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Non-current Liabilities - Intro to Bonds (Financial Accounting)
The topic focuses on a financial instrument, formal in nature, that intends to borrow money from the public through this thing - with ensured interest in return.
PREFACE
This is in accordance with the written standards of International Financial Reporting Standards, International Accounting Standards and other legitimate standards as is relevant to this topic. The topic and all of the samples given are indeed right and just.
OVERVIEW
In discussing bonds payable, we will encounter many things that consisting a bond. It is divided into four subtopics:
- Issuing bonds
- Types and Ratings
- Valuation
- Effective Interest
Before proceeding, somebody may ask "what really is a financial instrument?" By detail, it is a contract that gives rise to a financial asset of one entity; and a financial liability or equity instrument of another entity.
In a financial instrument there's financial asset. It is any kind of asset that is:
a. Cash
b. An equity instrument of another entity
c. A contractual right
- To receive cash or another financial asset from another entity, or
- To exchange financial assets or financial liabilities with another entity under conditions that are financially favorable to the entity, or
If there is financial asset, there is also a financial liability, Is any liability that is:
a. A contractual obligation, that is:
- To deliver cash or another financial asset to another entity; or
- To exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or
b. A contract that will or may be settled in the entity’s own equity instruments (with conditions)
There are six (6) existing financial instruments in the world of business. Namingly:
1. Bonds
2. Loans and notes
3. Trade accounts
4. Cash
5. Equity securities
6. Derivatives (Swaps, Futures, Options)
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| Classification and Measurement of Financial Assets |
1. Financial liability at fair value through Profit or Loss
- Only if it is held for trading, or
- Fair Value Option was elected and PFRS 9 qualifying criteria were met; or
- It is a derivative in a net liability position or an embedded derivative
2. Financial liability at amortized cost (default classification and measurement)
BONDS - CONTEXT: WHY BONDS?
On one, serious note: Why bonds? What is bonds? To answer such questions, a bond is:
- A formal,unconditional promise, made under seal
- To pay a specified sum of money at a determinable future date; and
- To make periodic interest payment at a stated rate until the principal sum is paid.
And also, there are eight kinds of bonds, and they are categorized into:
• As to maturity (Term and Serial)
• Payment of Interest (Coupon, zero-coupon)
• As to security and risk (Mortgage, collateral, Junk, Debenture)
• As to right of redemption (Callable, convertible)
• As to issuer (Corporate, government)
ACCOUNTING FOR TERM BOND LIABILITIES
At this juncture, we will discuss the following about term bond liabilities:
• Issuance
• Interest Accrual and Payment
• Settlement
Example:
On January 1, 2014, X Co. issued 1,000, Php1,000, 12% 3-year bonds at face amount. Transaction costs are negligible. Principal is due on December 31, 2016 but interests are due annually every after year-end.
Journal Entry:
In accounting the bonds, there are many issues that you may encounter and this are your considerations:
1. Accounting for issuances at a discount or premium
2. Accounting for transaction costs
3. Accounting for issuances between interest payment dates
4. Accounting for retirement of bonds
Also, here is the table that includes bond discounts and premiums and the effects on the bonds such as cash proceeds, effective interest and nominal interest.
To apply what it is on the table and see the effects, let us give a case example of bonds at a discount.
Bonds issued at discount
On January 1, 2014, X Co. issued 1,000, 10%, 3-year bonds for Php951,963. Principal is due on December 31, 2016 but interests are due annually every year-end. The effective interest rate is 12%.
In this case, given the problem:
• There is discount since the cash proceeds are less than the face amount of the bond and the effective interest rate is greater than the nominal rate.
• The discount is recorded separately while the bonds payable is credited at face amount.
• The discount is a contra-account to the bonds payable when determining the carrying amount.
Journal Entries:
Other Relevant Journal Entries:
We will give you another example about bonds. This time, at a premium.
Bonds issued at a premium
On January 1, 2014, X Co. issued 1,000, 12%, 3-year bonds for Php1,049,737. Principal is due on December 31, 2016 but interests are due annually every year-end. The effective interest rate is 10%.
In this case;
• There is premium since the cash proceeds are more than the face amount of the bond and the effective interest rate is less than the nominal rate
. • The premium is recorded separately while the bonds payable is credited at face amount.
• The premium is an adjunct-account to the bonds payable when determining the carrying amount.
Journal Entries:
Amortization Table:
Other Relevant Journal Entries:
These are incremental costs that are directly attributable to the issue of the bonds payable. Examples include:
Printing and engraving costs
Legal fees
Accounting fees
Registration fees
Commissions paid to agents and underwriters
Other similar charges
Transaction costs are not treated as outright expense but amortized over the life of the bond. These are treated as “borrowing costs” and therefore will increase interest expense. It shall be presented as deduction to bonds payable. These costs are lumped with discount on bonds and netted against premium on bonds. The investor usually pays for the bond issue costs. The following are the examples about bonds with given transaction cost. We will be showing first an example about bonds issued at face amount, followed by bond issuance at a discount, then premiums.
Bonds issued at a face amount with transaction cost
On January 1, 2014, X Co. issued 10%, Php1,000,000 bonds at face amount. Commission paid to underwriters amounted to Php48,037. Principal is due on December 31, 2016 but interest payments are made annually every year end.
Journal Entries:
• Although the bonds are issued at face, it is as if there is discount since the cash proceeds are less than the face amount of the bonds.
• The transaction cost is recorded separately.
• Since the carrying amount is not equal to the face amount, effective interest rate should be determined.
Still on the same problem:
Since cash proceeds is not equal to the face amount of the bond, what is the effective interest rate(true rate)?
Amortization Table:
Other Relevant Journal Entries:
Bonds issued at a discount with transaction cost
On January 1, 2014, X Co. issued 1,000, 10%, 3-year bonds for Php951,963. Principal is due on December 31, 2016 but interests are due annually every year-end. In addition, X incurred bond issue costs of Php44,829. The effective interest rate is 12% before adjustment for bond issue costs and 14% after adjustment for bond issue costs.
Journal Entries:
Amortization Table:
In this case, the other relevant journal entries will be similar as those to the previous examples given at this topic. Now, we will show you another example - this time, it is about bonds at a premium, with transaction cost.
Bonds issued at a premium with transaction cost
On January 1, 2014, X Co. issued 1,000, 12%, 3-year bonds for Php1,103,084. Principal is due on December 31, 2016 but interests are due annually every year-end. In addition, X incurred bond issue costs of Php53,347. The effective interest rate is 8% before adjustment for bond issue costs.
Journal Entries:
Amortization Table:
In this case, the other relevant journal entries will be similar as those to the previous examples given at this topic.
We now all know how to account bonds. However, some will say that: how if the bonds were issued in-between determining issue price? Nice question! Here is an example for you to understand.
Bonds issued between interest dates – determining issue price
X Co. is contemplating on issuing a 12%, 3-year, Php1,000,000 bonds. Principal is due at maturity but interest is due annually at each year-end. X determines that the current market rate on January 1, 2014 is 10%.
1. How much is the estimated issue price of the bonds assuming X issues bonds on January 1, 2014?
2. How much is the estimated issue price of the bonds assuming X plans to issue the bonds on April 1, 2014?
Answer(s):
Bonds issued between interest dates – Accounting for pre-issuance interest
When bonds are issued in between interest dates, any accrued interest prior to the issuance date, is sold to the investor together with the bonds. By charging the investor of any accrued interest, subsequent payment of interest will be made on their regular scheduled amounts therefore simplifying recording.
Points to remember:
• Any accrued interest charged to an investor should not be included in the carrying amount of the bond but rather credited to interest expense or interest payable.
• Net interest expense recognized during the period should represent only post-issuance interest expense.
Case Example:
On April 1, 2014, Z Company issued 12%, Php1,000,000 bonds dated January 1, 2014 at 97 including accrued interest. The bonds mature in ten years and pay interest annually every year-end. Compute for the initial carrying amount of the bonds on April 1, 2014.
Answer(s):
For Interest Expense Method
For Interest Payable Method
ACCOUNTING FOR THE RETIREMENT OF BONDS
If there is accounting for the issuance of bonds, there is also accounting for the retirement of bonds. In this case, it is the end of the bond's life after several payments were settled and the contract was extinguished. Here are the terms:
Treasury bonds – are an entity’s own bonds which were originally issued but subsequently reacquired but not cancelled.
Bond refunding – refers to issuance of new bonds, the proceeds from which is used to retire existing outstanding bonds.
Bond refunding is treated as an extinguishment of the outstanding bonds. Any difference between the carrying amount of the replaced bonds and the reacquisition price is recognized in profit or loss.
Retirement of Bonds prior to maturity
• Whether prior to maturity or at maturity and whether through refunding or non-refunding, is treated as extinguishment of liability.
• The carrying amount of the bonds is updated for any discount or premium amortization up to the date of extinguishment and any difference between the updated carrying amount and the reacquisition price is recognized in profit or loss as gain or loss from extinguishment.
SUMMARY:
Bonds are a contractual right to receive cash and/or any other kinds of investment from other entity or people. In a company, it is their obligation to release bonds so as it is far more safe for investors to take than notes. Bonds are formal financial instruments, like a contract, wherein two or more sides involve agree in an undertaking with each having their own obligations. It is the firm's role in this case to receive cash from investors, earn from it, and return it again to them with fruits varying from the offer. Simplified, bonds is a very structure in a company's strategy to control obligations, and when it comes to effective control, there must be a financial accountability to check it and to regulate it for a better, effective yet trusted company with good earnings.
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