Financial Asset at Amortized Cost

PFRS 9, paragraph 4.2 financial asset shall be measured at amortized cost if both of the ff. conditions are met: a. The business model is to hold the financial asset in order to collect contractual cash flows on specified dates. b. The contractual cash flows are solely payments of principal and interest on the principal amount outstanding. The business model is to collect contractual cash flows if the contractual cash flows are solely payments of principal and interest. measured at amortized cost Examples of FA at amortized cost : investments in bonds and other debt instruments Classification of FA at amortized cost : NONCURRENT assets

Bond formal unconditional promise made under seal to pay a specified sum of money at a determinable future date, and to make periodic interest payments at a stated rate until the principal sum is paid. Contract of debt : issuer borrows bonds from another party called the investor Evidenced by a certificate; the contractual agreement between the issuer and the investor is contained in another document known as bond indenture Issued in small denomination of P100, P1000 or P10000 to enable more investors to purchase the bond issue Acquired either as a temporary or permanent investment; income in the form of interest

Classification of Bond Investments a. Trading Securities b. Financial Assets at Amortized Cost Initial Measurement Bond investments are recognized initially at fair value plus transaction costs that are directly attributable to the acquisition Fair value of the bond investment is usually the transaction price the fair value of the consideration given

Transaction costs include : fees and commission paid to agents, advisers, brokers and dealers, levies by regulatory authorities and securities exchanges, and transfer taxes and duties. Transaction costs attributable to the acquisition of trading bond investments EXPENSED immediately

Subsequent measurement 1. Trading bond investments are measured at fair value through profit or loss. When bond investment is held for trading not necessary to amortize any premium or discount 2. Bond investments are classified as financial assets measured at amortized cost using the EFFECTIVE INTEREST METHOD. Acquisition of Bond Investments a. On interest date there is no accounting problem because the purchase price is initially recognized at acquisition cost b. Between interest dates the date of acquisition is not any one of the interest dates, PP normally includes the accrued interest. * the portion of the PP representing accrued interest should not be reported as part of the cost of investment but should be accounted for separately. - In effect, two assets are acquired : bonds & accrued interest. On the date of acquisition, the accrued interest is charged either to accrued interest receivable or interest income. = when accrued interest receivable is debited, upon receipt of the first semiannual interest, the accrued interest receivable account is closed and interest income is credited for the excess. Ex. Bonds held for trading Trading securities Accrued interest receivable Cash Cash Accrued interest receivable Interest income 2,180,000 20,000 2,200,000 120,000 20,000 100,000

= when interest income is debited, the receipt of the first semiannual interest is credited entirely to interest income. Trading securities 2,180,000 Interest income 20,000 Cash 2,200,000 Cash Interest Income 120,000 120,000

Accrued interest receivable Interest Income To record adjustment for accrued interest Should preferably be reversed at the beginning of the next period in order that interest collection may be recorded normally.

*Changes in fair value of Trading securities are recognized in profit or loss. Entry to record the increase in market value: Trading securities Unrealized Gain TS Market Value CA of bonds = Unrealized gain Investment in bonds at amortized cost Classified as NONcurrent investments Acquisition of bonds, collection of interest periodically and accrual of interest at the end of the period are the same as those used for trading bond investment Instead of debiting trading securities , the debit should be investment in bonds or financial assets at amortized cost

Amortization of premium or discount PFRS 9 requires that investment in bonds shall be measured at AMORTIZED COST meaning, any premium or discount on the acquisition of long-term investment in bonds must be amortized. Bond premium or discount is amortized over the life of the bonds. On the part of the bondholder, the life of the bonds is from the date of acquisition to the date of maturity.

Amortization is done through the interest income account. a. Amortization of bond discount : Investment in bonds Interest Income (Face Value Cost = Discount) b. Amortization of bond premium : Interest Income Investment in bonds

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*Amortization may be made on interest dates or at the end of the reporting period. If amortization is made on every interest date, it would still be necessary to record amortization at the end of the reporting period should there be accrued interest. It is more convenient to record amortization at the end of the reporting period.

Philosophy on amortization Reason for amortization of bond premium or discount to bring the investment balance to face value on the date of maturity so that when the bonds are redeemed on the date of maturity, the entry will simply be a debit to cash and a credit to investment in bonds at face value. The bondholder is a creditor and will collect on that date of maturity an amount equal only to the face value of the bonds no more and no less. Bond premium LOSS on the part of the bondholder because the bondholder paid more than what can be collected on the date of maturity. Such loss is not recognized outright but allocated over the life of the bonds to be offset against the interest income to be derived from the bond investment. Bond discount GAIN on the part of the bondholder because the bondholder paid less than what can be collected on the date of maturity. Such gain is not recognized outright but allocated over the life of the bonds to be added to the interest income derived from the bond investment. AMORTIZATION process of allocating the bond premium as deduction from the interest income and the bond discount as addition to interest income Acquisition on interest date no accrued interest is involved Redemption of bonds entry:

Cash Investment in bonds

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*When bonds are acquired between interest dates, it is more convenient to compute monthly amortization rather than an annual amortization. Sale of bonds prior to maturity It is necessary to determine the book value or carrying amount of the bonds to be used as basis in computing gain or loss on sale In such a case, amortization of premium or discount, if any, should be recognized up to the date of sale. If the sale is between interest dates, the sales price normally includes the accrued interest. That portion of the sales price pertaining to the accrued interest should be credited to interest income. The difference between the sales price, after deducting the accrued interest, and the carrying amount of the bond investment represents the gain or loss on the sale of investment.

Sales price + accrued interest = total cash received Original cost amortization = carrying amount of bonds CA of bonds sales price = gain on sale To record the sale of bonds : Cash Investment in bonds Interest Income Gain on sale of bond investment

Callable Bonds Those which may be called in or redeemed by the issuing entity prior to their date of maturity Usually, the call price or redemption price is at a premium or more than the face value of the bonds The difference between the redemption price and the CA of the bonds on the date of redemption is recognized in profit or loss

Convertible Bonds

Those which give the bondholders the right to exchange their bonds for share capital of the issuing entity at any time prior to maturity Involve an embedded derivative the equity conversion option The existence of the conversion feature generally precludes classification of the convertible bonds as financial assets at amortized cost because that would be inconsistent with paying for the conversion feature, meaning the right to convert into equity shares before maturity Investment in convertible bonds can be classified as financial assets measured at fair value.

Serial Bonds those which have a series of maturity dates or those bonds which are payable in installments *Term bonds bonds with a single maturity date

Methods of amortization a. Straight line method provides for an equal amount of premium or discount amortization each accounting period b. Bond outstanding method applicable to serial bonds, whether acquired at a premium or discount c. Effective interest method interest method or scientific method PFRS 9, bond investments shall be classified as financial assets measured at amortized cost using the effective interest method. This means that any discount or premium must be amortized using the effective interest method. (a) & (b) are acceptable only when the computation will result in periodic interest income that is not materially different from the amount that would be computed using the effective interest method. Effective interest method Kinds of Rate of Interest: a. Nominal or coupon rate or stated rate rate of interest appearing on the face of the bonds. Nominal rate X face value of the bonds = periodic interest received by the bondholder b. Effective or yield rate or market rate true or actual rate of interest which bondholder earns on the investment. CA of the bond investment X effective rate = actual interest income

CA of the bonds initial cost gradually increased by periodic amortization of discount or gradually reduced by periodic amortization of premium The effective rate and the nominal rate are the same if the cost of the bond investment is equal to the face value. Nominal rate > Effective rate bonds are acquired at a premium. Reason: the premium is a loss on the part of the bondholder Effective rate > Nominal rate bonds are acquired at a discount. Reason: the discount is a gain on the part of the bondholder Interest earned or interest income interest received = premium or discount amortization Interest earned or interest income = effective rate X carrying amount of bond investment Interest received = nominal rate X face value of the bonds Date | Interest received | Interest income | Discount/Premium Amortization | Carrying amount In effective interest method, amortization is done on every interest date rather than at the end of the reporting period. Effective interest method serial bonds : interest received = outstanding face value times nominal rate Computation of effective rate Determined by means of trial and error or the so called interpolation process The theory is to find an effective rate that would equate the acquisition cost and the present value of the future cash flows from the bonds.

PV of principal + PV of future interest payments = total present value of cash flows Differential between 11% and 12% (x-11%)/(12%-11%) The present values applicable to the rates are substituted to the corresponding percentages and the differential that we can get is added to 11% Purchase price or market price of bonds The procedures for the computation of the purchase price of bonds are:

1. Using the effective rate, find the present value of an ordinary annuity of 1 for the number of interest periods involved. 2. Multiply the nominal rate by the face value of the bonds for one interest period. Also multiply the effective rate by the face value for one interest period. Get the difference between the two products. 3. The difference computed in No. 2 is multiplied by the present value factor determined in No. 1. The answer represents either a discount or premium. *If the effective rate is more than the nominal rate, the answer in No. 3 is a discount. If the effective rate is less than the nominal rate, the answer in No. 3 is a premium. The face value of the bonds plus premium or minus discount equals the purchase price of the bond. Another approach The market price of bonds is equal to the present value of the principal plus the present value of future interest payments using the effective rate. PV factors needed : PV of an ordinary annuity & PV of 1 Total market price = PV of principal + PV of future interest payments Market price of serial bonds The market price of the bonds is equal to the present value of the principal plus the present value of future interest payments using the effective rate. The simple approach is to compute the present value of the cash flows from the bonds. Principal due + interest received = total cash flows The purchase price or market price of the serial bonds is computed by multiplying the total cash flows every December 31 by the relevant present value factor.