BONDS PAYABLE
Fair Value option
Technical
Knowledge
o
To understand the nature and purpose of a bond
o
To identify the types of bond
o
To know the measure of bonds payable
o
To understand the concept of bond premium and bond discount
o
To describe the methods of amortizing bond premium and bond
discount
o
To apply the fair value option of measuring bond payable
Definition of Bond
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 amount is
paid.
Bonds are used primarily by corporations and government units.
A bond is evidenced by a certificate and the contractual agreement
between the issuer and investor is contained in a document known as
bond indenture.
Term and serial bonds
Term bonds are bonds with a single date of maturity.
Term bonds may require the issuing entity to establish a sinking fund to
provide adequate money to retire the bond issue at one time.
Serial bonds are bonds with a series of maturity dates instead of a single
one.
In other words, serial bonds allow the issuing entity to retire the bonds by
installments.
Secured and unsecured
bonds
o
Mortgage bonds are bond secured by a mortgage on real properties.
o
Collateral trust bonds are bonds secured by shares and bonds of
other corporation.
o
Debenture bonds are unsecured or bonds without collateral security
Registered and bearer
bonds
o
Registered bonds require the registration of the name of the
bondholders on the books of the corporation.
o
Coupon or bearer bonds are unregistered bonds in the sense that the
name of the bondholder is not recorded on the entity books.
Other types of bonds
o Convertible bonds are bonds that can be exchanged for shares of the
issuing entity.
o Callable bonds are bonds which may be called in for redemption prior
to the maturity date.
o Guaranteed bonds are bonds issued whereby another party promises
to make payment if the borrower fails to do so.
o Junk bonds are high-risk, high-yield bonds issued by entities that are
heavily indebted or otherwise in weak financial condition.
o Zero-coupon bonds are bonds that pay no interest but the bonds offer
a return in the form of a “deep discount” or huge discount from the
face amount
Features of bond issue
a.
A bond indenture or deed of trust is the document which shows in detail the terms
of the loan and the rights and duties of the borrower and other parties to the
contract.
b.
Bond certificates are used. Each bond certificate represents a portion of the total
loan. The usual minimum denomination in business practice is P1,000, although
smaller denomination may be used occasionally.
c.
If property is pledged as security for the loan, a trustee is named to hold title to the
property serving as security. The trustee acts as the representative of the
bondholders and is usually a bank or trust entity.
d.
A bank or trust entity is usually appointed as registrar or disturbing agent. The
borrower deposits interest and principal payments with the disturbing agent, who
Bond Indenture
The bond indenture is the contract between the bondholders
and the borrower or issuing entity.
Contents of bond indenture
a.
Characteristics of the bonds
b.
Maturity date and provisions for repayment
c.
Period of grace allowed to issuing entity
d.
Establishment of a sinking fund and the periodic deposit therein
e.
Deposit to cover interest payment
f.
Provisions affecting mortgaged property, such as taxes, insurance coverage,
collection of interest or dividends on collaterals
g.
Access to corporate books and records of trustee
h.
Certification of bonds by trustee
i.
Required debt to equity ratio
j.
Minimum working capital to be maintained, if any
Sale or issuance of bonds payable
The bonds needed for the issuance of bonds are usually too large for one
buyer to pay. Thus, very often, the bonds are divided into various
denominations of say P100, P1,000, P10,000, thus enabling more than
one buyer or investor to purchase the bonds.
Quite often, however, instead of selling bonds of various denominations,
the bonds are sold in equal denomination of say P1,000 only. The P1,000
denomination is called the face amount of the bonds. Each bond is
evidenced by a certificate called a bond certificate.
Thus, if a bond with face amount of P50,000,000 are sold, divided into
P1,000 denomination, there shall be 50,000 bond certificates containing a
face amount of P1,000.
The sale of the bonds may be undertaken by the entity itself. Normally
however, the issuing entity does not attempt to sell the bond directly to the
public.
Instead, the entire bond issue is sold to an underwriter or investment
bank that assumes responsibility for reselling the bonds to investors.
Sometimes, the underwriter merely undertakes to sell the bonds on the
basis of a commission to be deducted from the proceed of sale.
When an entity sells a bond issue, it undertakes to pay the face amount of
the bond issue on maturity date and the periodic interest.
Interest is usually payable semiannually or every six
months.
a.
b.
c.
d.
e.
f.
January 1 and July 1
February 1 and August 1
March 1 and September 1
April 1 and October 1
May 1 and November 1
June 1 and December 1
Of course, there are certain bonds that pay interest annually or at the end
of every bond year.
PFRS 9, paragraph 5.1.1, provides that bonds payable not designated at fair value
through profit or loss shall be measured initially at fair value minus transaction costs
that are directly attributable to the issue of the bonds payable.
The fair value of the bonds payable is equal to the present value of the future cash
payments to settle the bond liability.
Bonds issue costs shall be deducted from fair value or issue price of the bonds
payable in measuring initially the bonds payable.
However, if the bonds are designated and accounted for at fair value through profit or
loss, the bond issue costs are treated as expense immediately.
Actually, the fair value of the bonds payable is the same as the issue price or net
proceeds from the issue of the bonds, excluding accrued interest.
PFRS 9, paragraph 5.3.1, provides that after initial recognition,
bonds payable shall be measured either:
a. At amortized cost, using the effective interest method
b. At fair value through profit or loss
The amortized cost of bonds payable is the amount at which the bond
liability is measured initially minus principal repayment, plus or minus
the cumulative amortization using the effective interest method of any
difference between the face amount and present value of the bonds
payable.
Actually, the difference between the face amount and present value is
either discount or premium on bonds payable.
There are two approaches in accounting for the authorization
and issuance of bonds namely:
a. Memorandum approach
b. Journal entry approach
If the issue price is more than the face amount of the bonds payable, the bonds
are said to be sold at a premium.
For example, an entity issued bonds payable with face amount of P5,000,000 at
105. the quoted price of 105 means “105% of the face amount of the bonds”.
Thus, the issue price is P5,250,000, computed by multiplying 105% by
P5,000,000.
The premium on bonds payable is I effect a gain on the part of the
issuing entity because it receives more that what it is obligated to pay
under the terms of the bond issue.
The obligation of the issuing entity is limited only to the face amount
of the bonds payable.
The premium on the bonds payable however is not reported as an
outright gain. When the bonds are sold at a premium, it means that the
investor or buyer is amenable to receive interest that is somewhat less
than the nominal or stated rate of interest.
Thus in such a case, the effective rate is less than the nominal rate of
interest.
The nominal rate of interest is the rate of appearing on the face of the
bond certificate. It is that interest which the issuing entity periodicaly
pays to the buyer or bondholder.
Because of the relationship of the premium to the interest, the
premium on bonds payable is amortized over the life of the bonds
payable and credited to interest expense.
If the issue price of the bonds payable is less than the face amount, the bonds are
said to be sold at a discount.
For example, an entity issued bonds payable with face amount of P5,000,000 at
95.
The discount on bonds payable is in effect a loss to the issuing entity.
However, the discount on bonds payable is not treated as an outright loss.
When bonds are sold at a discount, it means that the buyer or investor is not
wiling to accept simply the nominal rate of interest.
The buyer wants to accept a rate of interest that is somewhat higher than the
nominal rate.
Accounting wise, the discount on bonds payable is amortized as loss over the
life of the bonds payable and charged to interest expense.
Discount on bond payable and premium on bond payable are reported as
adjustments to the bond liability account.
The discount on bond payable is a deduction from the bond payable and the
premium on bond payable is an addition to the bond payable.
This treatment is on the theory that the discount represents an amount that the
issuer cannot borrow because of interest differences, and the premium
represents an amount in excess of face amount that the issuer is able to borrow.
The discount on bonds payable and the premium on bonds payable shall not be
considered separate from the bonds payable account. Both accounts shall be
treated consistently as valuation accounts of the bond liability.
Bond issue costs
Bond issue costs are transaction costs directly attributable to the issue of bonds
payable.
Such costs include printing and engraving cost, legal and accounting fee,
registration fee with regulatory authorities, commission paid to agents and
underwriters and other similar charges.
Under PFRS 9, bond issue cost shall be deducted from the fair value or issue
price of bond payable in measuring initially the bonds payable.
Under the effective interest method of amortization, the bond issue cost must be
“lumped” with the discount of bonds payable and “netted” against the premium
on bonds payable.
However, if the bonds are measured at fair value through profit or loss, the bond
issue costs are expensed immediately.
Recording interest on bonds
payable
Accounting for interest expense on bonds payable requires recognition
of two items, namely:
a. Payment of interest during the year
b. Accrual of interest at the end of the year
Issuance of bonds payable on
interest date
On June 1, 2021, an entity issued bonds payable with face amount
of P5,000,000 at 97.
The bonds mature in 5 years and pay 12% interest semiannually
on June 1 and December 1.
The straight line method is used for simplicity in amortizing
discount on bonds payable.
The amortization of the discount on bonds payable or premium on
bonds payable may be on every interest date or at the end of
every year.
In the given example, the amortization is made at the end of the
year.
If a statement of financial position is prepared on December 31, 2022,
the accrued interest payable of P50,000 is classified as current
liability.
Note that if the bonds are issued between interest dates, an accrued interest is
involved.
Normally, when bonds are issued between interest dates, the accrued interest is
paid by the buyer or investor.
Treasury Bonds
Treasury bonds are an entity’s own bonds originally issued and reacquired but
not canceled. The acquisition of treasury bonds calls for the same accounting
procedures accorded to a formal retirement of bonds prior to the maturity date.
In other words, the treasury bonds should be debited at face amount and any
related unamortized premium or discount on bonds payable should be canceled.
Any accrued interest paid is charged to interest expense.
The difference between the acquisition cost and the carrying amount of the
treasury bonds is trested as gain or loss on the acquisition of treasury bonds.
Amortization of bond discount or
premium
There are three approaches in amortizing premium or discount on bonds
payable, namely:
a. Straight line
b. Bond outstanding method
c. Effective interest method or simply “interest method” or scientific
method
PFRS 9 requires the use of the effective interest method in amortizing
bond discount, bond premium and bond issue cost/\.
Straight line method
The straight line method provides an equal amortization of premium or discount
on bonds payable.
The procedure is simply to divide the amount of premium or discount on bonds
payable by the life of the bonds to arrive at the periodic amortization.
The life of the bonds is that period commencing on the date of sale of the bonds
up to the maturity date.
Bonds outstanding
method
The bonds outstanding method is applicable to serial bonds whether issued at
discount or premium.
Serial bonds are those with a series of maturity dates.
For example, bonds with face amount of P5,000,000 are issued and mature at
the rate of P1,000,000 every year for 5 years.
As the name implies, the bond outstanding amortization approach gives
recognition to the diminishing balance of the bonds payable.
It is based on the theory that interest expense shall decrease every year by
reason of the deceasing principal bond liability.
Premature retirement of serial
bonds
When serial bonds are paid on the regular maturity dates, no accounting
problem arises because no unamortized discount or premium is related to such
serial bonds retired.
The problem occurs when the serial bonds are retired prior to their scheduled
maturity dates.
In this case, the retirement calls for the cancelation of any unamortized discount
or premium on bonds payable related to the serial bonds retired.
The question is how much unamortized premium or discount on bonds payable
is applicable to the serial bonds retired prior to their maturity dates?
Fair value option of measuring bonds
payable
PFRS 9, paragraph 4.2.2 provides that at initial recognition, bonds payable may
be irrevocably designated as at fair value through profit or loss.
In other words, under the fair value option, the bonds payable shall be measured
initially at fair value and remeasured at every year-end with any changes in fair
value generally recognized in profit or loss.
There is no more amortization of bond discount and bond premium. Any
transaction cost or bonds issue cost should be expensed immediately.
As a matter of fact, interest expense is recognized using the nominal or stated
rate.
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