COLLEGE OF BUSINESS AND ACCOUNTANCY

Topic: Bonds Payable

Learning Outcomes:
1. Accounting for bond refunding
2. Accounting for serial, zero-coupon bonds, redeemable preference shares etc.
3. Accounting for compound financial instruments.

Core Value/Biblical Principles:

Proverbs 3:5
Trust in the LORD with all your heart; and lean not to your own understanding.

Learning Activities and Resources:

Investors buy bonds because:
• They provide a predictable income stream. Typically, bonds pay interest twice a year.
• If the bonds are held to maturity, bondholders get back the entire principal, so bonds are a way to
preserve capital while investing.
• Bonds can help offset exposure to more volatile stock holdings.

Companies, governments, and municipalities issue bonds to get money for various things, which may include:
• Providing operating cash flow
• Financing debt
• Funding capital investments in schools, highways, hospitals, and other projects

Introduction:
One source of financing available is issuance of long‐term bonds. Bonds represent an obligation to repay a
principal amount at a future date and pay interest, usually on a semi‐annual basis. Unlike notes payable, which
normally represent an amount owed to one lender, a large number of bonds are normally issued at the same
time to different lenders. These lenders, also known as investors, may sell their bonds to another investor prior
to their maturity.

Body:

BONDS REFUNDING

Bond refunding refers to the issuance of new bonds (normally with lower interest rate), the proceeds
from which is used to retire existing outstanding bonds.
Bond refunding is treated as an extinguishment of the outstanding bonds.

Retirement of Bonds Prior to Maturity

Retirement of bonds, 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.

ILLUSTRATION 1: Retirement of bonds - Bond refunding

On January 1, 20x1, ABC Co. issued new bonds with face amount of P10M for P10,800,000 and used the
proceeds to retire outstanding bonds with face amount of P8,000,000 and unamortized discount of P340,000.
ABC Co. paid a call premium of P400,000 and incurred P50,000 direct costs on the retirement. ABC Co.'s income
tax rate is 30%:

Requirement: Compute for the gain or loss on the retirement.

Carrying amount of bonds retired:
Face amount of bonds retired 8,000,000
Unamortized discount, Jan. 1, 20x1 340,000 7,660,000

Retirement price (Call price):

Face amount of bonds retired 8,000,000
Call premium 400,000
Expense of reacquisition 50,000 8,450,000
LOSS ON EXTINGUISHMENT OF BONDS (790,000)

There is loss because the settlement amount is more than the carrying amount of the liability.
The loss is gross of tax. Netting of tax is normally permitted only for results of discontinued operations, items
of other comprehensive income, and retrospective adjustments to the beginning balance of retained earnings.

The issuance of the new bonds is recorded as follows:

Jan. 1, 20x1 Cash 10,800,000
Bonds payable – new 10,000,000
Premium on bonds payable – new 800,000

The retirement of the old bonds is recorded as follows:

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

ILLUSTRATION 2: Retirement - between interest payment dates

On January 1, 20?1, ABC Co. issued 5-year, 12%, P1,000,000 bonds for P1,075,816. Principal is due at maturity,
but interest is due annually. The effective interest rate is 10%.

On July 1, 20x3, ABC retired the bonds at 102, including payment for accrued interest.

Requirement: Compute for the gain or loss on the retirement.

Date Interest Payments Interest Expense Amortization Present value

01/01/x1 1,075,816
12/31/x1 120,000 107,582 12,418 1,063,398
12/31/x2 120,000 106,340 13,660 1,049,737
07/01/x3 60,000 52,487 7,513 1,042,224

The gain or loss is computed as follows:

Carrying amount of bonds retired 1,042,224

Retirement price including accrued interest 1,020,000

Less: Accrued Interest -60,000 960,000
GAIN ON EXTINGUISHMENT OF BONDS 82,224

07/01/20x3 Interest expense 52,487

Premium on bonds payable 7,513
Interest Payable 60,000

07/01/20x3 Bonds payable 1,000,000

Premium on bonds payable 42,225
Interest payable 60,000
Cash 1,020,000
Gain on extinguishment of bonds 82,225
ILLUSTRATION 3: Retirement of bonds prior to maturity (page 157)

On January 1, 20x1, an entity issues bonds with face amount of P5,000,000 for P5,773,129. The bonds mature
on December 31, 20x3 and pay annual interest of 14%. The effective interest rate is 8%. On December 31, 20x2,
after paying the annual interest, the entity retires the bonds at a call premium of P400,000.

Requirement: Journal entry for the gain or loss on the retirement.

12/31/x2 Bonds payable 5,000,000

Premium on bonds payable 277,777
Loss on derecognition 122,223
Cash (5M + 400,000) 5,400,000

Date Interest paid Interest expense Amortization Present value

1/1/x1 5,773,129
12/31/x1 700,000 461,850 238,150 5,534,979
12/31/x2 700,000 442,798 257,202 5,277,777

Carrying amount of bonds retired: 5,277,777

Retirement price (Call price):

Face amount of bonds retired 5,000,000
Call premium 400,000 5,400,000
LOSS ON EXTINGUISHMENT OF BONDS (122,223)

SERIAL BONDS
Serial bonds are bonds that mature in installments. The installment payments consist of payments for
both interest and principal.

ILLUSTRATION 4: Serial bonds

On January 1, 20x1, ABC Co. issued 10%, P3,000,000 bonds for P2,900,305. The principal matures in three equal
annual installments, payable at each year-end, plus interest on the outstanding principal balance. The effective
interest rate is 12%.

Initial Measurement
01/01/20x1 Cash 2,900,305
Discount on bonds payable 99,695
Bonds payable 3,000,000

Interest on
Principal Future Cash PV @ 12%,
Date Outstanding Present value
payments Principal Balance Flows n=3
12/31/x1 1,000,000 3,000,000 x 10% 1,300,000 0.892857143 1,160,714
12/31/x2 1,000,000 2,000,000 x 10% 1,200,000 0.797193878 956,633
12/31/x3 1,000,000 1,000,000 x 10% 1,100,000 0.711780248 782,958
2,900,305

Subsequent Measurement
Date Total Payments Interest Expense Amortization Present value
01/01/x1 2,900,305
12/31/x1 1,300,000 348,037 951,963 1,948,342
12/31/x2 1,200,000 233,801 966,199 982,143
12/31/x3 1,100,000 117,857 982,143 0
 12/31/20x1 Interest expense 348,037
Bonds payable 1,000,000
Cash 1,300,000
Discount on bonds payable 48,037

12/31/20x2 Interest expense 233,801

Bonds payable 1,000,000
Cash 1,200,000
Discount on bonds payable 33,801

12/31/20x3 Interest expense 117,857

Bonds payable 1,000,000
Cash 1,100,000
Discount on bonds payable 17,857

ZERO-COUPON BONDS
Zero-coupon bonds are bonds that do not pay periodic interests. Both the principal and compounded
interests are due only at maturity date.

ILLUSTRATION 5: Zero-coupon bonds

On January 1, 20x1, ABC Co. issued 10%, P3,000,000 bonds at a yield to maturity interest of 18%. Principal and
interest are due on December 31, 20x3.

01/01/20x1 Cash 2,430,263

Discount on bonds payable 569,737
Bonds payable 3,000,000

Initial Measurement:
Face amount 3,000,000 Future Cash Flows 3,993,000
FV of OA P1@10%, n=3 1.331 PV of P1@18%, n=3 0.6086309
Maturity Value of Bonds (FCF) 3,993,000 Present Value (Issue Price) 2,430,263

Subsequent Measurement:
Date Interest Expense PV of Cash Flows Interest Payable Amortization Present value
(a) = EIR x (b) (b) = Prev. Bal. + (a) (c) = NR x Outs Prin (d) = (a) - (c) (e) = Prev Bal + (d)

01/01/x1 2,430,263 2,430,263

12/31/x1 437,447 2,867,710 300,000 137,447 2,567,710
12/31/x2 516,188 3,383,898 330,000 186,188 2,753,898
12/31/x3 609,102 3,993,000 363,000 246,102 3,000,000

12/31/20x1 Interest expense 437,447

Discount on Bonds Payable 137,447
Interest Payable 300,000

12/31/20x2 Interest expense 516,188

Discount on Bonds Payable 186,188
Interest Payable 330,000

12/31/20x3 Interest expense 609,102

Discount on Bonds Payable 246,102
Interest Payable 363,000

Bonds Payable 3,000,000

Interest Payable 993,000
Cash 3,993,000
CALLABLE BONDS
Callable bonds are bonds that the issuer can redeem prior to maturity date. When measuring callable
bonds at amortized cost, the issuer should estimate its expected holding period (which may be shorter than the
original maturity date) and amortize any discount or premium over that period. Subsequent changes are
treated as changes in accounting estimates and are accounted for prospectively.

PUTTABLE INSTRUMENT
A puttable instrument is one which the holder has the right to return (put back) to the issuer in
exchange for cash or another financial asset or is automatically put back to the issuer upon the occurrence of a
specified future event, e.g., death of the holder.
A puttable instrument includes a contractual obligation of the issuer to redeem or repurchase the
instrument. Accordingly, it is classified as a financial liability except when the instrument also represents a
residual interest in the net assets of the issuing entity, in which case the instrument is classified as an equity
instrument.

Examples of puttable financial liabilities

a. Extendible and retractable bonds
b. Preference shares with mandatory redemption (Redeemable preference shares)

ILLUSTRATION 6: Redeemable preference shares

On January 1, 20x1, ABC Co. issued 6% redeemable preference shares with an aggregate par value of
P1,000,000 for P880,000. ABC Co. incurred transaction costs of P17,391. The shareholders can present the
shares for redemption at any time beginning January 1, 20x3. Based on ABC Co.'s past experience, shares are
usually redeemed after 5 years. The effective interest rate is 3%.

Initial measurement:
01/01/20x1 Cash (880,000 – 17,391) 862,609
Discount on RPS 137,391
Redeemable preference shares 1,000,000

The redeemable preference shares are presented in the financial statements, under liabilities as follows:
Redeemable preference shares (RPS) 1,000,000
Discount on Redeemable preference shares (137,391)
Carrying amount – 01/01/20x1 862,609

Subsequent Measurement:
Date Interest Expense Amortization Present value
01/01/x1 137,391 862,609
12/31/x1 25,878 111,513 888,487
12/31/x2 26,655 84,858 915,142
12/31/x3 27,454 57,404 942,596
12/31/x4 28,278 29,126 970,874
12/31/x5 29,126 0 1,000,000

The entry on December 31, 20x1 to record the amortization is:

12/31/20x1 Interest expense 25,878
Discount on RPS 25,878

ABC Co. declares dividends on March 31, 20x2.

03/31/20x2 Interest Expense (1M x 6%) 60,000
Cash 60,000
Scenario 1: ABC Co. redeems the preference shares on December 31, 20x5 at a premium of P100,000.
12/31/20x5 Redeemable preference share 1,000,000
Loss on redemption of preference sh. 100,000
Cash 1,100,000

Scenario 2: ABC Co. redeems the preference shares on December 31, 20x3 at a premium of P100,000.
12/31/20x3 Redeemable preference share 1,000,000
Loss on redemption of preference sh. 157,404
Discount on RPS 57,404
Cash 1,100,000

Extendible and Retractable bonds are accounted for similar to redeemable preference shares.

COMPOUND FINANCIAL INSTRUMENTS

A compound financial instrument is a financial instrument that, from the issuer's perspective, contains
both a liability and an equity component. These components are classified and accounted for separately.
An example of a compound instrument is convertible bonds. Convertible bonds are bonds that can be
converted into shares of stocks of the issuer. When an entity issues convertible bonds, in effect, it is issuing two
instruments - (1) a debt instrument for the bonds payable and (2) an equity instrument for the equity
conversion feature. These two components are' presented
separately in the statement of financial position.

Accounting for compound financial instruments

Issue Price of compound instrument xx
Less: Fair value of debt instrument without equity feature (xx)
Equity Component xx

The sum of the carrying amounts allocated to the liability and equity components is always equal to
the fair value of the whole instrument. No gain or loss is recognized on the initial recognition of the
components.
The separate classifications of the components are not revised for subsequent changes in the likelihood
that the conversion option will be exercised.

ILLUSTRATION 7: Issuance of convertible bonds

On January 1, 20x1, ABC Co. issued 10%, 3-year, P1,000,000 convertible bonds at face amount. Each P1,000
bond is convertible into 8 shares with par value of P100 per share. On issuance date, the bonds were selling at
98 without the conversion option. ABC Co. incurred P50,000 transaction costs on the issuance.

Initial measurement:
The issue price is allocated to the liability and equity components as follows:
Issue price 1,000,000
Fair value of debt instrument without equity feature (1M x 98%) (980,000)
Equity component 20,000

The transaction costs are also allocated to the liability and equity components in proportion to the
allocated issue price.

Allocated amount from Allocation of

Component Fraction
issue price transaction costs
Debt component 980,000 980/1,000 49,000
Equity component 20,000 20/1,000 1,000
1,000,000 1,000/1,000 50,000
 The carrying amounts of the liability and equity components are as follows:
Debt Component Equity Component Totals
Allocation of issue price 980,000 20,000 1,000,000
Allocation of transaction costs (49,000) (1,000) (50,000)
931,000 19,000 950,000

01/01/20x1 Cash 1,000,000

Discount on bonds payable 20,000
Bonds payable 1,000,000
Share premium – conversion feature 20,000

Discount on bonds payable 49,000

Share premium – conversion feature 1,000
Cash 50,000

ILLUSTRATION 8: Conversion of convertible bonds

On January 1, 20x1, ABCCo. issued 10%, 3-year, P1,000,000 convertible bonds at 105. Each P1,000 bond is
convertible into 8 shares with par value of P100 per share. Principal is due at maturity, but interest is due
annually at each year-end. On issuance date, the bonds were selling at a yield to maturity market rate of 12%
without the conversion option.

On December 31, 20x2, ABC Co. converted all of the bonds, incurring stock issuance costs of P20,000.

Initial measurement:
The fair value of the bonds without the conversion option is computed as follows:
Future Cash Flows PV @ 12%, n=3 PV Factors Present value
Principal 1,000,000 PV of P1 0.711780 711,780
Interest 100,000 PVOA of P1 2.401831 240,183
Fair value of Debt instrument without conversion feature 951,963

The equity component is computed as follows:

Issue price 1,050,000
Fair value of debt instrument without equity feature (1M x 98%) (951,963)
Equity component 98,037

01/01/20x1 Cash 1,050,000

Discount on Bonds payable 48,037
Bonds payable 1,000,000
Share premium – conversion feature 98,037

Subsequent measurement:
Date Interest Payments Interest Expense Amortization Present value
01/01/x1 951,963
12/31/x1 100,000 114,236 14,236 966,199
12/31/x2 100,000 115,944 15,944 982,143
12/31/x3 100,000 117,857 17,857 1,000,000

The other pertinent entries prior to conversion:

12/31/20x1 Interest expense 114,236
Discount on bonds payable 14,236
Cash 100,000
 12/31/20x2 Interest expense 115,944
Discount on bonds payable 15,944
Cash 100,000

The entries on to record the conversion are as follows:

12/31/20x2 Bonds payable 1,000,000
Discount on bonds payable 17,857
Share capital 800,000
Share premium 182,143

Share premium 20,000

Cash 20,000

Share premium – conversion feature 98,037

Share premium 98,037

Life Application:
The type of bonds that might be right for you depend on several factors, including your risk tolerance, income
requirements and tax situation.
A good bond allocation might include each type -- corporate, federal, and municipal bonds -- which will help
diversify the portfolio and reduce principal risk. Investors can also stagger the maturities to reduce interest-
rate risk.
Diversifying a bond portfolio can be difficult because bonds typically are sold in 1,000 increments, so it can take
a lot of cash to build a diversified portfolio.
Instead, it’s much easier to buy bond exchange-traded fund (ETF). These funds can provide diversified
exposure to the bond types you want, and you can mix and match bond ETFs even if you can’t invest a large
amount at once.

Summary:
• Bonds are units of corporate debt issued by companies and securitized as tradeable assets.
• Bond prices are inversely correlated with interest rates: when rates go up, bond prices fall and vice-
versa.
• Bonds have maturity dates at which point the principal amount must be paid back in full or risk default.

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References: INTERMEDIATE ACCTG 2 [by: Millan, Zeus Vernon B. (2021)]
https://www.cliffsnotes.com/study-guides/accounting/accounting-principles-ii/long-term-liabilities/bonds-
payable
https://www.nerdwallet.com/article/investing/how-to-buy-bonds
https://www.investopedia.com/terms/b/bond.asp