Auditing Problems Liabilities Ac42

 

AUDITING PROBLEMS Audit of Liabilities

Submitted by: Ma. Mikaella D. Bagadiong Brittney Dianne D. Felin

Submitted to: Marcial C. Paglinawan, CPA

September 2018

PROBLEM 1: National Banks grants a 10-year loan to Cabo Company in the amount of P1,500,000 with a stated interest rate of 6%. Payments are due monthly and are computed to be P16,650. National Bank incurs P40,000 of direct loan origination cost and P20,000 of indirect loan origination cost. In addition, National Bank charges Cabo a 4-point nonrefundable loan origination fee. Cabo, the borrower, has a carrying amount of:

  a. P 1,440,000 b. P 1,480,000 c. P 1,500,000 d. P 1,520,000 Solution: Loan Payable Origination Fees (4% x P1.5M).

P 1,500,000 60,000 P 1,440,000

NOTES: •

PFRS 9, par 5.1.1, an entity shall measure INITIALLY a financial liability at fair value minus, in the case of financial liability not designated at fair value through profit/loss, transaction costs that are directly attributable to the issue of the financial liability.

•

Origination fees are charged by the bank (National Bank, the lender) against the borrower for the creation of the loan. Origination fees include compensation for activities such as evaluating the borrower’s financial condition, evaluating guarantees, collateral and other security, negotiating the terms of the loan, preparing and processing documents and closing the loan transaction.

PROBLEM 2: House Publishers offered a contest in which the winner would receive P1 million payable over 20 years. On December 31, 2011, House announced the winner of the contest and signed a note payable to the winner for P1 million, payable in P50,000 installments every January 2. Also on December 31, 2011, House purchased an annuity for P418,250 to provide the P950,000 prize monies remaining after the first P50,000 installment, which was paid on January 2, 2012. In its 2011 profit or loss, what should House report as contest prize expense?

  a. P 0 b. P 418,250 c. P 468,250 d. P 1,000,000 Solution: Purchase of annuity Payment of first installment Contest prize expense.

P 418,250 50,000 P 468,250

NOTES: •

The noncurrent N/P of P 950,000 is presented minus the discount on N/P of P531,750 or P 418,250.

•

An annuity is a contract between a purchaser and an insurance company in which the purchaser makes a lump sum payment or series of payments and in return obtain regular disbursements beginning immediately or at some point in the future.

•

Journal Entries: Contest pize expense P418,250 Discount on N/P 531,750 N/P- noncurrent P950,000 Contest prize expense P 50,000 N/P - current P 50,000

PROBLEM 3. INTEREST-BEARING NOTE - LUMP SUM On January 1, 2017, Davao Company bought a machine from Tagum Co. In lieu of cash payment, Davao gave Tagum a 4-year, P 4,000,000, 15% note payable. Principal is due on December 31, 2020 but interest is due annually every December 31. The prevailing interest rate for this type of note is 10%.

 

Questions: Based on the above data, answer the following: 1. How much is the cost of the machinery acquired on January 1, 2017? a. P 3,783,973 b. P 3,796,160 c. P 4,000,000 d. P 4,633,973 Solution: Present value of 1 for 4 periods @ 10% Present value of an ordinary annuity of 1 for 4 periods @ 10%

0.6830 3.1699

Present value of principal (4,000,000 x 0.6830) Present value of annual interest payments (4,000,000 x 15% x 3.1699) Cost of machinery

P 2,732,053.821 1,901,919.268 P 4,633,973.089

Schedule of Premium Amortization Date Interest paid Jan 1 2017 Dec 31 2017 600,000 Dec 31 2018 600,000 Dec 31 2019 600,000 Dec 31 2020 600,000

Interest expense

Amortization

463,397 449,737 434,711 418,182

136,603 150,263 165,289 181,818

Carrying Amount 4,633,973 4,497,370 4,347,107 4,181,818 4,000,000

NOTES: •

When a 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.

2. How much is the interest expense for 2017? a. P 232,308 b. P 434,711 c. P 463,397 d. P 600,000 Solution: Carrying amount 2017. Effective interest rate Interest expense

P 4,633,973 10% P463,397

3. How much is the carrying amount of the note on December 31, 2017? a. P 4,000,000 b. P 4,347,107 c. P 4,497,370 d. P 4,578,468 Solution: Carrying amount of note 1/1/2017 Less: Premium Amortization Interest paid Interest expense

P4,633,973 600,000 (463,397)

(136,603) P4,497,370

4. How much is the current portion of the note on December 31, 2017? a. Nil b. P 71,077 c. P 150,263 d. P 4,497,370 NOTE: • The note is to be paid in full on Dember 31, 2020.

5. How much is the noncurrent portion of the note on December 31, 2017? a. Nil b. P 71,077 c. P 4,497,370 d. P 4,347,107 Solution: Note payable, due December 31, 2020 Premium on note payable Less: Premium amortization 2017 Carrying amount

P 4,000,000 633,973 (136,603) P 4,497,370

PROBLEM 4. INTEREST-BEARING NOTE - UNIFORM INSTALLMENTS On January 1, 2017, Davao Co. acquired machinery from Malita Co. In lieu of cash payment, Davao gave Malita a 4-year, 15% P 4,000,000, interest-bearing note. Principal is due in equal payments starting December 31, 2017. Interest is also payable every December 31. The prevailing rate for this type of note is 10%.

  Questions: Based on the above data, answer the following: 1. How much is the cost of the machinery acquired on January 1, 2017? a. P 3,783,973 b. P 4,000,000 c. P 4,415,067 d. P 4,633,973 Solution: Present value of 1 at 10%: One period Two periods Three periods Four periods Date of payment Dec 31 2017 Dec 31 2018 Dec 31 2019 Dec 31 2020 Total present value

0.9091 0.8264 0.7513 0.6830 Interest Payments 4,000,000 x 15% = 600,000 3,000,000 x 15% = 450,000 2,000,000 x 15% = 300,000 1,000,000 x 15% = 150,000

Principal Payments 1,000,000

Total Payments 1,600,000

PV Factor 0.9091

Present Value

1,000,000

1,450,000

0.8264

P 1,454,545.455 1,198,347.107

1,000,000

1,300,000

0.7513

976,709.2412

1,000,000

1,150,000

0.6830

785,465.4737 P 4,415,067.276

Schedule of Premium Amortization Date Interest paid Interest expense Jan 1 2017 Dec 31 2017 600,000 441,507 Dec 31 2018 450,000 325,657 Dec 31 2019 300,000 213,223 Dec 31 2020 150,000 104,545

Amortization

Principal Payment

158,493 124,343 86,777 45,454

1,000,000 1,000,000 1,000,000 1,000,000

2. How much is the interest expense for 2017? a. P 434,711 b. P 441,507 c. P 463,397 d. P 600,000 Solution: Carrying amount 2017 Effective Rate

P 4,415,067 10% P 441,507

3. How much is the carrying amount of the note on December 31, 2017? a. P 3,000,000 b. P 3,256,574 c. P 3,400,000 d. P 4,578,468 Solution: Carrying amount, Jan 1 2017 Less: Premium Amortization Interest paid Interest expense Principal payment Carrying amount Dec 31 2017

P 4,415,067 600,000 (441,507)

(158,493) (1,000,000) P 3,256,574

4. How much is the current portion of the note on December 31, 2017? a. Nil b. P 124,343 c. P 1,124,343 d. P 2,132,231 Solution: Note payable P 1,000,000 Premium amortization 124,343 Carrying amount. P 1,124,343

Carrying Amount 4,415,067 3,256,574 2,132,231 1,045,454 -

NOTE: The current portion of the note as of December 31,2017 is equal to the principal payment and amortization that are to be settled on December 31, 2018, which is within12 months after the 2017 reporting period.

•

5. How much is the noncurrent portion of the note on December 31, 2017? a. Nil b. P 124,343 c. P 1,124,343 d. P 2,132,231 Solution: Note payable, due 2019 Premium amortization, due 2019 Note payable, due 2020 Premium amortization, due 2020 Carrying amount on Dec 31 2018

P 1,000,000 86,777 P 1,000,000 45,454 P 2,132,231

NOTE: The noncurrent portion of the note as of December 31,2017 is equal to the principal payments and amortizations that are to be settled more than 12 months after the 2017 reporting period.

•

PROBLEM 5. Initial Recognition, Subsequent Measurement and Derecognition and Reclassification of Financial Liabilities at fair value through profit or loss On January 1, 2017, Oroquieta Co. issued 4-year bonds with a face value of P 4,000,000 for P 4,633,973. The bonds carry an interest of 15% per year payable annually on December 31. The prevailing rate of interest is 10%. The bonds are to be appropriately classified as financial liabilities at fair value through profit or loss. On December 31, 2017, the bonds are quoted at 103%. On January 1, 2018, 40% of the bonds were retired at 105% its fair value on that date.

  Questions: Based on the above data, answer the following: Assume that there are no changes due to credit risk: 1. How much is the interest expense for 2017? Answer: P600,000 Solution: Bonds payable 4,000,000 Nominal interest rate 15% Interest expense. 600,000

2. How much is the unrealized loss (or gain) in 2017 to be recognized in the profit or loss? Answer: P513,973 Solution: Bonds payable, Jan 2017 Fair value @103, Dec 2017 Decrease in fair value of bonds payable – gain

4,633,973 4,120,000 513,973

JE: Jan 1 2017

Cash

4,633,973 Bonds payable

Dec 31 2017 Interest expense Cash

4,4633,973

600,000 600,000

Bonds payable 513,973 Unrealized gain from change in fair value

513,973

NOTES: •

In accordance with PFRS 9, paragraph 4.2.2, at initial recognition, bonds payable may be irrevocably designated at fair value through profit or loss. In other words, under the fair value option, the bonds payable shall be measured initially at fair value and remeasured at every year-end with any changes in fair value generally recognized in profit or loss. The carrying amount of the bonds payable is always equal to the fair value at every year-end.

•

There is no more amortization of bond discount and bond premium. Any transaction cost or bond issue cost should be expensed immediately. As a matter of fact, interest expense is recognized using the nominal or stated rate.

3. How much is the realized loss (or gain) on derecognition in 2018 to be recognized in the profit or loss? Answer: P32,000 Solution: Bonds payable retired (4,000,000 x 40% x 103) Retirement price (4,000,000 x 40% x 105) Loss on early retirement of bonds JE: Bonds payable Loss on early retirement of bonds Cash

P 1,648,000 1,680,000 32,000

1,648,000 32,000 1,680,000

NOTES: PFRS 9 Derecognition of a financial liability •

A financial liability should be removed from the statement of financial position when, and only when, it is extinguished, that is, when the obligation specified in the contract is either discharged, cancelled, or expired.

•

Where there has been an exchange between an existing borrower and lender of debt instruments with substantially different terms, or there has been a substantial modification of the terms of an existing financial liability, this transaction is accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability.

•

A gain or loss from extinguishment of the original financial liability is recognized in the income statement.

4. Assuming that on January 1, 2018, the remaining bonds were reclassified to financial liabilities at amortized cost, how much is the gain or loss on reclassification? Answer: Nil NOTES: •

PFRS 9, provides that an entity shall reclassify financial instruments only when it changes its business model for managing the financial instrument.

•

Where reclassification occurs, an entity shall apply the reclassification prospectively from the reclassification date. The entity shall not restate any previously recognized gains, losses and interest.

•

The reclassification date is the first day of the reporting period following the change in business model that results in an entity reclassifying financial asset.

Reclassification from FVPL to amortized cost •

PFRS 9 provides that when an entity reclassifies a financial instrument from fair value through profit or loss to amortized cost, the fair value at the reclassification date becomes the new carrying amount of the financial instrument at amortized cost.

•

The difference between the new carrying amount of the financial instrument at amortized cost and the face value of the financial instrument shall be amortized through profit or loss over the remaining life of the financial asset using the effective interest method.

PROBLEM 6. Unrealized Gain or Loss of FVTPL with Change due to Credit Risk On January 1, 2015, Tubod Co. issues a 6-year bond with a par value of P 2,000,000 and an annual fixed coupon rate of 10% which is consistent with market rates for bonds with similar characteristics. Tubod uses observed (benchmark) interest rate. At the date of inception of the bonds, this rate is 7%. At the end of the first year: a. Observed (benchmark) interest rate has decreased to 6%. b. The fair value interest rate of the bonds is 8%. Tubod is required to present the effects of changes in the liability's credit risk in other comprehensive income.

  Questions: Based on the above data, answer the following: 1. How much is the unrealized gain or loss to be recognized in the OCI during 2015? a. Nil b. P 82,000 c. P 77,740 d. P 159,740 2. How much is the unrealized gain or loss to be recognized in the P&L during 2015? a. Nil b. P 82,000 c. P 77,740 d. P 159,740 Solution: The bonds internal rate of return is 10%, because the oberved (benchmark) interest rate is 7%, the instrument specific component of the internal rate of return is 3%. The discount rate to calculate the present value of the bond is thus, 9% (6% + 3%). At the end of 2015: Present value of 1 for 5 period at 8% Present value of an ordinary annuity of 1 for 5 periods at 8% Present value of principal Present value of annual interest payments Total present value

(2,000,000 x 0.6806) P 1,361,200 (2,000,000 x 10% x 3.9927) 798,540 P 2,195,740

Present value of 1 for 5 periods at 9% Present value of an ordinary annuity of 1 for 5 periods at 9% Present value of principal Present value of annual interest payments Total present value

0.6806 3.9927

0.6499 3.8897

(2,000,000 x 0.6499) P 1,299,800 (2,000,000 x 10% x 3.8897) 777,940 P 2,077,740

Fair value at 8% Fair value at 9% Increase in fair value – other comprehensive income

P 2,159,740 2,077,740 82,000

Increase in the fair value of bonds payable P 159,750 Increase attributable to credit risk 82,000 Increase attributable to change in the market interest rate 77,740 JE: Dec 31 2015 Unrealized loss on credit risk – OCI Unrealized loss from change in fair value Bonds payable

82,000 77,740 159,740

NOTES: •

PFRS 9, paragraph 5.7.7 Gains and losses arising from remeasuring a financial asset or financial liability at fair value should be normally recognized in profit or loss. However, there is an exception for most non-derivative financial liabilities that are designated as measured at fair value through profit or loss. For these liabilities the element of the gain or loss attributable to changes in credit risk should be recognized in other comprehensive income (with remainder recognized in profit or loss).

•

Amounts presented in other comprehensive income should not be subsequently transferred to profit or loss. However, the cumulative gain or loss may be transferred within the equity.

•

This exception does not apply to loan commitments or financial guarantee contracts (PFRS 9 par 5.7.9), nor does it apply if it would create or enlarge an accounting mismatch in profit or loss. In these cases all changes in fair value of the liability (including the effects of changes in the credit risks) should be recognized in profit or loss. (PFRS 9. B5.7.8) Credit risks – the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation

•

Changes in market conditions that give rise to market risk include changes in benchmark interest rate, the price of another entity’s financial instrument, a commodity price, foreign excahnge rate or index of prices or rates.

PROBLEM 7. Initial Recognition, Subsequent Measurement and Derecognition and Reclassification of Financial Liabilities at Amortized Cost On January 1, 2017, Oroquieta Co. issued 4-year bonds with a face value of P 4,000,000 for P 4,633,973. The bonds carry an interest of 15% per year payable annually on December 31. The prevailing rate of interest is 10%. The bonds are to be appropriately classified as financial liabilities at amortized cost. On December 31, 2017, the bonds are quoted at 103%. On January 1, 2018, 40% of the bonds were retired at 105% its fair value on that date.

  Questions: Based on the above data, answer the following: 1. How much is the interest expense for 2017? Answer: P463,397 Solution: Carrying amount 2017. Effective interest rate Interest expenses.

P 4,633,973 10% P463,397

Schedule of Premium Amortization

Date

Interest paid

Interest expense

Amortization

Jan 1 2017 Dec 31 2017 Dec 31 2018 Dec 31 2019 Dec 31 2020

600,000 600,000 600,000 600,000

463,397 449,737 434,711 418,182

136,603 150,263 165,289 181,818

Carrying Amount 4,633,973 4,497,370 4,347,107 4,181,818 4,000,000

2. How much is the unrealized loss (or gain) in 2017 to be recognized in the profit or loss? Answer: Nil NOTE: •

Unrealized gain and loss on financial instrument at amortized cost are not recognized simply because such investments are not reported at fair value.

•

PFRS 9, provides that gain and loss on financial instrument measured at amortized cost and is not part of a hedging relationship shall be recognized in profit or loss when the financial instrument is derecognized, sold, impaired or reclassified, and through the amortization process.

3. How much is the realized loss (or gain) on derecognition in 2018 to be recognized in the profit or loss? Answer: P7,273 Solution: Carrying amount of 40% of bonds (4,181,818 x 40%) Retirement price (4,000,000 x 40% x 105) Loss on retirement of bonds

P 1,672,727 1,680,000 7,273

4. Assuming that on January 1, 2018, the remaining bonds were reclassified to financial liabilities at fair value through profit or loss, how much is the gain or loss on reclassification? Answer: P10,909 Solution: Fair value of remaining 60% bonds (4,000,000 x 60% x 105) Carrying amount of remaining 60% bonds (4,181,818 x 60%) Loss on reclassification of bonds payable

P 2,520,000 2,509,091 10,909

PROBLEM 8. Financial Liabilities at Amortized Cost - Term Bonds On January 1, 2015, NCPAR Co. issued 3-year bonds with a face value of P 1,200,000 and stated interest of 8% per year payable annually on Dec 31. the bonds were acquired to yield 10%. The bonds were appropriately classified as financial liability at amortized cost.

  Questions: Based on the above data, answer the following: 1. How much is the issue price of bonds on January 1, 2015? a. Nil b. P 290,302 c. P 1,140,302 d. P 1,051,730 Solution: Present value of 1 for 3 periods at 10% Present value of an ordinary annuity of 1 for 3 periods at 10%

0.7513 2.4869

Present value of principal (1,200,000 x 0.7513) P 901,560 Present value of ordinary annuity of interest payments(1,200,000 x 8% x 2.4869) 238,742 Issue price P 1,140,302

2. How much is the interest expense for 2015? a. P 96,000 b. P 114,030 c. P 117,817 d. P 114,104 Solution: Carrying amount, Jan 1 2015 P 1,140,302 Effective interest rate 10% Interest expense P 114,030 PROBLEM 9. Financial Liabilities at Amortized Cost - Serial Bonds On January 1, 2015, Bukidnon Co. issued 3-year bonds with a face value of P 1,200,000 and stated interest of 8% per year. The bonds mature in 3 equal annual installments every December 31. The interest is also payable every December 31. The bonds were acquired to yield 10%. The bonds were appropriately classified as financial liability at amortized cost.

  Questions: Based on the above data, answer the following: 1. How much is the issue price of the bonds on January 1, 2015? a. P 1,158,925 b. P 907,875 c. P 1,432,125 d. P 896,042 Solution: Present value of 1 at 10% One period Two periods Three periods Date of payment Dec 31 2015 Dec 31 2016 Dec 31 2017 Total present value Face vale Discount on bonds payable

0.9091 0.8264 0.7513

Interest Payments 1,200,000 x 8% = 96,000 800,000 x 8% = 64,000 400,000 x 8% = 32,000

Principal Payments

Total Payments

400,000

496,000

PV Factor 0.9091

400,000 400,000

464,000 432,000

0.8264 0.7513

Present Value 450,913.6 383,449.6 324,561.6 P 1,158,924.8 1,200,000 41,075

2. How much is the interest expense for 2015?

a. P 115,892 b. P 143,212 c. P 107,934 d. P 174,604 Solution: Carrying amount, Jan 2015 Effective interest rate Interest expense

P 1,158,925 10% P 115,892

NOTES: •

Term bonds are bonds with a single date of maturity.

•

Serial bonds are bonds with a series of maturity dates and allow the issuing entity to retire the bonds by installment.

•

Initial measurement of bonds payable

PFRS 9, par 5.1.1:

Bonds payable not designated at fair value through profit or loss shall be measured initially at fair value minus transaction costs that are directly attributable to the issue of the bonds payable. The market price or issue price of the bonds payable is equal to the present value of the principal bond liability plus the present value of future interest payments. PROBLEM 10. Issuance, Retirement and Conversion of Non-Convertible Bonds On January 1, 2017, Dumagete Co. issued its, P 4,000, 10%, 5-year bonds at the prevailing rate of interest of 15%. Interest is payable every December 31. On December 31, 2017, after payment of interest, 1/2 of the bonds were retired at P 1,900,000 when the fair value of the securities is P 350. The prevailing rate of interest of the bonds is 12%. On December 31, 2018, after payment of interest, the remaining bonds were converted into P 100 par value, 4,000 ordinary shares when the fair value of the securities is P 400. The bonds were converted because of the equity swap.

  Questions: Based on the above data, answer the following: 1. Issue price of the bonds on January 1, 2017. Answer: P3,329,680 Solution: Present value of 1 for 5 periods @ 15% Present value of an ordinary annuity of 1 for 5 periods @ 15% Present value of principal Present value of annual interest payments Issue price of bonds

0. 4972 3.3522

(4,000,000 x 0.4972) P 1,988,800 (4,000,000 x 10% x 3.3522) 1,340,880 P 3,329,680

Schedule of Discount Amortization Date Interest paid Interest expense Jan 1 2017 Dec 31 2017 400,000 499,452 Dec 31 2018 400,000 514,370 Dec 31 2019 400,000 531,525 Dec 31 2020 400,000 551,254 Dec 31 2021 400,000 573,942

Amortization 99,452 114,370 131,525 151,254 173,942

Carrying Amount 3,329,680 3,429,132 3,543,502 3,675,027 3,826,281 4,000,000

2. The gain or loss on the retirement of the bonds on December 31, 2017. Answer: P185,434 Solution: Carrying amount of ½ of bonds, Dec 31, 2017 Retirement price Loss on retirement of bonds

P 1,714,566 1,900,000 185,434

NOTES: Retirement of Non-convertible Bonds •

Gain or loss may be recognized on retirement of bonds prior to maturity.

•

No gain or loss on retirement of bonds on maturity.

Conversion of nonconvertible bonds because of equity swap •

Gain or loss on conversion may be recognized: Fair value of equity instrument ( or if not reliably determinable, fair value of liability) minus carrying amount of liability

3. The interest expense in 2018. Answer: P257,185 Solution: Carrying amount of remaining ½ of bonds Effective interest rate Interest expense

P 1,714,566 15% 257,185

4. The gain (or loss) on the conversion of the bonds on December 31, 2018. Answer: P171,751 Solution: . Carrying amount of the remaining bonds, Dec 2018 (3,543,502 x 50%) Fair value of shares ( 4,000 ordinary shares x P 400) Gain on conversion of bonds

P 1,771,751 1,600,000 171,751

NOTES: Equity Swap •

An equity swap is a transaction whereby a debtor and creditor 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.

•

IFRC 19 provides that an entity shall initially measure equity instruments issued to extinguish all or part of a financial liability at the fair value of the equity instruments issued or the fair value of the liability extinguished, whichever is more reliably determinable. 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 be measured at the carrying amount of the financial liability extinguished.

Conversion of nonconvertible bonds because of equity swap •

Gain or loss on conversion may be recognized: Fair value of equity instrument ( or if not reliably determinable, fair value of liability) minus carrying amount of liability

5. The net increase (or decrease) in the share premium as a result of the conversion of the bonds on December 31, 2018. Answer: P1,200,000 Solution: Fair value of shares issued (4,000 ordinary shares x 400) Par value of shares issued (4,000 ordinary shares x 100) Share premium

P 1,600,000 400,000 1,200,000

PROBLEM 11. Issuance, Retirement and Conversion of Convertible Bonds

On January 1, 2017, Tagbilaran Co. issued its 10%, 4-year, P4,000,000 convertible bonds for the face amount of P4,000,000. The bonds are convertible into P200 par ordinary shares at a conversion price of P250 per share. The prevailing rate of interest of the bonds without the conversion option is 15%. Interest is payable every December 31. On December 31, 2017, after payment of interest, 1/2 of the bonds were retired at P 1,900,000 when the fair value of the securities is P350. The prevailing rate of interest of the bonds is 12%. On January 1, 2018, to induce the holder to convert the convertible debenture promptly, Tagbilaran reduces the conversion price to P200 if the debenture is converted before March 1, 2018 (i.e. within 60 days). All the bondholders accepted the offer on January 1, 2018. On the date of conversion, the fair value of the Tagbilaran Co.'s ordinary share is P240 per share.

  Questions: Based on the above data, answer the following: 1. The amount allocated to equity component on January 1, 2017. Answer: P570,800 Solution: Present value of 1 for 4 periods at 15%. Present value of an ordinary annuity of 1 for 4 periods at 15%. Issue price Less: liability component Present value of principal (4M x 0.5718) Present value of interest payment (4M x 2.8550) Equity Component

P 4,000,000 2,287,200 1,142,000

JE: Cash 4,000,000 Discount on bonds payable 570,800 Bonds payable Share premium-conversion privilege

0.51718 2.8550

4,000,000 570,800

3,429,200 570,800

2. The gain or loss on the retirement of the bonds on December 31, 2017. Answer: P132,170 Solution: Present value of 1 for 3 periods at 12% Present value of an ordinary annuity of 1 for 3 periods at 12%

0.7118 2.4018

Carrying amount of bonds retired, Dec 2017 (3,543,580 x 50%) Less: Payment applied to liability component PV of principal (2M x 0.7118) PV of Interest payments (2M x 10% x 2.4018)

P 1,771,790

1,423,600 480,360

1,903,960

Loss on Retirement Schedule of Discount Amortization Date Interest paid Interest expense Jan 1 2017 Dec 31 2017 400,000 514,380 Dec 31 2018 400,000 531,537 Dec 31 2019 400,000 551,268 Dec 31 2020 400,000 573,958

132,170

Amortization

114,380 131,537 151,268 173,958

Carrying Amount 3,429,200 3,543,580 3,675,117 3,826,385 4,000,000

3. The net increase (or decrease) in equity as a result of the retirement of the bonds on December 31, 2017. Answer: P3,960 Solution: Retirement price Less: Payment applied to liability component Payment allocated to equity component (decrease) 4. The interest expense in 2017. Answer: P514,380 Solution: Carrying amount of bonds, Jan 2017 Effective interest rate Interest expense

P 3,429,200 15 % 514,800

P 1,900,000 1,903,960 3,960

5. The amount to be recognized in profit or loss as a result of the amendment of the terms on January 1, 2018. Answer: P480,000 Solution: Ordinary shares to be issued Ordinary shares to be issued- original terms Incremental ordinary shares to be issued

(2,000,000 / P 200) (2,000,000 / P 250)

Value of incremental shares to be issued (2000 x P 240)

10,000 8,000 2,000

P 480,000

NOTES: •

PAS 32 paragraph 29 states that an entity recognizes separately the components of a financial instrument that (a) creates a financial liability of the entity and (b) grants an option to the holder of the instrument to convert it into an equity instrument of the entity.

•

The liability component is equal to the market value of the bonds without conversion privilege.

•

If the market value of the bonds without the conversion privilege is unknown, the amount equal to the present value of the principal bond liability plus the present value of the future interest payments using the market rate of interest for similar bonds without the conversion privilege.

•

Paragraph 31 further states that equity instruments are instruments that evidence a residual interest in the assets of an entity efter deducting all of its liabilities. Therefore, when an initial carrying amount of a compound financial instrument is allocated to its equity and liability components, the equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole the amount separately determined for the liability component.

•

On conversion of a convertible instrument at maturity, the entity derecognizes the liability component and recognizes it as equity. The original equity component remains as equity (although it may be transferred from one line item within equity to another). There is no gain or loss on conversion at maturity. (PAS 32 AG32)

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When an entity extinguishes a convertible instrument before maturity through an early redemption or repurchase in which the conversion privileges are unchanged, the entity allocates the consideration paid and any transaction costs for the repurchase or redemption to the liability and equity components of the instrument at the date of transaction. The method used in allocating the consideration paid and transaction costs to the separate components is consistent with that used in the original allocation to the separate components of the proceeds received by the entity when the convertible instrument was issued. (PAS 32 AG33)

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Once the allocation of the consideration is made, any resulting gain or loss is treated in accordance with accounting principles applicable to the related component, as follows:

a. The amount of gain or loss relating to the liability component is recognized in profit or loss; and b. The amount of consideration relating to the equity component is recognized in equity. (PAS 32 AG34) •

An entity may amend the terms of a convertible instrument to induce early conversion, for example by offering a more favorable conversion ratio or paying other additional consideration in the event of conversion before a specified date. The difference, at the date the terms are amended, between the fair value of the consideration the holder receives on conversion of the instrument under the revised terms and the fair value of the consideration the holder would have received under the original terms is recognized as a loss in profit or loss. (PAS 32 AG35)