BATANGAS STATE UNIVERSITY
The National Engineering University
Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and International
Hospitality Management
INTERMEDIATE ACCOUNTING II
BS Management Accounting
1st Semester, AY 2024 – 2025
Reference: Conrado Valix, et.al
FINANCIAL INSTRUMENT
PAS 32, para.graph 11, defines a financial instrument as any contract that gives rise to both a financial asset of one
entity and a financial liability or equity instrument of another entity.
Characteristics of a financial instrument
a. There must be a contract.
b. There are at least two parties to the contract.
c. The contract shall give rise to a financial asset of one party and financial liability or equity instrument of
another party.
Financial liability
A financial liability is a contractual obligation:
a. To deliver cash or other financial asset to another entiy.
b. To exchange financial instruments with another entity under conditions that is potentially unfavorable.
Examples of Financial liabilities:
a. Trade accounts payable c. Loans payable
b. Notes payable d. Bonds payable
Nonfinancial liabilities
a. Deferred revenue and warranty obligations are not financial liabilities because the outflow of economic
benefit is the delivery of goods and services rather than a contractual obligation to pay cash.
b. Income tax payable is not a financial liability because it is statutory or imposed by law and noncontractual.
c. Constructive obligations are not financial liabilities because the obligations do not arise from contracts.
Equity instrument
An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all
of the liabilities.
Equity instruments include ordinary share capital, preference share capital and warrants or option.
COMPOUND FINANCIAL INSTRUMENT
PAS 32, paragraph 28, defines a compound financial instrument as a financial instrument that contains both a
liability and an equity element from the perspective of the issuer.In other words, one component of the financial
instrument meets the definition of a financial liability and another component of the financial instrument meets the
definition of an equity instrument.
The common examples of compound financial instrument are:
a. Bonds payable issued with share warrants
b. Convertible bonds payable
Accounting for compound instrument
If the financial instrument contains both a liability and an equity component, PAS 32 mandates that such
components shall be accounted for separately.
The approach in accounting for a compound financial instrument is split accounting.Split accounting means that
the consideration received from the issuance of the compound financial instrumentshall be allocated between the
liability and equity components.
The fair value of the liability component is first determined.
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BATANGAS STATE UNIVERSITY
The National Engineering University
Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and International
Hospitality Management
The fair value of the liability component is then deducted from the total consideration received from the issuance
of the compound financial instrument. The residual amount is allocated to the equity component.
Bonds payable issued with share warrants
When the bonds are sold with share warrants, the bondholders are given the right to acquire shares of the issuing
entity at a specified price at some future time.
Actually, in this case, two securities are sold — the bonds and the share warrants.
Share warrants attached to bonds payable may be detachable or non-detachable. Detachable warrants can be traded
separately from the bond and non-detachable warrants cannot be traded separately.
IFRS does not differentiate whether the equity component is detachable or non-detachable. Whether detachable or
non-detachable, the share warrants have a value and shall be accounted for separately.
Share warrants are rights granted to the holder to acquire shares of the issuer at a specified price during a specified
period.
Allocation of Issue Price
The bonds are assigned an amount equal to the market value of the bonds ex-warrants, regardless of the market
value of the share warrants.
The residual amount or remainder of the issue price shall then be allocated to the share warrants.
The residual approach is based on the definition of an equity instrument as a contract that evidences a residual
interest in the assets of an entity after deducting all of the liabilities.
Illustration
An entity issued 5,000 10-year bonds payable, face amount P 1,000 per bond, at 105.Each bond is accompanied by
one warrant that permits the bondholder to purchase 20 equity shares, par P 50, at P55 per share, or a total of
100,000 shares, 5,000 x 20.
The market value of the bond without warrant at the time of issuance is 98.
To record the issuance of the bonds payable:
To record the exercise of 60% of the warrants:
To record the expiration of the remaining warrants:
Market value of bonds without warrants unknown
In the absence of market value of bonds without the warrants, the amount allocated to the bonds payable is equal
to the present value of the principal bond liability plus the present value of the future interest payments using the
effective or market interest rate for similar bonds payable without the share warrants.
Illustration
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BATANGAS STATE UNIVERSITY
The National Engineering University
Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and International
Hospitality Management
An entity issued face amount 5-year bonds payable at 120. Each P 1,000 bond was issued with 20 non detachable
share warrants. Each warrant entitled the bondholder to purchase one share of P20 par value for P25. The interest
rate is 10% payable annually every December 31.
The prevailing market rate Of interest for similar bonds without warrants is 12%. The PV of 1 at 12% for 5 periods
is 0.57 and the PV of an ordinary annuity of 1 at 12% for 5
To record the issuance of the bonds payable:
To record the exercise of the share warrants:
Convertible bonds payable
Convertible bonds are bonds which give the holders the right to convert their bondholdings into share capital or
other securities of the issuing entity within a specified period of time.
When convertible bonds are issued at a premium or discount, amortization period is up to the maturity date instead
of the conversion date because it is impossible to predict, if at all, that the conversion privilege will be exercised.
Accounting problems arise in two situations, namely:
a. When the convertible bonds are originally issued
b. When the convertible bonds are converted
Convertible bonds are conceived as compound financial instruments. Accordingly, the issuance of convertible
bonds payable shall be accounted for as partly liability and partly equity.
Otherwise stated, the issue price of the convertible bonds shall be allocated between the bonds payable and the
conversion privilege.
Allocation of issue price
The bonds are assigned an amount equal to the market value of the bonds without the conversion privilege.
The residual amount or remainder of the issue price shall then be allocated to the conversion privilege or equity
component.
In the absence of market value of the bonds payable without conversion privilege, the amount allocated to the
bonds payable is equal to the present value of the principal bond liability plus the present value of future interest
payments using the effective or market interest rate for similar bonds payable without conversion privilege.
Illustration
An entity issued 5,000, 5-year bonds payable, face amount PI,OOO each at 110.The bonds contain a conversion
privilege that provides for an exchange of a P 1,000 bond for 20 equity shares with par value of P50.
It is reliably determined that the bonds would sell only at 95 without the conversion privilege.
Conversion of bonds payable
If bonds are converted into share capital of the issuing entity, the accounting problem is the determination of a
value to be assigned to the share capital issued.
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BATANGAS STATE UNIVERSITY
The National Engineering University
Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and International
Hospitality Management
The carrying antoun,t, of the bonds is the measure of the share capital issued because the carrying amount is the
"effective price" for the shares issued as a result of the conversion.
Application Guidance 32 of PAS 32 provides that there is no gain or loss on conversion at maturity.The reason is
that the convertible bond is viewed in substance as an equity and the conversion is really an exchange of one
type of equity capital for another.
Any cost incurred in connection with the bond conversion shall be deducted from share premium arising from the
bond conversion.
The carrying amount of the bonds payable is equal to the face amount plus accrued interest if not paid, plus
unamortized premium on bonds payable or minus unamortized discount on bonds payable and bond issue cost.
Accounting procedures
a. The amortization of discount and issue cost or premium up to the date of conversion shall be recorded.
b. The face amount of the bonds payable converted shall be canceled together with the related unamortized
premium or discount on bonds payable and bond issue cost.
c. If only a portion of the bonds is converted, the unamortized premium or discount on bonds payable and
issue cost balance shall be cancelled proportionately.
d. Normally, conversion is at an interest date. When at other dates, the accrued interest up to the date of
conversion is ordinarily paid.
If the interest is not paid, it is added to the face amount of the bonds payable converted to get the carrying
amount of the bonds payable for conversion purposes. The accrued interest is charged to interest expense.
EXERCISES
1. At the beginning of current year, Susan Company issued 5,000 convertible bonds payable. The bondshave
a three-year term and are issued at 110 with a face amount of P 1,000 per bond.
Interest is payable annually in arrears at a nominal 6% interest rate. Each bond is convertible at anytime up
to maturity into 100 ordinary shares with par value of P 5.
When the bonds are issued, the prevailing market interest rate for similar debt instrument without
conversion option is 9%.
The present value of 1 at 9% for 3 periods is .77 and the present value of an ordinary annuity of 1 at 9%
for 3 periods is 2.53.
What amount should be recorded as equity component arising from the original issuance of the convertible
bonds payable?
2. Moses Company issued face amount, 5-year bonds payable at 109. Each P 1,000 bond was issued with 10
Share warrants, each Of which entitled the bondholder to-purchase one share of P 100 par value at P 120.
Immediately after issuance, the market value of each share warrant was P5. The stated interest rate on the
bonds is 11% payable annually every end of the year. However, the prevailing market rate of interest for
similar bonds without warrants is 12%.
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BATANGAS STATE UNIVERSITY
The National Engineering University
Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and International
Hospitality Management
The present value of 1 at 12% for 5 periods is 0.57 and the present value of an ordinary annuity of 1 at
12% for 5 periods is 3.60.
What is the carrying amount of the bonds payable on the date of issuance?
What amount should be recorded initially as discount or premium on bonds payable?
What amount should be recorded as equity component arising from the issuance of bonds payable?
What amount should be credited to share premium if all of the share warrants are exercised?
3. On December 31, 2022, Cey Company had outstanding 12%, 5,000,000 face amount convertible bonds
payable maturing on December 31, 2027.Interest is payable on June 30 and December 31. Each P 1,000
bond is convertible into 50 shares of Cey Company with PI0 par value.
On December 31, 2022, the unamortized premium on bonds payable was P 300,000. No equity component
was recognized from the original issuance of the convertible bonds.
On December 31, 2022, 2,000 bonds were converted when the share had a market price of P24. The entity
incurred P20,000 in connection with the bond conversion.
What amount should be recorded as share premium arising from the bond conversion?
MULTIPLE CHOICES
1. What is the principal accounting for a compound financial instrument?
a. The issuer shall classify a compound instrument as either liability or equity.
b. The issuer shall classify the liability and equity components of a compound instrument separately as
liability or equity instrument.
c. The issuer shall classify a compound instrument as a liability in its entirety, until converted into equity.
d. The issuer shall classify a compound instrument as a liability in its entirety.
2. How are the proceeds from issuing a compound instrument allocated between the liability and equity?
a. The liability component is measured at fair value and the remainder of the proceeds is allocated to the
equity component.
b. The proceeds are allocated to the liability and equity based on fair value.
c. The proceeds are allocated to the liability and equity based on carrying amount.
d. The proceeds are not allocated because the compound instrument is accounted for either as liability or
equity.
3. The proceeds from an issue of bonds payable with share warrants should not be allocated between the
liability I and equity components when
a. The fair value of the share warrants is not readily available.
b. The exercise of the share warrants within the next reporting period seems remote.
c. The share warrants issued are non-detachable.
d. The proceeds should be allocated between liability and equity under all of these circumstances.
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BATANGAS STATE UNIVERSITY
The National Engineering University
Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and International
Hospitality Management
4. When the cash proceeds from bonds payable issued with share warrants exceed the fair value of the bonds
payable without the warrants, the excess should be credited to
a. Share premium — ordinary
b. Retained earnings
c. Liability account
d. Share premium — share warrants
5. When bonds are issued with share warrants, the equity component is equal to
a. Zero
b. The excess of the proceeds over the face amount of the bonds payable.
c. The market value of the share warrants.
d. The excess of the proceeds over the fair value of the bonds payable without the share warrants.
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