Big Picture C

Week 6-7 (Unit 3): Unit Learning Outcomes (ULO): At the end of the unit, you
are expected to:
a. Demonstrate the procedures in accounting for compound financial
instruments.
b. Demonstrate the procedures in accounting for note payable.
c. Demonstrate the procedures in accounting for debt restructuring.

d.
e.Big Picture in Focus: ULOa. Demonstrate procedures in
accounting for compound financial instruments.

Metalanguage
In this section, the most essential terms relevant to the study of curriculum and to
demonstrate ULOa will be operationally defined to establish a common frame of
refence as to how the texts work in your chosen field or career. You will encounter
these terms as we go through the intermediate accounting. Please refer to these
definitions in case you will encounter difficulty in the understanding educational
concepts.
Please proceed immediately to the “Essential Knowledge” part since this is the first
time you will encounter the nature of this lesson.

Essential Knowledge

FINANCIAL INSTRUMENT

PAS 32, paragraph 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. Thus, the term financial instrument encompasses a financial asset, a
financial liability and an equity instrument.

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.

Examples of financial instrument

a. Cash in the form of notes and coins - This is a financial asset of the holder or
bearer and a financial liability of the issuing government.
b. Cash in the form of checks - This is a financial asset of the payee and a financial
liability of the drawer or issuer.
 c. Cash in bank - This is a financial asset of the depositor and a financial liability
of the depository bank.
d. Trade accounts - This is a financial asset of the seller as accounts receivable
and a financial liability of the customer or buyer as accounts payable.
e. Notes and loans - This a financial asset of the lender or Creditor as notes
receivable or loans receivable and a financial liability of the borrower or debtor
as notes payable or loans payable.
f. Debt securities - This is a financial asset of the investor and a financial liability
of the issuer
g. Equity securities - This is a financial asset of the investor and an equity of the
issuer.

Financial liability

A financial liability is any liability that is a contractual obligation:

a. To deliver cash or other financial asset to another entity
b. To exchange financial instruments with another entity under conditions that
are potentially unfavorable.

Examples of financial liabilities

a. Trade accounts payable
b. Notes payable
c. Loans payable
d. Bonds payable

Nonfinancial liabilities
a. Deferred revenue and warranty obligations are not financial liabilities because
the outflow of economic benefits 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 imposed by law and
noncontractual.
c. Constructive obligations are not financial liabilities because the obligations do
not arise from contracts.

Equity instrument

The definition of an equity instrument is very brief and succinct. It reflects the basic
accounting equation that equity equals asset minus liability. 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 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 as follows:
a. Bonds payable issued with share warrants
b. Convertible bonds payable

Accounting for compound instrument

The issuer of a financial instrument shall evaluate the terms of the instrument whether
it contains both a liability and an equity component. 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 to apply "split

accounting". This means that the consideration received from the issuance of the
compound financial instrument shall be allocated between the liability and equity
components. In other words, the fair value of the liability component is first determined.

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 a bond may be detachable or nondetachable.

Detachable warrants can be traded separately from the bond and nondetachable
warrants cannot be traded separately. PAS 32 does not differentiate whether the
equity component is detachable or nondetachable. Whether detachable or
nondetachable, the warrants have a value and therefore shall be accounted for
separately.

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 warrants. The residual amount or
remainder of the issue price shall then be allocated to the warrants. This 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, face amount P1,000 per bond, at 105. Each
bond is accompanied by one warrant that permits the bondholder to purchase 20
equity shares, par P50, at P55 per share, or a total of 100,000 shares, 5,000 x 20. The
market value of the bond ex-warrant at the time of issuance is 98.
1. To record the issuance of the bonds:

Cash (5,000,000 x 105) 5,250,000

Discount on bonds payable 100,000
Bonds payable 5,000,000
Share warrants outstanding 350,000

Issue price of bonds with warrants 5,250,000

Market value of bonds ex-warrants (5,000,000 x 98) (4,900,000)
Residual amount allocated to warrants 350,000

2. To record the exercise of 60% of the warrants:

Cash (60,000 shares x 55) 3,300,000

Share warrants outstanding (60% x 350,000) 210,000
Share capital (60,000 shares x 50) 3,000,000
Share premium 510,000

3. To record the expiration of the remaining warrants:

Share warrants outstanding 140,000

Share premium -unexercised warrants 140,000

Market value of bonds ex-warrants unknown

In the preceding illustration, the market value of the bonds ex-warrants of 98 is

available. Suppose such market value is not known. In such a case, the amount
allocated to the bonds 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 without the warrants.

Using the preceding illustration, assume the interest is payable annually at a nominal
rate of 10% per annum. When the bonds are issued, the prevailing market rate of
interest for similar bonds without warrants is 12% per annum. The present value of 1
at 12% for 10 periods is 0.322 and the present value of an ordinary annuity of 1 at
12% for 10 periods

The present value of the bonds payable is computed as follows:

Present value of principal (5,000,000 x 0.322) 1,610,000

Present value of interest payments (10% x 5,000,000 = 500,000x 5.65) 2,825,000
Total present value 4,435,000

Issue price of bonds with warrants 5,250,000

Present value of bonds payable (4,435,000)
Residual amount allocated to warrants 815,000
Journal entry to record the issuance of bonds

Cash 5,250,000
Discount on bonds payable 565,000
Bonds payable 5,000,000
Share warrants outstanding 815,000

Convertible bonds

An entity frequently makes its bond issue more attractive to investors by making the
bonds convertible. Convertible bonds are those which give the holders the right to
convert their bond holdings into share capital or other Securities or the issuing entity
within a specified period of time. Often, the conversion privilege becomes less
attractive as time goes by.

For example, a 15-year, P1,000 bond may be convertible into. 20 shares of capital
during the first five years from date of issue, 10 shares of capital the next five years
and may not be convertible during the last five years. 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

Original issuance

Convertible bonds are conceived as compound financial instruments. Accordingly, the

issuance of convertible bonds shall be accounted for as partly liability and partly equity.
In other words, the issue price of the convertible bonds shall be allocated between the
bonds payable and the conversion privilege.

Allocation of issue price

The economic effect of issuing convertible bonds substantially the same as issuing
simultaneously payable with share warrants. 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 without conversion privilege, the amount
allocated to the bonds 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 without conversion privilege.
Illustration

An entity issued 5,000, 5-year bonds, face amount P1,000 each at 105. The bonds
contain a conversion privilege that provides for an exchange of a P1,000 bond for 20
equity shares with par value of P50. It is reliably determined that the bonds would sell
only at 98 without the conversion privilege.

Cash (5,000,000 x 105%) 5,250,000

Discount on bonds payable 100,000
Bonds payable 5,000,000
Share premium-conversion privilege 350,000

Total issue price 5,250,000

Issue price of bonds without conversion privilege (5,000,000 x 98%6) (4,900,000)
Residual amount allocated to conversion privilege 350,000

Bonds payable 5,000,000

Allocated issue price 4,900,000
Discount on bonds payable 100,000

Market value of bonds unknown

Using the preceding illustration, assume that the interest on the bonds is payable
semiannually at a nominal rate of 8% per annum. When the bonds are issued, the
prevailing market rate of interest for similar bonds without conversion privilege is 10%
per annum. The present value of 1 at 5% for 10 periods is 0.6139 and the present of
an ordinary annuity of 1 at 5% for 10 periods is 7.72.

Note that the interest is payable semiannually. Since the life of the bonds is 5 years,
then there are 10 interest periods. The semiannual effective or market interest rate is
5% which is one-half of 10%.

The present value of the convertible bonds is computed as follows:

Present value of principal (5,000,000 x 0.6139) 3,069,500
Present value of semiannual interest payment (5,000,000 x 4% =
200,000 x 7.72) 1,544,000
Total present value 4,613,500

Issue price of bonds with conversion privilege 5,250,000

Present value of bonds payable (4,613,500)
Residual amount allocated to conversion privilege 636,500

Journal entry

Cash 5,250,000
Discount on bonds payable 386, 500
Bonds payable 5,000,000
Share premium conversion privilege 636,500
Conversion of bonds

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. The carrying
amount 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 or debited to "share issue Cost". The carrying amount of the bonds is equal
to the face amount plus accrued interest if not paid, plus unamortized premium or
minus unamortized discount 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 converted shall be cancelled together with the
related unamortized premium or discount and issue cost.
c. If only a portion of the bonds is converted, the unamortized premium or
discount and issue cost balance shall be canceled 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 converted to get
the carrying amount of the bonds for conversion purposes. The accrued interest is
charged to interest expense.

Illustration

The statement of financial position showed the following balances at year-end:

Bonds payable-12% convertible 5,000,000
Premium on bonds payable 200,000
Share capital, P40par, 400,000 shares authorized and
250,000 shares issued 10,000,000
Share premium -issuance 3,000,000
Share premium -conversion privilege 500,000

On the same date, the bonds are converted into share capital. The conversion ratio is
20 shares for each P1,000 bond or a total of 100,000 shares. Cost incurred in
connection with the conversion amounts to P100,000. The accrued interest on the
bonds payable on the date of conversion is P150,000 which is paid in cash.
Bonds payable 5,000,000
Premium on bonds payable 200,000
Share premium - conversion privilege 500,000
Total consideration 5,700,000
Par value of share capital issued (100,000 shares x 40) 4,000,000
Share premium 1,700,000
Journal entry for the conversion

Bonds payable 5,000,000

Premium on bonds payable 200,000
Share premium- Conversion privilege 500,000
Interest expense 150,000
Share capital 4,000,000
Share premium- issuance 1,700,000
Cash 150,000

Share premium-issuance 100,000

Cash 100,000

Note that the share premium conversion privilege is cancelled upon conversion
because this would effectively form part of the total consideration received ultimately
issued as a result of the conversion

Payment of convertible bonds at maturity

On December 31, 2020, the statement of financial position showed the following
balances before payment:
Bonds payable - due December 31, 2020 5,000,000
Share capital 10,000,000
Share premium- issuance 4,000,000
Share premium -conversion option 400,000

The bonds are convertible and originally 1ssued on January 1, 2011. The stated rate
interest is 10% payable annually every December 31. The original issue price of the
convertible bonds was P6,000,000 allocated as follows:

Original issue price 6,000,000

Issue price of bonds without conversion option (5,600,000)
Share premium -conversion option 00,000

Issue price of bonds without conversion option 5,600,000

Face amount 5,000,000
Premium on bonds payable 600,000

Since the bonds already matured, the premium on bonds payable is already fully
amortized on December 31, 2020. The convertible bonds are not converted but fully
paid on December 31, 2020.

Journal entries

1. To record the payment on December 31, 2020:

Bonds payable 5,000,000
Interest expense (10% x 5,000,000) 500,000
Cash 5,500,000
The payment at maturity is equal to the face amount plus interest.
2. To close the share premium from conversion privilege:
 Share premium -Conversion option 400,000
Share premium – issuance 400,000

Payment Convertible bonds before maturity

On December 31, 2020, the entity showed the following balances:

Bonds payable Convertible, due December 31, 2025 5,000,000
Premium on bonds payable 300,000
Share capital 8,000,000
Share premium 1,000,000
Share premium – conversion privilege 600,000

The interest is payable annually every December 31. The convertible bonds are not
converted but fully paid on December 31, 2020. On December 31, 2020, the quoted
price of the convertible bonds with conversion privilege is 108 which is the payment
to the bondholders plus interest. However, the quoted price of the bonds without the
conversion privilege is 103.
Fair value of bonds with conversion privilege (5,000,000 x 108) 5,400,000
Fair value of bonds without conversion privilege (5,000,000 x 103) 5,150,000
Fair value of equity component 250,000

Bonds payable 5,000,000

Premium on bonds payable 300,000
Carrying amount of bonds payable 5,300,000
Payment equal to the fair value of bonds without conversion privilege (5,150,000)
Gain on extinguishment 150,000

Note that the total payment of P5,400,000 to the bondholders partly liability of
P52,150,000 and partly equity of P250,000.

Journal entries

1. To record the payment before maturity:

Bonds payable 5,000,000
Premium on bonds payable 300,000
Share premium -conversion privilege 250,000
Cash 5,400,000
Gain on extinguishment 150,000

Interest expense (8% x 5,000,000) 400,000

Cash 400,000

2. To close the remaining balance of the share premium from conversion privilege:
Share premium - conversion privilege 350,000
Share premium – issuance (600,000-250,000) 350,000
 Self Help: You can also refer to the sources below to help
you further understand the lesson.

Cabrera, M. E. B. &Ocampo, R. R. (2015) Financial accounting & reporting Standards

& Applications (VOL 3, 2014-2015 ed). Manila: GIC Enterprises & Co., Inc.

Valix, C.T., Peralta, J.F. &Valix, C.M. (2019). Intermediate Accounting. (2019 ed., Vol. Commented [d1]:
Sort A-Z. Same to other ULOs
2). Manila: GIC Enterprises & Co., Inc.

Valix, C. &Valix, C. (2018). Theory Financial Accounting (CPA Examination). Manila:

GIC Enterprises & Co., Inc.

Valix, C., &Valix, C. A. M. (2016). Practical financial accounting. (Vol.1). Manila,

Philippines: GIC enterprises & Co., Inc.

Let’s Check
Activity 1. Determine each question’s correct answer among the given choices.
1. What is the principal accounting for a compound financial instrument?
a. The issuer sha!l classify a compound instrument a 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 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 1ssuing 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 with share warrants should not be
allocated between the liability and equity components when
a. The fair value of the warrants is not readily available
b. The exercise of the warrants within the next reporting period seems
remote.
c. The warrants issued are nondetachable.
d. The proceeds should be allocated between liability and equity under all of
these circumstances.
4. When the cash proceeds from bonds issued with share warrants exceed the
fair value of the bonds without 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.
c. The market value of the share warrants.
d. The excess of the proceeds over the fair value of the bonds without the
share warrants.
6. What is the main reason for issuing convertible bond?
a. The ease with which convertible bond is sold even if the entity has a poor
credit rating.
b. The fact that equity capital has issue cost and convertible bond has none.
c. Entities can obtain financing at lower rate.
d. Convertible bond will always sell at a premium.
7. The major difference between convertible bonds and bonds issued With share
warrants is that upon exercise of the warrants
a. The shares are held by the 1ssuer for a certain period before issuance to
the warrant holder.
b. The holder has to pay a certain amount to obtain the shares.
c. The shares involved are restricted.
d. No share premium can be part of the transaction.
8. What is the accounting for issued convertible bond?
a. The instrument should be presented solely as bond.
b. The instrument should be presented either as bond or equity but not both.
c. The Instrument should be presented as part bond and part equity.
d. The instrument should be presented solely as equity.
9. Issued convertible bonds are
a. Separated into debt and equity components with the liability component
recorded at fair value and the residual assigned to the equity component.
b. Always recorded using the fair value option.
c. Recorded at face amount for the liability along with the associated
premium or discount.
d. Recorded at face amount without consideration of a premium or discount.
10. When convertible bond payable is not converted but paid at maturity
a. A gain or loss is recorded for the difference between the carrying amount
of the bond and the present value of the cash flows.
b. The amount allocated to equity is recorded as a gain.
c. The amount allocated to equity is recorded as a loss.
d. The carrying amount of the bond equal to face amount is derecognized.

Let’s Analyze
Activity 1. MCQ Problem solving
Armada Company issued P5,000,000 face amount, 5 year bonds at 109. Each P1,000
bond was issued with 10 warrants, each of which entitled the bondholder to purchase
one share of P100 par value at P120. Immediately after issuance, the market value of
each 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%. 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.
 1. What is the carrying amount of the bonds payable on the date of issuance?
a. 5,450,000
b. 4,830,000
c. 5,000,000
d. 4,380,000
2. What is the equity component arising from the issuance of bonds payable?
a. 450,000
b. 500,000
c. 620,000
d. 0
3. What amount is credited to share premium if all of the share warrants are
exercised?
a. 1,000,000
b. 1,450,000
c. 1,500,000
d. 1,620,000

At the beginning of current vear, Case Company issued P5,000,000 of 12%

nonconvertible bonds payable at 103 which are due in five years. In addition, each
P1,000 bond was issued with 30 detachable snare warrants, each of which entitled
the bondholder to purchase, for P50, one ordinary share of Case Company, par value
P25. On the date of issuance, the quoted market value of each warrant was P4. The
market value of the bonds ex-warrants at the time of issuance is 95.
4. What amount of the proceeds from thé bond issue should be recognized as
an increase in shareholders' equity?
a. 600,000
b. 300,000
c. 200,000
d. d 400,000
5. What amount is credited to share premium if all of the share warrants are
exercised?
a. 4,350,000
b. 3, 750,000
c. 4,150,000
d. 0

6. At the beginning of current year, Susan Company issued 5,000 convertible

bonds. The bonds have a three-year term and are issued at 110 with a face
amount of P1,000 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 P5. 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 I at 9% for 3 period is 2.53. What is the equity component
arising from the original issuance of the convertible bonds?
a. 1,150,0000
b. 1,650,000
c. 891,000
d. 391,000
 7. Spare Company had an outstanding share capital with par value of
P50,000,000 and a 12% convertible bond issue in the face amount of
P10,000,000. Interest payment dates of the bond issue are June 30 and
December 31. The conversion clause in the bond indenture entitled the
bondholders to receive 40 shares of Spare Company with P20 par value in
exchange for each P1,000 bond. The holder of P5,000,000 face value bonds
exercised the conversion privilege at year-end. The market price of the bonds
at year-end was Pl, 100 per bond and the market price of the share was P30.
The total unamortized bond discount was P500,000 and the share premium
from conversion privilege has a balance of P2,000,000 at the date of
conversion. What amount of share premium should be recognized by reason of
the conversion or bonds payable into share capital?
a. 2,000,000
b. 2.750,000
c. 3,000,000
d. d 1,750,000

On December 31, 2020, Tamia Company showed the following balances:

Bonds payable-6% 4,000,000
Discount on bonds payable 500,000
Share premium-issuance 5,000,000
Share premium conversion privilege 700,000
The interest is payable annually every December 31. The convertible bonds are not
converted but fully paid on December 31, 2020. On such date, the quoted price of the
convertible bonds with conversion option is 105 which is the payment to the
bondholders plus interest. However, the quoted price of the bonds without the
conversion privilege is 95.
8. What is the carrying amount of the bonds payable on December 31, 2020?
a. 4,000,000
b. 4,500,000
c. 3,500,000
d. 4,200,000
9. What is the gain or loss from extinguishment of bonds?
a. 700,000 gain
b. 700,000 loss
c. 300,000 gain
d. 300,000 loss
10. What is the total payment to the bondholders on December 31, 2020?
a. 4,200,000
b. 4,440,000
c. 4,240,000
d. 4,040,000

In a Nutshell

I. At the beginning of current year Zamboanga Company issued P8,000,000 of 12%

bonds payable maturing in 5 years. The bonds pay interest semi annually on June 30
and December 31. The bonds include share warrants giving the bondholder the right
to purchases 16,000 P100 par value shares for P150 per share within the next three
years. The bonds and warrants were issued at 120. The value of the warrants at the
time of issuance was P1,500,000. All share warrants were exercised at current year
end.

Required:

Prepare journal entries for the current year in connection with the bonds. The interest
method of amortization is used.

II. At the beginning of current year, Silay Company issued 2,000 convertible bonds.
The bonds have a three-year term and are issued at 110 with a face amount of P1,000
per bond, giving total proceeds of P2,200,000. Interest is payable annually in arrears
at a nominal annual interest rate of 6%. Each bond is convertible at any time up to
maturity into 25 shares of capital with par value of P20. The bonds are converted at
the end of current year. When the bonds are issued, the prevailing market rate for
similar bonds without conversion privilege is 9%. The present value of 1 at 9o Tor
three periods is 0.77 and the present value of an ordinary annuity of I at 9% for three
periods is 2.53.

Required:

Prepare journal entry to record issuance of the bonds, interest payment, effective
amortization and bond conversion.

Q and A

In this section you are going to list what boggles you in this unit. You may indicate
your questions but noting you have to indicate the answers after your questions is
being raised and clarified. You can write your questions below:

Questions/ Issues Answers

1.
2.
3.
4.
5.
 f.
Big Picture in Focus: ULOb. Demonstrate the procedures
g.
in accounting for note payable.

Metalanguage
In this section, the most essential terms relevant to the study of curriculum and to
demonstrate ULOb will be operationally defined to establish a common frame of
refence as to how the texts work in your chosen field or career. You will encounter
these terms as we go through the intermediate accounting. Please refer to these
definitions in case you will encounter difficulty in the understanding educational
concepts.
Please proceed immediately to the “Essential Knowledge” part since this is the first
time you will encounter the nature of this lesson.

Essential Knowledge

A promissory note is an unconditional promise in writing made by one person to

another, signed by the maker, engaging to pay on demand or at a fixed or determinable
future time a sum certain in money to order or to bearer.

Initial measurement of note payable

PFRS 9, paragraph 5.1.1, provides that a note 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 note payable. In other words, transaction
costs are included in the measurement of note payable.

However, if the note payable is irrevocably designated at fair value through profit or
loss, the transaction costs are expensed immediately. The "'fair value'" of the note
payable is equal to the present value of the future cash payment to settle the note
payable using market rate of interest.

Subsequent measurement of note payable

PFRS 9, paragraph 5.3.1, provides that after initial recognition, a note payable shall
be measured:
a. At amortized cost using the effective interest method.
b. At fair value through profit or loss if the note payable is designated irrevocably
as measured at fair value through profit or loss.

Amortized cost of note payable

The amortized cost of note payable is the amount at which the note payable is
measured initially:
 a. Minus principal repayment
b. Plus or minus the cumulative amortization using the effective interest method
of any difference between the face amount and present value ot the note
payable.

Actually, the difference between the face amount and present value is either discount
or premium on the issue of note payable.

Note issued solely for cash

When a note is issued solely for cash, the present value is equal to the cash proceeds.

Illustration

On November 1, 2020, an entity discounted its own note of P1,000,000 at 12% for one
year.

Note payable 1,000,000

Less: Discount (12% x 1,000,000) 120,000
Net proceeds 880,000

Journal entry

Cash 880,000
Discount on note payable 120,000
Note payable 1,000,000

Actually, the discount on note payable of P120,000 is the total interest expense for
one year. Thus, on December 31, 2020, after 2 months, the discount on note payable
is amorti1zed as interest expense.

Interest expense 20,000

Discount on note payable 20,000
(120,000 x 2/12)

The straight line method is used in amortizing the discount on note payable for
simplicity. Besides, the note payable has only a term of one year.

lf a statement of financial position is prepared on December 31, 2020, the note payable
is classified and reported as current liability.

Note payable 1,000,000

Discount on note payable ( 100,000)
Carrying amount 900,000

Observe that the discount on note payable 18 a direct deduction from the face amount
of the note payable. The carrying amount of P900,000 is actually the "amortized cost"
of the note payable.
lnterest bearing note issued for property

When property or noncash asset is acquired by issuing a promissory note which is

interest bearing, the property or asset is recorded at the purchase price.

The purchase price is reasonably assumed to be the present value of the note and
therefore the fair value of the property because the note issued is interest bearing

Illustration

On January 1, 2020, an entity acquired an equipment for P1,000,000 payable in 5

annual equal installments every December 31 of each year. Interest is 10% on the
unpaid balance.

Journal entries

2020

Jan. 1 Equipment 1,000,000

Note payable 1,000,000

Dec. 31 Interest expense (10% x 1,000,000) 100,000

Note payable 200,000
Cash 300,000
Payment of the first instalment and the interest for 2020.

2021

Dec . 31 Interest expense (10% x 800,000) 80,000

Note payable 200,000
Cash 280,000
Payment for second instalment and interest for 2021

Noninterest bearing note issued for property

When a noninterest bearing note is issued for property, the property is recorded at the
cash price of the property.

The cash price is assumed to be the present value of the note issued.

The difference between the cash price and the face of the note issued represents the
imputed interest.

The imputed interest is based on the sound philosophy that no lender would part away
with his money or property interest-free.
Illustration

On January 1, 2020,an entity acquired an equipment with a cash price of P350,000

for P500,000, P100,000 down and the balance payabłe in 4 équal annual installments.

Journal entries for 2020

Jan. 1 Equipment 350,000

Discount on note payable 150,000
Cash 100,000
Note payable 400,000
Payment of annual instalment.
Dec. 31 Note payable 60,000
Cash 60,00

31 Interest expense 100,000

Discount on note payable 100,000
Amortization of the discount for 2020.

Table of amortization

Year Note Payable Fraction Amortization

2020 400,000 4/10 60,000
2021 300,000 3/10 45,000
2022 200,000 2/10 30,000
2023 100,000 1/10 15,000

 Note payable represents the amount outstanding every year.

 The note was issued on January 1, 2020 and the first payment was made on
December 31, 2020.
 Thus, for 2019, the note payable outstanding is P400,000.
 Fraction is developed from the note payable outstanding every year.
 Amortization is the amount of discount multiplied by the fraction developed.
 Thus, for 2020, P150,000 times 4/10 equals P60,000.

Another illustration- no cash price

On January 1, 2020, an entity acquired an equipment for P1.000,000 payable in equal

annual installments on every December 31 of each year.

Observe that there is no agreed interest and no cash price is available for the
equipment.

In such a case, the cost of the equipment is equal to the present value of the P200,000
annual installments in 5 years at an appropriate rate of 10%.

The rate of 10% is assumed to be the prevailing market rate of interest.

The present value of an ordinary annuity of 1 for 5 years at 10% is 3.7908.

Therefore, the present value of five P200,000 installments is P758,160, computed by
multiplying P200,000 by the present value factor of 3.7908.

Journal entries for 2020

Jan. 1 Equipment 758,160

Discount on note payable 241,840
Note payable 1,000,000

Dec. 31 Note payable 200,000

Cash 200,000

31 Interest expense 75,816

Discount on note payable 75,816
Amortization of the discount on note payable for 2020.

The "effective interest" method is followed in the amortization of the discount.

Table of amortization

Date Payment Interest Principal Present Value

Jan. 1, 2020 200,000 758,160
Dec. 31, 2020 200,000 75,816 124,184 633,976
Dec. 31, 2021 200,000 63,398 136,602 497,374
Dec. 31, 2022 200,000 49,737 150,263 347,111
Dec. 31, 2023 200,000 34,711 165,289 181,822
Dec. 31, 2024 200,000 18,178 181,822 -

Payment represents the annual installment.

Interest is equal to the preceding present value multiplied by the implied interest rate.
Thus, for 2020, P758,160 times 10% equals P75,816.

Principal is the portion of the payment after deducting interest representing principal.

Thus, on December 31, 2020, P200,000 minus the interest of P75,816 equals P124,
184.

Present value is the balance of the preceding present value after deducting the
principal payment.

Thus, on December 31, 2020, P758, 160 minus the principal payment of P124, 184
equals P633,976.

On December 31, 2020, the current portion of the note payable would be reported as
current liability.

Note payable 200,000

Discount on note payable (63,398)
Carrying amount- amortized cost 136,602
The noncurrent portion of the note payable would be reported as noncurrent liability.

Note payable 600,000

Discount on note payable (102,626)
Carrying amount- amortized cost 497,374

Noninterest bearing note payable lump sum

On January 1, 2020, an entity acquired an equipment for P1,000,000. The entity paid
P100,000 down and signed a noninterest bearing note for the balance which is due
after three years on January 1, 2023.

There was no established cash price for the equipment. The prevailing interest rate
for this type of note is 10%. The present value of 1 for 3 periods is .7513.

Computation

Down payment 100,000

Present value of note (P900,000 x .7513) 676,170
Cost of equipment 776,170

Imputed interest

Face value of note 900,000

Present value of note 676,170
Imputed interest 223,830

Journal entries

1. To record the purchase of equipment on January 1, 2020:

Equipment 776,170
Discount on note payable 223,830
Cash 100,000
Note payable 900,000

2. To record the interest expense for 2020:

Interest expense 67,617

Discount on note payable 67,617

The discount on note payable is amortized as interest expense using the "effective
interest method.

3. To record the full payment of the note on January 1, 2023:

Note payable 900,000

Cash 900,000
Table of amortization

Date Interest Expense Discount on Note Payable Present Value

1/1/2020 223,830 676,170
12/31/2020 67,617 156,213 743,787
12/31/2021 74,379 81,834 818,166
12/31/2022 81,834 - 900,000

Interest expense is equal to the preceding present value multiplied by the implied
interest rate. Thus, for 2020, P676,170 times 10% equals P67,617.

Discount on note payable is the balance minus the interest expense every year.
Thus, on December 31, 2020, P223,830 minus the interest of P67,617 equals
P156,213.

Present value is the preceding balance plus the interest expense every year. Thus,
on December 31, 2020, P676,170 plus the interest of P67,617 equals P743,787.

Fair value option of measuring note payable

PFRS 9, paragraph 4.2.2, provides that at initial recognition, a note payable may be
irrevocably designated as at fair value through profit or loss.

PFRS 9, paragraph 5.7.7, provides that the gain or loss on financial liability designated
at fair value through profit or loss shall be accounted for as follows:

a. The change in fair value attributable to the credit risk is recognized in other
comprehensive income. Credit risk is the risk that the issuer of the liability would
cause a financial loss to the other party by failing to discharge the obligation. Credit
risk does not include market risk such as interest risk, currency risk and price risk.

b. The remaining amount of the change in fair value is recognized in profit or loss.

Application Guidance B5.7.9 provides that amount recognized in other comprehensive

income resulting from change in fair value attributable to credit risk shall not be
subsequently transferred to profit or loss. However, the cumulative gain or loss
recognized may be transferred within equity or retained earnings.

Under the fair value option, any transaction cost is recognized as outright expense.
There is no amortization of discount and premium on note payable.

As a matter of fact, interest expense is recognized using the nominal or stated interest
rate.
Illustration

On January 1, 2020, an entity borrowed from a bank P4,000,000 on a 12% 5-year

interest bearing note. The entity received P4,000, 000 which is the fair value of the
note on January 1, 2020. Transaction cost of Pl00,000 was paid by the entity. The fair
value of the note payable was P3,500,000 on December 31, 2020. The entity has
elected irrevocably the fair value option for measuring the note payable. The change
in fair value comprised P50,000 attributable to credit risk and P450,000 attributable to
interest risk.

Journal entries for 2020

Jan. 1 Cash 4,000,000

Note payable 4,000,000

1 Transaction cost 100,000

Cash 100,000

Dec. 31 Interest expense (12% x 4,000,000) 480,000

Cash 480,000

31 Note payable 500,000

Gain from change in fair value 50,000
Gain from credit risk- OCI 450,000

Carrying amount 4,000,000

Fair value - December 31, 2020 3,500,000
Decrease in fair value of liability – gain 500,000

The gain from change in fair value is recognized profit or loss. The gain from credit
risk is recognized in other comprehensive income.

Self Help: You can also refer to the sources below to help
you further understand the lesson.

Cabrera, M. E. B. &Ocampo, R. R. (2015) Financial accounting & reporting Standards

& Applications (VOL 3, 2014-2015 ed). Manila: GIC Enterprises & Co., Inc.

Valix, C.T., Peralta, J.F. &Valix, C.M. (2019). Intermediate Accounting. (2019 ed., Vol. Commented [d2]:
Sort A-Z. Same to other ULOs
2). Manila: GIC Enterprises & Co., Inc.

Valix, C. &Valix, C. (2018). Theory Financial Accounting (CPA Examination). Manila:

GIC Enterprises & Co., Inc.

Valix, C., &Valix, C. A. M. (2016). Practical financial accounting. (Vol.1). Manila,

Philippines: GIC enterprises & Co., Inc.
Let’s Check
Activity 1. Determine each question’s correct answer among the given choices.
1. When an entity issued a note solely in exchange for cash, the present value of
the note at issuance is equal to
a. Face amount
b. Face amount discounted at the prevailing interest rate
c. Proceeds received
d. Proceeds received discounted at the prevailing interest rate
2. If the present value of a note issued in exchange for a property is less than face
amount, the difference should be
a. Included in the cost of the asset
b. Amortized as interest expense over the life of the note
c. Amortized as interest expense over the life of the asset
d. Included in interest expense in the year of issuance
3. An entity borrowed cash from a bank and issued to the bank a short-term
noninterest bearing note payable. The bank discounted the note at 10% and
remitted the proceeds to the entity. The effective interest rate paid by the entity
in this transaction would be
a. Equal to the stated discount rate of 10%
b. More than the stated discount rate of 10%
c. Less than the stated discount rate of 10%
d. Independent of the stated discount rate of 10%
4. At issuance date, the present value of a promissory note is equal to the face
amount if the note
a. Bears a stated rate of interest which is realistic.
b. Bears a stated rate of interest which is less than the pervailing market rate
for similar notes.
c. Is noninterest bearing and the implicit interest rate is less than the prevailing
market rate for similar notes.
d. Is noninterest bearing and the implicit interest rate is equal to the prevailing
market rate for similar notes.
5. Which statement concerning discount on note payable is incorrect?
a. Discount on note payable may be debited when entity discounts its own note
with the bank.
b. The discount on note payable is a deduction from the face amount note
payable.
c. The discount on note payable represents interest charges applicable to
future periods.
d. Amortizing the discount on note payable gradually decreases the carrying
amount of the liability over the life of the note.
6. A note payable with no ready market is exchanged for property whose fair value
is currently indeterminable. When such a transaction takes place
a. The present value of the note payable must be approximated using an
imputed interest rate.
b. The note payable should not be recorded until the fair value of the property
becomes evident.
c. The entity receiving the property should estimate a value for the property.
d. Both entities involved in the transaction should negotiate a value to be
assigned to the property.
 7. When a note payable is issued for property, the present value of the note is
measured by
a. The fair value of the property
b. The fair value of the note payable
c. Using an imputed interest rate to discount all future payments on the note
payable
d. All of these are considered in measuring the present value of the note
payable
8. When a note payable is exchanged for property, the Stated interest rate is
presumed to be fair when
a. No interest rate is stated.
b. The stated interest rate is unreasonable.
c. The face amount of the note is materially different from the cash sale price
for similar property.
d. The stated interest rate is equal to the market rate
9. The discount resulting from the determination of the present value of a note
payable should be reported as
a. Deferred credit
b. Direct deduction from the face amount of the note
c. Deferred charge
d. Addition to the face amount of the note
10. Which statement is correct when an entity issued a note payable with no stated
interest rate in exchange for a depreciable asset?
a. The asset should be depreciated over the term of the note payable.
b. If fair value is unavailable, the note payable should be recorded at present
value discounted at the market rate of interest.
c. Both the note and the asset are recorded at the face amount of the note
payable.
d. The note payable 1s recorded at face amount even if the fair value of the
asset is readily available.

Let’s Analyze

Activity 1. MCQ Problem solving

1. Mann Company reported a 10% note payable of P3, 600,000 on June 30, 2020.
The note is dated October 1, 2018 and 4% payable in three equal annual
payments of P1,200,000 plus interest. The first interest and principal payment
was made on October 1, 2019. On June 30, 2020, what amount should be
reported as accrued interest payable for this note?
a. 270,000
b. 180,000
c. 90,000
d. 60,000
2. On December 31, 2020, Bart Company purchased a machine from Fell
Company in exchange for a noninterest bearing note requiring eight payments
of P200,000. The first payment was made on December 31, 2020 and the
others are due annually on December 31. At date of 1ssuance, the prevailing
rate of interest for this type of note was 11%.
PV of an ordinary annuity of 1 at 11% for 8 periods 5.146
 PV of an annuity of 1 in advance at 11% for 8 periods 5.712
On December 31, 2020, what is the carrying amount of the note payable?
a. 1,142,400
b. 1,029,200
c. 1,046,200
d. 942,400
3. t the beginning of current year, Pares Company borrowed P8,600,000 from a
major customer evidenced by a noninterest bearing note due in three years.
The entity agreed to supply the customer's inventory needs for the loan period
at an amount lower than market price. At the 12% imputed interest rate for this
type of loan, the present value of the note is P2,550,000 at the date of issuance.
What amount of interest expense should be reported in the income statement
for the current year?
a. 432,000
b. 350,000
c. 306,000
d. 0
4. At year-end, Roth Company issued a Pl,000,000 note payable in exchange for
service rendered. The made at usual trade terms, is due in nine months and
bears interest, payable at maturity, at the annual rate of 3%. The market interest
rate is 8%. The compound interest factor of I due in nine months at 8% 1s.944.
At what amount should the note payable be reported at year-end?
a. 1,030,0000
b. 1,000,000
c. 965,200
d. 944,000
5. On September 1, 2019, Pine Company issued a note payable in the amount of
P1,800,000, bearing interest at 12%, and payable in three equal annual
principal payments of P600,000. On this date, the prime rate was 11. The first
interest and principal payment was made on September 1, 2020. On December
31, 2020, what amount should be reported as accrued interest payable?
a. 44,000
b. 48,000
c. 66,000
d. 72,000
6. On January 1, 2020, Solemn Company sold land to Glory Company. There was
no established market price for the land. Glory gave Solemn a P2,400,000
noninterest bearing note payable in three equal annual installments of
P800,000 with the first payment due December 31, 2020. The note has no
ready market. The prevailing rate of interest for a note of this type is 10%. The
present value of a P2,400,000 note payable in three equal annual installments
of P800,000 at a 10% rate of interest is P1,989,600. What is the carrying
amount of the note payable on December 31, 2020?
a.1,989,600
b. 2,126,400
c. 1,388,560
d. 2,400,000
Loob Company frequently borrowed from the bank in order to maintain sufficient
operating cash. The loans were at a 12% interest rate, with interest payable a maturity.
The entity repaid each loan on the scheduled maturity date.
Date of Loan Amount Maturity date Term of Loan
11/1/2019 500,000 10/31/2020 1 year
2/1/2020 1,500,000 7/31/2020 6 months
5/1/2020 800,000 1/31/2021 9 months
The entity recorded interest expense when the loans are repaid. As a result, interest
expense of P150,000 was recorded in 2020.
7. What amount should be reported as interest expense for 2020?
a. 150,000
b. 204,000
c. 246,000
d. 236,000
8. If no correction is made, by what amount would interest expense for 2020 be
understated2
a. 54,000
b. 62,000
c. 64,000
d. 72,000

On January 1, 2020, Lizelle Company received P1,000,000 on a noninterest-bearing

note due in three years. 'The market rate of interest on such date is 10%. The entity
irrevocably elected the fair value option in measuring the note payable. On December
31, 2020, the risk factors indicated that the rate of interest applicable to the borrowing
was 9%. The present value factors at 10% and 9% are
PV factor 10%, 3 periods .751
PV factor 10%, 2 periods .826
PV factor 10%, 1 period .909
PV factor 9%, 3 periods .772
PV factor 9%, 2 periods .842
PV factor 9%, 1 period .917
9. What is the carrying amount of the note payable on December 31, 2020?
a. 751,000
b. 772,000
c. 917,000
d. 842,000
10. What amount of net gain or loss from the change in fair value of the note
payable should be reported for 2020?
a. 158,000 gain
b. 158,000 loss
c. 174,000 gain
d. 174,000 loss

In a Nutshell

On January 1, 2020, Heritage Company has a note payable to bank in the amount P2,
800,000. Transactions during 2020 and other information relating to liabilities are:
a. Principal amount of the note payable to bank is P2,800,000 and bears a 12%
interest. The note is dated April 1, 2019 and is payable in four equal annual
installments beginning April 1, 2020. The first principal and interest payment was made
on April 1, 2020.
b. On July 1, 2020, the entity issued for P1,774,000a P2,000,000 face amount note to
a wealthy shareholder. The note was dated July 1, 2020 and matures on July 1, 2021.
No explicit interest rate is stated in the note and the entire face amount of the note is
payable at maturity date.

Required:

a. Prepare journal entries for 2020.

b. Compute the total current liabilities on December 31, 2020.
c. Determine the interest expense to be reported in 2020.

Q and A

In this section you are going to list what boggles you in this unit. You may indicate
your questions but noting you have to indicate the answers after your questions is
being raised and clarified. You can write your questions below:

Questions/ Issues Answers

1.
2.
3.
4.
5.

a.
Big Picture in Focus: ULOc. Demonstrate the procedures
b.
in accounting for debt restructure.
c.

Metalanguage
In this section, the most essential terms relevant to the study of curriculum and to
demonstrate ULOc will be operationally defined to establish a common frame of
refence as to how the texts work in your chosen field or career. You will encounter
these terms as we go through the intermediate accounting. Please refer to these
definitions in case you will encounter difficulty in the understanding educational
concepts.
Please proceed immediately to the “Essential Knowledge” part since this is the first
time you will encounter the nature of this lesson.
Essential Knowledge

Debt restructuring is a situation where the creditor, for economic or legal reasons
related to the debtor's financial difficulties, grants to the debtor concession that would
not otherwise be granted in a normal business relationship. The concession either
stems from an agreement between the creditor and debtor or is imposed by law or a
court. The objective of the creditor in a debt restructuring is to make the best of a bad
situation or maximize recovery of investment. Thus, the creditor usually sustains an
accounting loss on debt restructuring and the debtor-usually realizes an accounting
gain.

Types of debt restructuring

There are three types of debt restructuring, namely:

1. Asset swap
2. Equity swap
3. Modification of terms

Asset swap

An asset swap 1s the transfer by the debtor to the creditor of any asset, such as real
estate, inventory, receivables and investment, in full payment of an obligation. Under
PFRS 9, paragraph 3.3.1, asset swap is treated as a derecognition of a financial
liability or extinguishment of an obligation. Paragraph 3.3.3 provides that the difference
between the carrying amount of the financial liability and the consideration given shall
be recognized in profit or loss.

Illustration

An entity provided the following balances at year-end:

Note payable 2,000,000

Accrued interest payable 400,000

At year-end, the entity transferred to the creditor land with carrying amount of
P1,500,000 and fair value of P2,200,000.

Computation

Note payable 2,000,000

Accrued interest payable 400,000
Total liability 2,400,000
Less: Carrying amount of land 1,500,000
Gain on extinguishment of debt 900,000
Journal entry

Note payable 2,000,000

Accrued interest payable 400,000
Land 1,500,000
Gain on extinguishment of debt 900,000

USA GAAP

Under USA GAAP, asset swap is recorded as if two transactions have taken place,
namely, the sale of the asset and the extinguishment of the liability. Accordingly, two
gains or losses are recognized. The difference between the fair value of the asset and
the carrying amount is the gain or loss on exchange. The difference between the
carrying amount of the liability and the fair value of the asset is gain or loss from
restructuring.

Fair value of land 2,000,000

Carrying amount of land 1,500,000
Gain on exchange 700,000

Note payable 2,000,000

Accrued interest payable 400,000
Total liability 2,400,000
Fair value of land 2,200,000
Gain on debt restructuring 200,000

Journal entry

Note payable 2,000,000

Accrued interest payable 400,000
Land 1,500,000
Gain on exchange 700,000
Gain on debt restructuring 200,000

Note that the gain on extinguishment under PFRS 9 includes both the gain on
exchange and gain on debt restructuring under USA GAAP.
PFRS 9 shall be followed as this is in conformity with international accounting
standard.

Dacion en pago accounting

Dacion en pago arises when a mortgaged property is offered by the debtor in full
settlement of the debt. The transaction shall be accounted for as an "asset swap" form
of debt restructuring. This requires recognition of gain or loss based on the balance of
the obligation including accrued interest and other charges.

If the balance of the obligation including accrued interest and other charges is more
than the carrying amount of the property mortgaged, there is a gain on extinguishment
of debt. Otherwise, if the balance of the obligation is less than the carrying amount of
property mortgaged, there is a loss on extinguishment.
Illustration

Land costing P500,000 and building costing P4,000,000 with accumulated

depreciation of P800,000, were mortgaged to secure a bank loan of P3,000,000.
Face amount of the loan 3,000,000
Accrued interest payable 200,000
Legal fee and bank service charges 50,000
Subsequently, the land and building were given to the bank in full payment of the
liability.

Journal entry

Mortgage payable 3,000,000

Accrued interest payable 200,000
Bank service charges 50,000
Loss on extinguishment of debt 450,000
Accumulated depreciation 800,000
Land 500,000
Building 4,000,000

Total liability 3,250,000

Less: Carrying amount of land and building (500,000+3,200,000) 3,700,000
Loss on extinguishment of debt (450,000)

Equity swap

Equity swap is a transaction where by a debtor and to may renegotiate the terms of a
financial liability with the result that the liability is fully or partially extinguished by the
debtor issuing equity instruments to the creditor. Simply stated, an equity swap is the
issuance of share capital by the debtor to the creditor in full or partial payment or an
obligation

Accounting issue

How should an entity initially measure the equity instruments issued to extinguish a
financial liability. The accounting issue of "extinguishment of a financial liability by
issuing equity instruments" is now well-settled under FRIC 19.

IFRIC 19 provides that when equity instruments issued to extinguish all or part of a
financial liability are recognized initially, an entity shall measure the equity instruments
at the fair value of the equity instruments issued, unless that fair value cannot be
reliably measured.

If the fair value of the equity instruments issued cannot be reliably measured, the
equity instruments shall be measured to reflect the fair value of the financial liability
extinguished.
Simply stated, the equity instruments issued to extinguish a financial liability shall be
measured at the following amounts in the order of priority:

a. Fair value of equity instruments issued

b. Fair value of liability extinguished
c. Carrying amount of liability extinguished

The difference between the carrying amount of the financial 1iability and the initial
measurement of the equity instruments issued shall be rec0gnized n profit or loss. The
gain or loss on extinguishment shall be reported as a separate line item in the income
statement.

Illustration

An entity showed the following data at year-end:

Bonds payable 5,000,000

Accrued interest payable 500,000

The entity issued share capital with a total par value of P2,000,000 and fair value of
P4,500,000 in full settlement of the bonds payable and accrued interest.

On the other hand, the fair value of the bonds payable is P4,700,000.

Fair value of shares issued is used

Bonds payable 5,000,000

Accrued interest payable 500,000
Share capital 2,000,000
Share premium 2,500,000
Gain on extinguishment of debt 1,000,000

Fair value of shares issued 4,500,000

Par value of shares issued 2,000,000
Share premium 2,500,000
Bonds payable 5,000,000
Accrued interest payable 500,000
Carrying amount of bonds payable 5,500,000
Fair value of shares issued 4,500,000
Gain on extinguishment of debt 1,000,000

Fair value of bonds payable is used

Bonds payable 5,000,000

Accrued interest payable 500,000
Share capital 2,000,000
Share premium 2,700,000
Gain on extinguishment of debt 800,000
Fair value of bonds payable 4,700,000
Par value of shares issued 2,000,000
Share premium 2,700,000
Carrying amount of bonds payable 5,500,000
Fair value of bonds payable 4,700,000
Gain on extinguishment of debt 800,000

Carrying amount of bonds payable is used

Bonds payable 5,000,000

Accrued interest payable 500,000
Share capital 2,000,000
Share premium 3,500,000

Carrying amount of bonds payable 5,500,000

Par value of shares issued 2,000,000
Share premium 3,500,000
* If the carrying amount of the liability is used, there is gain or loss on extinguishment.

Modification of terms

Modification may involve either the interest, maturity value or both.

 Interest concession may involve a reduction of interest rate, forgiveness of
unpaid interest or a moratorium on interest.
 Maturity value concession may involve an extension of the maturity date or a
reduction of the principal amount.
PFRS 9, paragraph 3.3.2, provides that a substantial modification of terms of an
existing financial liability shall be accounted for as an extinguishment of the old
financial liability and the recognition of a new financial liability.

Under Application Guidance B3.3.6 of PFRS 9, there is substantial modification of

terms it the gain or loss on extinguishment is at least 10% of the old financial liability.
The difference between the carrying amount of the old liability and the present value
of new or restructured liability shall be accounted for as gain or loss on extinguishment
debt.

The old effective rate is used in computing the present value of the new liability. Any
costs or fees incurred as a result of the substantial modification of terms shall be
recognized as part of gain or loss on extinguishment.

Illustration- Modification of terms

On January 1, 2020, an entity showed the following:

Note payable - due January 1, 2020-14% 5,000,000
Accrued interest payable 1,000,000
The entity is granted by the creditor the following concessions on January 1, 2020:
a. The accrued interest of P1,000,000 is forgiven.
b. The principal obligation is reduced to P4,000,000.
C. The new interest rate is 10% payable every December 31.
d. The new date of maturity is December 31, 2023.
This requires computation of the present value of the new note payable using the old
rate of 14%. The present value of the new note payable is equal to the present value
of the new principal plus the present value of the interest payments on the new
principal liability.

Computation

The present value of 1 at 14% for 4 periods is 0.5921 and the present value of an
ordinary annuity of l at 14% for 4 periods is 2.9137.

PV of principal (4,000,000 x .5921) 2,368,400

PV of interest payments (400,000 x 2.9137) 1,165,480
Present value of new note payable 3,533,880
Face value of new note payable 4,000,000
Discount on note payable 466,120
Note payable – old 5,000,000
Accrued interest payable 1,000,000
Carrying amount of old liability 6,000,000
Present value of new note payable 3,533,880
Gain on extinguishment of debt 2,466,120

Journal entries

1. To record the extinguishment of the old note payable:

Note payable –old 5,000,000

Accrued interest payable 1,000,000
Discount on note payable 466,120
Note payable- new 4,000,000
Gain on extinguishment of debt 2,466,120

2. To record the interest payment on the new note payable

Interest expense (10% x 4,000,000) 400,000

Cash 400,000

3. To amortize the discount on note payable for 2020:

Interest expense 94,743

Discount on note payable 94,743

Date Interest Interest Discount Carrying Amount

paid expense amortization
1/1/2020 3,533,880
12/31/2020 400,000 494,743 94,743 3,628,623
12/31/2021 400,000 508,007 108,007 3,736,630
12/31/2022 400,000 523,128 123,128 3,858,758
12/31/2023 400,000 540,242 140,242 4,000,000
December 31, 2020

Interest paid (10% x 4,000,000) 400,000

Interest expense (14% x 3,533,880) 494,743
Discount amortization 94,743
Carrying amount- January 1, 2020 3,533,880
Carrying amount-December 31, 2020 3,628,623

December 31, 2021

Interest paid 400,000

Interest expense (14% x 3,628,623) 508,007
Discount amortization 108,007
Carrying amount-December 31, 2020 3,628,623
Carrying amount--December 31, 2021 3,736,630

Books of creditor

Journal entries for 2020 on the books of creditor

Jan. 1 Note receivable-new 4,000,000

Loss on debt restructure 2,466,120
Note receivable –old 5,000,000
Accrued interest receivable 1,000,000
Unearned interest income 466,120

Dec. 31 Cash 400,000

Interest income 400,000

31 Unearned interest income 94,743

Interest income 94,743

No substantial modification

Note payable - due January 1, 2020-10% 5,000,000

Accrued interest payable 1,000,000

a. The accrued interest of P1,000,000 is forgiven

b. The interest rate is 14% payable every December 31
C. The date of maturity is December 31, 2022.

Note payable 5,000,000

Accrued interest payable 1,000,000
Carrying amount of old liability 6,000,000

This requires computation of the present value of the new note payable using the old
rate of 10%.
The present value of 1 at 10% for three periods is 0.7513 and the present value of an
ordinary of 1 at 10% for three period is 2.4869.

PV of principal (5,000,000 x .7513) 3,756,500

PV of interest payments (5,000,000 x 14% x 2.4869) 1,740,830
Total present value of new liability 5,497,330

Carrying amount of old liability 6,000,000

Present value of new note payable 5,497,330
Gain on modification 502,670

Present value of new note payable 5,497,330

Face amount of new note payable 5,000,000
Premium on the new note payable 497,330

The gain is less than 10% of the carrying amount of old liability of P6,000,000. Under
Application Guidance B3.3.6 of PFRS 9, there is no substantial modification of terms.

In accordance with PFRS 9, paragraph B5.4.6, the IASB recently clarified that any
gain or loss on modification should be recognized n profit or loss even if there 1s no
substantial modification of terms. The interest expense is computed based on the
original effective rate and any discount or premium on the new liability is amortized
using the effective interest method.

Journal entries

1. To record the modified liability on January 1, 2020:

Accrued interest payable 1,000,000

Premium on note payable 497,330
Gain on modification of terms 502,670

2. To record the annual interest payment for 2020:

Interest expense (5,000,000 x 14%) 700,000

Cash 700,000

3. To amortize the premium on note payable:

Premium on note payable 150,267

Interest expense 150,267

Date Interest Interest Premium Carrying

paid expense amortization amount
1/1/2020 5,497,330
12/31/2020 700,000 549,733 150,267 5,347,063
12/31/2021 700,000 534,706 165,294 5,181,769
12/31/2022 700,000 518,231* 181,769 5,000,000
Interest paid equals face value times modified stated rate. Thus, for 2020,
P5,000,000x 14% equals P700,000.

Interest expense equals carrying amount times original effective rate. Thus, for 2020,
P5,497,330 x 10% equals P549,733 and so on.

Premium amortization equals interest paid minus interest expense. Thus, for 2020,
P700,000 minus P549,733 equals P150,267, and so on.

Self Help: You can also refer to the sources below to help
you further understand the lesson.

Cabrera, M. E. B. &Ocampo, R. R. (2015) Financial accounting & reporting Standards

& Applications (VOL 3, 2014-2015 ed). Manila: GIC Enterprises & Co., Inc.

Valix, C.T., Peralta, J.F. &Valix, C.M. (2019). Intermediate Accounting. (2019 ed., Vol. Commented [d3]:
Sort A-Z. Same to other ULOs
2). Manila: GIC Enterprises & Co., Inc.

Valix, C. &Valix, C. (2018). Theory Financial Accounting (CPA Examination). Manila:

GIC Enterprises & Co., Inc.

Valix, C., &Valix, C. A. M. (2016). Practical financial accounting. (Vol.1). Manila,

Philippines: GIC enterprises & Co., Inc.

Let’s Check
Activity 1. Determine each question’s correct answer among the given choices.
1. In a debt restructuring that is considered an asset swap, the gain on
extinguishment is equal to
a. Excess of the fair value of the asset over its carrying amount
b. Excess of the carrying amount of the debt over the fair value of the asset
c. Excess of the fair value of the asset over the carrying amount of the debt
d. Excess of the carrying amount of the debt over the carrying amount of the
asset
2. For a debt restructuring involving substantial modification of terms, it is
appropriate for a debtor to recognize a gain when the carrying amount of the
debt
a. Exceeds the total future cash payments specified by the new terms.
b. Is less than the total future cash payments specified by the new terms.
c. Exceeds the present value of the future cash payments specified by the new
terms.
d. Is less than the present value of the future cash payments specified by the
new terms.
3. For a debt restructuring 1nvolving a substantial modification of terms, which of
the following specified by the new terms would be compared to the carrying
 amount of the debt to determine if the debtor should report a gain on
extinguishment?
a. The total future cash payments
b. The present value of the new debt at the original interest rate
c. The present value of the new debt at the modified interest rate
d. The amount of future cash payments
4. Under a debt restructuring involving substantial modification of terms, the future
cash flows under the new terms shall be discounted using
a. Original effective interest rate
b. Interest rate under the new terms
c. Market rate of interest
d. Prime interest rate
5. An entity shall initially measure equity instruments issued to extinguish a
financial liability at
a. Fair value of the equity instruments issued
b. fair value of the liability extinguished
c. par value of the equity instruments issued
d. carrying amount of the liability extinguished
6. If the fair value of the equity instruments issued cannot be reliably measured,
the equity instruments issued to extinguish a financial liability shall be measured
at
a. fair value of the liability extinguished
b. par value of the equity instruments issued
c. carrying amount of the liability extinguished
d. book value of the equity instruments issued
7. If both the fair value of the equity instruments issued and the fair value of the
financial liability extinguished cannot be measured reliably, the equity
instruments issued shall measured at
a. carrying amount of the liability extinguished
b. par value of the equity instruments issued
c. carrying amount of the equity issued
d. value assigned by the Board of directors
8. the difference between the carrying amount of the financial liability extinguished
and the fair value of equity instruments issued shall be recognized in
a. profit and loss
b. other comprehensive income
c. retained earnings
d. general reserve
9. the gain or loss from extinguishment of a financial liability by issuing equity
instruments is presented as
a. other income or other expense
b. separate line item in the income statement
c. component of other comprehensive income
d. component of finance cost

Let’s Analyze
Activity 1. MCQ Problem solving
1. Hull Company is indebted to Apex Company under a P5,000,000, 12%6, three-
year note dated December 31, 2018. Because of financial difficulties developing
in 2020, Hull Company owed accrued interest of P600,000 on the note on
 December 31, 2020. Under a debt restructuring on December 31, 2020, Apex
Company agreed to settle the note and accrued interest for a tract of land
having a fair value of P4,500,000. The acquisition cost of the land is
P3,600,000. What amount of pretax gain on extinguishment should Hull
Company report as component of income from continuing operations in 2020?
a. 2,000,000
b. 1,400,000
c. 1,100,000
d. 900,000
2. During 2020, Mann Company experienced financial difficulties and is likely to
default on a P5,000,000, 15% three year note dated January 1, 2018 payable
to Summit bank. On December 31, 2020, the bank agreed to settle the note
and unpaid interest of P750,000 for P4,100,000 cash payable on January 31,
2021. What amount should be reported as gain from extinguishment of debt in
the 2020 income statement?
a. 1,650,000
b. 900,000
c. 750,000
d. 0
3. The following information pertains to the transfer of real estate pursuant to a
debt restructuring by Knob Company to Mene Company in full liquidation of
Knob Company's liability to Mene Company:
Carrying amount of liability liquidated 1,500,000
Carrying amount of real estate transferred 1,000,000
Fair value of real estate transferred 1,200,000
What amount of pretax gain on extinguishment should Knob Company report
as component of income from continuing operations?
a. 300,000
b. 500,000
c. 200,000
d. 0
Due to extreme financial difficulties, Armada Company had negotiated a restructuring
of a 10% P5,000,000 note payable due on December 31, 2020. The unpaid interest
on the note on such date was P500,000. The creditor agreed to reduce the face
amount to P4,000,000, forgive the unpaid interest, reduce the interest rate to 8% and
extend the due date three years from December 31, 2020. The present value of 1 at
10% for three periods is 0.75 and the present value of an ordinary annuity of l at 10%
for three periods is 2.49.
4. What is the gain on extinguishment for 2020?
a. 1,703,200
b. 1,203,200
c. 2,000,000
d. 540,000
5. What is the interest expense for 2021?
a. 320,000
b. 379,680
c. 500,000
d. 400,000
Due t0 adverse economic circumstances and poor management, Tagaytay Highlands
Company had negotiated a restructuring of a 9% P6,000,000 note payable to Second
Bank due on January 1, 2020. There was no accrued interest on the note on January
1, 2020. The bank reduced the principal obligation from P6,000,000 to P5,000,000
and extended the maturity to three years on December 31, 2022. However, the new
interest rate is 13% payable annually every December 31.The present value of 1 at
9% for three periods is .77 and the present value of an ordinary annuity of 1 at 9% for
three periods is 2.53.
6. What is the present value of the new note payable on January 1, 2020?
a. 6,000,000
b. 5,000,000
c. 5,494,500
d. 3,850,000
7. What is the gain on modification of debt to be recognized for 2020?
a. 500,000
b. 350,000
c. 505,500
d. 0
8. What is the interest expense for 2020 as a result of the modification?
a. 650,000
b. 450,000
c. 494,505
d. 540,000
On January 1, 2020, Granada Company had an overdue 10% note payable to First
Bank at P8,000,00 and accrued interest of P800,000. As a result of a restructuring
agreement on January , 2040, First Bank agreed to the following provisions. The
principal obligation is reduced to P6,000,000. The accrued interest of P800,000 is
forgiven. The date of maturity is extended to December 31, 2023. Annual interest of
12% is to be paid for 4 years every December 31. The present value of 1 at 10% for 4
periods is 0.683 and the present value of an ordinary annuity of 1 at 10% for 4 periods
is 3.17.
9. What is the present value of the new note payable on January 1, 2020?
a. 6,380, 400
b. 6,000,000
c. 4,098,000
d. 5,464,000
10. What is the gain on extinguishment of debt to be recognized for 2020?
a. 2,000,000
b. 2,800,000
c. 2,419,600
d. 1,619,600

In a Nutshell

I. On January 1, 2020, Sunrise Company is experiencing extreme financial pressure

and is in default in meeting interest payment on a long term note of P6,000,000 due
on December 31, 2021. The interest rate is 12% payable every December 31. The
accrued interest payable on January 1, 2020 is P720,000. In an agreement with the
creditor, the entity obtained the following changes in the terms of note:
a. The accrued interest on January 1, 2020 is forgiven.
b. The principal is reduced by P500,000.
C. The new interest rate is 8% payable every December 31.
 d. The new date of maturity is December 31, 2023.
The present value of 1 at 12% for four periods is 0.6355 and the present value of an
ordinary annuity of 1 at 12% for four periods is 3.0373.

Required:

Prepare all indicated entries for 2020.

II. White Company is indebted to Black Company for P5,000,000 on January 1, 2020.
The principal and accrued interest of P1,000,000 are long overdue. The interest on
the note is 10%.The entity negotiated with Black Company for the restructuring of the
obligation.
a. The principal obligation is reduced by P500,000.
b. The accrued interest of P1,000,000 is waived.
c. The obligation will mature on December 31, 2021
d. The entity shall pay an annual interest of 12% every December 31.
The present value of 1 at 10% Ior two periods is 0.8264 and the present value of an
ordinary annuity of I at 10% for two periods 18 1.7855.

Required:

Prepare journal entries for 2020.

Q and A

In this section you are going to list what boggles you in this unit. You may indicate
your questions but noting you have to indicate the answers after your questions is
being raised and clarified. You can write your questions below:

Questions/ Issues Answers

1.
2.
3.
4.
5.