equity components:
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Chapter 15 - Shareholders’ Equity - Contributed Capital
Share capital Pxx

Share premium XX
Subscribed share capital XX
Less: Subscription receivable XX
Treasury shares XX
Net contributed capital PXxx
a. Subscription receivable is deducted in computing for contributed capital since
this amount is yet to be actually contributed by the subscribers.
b. Treasury shares are deducted in computing contributed capital since this
represent the amount paid (i.e., returned) to shareholders.
LEGAL CAPITAL
Legal capital is the portion of equity that a corporation cannot legally distribute
to its shareholders. This is based on the trust fund doctrine which provides that
the capital stock, property, and other assets of a corporation are regarded as equity
in trust for the payment of corporate creditors (Philip Turner v. Lorenzo Shipping
Corporation, G.R. 157479, 2010).
The actual amount of legal capital will depend on whether the shares have par value
or do not have par value:
- -Typeofshare - | ~~. ‘Components oflegal capital —
Total par value of issued and subscribed shares
Par value share
(i.e., excluding share premium)
Total proceeds from issuance, including
No-par value share ~
subscription (stated value plus share premium)
Illustration 1. A corporation reported the following amounts at the end of 2023:
Ordinary share capital, no par, with stated value of P20 P2,000,000
Share premium - ordinary 500,000
Preference share capital, P40 par 1,000,000
Share premium - preference 200,000
Common share of another corporation at fair value 3,000,000
Subscribed share capital - preference 800,000
Subscription receivable 400,000
Retained earnings 7,000,000
Treasury shares 600,000
Cumulative unrealized loss - FVTOCI 900,000
Cumulative actuarial gains 750,000
From the given information, the amounts of (a) shareholders’ equity; (b) net
contributed capital; and (c) legal capital are computed as follows:
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Net
Shareholders’ Contributed Legal
Equity Capital Capital
Ordinary share capital, no par P2,000,000 P2,000,000 P2,000,000
Share premium - ordinary 500,000 500,000 500,000
Preference share capital, P40 par 1,000,000 1,000,000 1,000,000
Share premium - preference 200,000 200,000
Subscribed share capital - pref. 800,000 800,000 800,000
Subscription receivable (400,000) (400,000)
Treasury shares (600,000) (600,000)
Cumulative unrealized loss -
FVTOCI (900,000)
Cumulative actuarial gains 750,000
Total amounts P11,850,000 P3,500,000 P4,300,000

a. Common shares of other entities are not included in the shareholders’ equity
computation but will be presented as part of the assets (i.e., investments).
b. Share premium - ordinary is included in the legal capital computation since the
ordinary shares do not have par value. Share premium - preference is excluded
since the preference shares have par value.
c. Subscribed share capital is included at gross (i.e., not reduced by subscription
receivable) in computing the legal capital. [SEC-OGC Opinion No. 19-50].
ACCOUNTING FOR ISSUANCE OF SHARE CAPITAL

A corporation can issue its share by receiving any or a combination of the following
as proceeds (with the related accounting procedures):
Proceeds Accounting Consequence

The shareholders’ equity will increase by the same amount of
Cash cash received. Share premium to be recognized is equal to the
cash proceeds less aggregate par value of issued shares.
The amount of noncash asset shall be measured using the
following hierarchy [PFRS 2.10]:
1. Fair value of noncash asset received
aiaiirsel asc: 2. Fair value of shares issued
3, Par value of shares issued
Of course, the amount of increase in shareholders’ equity and
share premium to be recognized will depend on the
measurement of the noncash asset received.
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- Proceeds Accounting Consequence

If the liability is considered as a compound financial instrument
Previous liability | (j,¢,, convertible bonds), apply the concepts in Chapter 7.
incurred by the
corporation In all other scenarios, apply the concepts in Chapter 8 involving
the extinguishment of liability by issuing equity securities.
The services provided by professional outsiders (lawyers,
consultants, etc.) shall be valued using the following hierarchy
[PFRS 2.10):
1. Fair value of services
Services - 2. Fair value of shares issued
provided by 3. Par value of shares issued
non-employees
Billing price is not necessarily equal to the fair value of services
since it is subject to negotiation. Similar to noncash assets, the
amount of share premium will depend on the measurement of
the services.
The services provided by employees are measured by reference
Services - to the fair value of shares or other equity instruments issued.
provided by [PFRS 2.11]. The reason is that it is not possible to estimate
employees reliably the fair value of the services received from employees.
Details of this will be discussed in Chapter 16.
Illustration 2 - Cash Received. A corporation is authorized to issue 200,000

ordinary shares with par value of P50 and 50,000 preference shares with par value
of P100. During the current month, it had the following equity transactions:
a. Issued 10,000 ordinary shares by receiving a total of P720,000.
b. Issued 25,000 preference shares for P125/share.
These transactions are recorded as follows:
Cash 720,000
Share capital - ordinary (10,000x P50) 500,000
Share premium - ordinary
(P720,000 - P500,000) 220,000
Cash (25,000x P125) : 3,125,000

Share capital ~ pref, (25,000xP100) 2,500,000
Share premium - pref.
[25,000 x (P125 - P100)] 625,000
Illustration 3 - Noncash Asset Received. During the year, a corporation issued

30,000 of its P100 par value ordinary shares (the corporation does not have any
other type of shares) in exchange for a land. Required: Under each of the following
independent scenarios, determine the journal entry to record the issuance:
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1. The land has fair value of P4,200,000 while the shares have fair value of
P150/share.
2. The land has fair value of P4,200,000 while the fair value of shares cannot be
reliably estimated.
3. The land’s fair value cannot be reliably estimated while the shares have fair
value of P150/share.
4, Both the land’s and shares’ fair values cannot reliably estimated.
Scenario 1
The fair value of the shares will be ignored since the first in hierarchy (ie., fair value
of land) in the measurement of noncash asset is available:
Land 4,200,000
Share capital (P100 x 30,000) 3,000,000
Share premium (squeeze) 1,200,000
Scenario 2
The entry is similar to Scenario 1 since the lack of the fair value of the shares issued
will not affect the measurement of the noncash asset if that asset’s fair value is
reliably determinable.
Scenario 3
Since the fair value of the land is not determinable, the second in hierarchy, the fair
value of shares issued, shall be used in measuring the land:
Land (30,000x P150) 4,500,000
Share capital (P100 x 30,000) 3,000,000
Share premium (squeeze) 1,500,000
Scenario 4
Since both the fair value of land and shares issued are not determinable, the land
shall be measured equal to the total par value of shares (i.e., no share premium will
be recognized):
Land (30,000x P100) 3,000,000
Share capital (P100 x 30,000) 3,000,000
BASKET ISSUANCE OF DIFFERENT CLASSES OF SHARES
A corporate entity may issue a certain number of its ordinary shares and a certain
number of its preference shares in a single transaction at a basket issue price. In
this case, the following allocation procedures are relevant:
1. If both fair values of each class of shares are determinable, allocate the basket
issue price based on the relative total fair values of the shares,
2. Otherwise, allocate the basket issue price to the extent of the determinable fair
value of a class of shares. Any excess basket issue price shall be attributed to the
class of share with no determinable fair value.
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Chapter 15 — Shareholders’ Equity — Contributed Capital
Illustration 4. During the year, a corporate entity issued 120,000 of its P25 par
value ordinary shares and 25,000 ofits P100 par value preference shares ata basket
issue price of P9,000,000.
journal entry to record the issuance of the shares:
1. The ordinary shares have P50 fair value per share while the preference shares
have P160 fair value per share.
2. The ordinary shares have P50 fair value per share while the fair value of the
preference shares cannot be determined reliably.
Scenario 1
Since both the fair values of each class of shares are determinable, the P9,000,000
basket issue price shall be allocated based on their relative total fair values (FV):
[A] . Allocation
TotalFV Proportion (P9M x [A])
Ordinary (120K x P50) P6,000,000 6M/10M P5,400,000
Preference (25K x P160) 4,000,000 4M/10M 3,600,000
P10,000,000 10M/10M P9,000,000
Compound journal entry to record the issuance is as follows:

Cash 9,000,000
Share capital - ord. (P25 x 120K) 3,000,000
Share premium - ord. (P5.4M-P3M) 2,400,000
Share capital - pref. (P100 x 25K) 2,500,000
Share premium - pref. (P3.6M-P2.5M) 1,100,000
Scenario 2
Since only the fair value of the ordinary shares is determinable, P6,000,000 (P50 x
120,000) will be allocated outright to these shares. The excess of P3,000,000
(P9,000,000 - P6,000,000) shall be allocated to preference shares.
Compound journal entry to record the issuance is as follows:

Cash 9,000,000
Share capital - ord. (P25 x 120K) 3,000,000
Share premium - ord. (P6M - P3M) 3,000,000
Share capital - pref. (P100 x 25K) 2,500,000
Share premium - pref. (P3M - P2.5M) 500,000
SUBSCRIPTION OF SHARES
A corporation may also issue its shares to shareholders on an installment basis (i.e..,
subscription basis). Most subscriptions require down payment with the balance
payable on specific date/s or payable upon the call of board of directors of a
corporation. The readers should take note that the 25%-25% rule on the pre-
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incorporation subscription was already repealed under the Revised Corporation

Code (RCC).
It is only when the shares are fully paid that the related share certificate will be
issued to the subscriber. A share certificate is a legal document that serves as the
proof of ownership of shares in a particular corporation.
However, pending the full payment of the subscription price, a non-delinquent

subscriber is considered as a shareholder and shall have the same rights as
fully paid shareholders, except the right to the share certificate. (Section 71,
RCC).
The following are the pro-forma entries made in connection with the subscription
of shares and subsequent payment:
To record the subscription and down payment from subscribers:
Cash (if any) . XX
Subscription receivable XX
Subscribed share capital (at par) XX
Share premium (if any) XX
The amount of subscription receivable is equal to subscription price times the

number of shares subscribed. This is reduced by the amount of down payment, if
there is any. It should also be noted that the share premium is recognized as
early as the date of subscription (i.e., not when the full payment was received).
To record the receipt of subscription balance:
Cash XX
Subscription receivable XX
To record the issuance of share certificates upon full payment of subscription

balance:
Subscribed share capital (at par) XX
Share capital (at par) XX
The readers should take note that this transfer shall be made equal to the par value
of the fully paid shares (not at the amount of final payment).
Illustration 5. On January 1, 2023, a corporation received subscription on its P20
par value shares from five subscribers at a subscription price of P35/share, Each
subscriber subscribed 10,000 shares (total of 50,000 subscribed shares), Down
payment of 25% of subscription price is required to be paid, On February 1, 2023,
each of the subscribers paid 60% of the subscription balance. Three subscribers fully
paid their subscription on February 15, 2023 while the remaining subscribers fully
paid their subscription on March 1, 2023.
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In this case, the total subscription price is P1,750,000 (5 subscribersx 10,000 shares
x P35). The amount of P437,500 (P1,750,000 x 25% ) down payment will reduce the
subscription receivable balance to P1,312,500 (P1,750,000 - P437,500). On January
1, 2023, the entry to record subscription is as follows:
Cash 437,500
Subscription receivable 1,312,500
Subscribed share capital (50,000 x P20) 1,000,000
Share premium [(P35 - P20) x 50K] 750,000
On February 1, 2023, to record the partial payment of P787,500 (P1,312,500x 60%):

Cash 787,500
After this entry, the subscription receivable balance will be P525,000 (P1,312,500 —
P787,500 or P1,312,500x 40%). Since each subscriber paid the same amounts, each
of them owes the corporation P105,000 (P525,000/5 subscribers).
On February 15, 2023, to record the full payment of three subscribers and the
related issuance of share certificates:
Cash (P105,000 x 3 shareholders) 315,000

Subscribed share capital 600,000
Share capital (3 x 10,000 x P20) 600,000
On March 1, 2023, to record the full payment of two subscribers and the related
issuance of share certificates:
Cash (P105,000 x 2 shareholders) 210,000
Subscribed share capital 400,000
Share capital (2 x 10,000 x P20) 400,000
After these journal entries, subscribed share capital and subscription receivable
accounts will have zero balances.
DELIQUENT SUBSCRIPTIONS
Of course, lending credit to subscribers may result to some of them being unable or
unwilling to pay for the subscription balance. In this case, the subscription may be
declared delinquent, and the process for finding the highest bidder for the
delinquent shares will be initiated.
The highest bidder is the one who is willing to pay the unpaid subscription
balance, interest, and other costs/expenses, if there are any, for the smallest
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number of shares. In effect, the “highest” pertains to the highest bid amount per
share (i.e., lower divisor will result to higher quotient).
When there are no bidders, all of the delinquent shares will be issued in the name
of the corporation and will be considered as treasury shares. The previous
amounts paid by the subscriber shall be forfeited (i.e., recorded as share premium).
Concepts on accounting for treasury shares will be discussed later in the chapter.
Illustration 6. On June 1, 2023, a corporation received subscription at P40/share
for 50,000 of its P30 par value shares. A 30% down payment was received on that
date. The entry made to record the subscription is as follows:
Cash (50K x P40 x 30%) 600,000
Subscribed share capital (50K x P30) 1,500,000
Share premium 500,000
However, the subscriber failed to pay the balance and as a result, the subscription
was declared delinquent. Total costs of publishing and organizing the delinquency
sale amounted to P150,000. The following entries were made before the actual
delinquency sale:
Due from the highest bidder 1,550,000
Cash (publishing and organizing costs) 150,000
The following bids were received: Bidder A for 30,000 shares; Bidder B for 20,000
shares; and Bidder C for 26,000 shares.
Bidders | No.ofShares | Effective Bid Amount per Share

A 30,000 P51.67 (P1.55M/30K)
B 20,000 P77.50 (P1.55M/20K)
C 26,000 P59.62 (P1.55M/26K)
In this case, Bidder B is considered as the highest bidder (smallest number of shares
at 20,000 or highest bid amount per share of P77.50), who is entitled to 20,000
shares. The other 30,000 shares are issued on the name of the original subscriber:
Cash 1,550,000
Subscribed share capital 1,500,000
Share capital (50,000x P30) 1,500,000
Assuming instead that there are no bidders, the following entry will be made:
Treasury shares 1,550,000

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Chapter 15 —- Shareholders’ Equity - Contributed Capital
RETIREMENT OF SHARES
A corporation may purchase shares and immediately retire them for good (i.e., may
not be resold), which will decrease the shareholders’ equity. Accounting
procedures will depend on the relationship between the par value and the
retirement price of the shares:
_ Scenarios Accounting Consequences... |
Par value > ‘ ‘ ; ' :
retirement price The difference is credited to share premium - retirement.
The difference is charged using the following hierarchy:
Par value < 1. Share premium related to the original issuance of the retired
retirement price shares only (i.e., not the whole share premium balance)
2. Retained earnings
In the absence of explicit amount of share premium related to the original issuance
of the retired shares, that amount can be estimated as follows:
Share premiumrelated _ _ Beginning share No. of retired shares
to retired shares premium No. of issued shares
Illustration 7. On January 1, 2023, an entity reported the following information:
Share capital, P50 par, 200,000 sharesissued § P10,000,000
Share premium 2,000,000

journal entry to record the retirement of shares:
1. 4,000 shares were retired by paying shareholders P45/share
Scenario 1
The share capital account will always be debited at the total par value of the
retired shares. Since the retirement price is less than the par value, an amount will
be credited to share premium - retirement:
Share capital (4,000x P50) 200,000
Cash (4,000 x P45) 180,000
Share premium - retirement 20,000
Scenario 2
Since the retirement price is higher than the par value, an amount will be deducted
from the share premium arising from original issuance:
Share capital (4,000 x P50) 200,000
Share premium 8,000
Cash (4,000 x P52) 208,000
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It should be noted that the share premium from original issuance related to the 4,000
retired shares is equal to P40,000 [P2,000,000 x (4,000/200,000)]. This averaging is
just an approximation in the absence of additional information.
Scenario 3
Since the retirement price is higher than the par value, an amount will be deducted
from the share premium arising from original issuance:

Share premium (computed in scenario 2) 40,000
Retained earnings (squeeze) 20,000
Cash (4,000 x P65) 260,000
An amount is charged against retained earnings since the difference in par value
and retirement price (i.e. P60,000) is higher than the amount of share premium
from original issuance (i.e, P4¢0,000, as computed in Scenario 2).
TREASURY SHARES
Treasury shares are shares previously issued by a corporation that were reacquired
from its shareholders. Unlike in the retirement of shares, there is a plan to resell the
treasury shares for a reasonable price fixed by the corporation. In addition, unlike the
other equity accounts, treasury shares account has a normal debit balance.
Initially, treasury shares are measured at their purchase price. Subsequently,
these shares may be sold again at an amount higher or lower than the repurchase
price, or these shares may be also retired for good. Relevant accounting procedures
are the following:
Scenarios Accounting Consequences
Retssep nee The “gain” is credited to share premium - treasury.

purchase price
Relssiie price The “loss” is charged using the following hierarchy:
: 1. Share premium - treasury, to the extent of its balance
purchase price 2. Retained earnings
Retirement of treasury
shares (parvalue> | The difference is credited to share premium - retirement
purchase price)
Retirement of treasury | 1. Share premium related to the original issuance of the
shares (par value < retired treasury shares only
purchase price) 2. Share premium - treasury, to the extent of its balance
3, Retained earnings
a. The acquisition of treasury shares decreases the shareholders’ equity, equal
to the amount of acquisition price.
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b. The reissuance of treasury shares, whether at a price higher or lower than the
shares’ purchase price, increases the shareholders’ equity, equal to the
amount of reissue price.
c. The retirement of treasury shares does not affect the shareholders’ equity
since the treasury shares have already decreased the shareholders’ equity at the
date of acquisition.
d. The retirement of treasury shares differs from the immediate retirement
of shares in that in the former, the difference may be charged to share
premium - treasury.
e. The cost of remaining treasury shares shall not be available for dividend
payment and shall be recorded as appropriation in the retained earnings, to be
discussed in the next chapter.
Illustration 8. At the beginning of the current year, an entity reported the following
information:
Share capital, P20 par, 400,000 shares issued P8,000,000
Share premium - treasury 40,000
Treasury shares, 20,000 shares, P28 cost 560,000

journal entries to record the transaction:
1. All of the treasury shares were sold for P32/share.
4. All of the treasury shares were retired.
Scenario 1
Since the reissue price (P32) is higher than the related cost (P28), a credit to share
premium - treasury will be made as follows:
Cash (20,000 x P32) 640,000
Scenario 2
Since the reissue price (P27) is lower than the related cost (P28), a charge against
share premium - treasury will be made as follows:
Cash (20,000 x P27) 540,000
The P40,000 balance of share premium - treasury is enough to absorb the “loss”.
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Scenario 3
Since the reissue price (P24) is lower than the related cost (P28), a charge against
share premium - treasury will be made as follows:
Cash (20,000 x P24) 480,000
The P40,000 balance of share premium - treasury is not enough to absorb the
P80,000 “loss” [(P28 - P24) x 20,000). As a result, the excess is charged against
retained earnings.
Scenario 4
Since there is a retirement, it is necessary to determine the amount of share premium
— issuance related to the retired shares amounting to P60,000 /P1,200,000 x
(20,000/400,000)]. The total difference between the purchase cost and par value is
P160,000 (P560,000 - P400,000), and shall be allocated in the following manner:
1. First, against the P60,000 share premium - issuance related to the retired
treasury shares.
2. Next, against the share premium - treasury of P40,000.
3. Finally, P60,000 (P160,000 - P60,000 - P40,000) against retained earnings.
The related journal entry to record the retirement is as follows:
Share capital (20,000 x P20) 400,000

Illustration 9. On May 1, 2023, a corporation acquired 40,000 of its own P30 par
value shares from its shareholders by paying them P40/share. These shares were
sold in the following manner:
Date Number ofshares _ Reissue price
May 15, 2023 20,000 P50/share
June 30, 2023 5,000 P34/share
August 10, 2023 15,000 P28/share
On May 1, 2023, the entry to record the purchase of treasury shares and the related
appropriation of retained earnings:
Treasury shares 1,600,000
Cash (40,000 x 40) 1,600,000
_Unappropriated retained earnings 1,600,000

Appropriated retained earnings 1,600,000
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On May 15, 2023, to record the sale of treasury shares above the purchase price:
Cash (20,000 x P50) 1,000,000
Treasury shares (20,000 x P40) 800,000
On June 30, 2023, to record the sale of treasury shares below the purchase price:
Cash (5,000 x P34) 170,000
Before recording this sale, there is a balance of P200,000 in the share premium -
treasury from May 15 sale against which the P30,000 “loss” can be fully charged. After
the sale, the balance in the share premium - treasury will be reduced to P17 0,000
(P200,000 less P30,000).
On August 10, 2023, to record the sale of treasury shares below the purchase price:
Cash (15,000x P28) 420,000 |
There is a “loss” of P180,000 [15,000 x (P40 - P28)] arising from this transaction.
However, the balance of share premium - treasury is only P170,000, resulting to
P10,000 charge against retained earnings.
Finally, to record the ultimate removal of the appropriation:
Unappropriated retained earnings 1,600,000
SHARE ISSUANCE COSTS
According to paragraph 37 of PAS 32, transaction costs that are directly attributable
to the issuance of new shares be deducted from equity, net of any related income tax
benefit. However, the standard does not further elaborate on what account title
shall be used in recording these costs.
Consequently, Philippine Interpretations Committee (PIC) Q&A No. 2011 - 04
opined that such transaction costs be accounted as follows:
1. First, as direct deduction from the related share premium arising from the
issued shares,
2. Any excess of these transaction costs over the share premium from this
particular issuance are recorded in a contra-equity account (with debit balance)
titled “share issuance costs” from the following equity accounts in the order of
priority:
a. share premium from previous share issuance; or
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b. retained earnings with appropriate disclosure.

In other words, share issuance costs are not recognized in profit or loss.
Illustration 10. Right before the end of the year 2023, a corporate entity had the
Share capital, P30 par value §P6,000,000
On December 31, 2023, the entity issued 50,000 ordinary shares at P35 issue price.
In connection with the issuance, the entity also incurred a certain amount of
transaction costs. Required: Under each of the following independent scenarios,
determine the journal entries to record the issuance of the shares:
1. Transaction costs amounted to P150,000.
Scenario 1
The following are the journal entries to be made on December 31, 2023:
Cash (50,000 x P35) 1,750,000
Share capital (50,000 x P30) 1,500,000
Share premium - issuance (squeeze) 250,000
Cash 150,000
The P150,000 amount of transaction costs is wholly deducted from the share
premium account since it is lower than the P250,000 share premium arising from
this particular issuance. Net share premium from this transaction is P100,000.
Scenario 2
Cash (50,000x P35) 1,750,000

Share capital (50,000 x P30) 1,500,000
Share issuance costs (squeeze) 50,000
Cash 300,000
The P50,000 balance in the share issuance costs account will be presented wholly
as a deduction from the P200,000 balance in the share premium - issuance account.
Scenario 3
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Cash (50,000 x P35) 1,750,000

Share capital (50,000 x P30) 1,500,000
Share issuance costs (squeeze) 240,000
Cash 490,000
The P200,000 balance in the share issuance costs will be presented as a deduction
to the extent of the P200,000 balance in the share premium - issuance account. The
P40,000 excess (P240,000 - P200,000) will be presented as a deduction from the
retained earnings account.
Scenarios 1 to 3 - Presentation
Under each of the scenarios previously mentioned, the share premium - issuance
and retained earnings will have the following carrying amounts as of December 31,
2023:
Scenario1 Scenario2 Scenario3
Share premium - issuance, January 1 P200,000 P200,000 P200,000
Add: Net share premium from January 5 100,000
Less: Share issuance costs account (50,000) _ (200,000)
Share premium - issuance, end P300,000 P150,000
Retained earnings P1,750,000 P1,750,000 P1,750,000
Less: Share issuance costs account - - (40,000)
Retained earnings, end P1,750,000 1,750,000 P1,710,000
Note that in Scenario 3, the P240,000 balance in share issuance costs account is split
since the P200,000 balance in share premium - issuance is not enough.
COSTS OF INITIAL PUBLIC OFFERING OF SHARES

Entities who make an initial public offering (IPO) of its existing shares in a stock
market often simultaneously issue additional shares. However, the readers should
take note that unlike the share issuance costs, costs related to the listing of existing
shares shall be expensed outright. Fortunately, PIC Q&A No. 2011 - 04 identified the
following costs and their related classification:
Costs -. Cost Classification
Documentary stamp tax Share issuance
Other percentage tax Share issuance
Underwriting costs Share issuance
Audit and other a advice relating to joltit - share igguanes and listing
Opinion of counsel Joint - share issuance and listing

Tax opinion Joint - share issuance and listing
Fairness opinion and valuation report Joint - share issuance and listing
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Prospectus design and printing Joint - share issuance and listing

Road show presentation Listing
Public relations consultant fees Listing
Newspaper publication fees for the share issue Share issuance
SEC registration fees for new shares Share issuance
Stock exchange listing fees Listing
Share issuance costs are accounted for as a direct deduction from equity (i.e.,
direct deduction from share premium - issuance) in the similar manner as in the
previous section, while listing costs are expensed outright.
On the other hand, joint costs shall be allocated as follows:
Joint costs to be _ Amountof , _No. ofnewly issued shares in the IPO

deducted from equity joint costs Total no. of shares after IPO
Joint costs to be _ Amountof , No. of existing shares before IPO

expensed outright joint costs Total no. of shares after IPO
Illustration 11. During the current year, an rene made an IPO of its shares and
incurred the following costs:
Documentary stamp tax P450,000
Other percentage tax 120,000
Underwriting costs 180,000
Audit and other professional advice relating to prospectus 400,000
Opinion of counsel 200,000
Tax opinion 150,000
Fairness opinion and valuation report 300,000 |
Prospectus design and printing 50,000
Road show presentation 500,000
Public relations consultant fees 250,000
Newspaper publication fees for the share issue 60,000
SEC registration fees for new shares 350,000
Stock exchange listing fees 600,000
Right before the IPO, the entity already had 200,000 ordinary shares with P20 par
value while an additional 300,000 ordinary shares were issued during the IPO at an
average price of P30. Required: Determine the accounting treatment for these costs.
First, determine the total amount of joint costs:
Audit and other professional advice relating to prospectus P400,000
Tax opinion 150,000
Fairness opinion and valuation report 300,000
Total joint costs P1,100,000
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This P1,100,000 total joint costs shall be allocated as follows:

Jointcoststobe =| 300K shares i
deducted from equity ~ Bie 200K+300Kshares ~ Rae 000
Joint costs to be _ 200K shares P 000
expensed outright TS Onis 300K shares sian.
Next, determine the total amount of costs that shall be recognized as a direct
deduction from equity and the total amount of costs to be expensed outright:
Deduction Expensed
from Equity Outright
Documentary stamp tax P450,000
Underwriting costs 180,000
Road show presentation P500,000
Joint costs to be deducted from equity 660,000
Joint costs to be expensed outright 440,000
P1,820,000 P1,790,000
Journal entry to record the issuance of 300,000 new shares during the IPO:
Cash (300,000x P30) 9,000,000
Share capital (300,000x P20) 6,000,000
The P1,820,000 share issue costs shall be wholly deducted from the share premium
since it is lower than the P3,000,000 share premium arising from this particular
issuance:
Cash (for share issuance costs) 1,820,000
Total listing fees of P1,790,000 shall be expensed outright as follows:

Listing costs - P/L 1,790,000
Cash (for listing costs) 1,790,000
DONATION OF AN ENTITY'S OWN SHARES

Shareholders may return shares to the issuing corporation without asking for any
amount, thus in effect, donating the said shares. Since this donation is not
considered an economic event (i.e., no effect in equity), the receipt of donated
shares is recorded only through a memorandum entry. Only when these
donated shares are reissued that a credit to share premium - donated shares
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shall be made, equal to the amount of proceeds received. This reissuance will
increase the shareholders’ equity.
Illustration 12. A wealthy shareholder of a corporation donated all of its

shareholdings in that corporation. The donated shares numbered 50,000 and have
par value of P10. These shares were subsequently sold for P42 per share.
On the date of donation, a memorandum entry will be made as follows:

“A shareholder donated 50,000 shares with par value of P10.”
On the date of selling the donated shares, the following entry will be made:
Cash (50,000 x P42) 2,100,000
Share premium - donated shares 2,100,000
It should be noted that the donation of shares and their subsequent reissuance
do not affect the amount of share capital and share premium from original
issuance.
DONATION OF ASSET
A corporation may also receive assets through donation. The asset shall be
measured at its fair value but the corresponding credit will depend on the identity
of the donor:
Donor — Cae Creditto =
Shareholder Share premium - donation
Non-shareholder Other income (in profit or loss)
Unlike in the donation of an entity’s own shares, the donation of assets has an
immediate effect of increasing the shareholders’ equity equal to its fair value
as early as of the date of donation.
Illustration 13. An entity received a land with fair value of P2,400,000 from a
donor. If the donor is a shareholder, the following entry will be made on the date
of donation:
Land 2,400,000
Share premium - donated assets 2,400,000
If the donor is a non-shareholder, the following entry will be made:

Land 2,400,000
Other income - P/L 2,400,000
CONVERSION OF PREFERENCE SHARES

Convertible preference shares allow their holders to convert the shares into a
specified number of ordinary shares. Upon conversion, the sum of the par value
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of converted shares and the corresponding share premium - preference will

be considered as the issue price for the issued ordinary shares.
Illustration 14. A corporation maintains 80,000 convertible preference shares
with par value of P100 (i.e., total par value of P8,000,000). These were all issued at
a premium of P2,000,000. Each preference share is convertible to four ordinary
shares with par value of P20. Required: Under each of the following independent
scenarios, determine the journal to record the conversion:
1. All of the preference shares were converted
2. 60,000 preference shares were converted
Scenario 1
The conversion is recorded as follows:
Pref. share capital - convertible 8,000,000
Share premium - preference 2,000,000
' Ordinary share capital (4x 80KxP20) 6,400,000
Share premium - ordinary (squeeze) 3,600,000
Scenario 2
The conversion is recorded as follows:
Pref. share capital - convertible
(60,000 x P100) 6,000,000
Share premium - preference
(P2M x 60,000/80,000) 1,500,000
Ordinary share capital
(4.x 60,000 x P20) 4,800,000
SHARE SPLITS
Corporations may also change the number of its shares without issuing new shares
or buying treasury shares by either splitting up or splitting down the shares. All the
shares belonging to a class of share that was subjected to the share split will be
affected, including the issued shares, unissued shares, and the treasury shares.
__ Share Split-Up Share Split-Down
Effect to the number
abehiras Increase (Multiplying) Decrease (Dividing)
Effect to the par value Proportional decrease Proportional increase
To promote diversity in To limit the number of
the composition of shareholders ina
Main rationale shareholders by making corporation by making
the value of each share the value of each share
lower higher
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Effect in share capital

and share premium No effect No effect
Effect in the total
shareholders’ equity No effect No effect
Manner of recording | Memorandum entry only | Memorandum entry only
-IHustration 15. Currently, an entity maintains 120,000 ordinary shares with par
value of P60. Required: Under each of the following independent scenarios,
determine the number of shares and par value after the share split:
1. Share split-up where 2 new shares were exchanged for each share.
2. Share split-down where 1 new share was exchanged for every 2 shares
3. Share split-up where 3 new shares were exchanged for every 2 shares
4. Share split-down where 2 new shares were exchanged for every 3 shares
For each share split scenario, the revised number of shares and par value are the
following:
Revised Number of shares Revised Par value
2-for-1 share split-up 240,000 (120,000 x 2) P30 (P60/2)
1-for-2 share split-down 60,000 (120,000/2) P120 (P60 x2)
3-for-2 share split-up 180,000 [(120,000/2) x 3] P40 [(P60/3) x 2]
2-for-3 share split-down 80,000 /(120,000/3) x 2] P90 [(P60/2) x 3]
The readers should take note that before and after each share split scenario, the
total par value of the shares is the same (in this particular illustration, always at
P7,200,000). For example, after the 2-for-1 share split-up, the total par value is still
at P7,200,000 (240,000x P30). After the 1-for-2 share split-down, the total par value
is still at P7,200,000 (60,000 x P120).
REDEEMABLE PREFERENCE SHARES
As previously stated, these shares shall be classified as liability. Because of this,
dividends paid to these shares are reported as interest expense in profit or loss.
Illustration 16. At the beginning of 2023, GUEVARRA Company issued 6%

preference shares with total par value of P3,000,000. These shares are required to
be redeemed on December 31, 2025, with annual dividends required to be paid
each year.
On the issuance date, the following entry shall be made:
Cash 3,000,000
Redeemable pref. shares - liability 3,000,000
Every year, the payment of annual dividends is recorded as follows:

Cash (P3,000,000 x 6%) 180,000
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AUTHORIZED VS ISSUED VS OUTSTANDING NUMBER OF SHARES

Now is the best time to differentiate the terms that are usually associated with the
number of shares. These terms can be distinguished as follows:
Authorized Shares
\ J\ JL J
Y Y Y
Unissued Subscribed
Shards Issued Shares Shares
\ )\ J
Y Y
Treasury Shares Outstanding Shares
Based on the above graphical representation:

a. Authorized number of shares is the starting point for all corporations since
this is the maximum number of shares that are legally allowed to be issued by
the corporation to its shareholders. This is the least affected classification of the
number of shares as this is increased only when there is an increase in
authorized capitalization.
b. Unissued shares are those authorized shares that are neither fully paid by the
shareholders (i.e., issued) nor covered by a subscription agreement (i.e.,
subscribed).
c. Issued shares are those that are fully paid and with the related share
certificates issued. These shares include those that are in the treasury and those
that are in the hands of shareholders (i.e., outstanding).
d. Treasury shares are previously issued shares of a corporation that were
subsequently acquired by that same corporation from its shareholders.
e. Subscribed shares are those that are covered by a subscription agreement and
with the related share certificates yet to be issued.
f. Outstanding shares include the subscribed shares and issued shares less
the treasury shares.
Subscribed shares are considered as outstanding shares since they have the
same rights as a fully paid shareholder (except the right to share certificate),
provided that the subscription is not delinquent. [Section 71 of RCC].
As a result of the inclusion of the subscribed shares, the number of outstanding
shares can be higher than the number of issued shares.
The importance of the classification of shares, especially the number of outstanding

shares, can be fully realized in the next chapter when computing for the amount of
dividends.
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Illustration 17. A corporation was authorized to issue 100,000 shares. At the end
of the year, 60,000 shares have been fully paid while 15,000 shares were not yet
paid by the subscribers. In addition, 8,000 fully paid shares were reacquired from
the shareholders. In this case, the relevant numbers of shares are the following:
Authorized Shares 100,000
l ee } \
Y Y Y J
Unissued Subscribed
- Issued Shares 60,000 UDSClive
Shares Shares 15,000
25,000 | rl
(100,000 - Y f J
60,000 -
15,000) Treasury Shares Outstanding Shares 67,000
8,000 (15,000 + 60,000 - 8,000)
TRANSACTIONS AFFECTING ISSUED AND OUTSTANDING SHARES

The following transactions have the following effects on the number of issued and
outstanding shares for a particular class of shares:
: Rion Outstanding
Issued Shares Shares
Share issuance for cash, noncash assets,
; : Se ; Increase Increase
previously incurred liability, services
Subscription of shares No Effect Increase
Fully payment on subscribed shares Increase No Effect
Immediate retirement of shares Decrease Decrease
Purchase of treasury shares No Effect Decrease
Reissuance of treasury shares No Effect Increase
Retirement of treasury shares . Decrease No Effect (Note
Share split-up Increase Increase
Share split-down ; Decrease _ Decrease
Conversion from other class of shares Increase Increase
Conversion to other class of shares Decrease Decrease
The readers should take note that the retirement of treasury shares does not affect
the outstanding shares since the purchase of treasury shares already decreased the
number of outstanding shares from the time they were acquired from shareholders.
In addition, the full payment of the subscribed shares has no effect in the number
outstanding shares since these were already considered outstanding from the date
these were initially subscribed.
Illustration 18. At the beginning of 2023, an entity was authorized to issue 500,000
ordinary shares. During the year, the following share transactions were entered
into (in chronological order):
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a. 120,000 shares were issued for cash.

b. 50,000 shares were issued in exchange for a land.
c. Subscriptions for 80,000 shares were received.
d. 30,000 shares were acquired to be held in treasury
e. 10,000 of treasury shares were reissued at an amount higher than the purchase
price while 8,000 were reissued at an amount lower than the purchase price.
f. 25,000 shares were issued in exchange for services performed by professionals
g. 5,000 treasury shares were retired.
h. 60,000 of the subscribed shares have been paid.
i. 11,000 shares were acquired to be immediately retired.
The effects of these transactions in the issued and outstanding shares are the
following:
Transaction Issued Outstanding
a 120,000 120,000
b 50,000 50,000
c 80,000
d - (30,000)
e > 18,000
f 25,000 25,000
g (5,000) -
h 60,000 -
i (11,000) (11,000)_
Ending Numbers 239,000 252,000
ISSUANCE OF SHARE RIGHTS
As existing owners ofa corporation, the shareholders are given priority in acquiring
new shares to be issued by the corporation. This is done to give the shareholders
the chance to maintain their ownership over the issuing corporation (i.e., right of
preemption and right of first refusal).
As such, unless otherwise stated, one share right is given for every outstanding
share, which can be used in acquiring one new share at a pre-determined exercise
price. Since the share rights are granted free of charge (i.e., not considered an
economic event), only a memorandum entry shall be made on the grant date.
Illustration 19, At the beginning of 2023, TRISHA Company had 200,000 issued
and outstanding ordinary shares with P5 par value. On March 1, ‘2023, 30,000
ordinary shares were issued, while on April 30, 2023, 10,000 ordinary shares were
purchased to be held in treasury. On May 15, 2023, the Company granted share
rights to its shareholders, with each right granting the holder the right to purchase
one ordinary share for P8 per share. Fast forward to June 12, 2023, 60% of the share
rights were exercised, while the remaining 40% were exercised on July 1, 2023.
Required: Determine the journal entries related to the share rights.
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The number of outstanding number of shares as of May 15, 2023 is 220,000 shares
(200,000 + 30,000 - 10,000). As such, there were 220,000 share rights granted on
the same date, which shall be recorded through a memorandum entry only.
The exercise of 60% of share rights on June 12, 2023 shall be recorded as follows:
Cash (220,000 x 60% x P8) 1,056,000
Share capital (220,000 x 60% x P5) 660,000
The exercise of 40% of share rights on July 1, 2023 shall be recorded as follows:
Cash (220,000 x 40% x P8) 704,000
Share capital (220,000 x 40% x P5) 440,000
COMPREHENSIVE ILLUSTRATION J
At the beginning of the year 2023, a corporate entity had the following
shareholders’ equity balances:
Share capital - ordinary, P10 par value, 300,000 issued shares P3,000,000
Share premium - ordinary 1,500,000
Share capital - preference, P30 par value, 150,000 issued shares 4,500,000
During the year, the entity had the following shareholders’ equity transactions:
Date Transactions
01/05/23 | 40,000 ordinary shares were issued for P16 per share
02/10/23 | 20,000 preference shares were issued for P37 per share.
03/20/23 A land with fair value of P2,000,000 was received by issuing 100,000
ordinary shares with fair value of P18 per share.
04/12/23 30,000 ordinary shares from the beginning issued shares were
acquired for P17 per share.
40,000 ordinary shares were subscribed at P18 per share. Down
05/09/23 | payment of 40% was required with the balance due after two years.
However, the subscribers may pay earlier than the deadline.
06/26/23 | 20,000 treasury shares were issued at P18,.50 per share.
10,000 of the ordinary shares from January 5, 2023 issuance was
es Sid immediately retired by paying P17 to the shareholders.
10/10/23 The subscriber of 15,000 shares has fully paid its subscription balance.
The related share certificates were issued immediately.
11/17/23 | 5,000 of the treasury shares were reissued for P15 per share.
12/31/23 | Netincome for the year amounted to P800,000.
Required: Determine the journal entries to record the transactions and the ending
total balance of shareholders’ equity.
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Date Journal entries ny

Cash (P16
x 40,000) 640,000
01/05/23 Share capital - ordinary (P10x 40,000) 400,000
Share premium - ordinary (squeeze) 240,000
Cash (P37x 20,000) 740,000
02/10/23 ' Share capital - preference (P30 x 20,000) 600,000
Share premium - preference (squeeze) 140,000
Land (at its fair value) 2,000,000
03/20/23 Share capital - ordinary (P10 x 100,000) 1,000,000
Treasury shares (P17 x 30,000) 510,000
04/12/23 Cash 510,000
Cash (P18 x 40,000 x 40%) 288,000
05/09/23 Subscription receivable (P18 x 40,000 x 60%) 432,000
Subscribed share capital - ordinary (P10 x 40,000) 400,000
Share premium - ordinary [(P18 - P10) x 40,000] 320,000
Cash (P18.50
x 20,000) 370,000
06/26/23 Treasury shares (P17 x 20,000) 340,000
Share premium - treasury (squeeze) 30,000
Share capital - ordinary (P10 x 10,000) 100,000
Share premium - ordinary [(P16 - P10) x 10,000] 60,000
Cash (P17 x 10,000) 170,000
08/16/23
The amount of share premium debited is related to the share premium
per share from their issuance last January 5, 2023 (i.e. at P16). In
addition, no amounts were charged against the share premium - treasury
since the retired shares did not become part of treasury shares.
Cash (P18 x 15,000 x 60%) 162,000
60% in the above computation represents the unpaid portion of the
10/10/23 subscription last May 9, 2023 (i.e., complement of 40% down payment).
On the other hand, the entry to record the issuance of the share
certificate for these shares is as follows:
Subscribed share capital - ordinary (P10 x 15,000) 150,000
Share capital - ordinary (P10 x 15,000) 150,000
Cash (P15 x 5,000) 75,000
Share premium - treasury (squeeze) 10,000
11/17/23 Treasury shares (P17 x 5,000) 85,000
The P10,000 “loss” is wholly deducted from the share premium -
treasury balance of P30,000 arising from June 26, 2023.
Income Summary 800,000
tejel/2s Retained earnings 800,000
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These transactions can be summarized as follows to determine the ending balances of each shareholders’ equity account (positive
Book Readexs-
amounts denote credits while negative amounts denote debits):
Share Share Share Share Share Subs. Total

Capital - Premium - Capital - Premium - Prem. - Share Subs. | Treasury Retained
R̶e̶a̶d̶e̶r̶s̶ Raiders
Date Ordinary Ordinary Preference Preference | treasury Capital Receiv. Shares Earnings Total
Beg. Bal. P3,000,000 P1,500,000 P4,500,000 P750,000 p- P- P- P- | P2,500,000 P12,250,000
01/05/23 400,000 240,000 640,000
02/10/23 600,000 140,000 740,000
Nevule
03/20/23 1,000,000 1,000,000 2,000,000
Raiders || Nevule
04/12/23 (510,000) (510,000
05/09/23 320,000 400,000 (432,000) 288,000
06/26/23 30,000 340,000 370,000
08/16/23 (100,000) (60,000) (10,000) (170,000
10/10/23 150,000 (150,000) 162,000 162,000
11/17/23 (10,000) 85,000 75,000
12/31/23 800,000 800,000
End. Bal. P4,450,000 P3;,000,000 P5,100,000 P890,000 P20,000 | P250,000 (P270,000)| (P85,000)| P3,290,000 P16,645,000
Note: The appropriation of retained earnings related to the treasury shares were intentionally omitted above. Nevertheless, as of December 31,
2023, the total amount of appropriated retained earnings based on the 5,000 remaining treasury shares (30K — 20K — 5K) is P85,000 (P17 x
5K). On the other hand, unappropriated retained earnings amounted to P3,205,000 (P3,290,000 - P85,000).
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CHAPTER SUMMARY
1. Equity represents the residual interest in an entity. For a security to be classified as
such, the issuing entity shall have no obligation to pay cash or transfer noncash asset.
Z: Shareholders’ equity is more complex than a sole proprietor’s equity or
partnership’s equity. It has the following major components:
Component | Description Sica: :

Share Represents the total par value or stated value of issued shares.
capital
Share This is primarily the excess of consideration over the shares’
premium _ | total par value or stated value.
Subscribed | Represents the total par value of shares that were subscribed but
share not yet fully paid.
capital
Subscription Represents the amount of subscription price not yet paid by the
: subscribers. This is normally presented as a deduction from
receivable ' Ati
shareholders’ equity.
Retained | Total earnings of the entity less total dividends declared, over the
earnings life of the entity so far.
Treasury | Issued shares that were subsequently bought back from
shares shareholders. Presented as a deduction from equity.
Cumulative | Represent the cumulative amounts of unrealized gains and
OCI losses recognized in other comprehensive income (OCI) that
amounts are yet to be transferred to retained earnings.
From the term itself, contributed capital represents the amounts contributed by the
shareholders to the entity.
Legal capital is the portion of the equity that a corporation cannot legally distribute
to its shareholders. This is based on the trust fund doctrine.
If the shares were issued for cash, the share premium is the difference between cash
received and the total par value of shares issued.
If the shares were issued for noncash asset, the asset shall be measured using the
following hierarchy:
1. Fair value of noncash asset received
2. Fair value of shares issued
3. Par value of shares issued
By default, the basket issue price shall be allocated based on the relative fair values
of the different classes of shares issued,
8. Share premium from subscribed shares shall be recognized as early as the date of
subscription.
9. The non-delinquent subscribers have the same rights as fully paid shareholders,
except the right to a share certificate.
10.If a subscriber failed to pay on time, the subscription is considered to be delinquent
and a bidding for these shares shall be made.
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11.The highest bidder is the one who is willing to pay the unpaid subscription balance,
interest, and other costs/expenses, if there are any, for the smallest number of
shares.
12.The following procedures are relevant when there is an immediate retirement of
shares:
_ Scenarios Accounting Consequences
Est vale es The difference is credited to share premium - retirement.
retirement price
Par value < 1. Share premium related to the original issuance of the
retirement price retired shares only
13.Initially, treasury shares are measured at their purchase price. Subsequent

accounting procedures when the treasury shares are reissued or retired are the
following:
Scenarios Accounting Consequences
Reissue price > Be i .
ae The “gain” is credited to share premium - treasury.
purchase price
The “loss” is charged using the following hierarchy:
Relseue price < 1. Share premium - treasury, to the extent of its balance
purchase price 2. Retained earnings
Retirement of
treasury
value > shares (par
purchase :
The difference is. credited
: ‘um - retirement
to share premium ret
price)
Retirement of ‘
The difference isi charged using
i the followi i
following hierarchy :
1. Share premium related to the original issuance of the
treasury shares (par
retired treasury shares only
value < purchase
2. Share premium - treasury, to the extent of its balance
price)
14. Share issuance costs shall be recorded as a direct deduction from equity. Other costs,
such as listing fees, shall be expensed outright.
15.Donation of shares are initially recorded as a memo entry. If the shares were
subsequently issued, the proceeds are credited to share premium - donated shares.
16.Assets received as donation are measured at their fair values. If these are received
from shareholders, the credit shall be to share premium. Otherwise, the credit shall
be to other income.
17.In converting preference shares to ordinary shares, the total issue price for the
ordinary shares shall include both the par value and share premium related to the
converted preference shares.
18.Share splits have no effect in the amounts recorded. However, these affect the par
value and the number of shares.
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19. Redeemable preference shares are presented as a liability. Dividends paid to these
shares are recognized in the profit or loss.
20.Total number of outstanding shares is equal to number of subscribed shares plus
number of issued shares less treasury shares.
21.The following transactions affect the total amount of shareholders’ equity (SHE) in
the following manner:
‘Transactions Effect in Total Shareholders’ Equity

Shares issued for cash Increase equal to the amount of cash received
Shares issued for noncash asset Increase equal to the measurement of the asset
No effect since the debit is on expenses
Shares issued for services (reduction from SHE) and the credit is on share
capital and share premium (additions to SHE).
Shares issued for liability Increase equal to the liability’s carrying amount
Subscription of shares Increase equal to the down payment received
Receipt of subscription price Increase equal to the cash received
Share splits No effect
Retirement of shares Decrease equal to the retirement price
Purchase of treasury shares Decrease equal to the purchase price
Increase equal to the proceeds, whether higher or
Reissuance of treasury shares
lower than the cost of the treasury shares
No effect since the purchase has already been
Retirement of treasury shares deducted when the treasury shares were
acquired
Share issue costs Decrease
Listing fees Decrease in the form of expense
Receipt of donated shares No effect ell
Receipt from reissuing donated
Increase equal to the reissue price
shares
Receipt of donated asset from
Increase equal to the fair value of the asset
all donors
Conversion of preference No effect since one equity account is transferred
shares to ordinary shares to other equity accounts
Declaration of cash dividends Decrease equal to the amount of declaration
No effect since these amounts were already
Payment of cash dividends
deducted upon declaration
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True or False
1, A security is classified as an equity if the issuer has the obligation to pay cash or
other noncash assets to the holders of the security.
Z In liquidation, securities classified as liability will receive cash ahead of securities
classified as equity.
3: Returns paid to the holder of securities classified as equity are recognized in profit
or loss.
In general, ordinary shares have the right to vote, while preference shares do not
have such right.
The share capital account is equal to the total amount of proceeds received when
issuing the shares.
The share premium represents the excess of the proceeds received over the total
o
par value of the shares issued.

Generally, the balance of the subscription receivable is a contra-equity account.
NI
Subscribed share capital is credited equal to the total subscription price.

RePrR OO
Treasury shares account has a normal credit balance.

. Contributed capital excludes the amount of retained earnings.
mo’:
. The amount of legal capital coming from no-par value shares is equal to the total
proceeds received from their issuance.
If the shares were issued for noncash asset, the asset shall be initially recorded
equal to total fair value of issued shares.
13. The highest bidder is the one who is willing to pay the bid price for the highest
number of shares.
14. If the retirement price is higher than the par value of the retired shares, the
difference shall be initially charged to the extent the share premium from the
shares’ original issuance.
15. Treasury shares are initially measured at the shares’ par value.
16. The acquisition of treasury shares will result to reduction from the shareholders’
equity equal to the acquisition price.
17. Costs related to the issuance of shares shall be expensed outright.
18. Share splits affect the total shareholders’ equity but not the par value nor the
number of shares.
19. Outstanding shares include the subscribed shares.
20, Dividends paid to redeemable preference shares are recognized in profit or loss.

1. The following are the characteristics or attributes of equity securities, except
a. There is no contractual obligation on the part of the issuer to pay cash or
noncash asset to the holders of such securities.
b. Equity shareholders will only receive cash when all the issuer's liabilities have
been paid.
c. Returns paid to the holders of equity securities are recognized in profit or loss.
d. Changes in the value are not recognized in profit or loss.
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2. Which of the following does not properly describe the difference between the
ordinary shares and preference shares?
a. Ordinary shares can be issued without par value, but the preference shares
cannot be issued without par value.
b. Ordinary shares can ordinarily vote, but the preference shares cannot.
c. Preference shares have priority in dividends over the ordinary shares
3. The following are components of shareholders’ equity, except
a. Investmentin preference shares
b. Ordinary share capital
c. Cumulative other comprehensive income items
d. Treasury shares
4. Given the following account names:

I. Share capital
I]. Cumulative other comprehensive income
Ill. Share premium
IV. Retained earnings
Which of these are included in the amount of contributed capital?
a. IlandIV only
b. Iand III only
c. lonly
d. Iland III only
5. Share premium arising from the shares issued for noncash asset received is equal to
the difference between the
a. Fair value of the noncash asset and its carrying amount.
b. Fair value of the noncash asset and total par value of the shares issued.
c. Carrying amount of the noncash asset and total par value of the shares issued.
d. Fair value of the shares issued and fair value of the noncash asset.
6. Given the following account names:

I. Share capital
Il. Cumulative other comprehensive income
Ill. Share premium
IV. Retained earnings
Which of these are included in the amount of legal capital for par value shares?
a. IandIVonly
b. land III only
c. lonly
d. Iand III only
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7. If shares are issued for noncash asset, one of the following amounts may be used in
valuing the noncash asset:
|. Fair value of the shares issued
Il. Par value of the shares issued
Ill. Fair value of the noncash asset
Which of the following correctly enumerates the hierarchy of values that shall be
used in valuing the noncash asset?
a. 1, 1,11
b. 1, I, Hl
c. IIL 1,1
d. Il, 1,1
g. If two classes of shares were issued in a single transaction, the total issue price shall
be
a. Allocated based on the relative total fair values.
b. Allocated based on the relative total par values.
c. Allocated first to the class of shares with higher total par value, with the
remainder allocated to the class of shares with lower total par value.
d. Allocated first to the class of shares with higher total fair value, with the
remainder allocated to the class of shares with higher total fair value.
9. The following statements regarding the subscription of shares are true, except
a. The nondelinquent subscriber have the same rights as the fully paid
shareholders, except the right to share certificate.
b. The share premium from the subscription will be recognized only upon the full
payment of the subscription price.
c. Upon full payment of the subscription price, the total par value of the relevant
shares is classified from subscribed share capital to issued share capital.
d. Ifthe balance of the subscription receivable is collectible beyond one year from
the reporting date, its balance shall be presented as deduction from equity.
10.If the subscribed shares became delinquent, the following are the following
consequences, except
a. Adelinquency sale shall be initiated.
b. The bidders shall pay the total of delinquent subscription balance, interest (if
any), and costs of publishing and organizing the delinquency sale.
c. The highest bidder is the one willing to pay for the total bid price for the least
number of shares.
d. The delinquent shares share shall be allocated first to the highest bidder to the
extent of the number of shares it bid and with the remainder to the issuing
entity.
11.1If there is an immediate retirement of shares and the retirement price is higher than
the par value, the difference shall be
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a. Charged first against share premium related to the original issuance, then to the
retained earnings.
b. Charged first against retained earnings, then share premium related to the
original issuance,
c. Charged first against share premium related to the original issuance, then to the
share premium - treasury, then to retained earnings.
d. Charged first against share premium - treasury, then to the share premium
related to the original issuance, then to retained earnings.
12.Which of the following statements is true regarding treasury shares?

a. Changes in the fair value of the treasury shares are recognized directly in equity.
b. Treasury shares are initially measured at the purchase cost.
c. Ifthe treasury shares are issued at a price lower than its cost, there will be a net
decrease in the shareholders’ equity balance.
d. The retirement of treasury shares will have a net decreasing effect in the
shareholders’ equity balance.
13.When reissuing treasury shares at an, amount less than the purchase cost, the
difference in these amounts shall be
a. Charged asa loss in profit or loss.
b. Charged directly against retained earnings.
c. Charged to the extent of the balance of share premium - treasury, then to
retained earnings.
d. Charged to the extent of the balance of share premium from original issuance,
then to the balance of share premium - treasury, and then to retained earnings.
14.Treasury shares were acquired at an amount higher than shares’ par value. If these
were subsequently retired, the difference between purchase cost and par value shall
be
a. Charged asa loss in profit or loss.
b. Charged directly against retained earnings.
c. Charged to the extent of the balance of share premium - treasury, then to
retained earnings.
d. Charged to the extent of the balance of share premium from original issuance,
then to the balance of share premium - treasury, and then to retained earnings.
15.Transaction costs that are directly attributable to the issuance of shares shall be
recognized in
a. Profitor loss
b. Equity
c. Other comprehensive income
d. Retained earnings
16. |fan entity listed its share through initial public offering, which of the following costs
shall be recognized as expenses in profit or loss?
a. SEC registration fees for new shares
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b. Underwriting costs
c. Documentary stamp tax
d. Road show presentation costs
17. The following costs are recognized partly in equity and partly in profit or loss, except
a. Costs of prospectus design and printing
b. Costs of newspaper publication fees for the share issue
c. Costs of opinion of counsel
d. Costs of fairness opinion and valuation report
18.If a shareholder donated a certain number of the shares issued by the entity, the
increase in the total shareholders’ equity shall occur
a. upon the receipt of the shares
b. upon the retirement of the shares
c. upon the reissuance of the shares
d. none of the above. ,
19. Given the following statements:

]. Share split-up increases the number of shares but decreased the par value per
share.
II. Share split-down decreases the number of shares but increases the par value per
share.
Which of these statements is/are true?
a. lonly c. Both I and II
b. Ilonly d. Neither I nor Il
20.Which of the following incorrectly describes the effect of each transaction to the
shareholders’ equity balance?
a. Shares issued for noncash asset will increase the shareholders’ equity equal to
the par value of the shares.
b. Reissuance of treasury shares will increase the shareholders’ equity equal to the
amount of proceeds received.
c. Retirement of treasury shares will have no effect in shareholders’ equity.
d. Shares purchased and immediately retired will have a decreasing effect to the
shareholders’ equity equal to the retirement price paid.
Straight Problems
1, During the current year, PACIFIC Company issued 200,000 of its P15 par value
ordinary shares for an equipment with carrying amount of P4,500,000 in the books
of the contributor.
entry to record the issuance:
1. The equipment’s fair value is P3,500,000, while the shares have fair value of
P18 per share.
2. The equipment’s fair value is P3,500,000, while the shares’ fair value cannot be
reliably determined.
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3. The equipment’s fair value cannot be reliably determined, while the shares
have fair value of P18 per share.
4. Both the equipment'’s and shares’ fair value cannot be measured reliably.
2. On February 1, 2023, SPEEDY Company issued 50,000 of its P50 par value ordinary
shares and 10,000 of its P200 par value preference shares for a total price of
P6,500,000.
entry to record the basket issuance:
1. The ordinary shares have fair value of P77 per share, while the preference
shares have fair value of P315 per share.
2. The ordinary shares have fair value of P77 per ata while the preference
shares’ fair value cannot be determined reliably.
3. The ordinary shares’ fair value cannot be determined reliably, while the
preference shares have fair value of P315 per share.
3. On January 1, 2023, CAPTAIN Company reported the following balances in its

shareholders’ equity:
Share capital, P20 parvalue P5,000,000
On January 5, 2023, the Company retired 30,000 of its shares by paying a certain
amount to its shareholders.
entry to record the retirement:
1. Retirement price is P18 per share.
4. On January 1, 2023, TETRA Company reported the following account balances in its
Share capital, P40 par value P6,000,000
Treasury shares (P48 cost per share) 480,000
During the month of January 2023, the following treasury share transactions
occurred:
e On January 10, 2023, 5,000 of the treasury shares were issued for P45 per share.
e On January 15, 2023, 3,000 of the treasury shares were issued for P44 per share.
e On January 22, 2023, the remaining treasury shares were retired.
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a. Journal entries to record the transactions during the month of January 2023.
b. Total amount of shareholders’ equity as of January 31, 2023.
5. At the beginning of the year 2023, CALYPSO Company had the following
shareholders’ equity account balances:
Share capital, P50 parvalue P10,000,000
During the month of January 2023, the Company had the following equity
transactions: “tot
e On January 2, 2023, 20,000 shares were acquired at P62 per share.
On January 10, 2023, 6,000 of the treasury shares were reissued at P60 per share.
On January 31, 2023, 3,000 of the treasury shares were retired.

a. Journal entries to record the transactions during the month of January 2023.
b. Total amount of shareholders’ equity as of January 31, 2023.
6. During the current year, SASHIMI Company issued 50,000 of its P30 par value
ordinary shares at P40 per share. In addition, the Company also incurred a certain
amount of transaction costs.
entry to record the issuance of the shares:
7. MORGAN Company conducted an initial public offering ofits shares and incurred the
following costs:
Fairness opinion and valuation report P120,000
Documentary stamp tax 500,000
Underwriting costs 1,000,000
Audit and other professional advice relating to prospectus 250,000
Tax opinion 350,000
Road show presentation 480,000
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Before the IPO, the Company had 600,000 outstanding shares with P20 par value,
During the IPO, the Company was able to issue additional 1,400,000 shares at P25
per share.
Required: Determine the journal entries to record the preceding transactions.
8. On January 1, 2023, FINLEY Company was authorized to issue 500,000 P6 par value
ordinary shares and 300,000 P20 par value preference shares.
During the year 2023, it had the following shareholders’ equity transactions:
e On January 5, 2023, 50,000 ordinary shares were issued for P10 per share.
e On January 6, 2203, 60,000 preference shares were issued for P29 per share.
e A total of 100,000 ordinary shares were subscribed on January 30, 2023 for P12
per share. A 30% down payment was required with the balance required to be
paid after three yours, though the subscribers can pay much earlier.
e 20,000 preference shares were issued to a acquire an equipment with P650,000
fair value on March 1, 2023. The preference shares’ fair value as of that date
amounted to P30 per share.
e On April 30, 2023, 80,000 ordinary shares and 40,000 preference shares were
issued for a total price of P1,600,000. The ordinary shares and preference shares
had fair values per share of P9 and P27, respectively.
e On June 30, 2023, the subscriber of the 20,000 ordinary shares fully paid the
balance of its subscription.
e On July 15, 2023, the subscriber of the 30,000 ordinary shares paid 50% of the
relevant subscription balance.
e On September 1, 2023, 5,000 ordinary shares were issued as a payment for
consultants when fair value per share amounted to P8., Billed amount of P35,000
is not considered to be the fair value of the services.
e On October 31, 2023, 25,000 ordinary shares were issued in exchange for a
vacant land. The shares had P9 fair value per share, while the fair value of the
land is not reliably determinable.
e Netincome for the year, before considering the consultant fees last September 1,
2023, amounted to P700,000.

a. Journal entries to be recorded for the year 2023.
b. Shareholders’ equity balance as of December 31, 2023.
9. At the beginning of the year 2023, WASABI Company had the following balances in
its shareholders’ equity:
Ordinary share capital, P10 par value P5,000,000
Preference share capital, P40 parvalue 4,000,000
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During the year 2023, the Company had the following transactions in chronological
order:
February 1, 2023 -80,000 of the Company’s ordinary shares were issued at P16
per share.
March 1, 2023 - 30,000 of the Company's preference shares were issued at P45
per share.
April 1, 2023 - the Company declared a 2-for-1 share split-up.
June 15, 2023 - 40,000 of the Company’s ordinary shares were issued at P11 per
share.
August 31, 2023 - 50,000 of the Company's ordinary shares were issued for a
land with fair value of P550,000. The shares had fair value of P12 per share.
Net income for the year amounted to P1,200,000.

10.On January 1, 2023, POPCORN Company reported the following shareholders’

equity:
Preference share capital, P50 parvalue 4,000,000
The following equity transactions during the year 2023:

January 15, 2023 - 20,000 ordinary shares were acquired for P30 per share to be
held in treasury.
February 1, 2023 - 40,000 preference shares were issued for P58 per share.
March 1, 2023 - 6,000 treasury shares were issued for P32 per share.
April 15, 2023 - 4,000 treasury shares were issued for P28 per share.
May 31, 2023 - the Company executed a 2-for-1 share split-up for its ordinary
shares.
June 10, 2023 - 60,000 ordinary shares were issued for P16 per share.
July 10,2023 - 7,000 treasury shares were issued for P17 per share.
September 5, 2023 - the remaining treasury shares were retired.
Net loss for the year amounted to P600,000.
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1. On December 31, 2023, SAMMY Company reported the following account balances;
Investment in ordinary shares of other entity, fair value P1,500,000
Investment in the Company’s ordinary shares, cost 900,000
Ordinary share capital, no par value but with stated value of P20 3,000,000
Preference share capital, P100 par value 2,000,000
Redeemable preference shares 1,000,000
Cumulative remeasurement losses from pension plans 850,000
Cumulative unrealized gains from FVTOCI investment 450,000
From the given information, the total amount of shareholders’ equity shall be
a. P10,300,000 c. P11,400,000
b. P10,900,000 d. P13,900,000
The net amount of contributed capital shall be
a. P4,700,000 c. P5,900,000
b. P5,200,000 d. P6,800,000
The total amount of legal capital shall be
a. P3,500,000 c. P5,500,000
b. P5,000,000 d. P6,100,000
2. SURFER Company has only one class of shares: ordinary shares with P20 par value.
During the year 2023, the Company had the following acquisitions of noncash assets:
e March 10, 2023 - a land with fair value of P4,000,000 was acquired by issuing
120,000 ordinary shares with fair value of P35 per share as of that date.
e June 20, 2023 - an equipment with fair value that is not reliably determinable
was acquired by issuing 50,000 ordinary shares with fair value of P32 as of that
date.
e November 23, 2023 - a transportation vehicle with fair value of P2,400,000 was
acquired by issuing 80,000 ordinary shares with the fair value that is not reliably
determinable as of that date.
Total amount of increase in shareholders’ equity from these transactions shall be
a. P8,000,000 c. P6,720,000
b. P8,200,000 d, P7,500,000
Total amount of increase in share premium from these transactions shall be

a. P3,200,000 c. P3,000,000
b. P1,720,000 d. P2,500,000
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3. During the current year, BILLIE Company issued 100,000 of its P5 par value ordinary
shares and 60,000 of its P15 par value preference shares for a total price of
P3,400,000. The fair values of each share were P10.80 and P42.00 for ordinary
shares and preference shares, respectively.
From this transaction, the increase in share premium - ordinary shall be
a. P580,000 c. P520,000
b. P620,000 d. P470,000
From this transaction, the increase in share premium - preference shall be

a. P1,050,000 c. P1,340,000
b. P1,260,000 d. P1,480,000
4, On January 1, 2023, LUCKY Company had the following shareholders’ equity

balances:
During the current year, the following number of shares were retired:
e March 16, 2023 - 15,000 ordinary shares were retired for P48 per share.
e May 20, 2023 - 10,000 ordinary shares were retired for P43 per share.
e September 15, 2023 - 30,000 new ordinary shares were issued for P49 per share.
Net income for the year amounted to P300,000.
After considering these transactions, the balance of the share premium shall be
a. P895,000 c. P875,000
b. P1,650,000 d. P1,145,000
After considering these transactions, the balance of the retained earnings shall be
a P4,500,000 c. P4,755,000
b. P4,800,000 d. P4,655,000
After considering these transactions, the balance of the share capital shall be
a. P8,000,000 c. P8,700,000
b. 9,200,000 d. P8,200,000
5. At the beginning of the year 2023, FLOWER Company reported the following
amounts in its shareholders’ equity:
Share capital, P40 par value 6,000,000

During the month of January 2023, the Company had the following equity
transactions:
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e January 2, 2023 - 40,000 shares were acquired for P52 per share to be held in
treasury.
January 5, 2023 - 30,000 new shares were issued for P53 per share.
January 12, 2023 - 15,000 treasury shares were reissued for P50 per share.
January 30, 2023 - the remaining treasury shares were retired.
January 31, 2023 - the Company had net income of P300,000 for the month.
The balance of share capital as of January 31, 2023 shall be

a. P7,200,000 c. P7,420,000
b. P6,920,000 d. P8,240,000
The balance of share premium from ALL sources as of January 31, 2023 shall be
a. P1,534,000 c. P1,744,000
b. P1,589,000 d. P1,954,000
The balance of retained earnings as of January 31, 2023 shall be

a. P3,770,000 c. P3,823,000
b. P3,905,000 d. P3,754,000
The total amount shareholders’ equity as of January 31, 2023 shall be

a. P12,487,000 c. P12,694,000
b. P12,208,000 d. P12,224,000
6. QUIMBY Company reported the following account balances:
January 1,2023 December 31,2023

Share capital, P10 par value P3,000,000 P4,500,000
Share premium 600,000 2,200,000
Subscribed share capital - 500,000
Subscription receivable - 850,000
Retained earnings 4,000,000 "5,000,000
During the year 2023, the Company had the following equity transactions:
e 40,000 shares were issued for P15 per share.
e 60,000 shares were issued for P18 per share.
e 20,000 shares were issued in exchange for an equipment with P320,000 fair
value.
e Netincome for the year amounted to P1,000,000
The rest of the changes in the equity balances are due to the subscription of a
certain number of shares, some of which became also fully paid during the year.
From the given information, the initial number of subscribed shares is

a. 80,000 c. 50,000
b. 30,000 d, 70,000
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From the given information, the average amount of subscription per share is
a. P12 c. P20
b. P10 d. P18
From the given information, the total amount received from the subscribed shares
shall be
a. P550,000 c. P750,000
b. P680,000 d. P940,000
7. At the beginning of the year 2023, SPOT Company had the following shareholders’
equity balances: .
Preference share capital, P40 par value 6,000,000
Retained earnings | 8,000,000
Cumulative unrealized gains - FVTOCI investment 900,000
Treasury ordinary shares (P30 purchase cost) 1,050,000
The following equity transactions have occurred during the year 2023:
e January 6, 2023 - 60,000 ordinary shares were issued at P29 per share.
e April 5, 2023 - 40,000 preference shares were issued at P50 per share.
e May 21, 2023 - 50,000 ordinary shares were issued for a land with P1,650,000
fair value. The shares had fair value of P32 per share.
e June 26, 2023 - half of the treasury shares were issued for P33 per share, while
the other half were retired.
e July 1, 2023 - the Company executed a 2-for-1 share split-down for both the
ordinary shares and preference shares.
e August 15,2023 - 10,000 ordinary shares were acquired for P55 per share to be
held in treasury.
September 30, 2023 - 70,000 ordinary shares were issued for P54 per share.
November 10, 2023 - 30,000 preference shares were issued for P85 per share.
Net income for the year amounted to P450,000, while unrealized loss from
FVTOCI investments amounted to P220,000.
The total share premium from all sources as of December 31, 2023 shall be
a. P6,820,000 c. P7,344,500
b. P7,022,500 d. P7,590,500
The total amount of shareholders’ equity as of December 31, 2023 shall be
a. P33,480,500 c. P36,578,500
b. P34,672,500 d. P37,077,500
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Chapter 15A - Shareholders’ Equity - Retained Earnings
CHAPTER 15A
SHAREHOLDERS’ EQUITY - RETAINED EARNINGS

The general description of retained earnings.
Ee
The transactions affecting retained earnings.

WN
The different classifications of dividends and the accounting requirements.

The appropriation of retained earnings.
Wr
The concept of quasi-reorganization.
RETAINED EARNINGS
Generally, retained earnings (or accumulated profits) represent a corporation’s
cumulative amounts of net income earned less the cumulative amounts of
dividends it has declared since the corporation’s inception. Similar to other
equity accounts, retained earnings account has a normal credit balance. However,
if there are excessive losses incurred, retained earnings can have a negative balance
(i.e., deficit), which will now be called “accumulated losses” and has a debit balance.
Total retained earnings can be classified as either unappropriated or

appropriated. The unappropriated portion of the retained earnings represents the
amount available for distribution to shareholders. Appropriation of retained
earnings will be discussed later in the chapter.
TRANSACTIONS AFFECTING UNAPPROPRIATED RETAINED EARNINGS
The main driver of the retained earnings balance for most entities is the amount of
the after- tax profit or loss each year. Pro-forma journal entries to close the amount
of profit or loss are the following:
Income summary (if profit) XX
Retained earnings - unappropriated XX

Income summary (if loss) XX
Dividends also have great impact in the retained earnings balance through this
entry:
Dividends (cash/property/share) XX
However, there are also other transactions affecting retained earnings, which are
shown in the following comprehensive scope of transactions (credits increase
retained earnings while debits decrease retained earnings):
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Retained earnings -
unappropriated
Loss (after income tax) XX XX Beginning balance
Dividends declaration XX XX Profit (after income tax)
Direct transfers of OCI loss XX XX Direct transfers of OCI gain
items (e.g., unrealized losses items (e.g., revaluation
in FVTOCI assets) surplus, unrealized gains)
Increase in appropriation XX XX Decrease in appropriation
Amounts charged, if any, from XX XX Prior period error correction
retirement of shares with increasing effect
Amounts charged, if any, from XX
reissuance of treasury shares
below the purchase cost
Prior period error correction XX
with decreasing effect
Totals (should be equal) Xe XX
Illustration 1. At the beginning of 2023, DEGAMO Company reported retained

earnings balance of P8,400,000. During the year, total revenues of P10,000,000
were earned while total expenses of P7,500,000 were incurred. Relevant tax rate is
25%. In addition, the following information might be of relevance:
a. A building with estimated remaining useful life of 10 years was revalued on
December 31, 2022 (i.e., last year), resulting to P1,200,000 revaluation surplus.
b. An investment at FVTOCI was sold during the year. Cumulative unrealized loss
— OCI on the date of sale amounted to P80,000.
c. Total dividends of P900,000 were declared during the year.
The ending balance of retained earnings is computed as follows:
Retained earnings -
unappropriated
Dividends declared 900,000 | 8,400,000 | Beginning balance
Transfer of unrealized loss - OCI 80,000 | 1,875,000 | Profit after income tax
[(P10M - P7.50M) x 75%]
Ending balance (squeeze) | 9,415,000 120,000 | Piecemeal transfer of
(P10,395K - P900K - P80K) revaluation surplus
(P1,200,000/10 years)
DIVIDENDS - IN GENERAL
Generally, dividend is the portion of the earnings of an entity that is distributed to
the shareholders. This is one of the returns on investment that the investors are
interested (the other one being the changes in the shares’ fair value). The following
are the major types of dividends that an entity can declare:
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Chapter 15A — Shareholders’ Equity - Retained Earnings
Type Description
Cash dividends Cash is paid to shareholders. Most common and attractive
type of dividends. Decreases the amount of equity.
Noncash asset is paid to shareholders. Most uncommon
Property dividends and least attractive type of dividends, Decreases the
amount of equity.
Share dividends (also ae of = entity are ae - eee
known as bonus issue) just a mere transfer from retained earnings
contributed capital. No effect in total amount of equity.
Normally distributed during liquidation or if the entity is a
Liquidating dividends | wasting asset entity. Decreases the amount of equity but
generally do not affect the balance of retained earnings.
The amount to be deducted, if any, from retained earnings will depend on the type
of dividends, which will be discussed in detail in the succeeding sections.
Dividends are voluntary, and the entity does not have an obligation to pay it unless
there is an actual declaration. The power to declare dividends rests on the Board
of Directors of an entity. In normal circumstances, an entity shall have
unrestricted retained earnings before it can legally distribute dividends, except
for liquidating dividends.
The following dates are relevant in accounting for dividends:
Date Description
This is when the dividend declaration is made and that the
Board of Directors binds the entity to pay dividends (i.e., the
Date of declaration
obligation to pay dividend arises). This is also the time when
the amount of retained earnings is reduced.
This is the date when the names of shareholders that are
Date of record entitled to receive the dividends are determined. Only
memorandum entry is prepared on this date.
Date when the dividends are actually paid (for cash, property
Date of payment
and liquidating) or distributed (for share dividends)
CASH DIVIDENDS - ORDINARY SHARES

Cash dividends paid on ordinary shares are usually stated on a per share dividend
amount and only which the outstanding shares as of the date of
declaration/record are entitled to receive. As discussed in the previous chapter,
outstanding shares include those that are subscribed and issued, less the
number of treasury shares.
Illustration 1. As of November 30, 2023, SALGADO Company reported the
following amounts in its shareholders’ equity:
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Share capital, P50 par P12,000,000

Treasury shares, P60 cost 1,200,000
On the same date, the Company declared P2 cash dividends per share that is payable
on December 31, 2023 for shareholders on record on December 15, 2023.
In this case, the amount of dividends to be paid is computed as follows:
Issues shares (P12,000,000/P50) 240,000
Add: Subscribed shares (P4,250,000/P50) 85,000
Less: Treasury shares (P1,200,000/P60) (20,000)
Outstanding shares entitled to dividends 305,000
Multiply by: Cash dividend per share P2
Total cash dividends payable P610,000
On November 30, 2023, the date of declaration, the following entry shall be made:
Retained earnings 610,000
Cash dividends payable 610,000
On December 15, 2023, the date of record, a memo entry is prepared.

On December 31, 2023, the payment of the dividends is recorded as follows:
Cash 610,000
CASH DIVIDENDS - PREFERENCE SHARES

Unlike cash dividends, preference shares usually bear a certain percentage which
is multiplied to the par value of outstanding preference shares to determine
the annual amount of cash dividends. However, the obligation to pay this annual
amount of dividend will arise only upon declaration. In the absence of additional
information, preferences shares are presumed to be noncumulative and
nonparticipating.
Illustration 2, VILLACORTA Company reported the following information
regarding its preference shares;
8% Preference share capital, P200 par P8,000,000
Subscribed share capital - preference 3,000,000
Treasury preference shares, P230 cost, 6,000 shares 1,380,000
If the Company is to declare dividends, the amount of preference share dividends is
computed as:
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Issues shares, par value P8,000,000

Add: Subscribed shares, par value 3,000,000
Less: Treasury shares, par value (6,000 x P200) (1,200,000)
Par value of outstanding shares entitled todividends P9,800,000
Multiply by: Annual dividend rate 8%
Total cash dividends payable P784,000
It should be noted that the balance in the share premium is excluded from the basis
of computation,
CASH DIVIDENDS - ALLOCATION TO ORDINARY AND PREFERENCE SHARES
In the previous section, the basic scenario of preference share dividends has been
discussed. However, the actual amount of preference dividends will depend on its
features as follows:
Feature Description — a wis Ses
Cumulative Preference shares are also entitled to annual amount of dividends
that are not declared in the prior periods (ie., dividends in
arrears), in addition to current period’s entitlement.
Participating | Generally, preference shares are entitled only to annual dividends
expressed as % of par value (i.e., nonparticipating). The remainder
of declared dividends is attributed to ordinary shares.
However, participating preference shares are also entitled to the
amounts in excess of the annual dividends based on the par
value.
These features of preference shares are best illustrated together with ordinary
shares.
Illustration 3. As of December 31, 2023, USOP Company reported the following

components of its shareholders’ equity:
9% Preference share capital, P100 par P3,200,000
Ordinary share capital, P20 par 5,600,000
Treasury shares ~ ordinary, 30,000 shares 750,000
Treasury shares - preference, 2,000 shares 240,000
On this date, P2,000,000 cash dividends were declared to ordinary and preference
shares. The last time that the Company paid dividends was during the year 2020.
Under each of the following independent scenarios, determine the dividends
allocated to ordinary shares and preference shares:
1. Preference shares are noncumulative and nonparticipating
2. Preference shares are cumulative but nonparticipating
3. Preference shares are noncumulative but participating
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4. Preference shares are cumulative and participating

Before answering each scenario, the par value of preference and ordinary shares
that are entitled to dividends (i.e., outstanding shares) are determined as follows:
Preference Ordinary Total
Par value of issued shares P3,200,000 5,600,000 P8,800,000
Less: Par value of treasury shares -
preference (2,000x P100) 200,000 200,000
Par value of treasury shares -
ordinary (30,000 x P20) 600,000 600,000
Total par value of outstanding shares — P3,000,000 5,000,000 P8,000,000
Scenario 1 - Preference Shares are Noncumulative and Nonparticipating

Preference shares are entitled only to the annual dividend for the year 2023. The
rest of the dividends will be given to ordinary shareholders:
Preference Ordinary
2023 annual pref. dividend (P3M x 9%) P270,000
Remainder to ordinary shares
(P2,000,000 - P270,000) P1,730,000
Total Allocation P270,000 1,730,000
Scenario 2 - Preference Shares are Cumulative and Nonparticipating

Preference shares are entitled to the unpaid dividends for the years 2021 and 2022
(i.e., 2 years), and for the current year 2023. The rest is given to the ordinary
shareholders.
Preference Ordinary
2023 annual pref. dividend (P3M x 9%) P270,000
Prior years’ annual pref. dividend
(P3,000,000 x 9% x 2 years) 540,000
Remainder to ordinary shares
(P2,000,000 - P270,000 - P540,000) P1,190,000
Total Allocation P810,000 __P 1,190,000
Scenario 3 - Preference Shares are Noncumulative and Participating

Preference shares are not entitled to the unpaid dividends for the years 2021 and
2022. However, because of participating feature, these shares will now have a
share in the excess dividend after giving the ordinary shares an equivalent annual
dividend based on preference rate (i.e., 9%), The allocation of the excess is based on
the relative total par values of preference and ordinary shares.
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Chapter 15A — Shareholders’ Equity —- Retained Earnings
Preference Ordinary Total

2023 annual pref. dividend (P3M x 9%) P270,000 P270,000
Initial allocation to ordinary shares
(P5,000,000x 9%) P450,000 450,000
Total initial allocation P270,000 P450,000 P720,000
Proportional allocation of P1,280,000
remainder (P2,000,000 - P720,000):
Pref. shares (P1.28M x P3M/P8M) 480,000 480,000
Ord. shares (P1.28M x P5M/P8M) 800,000 800,000
Total Allocation P750,000 P1,250,000 P2,000,000
Scenario 4 - Preference Shares are Cumulative and Participating .

Preference shares are entitled to the unpaid dividends for the years 2021 and 2022,
on top of 2023 entitlement. In addition, because of participating feature, these
shares will now have a share in the excess dividend after giving the ordinary shares
an equivalent annual dividend based on preference rate (i.e., 9%). The allocation of
the excess is based on the relative total par values of preference and ordinary
shares.
Preference — Ordinary Total
2023 annual pref. dividend (P3M x 9%) P270,000 P270,000
Prior years’ annual pref. dividend
(P3,000,000 x 9% x 2 years) 540,000 540,000
Initial allocation to ordinary shares
(P5,000,000 x 9%) P450,000 450,000
Total initial allocation P810,000 P450,000 P1,260,000
Proportional allocation of P740,000
remainder (P2,000,000 — P1,260,000):
Pref. shares (P740K x P3M/P8M) 277,500 277,500
Ord. shares (P740K x PSM/P8M) 462,500 462,500
Total Allocation P1,087,500 P912,500 P2,000,000
PROPERTY DIVIDENDS
An entity may also declare noncash dividends in case the cash balance is insufficient
and impractical for a cash dividend declaration or that the existing noncash assets
cannot be realized in cash immediately. In case there are property dividends, the
following are the accounting procedures to be applied for the dividends payable
and for the noncash asset to be distributed:
Account | Accounting Procedures
Property On the date of declaration recognize and measure the dividend
dividends payable amount equal to the fair value as of that date of the noncash
asset to be distributed. The same amount will be deducted from
payable
retained earnings
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At each reporting date and on the date of settlement, update the

dividend payable amount to reflect the fair value of the noncash asset
on those dates, with corresponding changes in the retained earnings:
1. Increase in asset's fair value will increase property dividends
payable and will decrease retained earnings
2. Decrease in asset’s fair value will decrease property dividends
payable and will increase retained earnings
of
settlement
On the date , any difference between the updated
dividend payable amount and the carrying amount of the noncash
asset will be recognized in profit or loss.
Generally, accounted for under PFRS 5 at the lower of the asset's
carrying amount and fair value less costs to distribute [PFRS
5.154], except for the following:
1. Current assets, such as inventories which shall still be accounted for
under lower of cost and net realizable value.
2. Financial assets, which shall be based on their classification under
PERS 9 (i.e., FVTPL, Amortized Cost, FVTOCI).
3. All other non-current assets that were explicitly excluded in the
scope of PFRS 5, such as investment properties measured at fair
Noncash value and biological assets measured at fair value less costs to sell.
asset to be [PFRS 5.5].
distributed
These exceptions were also mentioned in the paragraph BC13 of PFRS
5 Basis for Conclusions. Nonetheless, the measurement of the property
dividends payable amount shall not be affected and shall still follow
the fair value of the related noncash asset (i.e., not considering the
estimated costs to distribute).
The readers are advised to be vigilant in applying accounting standards

by thoroughly checking the scope and scope limitations of each
standard. PFRS 5 only applies to noncurrent assets.
Illustration 4 - Noncash Asset Within the Scope of PFRS 5. On November 15,

2023, DOLOR Company declared unused items of equipment as property dividends
to its shareholders to be paid on January 15, 2024. Total carrying amount of the
items of equipment is P6,000,000. Fair value and estimated costs of distribution are
the following:
Costs to Fair value less
Date Fair value distribute costs to distribute
11/15/23 P5,900,000 P300,000 P5,600,000
12/31/23 5,700,000 250,000 5,450,000
01/15/24 5,400,000 220,000 5,180,000
On November 15, 2023, on the date of declaration, the following entries shall be
made:
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Property dividends payable 5,900,000
Asset held for distribution 5,600,000
Impairment loss (P6M - P5.6M) 400,000
Equipment, net 6,000,000
It should be noted that in measuring the dividends payable, the amount of costs
to distribute is ignored. This will be used only in the measurement of the
equipment to be distributed (i.e., lower of carrying amount and fair value less costs
to distribute) since it is within the scope of PFRS 5. In addition, the carrying amount
of the equipment is reclassified to a different account to indicate that it is indeed for
distribution as property dividend.
On December 31, 2023, the following entries shall be made:
Property dividends payable 200,000

Retained earnings (P5.9M - P5.7M) 200,000
Impairment loss (P5.6M - P5.45M) 150,000
Asset held for distribution 150,000
The amount of dividends payable decreased since there is a decrease in the fair
value of the equipment. In addition, there is also a decrease in fair value less costs
to distribute resulting to the recognition of additional impairment loss on the
equipment.
On January 15, 2024, before recording the distribution of equipment for the
payment of dividends payable, the following entries shall be made to update the
carrying amounts:
Impairment loss (P5.45M - P5.18M) 270,000

Asset held for distribution 270,000
After updating the amounts, dividends payable will have a balance of P5,400,000,
while the equipment will have carrying amount of P5,180,000. The entry to record
the distribution (or settlement) on January 15, 2024 is as follows:
Asset held for distribution 5,180,000
Gain on distribution of dividends 220,000
The gain shall be recognized in profit or loss, The overall effects of these entries to
retained earnings are summarized as follows:
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Chapter 15A - Shareholders’ Equity — Retained Earnings
Effect to Retained Earnings (including Profit or Loss)

Property dividends - Asset held for
Date payable distribution Net effect
11/15/23 (P5,900,000) (P400,000) (P6,300,000)
12/31/23 200,000 (150,000) 50,000
01/15/24 - updating 300,000 (270,000) 30,000
01/15/24 - distribution - - 220,000
; Net effect (equal to | n ratio )} (P6,000,000)
Illustration 5 - Noncash Asset Outside the Scope of PFRS 5. Due to cash

constraints, on December 1, 2023, MERCADER Company declared its investment in
equity securities of another entity as property dividends to be paid on January 31,
2024. On that date, the investments had carrying amount of P8,000,000 and was
classified as financial asset at FVTPL. Fair value information related to these equity
securities is as follows:
[A] [B] Costs to [A] - [B] Fair value
Date Fair value distribute — less costs to distribute
12/01/23 ~—-P7,500,000 P400,000 P7,100,000
12/31/23 8,200,000 480,000 7,720,000
01/31/24 7,800,000 430,000 7,370,000
On December 1, 2023, the date of declaration, the following entries shall be made:
Unrealized loss - PL (P8M - P7.5M) 500,000

Financial asset at FVTPL 500,000
Again, the dividends payable shall ignore the amount of costs to distribute. As
to the financial asset at FVTPL, costs to distribute are also ignored since the
financial asset shall be measured using the provisions of PFRS 9 (recognition
of changes in fair value at profit or loss) and not under PFRS 5 since financial
assets are explicitly excluded from the scope of PFRS 5. Accounting for financial
assets at FVTPL has been discussed in the Volume 1 of this Intermediate Accounting
series.
Retained earnings (P8.2M - P7,5M) 700,000
Unrealized Gain - PL(P8.2M-P7.5M) 700,000
The amount of dividends payable increased since there is an increase in the fair
value of the financial asset at FVTPL. That increase in fair value is also reflected
571
The
in the carrying amount of the financial asset at FVTPL. Again, costs to distribute are
ignored.
On January 31, 2024, before recording the distribution of investment for the
payment of dividends payable, the following entries shall be made to update the
carrying amounts:
Unrealized loss - PL (P8.2M - P7,8M) 400,000
After updating the amounts, both the dividends payable and financial asset at
FVTPL have balance of P8,200,000. The entry to record the distribution is as
follows:
Financial asset at FVTPL 8,200,000
No gain or loss on distribution was recognized since the dividends payable and
financial asset at FVTPL have the same carrying amounts on the date of distribution.
The overall effects of these entries to retained earnings are summarized as follows:
Effect to Retained Earnings (including Profit or Loss)
Property dividends Noncash asset
Date payable - investment Net effect
12/01/23 (P7,500,000) (P500,000) (P8,000,000)
12/31/23 (700,000) 700,000 -
01/31/24— updating 400,000 (400, nn) -
01/31/24- distribution
Net effect (equal to cAGPtavestinent ofl declaration data) (P8,000,000)
SHARE DIVIDENDS
Aside from cash and noncash assets, an entity may also issue additional shares to
its existing shareholders, without receiving any proceeds, in the form of share
dividends (also called “bonus issue”). The number of share dividends to be issued
is normally stated as a percentage of outstanding shares (issued plus subscribed,
less treasury shares).
The effect of the share dividend transaction is simply a transfer of amount from
retained earnings to the contributed capital. As such, the declaration and subsequent
distribution of share dividends will have no effect in total shareholders’ equity.
However, the amount of transfer will depend whether the share dividend is “large”
or “small”:
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SSS See PGS paisa Large Share Dividends | Small Share Dividends
Quantitative threshold
(generally accepted 2 20% (at least 20%) < 20% (less than 20%)
threshold)
Amounts deducted rom Number of share Number of share
retained earnings and dividends x par value of | dividends x fair value
transferred to contributed per ve Dee erate ae yetes
‘ the shares of the shares
capital
Affected contributed capital Share capital only Share capital and share
accounts premium
Effect in the number of
issued and outstanding Increase Increase
shares
The following pro-forma journal entry shall be made on the date of declaration:
Retained earnings XX
Share dividends payable XX
Share dividends payable (or distributable) is not a liability but considered as part
of equity. This entry also shows that share dividends do not affect the total balance
of equity (i.e., it is a mere transfer of amounts from one equity account to another).
Only a memorandum entry will be made on the date of record.
The following pro-forma journal entry shall be made on the date of distribution:
Share dividends payable XX
Share capital XX
Share premium (for small dividends) XX
Illustration 6. On July 1, 2023, CAMPOSANO Company declared share dividends

for its P20 par value ordinary shares to be distributed on August 31, 2023. On the
same date, 500,000 of these shares were issued and that 20,000 of these issued
shares are in the treasury. Also, on the same date, fair value of the shares amounted
to P25/share. Required: Under each of the following independent scenarios,
determine the journal entries on the date of declaration and distribution:
1. 10% share dividends were declared
Scenario 1 - 10% Share Dividends
Total number of share dividends to be distributed is 48,000 shares [10% x (500,000
shares - 20,000 shares]. Since the percentage is lower than 20%, the declaration
will be considered as small share dividends (i.e., based on P25 fair value). Entry to
be made on July 1, 2023 is as follows:
573
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The
Retained earnings (48,000 x P25) 1,200,000

Entry to be made on August 31, 2023, upon distribution, is as follows:
Share capital (48,000 x P20) 960,000
Share premium (squeeze) 240,000
Total number of share dividends to be distributed is 72,000 shares [15% x (500,000
shares - 20,000 shares)]. Similar to Scenario 1 where percentage is lower than 20%,
the declaration will be considered as small share dividends (i.e., based on P25 fair
value). Entry to be made on July 1, 2023 is as follows:


Share capital (72,000 x P20) 1,440,000
Share premium (squeeze) 360,000
Total number of share dividends to be distributed is 144,000 shares or [30% x
(500,000 shares - 20,000 shares)}. Since percentage is higher than 20%, the
declaration will be considered as large share dividends (i.e. based on P20 par
value). Entry to be made on July 1, 2023 is as follows:
Retained earnings (144,000x P20) 2,880,000
Share capital (144,000x P20) 2,880,000
There is no increase in share premium since the share dividends were measured at
their par value.
LIQUIDATING DIVIDENDS
Unlike the other types of dividends (cash, property and share), which represents
return ON investment, liquidating dividends represent the return OF contributed
capital made by the shareholders. These can be made during liquidation or when
the entity is a wasting asset entity. The pro-forma entries on the date of declaration
and payment in recording this type of dividends are the following, respectively:
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Chepter 15A - Shareholders’ Equity - Retained Earnings
Capital liquidated XX
Liquidating dividends payable XX
Liquidating dividends payable XX
Cash XX
This Capital Liquidated account is presented as a contra-equity account (as a
deduction from shareholders’ equity). The maximum amount of dividends that can
be declared by wasting asset entities is thoroughly discussed in the Volume 1 of this
Intermediate Accounting series by the same author.
EFFECTS OF DIFFERENT TYPES OF DIVIDENDS

The following table summarizes the effects of the different types of dividends to the
basic accounting equation:
Effect of Each Type of Dividends
Cash/Liquidating — Property Share .
Declaration Date:
Assets No Effect No Effect No Effect
Liabilities Increase Increase No Effect
Equity Decrease Decrease No Effect
Payment Date:
Assets Decrease Decrease No Effect
Liabilities Decrease Decrease No Effect
Equity No Effect ‘No Effect No Effect
COMPREHENSIVE ILLUSTRATION FOR DIVIDENDS

Illustration 7. At the beginning of the year 2023, POPCORN Company had the
following shareholders’ equity balances:
During the year 2023, the Company had the following equity transactions in
chronological order:
¢ January 20, 2023 - 20,000 ordinary shares were issued at P40 per share.
e February 10, 2023 - cash dividends of P1.50 per share were declared and were
paid shortly after.
¢ April 30, 2023 - 10% share dividends were declared and were distributed
shortly after. Fair value of the shares as of that date amounted to P42 per share.
¢ June 15, 2023 - cash dividends of P1.80 per share were declared and were paid
shortly after.
° October 1, 2023 - 30% share dividends were declared and were distributed
shortly after. Fair value of the shares as of that date amounted to P39 per share.
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e November 30, 2023 - cash dividends of P2.00 per share were declared and were
paid shortly after.
e December 31, 2023 - The Company reported net income of P1,500,000.
Required: From the given information, determine balance of the retained earnings
as of December 31, 2023.
In this case, the first step is to determine the number of outstanding shares as of
each date of declaration of dividends:
Issued shares (P3M/P30) 100,000
Less: Treasury shares (P380,000/P38) (10,000)
Outstanding shares, (01/01/23 - 01/19/23) 90,000
Add: Shares issued (01/20/23) 20,000
Outstanding shares (01/20/23 - 04/29/23) 110,000
Add: 10% share dividends on 4/30 (110,000x 10%) 11,000
Add: 30% share dividends on 10/01 (121,00 x 30%)
0 36,300
Using the relevant numbers of shares, the balance of retained earnings as of
December 31, 2023 is determined as follows:
Beginning balance, 01/01/23 P4,000,000
Less: 02/10/23 cash dividends (P1.50x 110,000) (165,000)
04/30/23 small share dividends (P42 x 11,000) (462,000)
06/15/23 cash dividends (P1.80 x 121,000) (217,800)
10/01/23 large share dividends (P30 x 36,300) (1,089,000)
11/30/23 cash dividends (P2.00 x 157,300) (314,600)
Add: Net income, 2023 1,500,000
Ending balance, 12/31/23 P3,251,600
APPROPRIATION OF RETAINED EARNINGS

Appropriation of retained earnings means that a portion of the cumulative net
income earned by an entity is not available to be distributed as dividends due to a
variety of reasons, such as the following:
1. Legal - restrictions that are required by laws and regulations, such as those
arising from treasury shares and quasi-reorganization (will be discussed in the
next section). For treasury shares, the amount to be appropriated shall be equal
to the cost of purchase from shareholders.
2. Contractual - restrictions arising from agreement with other parties, such as
covenants from loan agreements.
3. Voluntary - restrictions arising from and entity's internal decisions, such as
earmarking for the purchase or construction of long-term assets, and self
insurance.
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There is an inverse relationship between the unrestricted retained earnings and

the appropriated retained earnings. Increase in appropriations will decrease the
unrestricted retained earnings while decrease in appropriations will increase the
unrestricted retained earnings.
Nevertheless, both the unappropriated and appropriated retained earnings
form the total amount of retained earnings. Transfers between these categories
do not affect the balance of total retained earnings and total shareholders’ equity.
It should be noted that, appropriation does not mean that a separate fund has been
established nor the existence of a separately established fund automatically results
to appropriation of retained earnings.
Illustration 8 - Appropriation for Treasury Shares. On September 1, 2023,
LAURETA Company acquired 50,000 P20 par value ordinary shares from its
shareholders at P42/share. On December 15, 2023, 30,000 of these shares were
sold for P45/share.
On September 1, 2023, the following entries shall be made:
Treasury shares (50,000 x P42) 2,100,000
Cash 2,100,000


Cash (30,000x P45) 1,350,000
Treasury shares (30,000 x P42) 1,260,000

At the end of the year, the amount of appropriated retained earnings related to
treasury shares will have a balance of P840,000 (or 20,000 x P42), or equal to the
cost of the remaining treasury shares.
Illustration 9 - Comprehensive. At the beginning of 2023, SIMBULAN Company
reported information related to its total retained earnings:
Retained earnings - unappropriated P15,000,000
Appropriated retained earnings for self-insurance 2,500,000
Appropriated retained earnings for factory construction 4,000,000
Total retained earnings, 1/1/23 P21,500,000
During the year the following transactions were summarized:
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The
a. Net income amounted to P3,200,000 while dividends declaration amounted to

P1,800,000.
b. Due to the increase in the properties acquired, self-insurance appropriation will
be increased by P500,000.
c. The construction of the factory was completed and no appropriation is needed.
d. Treasury shares were acquired for a total cost of P800,000. None of these were
resold by year-end.
In this case, the balance of retained earnings - unappropriated as the end of 2023
Retained earnings -
unappropriated
Dividends declared | _ 1,800,000 | 15,000,000 | Beginning balance
Increase in self-insurance 500,000 | 3,200,000 | Profit
appropriation
Increase in appropriation due 800,000 | 4,000,000 | Decrease in the factory
to purchase of treasury shares appropriation
Ending balance (squeeze) | 19,100,000
Total retained earnings has the following components at year-end:

Retained earnings unappropriated (computed above) P19,100,000
Appropriated retained earnings for self-insurance (P2.5M + P500K) 3,000,000
Appropriated retained earnings for treasury shares 800,000
Total retained earnings, 12/31/23 P22,900,000
Less: Total retained earnings, 1/1/23 21,500,000
Net increase (also equal to P3.2M net income less P1.8M dividends) P1,400,000
This only shows that transfers between unappropriated and appropriated portions
of retained earnings do not have an impact on a total retained earnings basis.
QUASI-REORGANIZATION
Quasi-reorganization is a process in which an entity wipes out the excessive amount
of deficit (negative) balance in its retained earnings, which will bring a “brand new”
start for an entity. There are two major methods in wiping out the deficit in the
retained earnings:
Method | Procedures ee oes SS ;
Reduction of | Par value of shares are reduced to increase the amount of share
par value premium (additional paid in capital), From this increased share
premium, the deficit in retained earnings will be wiped out.
Revaluation | Properties, especially land and building, with higher fair values
of properties | relative to their carrying amounts, are to be revalued upwards,
resulting to amounts of revaluation surplus, From this revaluation
surplus, the deficit in retained earnings will be wiped out.
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It should be noted that regardless of the method applied, the assets and liabilities
shall be measured at their fair values on the date of quasi-reorganization. Any
adjustment to the carrying amount of these assets and liabilities to measure them
at their values will directly affect the amount of deficit in retained earnings.
The amount of wiped-out deficit in retained earnings shall not be available for
dividends declaration, even if the entity subsequently reports a positive balance
in its retained earnings.
Illustration 10 - Reduction of Par Value. ALFONSO Company reported the

following balances as of December 31, 2023:
Cash P3,000,000
Receivables 4,000,000
Inventories 8,000,000
Property, plant and equipment 25,000,000
Total assets ; P40,000,000
Total liabilities : P14,000,000
Share capital, P50 par, 700,000 shares = P35,000,000
Retained earnings (deficit) (12,000,000)
Total equity P26,000,000
The Company's plan for quasi-reorganization, which has been approved on the
same date, contained the following provisions:
a. Reduction of par value to P30. Any final amount of deficit in retained earnings
shall be charged to the increased share premium.
b. Writing-down receivables and inventories to their fair values of P3,500,000 and
P7,000,000, respectively.
c. Property, plant, and equipment have total fair value of P27,000,000. Liabilities’
carrying amount is the same with their fair value.
The reduction of par value is recorded as follows:

Share capital [(P50 - P30)x 700K] 14,000,000
Entries updating the carrying amounts of the assets (directly closed to retained
earnings) are the following:
Receivables (P4M - P3.5M) 500,000
Inventories (P8M - P7M) 1,000,000
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Retained earnings (P27M - P25M) 2,000,000
After updating the carrying amounts of the assets and liabilities, retained earnings
will now have a deficit balance of P11,500,000 (P12,000,000 + P500,000 +
P1,000,000 - P2,000,000). To wipe out this deficit, the following entry shall be made:
After the reorganization, the Company’s balance sheet will now show the following
balances:
Cash P3,000,000
Receivables 3,500,000
Total assets * P40,500,000
Total liabilities P14,000,000
Share capital, P30 par, 700,000 shares _ P21,000,000

Share premium (P3M + P14M - P11.5M) 5,500,000
Retained earnings ec
Query: If, during 2024 ALFONSO Company earned P15,000,000 net income, how
much of this amount is available for declaration as dividends?
In this case, only P3,500,000 (P15M - P11.5M) is declarable as dividends since the
total P11,500,000 deficit that was wiped during the quasi-reorganization is not
available for dividend declaration moving forward. Needless to say, this P11,500,000
amount shall form part of the appropriated retained earnings account
Illustration 11 - Revaluation. On June 30, 2023, JOCSON Company provided the
following condensed information regarding its financial position on that date:
Current assets P10,000,000 ~
Land (acquired in 2001) 15,000,000
Other long-term assets 17,000,000
Total assets P42,000,000

Retained earnings (deficit) _ (10,000,000)
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The Company’s approved quasi-reorganization plan contained the following

procedures:
a. The land shall be revalued upwards to its current value of P27,000,000. The
resulting revaluation surplus will absorb the final deficit amount in the retained
earnings.
b. Current assets have fair value of P9,200,000 while other long-term assets have
c. Liabilities have fair value of P30,000,000 (i.e., unchanged).
The revaluation of land is recorded as follows:
Land [(P27M - P15M) 12,000,000
Entries updating the carrying amounts of the assets (directly closed to retained
earnings) are the following:
Current assets (P10M - P9.2M) 800,000
Other long-term assets (P17M - P16M) 1,000,000
After updating the carrying amounts of the assets and liabilities, retained earnings
will now have a deficit balance of P11,800,000 (P10,000,000 + P800,000 +
P1,000,000). To wipe out this deficit, the following entry shall be made:
After the reorganization, the Company's balance sheet will show the following
balances:
Current assets P9,200,000
Land 27,000,000
Other long-term assets 16,000,000
Total assets P52,200,000
Revaluation surplus (P12M - P11.8M) 200,000
Retained earnings -
Query: If during the remainder of 2023 and for the year 2024, JOCSON Company
earned net income of P4,000,000 and P12,000,000, respectively, how much of these
amounts is available for declaration as dividends?
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Chapter 15A — Shareholders’ Equity — Retained Earnings
In this case, only P4,200,000 (P4M + P12M - P11.8M) is declarable as dividends since
the total P11,800,000 deficit that was wiped during the quasi-reorganization is not
available for dividend declaration moving forward. Needless to say, this P11,800,000
amount t i L :
CHAPTER SUMMARY
1. Retained earnings represent the total net income (loss) earned (incurred) by an
entity less the total dividends it declared over its operating life so far.
2. If an entity incurred excessive loses to the point where its retained earnings is
negative, this negative amount is called accumulated losses (this account has debit
balance).
3. Total retained earnings is composed of unappropriated and appropriated portions.
4. The unappropriated portion of the retained earnings is available for distribution to
shareholders and is affected by the following transactions (credits increase its
balance while debits decrease its balance):
Retained earnings -
unappropriated
Loss XX XX Beginning balance
Dividends declaration xX XX Profit
Direct transfers of OCI loss xx XX Direct transfers of OCI gain
items (e-g., unrealized losses in items (e.g., revaluation surplus,
FVTOCI assets) unrealized gains)
Increase in appropriation xx xx Decrease in appropriation
Amounts charged, if any, from XX XX Prior period error correction
retirement of shares with increasing effect
Amounts charged, if any, from xx
reissuance of treasury shares
below the purchase cost
Prior period error correction XX
with decreasing effect
5. An entity may choose, but has no obligation, to declare cash, property, share or
liquidating dividends.
6. Only those outstanding shares are entitled to dividends (issued plus subscribed, less
treasury shares).
7. Cash dividends involve returns to shareholders that were paid in cash. It is usually
stated at dividends per ordinary share or as percentage of par value for preference
shares.
8. The total amount of dividends that preference shares can receive will depend
whether it is cumulative and/or participating.
a. Cumulative means that the undeclared preference dividends in the prior years
shall still be paid upon actual dividend declaration.
b. Participating means that the preference shares can share in excess of dividends
on top of the annual preference dividend rate.
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9. Property dividends involve the distribution of noncash assets to shareholders. The

dividend payable is measured equal to the fair value of the noncash asset to be
distributed.
10. Share dividends involve the distribution of an entity's own shares as dividends, The
amount to be deducted from the retained earnings will depend on the following:
a. If it is a small share dividend (less than 20%), the amount to be deducted is
based on the shares’ fair value.
b. If itisa large share dividend (at least 20%), the amount to be deducted is based
on the shares’ par value.
11. Liquidating dividends represent the return OF investment rather than return ON
investment. These amounts are recorded in a “capital liquated” account which
considered as a contra-equity account.
12. Appropriation of retained earnings may arise from legal requirements, contractual
requirements, or from voluntary restrictions.
13. There is an inverse relationship between the unrestricted retained earnings and the
appropriated retained earnings. Increase in appropriations will decrease the
unrestricted retained earnings while decrease in appropriations will increase the
unrestricted retained earnings.
14. Quasi-reorganization is a process in which an entity wipes out the excessive amount
of deficit (negative) balance in its retained earnings, which will bring a “brand new”
start for an entity.
15.Quasi-reorganization may be facilitated by: (a) reduction in the share capital to
increase the share premium; or (b) upward revaluation of long-term assets.
16. The total amount of deficit that was wiped out during the quasi-organization shall
not be available for dividend declaration moving forward.
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CamScanner
Chapter 15A — Shareholders’ Equity —- Retained Earnings
True or False
1. Retained earnings account has a normal credit balance.
2. Total retained earnings amount is composed of unappropriated and appropriated
portions.
3. Netincome for the year decreases the balance in retained earnings account.
4. Dividends increase the balance in the retained earnings account.
5. On the date of declaration of cash dividends, the amount declared as such are
deducted from the retained earnings balance and transferred to liabilities.
6. Cash dividends on ordinary shares are usually stated at a certain percentage of its
par value.
7. Property dividend payable is initially recognized equal to the carrying amount of
the noncash asset that will be distributed.
8. Ingeneral, the noncurrent asset to be distributed as property dividend is measured
at the lower of its carrying amount and fair value less costs to distribute.
9. The declaration of share dividends will decrease an entity's shareholders’ equity.
10. The amount of small share dividends to be deducted from the retained earnings
balance shall be based on the shares’ fair value.
11. Liquidating dividends are considered as return on investment rather than return of
investment.
12. The appropriation of retained earnings will have no effect in the total balance of
retained earnings.
13. The appropriation for treasury shares is an example of contractual type of
appropriation.
14. Quasi-reorganization may be executed by wiping out the deficit against either the
share premium or the revaluation surplus.
15. The amount of wiped-out deficit is not available for declaration as dividends
moving forward.
1. Which of the following transactions does not affect the balance of the retained
earnings during the current period?
a. Unrealized gain from FVTOCI debt security.
b. Profit or loss.
c. Prior period error.
d. Direct transfers of realized revaluation surplus,
2. The following transactions have the correct corresponding effects to the balance of
the retained earnings, except
a. Net loss for the year has a decreasing effect to the retained earnings balance.
b. Direct transfer of revaluation surplus has an increasing effect to the retained
earnings balance.
c. “Loss” on reissuing treasury shares has a decreasing effect to the retained
earnings balance.
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d. Excess of the retirement price over the par value and the corresponding share
premium - issuance of the retired shares has an increasing effect.
3. Anentity may declare the following dividends only when there is a sufficient balance
in the retained earnings, except
a. Cash dividends
b. Liquidating dividends
c. Share dividends
d. Property dividends
4. Which of the following shares are entitled to receive dividends?
a. Authorized shares
b. Treasury shares
c. Subscribed shares
5. The following statements regarding cash dividends are correct, except
a. Thecash dividends to be paid to preference shareholders are normally stated as
a percentage of the total par value, excluding the share premium - preference.
b. The cash dividends will decrease the shareholders’ equity only during the date
of payment or distribution.
c. Cumulative preference shares are entitled to cash dividends that were not
declared during the prior periods.
d. The cash dividends to be paid to ordinary shareholders are normally stated as
dividend amount per share.
6. The amount of property dividends payable shall be measured equal to the
a. Carrying amount of the noncash asset
b. Original cost of the noncash asset
c. Fair value of the noncash asset
d. Fair value less costs to distribute of the noncash asset
7. The amount of the noncurrent asset that will distributed as property dividends and
is covered by PFRS 5 shall be measured as of the reporting period at its
a. Carrying amount
b. Fair value less costs to distribute
c. Carrying amount or fair value less costs to distribute, whichever is higher
d. Carrying amount or fair value less costs to distribute, whichever is lower
8. Which of the following is the correct effect of share dividends to the amounts on the
entity's financial statements?
a. On the date of distribution of the share dividends, the amount of share capital
will increase.
b. On the date of declaration, the share dividends will decrease the total
shareholders’ equity.
c. On the date of declaration, the share dividends will increase the total liabilities.
d. The share dividends will decrease the balance in the retained earnings only
during the date of distribution.
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9. The amount of share dividends to be deducted from the retained earnings shall be
based on the shares’
a. fair value for both the large and small share dividends
b. par value for both the large and small share dividends
c. fair value for small share dividends, while par value for large share dividends
d. par value for small share dividends, while fair value for large share dividends
10. Which of the following statements is/are true regarding the liquidating dividends?
a. An entity can declare liquidating dividends only when there is an available
retained earnings balance.
b. Liquidating dividends are recorded in a capital liquidated account, a contra-
equity account.
c. Bothaandb
d. Neitheranorb
11. The following statements regarding appropriation are correct, except

a. The appropriation of retained earnings decreases the balance of
unappropriated retained earnings.
b. The balance in the appropriated retained earnings account plus the balance in
the unappropriated retained earnings account is equal to the total retained
earnings.
c. There is a direct relationship between the appropriated retained earnings
account and unappropriated retained earnings account.
d. The increase or decrease in appropriation has no effect in the total balance of
the retained earnings.
12.A portion of unappropriated retained earnings may be appropriated under which of

the following requirements or purposes?
a. Legal requirements
b. Contractual requirements
c. Voluntary purposes
d. All ofthe above
13. The following are examples of voluntary appropriations, except

a. Appropriations related to treasury shares.
b. Appropriations related to the purchase of land in few years’ time.
c. Appropriations related to self-insuring the fixed assets.
d. Appropriations related to the construction of new headquarters.
14. The appropriation in accordance with loan covenants is considered as
a. Legal appropriation
b. Contractual appropriation
c. Voluntary appropriation
d. Mandatory appropriation
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15. The following statements pertaining to quasi-reorganization are correct, except

a. Quasi-reorganization is conducted by some entities with huge amounts of deficit
to have a brand new and fresh start after tumultuous financial performance
during the previous years.
b. Ina quasi-reorganization, the assets and liabilities of an entity shall be adjusted
to their fair values.
c. The adjustments to be made to the carrying amounts of the assets shall be
directly recorded to the retained earnings account.
Straight Problems
1. On January 1, 2023, DOBBY Company had a beginning retained earnings amounting
to P4,000,000, of which, P1,000,000 is appropriated for the construction of a
building that is expected to be finished in 2026. During the years 2023 and 2024:
The Company reported the following amounts:
2023 2024
Net income (loss) P4,000,000 (P600,000)
Dividends declared 2,500,000 1,200,000
Dividends paid 2,200,000 1,400,000
In addition, at the beginning of the year 2023, the Company had a total revaluation
surplus of P2,000,000, of which, P1,500,000 is related to a building with remaining
useful life of 10 years, while the balance is related to a land that was actually sold
during 2024.
Required: Determine the balances of the retained earnings - unappropriated as of
December 31, 2023 and 2024.
2. On December 31, 2023, KIKO Company reported the following components of its
8% preference share capital, P30 par value 9,000,000
Subscribed share capital - ordinary 900,000
Subscription receivable - ordinary 750,000
Subscription receivable - preference 800,000
Retained earnings - appropriated 1,800,000
Retained earnings - unappropriated 4,000,000
Treasury shares - ordinary (at P18 cost per share) 720,000
Treasury share - preference (at P34 cost per share) 680,000
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The preference shares are both noncumulative and nonparticipating. As of the same
date, the Company declared P2.50 cash dividends per ordinary share and the annual
preference dividends.
Required: From the given information, determine the following: .
a. Total amount of cash dividends to be declared to all shareholders.
b. Total shareholders’ equity as of December 31, 2023.
3. On January 1, 2023, LOUIE Company had the following shareholders’ equity:

6% preference share capital, P100 parvalue 5,000,000
During the year 2023, the Company had the following equity transactions:
January 2, 2023 - 10,000 preference shares were subscribed at P125 per share.
Down payment 40% of the subscription price was required, while the remaining
balance is payable within the next three years.
February 14, 2023 - 40,000 ordinary shares were issued for P32 per share.
March 10, 2023 - 20,000 ordinary shares were acquired for P33 per share, to be
held in treasury.
April 10, 2023 - the Company declared and paid P3.20 cash dividends per
ordinary share.
June 30, 2023 - 10,000 treasury shares were reissued for P30 per share.
July 31, 2023 - 50,000 ordinary shares were subscribed at P36 per share. Down
payment of 30% was required, while the remaining balance is payable within the
next three years.
September 1, 2023 - the subscriber of 4,000 preference shares fully paid its
subscription. The related share certificates were issued shortly.
October 1, 2023 - the Company declared and paid P2.40 cash dividends per
ordinary share.
December 31, 2023 - the Company generated P1,500,000 net income and
declared the annual preference dividends.
From the given information, determine the following:

a. Total amount of cash dividends paid during the year 2023,
b. Unappropriated balance of retained earnings as of December 31, 2023.
Cc. Total shareholders’ equity as of December 31, 2023,
4. On December 31, 2023, CLEO Company reported its shareholders’ equity as follows:
10% preference share capital, P50 par value 3,600,000
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aT
Subscribed share capital - ordinary 1,200,000

Subscribed share capital - preference 800,000
Treasury shares - ordinary (10,000 shares) 300,000
Treasury shares - preference (8,000 shares) 500,000
As of the same date, the Company declared P3,000,000 cash dividends. The last time
that the Company has paid dividends was in 2021.

amounts of (a) dividend per ordinary share; and (b) dividend per preference share:
1. The preference shares are noncumulative and nonparticipating.
2. The preference shares are cumulative but nonparticipating.
3. The preference shares are noncumulative but participating.
4. The preference shares are cumulative and participating.
. On October 1, 2023, ROCKY Company declared some of its vacant lands with
carrying amount of P6,000,000 as property dividend. These lands will be actually
transferred to shareholders on January 31, 2024. Fair value and estimated costs of
distribution are the following:
Costs to
Date Fair value distribute
10/01/23 P6,300,000 400,000
12/31/23 6,400,000 550,000
01/31/24 6,200,000 450,000
Required: From the given information, determine the journal entries to be made
during 2023 and 2024.
. On October 31, 2023, SWIMMY Company declared 100,000 of its investment in

equity securities of another entity as property dividends, to be actually distributed
on January 20, 2023. On the date of declaration, the shares had carrying amount of
P40 per share. Fair value per share and costs to distribute per share are the
following:
Costs to
Date Fair value distribute
10/31/23 P45,.00 P4.50
12/31/23 43.00 1.50
01/20/24 47.00 5.50
Required: From the given information, determine the journal entries to be made
during 2023 and 2024.
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7. On June 30, 2023, SANDY Company is contemplating to declare share dividends but
unsure how to account for the said dividends. As of the dame date, the Company had
the following components of its shareholders’ equity:
In addition, as of the same date, the shares have fair value of P8 per share.
Required: Under each of the following independent scenarios, identify the journal
entries that the Company shall make on the date of declaration and on the date of
distribution of the share dividends:
1. Share dividends of 5% were declared.
. At the beginning of the year 2023, ROXY Company’s shareholders’ equity is as

follows:
e Inaddition, the following equity transactions occurred during the year:

e January 3, 2023 - 20,000 shares were acquired for P55 per share to be held in
treasury.
e January 31, 2023 - 50,000 shares were subscribed for P54 per share. Down
payment of 30% was required, while the remaining balance is payable within the
next two years.
e February 1, 2023 - P3.00 cash dividends per share were declared and were paid
on February 10, 2023.
e March 1, 2023 - 10% share dividends were declared and were distributed on
March 10, 2023. The shares have fair value of P56 per share.
e June 1, 2023 - 10,000 treasury shares were reissued for P53 per share.
e July 1, 2023 - the subscriber of the 20,000 shares has fully paid its subscription
balance.
© October 1, 2023 - 30% share dividends were declared and distributed on October
15. 2203. The shares have fair value of P55 per share.
e November 1, 2023 - P2.00 cash dividends per share were declared and were paid
on November 20, 2023,
¢ December 31, 2023 - net income for the year amounted to P1,700,000.
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b. Balance of unappropriated retained earnings as of December 31, 2023.
c. Total shareholders’ equity as of December 31, 2023.
9. On January 1, 2023, MARBLE Company had a beginning balance of P7,000,000, of

which, P2,000,000 is appropriated as follows:
Appropriation for treasury shares P800,000
Appropriation for self-insurance 1,200,000
During the year, the following events related to retained earnings have occurred:
e Half of the treasury shares were sold for P370,000. There was no balance in the
share premium - treasury account.
e The Company decided to expand its operations in a new location and expects that
P2,000,000 will be incurred in the expansion. Appropriation for the same amount
was established.
e Due to improvements in the security and decrease in criminality in the entity’s
place of business, the Company decided to reduce its appropriation for self-
insurance by P300,000.
e Aland with related revaluation surplus balance of P500,000 was sold during the
year.
e Net income for the year amounted to P2,500,000, while the cash dividends
declared amounted to P1,000,000.
Required: From the given information, determine the amounts of the

unappropriated portion of the retained earnings and the appropriated portion of the
retained earnings.
10.As of December 31, 2023, TURBO Company had the following information:
Carrying Fair
amounts values
Cash P4,000,000 P4,000,000
Accounts receivable, net 8,000,000 7,000,000
Inventories 18,000,000 16,500,000
Fixed assets 20,000,000 17,000,000
Accounts payable 14,000,000 14,000,000
Loan payable 6,000,000 7,500,000
To wipe out the final amount of the deficit, the quasi-reorganization contained a
provision of decreasing the par value of the shares to P20, Fast forward to 2024 and
2025, the Company was able to earn profits of P8,000,000 and P12,000,000,
respectively.
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a. Journal entries to record the quasi-reorganization,
b. The maximum amount of dividends that can be declared as of December 31,
2024 and 2025.
1. On December 31, 2023, ROCKET Company reported the following account balances:
Ordinary share capital P5,000,000
Preference share capital 2,500,000
Subscribed share capital - ordinary 1,000,000
Unrestricted retained earnings 17,500,000
Appropriated retained earnings for factory expansion 6,000,000
Appropriated retained earnings for self-insurance 4,000,000
Cumulative net unrealized gains from investment in
equity securities - FVTOCI 400,000
Cumulative net unrealized losses from investment in
debt securities - FVTOCI 250,000
Revaluation surplus 650,000
Cumulative net actuarial gains 300,000
Cumulative net remeasurement losses 1,100,000
From the given information, the total shareholders’ equity shall be

a. P55,500,000 c. P60,150,000
b. P57,500,000 d. P61,400,000
2. OLLIE Company reported the following amounts during its first three years of
operations:
Year Netincome Dividendsdeclared Dividends paid
2020 P1,100,000 P800,000 P800,000
2021 3,300,000 1,500,000 1,300,000
2022 2,300,000 1,200,000 1,300,000
During 2023, the Company earned revenues of P6,000,000 and expenses of
P3,400,000. Applicable tax rate is 25%. During the year, the Company declared
dividends of P1,200,000 and paid P 1,000,000 dividends.
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The balance of the retained earnings as of December 31, 2023 shall be

a. 3,200,000 c. P3,950,000
b. P3,300,000 d. P4,250,000
3. On May 1, 2023, ELSA Company was authorized to issue 600,000 ordinary shares
with par value of P30. After few days, it issued 350,000 ordinary shares at
P48/share. On June 1, 2023, the Company repurchased 30,000 shares for P55/share.
During the last week of July 2023, the Company split the shares 2-for-1 split-up. On
December 1, 2023, the Company declared a P2.60/share cash dividend to be paid on
December 15, 2023. Lastly, on December 31, 2023, the Company purchased 40,000
shares from its shareholders to be held in the treasury.
The total amount of cash dividends that the Company declared on December 1, 2023
shall be
a. P4,784,000 c. P4,286,000
b. P4,680,000 d. P4,042,000
4. On December 31, 2023, HINKLE Company declared a total cash dividend of

P4,000,000 to its ordinary and preference shareholders. As of the same date, the
Company had the following shareholders’ equity:
Ordinary share capital. P20 par value P14,600,000
9% Preference shares, P100 par value 6,000,000
Treasury shares - ordinary (P28 cost per share) 840,000
The last time that the Company has ever paid dividends was in 2020.
Assumption 1: The preference shares are noncumulative and nonparticipating.
The cash dividends to be received by preference shareholders shall be

a. P270,000 c. P540,000
b. P480,000 d. P1,620,000
The cash dividends to be received by ordinary shareholders shall be
a. P2,380,000 c. P3,520,000
b. P3,460,000 d. P3,730,000
Assumption 2: The preference shares are cumulative and participating.
The cash dividends to be received by preference shareholders shall be
a. P1,420,000 c. P1,880,000
b. P1,620,000 d, P1,956,000
The cash dividends to be received by ordinary shareholders shall be
a. P2,044,000 c. P2,380,000
b. P2,120,000 d, P2,580,000
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5. On January 1, 2023, GORDY Company reported the following components of its

Ordinary share capital, P80 par value —_— P7,000,000

The Company issued additional 30,000 shares for P86/share on July 15, 2023. In
addition, a shareholder donated an equipment with fair value of P1,700,000 on
October 31, 2023.
The Company also had treasury share transactions wherein it purchased 20,000
shares to be held in treasury by paying shareholders P1,800,000 on April 1, 2023. Of
these treasury shares, 8,000 shares were sold on August 1, 2021 for P736,000, while
7,000 were sold on November 5, 2023 for P635,000.
Cash dividends were also declared during the year, P0.80/share on May 1, 2023 and
P1.25/share on October 1, 2023. Lastly, the Company also declared 30% share
dividends on December 1, 2023 when the shares’ fair value amounted to P96/share.
Net income during the current year amounted to P1,400,000.
The total cash dividends declared during the year 2023 shall be
a. P148,425 c. P185,875
b. P156,765 d. P196,275
Unappropriated retained earnings as of December 31, 2023 shall be
a. P4,564,125 c. P5,043,235
b. P5,014,125 d. P5,051,575
Total shareholders’ equity as of December 31, 2023 shall be
a. P19,805,165 c. P21,645,775
b. P20,565,125 d. P22,034,225
6. On January 1, 2023, SPOT Company reported its shareholders’ equity as follows:
Retained earnings:
Unappropriated retained earnings 5,000,000
Appropriation for treasury shares 900,000
Appropriation for building construction 1,800,000
Appropriation for contingency 2,000,000
During the year, one-half of the treasury shares were sold in a single transaction for
a total price of P390,000. The construction of the building has finished during the
year. On the other hand, the amount of appropriation for contingency is initially
based on initial estimate of the adverse financial effect of a lawsuit. The estimate has
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been revised to P2,400,000. Net income for the year amounted to P600,000, while
dividends declared amounted to P450,000.
The ending balance of the retained earnings - unappropriated as of December 31,

2023 shall be
a. P6,490,000 c. P6,940,000
b. P6,550,000 d. P7,270,000
The total ending balance of the retained earnings - appropriated as of December 31,
2023 shall be
a. P2,450,000 c. P3,300,000
b. P2,850,000 d. P4,650,000
7. During the past few years, SEBASTIAN Company experienced business reversals and
decided to undertake quasi-reorganization on January 1, 2023. The Company
reported the following condensed balance sheet as of this date:
Cash and cash equivalents P1,000,000
Property, plant and equipment (PPE) 14,000,000
Liabilities P5,000,000
The following are the steps that the Company should do in its financials based on the
reorganization plan approved by the SEC:
a. Write-down of inventory to its fair value of P2,000,000.
b. The PPE will be revalued to its fair value of P22,000,000.
c. Deficit will be wiped out with a corresponding reduction in the revaluation
surplus.
The total amount of assets after the quasi-reorganization shall be
a. P17,500,000 c. P23,000,000
b. P19,000,000 d. P25,000,000
The total amount of revaluation surplus after the quasi-reorganization shall be
a. P8,000,000 c. P1,500,000
b. 2,000,000 d, P1,000,000
Assuming that the Company earned net income of P3,500,000 and P7,500,000
during 2203 and 2024, the maximum amount of dividends that can be declared as of
December 31, 2024 shall be
a. P3,800,000 c, P5,000,000
b. P4,500,000 ~ d, P11,000,000
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Chapter 16 — Equity-Settled Share-Based Payment
CHAPTER 16
EQUITY-SETTLED SHARE-BASED PAYMENT

i. The measurement of services provided by non-employees and those provided
by employees.
2. The different types of vesting conditions.
a The recognition of equity-settled share-based payments if there are no vesting
conditions and if there are vesting conditions.
4. The estimation of compensation expense to be recognized for each year.
5 The accounting for the changes in the estimate of compensation expense.
6. The accounting for the modification of share-based payment.
SHARE-BASED PAYMENT ARRANGEMENT

Share-based payment arrangement is an agreement between the entity and
another party (e.g., a supplier or employee) that entitles the entity to receive goods
and services by transferring to the other party either of the following:
a. equity instrument (e.g., ordinary or preference shares) of the entity (i.e.,
equity-settled share-based payment); or
b. cash or other assets of the entity for amounts that are based on the price (or
value) of the entity's equity instruments (i.e. cash-settled share-based
payment). This will be discussed in the succeeding chapter.
EQUITY-SETTLED SHARE-BASED PAYMENT - A PRIMER

As previously mentioned in Chapter 15, an entity may acquire goods or services by
issuing its own equity instruments. For the services received, the accounting
procedures will depend on whether the services are provided by employees or third
parties (i.e., non-employees):
Proceeds Measurement of services

Services - The services provided by professional outsiders (lawyers,
provided by consultants, etc.) shall be valued using the following hierarchy
non-employees | /PFRS 2.10]:
(e.g., consultants, | 1. Fair value of services
external auditors | 2. Fair value of shares issued
and lawyers) 3. Par value of shares issued
The services provided by employees are measured by reference |
Services - to the fair value of shares or other equity instruments
provided by issued. [PFRS 2.11], The reason is that it is not possible to
employees estimate reliably the fair value of the services received from
| employees. Al
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The focus of this chapter is on the accounting for the equity-settled share-based
payment involving the services provided by employees.
EMPLOYEE EQUITY-SETTLED SHARE-BASED PAYMENT PLANS

Shares or other equity instruments (e.g., share options) may be given to employees
as part of their compensation package as additional compensation. These are given
to the employees to motivate them by realizing that their efforts will be ultimately
reflected in the market value of the equity securities they are holding.
Fair value information related to the employee services is usually not readily
available since the discussion of salary and other pay information is usually
considered as taboo. As a result, the value of employee services is measured by
reference to the fair value of the related equity instruments given to them.
ACCOUNTING FOR EMPLOYEE EQUITY-SETTLED SHARE-BASED PAYMENT PLANS

In connection with an employee equity-settled share-based payment plans, an
entity recognizes compensation expense (unless qualifies as an asset) and a
corresponding increase in equity as its employees render services. This is shown
in the following pro-forma journal entry:
Compensation expense XX
Share premium - share options XX
If the equity instrument granted is an actual share of stock, the credit would be on
share capital and in share premium, if applicable.
value
The employees’ services shall be measured by reference to the fair of the
equity instruments on the grant date. [PFRS 2.11]. This is the date at which the
entity and its employees agree to the terms and conditions of a share-based
payment arrangement. Fair values of equity instruments on subsequent dates
are generally ignored.
However, the amount of compensation expense per period shall depend on
whether or not the grant of equity instruments is subject to vesting
condition(s). Vesting conditions are described as follows:
Vesting Condition
A vesting condition determines whether the employees are ultimately entitled to the
equity instruments (i.e, to vest or when the employees’ entitlement becomes
unconditional). This can be either a service condition or a performance condition.
Service condition Performance condition
Requires the employee to | Performance condition includes both of the following:
complete a_ specified | a. Service condition; and
Period of service during | b. Specified performance target(s) to be met.
Which — services are : is
provided to the entity, Performance targets can be either of the following:
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1. Non-market condition such as reaching a specified

If an employee leaves the amount of profit or return on investment
entity before the equity | 2 Market condition such as reaching a specified price
instruments vest, his or or value of the entity's equity instruments
her entitlement to these
instruments will be | Failure to meet these conditions will result to forfeiture
forfeited. of equity instruments.
The amount of compensation expense to be recognized is determined as follows:
Not Subject to Vesting Conditions Subject to Vesting Conditions

Compensation expense is | Compensation expense shall be recognized
recognized wholly during the | over the vesting period. The entity shall
period ‘the equity instruments | estimate the number of equity instruments
were granted that will ultimately vest and the length of the
vesting period, if applicable.
Changes in the estimate and the difference

between the actual number of vested shares
compared to the estimated number shall be
accounted for prospectively (i.e., in the form
of catch-up adjustment). Previously reported
amounts shall not be restated.
ESTIMATING THE AMOUNTS OF COMPENSATION EXPENSE

In estimating the amounts of compensation expense, the following inputs are to be
considered:
Compensation Expense = Value x Number x Period
‘Input Description ox
Value As previously mentioned, indirectly measured by reference to the fair
component | value of the equity instruments on grant date.
Number | This is the expected number of equity instruments to vest. This is
component | usually based on one or combination of the following (list is non-
exhaustive):
a. Number of employees who remained employ (estimated no. of
employees entitled x equity instrument granted per employee).
b. Total number of equity instruments to be granted based on the
achieved level of net income or return on investment (i.e., tiered) |
Period If the compensation expense is recognized over the vesting period, the
component | following procedures may be followed:
1. First, determine the value of cumulative services rendered to date.
2. Next, Compensation expense for the current period = value of
cumulative services rendered to date - total amount of compensation
expense recognized during the prior periods.
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The readers should take note that the computations will depend on the conditions
agreed by the counterparties. As a result, the readers are hereby advised to
thoroughly understand the conditions and their accounting consequences.
Illustration 1. On January 1, 2023, GERVACIO Company granted 10,000 share
options to each member of its senior management team composed of 10 managers.
The options have fair value of P12/option and exercise price of P60/share. Fair
value of the Company’s P50 par value shares on that date is P75/share. It is reliably
estimated that all of the share options will vest. The share options have the
following fair values as of December 31 of each year: 2023, P15/option; 2024,
P18/option; and 2025, P16/option. Required: Under each of the following
independent scenarios, determine the amount. of compensation expense to be
recognized each year:
1. The share options vest immediately
2. The share options will vest after two-year service period
3. The share options will vest after three-year service period
Scenario 1
Since there are no vesting conditions, the value of the services shall be considered
expensed in full in 2023 and shall be based on the P12 fair value of each share
option on the grant date. Compensation expense of P1,200,000 (P12 x 10,000 share
optionsx 10 managers) shall be recorded as expense in 2023 as follows:
Share premium - share options 1,200,000
It should be noted that the P75/share fair value of shares was not be used since share
options were granted to the employees (i.e, not the actual shares of stock). In
addition, in all scenarios in this illustration, the subsequent fair values of the
share options shall be ignored.
Scenario 2
The total compensation expense of P1,200,000 computed in Scenario 1 shall be
used, except that it shall be allocated over the next two-year vesting period (in 2023
and 2024). Journal entry to be made in 2023 is as follows:
Compensation expense (P1.2M/2) 600,000
Share premium - share options 600,000
Journal entry to be made in 2024 is as follows:
On the vesting date of December 31, 2024, the share premium - share options
account shall have P1,200,000 balance.
599
ki
The
Scenario 3
The total compensation expense of P1,200,000 computed in Scenario 1 shall be
used, except that it shall be allocated over the next three-year vesting period (in
2023, 2024, and 2025). Journal entry to be made every December 31 of the years
2023, 2024, and 2025 is as follows:
Over the vesting period, the amounts that were recognized are summarized as
follows:
Compensation Share premium - share
Year expense options balance
2023 P400,000 P400,000
2024 400,000 800,000
2025 400,000 1,200,000
Generalizations — All Scenarios

he cumulative amoun mpensation expense recognized up to date is equal to th
balance of the share premium - share options account. In addition, the recording of
compensation expense, with corresponding credit to share premium, does not
affect the total amount of shareholders’ equity. The reason is that equal amounts
are recognized as compensation expense (deduction from retained earnings
through profit or loss) and as increase in share premium.
ACCOUNTING FOR THE EXERCISE OF VESTED SHARE OPTIONS

After the vesting date, the employees may exercise the share options to their liking,
provided that it is within the agreed exercise period. Generally, no amounts of
compensation expense are recognized during the exercise period. This can be
summarized as follows:
Vesting period - the entity Exercise period - generally, no

recognizes compensation expense expense is recognized, generally
[ ay \
~-=--- [ann nm nnn nnn
v y y
Grant date Vesting date End of exercise
period
Accounting for the exercise of share options is very similar to the accounting for the
exercise of share warrants in compound financial instruments. The balance of
600
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share premium- share options pertaining to the exercised share options shall be
2 ae TRE at this cate, the net increase in the
In cases where the share options were not exercised within the designated exercise
period, the balance of share premium - share options may be transferred to other
equity accounts (e.g., share premium - others).
Illustration 2. Going back to GERVACIO Company (Illustration 1), on vesting date

where the balance of share premium - share options amounted to P1,200,000, a
number of employees immediately exercised their share options. As a recap, each
of the 10 employees can purchase 10,000 of the Company’s P50 par value shares at
P60/share Required: Under each of the following independent scenarios,
determine the journal entry to record the exercise of share options:
1. All ten employees exercise the share options
2. Only six employees exercise the share options
Scenario 1
The entry to be made by the Company to record the full exercise is as follows:
Cash (10,000x 10 x P60) 6,000,000

Share capital (10,000 x 10 x P50) 5,000,000
It should be noted that each of the ten employees can purchase 10,000 shares at
P60/share exercise price. All of the balance of the share premium - share options
were included in the issuance since all employees exercised the share options.
Scenario 2
The entry to be made by the Company to record the partial exercise is as follows:
Cash (10,000 x 6 x P60) - 3,600,000
Share premium - share options
(P1,200,000 x 6/10) 720,000
Share capital (10,000 x 6 x P50) 3,000,000
It should be noted that only a portion of the share premium - share options was
included in the issuance since not all employees exercise the share options. The
excluded amount shall be included in the issuance when these remaining four
employees exercise their share options.
601
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ILLUSTRATIONS - CHANGES IN THE NUMBER COMPONENT

Illustration 3 - Employee Turnover. At the start of 2023, MANLAPAZ Company
instituted an additional compensation scheme to its 450 employees in the form of
share options. Each employee is entitled to 200 share options which allow them to
purchase 200 of the Company’s P25 par value ordinary shares at P30/share. During
this time, the Company’s shares have fair value of P45/share and the share options
have fair value of P6/option. To be entitled to the share options, the employees
should still be employed in the Company for the next three years.
Originally, the Company estimated that a total of 420 employees will ultimately be
entitled to the share options. On December 31, 2024, this estimate was revised to
440 employees. By December 31, 2025, the date of vesting of the share options, 425
employees actually became entitled to the share options. On this date, the shares
have fair value of P5S/share and the share options have fair value of P8/option.
The amounts of compensation expense per year during the vesting period are
Share premium - Comp.
FVof Expected no. share options, expense
share of options to ending balance = during
Year options vest (cum. comp.exp.) the year
2023 P6.00 84K (420x200) P168K [(P6x 84K)x1/3] P168,000 (P168K- PO)
2024 P6.00 88K (440x200) P352K [(P6x 88K)x2/3] P184,000 (P352K- P168K)
2025 P6.00 85K (425x200) P510K [(P6x 85K)x 3/3] _P158,000 (P510K - P352K)
Total compensation expense P510,000
Note: cum. comp. exp. means cumulative compensation expense.
Again, the P6 fair value of share options as of the grant date shall be used in the
computations all throughout the vesting period. In addition, the changes in the
estimate and in the actual number of vested options are adjusted to the amount of the
compensation expense during the period of change (i.e., catch-up adjustment) and
shall not affect the previously reported amounts.
Journal entry to record compensation expense during 2023 is as follows:
Compensation expense 168,000
602
The
Assuming that on January 15, 2026, 220 employees exercised the share options, the
following journal entry shall be made to record the exercise:
Cash (220 x 200 x P30) 1,320,000
Share premium - share options
(P510,000 x 220/425) 264,000
Share capital (220 x 200 x P25) 1,100,000
Illustration 4 - Tiered Number of Equity Instruments. On January 1, 2023,

CABRAL Company granted a total of 200,000 share options to purchase 200,000,
P20 par value ordinary shares of the Company at the exercise price of P40/share to
the executive members of its marketing department. The condition is that these
executives shall remain in employ in the Company for the next four years. Fair value
of the share options as of this date amounted to P5/option.
In addition, the number of share options to be granted will increase depending on
the average level of sales generated over the vesting period:
Average sales Number of share options to be granted
more than P15 million 300,000
P10 million to P15 million 250,000
less than P10 million 200,000
It is expected that none of the marketing executives will resign before the end of the
vesting period. For the year 2023, the total sales amounted to P9.50 million and that
level is expected to be maintained for the rest of the vesting period.
For the year 2024, total sales reached P14 million due to the strong marketing
efforts that are expected to benefit the remaining vesting period. Same amounts of
revenues are reasonably expected to be earned for the rest of the vesting period.
For the year 2025, total sales amounted to P19 million due to increase in the
number of long-term government procurement contracts entered into by the
marketing division. That same amount is expected to be earned in 2026. For the
year 2026, the actual amount of sales reached P17 million.
For this type of provided information, it is important to first compute for the
amount of average sales that the Company is expecting based on the combination of
actual data and estimates of future sales amounts, divided by the four-year vesting
period. This is to determine the corresponding number of share options expected to
be granted to the employees:
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Expected Expected No. of

Year Actual and Expected Sales Ave.Sales Options to Vest
2023 P9.5M+P9.5M+P9.5M+P9.5M P9,500,000 200,000
2024 P9.S5M+P14M+P14M+P14M 12,875,000 250,000
2025 P9.5M+P14M+P19M+P19M 15,375,000 300,000
2026 P95M+P14M+P19M+P17M 14,875,000 250,000
Note: Sales amounts in bold italic are estimates made during the year indicated. For the
year 2026, the average sales amount is already the actual average sales amounts from
2023 to 2026.
Expected Share premium - Comp.
no. of share options, expense
options ending balance during the
Year FV to vest (cum. comp. exp.) year
2022 PS 200,000 P250K [(P5 x 200K) x 1/4] P250,000 (P250K - PO)
2023. 5 250,000 625K /(P5x250K)x2/4] 375,000 (P625K - P250K)
2024 © 5 300,000 1,125K /(P5 x 300K) x 3/4] 500,000 (P1,125K- P625K)
2025 5S 250,000 1,250K /(P5 x 250K) x 4/4] 125,000 (P1,250K- P1,125K)
Total compensation expense P1,250,000

ILLUSTRATION - CHANGES IN THE PERIOD COMPONENT

Illustration 5. At the beginning of 2023, ZULUETA Company granted 300,000 share
options with fair value of P9/option to its employees. These options will vest at the
time the Company will earn at least P100 million aggregate net income from 2023
onwards. In addition, the employees must be employed on the vesting date to
become entitled to the share options.
604
The
For the year 2023, the Company earned P60 million net income and expects to earn
a similar amount in 2024. As a result, the Company expects that the options will vest
in 2024. It is also expected that only 96% (i.e., 288,000) of the share options will
ultimately vest.
For the year 2024, because of an economic downturn, the Company only earned
P30 million, thus, the options did not vest during that year (i.e., only an aggregate
P90 million net income from 2023 to 2024). In addition, it is expected that only 90%
(i.e., 270,000) of the share options will ultimately vest in 2025. For the year 2025,
the Company earned P45 million, thus meeting the performance condition,
resulting to the vesting of the 92% (i.e., 276,000) of the share options.
The amounts of compensation expense per year, during the vesting period are
2023 P9 288,000 P1,296K [(P9x288K)x1/2] 1,296,000 (P1,296K - PQ)
2024 9 270,000 1,620K /(P9 x 270K) x 2/3] 324,000 (P1,620K - P1,296K)
2025 9 276,000 2,484K [(P9 x 276K)x3/3] 864,000 (P2,484K- P1,620K)
The readers should take note that the much smaller amount of compensation
expense for 2024 is due to the extension of the expected vesting period until 2025.

ILLUSTRATIONS - CHANGES IN THE VALUE COMPONENT

Illustration 6 - Exercise Price Changes. On January 1, 2023, ARCILLA Company
granted 60,000 share options to its employees covering the purchase of 50,000 P10
par value ordinary shares of the Company. The exercise price will change
depending on the average return on investment (ROI) together with the
corresponding grant date fair value of share options:
605
The
Average ROI Exercise price FV ofshare option

25% and up P20 P9
20% - 24.99% 30 6
16% - 19.99% 40 4
The average ROI is measured over the next three years. In addition, the employees
are also required to remain in the employ of the Company over the vesting period.
It is expected that all of the share options will vest in 2025,
For the year 2023, the Company reported ROI of 26% and expects to maintain that
level for the next two years. For the year 2024, the Company reported an ROI of
21% due to a downturn in economic activity which is expected to persist until 2025,
For 2025, actual ROI reached 20%. Actual. number of vested share options
numbered 55,000 due to the sudden and unexpected resignation of some
employees.
For this type of provided information, it is important to first compute for the
amount of average ROI that the Company is expecting based on the combination of
actual data and estimates of future ROI in order to determine the corresponding
exercise price for the share options and the relevant fair value to be used in the
computations:
Actual and Expected Expected Corresponding

Year Expected ROI Ave.ROI ExercisePrice Option Fair Value
2023 26%+26%+26% 26.00% P20 P9
2024 26%+21%+21% 22.67% 30 6
2025 26%+21%+20% 22.33% 30 6
Note: Percentages in bold italic are estimates made during the year indicated. For the year 2025,
the average ROI is already the actual average ROI from 2023 to 2025. In addition, even though the
fair value of options changes depending on the exercise price, these fair values were all determined
as of grant date.
2023 P9 60,000 P180K /(P9x 60K) x 1/3] P180,000 (P180K - PO)
2024 6 60,000 240K [(P6 x 60K) x 2/3] 60,000 (P240K - P180K)
2025 6 55,000 330K [(P6 x 55K) x 3/3] 90,000 (P330K - P240K)
Total compensation expense P330,000
Accounting entries are intentionally omitted as they are very similar to the journal
entries in the previous illustrations, except for the amounts.
606
The
ACCOUNTING WHEN SHARE OPTIONS’ FAIR VALUE IS NOT DETERMINABLE

The previous illustrations assumed that the fair values of the share options are
reliably determinable. However, in real life, it is possible that the fair value of share
options is not reliably determinable. In this case, it is necessary to determine the
share options’ intrinsic value (i.e., use of intrinsic value method).
Intrinsic value is the difference between the fair value of the covered shares and
the exercise price of the share options, For the share options to have intrinsic value,
the fair value of the covered shares shall be higher than the exercise price of
the options.
Unlike in the previously discussed accounting procedures, the use of intrinsic value
method involves the updating of the “value component’ to reflect the changes
in the intrinsic value during the vesting period and during the exercise
period. In other words, when applying intrinsic value method, the amount of
intrinsic value used in the computations is not limited to its amount as of the
grant date and shall also consider the intrinsic values as of each reporting
date. In addition, it is also possible that intrinsic value can be zero.
In addition, as a way of exception to the general rule, compensation expense will
also be recognized during the exercise period. Depending on the period involved
in the calculation, the following computational procedures are relevant:
Period | Computation of Compensation Expense—

Vesting | Based on the pro-rated calculations in the previous illustrations, except
period | that the value component reflects the changes in the share options’
intrinsic value at the end of each year.
Exercise Compensation Compensation
Py eriod Total :
Compensation =
expense from
;
expense from
:
Expense unexercised share exercised share
options options
Compensation expense from unexercised share options is computed
as follows:
Compensation No. of Bea Boos
: Ending intrinsi
expense from be unexercised ‘ wali a hast
unexercised options at the i ee eae: 5
share options end of the year
Compensation expense from exercised share options during the year

Compensation Na coferorcinad Intrinsic value on
expense from 6 Bie aaeih i exercise date -
exercised P ce wear 6 beginning intrinsic
share options y value
607
The
Based on these formulas, there will be additional expense (or debit to

expense) under the following circumstances:
1. End. intrinsic value > beg. intrinsic value; or
2. Intrinsic value as of exercise date > beg. intrinsic value;
Based on these formulas, there will be a reduction in expense (or credit
to expense) under the following circumstances:
1. End. intrinsic value < beg. intrinsic value; or
2. Intrinsic value as of exercise date < beg. intrinsic value
Illustration 7. COLLADO Company granted 80,000 share options to its employees

on January 1, 2023. These share options cover 80,000 of the Company’s P100 par
value shares at an exercise price of P120/share. For the employees to become
entitled to the share options, they shall stay employed by the Company for the next
four years. After the four-year vesting period, the employees have additional three
years to exercise the share options.
As of the grant date, the share options’ fair value is not reliably determinable, thus,
necessitating the use of the intrinsic value method. Relevant data are the following:
No. of No. of
FV of exercised unexercised
Date shares Intrinsic value options options
12/31/23 P1i30 P10 (P130 - P120) 7 =
12/31/24 132 12 (P132 - P120) - =
12/31/25 131 11 (P131 - P120) - >
12/31/26 135 15 (P135 - P120) = =
12/31/27 133 13 (P133-P120) 30,000 50,000
12/31/28 134 14 (P134-P120) 35,000 15,000
12/31/29 136 16 (P136 - P120) 15,000 -
All of the share options vested on December 31, 2026. Compensation expense per
year during the vesting period are computed as follows:
Comp.
Share premium - share exp.
Intrinsic No.of optionsendingbalance during the
Year Value options (cum. comp. exp.) year
2023 P10 80,000 P200K /(P10x 80K)x1/4] _P200,000 (P200K - PO)
2024 12 80,000 480K /(P12 x 80K) x 2/4] 280,000 (P480K - P200K)
2025 11 80,000 660K /(P11 x 80K)x 3/4] 180,000 (P660K - P480K)
2026 15 80,000 1,200K (P15 x 80K) x 4/4] 540,000 (P1,200K - P660K)
Total compensation expense over the vesting period P 1,200,000
a ag of compensation expense during the exercise period are computed
as follows:
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Debit (Credit)
Year Components of Comp. Exp. to Comp. Exp.
Comp. exp. from unexercised options (P100,000) [50K x (P13 - P15)]
2027 Comp. exp. from exercised options (60,000) [30K x (P13 - P15)]
Total credit to comp. exp. for 2027 (P160,000)
Note: The credit to compensation expense has a corresponding
debit to share premium - share options account.
Comp. exp. from unexercised options P15,000 [15K x (P14 - P13)]

2028 Comp. exp. from exercised options 35,000 [35K x (P14 - P13)]
Total debit to comp. exp. for 2028 P50,000
Comp. exp. from unexercised options P-

2029 Comp. exp. from exercised options 30,000 15K x (P16 - P14)]
The readers should take note that in the absence of exact exercise date, the share
options are presumed to be exercised on December 31.
Accounting entries during the vesting period are intentionally omitted as they are
very similar to the journal entries,in the previous illustrations, except for the
amounts. On the other hand, the evolution of the balance of the share premium -
share options account after the vesting date is as follows:
Balance, 12/31/26 P1,200,000

Less: Credit to compensation expense, 2027 (160,000)
Exercise of share options, 12/31/27 (30,000 x P13) (390,000)
Balance, 12/31/27 (or 50,000 x P13) P650,000
Add: Debit to compensation expense, 2028 50,000
Less: Exercise of share options, 12/31/28 (35,000 x P14) (490,000)
Balance, 12/31/28 (or 15,000 x P14) P210,000
Add: Debit to compensation expense, 2029 30,000
Less: Exercise of share options, 12/31/29 (15,000 x P16) (240,000)
Balance, 12/31/29 P-
a. Ending balance of share premium - share options = no. of unexercised share
options x intrinsic value as of the reporting date.
b. Amount debited for share premium - share options due to the exercise of share
options = no. of exercised share options x intrinsic value on exercise date.
FAILURE TO MEET VESTING CONDITIONS

As previously illustrated, the employees shall meet the vesting conditions, if any,
before they become entitled to the share options. However, not all vesting
conditions are ultimately met resulting to the forfeiture of some of the share options
(i.e., employees are not entitled to the share options). The accounting for forfeiture
depends on what vesting condition/s is(are) not met:
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Market condition (i.e., reaching a

certain level of fair value of shares) All other vesting (i.e., nonmarket)
is not met condition is not met
Compensation expense shall still be Previously recognized amounts of
recognized even though a specified compensation expense and share
market price has not been reached. premium - share options shall be fully
. reversed,
However, the cumulative amounts of
share premium - share options shall be In other words, in cumulative basis,
transferred to other equity compensation expense and share premium
accounts. - share options shall have zero balances.
Different types of vesting conditions were discussed earlier in the chapter.
Illustration 8, At the beginning of 2023, COSTALES Company granted 18,000 share

options with fair value of P12/option to its president. The conditions for the
president to become entitled to these share options are the following:
a. Service period of four years; and
b. At least P50 market value of the Company’s shares as of December 31, 2026
From 2023 to 2025, the following amounts for compensation expense and share
premium - share options were computed during the vesting period:
Share premium-share Comp. exp.

Fair No.of optionsendingbalance duringthe
2023 P12 18,000 P5S4K /(P12 x 18K) x 1/4] P54,000 (P54K - PO)
2024 12 18,000 108K [(P12 x 18K) x 2/4] 54,000 (P108K- P54K)
2025 12 18,000 162K [(P12x 18K) x 3/4] 54,000 (P162K- P108K)
Cumulative compensation expense so far P162,000

journal entry to record the forfeiture of the share options in 2026:
1. The president did not resign but the market value of the Company’s shares as of
December 31, 2026 is only P45/share.
2. The president resigned on July 1, 2026 (i.e., breaching the service condition).
Scenario 1 - Market condition is not met
The value of service rendered by the president during 2026 shall still be recognized,
even though the market condition has not been met:
Compensation expense
[(P12x 18K) - P162K] 54,000
However, the updated balance of share premium - share options of P216,000

(P162,000 + P54,000) shall be transferred to other equity account as follows:
610
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Scenario 2 - Service condition (i.e., nonmarket condition) is not met

Since a nonmarket condition (i.e., four-year service period) has not been met, allof
the previously recognized compensation expense shall be reversed, whether or not the
market condition has been met:

It should be noted that the amount reversed is equal to the cumulative amount of
compensation expense as of the beginning of the current period (P162,000 for this
illustration) to arrive at a net zero amount of compensation expense over the duration
of the vesting period. This can be shown as follows:
Share premium-share Comp. exp
Fair No.of optionsendingbalance during the
2023 P12 18,000 P54K [(P12 x 18K) x 1/4] P54,000 (P54K- PQ)
2024 12 18,000 108K [(P12x 18K) x 2/4] 54,000 (P108K- P54K)
2025 12 18,000 162K [(P12x 18K) x 3/4] 54,000 (P162K- P108K)
2026 12 0 Zero(0) __ (162, wd (PO- P162K)
Cumulative compensation expense
MODIFICATIONS
An entity may modify the terms and conditions upon which the grant of the equity
instruments is based. Examples of modifications include, but are not limited to, the
following:
a. Changes in the exercise price.
b. Changes in the specific performance targets.
c. Changes in the vesting period.
Accounting for modification depends on the effects of the modification:
‘Any modification which increases the" Any modification which decreases the
fair value of equity instruments or fair value of equity instruments or
otherwise beneficial to employees otherwise not beneficial to employees
The increase (i.e., incremental fair value) The decrease in the fair value and other
shall be recognized over the period from modifications that are not beneficial to
the date of modification up to the date employees shall be ignored.
the modified equity instruments vest.
In other words, it is as if there is no
If the modified equity instruments vest modification.
immediately, the increase shall be
Examples include increasing the exercise
recognized immediately,
price, tightening of specific performance
targets, decreasing the number_of
611
The
The recognition of services based on the | options, and lengthening of the vesting
original terms of the equity instruments | period.
is continuous and shall not be affected
unless there are forfeitures.
Examples include decreasing exercise
price, relaxing of specific performance
targets, increasing the number of options,
and shortening of vesting period.
The increase or decrease in the fair value of equity instruments is determined by

comparing the equity instruments’ fair value right before and right after the
modification. In other words, the original fair value as of grant date shall not be
used in the comparison.
Illustration 9 - Beneficial Modification. At the beginning of 2023, FABIAN

Company granted a total of 30,000 share options to its management team members
for the purchase of 30,000 ordinary shares of the Company. As of that date, the fair
value of the shares amounted to P75/share and the exercise price is set at
P60/share. This resulted to a P10/option fair value for the share options.
To become entitled to the share options, the employees shall render four-year
service to the Company. It is expected that none of the grantees will resign over the
vesting period.
During 2025, the shares’ fair value unexpectedly dropped to P58/share making the
share options unappealing (i.e., exercise price is higher than the shares’ fair value).
As a result, on December 31, 2025, the Company decreased the exercise price to
P50/share. This modification increased the fair value of share options from
P2/option to P7 /option. These modified share options will vest over the next three
years.
Even though there is a modification, the amounts of compensation expense based
on the original grant date fair value shall not be affected at all (assuming that
no options will be forfeited and no changes in the estimate of options that will vest):

Year Value _ options (cum. comp. exp.) year
2023 P10 30,000 P75K (P10x 30K) x 1/4] P75,000 (P75K - PQ)
2024 10 30,000 150K /(P10x30K)x2/4] © 75,000 (P150K - P75K)
2025 10 30,000 225K {(P10 x 30K) x 3/4] 75,000 (P225K - P150K)
2026 10 30,000 300K {(P10x 30K) x 3/4] 75,000 (P300K - P225K)
Total compensation expense - originalterms — P300,000
612
The
The modification resulted to an increase in the share option’s fair value amounting
to P5/option (P7 - P2). Again, the original grant date fair value of P10/option shall
not be considered in the comparison. Subsequent recognition of compensation
expense (for the next three years) from the modified share options is determined
as follows:
Share premium -share Comp. exp
Increase No.of optionsendingbalance during the
Year inFV _ options (cum. comp. exp.) year
2026 PS 30,000 PSOK {(P5x30K)x 1/3] P50,000 (P50K - PO)
2027 5 30,000 100K {(P5x 30K) x 2/3] 50,000 (P100K-P50K)
2028 5 30,000 150K {(P5x 30K) x 3/3] 50,000 (P150K - P100K)
Total compensation expense - modified terms P150,000
Combining these computations, the Company shall recognize the following

amounts of compensation expense:
Year Comp.Exp.- Orig. Comp. Exp.- Modif. Total Comp. Exp.
2023 P75,000 P- P75,000
2024 75,000 = 75,000
2025 75,000 = 75,000
2026 75,000 50,000 125,000
2027 - 50,000 50,000
2028 - 50,000 50,000
It should be noted that the accounting for the modified equity instruments is
independent from the accounting for the original terms, and vice versa.
Illustration 10 - Non-Beneficial Modification. On January 1, 2023, ESTRELLA

Company granted 40,000 share options to its employees in exchange for a three-
year service period and a performance target that the average return on investment
(ROI) shall be at least 15% during the vesting period. Share options had fair value
of P15/option on the grant date.
For the year 2023, actual ROI reached 22% level, and as a result, the Company
modified the specific performance condition wherein the target ROI shall be at least
20% (i.e.,a higher ROI requirement), At the same time, because of the modification,
the share options’ fair value decreased from P11/option to P6/option. For 2024 and
2025, actual ROI level were 16% and 17%. Employees initially granted with 4,000
share options resigned during 2025,
In this scenario, despite the modification, the changes shall be ignored since the
modification is not beneficial to the employees (ie. tightening of specific
performance condition) and that there is a decrease in the fair value of the share
options. As a result, the following amounts of compensation expense shall still be
recognized over the vesting period (i.e, it is as if there is no modification):
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Share premium -share Comp. exp

Year Value _ options (cum. comp. exp.) year
2023 P15 40,000 P200K /(P15x40K)x1/3] | P200,000 (P200K - PO)
2024 15 40,000 400K [(P15x 40K) x 2/3] 200,000 (P400K - P200K)
2025 15 36,000 540K /(P15x 36K) x 3/3] 140,000 (P540K - P400K)
Total compensation expense - originalterms P540,000
Again, the decrease in the fair value of the share options shall be ignored.
CANCELLATION AND SETTLEMENT OF SHARE-BASED PAYMENT
If the cancellation (other than those arising from the forfeiture of share options due
to the failure to meet the vesting conditions) or settlement happened during the
vesting period, they are accounted for as an acceleration of vesting. As a result,
the entity shall recognize immediately the amounts that otherwise would have
been recognized for the services received for the remainder of the vesting period.
Any payment made to employees shall be considered as a direct deduction from
equity (i.e., no effect in profit or loss).
However, if the amount of payment > fair value of equity instruments measured
at the repurchase date, the difference shall be recognized as additional expense in
profit or loss. In other words, the carrying amount of the share premium -.share
options as of the repurchase date is not relevant in determining the amount of
additional expense to be recognized.
Illustration 11. At the beginning of 2023, BARCELONA Company granted 50,000
share options with fair value of P14/option to its chief executive officer (CEO). To
be entitled to the share options, the CEO shall stay with the Company for the next
five years.
However, due to the CEO’s old age, the Company decided to just cancel and settle
the share options during 2025. The amount of compensation expense to be
recognized during 2025 due to the acceleration of the vesting is computed as
follows:
Year Value options (cum, comp. exp.) year
2023 P14 50,000 P140K [(P14x50K)x1/5] 140,000 (P140K - Po)
2024 14 50,000 280K [(P14x 50K) x 2/5] 140,000 (P280K - P140k)
Total compensation expense recognizedsofar P280,000
Less: Total comp. exp. to be recognized over vesting period 700,000 (P14x50K)x 5/5
Total compensation expense to be recognized during 2025 P420,000
Based on the computations, the acceleration of vesting in 2025 is properly recorded

as follows: .
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After this entry, the share premium - share options will havea balance of P700,000.
journal entry to record the settlement of the share options:
1. The amount paid is P650,000, equal to the share options’ FV on that date.
2. The amount paid is P720,000, equal to the share options’ FV on that date.
3. The amount paid is P800,000, but share options’ FV on that date is only
P740,000.
Scenario 1
The entry to record the settlement is as follows:
Cash 650,000
Share premium - others (squeeze) 50,000
Since the amount of payment is equal to the share options’ fair value on that date,
the supposed “gain” of P50,000 is recognized directly in equity.
Scenario 2
Cash 720,000
Since the amount of payment is equal to the share options’ fair value on that date,
the supposed “loss” of P20,000 is recognized directly in equity. This is regardless of
the carrying amount of the share premium - share options. As long as the
settlement amount is equal to the share options’ fair value measured on the
repurchase date, no amount shall be recognized in profit or loss.
Scenario 3
Cash 800,000
The amounts of recognized compensation expense and charged to retained

earnings are computed as follows:
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Settlement Price
P800,000 said
Compensation expense of P60,000
(P800,000 - P740,000)
FV of share options
P740,000
Charge to retained earnings of P40,000
(P740,000 - P700,000)
Carrying amount of eatete
share premium
P700,000
Since the settlement price is higher than the fair value of share options, an
additional amount of compensation expense shall be recognized in profit or loss.
CHAPTER SUMMARY
1. Share-based payments are classified as equity-settled and those that are liability-
settled.
Z Equity-settled share-based payments involve the transfer of equity securities (e.g.,
shares of stock, share options) to counterparties (e.g., suppliers, employees).
3: Employee services are measured by reference to the fair value of equity securities
recognized as of the grant date.
Employee compensation expense is determined using the following formula:
If there are no vesting conditions/periods (i.e., the employees will be immediately
entitled to the securities), the grant date fair value of the securities shall be wholly
recognized during the period these securities were granted.
If there are vesting conditions, the grant date fair value of the securities shall be
recognized over the duration of the vesting period.
Vesting conditions can be classified as service condition (being employed over a
certain period of time) or performance condition (can be market or nonmarket
condition).
Changes in the estimate of inputs to the computation shall be accounted for
prospectively (i.e., recorded prior period amounts shall not be restated).
In case the fair value of share options cannot be reliably measured, the intrinsic
value method shall be applied. Intrinsic value = fair value of the covered shares -
option exercise price.
10. Modification of share-based payment shall be recognized only when it increases the
fair value of the share options or otherwise advantageous to employees. The amount
of expenses based on the original terms shall still continue to be recognized in
addition to the accounting for the modified terms.
11.Settlement of share-based payment shall be recognized as an acceleration of vesting.
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True or False
1s Services provided by non-employees are initially measured at the fair value of such
services, if reliably determinable.
Z. Services provided by employees are initially measured by reference to the fair value
of the equity instruments.
3. The journal entry to record the recognition of compensation expense from share-
based payments will have a net decreasing effect to the shareholders’ equity.
Ifa share-based compensation to employees has no vesting conditions, the amount
of expense shall be fully recognized during the period of grant.
If a share-based compensation to employees has vesting conditions and the fair
value of equity securities is reliably determinable, the amount of expense shall be
recognized over both the vesting and exercise periods.
Market vesting conditions include the attainment of specified amount of net
income.
Performance conditions include both a service condition component and specific
target/s component.
The exercise of share options will increase the shareholders’ equity equal to the
amounts received plus the fair value of the share options on that date.
3. Changes in the estimate of compensation expense shall be recorded using catch up
adjustments.
10. There is an intrinsic value if the option exercise price is higher than the fair value
of the covered shares.

1. Share-based payments are classified as either
a. Equity-settled or liability-settled
b. Equity-settled or cash-settled
c. Cash settled or noncash-settled
d. Asset settled or liability-settled
2. Compensation in the form of employee share options are recognized as

a. Increase in expenses and decrease in share premium
b. Decrease in expenses and decrease in share premium
c. Increase in expenses and increase in share premium
d. Decrease in expenses and increase in share premium
3. Services from non-employees shall be measured
a. Byreference to the fair value of equity instruments granted
b. At the fair value of services, if determinable, otherwise by reference to the fair
value of the equity instruments granted
c. By reference to the fair value of equity instruments granted, if determinable,
otherwise, at the fair value of services
d. At the fair value of services, if determinable, otherwise by reference to the par
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4. Services from employees shall be measured

a. Byreference to the fair value of equity instruments granted
b. At the fair value of services, if determinable, otherwise by reference to the fair
c. By reference to the fair value of equity instruments granted, if determinable,
otherwise, at the fair value of services
d. At the fair value of services, if determinable, otherwise by reference to the par
5. Additional compensation in the form of share options shall be measured as of
a. Vesting date
b. Grant date
c. Eachreporting date
d. Exercise date
6. Which of the following correctly describes the recognition of compensation expense

from employee share options?
a. If there are no vesting conditions, the fair value of the employee share options
shall be recognized fully during the period of granting.
b. If there are vesting conditions, the grant date fair value of the employee share
options, adjusted for options expected not to vest, shall be recognized as
expense during the vesting period.
c. Generally, no compensation expense shall be recognized during the exercise
period.
d. All ofthe above.
7. Vesting conditions
a. shall be met for the employees to become entitled to the share options.
b. are classified as either service conditions or performance conditions.
c. Classified as service conditions require the employees to render service to the
entity for a certain period of time.
d. allofthe above
8. Nonmarket performance conditions include the following, except
a. reaching a specified amount of sales
b. attaining a specified amount of net income
c. attaining a specified amount of share’s fair value
d. reaching a specified rate of return on investment
9. Generally, changes in the value of employee share option
a. shall be included in the computation and accounted prospectively.
b. shall be included in the computation and accounted retrospectively by restating
the previously reported amounts based on the prior value of the option.
c. shall not be included in current period’s computation but shall be deferred and
recognized on the vesting date.
d. shall not be included in the computations.
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10. The following statements regarding intrinsic value method are correct, except
a. There is an intrinsic value if the fair value of the share covered by the share
option is lower than the exercise price of the share option.
b. This method is applied whenever the fair value of the employee share option
cannot be measured reliably.
c. This method considers the changes in the share option’s intrinsic value at the
end of each year.
d. Compensation expense may be recognized during the exercise period.
11. Which of the following modifications does not have accounting consequences?
a. Shortening of the vesting period
b. Decreasing the exercise price
c. Decreasing the number of share options
d. Decreasing the revenue target
12. If there is a settlement of employee share options, the following accounting

procedures are correct, except
a. The entity shall recognize immediately the amounts that otherwise would have
been recognized for services received for the remainder of the vesting period.
b. In general, the settlement amount paid to employees shall be directly deducted
from the carrying amount of the share premium - share options account.
c. Ifthe settlement amountis higher than the fair value of the share options on the
settlement date, the difference shall be recognized as additional expense.
Straight Problems
1. On January 1, 2023, PAULIE Company granted a total of 40,000 share options to its
employees giving them the right to purchase 40,000 of the Company’s P20 par value
ordinary shares for P30 per share. As of the same date, these share options have fair
value of P7.20, while the covered shares have fair value of P40 per share. These share
options are exercisable for two years after the vesting date. The Company expects
that none of the employees will leave before the vesting date.
Required: Under each of the following independent scenarios, determine the annual
amount of compensation expense to be recognized each year:
1. The share options vest immediately.
2. The share options vest on December 31, 2024.
2. At the beginning of the year 2023, GRACIE Company granted 800 share options to
each of its 240 employees. As of the same date, the share options had fair value of
P9.60 per share. Each option can give the holder the right to buy one of the
Company’s P40 par value ordinary shares at P55/share. The Company expects that
only 220 of these employees will remain employ in the Company on December 31,
2025 vesting date.
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From 2023 to 2025, the following fair value data are relevant:
Fair values 12/31/23 12/31/24 12/31/25
Share options P10.50 P9.00 P11.20
Ordinary shares 56.00 53.00 57.00
On December 31, 2025, there were only 210 employees remained in the Company’s
employ. In addition, 150 employees have exercised their share options on December
31, 2026, while the remaining employees exercised their share options on December
31, 2027.
Required. From the given information, determine the following:
a. Compensation expense from 2023 to 2027.
b. Carrying amount of the share premium - share options every December 31 of
2023 to 2027.
3. On January 1, 2023, LARRY Company granted 600 share options to each of its 800
employees. On the same date, the share options had fair value of P8 per share. Each
share option gives the right to employee to purchase one of the Company’s P20 par
value ordinary shares for P30 per share. In addition, to become fully entitled to the
share options, the employees shall remain in the Company's employ for the next four
years.
During 2023, 20 employees have left, while 45 more are expected to leave before the
vesting date. During 2024, 15 employees have left, while 32 more are expected to
leave before the vesting date.
During 2025, 12 employees have left, while 25 more are expected to leave in 2026.
During 2026, 22 employees have actually left. On December 31, 2027, 500
employees have exercised their share options, while the remaining employees have
exercised their share options on December 31, 2028.
Required. From the given information, determine the following:
2023 to 2027.
4. At the beginning of the year 2023, FLASH Company granted a total of 300,000 share
options to its marketing department employees in the condition that the department
shall bring in total sales of P100 million for the next four years. However, they will
be immediately entitled to these share options if the department was able to reach
the target sooner than after four years,
On the grant date, the share options had fair value of P6.60 per share. The Company
expects that only 90% of the share options will vest due to the employee turnover
during the vesting period.
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During the year 2023 and 2024, the Company expected that it will be able to reach
the sales target only at the end of the four-year vesting period. However, during
2025, the department was able to strike a deal with a new major customer, thus
reaching the sales target during the year. Only 93% of the share options have vested
as of the vesting date.
2023 to 2025. ;
5. On January 1, 2023, PILLOW Company instituted a performance-based

compensation to its senior management team composed of 15 executives. The
compensation is in the form of share options, which vary in number per executive
depending on the level of average return on investment (ROI) for the next four years:
Average ROI Number of options per executive
more than 14.00% 1,000
12.00% to 13.99% 800
10.00% to 11.99% 600
less than 10.00% 200
On the same date, the share options had fair value of P12 per option. The Company
expects that only 12 of the executives will remain employed with the Company for
the next four years.
During 2023, the Company generated an ROI of 11.50% and expects that it can
generate roughly the same levels during the rest of the vesting period.
During 2024, the Company generated an ROI of 14.00% but expects that for the rest
of the vesting period, it can generate 16.00% ROI per year.
During 2025, the Company generated an ROI of just 13.00% but expects that it can
only generate an ROI of 12.00% in 2026.
During 2026, the Company generated an ROI of 15%. Only 11 executives remained
employed as of the end of 2026.
2023 to 2026.
6. At the beginning of the year 2023, ANGIE Company granted 240 share options to
each of its 400 employees. Each share option entitles the holder to purchase one of
the Company’s P10 par value shares for P25 per share. To become fully entitled to
the share options, the employees shall stay with the Company for the next three
years.
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As of the grant date, the Company was not able to reliably measure the fair value of
its share options. However, the Company’s shares had the following fair values:
Date Fair Values
January 1, 2023 P34
December 31, 2023 35
The Company expects that only 350 employees will stay with the Company until the
vesting date. Fast forward to the vesting date, there only 340 employees remaining
with the Company. On December 31, 2026, 200 employees have exercised their
share options.

2023 to 2026.
7. On January 1, 2023, COOKIE Company granted 360 share options to its 500
employees. Each of these options will allow the holder to acquire one of the
Company’s P50 par value shares for P70 per share. As a condition for the full
entitlement, the employees shall be employed with the Company for the next three
years.
However, the Company was not able to reliably measure the fair value of the share
options. On the other hand, the covered shares had the following fair values:
Date Fair Values
January 1, 2023 P86
During 2023, 16 employees left the Company, while a further 35 employees are
expected to leave during the rest of the vesting period.
During 2024, 20 employees left the Company, while a further 18 employees are
expected to leave in 2025.
During 2025, 12 employees left the Company. On December 31, 2026 and 2027, 200
employees and 150 employees, respectively, have exercised their share options.
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2023 to 2027.
g. At the beginning of the year 2023, TOBY Company granted a total of 45,000 share
options to its employees. Each of these options will allow the holder to acquire one
of the Company’s P20 par value shares for P35 per share. To become fully entitled
to these options, the employees shall render a four-year service period. On the grant
date, the options had fair value of P10 per option, while the shares had fair value of
P36 per share. The Company expects that only 94% of the share options will vest
after the service period.
Fast forward to December 31, 2024, the share’s fair value has dropped to P25 per
share, drastically reducing the option’s fair value to P4 per option. Consequently, the
Company decided to decrease the exercise price to P24 per share, increasing the fair
value of the option to P7 per option. These options will vest on December 31, 2027.
The Company still expects that only 94% of the share options will vest after the
additional service period.
Required: From the given information, determine the amount of compensation

expense from 2023 to 2027.
9. On January 1, 2023, ASTRO Company granted a total of 120,000 share options to its
employees. Each of these options has a fair value of P9 per option. To become fully
entitled to these options, the employees shall render a three-year service period and
reach an average net income of P40 million per year during the same period. The
Company expects that only 95% of these options will vest.
On December 31, 2024, the Company decided to increase the required average net
income to P60 million per year. This resulted to the decrease in the fair value of the
share option to P3 per option. Due to this requirement, the Company changed its
estimate that only 90% of the share options will vest on the vesting date.
Required: Determine the amounts of the compensation expense to be recognized
from 2023 to 2025.
10.At the beginning of 2023, ANNIE Company granted a total of 300,000 share options
for the purchase of the Company's P30 par value ordinary shares for P50/share.
These shares will be coming from the unapproved application of the Company to
increase its authorized share capital. The Company is very positive that the approval
of the relevant regulatory body will be obtained for the increase in capitalization. As
of the grant date, the ordinary shares and the share options had fair values of
P70/share and P12/option, respectively, To be entitled to the share options, the
grantees should still be employed in the Company by December 31, 2026.
For the years 2023 and 2024, there were no resignations and there will be no
resignations expected to happen during the remainder of the vesting period.
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However, during January 2025, the regulatory body rejected the application to
increase the Company's authorized share capital. As a result, the Company decided
to terminate the share option program and will just make settlement payments to
affected employees. There were no changes in the fair value of share options from
2023 to 2025.
entry to record the cancellation of share options and settlement payments to
employees:
1. The settlement payment amounted to P3,600,000, equal to options’ fair value.
11. Using the same information as in ANNIE Company, except that the share options had
P14/option fair value on settlement date.
Required: From the revised information, determine the journal entry to record the
cancellation of share options and settlement payments to employees:
1. The settlement payment amounted to P3,800,000.
2. The settlement payment amounted to P4,500,000.

1. On January 1, 2023, FLIPPER Company granted 60,000 share options to its
employees. These immediately vesting options have fair value of P7/option and
can be exercised for the next three years.
From the given information, determine the amount of compensation expense for
the year 2023
a. P140,000 c. P360,000
b. P280,000 d. P420,000
2. At the beginning of the year 2023, BINGO Company granted 50,000 shares to its
employees. Each share had a fair value of P24 on the grant date. To become fully
entitled to the shares, the employees are required to render four-year service to
the Company. The Company expects that only 95% of these shares will ultimately
vest. These shares had the following fair values over the vesting period:
Date Fair Values
December 31, 2023 P20
Fast forward to December 31, 2026, 48,000 shares have vested.

Compensation expense for the year 2023 shall be
a. P300,000 c, P250,000
b. P285,000 d, P237,500
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a. P285,000 c. P237,500
b. P300,000 d. P250,000
3, On January 1, 2023, COSMO Company, in recognizing the loyalty of its 600
employees, started an employee share option program wherein each employee is
entitled to 300 share options to buy 300 ordinary shares of the Company with par
value of P30. To be entitled to these share options, the employees shall stay in the
Company for the next three years. The exercise price of the option is P50/share.
The fair values of ordinary share and share options as of January 1, 2023 were
P65/share and P12/option, respectively.
During 2023, 21 employees left the Company and there are additional 36
employees that are expected to leave during the remainder of the vesting period.
During 2024, 18 employees left the Company and that there are additional 12
employees expected to leave during the remainder of the vesting period. For the
year 2025, 15 employees left the Company.
After vesting on December 31, 2025, the share options are exercisable up until
December 31, 2027 only. For the years 2026 and 2027, respectively, there were
220 employees and 180 employees who exercised their share options.

a. P603,400 c. P651,600
b. P636,900 d. P694,800
The balance of share premium - share options as of December 31, 2024 shall be
a. P1,276,400 c. P1,446,400
b. P1,317,600 d. P1,548,600
a. P417,000 c. P689,200
b. P519,200 d. P648,000
The amount of share premium - issuance arising from 2026 exercise shall be
a P1,123,000 c. P2,112,000
b. P1,320,000 d. P2,432,000
The amount of share premium - issuance arising from 2027 exercise shall be
a. P1,080,000 c. P1,958,000
b. P1,728,000 d. P2,108,000
4. DISCO Company wants to reward the business decisions of the 30 members of the
senior management that will bring in more profits by granting them share options,
subject to qualifying conditions on January 1, 2023, The first condition for
entitlement is that the member should not resign from the Company for the next
three years. The second condition is that the Company should generate at least
12% average return on investment (ROI) during the next three years. In case the
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average ROI is above 12%, the following table shows the number of share options
to be given to each senior management member:
Average ROI Options per Executive

12% to 12.99% 500
13% to 14.99% 750
15% and above 900
The Company expects that during the entire vesting period, there will be 5
members of the senior management that will resign and will forfeit their share
options. The fair value of share options on the grant date amounted to P18 per
option.
For the year 2023, the Company reported ROI of 14% and expects to reach the
same level for the rest of the vesting period. One member of the senior
management left the Company. The estimate for the total number of 5 resignations
during the entire three-year period is still relevant.
For the year 2024, the Company reported ROI of 9% but expects to reach 15% ROI
in 2025. One member of the senior management left the Company during the year.
The estimate for the total number of 5 resignations during the entire three-year
period still holds true.
For the year 2025, the Company reported ROI of 21%. Two members of the senior
management left the Company during the year.

a. P95,500 c. P127,000
b. P112,500 d. P135,000
a. P16,000 c. P54,500
b. P23,000 d. P37,500
a. P144,000 c. P201,000
b. P176,000 d. P246,000
5. At the beginning of 2023, ARENAS Company granted 600 share options to each of
its 240 employees, provided they are still employed with the Company by
December 31, 2025, the vesting date of the share options, The options are for the
purchase of the Company's P15 par value ordinary shares at P20/share. As of
January 1, 2023, share option’s fair value is not reliably determinable but the
ordinary shares have fair value of P25/share, As such these share options will be
accounted in reference to its intrinsic value,
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For the year 2023, 10 employees left the Company and further 24 employees are
expected to leave during the remainder of the vesting period. Fair value of the
ordinary shares as of December 31, 2023 amounted to P27/share.
For the year 2024, 14 employees left the Company and further 10 employees are
expected to leave during the remainder of the vesting period. Fair value of the
ordinary shares as of December 31, 2024 amounted to P30/share.
For the year 2025, 12 employees left the Company. Fair value of the ordinary
shares as of December 31, 2025 amounted to P28/share. The vested options are
exercisable for the next three years.
The vested shares were exercised in the following manner: 80,000 on December
31, 2026 and 40,000 on December 31, 2027. The shares had fair values of
P29/share and P32/share as of December 31, 2026 and 2027, respectively.
a. P272,400 c. P292,400
b. P288,400 d. P302,400
Share premium - share options balance as of December 31, 2024 shall be
a. P756,600 c. P804,000
b. P780,400 d. P824,000
a. P155,200 c. P198,800
b. P175,200 , d.P222,600
a. PO c. P122,400
b. P88,600 d. P235,600
Share premium - share options balance as of December 31, 2026 shall be
a. P177,500 c. P255,500
b. P189,400 d. P381,600
a. P118,000 c. P212,800
b. P127,200 . 4d,P342,000
6. On January 1, 2023, FABIAN Company granted 12,000 share options to each of the
Company’s ten directors for the purchase of the Company's P30 par value ordinary
shares for P50/share. As of that date, the ordinary shares had fair value of
P60/share and the share options have fair value of P8/option. To become entitled
to the share options, the directors should be employed in the Company for the next
four years (i.e., until December 31, 2026).
For the years 2023 and 2024, the Company expects that none of the directors will
resign before the end of the vesting period, However, for the year 2024, the
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ordinary shares’ fair value plummeted to P35/share and expected to stay around
that amount for the foreseeable future. As a result, on December 31, 2024, the
Company reduced the exercise price of the options from P50/share down to
P30/share. As of the same date, the share options had fair value of P3/share right
before modification but increased to P9/share right after the modification.
Because of the revision, the directors should stay in the Company for the next three
years to become entitled to the share options (i.e. December 31, 2027). There were
no resignations nor expected resignations during the modified vesting period.
a. P240,000 c. P360,000
b. P260,000 d. P420,000
a. P240,000 c. P480,000
b. P400,000 d. P520,000
Share premium - share options as of December 31, 2025 shall be
a. P720,000 c. P1,070,000
b. P960,000 d, P1,360,000
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Chapter 16A — Cash-Settled Share-Based Payments
CHAPTER 16A
CASH-SETTLED SHARE-BASED PAYMENTS

A The difference between equity-settled and cash-settled share-based payments.
2. The initial and subsequent accounting for cash-settled share-based payments.
3. The accounting for share-based payments with equity and liability alternatives.
4 The accounting for modification of share-based payment from equity-settled to
cash-settled or vice versa.
S: The accounting for the share-based payments among group entities.
CASH-SETTLED SHARE-BASED PAYMENT - A PRIMER

To understand the preliminary concepts on cash-settled share-based payments, its
features are first compared with equity-settled share-based payments:
Equity-Settled Cash-Settled
Items to be paid to Boh Cash and/or other assets
grantees on ene Sen ae (including equity instru-
settlement date IDSUMents ments of other entities)
At grant date fair value, Always updated for the
Measurement of except for the intrinsic value | changes in the fair value
goods or services method wherein changes in at the end of each year
received intrinsic values are reflected | during the vesting period
in the calculations and exercise period
If the instruments immediately vest, recognize the
Recognition of
services outright. If there are vesting conditions, then
received services
recognize the services over the vesting period
The instruments will be forfeited for failure to meet the
Consideration of vesting conditions. Details of the vesting:conditions
vesting conditions discussed in the previous chapter are also applicable in
this chapter
Effect in total ,
Increase (as compensation expense)
expenses
Corresponding Share premium - share Accrued compensation
account to be credited options (an equity account) (a liability account)
Effect in total
EGR No effect Increase
liabilities
Effect in total equity No effect Decrease
FE ae geen | Sener equa tot

C .
P aU, amount of cash paid

expense instruments
629
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The following general model in computing for the compensation expense in equity-
settled share-based payment is also applicable:
The difference is that the “value” component in the cash-settled share-based
payment reflects the changes in the fair value of the instruments during both
: ; kona
SHARE APPRECIATION RIGHTS (SARs)

In this arrangement, the grantees will receive in cash the amount of increase in
the share price (i.e., market value as of exercise date) from a predetermined
share price amount.
For example, an entity granted 10,000 SARs with P100/share predetermined share
price amount. If on the settlement date, the shares have a market value of
P115/share, the entity shall pay a total of P150,000 /(P115 - P100) x 10,000]. The
share price is normally used since this is reflective of the financial performance of
an entity which is greatly influenced by the actions and decisions of its employees.
In measuring the amount of compensation expense to be recognized, the following
specific guidelines are relevant:
Period |- Amount of compensation expense

Vesting | Pro- rated calculations over the vesting period, reflecting the changes trin
Period | the fair value of SARs at the end of each year. This is computed using the
Value x Number x Period approach.
In other words, during this period, the amount of “appreciation” or the
difference between the shares’ fair value and predetermined share price
shall not be used yet (ie., this will be used only in the computation of the
actual amounts to be paid to the employees on the exercise date).
Exercise | After the vesting period, the employees are normally given a reasonable
Period | time to exercise their rights. The amount of compensation expense is
Ending accrued liability XX
Add: Actual amounts paid to exercising employees XX
Less: Beginning accrued liability XX
Additional (reduction from) compensation exp. XX
The amount of ending accrued liability is computed as follows:
Ending No. of unexercised Fair value of SARs

accrued = SARsattheendof x atthe endofthe
liability the period period
Actual amounts paid to exercising employees are computed as follows:
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Chapter 16A - Cash-Settled Share-Based Payments
Actual No. of exercised Shares’ fair value on the

amounts = SARsduring = x date of exercise -
paid the period predetermined share price
Note: Shares’ fair value on exercise date - predetermined share price is the amount of
“appreciation”.
Illustration 1. MADRID Company granted 30,000 SARs to its employees on January

1, 2023. The predetermined share price is P50/share, which is equal to its fair value
on the grant date. To become entitled to the cash payment, employees shall remain
in the employ of the Company for the next three years. The employees were also
given additional three years (i.e., from January 1, 2026 to December 31, 2028) for
the exercise of the SARs. On December 31, 2025, all of the 30,000 SARs vested.
The following information is relevant in computing the amount of compensation
expense:
No. of No. of
FVof FVof Exercised Unexercised
Date SARs_ Shares SARs SARs
12/31/23 PS P54
12/31/24 7 58
12/31/25 6 57
12/31/26 8 59 10,000 20,000
12/31/27 6 56 8,000 12,000
12/31/28 - 60 12,000 -
The amounts of accrued compensation (i.e., a liability account) and compensation

expense for each year during vesting period are computed as follows:
Accrued comp. Comp. exp
FVof No.of ending balance during the
Year SARs SARs (cum. comp. exp.) year
2023 P5 30,000 P50K [(P5 x 30K) x 1/3] P50,000 (P50K - PO)
2024 7 30,000 140K [(P7x 30K) x 2/3] 90,000 (P140K - P50K)
2025 6 30,000 180K [(P6 x 30K) x 3/3] 40,000 (P180K - P140K)
Total compensation expense to date P180,000
The amounts of accrued compensation and compensation expense for each year
during exercise period are computed as follows:
Debit (Credit)
Year Components of Comp. Exp, to Comp. Exp.
Ending accrued liability, 12/31/26 P160,000 (20KxP&)
Add: Actual amounts paid to employees 90,000 [10K x (P59 - PS0))
2026 180,000) 12/31/25 balance
Less: Beginning accrued liability
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Ending accrued liability, 12/31/27 P72,000 (12K x P6)

2027 Add: Actual amounts paid to employees 48,000 [8Kx (P56 - P50)]
Less: Beginning accrued liability (160,000) 12/31/26 balance
Total credit to comp. exp. for 2027 (P40,000)
Ending accrued liability, 12/31/28 P-
2028 Add: Actual amounts paid to employees 120,000 [12K x (P60-P50)]
Less: Beginning accrued liability (72,000) 12/31/27 balance
On December 31, 2023, the entry to record the compensation expense for the year:
Accrued compensation 50,000
On December 31, 2026, the entry to record the compensation expense for the year
and the payment to exercising employees:
Cash . 90,000
Cash 48,000
Cash 120,000
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The events during the exercise period affect the accrued compensation account in
the following manner:
Accrued
compensation
Payments to employees, 2026 | P90,000 | P180,000 | 1/1/26 Balance
70,000 | Compensation expense, 2026
Compensation expense, 2027 | P40,000 | P160,000 | 12/31/26 or 1/1/27 Balance
Payments to employees, 2027 48,000
Payments to employees, 2028 | P120,000 | P72,000 | 12/31/27 or 1/1/28 Balance
48,000 | Compensation expense, 2028
p-
CHANGES IN THE ESTIMATES DURING THE VESTING PERIOD

Similar to the equity-settled share-based payment, changes in the estimates of the
number of SARs that will vest and changes in the length of estimated vesting period
shall be accounted for prospectively (i.e., change in accounting estimate).
Previously reported amounts during prior periods are not revised, but the amount
of change shall be reflected in the amount of compensation expense that will be
recognized during the period of change (i.e., catch-up or through-up adjustments).
Illustration 2 - Changes in the Estimate of SARs. MAURICIO Company granted

100,000 SARs to its employees on January 1, 2023. Predetermined share price was
set at P30/share. To be entitled to the cash payment, the employees shall still be
employed in the Company for the next four years. After the vesting period, the
employees will have additional two years to exercise their rights over SARs.
Relevant data to compute the compensation expense per year are the following:
No. of No. of
FVof FVof Exercised Unexercised
Date SARs _ Shares SARs SARs
12/31/23 P12 P45
12/31/24 10 41
12/31/25 14 46
12/31/26 15 48
12/31/27 20 52 60,000 32,000
12/31/28 - 51 32,000 -
As of December 31, 2023 and 2024, the Company expects that only 80,000 SARs
will vest. This estimate was changed on December 31, 2025 when 90,000 SARs are
expected to vest, On December 31, 2026, 92,000 SARs ultimately vested.
during vesting period are computed as follows:
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Accrued comp. ending Comp. exp

FV of No. of balance during the
Year SARs SARs (cum. comp. exp.) year
2023 P12 980,000 P240K/(P12 x 80K)x 1/4] P240,000 (P240K - PO)
2024 10 £80,000 400K/(P10.x 80K) x 2/4] 160,000 (P400K - P240K)
2025 14 90,000 945K /(P14x 90K) x 3/4] 545,000 (P945K - P400K)
2026 15 92,000 1,380K /(P15 x 92K) x 4/4] 435,000 (P1,380K - P945K)
during the exercise period are computed as follows:
Debit (Credit)
Year Components of Comp. Exp. to Comp. Exp.
Ending accrued liability, 12/31/27 P640,000 (32Kx P20)
Add: Actual amounts paid to employees 1,320,000 [60K x (P52 - P30)]
2027 Less: Beginning accrued liability (1,380,000) 12/31/26 balance
Total debit comp. exp. for 2027 P580,000
Ending accrued liability, 12/31/28 p-
Add: Actual amounts paid to employees 672,000 [32K

x (P51 - P30)]
ap28 Less: Beginning accrued liability (640,000) 12/31/27 balance
SHARE-BASED ARRANGEMENTS WITH SHARE AND CASH ALTERNATIVES

Some share-based arrangements may contain provision where a choice can be
made on whether the entity will settle the arrangement by transferring cash,
including noncash assets (i-e., cash-settled) or by issuing equity securities (equity-
settled). Specific accounting procedures will depend on whose party can make the
choice of settlement:
Counterparty has the choice Issuing entity has the choice

The whole arrangement is considered as The whole arrangement is considered as
a compound financial instrument (i.e., cash-settled if the entity has the present
composed of liability and equity obligation (i.e., cannot avoid) to settle in
components). cash or noncash assets.
As a result, split accounting as discussed Otherwise, the whole arrangement is
in Chapter 7 is relevant. considered as equity-settled.
Consequently, the terms and conditions
of the arrangement shall be carefully
considered.
ACCOUNTING IF THE COUNTERPARTY HAS THE CHOICE OF SETTLEMENT

Split accounting procedures will depend on what the entity received (or will
receive) in exchange for the share-based payment:
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Received or Will
Be Received Split accounting procedures
Goods and Since there is a rebuttable presumption that the fair values of
services in general | the goods or services received are reliably determinable, the
(excluding following split accounting is relevant:
a FV of goods or services XX
Less: FV of liability component XX
Amount attributed to equity component XX
Services from Since the fair value of employee services cannot be reliably
employees estimated, the following split accounting is relevant:
FV of share alternative XX
Less: FV of liability component XX
Amount attributed to equity component XX
The fair value of share alternative is computed as the fair value

of the shares that will be issued in case the counterparty
chose the share alternative.
After determining the amounts of the liability and equity components, each
component shall be accounted for separately. The subsequent accounting
procedures during the vesting and exercise periods are the following: ©
Liability Component Equity Component
Accounted for using the concepts in Accounted for using the concepts in
cash-settled share-based payments. equity-settled share-based payments.
In other words, changes in the In other words, changes in the

component's fair value during vesting component's fair value are ignored. All
and exercise periods are incorporated subsequent calculations are based on the
in the calculations. grant date fair value.
On the date of settlement, accounting procedures will depend on what alternative

the counterparty has chosen:
If Cash Alternative Was Chosen If Share Alternative Was Chosen
The amount of payment shall be The total of the carrying amounts of
attributed solely to _ liability the liability and equity components
component. shall be considered as the issue price for
the shares,
The carrying amount of the equity
component shall remain within total Any difference shall be recognized
equity but may be transferred to other directly in equity as “share premium -
equity accounts, issuance” (i.e., no gain or loss shall be
recognized in profit or loss).
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Illustration 3 - Goods Received from Counterparty. On January 1, 2023, NAVAL

Company acquired from another entity a land with fair value of P4,000,000. Since
the Company is currently short on cash, the following terms were agreed with the
peli as evidenced by a promissory note:
. The counterparty will receive cash equal to the fair value of 100, 000 of the
Company’s P20 par value shares on the date of settlement, which was set on
December 31, 2024.
b. However, the counterparty has the option to instead receive the actual shares
on December 31, 2024 and become a shareholder of the Company.
The Company's P20 par value shares have the following fair values:
Date Fair value per share
January 1, 2023 P38
On January 1, 2023, the allocation to liability and equity components is as follows:
Fair value of land P4,000,000
Less: Amount allocated to liability component (100K x P38) (3,800,000)
Amount allocated to equity component P200,000
Journal entry to record the receipt of the land on January 1, 2023 is as follows:
Land 4,000,000
Note payable, net 3,800,000
Share premium - share alternative 200,000
As of December 31, 2023, the entry to recognize the change in the fair value of the
liability is as follows:
Interest expense [100K - (P41 - P38)] 300,000
Note payable, net 300,000
As of December 31, 2024, the entry to recognize the change in the fair value of the
liability is as follows:
Interest expense [100K - (P43 - P41)] 200,000
Note payable, net 200,000
After this entry the carrying amount of the note payable (i.e., liability component)
is now P4,300,000. It should be noted that, unlike the liability component, the
amount initially attributed to the equity component is not changed until the
settlement date.
If, on the settlement date, the counterparty chose the cash alternative, it is
entitled to receive P4,300,000 (100,000 x P43). The following journal entries are
relevant in the books of NAVAL Company:
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Cash (100K x P43) 4,300,000
If, on the settlement date, the counterparty chose the share alternative, the
following journal entry is relevant in the books of NAVAL Company:
Share capital (100K x P20) 2,000,000
Illustration 4 - Services from Employees. As part of CORNELIO Company’s

additional compensation program for its employees, the Company gave its chief
accountant, on January 1, 2023, the choice between the following:
a. Cash payment equal to the value of 3,000 of the Company’s shares; or
b. 3,600 of the Company’s P50 par value shares
To become entitled to either of these, the chief accountant shall remain with the
entity for the next three years. Fair value information is as follows:
Date FV of Share Alternative FV of Cash Alternative
01/01/23 P90 P92
12/31/23 85 86
12/31/24 92 91
12/31/25 94 96
Based on this information, the split accounting on grant date, January 1, 2023, is as
follows:
Fair value of share alternative (3,600 x P90) P324,000

Less: Fair value of cash alternative - liability
component (3,000 x P92) (276,000)
Amount allocated to equity component P48,000
Only a memorandum entry shall be made on the grant date since the services are to
be received for the next three years.
Annual compensation expense arising from the equity component will amount to
P16,000 (P48,000/3). Changes in the fair value of the equity component are ignored.
On the other hand, the amounts of compensation expense arising from the liability
component are computed as follows:
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FV of Accruedcomp. Comp. exp

Liab. No.of ending balance during the
Year Comp. Shares (cum. comp. exp.) year
2023 P86 =: 3,000 - P86K [(P86 x 3K) x 1/3] P86,000 (P86K - PO)
2024 91 3,000 182K /(P91 x 3K)x2/3] 96,000 (P182K - P86K)
2025 96 3,000 288K [(P96 x 3K) x 3/3] 106,000 (P288K - P182K)
Compensation expense from liability component P288,000
Total compensation expense for each year is summarized as follows:

Year Comp. Exp.-Equity Comp. Exp.- Liability Total Comp. Exp.
2023 P16,000 P86,000 P102,000
2024 16,000 96,000 112,000
2025 — 16,000 106,000 © 122,000
On December 31, 2023, the journal entry to recognize the compensation expense:
Accrued compensation liability 86,000
After summarizing these entries, the share premium will have a balance of P48,000
(P16,000 x 3 years) while the liability will have a balance of P288,000 (P86,000 +
P96,000 + P106,000).
If the chief accountant chose the cash alternative on settlement date, the following
journal entries shall be made:
Cash (3,000 x P96) 288,000
If, on the settlement date, the counterparty chose the share alternative, the
following journal entry is relevant:
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MODIFICATION FROM CASH-SETTLED TO EQUITY-SETTLED

If a cash-settled share-based payment transaction has been modified to make it
equity-settled, the following accounting procedures are relevant:
a. Recognize equity-settled share-based payment transaction (i.e., share
premium) by reference to its fair value as of the modification date. The
amount actually recorded shall be based on the extent that the goods and
services have been received:
teaches ser FV of equity on Elapsed vesting period

share-based payment modification date Total vesting period
b. Derecognize the carrying amount of the liability related to the cash-settled
share-based payment transaction.
_c. Recognize in profit or loss the difference between the initial measurement of
equity-settled share-based payment transaction and the carrying amount of the
derecognized liability.
d. During the subsequent periods, the basis of the compensation expense is the
fair value of the equity-settled share-based payment as of the modification
date. Changes in the fair value shall not be recognized moving forward.
Illustration 5. On January 1, 2023, CARLOS Company granted 40,000 SARs to its
employees conditional on their five-year stay in the Company. Predetermined share
price is P30/share.
On December 31, 2024, when the SARs have fair value of P14/right and shares have
price of P45/share, the Company agreed with the employees that instead of the cash
payment, the employees will now be entitled to 40,000 share options with exercise
price of P35/share. There were no changes in the vesting period
This modification is necessary since based on the projections the Company will
have a hard time generating cash flows for the next three years.
journal entry to record the modification of share-based payment agreement from
cash-settled to equity-settled:
1. Share options have fair value of P14/option.
2. Share options have fair value of P16/option
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Scenario 1
On the date of modification, two years of the vesting period has already elapsed
(01/01/23 - 12/31/24). In connection with this, the carrying amount of the liability
right before the modification is computed as:
FV of No.of Accrued liability balance as of
Date SARs SARs December 31, 2024
12/31/24 P14 40,000 P224,000 [(P14 x 40K) x 2/5]
The amount to be recognized in equity on modification date is computed as follows:

FV of No. of Share premium to be
Date Options Options recognized on 12/31/24
12/31/24 P14 = 40,000 P224,000 [(P14x 40K) x 2/5]
Since there is no difference between the carrying amount of the liability to be
derecognized and equity to be recognized, no gain or loss shall be recognized:
The compensation expense shall now be based on the P14 fair value as of the
modification date and shall not reflect the fair value changes moving forward.
Scenario 2
The same carrying amount of liability (i-e., P224,000) as computed in Scenario 1 is
still relevant in this case. However, the amount to be recognized in equity on the
modification date is computed as follows:
12/31/24 P16 =_ 40,000 P256,000 [(P16x 40K) x 2/5]
Since the amount to be recognized in equity is higher than the carrying amount of
the liability to be recognized, a loss on modification shall be recognized as follows:
Loss on modification - P/L 32,000
The compensation expense shall now be based on the P16 fair value as of the
modification date and shall not reflect the fair value changes moving forward.
Scenario 3
The same carrying amount of liability (i.e., P224,000) as computed in Scenario 1 is
still relevant in this case. However, the amount to be recognized in equity on the
modification date is computed as follows;
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12/31/24 P11 = 40,000 P176,000 [(P11 x 40K) x 2/5]
Since the amount to be recognized in equity is lower than the carrying amount of
the liability to be recognized, a gain on modification shall be recognized as follows:
Gain on modification - P/L 48,000
MODIFICATION FROM EQUITY-SETTLED TO CASH-SETTLED

If an equity-settled share-based payment transaction has been modified to make it
cash-settled, the following accounting procedures are relevant:
a. Recognize a liability by reference to its fair value on the modification date.
The amount to be actually recorded shall be based on the extent that the goods
and services were received:
cfcashs
based payment
ofllabitionlityondate , __Blapsed
etted share- = FVmodifica vesting period
Total vesting period
b. The amount of the recognized liability shall be deducted from the balance of the
entity’s equity determined using the concepts in equity-settled share-based
payment. No gain or loss shall be immediately recorded (i.e., all differences are
recognized directly in equity).
c. During the subsequent periods, the equity and liability components shall be
accounted for separately using the concepts of equity-settled share-based
payments (i.e., changes in fair value are not considered) and of cash-settled
share-based payments (i.e., changes in fair value are considered), respectively.
d. The amount of total compensation expense over the vesting period is based on
the grant date fair value of the equity component, adjusted by the
remeasurement of the liability component (i.e., equity component shall not
be remeasured).
Illustration 6. At the beginning of 2023, MONICA Company granted 60,000 P30 par
value shares to its employees. To be entitled to the shares, the employees shall
remain employed in the Company for the next four years. On the grant date, these
shares have fair value of P40/share,
On December 31, 2025, when shares have fair value of P35/share, the Company
added a cash alternative wherein the employees may choose to receive in cash the
value of the shares on vesting date. On December 31, 2026, all of the shares vested.
Fair value of the shares on the same date amounted to P38/share.
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Right before the modification, on December 31, 2025, there were already three
years that elapsed from the four-year vesting period (from 2023 to 2025). The balance
of the share premium as of this date is computed as (based on the grant date fair
value):
FV of No. of Share premium
Date Shares Options balance as of 12/31/25
12/31/25 P40 60,000 P1,800,000 /(P40 x 60K) x 3/4]
The amount of liability to be recognized on modification date shall be based on the
fair value of the shares on that date (i.e., P35/share) adjusted by the portion of the
vesting period that has elapsed (i.e., three years):
FV of No.of Accrued compensation to be
Date Shares Options recognized on 12/31/25
12/31/25 P38 = =©60,000 = P1,575,000 /(P35 x 60K)
x 3/4]
The following entry shall be recorded on modification date:

Share premium - share alternative 1,575,000
Accrued compensation liability 1,575,000
The evolution of the equity component and liability component together with the
amount of compensation expense is shown as follows:
Total Equity Liability
compensation component component
Particulars ' expense balance balance
12/31/23 [(P40x 60K)/4] P600,000 P600,000
12/31/24 [(P40x 60K)/4] 600,000 600,000
12/31/25 [(P40x 60K)/4] 600,000 600,000
12/31/25 modification (1,575,000) 1,575,000
12/31/26 expense based on
grant date fair value (Note A) 600,000 75,000 525,000
12/31/26 remeasurement of
liability [(60K x P38) -
(P1,575K + P525K)] 180,000 180,000
Totals P2,580,000 P300,000 P2,280,000
Note A: The P600,000 supposed compensation expense based on unmodified terms shall be
allocated to liability component using the ratio of its fair value on the date of modification (i.e.,
P35) relative to the share’s fair value on grant date (i.e., P40), The P525,000 amountis computed
as P600,000 x (P35/P40). The remainder is allocated to the equity component.
The readers should take note that the remeasurement of the liability.component
balance is made to determine the additional expense to be recognized so that its
ending balance is equal to its fair value as of the reporting date (in this case,
P2,280,000 = P38 x 60,000). Total expense for 2026 is P780,000 (P600K + P180K).
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SHARE-BASED PAYMENT TRANSACTIONS AMONG GROUP ENTITIES

The illustrations in this chapter and in the previous chapter contain scenarios
wherein the entity receiving the services from employees is also settling the share-
based payment. However, in a group setting of a parent entity and its subsidiaries,
one entity may receive employee services (i.e, the receiving entity) while another
entity in the same group may settle the share-based payment (i.e., the settling entity).
Illustration 7. ABC Company, a parent entity, granted additional compensation in
the form of share-based payment to the employees of its subsidiary, XYZ Company.
Graphically, this can be shown as follows:
Grants share-based
ABC Company (parent and payment
settling entity)
Owns |
Services XYZ Company's

XYZ Company (subsidiary |g
and receiving entity) employees
In this case, XYZ Company is considered as the “receiving entity” since it receives the
services rendered by its employees. On the other hand, ABC Company is considered as
the “settling entity” since it will ultimately pay the share-based benefit to the
employees of XYZ Company.
The readers should take note that parent entities are not always considered as the
settling entity, and subsidiaries are not always considered as receiving entity as
their roles can be reversed, depending on the circumstances.
CLASSIFICATION OF GROUP SHARE-BASED PAYMENT TRANSACTIONS
Classification of the share-based payment in the perspective of the receiving entity
and of the settling entity is important since accounting procedures will primarily
depend on their classification:
Perspective of Receiving Entity | _ Perspective of Settling Entity —

The share-based payment is considered | The share-based payment is considered
as equity-settled when: as equity-settled only if it is settled in
a. the awards granted are its own equity | the entity's own equity instruments.
instruments, or
b. the entity has no obligation to settle the | All other share-based payments are
share-based payment transaction. considered cash-settled transaction.
All other share-based payments are

considered cash-settled transaction.
Note: The perspective of the consolidated financial statements is intentionally omitted for
simplification purposes.
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The readers should take note that the existence of repayment or reimbursement
agreement (also known as “recharge”) between the receiving entity and the settling
entity, belonging to the same group will not affect the classification of the share-
based payment.
Illustration 8. DEF Company, a parent entity, awarded a share-based
compensation to the employees of ZZZ Company, one of its subsidiaries. ZZZ
Company has no obligation to settle this share-based payment transaction.

classification of the share-based payment in the perspectives of DEF Company and
ZZZ Company:
1. DEF Company will settle the share-based compensation by issuing its own
shares.
2. DEF Company will settle the share-based compensation by issuing ZZZ
Company’s shares.
3. DEF Company will settle the share-based compensation by issuing its own
shares and it will claim reimbursement from ZZZ Company.
4, DEF Company will settle the share-based compensation by paying cash equal to
the fair value of its own shares.
Answer: ‘
Each scenario is classified in the perspectives of DEF Company and ZZZ Company
as follows:
Scenarios DEF Company (settling entity) ZZZ Company (receiving entity)
1 Equity-settled Equity-settled
2 Cash-settled Equity-settled
3 Equity-settled Equity-settled
4 Cash-settled Equity-settled
The following are the rationale for the classification under each scenario:
1. Under Scenario 1, the transaction is classified as equity-settled in DEF’s
perspective since it will issue its own equity securities.
2. Under Scenario 2, the transaction is classified as cash-settled in DEF’s
perspective since it will issue the equity securities of another entity (ZZZ’s
shares). In effect, this is a transfer of financial asset to ZZZ’s employees.
3. Under Scenario 3, the transaction is still classified as equity-settled in ZZZ’s
perspective since its reimbursement obligation is not relevant in classifying the
share-based payment transaction.
4. Under Scenario 4, the transaction is classified as cash-settled in DEF’s
perspective since it will pay cash to ZZZ’s employees, even though the amount
of cash payment is based on the fair value of DEF’s own shares.
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The readers should take note that the classification in the settling entity's perspective
is not necessarily the same as in the receiving entity's perspective.
ACCOUNTING FOR GROUP SHARE-BASED PAYMENT TRANSACTIONS
The receiving entity and settling entity shall account for the share-based payment
transactions based on the relevant classification. If the transaction is classified as
equity-settled, accounting procedures in Chapter 16 shall be applied. On the other
hand, if the transaction is classified as cash-settled, accounting procedures in this
chapter shall be applied.
The following additional accounting procedures are specific to group share-based
payment transactions (assuming the receiving entity is a subsidiary and settling
entity is the parent entity):
RECEIVING entity’s perspective:

Accounting matters Pro-forma journal entries
Services received from.employees -
recognized as compensation | Compensation expense XX
expense and corresponding Share premium - contri. from parent XX
increase in equity.
Settlement of the share-based
Not recorded in receiving entity’s perspective.
payment transaction — not recorded
Reimbursement, if any, made to the
settling entity - recognized as direct | Share premium - contri. from parent —-xx
deduction from equity. No gain or Cash XX
loss shall be recognized.
SETTLING entity’s perspective: :

Accounting matters Pro-forma journal entries
Services of receiving entity's
Not recorded in settling entity’s perspective.
employees — not recorded
Recognition of the share-based
payment transaction - added to the
carrying amount of investment in | Investment in receiving entity XX
the receiving entity and Contributed capital (if equity-settled)
corresponding increase in equity or or Liability (if cash-settled) XX
liability, depending on _ the
classification
Reimbursement received from the
receiving entity - recognized as | Cash XX
deduction from the carrying Investment in receiving entity Xxx
amount of the investment
However, even though it is common, the amounts recorded by one of the entities are
not necessarily equal to the amounts recorded by the other entity.
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Illustration 9 - No Vesting Conditions. On January 1, 2023, ALPHA Company

awarded 10,000 of its P20 par value ordinary shares to the employees of OMEGA
Company, its subsidiary. On the grant date, the shares had fair value of P25/share
(or P250,000 total grant date fair value). The shares vested immediately. Fast
forward to October 1, 2023, OMEGA Company reimbursed ALPHA Company
amounting to P15/share for ALPHA’S share-based compensation to OMEGA’s
employees. Required: From this given information, determine the journal entries to
be made in the books of ALPHA Company and OMEGA Company for the year 2023.
In this case, the following are the journal entries to be recorded in the books of
OMEGA Company and ALPHA Company:
OMEGA Company ALPHA Company
Date (receiving entity) (settling entity)
Comp. expense 250,000 Inv. in OMEGA 250,000
01/01/23 Share premium - Share capital (10Kx P20) 200,000
contri. from parent — 250,000 Share premium 50,000
Share premium -
10/01/23 | contri. from parent 150,000, | ©48" (10K x15) aa ce
Cash (10K
x P15) 1500005 \s ie A OMEN fg 008
Illustration 10 - With Vesting Condition. At the beginning of the year 2023, BETA
Company granted 30,000 of its P10 par value shares to the employees of one of its
subsidiaries, EPSILON Company. These employees are required to render two-year
service to EPSILON Company to become fully entitled to the shares. All of these
shares are expected to vest. On the grant date, the shares had fair value of
P18/share. Required: From this given information, determine the journal entries to
be made in the books of BETA Company and EPSILON Company for the years 2023
and 2024.
In this case, the following are the journal entries to be recorded in the books of
EPSILON Company and BETA Company:
EPSILON Company BETA Company
Date (receiving entity) (settling entity)
01/01/23 Memo entry only Memo entry only
Comp. expense* 270,000 Inv. in EPSILON 270,000
Share premium - Share prem.- others 270,000
12/31/23 contri. from parent 270,000 :
The amount was temporarily
*(30K x P18)/2-year vesting period | credited to share prem, account.
Comp. expense* 270,000 Inv. in EPSILON 270,000
Share premium - Share prem.- others 270,000
12/31/24 contri. from parent 270,000
Journal entry to record the actual
*(30K x P18)/2-year vesting period | issuance of the shares:
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e 7 Share prem. - others 540,000

Share capital (30Kx P10) 300,000
CHAPTER SUMMARY
1. Cash-settled share-based payments involve the transfer of cash or other noncash
assets to counterparties (e.g., suppliers, employees).
2. Compensation expense from cash settled share-based payment = Value x Number x
Period.
3. Cash-settled share-based payments result to the recognition of liability, resulting to
net increase in the entity’s liability and net decrease in the entity’s equity.
4. Unlike in the equity-settled share-based’ payment, cash-settled share-based
payments recognize the changes in the fair value of the liability subsequent to grant
date.
5. Changes in the estimate and changes in the fair value of the liability are accounted
prospectively through catch-up amounts during the current period.
6. Share-based payments with equity and cash alternatives are accounted using the
concepts of compound financial instruments if the choice of the alternative is on the
hands of the counterparty.
7. Ifthe counterparty chose the cash alternative, the carrying amount of the liability
shall be settled while the balance in the share premium - equity alternative is
transferred to other equity account.
8. If the counterparty chose the share alternative, the total issue price is equal to the
total of carrying amount of the liability and the share premium - share alternative.
Any excess issue price is credited to share premium - issuance. No gain or loss shall
be recognized.
9. Modification of share-based payment which resulted to change in the classification
of the transaction shall be accounted prospectively.
10.In a share-based payment transaction among group entities, the entity receiving the
services (i.e., receiving entity) is not the entity who will settle the transaction (i.e.,
settling entity).
11.Usually, the receiving entity is a subsidiary while the settling entity is the parent
entity.
12.The share-based payment among group entities shall be classified as equity-settled
or cash-settled in each of the entity’s perspectives. The existence of reimbursement
agreements is not relevant in the classification.
13.In the books of the receiving entity that is a subsidiary, the receipt of services is
recorded as expense and corresponding increase in equity contribution from parent.
14.In the books of the settling entity that is a parent, the recognition of share-based
payment shall be recorded as an addition to the investment in subsidiary account.
15.Any reimbursement shall be recorded as a direct deduction from receiving entity’s
equity and as a deduction from the investment in subsidiary account in settling
entity’s books.
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True or False
i Cash-settled share-based payments cover the transfer of equity instruments issued
by other entities.
Z. Cash-settled share-based payments shall be updated with the changes in its fair
value during the vesting period and the exercise period.
3. Similar to equity-settled share-based payments, cash-settled share-based
payments will have no effect in the entity’s equity.
Ultimately, the total amount of compensation expense from cash-settled share-
based payment is equal to the grant date fair value of the liability.
Share appreciation rights entitle the employees to an amount equal to the increase
in the share price from the grant date until the settlement date.
An entity shall never record a credit to compensation expense arising from a cash-
settled share-based payment.
Changes in the estimate from cash-settled share-based payments shall be
accounted prospectively.
Share-based payments, with equity-settled and cash-settled alternatives and the
choice belongs to the entity, shall be accounted as compound financial instruments.
If the counterparty has chosen the share alternative, gain or loss shall be recognized
equal to the difference between the fair value of the shares and the carrying amount
of the liability.
10. In a share-based payment transaction among group entities, the entity that is
receiving the employee services is different from the entity that will settle the
share-based payment.
11. In settling entity’s records, the share-based payment shall be classified as equity-
settled if the equity securities of other entities will be used in settlement.
iz. In receiving entity’s records, the share-based payment shall be classified as cash-
settled if it has to reimburse the settling entity.
i; The following concepts are correct under cash-settled share-based payments, except
a. These share-based payments increase the entity’s total liabilities.
b. These share-based payments decrease the entity’s total equity.
c. Compensation expense is limited to the grant date fair value of the related
securities. ,
Changes in the fair value of cash-settled share-based payments shall
a. be recognized prospectively by reflecting the amounts of adjustments in the
compensation expense reported during the current period.
b. be recognized retrospectively by adjusting the amounts reported during the
prior periods.
c. not be recognized at all.
d. either a orc, whichever will result to a higher amount of compensation expense
during the current period.
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3. Inshare appreciation rights (SARs) the amount of compensation expense during the
vesting period shall be based on the
a. SAR’s fair value
b. difference between the share’s current fair value and the predetermined share
price
c. aorb, whichever is higher
d. aorb, whichever is lower
4, Changes in the estimate of the number of SARs that will vest shall be accounted
a. retrospectively
b. retroactively
c. proactively
d. prospectively
5. Which of the following share-based payment alternatives are accounted as
compound financial instruments?
a. those where the counterparty has the choice between the alternatives
b. those where the entity has the choice between the alternatives
c. bothaandb
d. neitheranorb
6. If the relevant party has chosen the cash alternative, which of the following
statements is/are incorrect?
a. Thecarrying amount of the liability shall be derecognized.
. b. The carrying amount of the share premium - share alternative shall be
recognized in profit or loss.
c. Bothaandb
d. Neitheranorb
7. If the relevant party has chosen the equity alternative, which of the following
statements is/are incorrect?
a. The total issue price for the shares shall be equal only to the carrying amount of
the liability.
b. The difference between the total issue price and the par value of the issued
shares shall be credit to retained earnings.
c. Bothaandb
d. Neitheranorb
8. In ashare-based compensation among group entities, the following statements are
true, except
The entity receiving the services will also settle the share-based compensation.
oP
The receiving entity is usually a subsidiary,

The settling entity is usually the parent entity,
The classification of the share-based payment shall be assessed separately in the
ao
perspective of the receiving entity and the settling entity.
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9. The following are true regarding the classification of the share-based payment, as
equity-settled or cash-settled, in the perspectives of the entities involved, except
a. Inthe settling entity’s perspective, the share-based payment shall be classified
as equity-settled if it will settle the transaction using its own equity securities,
b. In the settling entity's perspective, the share-based payment shall be classified
as cash-settled if it will settle the transaction in cash by reference to its own
equity securities.
c. In the receiving entity’s perspective, the share-based payment shall not be
automatically classified as cash-settled if it has an obligation to repay the
settling entity.
d. The classification in the perspective of one of the entities, shall be the same as
the classification the perspective of the other entity.
10.Accounting for share-based payments among group entities are as follows, except
a. The settlement of the share-based payment is not recorded in the receiving
entity’s books.
b. Inreceiving entity’s books, the credit shall be made to other income.
c. The compensation expense is recognized in the books of receiving entity, but
not in settling entity’s books.
d. Insettling entity’s books, the recognition of share-based payment shall increase
the carrying amount of investment in receiving entity.
Straight Problems
1. On January 1, 2023, CHOWDER Company granted a share-based payment plan
where it will pay cash to its employees by reference to the Company’s 60,000
ordinary shares. The settlement date is on December 31, 2025. The Company’s
shares had fair value per share as follows:
Jan.1,2023 Dec.31,2023 Dec.31,2024 Dec.31,2025
P60 P68 P65 P69
The effects of the time value of money are deemed immaterial. All of the benefits
have vested on vesting date.
amounts of compensation expense from 2023 to 2025:
1. The benefit vested immediately.
2. The benefit will vest on December 31, 2024
3. The benefit will vest on December 31, 2025
2. At the beginning of the year 2023, IVORY Company granted an employee share-
based payment wherein it will pay in cash the equivalent of 90,000 of its ordinary
shares on December 31, 2025. To become entitled to the cash payment, the
employees shall still be employed with the Company until the vesting date. In
connection with this transaction, the following data are relevant:
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Jan.1, Dec.31, Dec.31, Dec,31,

2023 2023 2024 2025
Fair value P80 P75 P72 P78
Portion expected to vest 95% 96% 94% N/A
As of December 31, 2025, only 83,700 shares have actually vested. The effects of the
time value of money are deemed immaterial.
Required: Determine the compensation expense from 2023 to 2025.
3. OnJanuary 1,2023, CHIFFON Company introduced share appreciation rights (SARs)

to its employees covering 100,000 rights. For each right, the Company will pay in
cash the amount of increase in share’s fair value from a predetermined amount of
P40/share. These SARs will vest on December 31, 2026 and the employees have
another two years until December 31, 2028 to exercise this benefit. Relevant fair
value data from 2023 to 2028 are the following:
Date Fair ValueofSARs Fair Value of Shares
January 1, 2023 P14 P55
December 31, 2023 16 57
December 31, 2024 12 54
December 31, 2025 14 56
December 31, 2026 18 59
December 31, 2027 17 58
December 31, 2028 20 60
All throughout the vesting period, the Company expects that only 90,000 of the SARs
will ultimately vest. Fast forward to December 31, 2026, there were 92,000 SARs
vested, where 50,000 were exercised on December 31, 2027, while the remaining
SARs were exercised on December 31, 2028
b. Balance of accrued liability every December 31 from 2023 to 2028.
4. SNOWSTORM Company granted 600 SARs to each of its 500 employees. For each
right, the Company will pay in cash the amount of increase in the share’s fair value
from the predetermined amount of P80/share. To be entitled to this benefit, the
employees shall still be employed with the Company until December 31, 2025. The
employees are given until December 31, 2028 to exercise these rights.
For the year 2023, 15 employees have left and 40 more are expected to leave during
the vesting period. As of December 31, 2023, the SARs and the shares had fair values
of P8/right and P90/share, respectively.
For the year 2024, another 20 employees have left and 25 more are expected to leave
during the rest of the vesting period. As of December 31, 2024, the SARs and the
shares had fair values of P14/right and P95/share, respectively.
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For the year 2025, only 18 employees have actually left. As of December 31, 2025,
the SARs and the shares had fair values of P12/right and P93/share, respectively,
On the other hand, the following data are relevant during the exercise period:
Fair Value ‘Fair Value No. of Employees
Date of SARs ofShares Exercising the SARs
December 31, 2026 P14 P96 160
December 31, 2027 11 94 150
December 31, 2028 16 97 137

b. Balance of accrued liability every December 31 from 2023 to 2028.
5. On January 1, 2023, KENDALL Company instituted a performance-based

compensation to its senior management team composed of 30 executives. The
compensation is in the form of share appreciation rights (SARs), which vary in
number per executive depending on the level of average return on investment (ROI)
for the next four years:
Average ROI Number of options per executive

more than 14.00% 600
12.00% to 13.99% 400
10.00% to 11.99% 200
less than 10.00% 100
For each right, the Company will pay in cash the amount of increase in share’s fair
value from the predetermined amount of P50/share. In addition, the Company
expects that only 24 of the executives will remain in its employ for the next four
years. In addition, the executives are given another two years to exercise their SARs.
During 2023, the Company generated an ROI of 11.50% and expects that it can
generate roughly the same levels during the rest of the vesting period. As of
December 31, 2023, the SARs and shares have fair values of P9/right and P60/share,
respectively.
During 2024, the Company generated an ROI of 14.00% but expects that for the rest
of the vesting period, it can generate 16.00% ROI per year. As of December 31, 2024,
the SARs and shares have fair values of P7/right and P58/share, respectively.
During 2025, the Company generated an ROI of just 13.00% but expects that it can
only generate an ROI of 12.00% in 2026. As of December 31, 2025, the SARs and
shares have fair values of P11/right and P63/share, respectively.
During 2026, the Company generated an ROI of 15%. Only 22 executives remained
employed as of the end of 2026. As of December 31, 2026, the SARs and shares have
fair values of P14/right and P66/share, respectively.
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chapter 16A - Cash-Settled Share-Based Payments
|
on the other hand, the following data are rele
vant during the exercise Period:
Fair Value Fair Value
Date No. of Executiy
of SARs of Shares
December 31, 2027 Exercising theSARs
P12 P64
15
o7 é
Required: From the given information, determin
e th e following:
a. Compensation expense from 2023 to 2028,
b. Balance of accrued liability every December
31 from 2023 to 2028,
6. On January 1, 2023, BLIZZARD Compan y acquired an equ
ipment with fair value of
P6,000,000 . from another entity. Since the Company is cur
rently short in cash, it
decided to issue a promissory note wherein the
counterparty has the choice from
either of the following manner of settlement on December
31, 2025:
a. The counterparty will receive cash equal to the
fair value of 200,000 of the
Company’s P15 par value shares on the date of settlement.
b. Actual receipt of 200,000 shares of the Company
on the date of settlement and
become a shareholder of the Company.
The shares had fair values of P25, P27 and P28 as of Dece
mber 31, 2023, 2024 and
2025, respectively.

b. Journal entries to record the settlement under each of the following
independent scenarios:
1, The counterparty chose the cash-alternative.
2. The counterparty chose the equity-alternative.
PORCELAIN Company granted additional compensation program to its preside

nt on
January 1, 2023. The president has the choice between the following:
a. 5,400 of the Company’s P40 par value shares; or
b. Cash Payment equal to the value of 4,500 of the Company’s shares
entity for the next four years. Fair value information is as follows:

01/01/23 P80 P82
12/31/23 74 75
12/31/24 83 82
12/31/25 85 87
12/31/26 82 86
Requ
; ired: From the given information, determine the following:
Ompensation expense from 2023 to 2026.
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b. Journal entries to record the settlement under each of the following

independent scenarios:
1. The president chose the cash-alternative.
2. The president chose the equity-alternative.
8. On January 1, 2023, TROMBONE Company granted 60,000 SARs to its employees,
provided they employed in the Company for the next four years. Predetermined
share price is P50/share.
On December 31, 2024, when the SARs have fair value of P18/right and shares have
fair value of P70/share, the Company agreed with the employees that instead of the
cash payment, the employees will now be entitled to 60,000 share options with
exercise price of PS0/share. There were no changes in the vesting period.
following: (a) journal entry to record the modification of share-based payment
agreement from cash-settled to equity-settled and (b) compensation expense for the
year 2025:
1. Share options have fair value of P18/option.
9. At the beginning of the year 2023, VANILLA Company granted 90,000 ofits P15 par
value shares to the employees of one of its subsidiaries, OPAL Company. These
employees are required to render three-year service to OPAL Company to become
fully entitled to the shares. All of these shares are expected to vest. The shares have
the following fair values:
Jan.1,2023 Dec.31,2023 Dec.31,2024 Dec.31,2025
P24 P22 P26 P23
On December 31, 2025, OPAL Company reimbursed VANILLA Company for P18 per
share. All of the shares actually vested as of the same date.
Required: Determine the journal entries to be recorded in VANILLA Company’s
books and in OPAL Company’s books from 2023 to 2025.
10.On January 1, 2023, MUSTARD Company granted a share-based compensation to the

employees of one of its subsidiaries, DAISY Company. These employees are required
to render three-year service to DAISY Company to become fully entitled to the
benefit. The benefit involves the cash payment based on the fair value of 150,000 of
MUSTARD’s shares. Only 95% of these benefits are expected to vest.
The shares have the following fair values:
Jan.1,2023 Dec.31,2023 Dec.31,2024 Dec.31,2025
P36 P32 P37 P34
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On December 31, 2025, DAISY Company reimbursed MUSTARD Company for P20
per share. Only 93,000 shares worth of cash payment have actually vested and
settled as of the same date.
Required: Determine the journal entries to be recorded in MUSTARD Company's
books and in DAISY Company's books from 2023 to 2025.

1. On January 1, 2023, BUDDY Company gave a benefit to the members of the senior
management to reward them for their past services to the Company. The benefit is
in the form of cash payment equivalent to the fair value of 120,000 of Company’s
ordinary shares. There were no other conditions attached to the benefit except that
the settlement date is on December 31, 2024. Ordinary shares had fair values of
P46/share, P50/share, and P58/share as of January 1, 2023, December 31, 2023 and
December 31, 2024, respectively. The effects of the time value of money are
determined to be immaterial.
a. P5,520,000 c. P2,760,000
b. P6,000,000 d. P3,000,000
a. P4,200,000 c. P1,440,000
b. P3,960,000 d. P960,000
2. On January 1, 2023, CINDY Company granted 300,000 share appreciation rights

(SARs) to its employees. For each right, the Company will pay in cash the amount of
increase in its share’s fair value from a predetermined amount of P100/share. These
SARs will vest on December 31, 2025 and the employees have another two years
until December 31, 2027 to exercise this benefit. Relevant fair value data from 2023
to 2027 are the following:
Date Fair Value ofSARs Fair Value of Shares

January 1, 2023 P6 P108
December 31, 2023 4 106
December 31, 2024 8 109
December 31, 2025 10 112
December 31, 2026 9 110
December 31, 2027 12 113
All throughout the vesting period, the Company expects that only 288,000 of the
SARs will vest. Ultimately, on December 31, 2025, there were 291,000 SARs that
actually vested. Exercised rights numbered 180,000 rights and 111,000 rights on
December 31, 2026 and December 31, 2027, respectively.
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a. P384,000 c. P576,000
b. P400,000 d. P600,000

a. P1,136,000 c, P576,000
b. P1,152,000 d. P600,000

a. P1,476,000 c, P1,374,000
b. P1,574,000 d. P1,344,000

a. P111,000 debit c. P248,000 debit
b. P111,000 credit d. P248,000 credit

a. P286,000 c. P396,000
b. P308,000 d. P444,000
3. On January 1, 2023, CINDY Company granted 450,000 share appreciation rights

(SARs) to its employees. For each right, the Company will pay in cash the amount of
increase in its share’s fair value from a predetermined amount of P150/share. These
SARs will vest on December 31, 2025 and the employees have another two years
until December 31, 2027 to exercise this benefit. Relevant fair value data from 2023
to 2027 are the following:
Fair Value Fair Value Expected No. of
Date of SARs. ofShares SARs that will vest
January 1, 2023 P2 P150 435,000
December 31, 2023 6 157 435,000
December 31, 2024 10 162 429,000
December 31, 2025 9 160 N/A
December 31, 2026 12 164 N/A
December 31, 2027 15 165 N/A
On December 31, 2025, there were 432,000 SARs that actually vested. The
employees exercised 300,000 rights on December 31, 2026, while the remaining
rights were exercised on December 31, 2027.

a. P658,000 c. P870,000
b. P790,000 d. P912,000
a. P2,070,000 c. P2,202,000
b. P1,990,000 d, P1,948,000
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a. P1,028,000 c. P1,549,000
b. P1,156,000 d. P1,892,000
a. P1,389,000 c. P1,764,000
b. P1,492,000 d. P1,896,000
a. P308,000 c. P428,000
b. P396,000 d, PS578,000
4. OnJanuary 1, 2023, CORNELIO Company granted additional compensation program

for its employees, the Company gave its controller the choice between the following:
a. Cash payment equal to the value of 27,000 of the Company’s shares; or
b. 29,700 of the Company’s P20 par value shares
entity for the next three years. Fair value information is as follows:

01/01/23 P26 P28
12/31/23 24 25
12/31/24 28 30
12/31/25 30 33
a. P262,400 c. P225,000
b. P230,400 d. P216,400
a. P320,400 c. P294,400
b. P315,000 d. P276,400
a. P389,400 c. P356,400
b. P376,400 d. P351,000
5. Atthe beginning of 2023, VIRUS Company granted 80,000 of its P30 par value shares
to its employees. To be entitled to the shares, the employees shall remain employed
in the Company for the next five years. On the grant date, these shares had fair value
of P50/share. All of these shares are expected to vest.
Fast forward on December 31, 2025, when shares have fair value of P42/share, the
Company added a cash alternative wherein the employees may choose to receive in
cash the value of the shares on vesting date. The shares had fair values of P48/share
and P52/share as of December 31, 2026 and 2027, respectively.
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The initial measurement of the liability component on December 31, 2025 shall be
a. P1,856,000 c. P2,216,000
b. P2,016,000 d, P2,526,000

a. P964,000 c. P1,184,000
b. P1,024,000 d. P1,264,000
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About the Author
Vhinson is a proud son of Nueva Ecija anda true-
blooded Novo Ecijano. He was born into a family with a
mother who is a teacher and a father who is a farmer.
During his formative years as a toddler, he was raised
by his grandparents.
Growing up, he was inspired by his parents and

grandparents. It is through their hardwork and
perseverance that young Vhinson discovered the key ti.
success. He vowed to strive for excellence in all thina:
that he do. These principles served as his motivation ‘1:
pursuing excellence in academics as a means of giving
back for the help and sacrifices of people around him.
He was able to graduate as the class salutatorian in San Francisco Elementary
School and in high school, he was the class valedictorian in San Antonio
Montessori School. He obtained his Bachelor of Science in Accountancy degree
from Wesleyan University — Philippines where he graduated as Summa Cum
Laude and the batch valedictorian. A feat that he dedicates to his humble
beginnings and hardworking parents and grandparents.
After placing Ist in the October 2016 Licensure Examinations for Certified
Public Accountants (garnering a 94.33% rating), he joined the audit practice
of Sycip, Gorres, Velayo (SGV) & Company. After his stint in public practice as a
Senior Audit Associate, he joined a multinational bank as a reviewer of
derivative documentations primarily on credit derivatives.
During the height of the recent COVID-19 pandemic, he realized that his passion
is sharing his accumulated knowledge from the academe and his experience
in practice to the younger generation. Currently, he is a Financial Accounting
and Reporting (FAR) and Auditing Theory (AT) reviewer in REO CPA Review.
To the person reading this, the author offers the following wisdom:
“Work hard now and reap the benefits of tomorrow. All of our efforts will be
reciprocated in due time. Trust the process and put our heart and soul in
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2023 - 2024

VHINSON JAY GARCIA, CPA

The Book R̶e̶a̶d̶e̶r̶s̶ Raiders | Nevule

An Integrated Principle-based Approach

A Guide to Understanding and Mastering Financial Accounting

CPA Board Exam candidates

Finance & Business students

VHINSON JAY S. GARCIA, CPA

VHINSON JAY S. GARCIA, CPA

ALL RIGHTS RESERVED

Published and distributed by:

VHINSON JAY S. GARCIA, CPA

CPA Board Exam Top 1

National CPA Reviewer in Financial Accounting and Reporting (FAR)

Member of Technical Team and

Credit Derivatives Reviewer

Summa Cum Laude, BS Accountancy

Valedictorian, High School

To my former professors in Wesleyan University - Philippines, as spearheaded by

To every student and professor in quest of real excellence,

This book is dedicated to you.

Financial Accounting and Reporting is complex because it establishes the

After understanding the chapters, practice is the stepping stone to mastery.

For commentaries, inquiries, or suggestions:

Vhinson Jay S. Garcia, CPA

REAL EXCELLENCE PUBLISHING - Intellectual Property Rights Advisory

CHAPTER 1 Introduction to Liabilities 1-25

CHAPTER 2 Accounts Payable and Notes Payable 26-56

CHAPTER 3 Introduction to Provisions 57-84

CHAPTER 4 Warranties 85-105

CHAPTER 5 Premiums, Rebates, Discounts and Deferred Income 106-139

CHAPTER 6 Bonds Payable and Loans Payable 140-172

CHAPTER 7 Compound Financial Instruments 173-191

CHAPTER 8 Extinguishment of Liabilities 192-223

CHAPTER 9 Lessee Accounting - Basic Considerations 224-260

CHAPTER 9A Lessee Accounting - Other Matters 261-295

CHAPTER 10 Lessor Accounting - Finance Lease 296-325

CHAPTER 11 Sublease, and Sale and Leaseback 355-380

CHAPTER 12 Employee Benefits - Part 1 381-408

CHAPTER 12A Post-Employment Benefits 409-444

CHAPTER 13 Accounting for Income Taxes 445-490

CHAPTER 14 Accounting for Derivatives 491-516

CHAPTER 15 Shareholders’ Equity - Contributed Capital 517-561

CHAPTER 15A Shareholders’ Equity - Retained Earnings 562-595

CHAPTER 16A Cash-Settled Share-Based Payments 629-658

After this chapter, readers are expected to comprehend:

ALL of the following criteria shall be met for a liability to exist:

CAIN DIVTIND PAYADY, - Labi 2

OBLIGATION TO TRANSFER AN ECONOMIC RESOURCE

PRESENT OBLIGATION AS A RESULT OF PAST EVENTS

GENERAL CLASSIFICATIONS OF LIABILITIES

[se Financial Liabilities | fa Non-financial Liabilities et

O4y - Mya, Cornu

a. to deliver cash or another financial asset to another entity; or

ACCOUNTING FOR FINANCIAL LIABILITIES

The accounting for amortized cost is similar to investments at amortized cost,

ACCOUNTING FOR NON-FINANCIAL LIABILITIES

FINANCIAL REPORTING OF LIABILITIES

An entity shall classify all other liabilities as non-current. [PAS 1.69].