Ia201-intermediate-accounting-2

IA201 INTERMEDIATE ACCOUNTING 2

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STUDENT Name: Student Number: Program: Section: Home Address: Email Address: Contact Number:

PROFESSOR Name: AUREA B. NATIVIDAD Academic Department: DEPARTMENT OF BUSINESS AND EDUCATION Consultation Schedule: Monday – Friday 8:00-12:00nn and 1:00-3:00pm Email Address: [email protected] Contact Number: 09256093145

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General Instructions

1. Read your textbook, if you have, for initial understanding of the topic. 1. 2. Pay attention to the illustrations and explanation, make sure to follow all that is being required to you. 3. As you study the module, make sure to answer all the questions that are being asked in the module, this will help you understand more the lesson, and this may be discussed during consultation so better be prepared . 4. Provided in the module is the checklist for submission. Make sure to separate answer to the question, assessment, and Nature, Initial Recognition, Subsequent Measurement, T-account, Presentation and Disclosure per lesson, staple it individually. Please put your name on each activity for proper recording. Proper filing and recording is one of the good traits of an accountant. 5. If this module will not be printed, kindly write all your answers to enrichment and assessment on a yellow paper with your name, the NRMTPD will be on a bond paper. For the multiple choice questions, write the correct letter only with correct amount. But if you want to print the module it’s okay to pass the answers to assessment in printed form. 6. Periodical Exam may be given at the end of the semester 7. Students’ learning is primarily students’ responsibility, CCC BSA students shall maintain honesty and integrity at all times. 8. Contents of this material are owned by the City College of Calamba. You may not reproduce, distribute, publish, display, modify, create derivative works, transmit nor may you distribute any part of this or offer it for sale, or use it to construct any kind of database.

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Checklist for submission Lessons

NRMTPD (Nature, Initial Recognition, Subsequent Measurement, T account, Presentation and Disclosure)

Questions per lesson

Assessment

Remark

Module 1 Lesson 1 – Current Payable Lesson 2 – Notes Payable Lesson 3 – Bonds Payable Module 2 Lesson 1 – Provisions and Contingent Assets and Liabilities Lesson 2 - Share Capital Lesson 3 – Retained Earnings Module 3 Lesson 1 – Basic Earnings Per share Lesson 2 - Earnings Per Share Lesson 3 – Shared Based Compensation Lesson 4 - Employee Benefits

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LEARNING MODULE INFORMATION I. Course Code II. Course Title

IA201 INTERMEDIATE ACCOUNTING 2

III. Module Number IV. Module Title

1 Current Liabilities, Notes Payable, Bonds Payable

V. Overview of the Module

The course is all about the Liabilities, shareholder’s equity and other special topics in intermediate accounting II. Each topic of this module discusses the standards that govern the recognition of each account in liabilities and shareholder’s equity, there will be computations for illustrations, enrichment wherein you will be asked with problems and after that is the discussion of the problem. It is advised that if you are going to study this module focus on understanding the standards, the why and relationships of computation not just the how it is being computed.

VI. Module Outcomes

At the end of this module, the students should be able to: 1. Apply the financial accounting standards relative to the recognition, measurement, financial statement presentation, and disclosure requirements of liability in accordance with the Philippine Accounting Standards (PAS) and Philippine Financial reporting Standards (PFRS). 2. Compute amortization of discount, premium, and bond issue cost using the effective interest method.

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Lesson 1: CURRENT LIABILITIES Lesson Objectives: 1. State the recognition criteria for liabilities 2. Identify the characteristics of a financial liability 3. State the initial and subsequent measurement of financial and non-financial liabilities. 4. Classify liabilities as current and non-current Discussion and Application: Standards that are related to CURRENT LIABILITIES PAS 1: Presentation of Financial Statement PAS 32: Financial Instruments: Presentation PFRS 9: Financial Instruments Definition of Liability Liability is “a present obligation of the entity to transfer an economic resource as a result of past events” (Conceptual Framework 4.26) Transfer of an economic resource The liability is the obligation that has the potential to require the transfer of an economic resource to another party and not the future economic benefits that the obligation may cause to be transferred. Thus, the obligation’s potential to cause a transfer of economic benefits need not be certain, or even likely, for example, the transfer may be required only if a specified uncertain future event occurs. What is important is that the obligation is already exists and that, in at least one circumstance, it would require the entity to transfer an economic resource. An obligation to transfer an economic resource may be an obligation to: a. pay cash, deliver goods, or render services b. exchange assets with another party on unfavorable terms: c. transfer assets if a specified uncertain future event occurs; or d. issue a financial instrument that obliges the entity to transfer an economic resource. Present obligation as result of past events The obligation must be present obligation that exists as a result of past events. A present obligation exists as a result of past events if a. the entity has already obtained economic benefits or taken an action; and b. as a consequence, the entity will or may have to transfer an economic resource that it would not otherwise have had to transfer. (Conceptual Framework 4.43) If you are going to check whether in transaction if the liability exists you have to look at these three terms. 1. An obligation to transfer an economic resource may be an obligation to:

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a. pay cash, deliver goods, or render services – this may exist let say a supplier deliver goods to you on account you have to pay the supplier in cash, or a customer paid in advance for a service or a goods that is to be delivered on a specified time. So this means that the cash, goods, or services are the economic resources that will be used to pay an obligation. b. exchange assets with another party on unfavorable terms: Such obligations include, for example, a forward contract to sell an economic resource on terms that are currently unfavorable or an option that entitles another party to buy an economic resource from the entity. A forward contract is a commitment in the future to buy a certain quantity of inventory with certain amount, in this case, the buyer protects the price of the goods. However, in case there is unfavorable circumstances and the amount of goods suddenly becomes so low and you committed to buy it at higher than the market price then you are obliged to pay what you are committed to buy. c. transfer assets if a specified uncertain future event occurs; or the sample of this is the warranty, or insurance commitment for the insurance company. For the warranty, there is uncertainty whether you are going provide it to the customer or not but, you still need to recognize it as liability (we are going to discuss more of this later in this part) d. issue a financial instrument that obliges the entity to transfer an economic resource – in here the entity issued a financial instrument, can be a liability instrument (bond which we are going to discuss in later chapters) which you are going to pay in cash in the future. 2. A present obligation exists as a result of past events only if a. The entity has already obtained economic benefits or taken an action; and - these economic benefits would include, cash, goods or services. b. As a consequence, the entity will or may have to transfer an economic resource that it would not otherwise have had to transfer. Example of this is the constructive obligation that will be discussed below. Obligation “a duty or responsibility that an entity has no practical ability to avoid.” Conceptual framework 4.29 Two types of obligations a. Legal obligation – this is a result of a contract, legislation, or other operation of law; example of these are the agreement between the debtor and the creditor (contract), our obligation to pay taxes ( legislation or operation of law) b. Constructive obligation - this a result form an entity’s actions ( for example: as mining company you promised that if anything bad happen in the environment because of mining, the company is going to pay and restore the environment and the people who are affected). Remember: One party’s obligation is another party’s right. This means that if an entity incurred an obligation another entity shall have a right over the property of that entity. Let say entity A incurred an obligation because He borrows money from Entity B. Therefore, the entity B has the right to collect from Entity A. Take note: No past events no obligation.

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Executory Contracts “It is a contract that is equally unperformed neither party has fulfilled any of its obligations, or both parties have partially fulfilled their obligations to an equal extent.” (Conceptual Framework 4.56) A simple explanation of this is if the contract is basically not yet performed or partially performed and waiting to be executed first by other party, once executed the combined right and obligation changes to an asset. If the other party performs firs, the entity’s combined right and obligation changes to a liability. Example A contract entered by supplier and consumer, the supplier is entering into a contract to supply a certain number of face mask on a certain date with a certain price and the consumer agreed with it. But this is not yet being performed by the two parties, therefore it is being considered as executory contracts. Once the supplier already delivered the contact is no longer an executory contract, the consumer will now have a liability to the supplier. But if the consumer pays in advance therefore the supplier has a liability to deliver. The Consumer will have an assetthe right to receive a product from the supplier. Recognition Criteria An item is recognized if: a. it meets the definition of a liability; and b. recognizing it would provide useful information, i.e. relevant and faithfully represented information. Both the recognition criteria that is being presented above must be present before you can recognize a certain liability. Now if the other criteria is not present therefore you don’t have a liability to recognize however, you may still need to disclose it in the notes to financial statement. (I hope you remember the disclosure to financial statement this is the additional information that is being included in the financial statement which will be needed by the users of the FS for them to be properly guided). If you are going to look for item b, the relevant and faithful representation means that it is certain that liability may exist, now the liability is not being categorized as relevant if it is uncertain that liability exist or a liability may exist however, there is a low probability that there will be outflow of economic benefits. Meaning if there is liability the probability of the entity paying in the future is low. For the faithful representation, since sometimes the amount of liabilities are hard to measure, the use of reasonable estimates is an essential part to faithfully represent certain liability.

Liabilities can be categorized into two Financial and Non-Financial Liabilities Financial Liability – any liability that is: a. A contractual obligation to deliver cash or another financial asset to another entity

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b. A contractual obligation to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity; or c. A contract that may be settled in the entity’s own equity instruments and is not classified as entity’s own equity instrument. Non- Financial Liability – is a liability other than a financial liability A financial liability is recognized only when the entity becomes a party to the contractual provisions of the instrument. Examples of financial liabilities a. Payables, such as accounts, notes, loans, bonds, and accrued payables b. Lease Liability – this a financial obligation to make payments arising from a lease (lease means - a contract by which one party conveys land, property, services, etc. to another for a specified time, usually in return for a periodic payment.) if we are going to put it in layman’s term it is a rent, or a rent to own. c. Held for trading liabilities and derivatives liabilities - the held for trading liabilities are liabilities that the entity issued for trading. And the derivative liabilities are those forward contracts the commitment to buy a certain amount of goods and at a certain time with a certain price. d. Redeemable preference share issued – if you read it again, yes the redeemable preference share issued is considered as a liability since, in form that is considered as capital account, however, in substance this is considered as liability since anytime the holder of a redeemable preference share can go to the entity and let the preference share be redeemed by the entity, whether the entity has fund or not. e.

Security deposits and other returnable deposits – if you are going to remember in a store, there when you are buying a soft drinks and the vendor will tell you that you need to have a deposit of 5 pesos for the bottle so that you are going to return the bottle. So, this five pesos is just like a deposit and the vendor shall incur a liability, so when you returned the bottle the vendor is going to return to you the 5 pesos deposit.

Examples of non-financial liabilities a. Unearned revenues and warranty obligations that are to be settled through future delivery of goods or provision of services b. Taxes, SSS, Philhealth and Pag-ibig payables – these are the legal obligation. These will be discussed later in the benefits. c. Constructive obligations Classifications of financial Liabilities All financial liabilities are classified as subsequently measured at amortized cost, except for the following. a. Financial liabilities at fair value through profit or loss (FVPL) and derivative liabilities – subsequently measured at fair value (e.g. designated or held for trading) b. Financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition – subsequently measured on a basis that reflects the rights and obligations that the entity has retained.

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c. Financial guarantee contracts and Commitments to provide a loan at a below-market interest rate – subsequently measured at the higher of: i. the amount of the loss allowance (12-month expected credit losses); and ii. the amount initially recognized less, when appropriate, the cumulative amount of income recognized in accordance with the principle of PFRS 15. d. Contingent consideration recognized by an acquirer in a business combination – subsequently measured at fair value through profit or loss. Recognition of financial liabilities Note: Reclassification of financial liabilities after initial recognition is prohibited. As discussed above, you have two classifications of liabilities, the financial and non-financial and the financial liabilities are basically measured amortized cost. The liabilities which are held for trading is one of the exception in the measurement at amortized cost.

Measurement of Financial liabilities Initial Measurement Financial liabilities are initially measured at fair value minus transaction costs, except financial liabilities at FVPL whose transaction costs are expense immediately. Subsequent Measurement ➢ Financial liabilities classified as amortized cost are subsequently measured at amortized cost ➢ Financial liabilities classified as held for trading are subsequently measured at fair value with changes in the fair value recognized in profit or loss ➢ Financial liabilities designated at FVPL are subsequently measured at fair value with changes in fair values recognized as follows: a. The amount of change in the fair value of the financial liability that is attributable to changes in the credit risk of that liability is presented in other comprehensive income and b. The remaining amount of change in the fair value of the liability is presented in profit or loss. Measurement of Non-Financial Liabilities Non-financial liabilities are initially measured at the best estimate of the amounts needed to settle those obligations or the measurement basis required by other applicable standard. Examples of Non-Financial liabilities

a. b. c. d.

Obligation arising from statutory requirements (e.g. income tax payable) Warranty obligation Unearned or deferred revenues Commodity contracts that either cannot be settled in cash or which are expected to be settled by commodity exchange.

For the initial measurement, you have to check first if the liability is a Financial or non- financial liabilities.

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If that is a financial liability you have to measure the liability initially at fair value minus transaction cost, but if the entity opt to recognize the liability at FVPL then the transaction cost are expense immediately. How will you know that the liability is a financial liability or not please check above for the examples of financial liabilities. How will you know if that will be recorded through FVPL or not, initially it is the choice of the entity how to record the financial liabilities. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value normally be considered to be its quoted price, but a valuation technique such as discounted cash flow may be used if the market for the instruments is not active. Please remember that if you are going to initially recognize the non-financial liabilities you have to compute for its best estimate of how much it is to be settled. These principles will be applied in later topics, just continue reading your module. Financial Statement Presentation Liabilities are usually presented as current or non-current on a classified statement of financial position. A classified statement of financial position is one that shows current and noncurrent distinction. Current liabilities Current liabilities that are: a. Expected to be settled in the entity’s normal operating cycle b. Held primarily for trading c. Due to be settled within 12 months after the reporting period or d. The entity does not have an unconditional right to defer settlement of the liability for atleast twelve months after the reporting period. All other liabilities are non-current liabilities The operating cycle of an entity is the time between the acquisition of assets for processing and their realization in cash or cash equivalents. But if it is not clearly identifiable, it is assumed to be 12 months. Liabilities that settled as part of the entity’s normal operating cycle (ex. Trade payables and some accruals for employees and other operating costs ) are presented as current, even if they are expected to be settled beyond 12 months after the reporting period. Examples of current liabilities a. Financial assets measured at FVPL (i.e., designated or held for trading) b. Current portion of long term notes, bonds, loans and lease liabilities c. Trade accounts and notes payables d. Other non-trade payables due within 12 months after end of reporting period. e. Unearned income expected to be earned within 12 months after the end of the reporting period f. Bank overdrafts

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Trade payables were from the purchase of inventories on account shall be classified as current liabilities even if it will be settled/paid longer than the normal operating cycle or one year. All liabilities other than trade payables will be classified as other payables. Identifying whether the other payables is current or non-current will be dependent on when it will be settled. For trading or manufacturing entity, trade and non-trade payables that are currently due are normally aggregated and presented as one line item under the heading “Trade and other payables.” Financial institutions (e.g. banks) need not classify their payables as trade or non-trade because their statement of financial position is presented based on liquidity, i.e., no current and non-current distinction. However, payables expected to be settled within one year and beyond one year are disclosed in the notes.

Examples of payables ✓ Accounts payable – obligations not supported by formal promise to pay by the debtor ✓ Notes payable – obligations supported by promissory notes by the debtor ✓ Loans payable – usually used to connote bank loans ✓ Bonds payable – obligations issued by the debtor supported by promises to pay made under seal ✓ Liabilities under trust receipts. e.g., before the corresponding liability to the bank is paid, the goods is released to the buyer in trust for the bank which advanced the money for importation of goods. ✓ Other payables arising from sources other than purchases and borrowings, such as dividends payable, taxes payable, remittances payable and accrued expenses. Illustration 1: Current liabilities ABC Co. has the following liabilities as of December 31, 20x1. a. Trade accounts payable, net of debit balance in supplier’s account of P5,000, net of unreleased checks of P4,000 and net of postdated checks of P2,000 b. Credit balance in customer’s accounts c. Financial liability designated at FVPL d. Bonds payable (maturing in 10 equal annual installments of P100,000) e. 12%, 5-year note payable issued on October 1, 20x1 f. Deferred tax liability g. Unearned rent h. Contingent liability i. Reserve for contingencies

P300,000 2,000 50,000 1,000,000 100,000 5,000 4,000 10,000 25,000

Requirement: How much is the total current liabilities?

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Solution: a. Trade accounts payable gross of debit balance, unreleased check, and Post dated check (300k+5k+4k+2k) b. Advances from customers (Cr. Bal. in customer’s accounts) c. Financial liability designated at FVPL d. Current portion of bonds payable - Interest payable on the note in “e”(100k x 12%3/12) e. Unearned rent Total current liability

311,000 2,000 50,000 100,000 3,000 4,000 470,000

From the illustration above answer the following questions: 1. Why do you think the postdated checks, the debit balance of the notes receivable and the unreleased checks are being added back to the trade accounts payable? 2. Why is the credit balance of customer’s accounts is being included in liabilities? Where in fact, that is the account of the customer an Accounts receivable with only a credit balance? 3. Why the financial liability designated at FVPL is included in the current liabilities? Do you have any proof? 4. What is an unearned rent? Why is it being included in the current liabilities? Note: Deferred tax liabilities are always presented as noncurrent when an entity presents a classified statement of financial position. Contingent liability is not recognized but rather disclosed only in the notes Reserve for contingencies is an appropriation of retained earnings and, thus presented in equity. Illustration 2: Current liabilities ABC Co. has the following liabilities as of December 31, 20x1. a. Trade accounts payable, including cost of goods received on consignment of P10,000 b. Held for trading financial liabilities c. Deferred revenue d. Bank overdraft e. Income tax payable f. Accrued expenses g. Share dividend payable h. Advances from affiliates payable in 15 months after year-end i. Loan of XYZ, Inc. guaranteed by ABC – it is possible that ABC will be Held liable for the guarantee

P300,000 50,000 20,000 10,000 50,000 5,000 12,000 23,000 45,000

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Requirement: How much is the total current liabilities? Solution: a. Trade accounts payable, net of cost of goods received On consignment (300,000-10,000) b. Held for trading financial liabilities c. Bank overdraft d. Income tax payable e. Accrued expenses Total current liabilities

290,000 50,000 10,000 50,000 5,000 405,000

From the illustration above: 1. Why is the goods on consignment being deducted from the trade accounts payable? 2. What is the difference between income tax payable and deferred tax liabilities?

Notes: ✓ Deferred revenue is similar to unearned revenue except that deferred revenue is long-term. A deferred revenue is a collection in advance in a long term period, If there is an advance payment that will be applicable for the succeeding year then you must consider that one as unearned revenue and it should be a current liability. ✓ Share dividend’s payable (stock dividend payable) is not a liability but rather an adjunct equity account (i.e. presented as addition to share capital) ✓ The guarantee on the loan is not recognized as liability because it is not probable (i.e., it is possible only) that ABC will be held liable for the guarantee. (this will be discussed further in the later lesson)

Refinancing Agreement A long-term obligation that is maturing within 12 months after the reporting period is classified as current, even if a refinancing agreement to reschedule payment on a long term basis is completed after the reporting period but before the financial statements are authorized for issue. However, the obligation is classified as noncurrent if the entity expects, and has the discretion, to refinance it on a long-term basis under an existing loan facility. If the refinancing is not at the discretion of the entity (for example, there is no arrangement for refinancing), the financial liability is current. ✓ Refinancing refers to the replacement of an existing debt with a new one but with different terms, e.g., an extended maturity date or a revised payment schedule. Refinancing normally entails a fee or penalty. A refinancing where the debtor is under financial distress is called “troubled debt restructuring” ✓ Loan facility refers to credit line.

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Issuance of FS

Reporting period

Will mature during this 12 month period

Illustration: Refinancing Fact Pattern ABC Co. has a 10%, P1,000,000 loan payable as of December 31, 20x1 that is maturing on July 1, 20x2. Interest on the loan is due every July 1 and December 31. Case 1: NO DISCRETION On February 1, 20x2, ABC Co., entered into refinancing agreement with a bank to refinance the loan on a long term basis. Both parties are financially capable of honoring the agreement’s provisions. ABC’s financial statements were authorized for issued on March 15, 20x2. Question: How much is presented as current liability in relation to the loan in ABC’S 20X1 year-end financial statements? Answer: P1,000,000, the refinancing agreement is not at the discretion of ABC. The currently maturing obligation is presented as current liability. The refinancing agreement is disclosed in the notes as non-adjusting event after the reporting period. Case 2: With discretion On February 1, 20x2, ABC Co. entered into a refinancing agreement with a bank to refinance the loan on a long-term basis. Both parties are financially capable of honoring the agreement’s provision. ABC has the discretion to refinance or roll over the loan for at least twelve months from December 31, 20x1 under an existing loan facility. ABC’s financial statements were authorized for issue on March 15, 20x2. Question: How much is presented as current liability in relation to the loan in ABC’s 20x1 year-end financial statements? Answer: None, the refinancing agreement is at the discretion of ABC. The loan payable is presented as noncurrent. Case 3: Refinancing completed as of end of reporting period On December 1, 20x1, ABC Co. entered into a refinancing agreement with a bank to refinance the loan on a long-term basis. The refinancing and roll over transaction was completed on December 31, 20x1. Question: How much is presented as current liability in relation to the loan in ABC’s 20x1 year-end financial statements?

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Answer: None, the refinancing is completed as of the end of reporting period. The loan payable is presented as noncurrent. From the illustration above 1. What did you observe in each case? 2. How does the standard on refinancing agreement is being applied in each case?

Liabilities payable on demand Liabilities that are payable upon the demand of the lender are classified as current. A long-term obligation may become payable on demand when a loan provision is breached. Breached means an act of breaking or failing to observe a law, agreement, or code of conduct. Even if the lender provides a grace period after the reporting period. However, the liability is noncurrent if the lender provides the entity by the end of the reporting period (on or before December 31) This means that the long-term obligations maybe classified as current liability even if it is not yet due. How? Simple, breach of contracts, almost all of long term obligations has contracts that have terms and conditions, and this terms and condition should be followed by both parties in case these terms and conditions were not being followed then there is breach of contract that will make the obligation due and demandable. Examples of terms and conditions are maintaining of average inventory, or daily average cash balance of an entity. Included in the stipulation of contract is in case it is breached; the liability will be due and demandable. So, when it will be categorized as long-term obligation? If the grace period is being given by the end of the reporting period (on or before December 31).

Illustration: On January 1, 20x1, ABC Co. took a 3 year, P1,000,000 loan from a bank. The loan agreement requires ABC to maintain a current ratio of 2:1. If the current ratio falls below 2:1, the loan becomes payable on demand. As of December 31, 20x1, ABC’s current ratio is 1:8:1. Case 1: Obligation payable on demand Despite the breach of loan agreement on December 31, 20x1 (i.e. fall of current ratio below 2:1), there is no indication that the bank will demand payment over the next 12 months. Question: How much is presented as current liability in ABC’s 20x1 year-end financial statements? Answer: P1,000,000. The loan is payable on demand. Only if an enforceable promise is received from the bank on or before the end of the reporting period not to demand payment for at least 12 months from the end of reporting period that the loan is classified as noncurrent.

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Case 2: Grace period received after year-end On January 5, 20x2, the bank agreed not to collect the loan in 20x2 and gave ABC 12 months to rectify the breach of loan agreement . Question: How much is presented as current liability in ABC’s 20x1 year-end financial statements? Answer: P1,000,000 the loan is presented as current despite the receipt of the grace period because the grace period was received after the end of reporting period. Based on our observation on the illustration above. How does the payable on demand being applied in each case? Trade Accounts payable Accounts payable from purchases of inventory are recognized when ownership over the goods is transferred to the buyer. The amount recognized excludes trade discounts. Cash discounts are included if the entity uses the gross method of recording purchases; they are excluded if the entity uses the net method. Illustration 1: Accounts payable On December 31, 20x1, ABC Co. has accounts payable of P1,000,000 before possible adjustment for the following: a. Goods in transit from a vendor to ABC on December 31, 20x1 with an invoice cost of P50,000 purchased FOB shipping point was not yet recorded. b. Goods shipped FOB shipping point from a vendor to ABC was lost in transit. The invoice cost of P20,000 was not yet recorded. c. Goods shipped FOB shipping point from a vendor to ABC on December 31, 20x1 amounting to P8,000 was recorded and included in the year-end physical count as “goods in transit.” d. Good in transit from a vendor to ABC on December 31, 20x1 with an invoice cost of P10,000 purchased FOB destination was not yet recorded. The goods were received in January 20x2. e. Goods with invoice cost of P15,000 was recorded and included in the year-end physical count as “goods in transit.” It was found out that the goods were shipped from a vendor under FOB destination. Requirement: Compute for the adjusted accounts payable on December 31, 20x1. Solution: Unadjusted accounts payable a. FOB shipping point not yet recorded b. FOB shipping point lost in transit, not yet recorded e. FOB destination inappropriately recorded Adjusted accounts payable

1,000,000 50,000 20,000 (15,000) 1,055,000

Unearned Income Unearned income represents advanced collection of income that is not yet earned. Prior to earning, unearned income is classified as liability. Examples: a. Advances received for future delivery of goods or rendering of services. b. Proceeds from sale of gift certificates redeemable in goods or services.

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Illustration 1: Unearned revenue – sale of goods ABC Co. requires advance payments for custom-build guitar effects, gadgets, and racks. The records of ABC Co. show the following: Unearned revenue, January 1, 20x1 Advances received during 20x1 Advances applied to orders shipped in 20x1 Advances pertaining to orders cancelled in 20x1

1,000,000 10,000,000 8,000,000 300,000

Requirements: Compute for the current liability assuming: a. the advance payments received are non-refundable and b. the advance payments received are refundable Solution: Requirements (a): Advances are non-refundable

Advances earned Orders cancelled Dec. 31, 20x1

Unearned income 1,000,000 Jan. 1, 20x1 10,000,000 Advances received 8,000,000 300,000 2,700,000

Answer to requirement a, 2,700,000 Requirement b. Advances are refundable Unearned income – Dec. 31, 20x1 (see previous solution) Liability for refundable deposits (Orders cancelled) Total current liability for advances received

2,700,000 300,000 3,000,000

The advances pertaining to the cancelled orders remain as liability, not as unearned income but as liability for refundable deposits. Summary: • An obligation is either (a) legal obligation or (b) constructive obligation • Financial liabilities include contractual obligations to deliver cash or to exchange financial instruments under conditions that are potentially unfavorable • Financial liabilities are classified as FVPL or amortized cost • Reclassification of financial liabilities are prohibited • Financial liabilities are initially measured at fair value minus transaction costs, except FVPL liabilities whose transaction cost are expensed immediately • A liability is classified as current and non-current

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Deferred tax liabilities are always presented as non-current when an entity presents a classified statement of financial position. Share (stock) dividend payable are not liabilities but rather presented as part of equity, as an addition to share capital.

Enrichment Activity: 1. Entity A’s liabilities as of December 31, 20x1 include the following Accounts payable Preference shares issued with mandatory redemption Unearned income Utilities payable Warranty obligation Deferred tax liability Philhealth contribution payable Obligation to deliver a fixed number of own shares Worth a fixed amount of cash Share dividends payable Rent payable

15,000 100,000 7,000 16,000 7,000 2,000 5,000 12,000 3,000 9,000

Requirement: Compute for the total financial liabilities to be disclosed in Entity A’s 20x1 notes to financial statements. Answer: P140,000 2. Entity B’s liabilities as of December 31, 20x1 include the following: Accounts payable Held for trading financial liabilities Note payable (P1M due in 20x3) Unearned revenue Dividends payable Deferred tax liability

500,00 1,000,000 2,800,000 300,000 800,000 200,000

Requirement: Compute for the total current liability Answer: P4,400,000 3. Kew Co.s accounts payable balance at December 31, 20x1 was P2,200,000 before considering the following data. • Goods shipped to Kew FOB shipping point on December 22, 20x1 were lost in transit. The invoice cost of P40,000 was not recorded by Kew. On January 7, 20x2, Kew filed a P40,000 claim against the common carrier. • On December 27, 20x1, a vendor authorized Kew to return, for full credit, goods shipped and billed at P70,000 on December 3, 20x1. The returned goods were shipped by Kew on December 28, 20x1. A P70,000 credit memo was received and recorded by Kew on January 5, 20x2.

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•

Goods shipped to Kew FOB destination on December 20, 20x1 were received and recorded on January 6, 20x2. The invoice cost was P50,000.

Requirement: What amount should Kew report as accounts payable in its December 31, 20x1 statement of financial position? Answer: P 2,170,000 4. Entity C’s liabilities as of December 31, 20x1 (currently year-end) include the following: • P10,000,000, 8 year loan maturing on December 31, 20x2. Entity C intends to refinance this liability on a long-term basis on February 2, 20x2. Entity C’s 20x1 financial statements were authorized for issue on March 31, 20x2. • P6,000,000 loan that is payable on demand. There is no indication as of December 31, 20x1 that the creditor will demand repayment within the next 12 months. • P14,000,000 loan due on December 31, 20x9. Entity C breached a loan provision accelerating the repayment of this loan within the next 12 months. However, on January 12, 20x2, the creditor granted Entity C a12-month grace period to rectify the breach, within which the creditor will not demand immediate repayment. Requirement: Compute for the total current liabilities as of December 31, 20x2. Answer: P 30,000,000 5. On September 1, 2019, Beng Company issued a note payable to PNB in the amount of ₱3,120,000, with the stated rate of 12% and payable in 3 equal annual installments. On this date, the bank’s prime rate is 11%. The first interest and principal payments was made on September 1, 2020. How much should Beng record as accrued interest payable at December 31, 2020? ___________________________________ Answer: Interest payable 83,200

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Assessment Lesson 1 - CURRENT LIABILITIES Name: ___________________________________________

Section: _____________ Score: __________

1. Venerable Respected Co. has the following liabilities as of December 31, 20x1. a. Trade accounts payable, net of debit balance in supplier’s account of P10,000, net of unreleased checks of P8,000, and net of post dated checks of P4,000. b. Credit balance in customer’s accounts c. Financial liability designated at FVPL d. Bonds payable maturing in 10 equal annual installments of P200,000 e. 12%, 5 year note payable issued on Oct. 1, 20x1 f. Deferred tax liability g. Unearned rent h. Contingent liability i. Reserve for contingencies

P600,000 4,000 100,000 2,000,000 200,000 10,000 8,000 20,000 50,000

Requirement: How much is the total current liabilities? 2. Entity A’ account payable on December 31, 20x1 has a balance of P1,300,000. Additional information follows: a. Goods shipped FOB shipping point from a vendor to Entity A on December 29, 20x1 amounting to P20,000 was recorded and included in the year-end physical count as “goods in transit.” b. Goods shipped FOB destination from a vendor to Entity A on December 30, 20x1 amounting to P40,000 was recorded and included in the year-end physical count as “goods in transit”. c. ON December 31, 20x1, Entity A recorded a P60,000 check drawn as payment to a supplier. The check is dated January 7, 20x2. Requirement: Compute for the adjusted accounts payable on December 31, 20x1. 3. Eliot Corporation’s liabilities at December 31, 2005, were as follows: • Accounts payable and accrued interest 1,000,000 • 12% note payable issued November 1, 2004 Maturing July 1, 2006. 2,000,000 • 10% debentures payable, next annual principal instalment Of P500,000 due February 1, 2006 7,000,000 On March 1, 2006, Eliot consummated a non-cancelable agreement with the lender to refinance the 12% note payable on a long term basis, on readily determinable terms that have not yet been implemented. Eliot’s December 31, 2005 financial statements were issued on March 31, 2006. Requirement: In its December 31, 2005 balance sheet, what amount should Eliot report as current liabilities?

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4. Eliot Corporation’s liabilities at December 31, 2008 were as follows: Accounts payable and accrued interest 2,000,000 5-year 10% Notes payable – Due December 31, 2011 5,000,000 Part of the loan agreement is for Elliot to appropriate a fixed amount out of its accumulated profits and losses annually until the amount of appropriation has equaled the face amount of the obligation. Non-compliance will render the note payable on demand by the lender. As of December 31, 2008, Elliot Corporation has yet to comply with the loan agreement. a. What amount of current liabilities should Elliot Corporation report in its December 31, 2008 statement of financial position? b. Assume that the lender agreed on December 31, 2008 to provide Elliot a grace period of 12 months to rectify the breach and within which, the lender will not demand payment. What amount of current liabilities should Elliot Corporation report in its December 31, 2008 statement of financial position? 5. Paymaya Company operates a retail store and must determine the proper December 31, 2020, year-end accrual for the following expenses: • The store lease calls for fixed rent of ₱8,400 per month, payable at the beginning of the month, and an additional rent equal to 6% of net sales over ₱1,750,000 per calendar year, payable on January 31 of the following year. Net sales for 2020 ₱3,150,000. • An electric bill of ₱5,950 covering the period December 17, 2020 through January 16, 2020 was received January 23, 2021. • A ₱2,800 telephone bill was received on January 2, 2021, covering: Service in advance for January 2021 ₱1,050 Local and toll calls for December 2020 1,750 In its December 31, 2020 statement of financial position, what amount of accrued liabilities should Paymaya report? ___________________________________ 6. Angeli Hotel collects 15% in city sales taxes on room rentals, in addition to a P200 per month, per night, occupancy tax. Sales taxes for each month are due at the end of the following month and occupancy taxes are due fifteen days after the end of each calendar quarter. On January 3, 2021, the entity paid the November 2020 sales taxes and the fourth quarter 2020 occupancy taxes. Additional information for the fourth quarter of 2020 is as follows: Room rentals October November December

₱ 1,200,000 1,320,000 1,800,000

Room nights ₱ 1,320 1,440 2,160

What amount should be reported respectively as sales taxes payable and occupancy taxes payable on December 31, 2020? ___________________________________

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7. On March 1, 2019, Nicole Company borrowed ₱1,200,000 and signed a 2-year note bearing interest at 12% per annum compounded annually. Interest is payable in full ay maturity on February 28, 2021. What amount should be reported as accrued interest payable on December 31, 2020? ___________________________________ 8. On the first day of each month, Greyson Company received from Serenity Company an escrow deposit of ₱475,000 for real estate taxes. Greyson Company recorded the ₱475,000 in an escrow account. The 2020 real estate tax is ₱ 5,320,000, payable in equal installments on the first day of each calendar quarter. On January 1, 2020, the balance in the escrow account was ₱570,000. On September 30, 2020, what amount should be reported as escrow liability? ___________________________________ References: Millan, Z.V. (2019). Intermediate Accounting 2 Valix,(2019). Intermediate Accounting Uberita, (2013) Practical Accounting 1

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Lesson 2: NOTES PAYABLE Lesson Objectives: 1. State the initial and subsequent measurement of notes payable 2. Apply the present value factors properly 3. Prepare amortization tables Discussion and Application: Standards that are related to NOTES PAYABLE is PFRS 9: Financial Instrument Notes Payable Notes payable are obligations supported by debtor promissory notes. The accounting for notes payable is similar to the accounting for notes receivable. A note payable is created when a company signs a note for the purpose of borrowing money or extending a credit period. A note may be signed for an overdue invoice when the company needs to extend its payment, when the company borrows cash or exchange for an asset. An extension of the normal credit period for paying amounts owed often requires that a company sign a note, resulting in a transfer of the liability from accounts payable to notes payable.

Initial Measurement Notes payable are initially recognized at fair value minus transaction costs. Fair Value – is “the price that would be received to sell an asset as asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” (PFRS 13.Appdx.A) The difference in the notes receivable from accounts payable is, in notes receivable initial recognition the transaction price is being added to fair value. While in notes payable the transaction cost is being deducted from fair value.

For measurement purposes, notes payable are classified the following: a. Short-term payable – payable within 12 months or normal operating period b. Long-term payable - which are payable for more than a year and are categorized into 3

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b.1. with reasonable interest rate - meaning the interest that is on the face of the promissory note is same with the prevailing interest rate in the market. b.2. non-interest bearing - NO interest rate that is stated on the face of the promissory note b.3 INTEREST BEARING WITH UNREASONABLE INTEREST – the interest rate that is written in the promissory note is significantly LOWER compared with the market rate. A “short-term” payable matures in 1 year or less, while a “long-term” payable matures beyond 1 year. Other terms for market rate of interest include effective interest rate, imputed rate and yield rate. Effective interest rate is the rate that exactly discounts the future cash payments over the life of the financial liability. Summary of measurement Notes payable are initially measured at fair value minus transaction costs. The fair value is determined as follows:

Type of payable 1. Short-term payable

Initial measurement a. Face amount; or b. Present value (if the transaction clearly constitutes financing and the imputed interest can be determined without undue cost or effort0 ➢ Face amount

Subsequent measurement a. Face amount or expected settlement amount if the initial measurement is face amount. b. Amortized cost if the initial measurement is present value.

2. Long-term payable with ➢ Face amount or expected reasonable interest rate settlement amount 3. Long-term noninterest-bearing ➢ Present value ➢ Amortized cost payable 4. Long-term payable with ➢ Present value ➢ Amortized cost unreasonable interest rate ❖ If the cash price equivalent is determinable, the note is initially measured at this amount. The subsequent measurement is amortized cost. A note payable may be issued for cash, purchase goods or services, or other noncash consideration. Regardless of the consideration received, the accounting depends on the note’s classification for measurement purposes. Cash price equivalent The fair value of a payable may be measured in relation to the cash price equivalent of the noncash asset (noncash consideration) received in exchange for the payable. Cash price equivalent is the amount that would have been paid if the transaction was settled outright on cash basis, as opposed to installment basis or other deferred settlement.

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Example 1: An entity purchases a TV set on a 6-month installment basis. The installment price is ₱120,000. However, if the TV set is purchased outright in cash, the cash price would have been ₱100,000. •

The payable is initially recognized at ₱100,000, the cash price equivalent of the TV set. The ₱20,000 difference (₱120,000 installment price less ₱100,000 cash price) will be amortized over the credit term as interest expense using the effective interest method. Example 2: An entity purchases goods for ₱250,000 under a special credit period of 1 year. The seller normally sells the goods for ₱220,000 with a credit period of one month or with a ₱5,000 discount for cash basis (i.e. outright payment in cash). • The initial measurement of the payable is computed as follows: Normal purchase price with credit period of one month 220,000 Discount for outright payment (5,000) Cash price equivalent of the goods purchased 215,000 •

Both the purchase prices of ₱250,000 (special credit) and ₱220,000 (normal credit) constitute a financing transaction, i.e., that include consideration for the credit period. To compute for the cash price equivalent of the goods, the ₱5,000 discount for outright payment is deducted from normal selling price of ₱220,000.

Subsequent measurement Notes payable that are initially measured at face amount are subsequently measured at face amount or expected settlement amount. Notes payable are initially measured at present value are subsequently measured at amortized cost. Amortized cost is the “amount at which the financial asset or financial liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortization using the effective interest method of any difference between that initial amount and the maturity amount and, for financial assets adjusted for any loss allowance.” (PFRS 9.Appendix A) The principle that has been discussed in your IA1 is the same here only in a different perspective, the one you studied last sem is in the point of view of the lender, but now what you are going to study is in the point of view of the borrower. The amortized cost is determined using the effective interest method. When a note payable is initially measured at present value or cash price equivalent, the difference between that amount and the face amount is initially recognized as a discount (premium), in the case of the bonds payable) and subsequently amortized as interest expense using the effective interest method. Effective interest method is a method of calculating the amortized cost of a financial asset or a financial liability and of allocating the interest income or interest expense over the relevant period.

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Illustration 1: Short-term note On July 1, 20x1, ABAC Co. borrowed ₱1,000,000 and issued a one-year, note payable. The lender “discounted the note at 12%” (a). (a) The term “discounted” as used in this context means the lender deducted the 12% interest in advance ABC Co.’s proceeds from the note are net of the advanced interest. Case 1: Lump Sum The note is due in lump sum on June 30, 20x2. The effect of discounting (i.e., time value of money) is immaterial.

Analysis: The note is short-term and the effect of discounting is immaterial. Therefore, the note is initially measured at face amount (net of the advanced interest). The entries are as follows: July 1, 20x1 Cash (1M x 88%) Discount on notes payable (1M x 12%) Notes payable to record the note payable Dec. 31, 20x1 Interest expense (1M x 12%x 6/12) Discount on notes payable to record interest expense June 30, 20x2 Interest expense (1M x 12% x 6/12) Discount on notes payable to record interest expense June 30, 20x2 Notes payable Cash to record the settlement of note payable

880,000 120,000 1,000,000 60,000 60,000 60,000 60,000 1,000,000 1,000,000

The carrying amount of the note are determined as follows: Notes payable Discount on notes payable Carrying amounts

July 1, 20x1 1,000,000 (120,000) 880,000

Dec. 31, 20x1 1,000,000 (60,000) 940,000

Notes: ➢ ABC Co., the borrower, is referred to as the “maker” or “issuer’ of the note. The lender is the “payee.” ➢ “Discount on notes payable” is a contra-liability account (i.e., a valuation account). It is deducted when determining the carrying amount of the note. ➢ Theoretically, all liabilities should be measured at present value except when: a. The effect of discounting is deemed immaterial; b. Discounting is prohibited by a Standard (e.g., PAS 12 Income Taxes prohibits the discounting of tax liabilities); or c. The transaction is made in the usual or customary terms.

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➢ If the effect of discounting is not deemed immaterial, a short-term note is nonetheless measured at present value. Judgment on materiality rests with the entity’s management. ➢ The Standards do not require short-term notes to be measured at face amount nor prohibit their discounting. Case 2: Installment The note is due in equal quarterly installments starting September 30, 20x1. The effect of discounting is immaterial.

Analysis: The note is also measured at face amount. However, because the note is due in installments, the ₱120,000 advanced interest is allocated over the installment periods based on, for example, the outstanding principal balance of the note or some other arbitrary appointment. The entries are as follows: July 1, 20x1 Cash (1M x 88%) Discount on notes payable (1M x 12%) Notes payable Sept. 30, 20x1 Notes payable Interest expense (b) Cash Discount on notes payable (b) Dec. 31, 20x1 Notes payable Interest expense (b) Cash Discount on notes payable (b) ….the entries in 20x2 follow the same pattern.

Date 9.30.x1 12.31.x1 3.31.x1 6.30.x1

Outstanding balance of note 1,000,000 750,000 500,000 250,000 2,500,000

880,000 120,000 1,000,000 250,000 48,000 250,000 48,000 250,000 36,000 250,000 36,000

(b)

Allocation 120K x 1/2.5 120K x .75/2.5 120K x .5/2.5 120K x .25/2.5

The fractions used in the allocation are derived from the outstanding balances of the note. The carrying amounts of the note are determined as follows: July 1, 20x1 Sept. 30, 20x1 Notes payable 1,000,000 750,000 Discount on notes payable (120,000) (72,000) Carrying amounts 880,000 678,000

Interest expense 48,000 36,000 24,000 12,000 120,000

Dec. 31, 20x1 500,000 (36,000) 464,000

Illustration 2: Long-term note with reasonable interest – Simple Interest

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On October 1, 20x1, ABC Co. issued a two-year, 12%, ₱1,000,000 note payable in exchange for a piece of land. Principal is due on October 1, 20x3 but interest is due annually. Analysis: ➢ Type of payable: Long-term with reasonable interest rate – the 12% nominal rate is assumed to be equal to the current rate on initial recognition because no additional information is given. ➢ Initial measurement: Face amount ➢ Subsequent measurement: Face amount or expected settlement amount ➢ Type of interest: Simple interest – interest is computed only on the outstanding principal balance.

Journal entries: Oct. 1, 20x1

Dec. 31. 20x1

Oct. 1, 20x2

Dec. 31, 20x2

Oct. 1, 20x3

Oct. 1, 20x3

Land Notes payable to record the note payable Interest expense (1M x 12% x 3/12) Interest payable to record the accrued interest Interest expense (1M x 12% x 3/12) Interest payable Cash to record the payment of accrued interest Interest expense (1M x 12% 3/12) Interest payable to record the accrued interest Interest expense (1M x 12% x 3/12) Interest payable Cash to record the payment of accrued interest Notes payable Cash to record the settlement of note payable

1,000,000 1,000,000 30,000 30,000 90,000 30,000 120,000 30,000 30,000 90,000 30,000 120,000 1,000,000 1,000,000

Illustration 3: Long-term note with reasonable interest – Compounded interest On January 1, 20x1, ABC Co. issued a three-year, 12%, ₱1,000,000 note payable in exchange for a piece of land. Principal and interest are due on December 31, 20x3. Analysis: ➢ Type of payable and Measurement – same as Illustration 2 above ➢ Type of interest: Compound interest – interest is computed on both the outstanding balances of principal and accrued interest.

Journal entries:

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Oct. 1, 20x1

Dec. 31. 20x1

Dec. 31, 20x2

Dec. 31, 20x3

Dec. 31, 20x3

Land Notes payable to record the note payable Interest expense (1M x 12%) Interest payable to record the accrued interest Interest expense [(1M + 120K)x 12%] Interest payable to record the accrued interest Interest expense [(1M + 120K + 134K)x 12%] Interest payable Cash to record the accrued interest Note payable Cash to record the settlement of note payable

1,000,000 1,000,000 120,000 120,000 134,400 134,400 150,528 254,400 404,928 1,000,000 1,000,000

Illustration 4: Noninterest-bearing note – Lump sum On January 1, 20x1, ABC Co. acquires equipment in exchange for ₱100,000 cash and a 3-year, noninterest-bearing, ₱1,000,000 note payable due on January 1, 20x4. The prevailing interest rate is 12%. Analysis: ➢ Type of payable: Long-term noninterest-bearing (Lump sum) ➢ Initial measurement: Present value (using PV of ₱1) ➢ Subsequent measurement: Amortized cost

❖ Initial measurement: Future cash flow (face amount) Multiply by: PV of ₱1 @12%, n=3 Present value of note payable – Jan. 1, 20x1 Jan. 1, 20x1

Equipment (100K + 711,780) Discount on notes payable (1M – 711,780) Cash Notes payable

1,000,000 0.711780 711,780 811,780 288,220 100,000 1,000,000

Notes: ✓ The difference between the present value and face amount represents the discount on note payable. The unamortized balance of the discount is deducted from the face amount when determining the carrying amount of the note. ✓ The ‘discount o note payable’ on initial recognition of a noninterest-bearing note represent the total interest expense to be recognized over the term of the note. ✓ The equipment is measured at the amount of cash paid plus the present value of the note issued.

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❖ Subsequent measurement: Amortized table (Lump sum) Date Interest expense Discount on note payable Jan. 1, 20x1 288,220 Dec. 31, 20x1 85,414 202,806 Dec. 31, 20x2 95,663 107,143 Dec. 31, 20x3 107,143 Total 288,220

Present value 711,780 797,194 892,857 1,000,000

The total interest expense is equal to the discount on note payable on initial recognition.

Other pertinent entries: Dec. 31, 20x1 Interest expense Discount on notes payable Dec. 31, 20x2 Interest expense Discount on notes payable Dec. 31, 20x3 Interest expense Discount on notes payable Jan. 1, 20x4 Notes payable cash

85,4114 85,414 95,663 95,663 107,143 107,143 1,000,000 1,00,000

Alternative solution: Determine the carrying amount of the note on December 31, 20x1 and December 31, 20x2, respectively. ➢ Press 711,780, the PV of the note on Jan. 1, 20x1. Multiply the amount by 1.12 (100% + 12%). You should get 797,194, the carrying amount on December 31, 20x1. ➢ Multiply again by 1.12. You should get 892,857, the carrying amount on Dec. 31, 20x2. (Amounts are roundedoff) Illustration 5: Noninterest-bearing note – Installment On January 1, 20x1, ABC Co. acquired equipment in exchange for ₱100,000 cash and a 4-year, noninterest-bearing, ₱1,000,000 note payable due in 4 equal annual installments starting December 31, 20x1. The prevailing interest rate is 12%. Analysis: ➢ Type of payable: Long-term noninterest-bearing (Installment) ➢ Initial measurement: Present value (using PV of ordinary annuity of ₱1) ➢ Subsequent measurement: Amortized cost ❖ Initial measurement: Future cash flows – annual installments (₱1M ÷ 4) Multiply by: PV of an ordinary annuity of ₱1 @12%, n=4 Present value of note payable – Jan. 1, 20x1

250,000 3.037349 759,337

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Jan. 1, 20x1

Equipment (100K + 759.337) Discount on notes payable (1M – 759.337) Cash Notes payable

❖ Subsequent measurement: Amortization table (Installment) Date Payments Interest expense Jan. 1, 20x1 Dec. 31, 20x1 250,000 91,120 Dec. 31, 20x2 250,000 72,055 Dec. 31, 20x3 250,000 50,702 Dec. 31, 20x4 250,000 26,785 Other pertinent entries: Dec. 31, 20x1 Notes payable Interest expense Cash Discount on notes payable Dec. 31, 20x2 Notes payable Interest expense Cash Discount on notes payable Dec. 31, 20x3 Notes payable Interest expense Cash Discount on notes payable Dec. 31, 20x4 Notes payable Interest expense Cash Discount on notes payable

859,337 240,663 100,000 1,000,000

Amortization 158,880 177,945 199,298 223,215

Present value 759,337 600,458 422,513 223,215 0

250,000 91,120 250,000 91,120 250,000 72,055 250,000 72,055 250,000 50,702 250,000 50,702 250,000 26,785 250,000 26,785

Current and noncurrent portion of a note payable When the principal amount is due in installments, the carrying amount of the note includes both current and noncurrent portions. These portions are presented or disclosed separately in the financial statements. To determine the current and noncurrent portions, we simply refer to the amortization table. The current portion is the amortization in the immediately following year. This is the portion of the next year’s payment applied to the principal. The noncurrent portion is the present value on the immediately following year. For example, the carrying amount of the note on December 31, 20x1 is ₱600,458. The current and noncurrent portions of this amount are determined as follows:

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Date Jan. 1, 20x1 Dec. 31, 20x1 Dec. 31, 20x2

Payments

Interest expense

Amortization

250,000 250,000

91,120 72,055

158,880 177,945

Current portion of the note payable on Dec. 31, 20x1

Present value 759,337 600,458 422,513

Noncurrent portion of the note payable on Dec. 31, 20x1

When disclosing in the financial statements, the discount on notes payable is allocated to both the current and noncurrent portions of the note by deducting the present value of the portion from the related future cash payment. Current portion of notes payable: Notes payable (250,000 due in 20x2) Discount on notes payable (250K – 177,945 current portion) Notes payable, net (represented inn current liabilities) Noncurrent portion of notes payable: Notes payable (250,000 due in 20x2 + 250,000 due in 20x3) Discount on notes payable (500KK – 422,513 noncurrent portion) Notes payable – net (present noncurrent liabilities) Total notes payable, net – Dec. 31, 20x1

₱ 250,000 (72,055) 177,945 500,000 (77,487) 422,513 ₱ 600,458

Illustration 6: Noninterest-bearing note – Installment in advance On January 1, 20x1, ABC Co. acquired equipment in exchange for ₱100,000 cash and a 4-year, noninterest-bearing, ₱1,000,000 note payable due in 4 equal annual installments. The first installment is due on January 1, 20x1. The succeeding installment payments are due every December 31. The prevailing interest rate is 12%. Analysis: ➢ Type of payable: Long-term noninterest-bearing (Installment in advance) ➢ Initial measurement: Present value (using PV of annuity due of ₱1) ➢ Subsequent measurement: Amortized cost ❖ Initial measurement: Future cash flows – annual installments (₱1M ÷ 4) Multiply by: PV of an annuity due of ₱1 @12%, n=4 Present value of note payable – Jan. 1, 20x1 Jan. 1, 20x1

Jan. 1, 20x1

Equipment (100K + 850,458) Discount on notes payable (1M – 850,458) Cash Notes payable Notes payable Cash to record he first installment payment

250,000 3.401830 850,458 950,458 149,542 100,000 1,000,000 250,000 250,000

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❖ Subsequent measurement: Amortization table (Installment) Date Payments Interest expense Jan. 1, 20x1 Jan. 1, 20x1 250,000 Dec. 31, 20x1 250,000 72,055 Dec. 31, 20x2 250,000 50,702 Dec. 31, 20x4 250,000 26,785

Amortization 250,000 177,945 199,298 223,215

Present value 850,458 600,458 422,513 223,215 0

No interest is recognized on the installment because interest is incurred only after passage of time. The entry on December 31, 20x1 is as follows: Dec. 31, 20x1 Notes payable 250,000 Interest expense 72,055 Cash Discount on notes payable

250,000 72,055

❖ Query: What is the balance of the Discount on notes payable on December 31, 20x1? Answer: Outstanding face amount (1M less payments of 250K & 250K) 500,000 Present value on Dec. 31, 20x1 (422,513) Discount on note payable – Dec. 31, 20x1 77,487 Illustration 6.1 – Installments due at the start of each year Use the same information in ‘Illustration 6’ but assume that the succeeding installment payments are due every Jan. 1. Requirement: Compute for the carrying amount of the note on December 31, 20x1. Solution: Date Jan. 1, 20x1 Jan. 1, 20x1 Jan. 1, 20x2 Jan. 1, 20x3 Jan. 1, 20x4

Payments

Interest expense

Amortization

250,000 250,000 250,000 250,000

72,055 50,702 26,785

250,000 177,945 199,298 223,215

Present value 850,458 600,458 422,513 223,215 0

The amortization table above shows carrying amounts on January 1, of each of the subsequent years. These carrying amounts are net of the January 1 payments. To compute for the carrying amount of the note on December 31, the amount of payment on the following day (i.e. January 1 of next year) is simply added back to the January 1 present value. The carrying amount of the note on December 31, 20x1 is determined as follows: Carrying amount of note payable – Jan. 1, 20x2 422,513 Add back: Payment on Jan. 1, 20x2 250,000 Carrying amount of note payable – Dec. 31, 20x1 672,513 Illustration 7: Noninterest-bearing note – Semiannual installments On January 1, 20x1, ABC Co. issued a 3-year, ₱1,200,000 noninterest-bearing note payable due in equal semiannual payments starting July 1, 20x1. The prevailing interest rate is 10%.

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Discounting semiannual cash flows When discounting cash flow that are due in semiannual installments, the “n” (period) used in the present value factor is multiplied by 2 because there are two semiannual installments per year. Furthermore, the effective interest rate is divided by 2 because interest rates are normally expressed on a per annum basis. Therefore “n” to be used in the illustration above is 6 (i.e. 3 years x 2) and the discount rate is 5% (i.e., 10% ÷ 2). ❖ Initial measurement: Future cash flows – annual installments (1.2M ÷ 6) 200,000 Multiply by: PV of an ordinary annuity of ₱1 @5%, n=6 5.075692 Present value of note payable 1,015,138 ❖ Subsequent measurement: Amortization table (Installment) Date Payments Interest expense Jan. 1, 20x1 July 1, 20x1 200,000 50,757 Dec. 31, 20x1 200,000 43,295 July 1, 20x2 200,000 35,460 Dec. 31, 20x2 200,000 27,233 July 1, 20x3 200,000 18,594 Dec. 31, 20x3 200,000 9,253

Amortization 149,243 156,705 164,540 172,767 181,406 190,477

Present value 1,015,138 865,895 709,190 544,650 371,883 190,477 -

The interest expense in 20x1 is ₱94,053 (50,757+43,295). Illustration 8: Noninterest-bearing note – Non – uniform installments On January 1, 20x1, ABC Co. issued a 3-year, ₱1,200,000 noninterest-bearing note payable due as follows: Date Amount of installment December 31, 20x1 600,000 December 31, 20x2 400,000 December 31, 20x3 200,000 Total 1,200,000 The prevailing interest rate is 10%. Discounting non-uniform (unequal) cash flows Annuity factors are applicable only when the series of cash flows are uniform or equal. When the cash flows vary, the PV of ₱1 should be used. A cash flow that is due one period from initial recognition is discounted using an ‘n’ of 1. A cash flow that is due two periods from initial recognition is discounted using an ‘n’ of 2, and so on. ❖ Initial measurement: Date Cash flows PV of ₱1 @ 10%, n=1 to 3’ Present value Dec. 31, 20x1 600,000 0.90909 545,455 Dec. 31, 20x2 400,000 0.82645 330,579 Dec. 31, 20x3 200,000 0.75131 150,263 Totals 1,200,000 1,026,296

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*PV of ₱1 @10%: n=1 is 0.90909; n=2 is 0.82645; and n=3 is 0.75131 ❖ Subsequent measurement: Amortization table (Installment) Date Payments Interest expense Jan. 1, 20x1 Dec. 31, 20x1 600,000 102,630 Dec. 31, 20x2 400,000 52,893 Dec. 31, 20x4 200,000 18,181

Amortization 497,370 347,107 181,819

Present value 1,026,296 528,926 181,819 0

Variation: First installment payment due in advance Use the same information in Illustration 8 except that the payments are due as follows: Date Amount of installment January 1, 20x1 600,000 January 1, 20x2 400,000 January 1, 20x3 200,000 Total 1,200,000 ❖ Initial measurement: Date Cash flows PV of ₱1 @ 10%, n=0 to 2’ Present value Dec. 31, 20x1 600,000 1 600,000 Dec. 31, 20x2 400,000 0.90909 363,636 Dec. 31, 20x3 200,000 0.82645 165,290 Totals 1,200,000 1,128,926 *PV of ₱1 @10%: n=0 is 1; n=1 is 0.90909; and n=2 is 0.82645 Illustration 9: Noninterest-bearing note – Cash price equivalent On January 1, 20x1, ABC Co. issued a 3-year, ₱1,404,928 noninterest-bearing note in exchange for inventory with a list prior of ₱1,299,999 and a cash price of ₱1,00,000. Analysis: ➢ Initial measurement: The fair value of the note on initial recognition is the cash price equivalent of the inventory purchased. ➢ Subsequent measurement: Amortized cost

The note payable is recorded as follows: Jan. 1, 20x1 Inventory Discount on notes payable (1,404,928 – 1M) Notes payable

1,000,000 404,928 1,404,928

The list price is ignored because it is irrelevant. The difference between the ₱1,404,928 face amount and the ₱1M cash price equivalent represents the discount on note payable, which will be amortized as interest expense using the effective interest method. To apply the effective interest method, we need the effective interest rate, which the problem did not state. However, the effective interest rate is defined as the rate that exactly discounts the future cash flows to the carrying amount of the note.

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We can translate this definition into the following equation (which is just a variation of the formula we have used in the preceding illustration): Futute cash flows × PV factor at x% = Present value

Where: x% = the effective interest rate ➢ The future cash flow is ₱1,404,928 (i.e., the required payment on the note) ➢ The carrying amount of the note is ₱1,000,000 (i.e., the cash price equivalent or ₱1,404,928 face amount less ₱404,928 discount). The amounts are substituted in the equation as follows: ➢ 1,404,928 x PV of 1 @x% = 1,000,000 The PV of ₱1 factor is used because the note is due in lump sum. Trial and error approach We will “squeeze” for the effective interest rate (x%) in the equation above using a “trial and error” approach. To do this, we will initially use a random interest rate. Thereafter, we will adjust the interest rate depending on the outcome of the trial using, as a guide, the inverse relationship between the effective interest rate and the amount of present value. This means that if we need a higher amount of present value, we will use a lower interest rate, and vice-versa. We will continue adjusting the interest rate until we get the rate that balances the equation. O.K. let’s do this. We’ll try a random rate say 10%. First trial: (at 10%) Future cash flows x PV factor at x% = PV of note ➢ 1,404,928 x PV of ₱1 @ 10%, n=3 = 1,000,000 ➢ (1,404,928 * 0.7513148009) = 1,055,543 is not equal to 1,000,000 We need a lower amount of present value. Therefore, we need to increase the interest rate. Let’s try 12%. Second trial: (at 12%) Future cash flows x PV factor at x% = PV of note ➢ 1,404,928 x PV of ₱1 @ 12%, n=3 = 1,000,000 ➢ (1,404,928 * 0.7117802478) = 1,000,000 is equal to 1,000,000 The effective interest rate is 12%. This rate exactly discounts the future cash flow to the carrying amount of the note. The amortization table is prepared as follows: Date Interest expense Discount on N/P Present value Jan. 1, 20x1 404,928 1,000,000 Dec. 31, 20x1 120,000 284,928 1,120,000 Dec. 31, 20x2 134,400 150,528 1,254,400 Dec. 31, 20x3 150,528 1,404,928 Illustration 10: Long-term note issued solely for cash On January 1, 20x1, ABC Co. issued a 3-year, ₱1,000,000 noninterest-bearing note payable to XYZ, Inc., a related party, in exchange for cash. The prevailing interest rate is 12%

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Case #1: Proceeds equal to present value of note The proceeds received from the note are ₱711,780. ➢ The note is long-term and noninterest-bearing. Therefore, it is measured at present value (1M x PV of ₱1 @ 12%, n=3 = ₱711,780). Jan. 1, 20x1 Cash 711,780 Discount on notes payable (1M – 711,780) 288,220 Notes payable 1,000,000 Case #2: Proceeds equal to face amount of note The proceeds received from the note are ₱1,000,000, equal to the face amount.

➢ The note is also measured at the present value of ₱711,780. However, because the proceeds are equal to face amount, rather than the present value (which is usually the case in real-life transactions), a “Day-1 difference” arises. The entry is as follows: Jan. 1, 20x1 Cash 1,000,000 Discount on notes payable (1M – 711,780) 288,220 Notes payable 1,000,000 Unrealized gain – “Day-1 difference” 288,220 The “Day-1 difference” is recognized immediately in profit or loss on initial recognition. The “Discount on note payable” is amortized using the effective interest method (i.e., regular accounting). “Day-1 difference” is discussed in detail in Intermediate Accounting Part1.A. Illustration 11: Note with ‘below-market’ rate of interest On January 1, 20x1, ABC Co. issued a 3-year, ₱1,000,000 note payable in exchange for a machine. Principal is due on January 1, 20x4 but interest is due annually every January 1. The prevailing interest rate is 12%. Analysis: ➢ Type of payable: Long-term payable with unreasonable interest rate – nominal rate of 3% is below the current rate of 12%. ➢ Initial measurement: Present value ➢ Present value factors: “PV of ₱1” for the principal because it is due in lump sum at maturity date. “PV of ordinary annuity of ₱1” for the interests because they are due periodically. ➢ Subsequent measurement: Amortized cost ❖ Initial measurement: To compute for the present value of the note, the future cash flows are first determined then multiplied by the present value factors. Future cash flows PVF @12%, n=3 Present value a Principal 1,000,000 0.71178 711,780

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Interest (1M x 3%) Total a (PV of v1 @12%, n=30 b (PV of ordinary annuity of ₱ @12%, n=3)

30,000

❖ Subsequent measurement: Amortization table (Installment) Payments for Date interests Interest expense Jan. 1, 20x1 Jan. 1, 20x2 30,000 94,060 Jan. 1, 20x3 30,000 101,747 Jan. 1, 20x4 30,000 110,358

2.40183 b

Amortization 64,060 71,747 80,358

72,055 783,835

Present value 783,835 847,895 919,642 1,000,000

Journal entries Jan. 1, 20x1

Machinery 783,835 Discount on notes payable 216,165 Notes payable 1,000,000 Dec. 31, 20x1 Interest expense 94,060 Interest payable (1M x 3%) 30,000 Discount on note payable 64,060 Jan. 1, 20x2 Interest payable 30,000 Cash 30,000 Dec. 31, 20x2 Interest expense 101,747 Interest payable (1M x 3%) 30,000 Discount on note payable 71,747 *Entries in succeeding periods follow the same pattern. Notes: ✓ Interest payable is computed by multiplying the nominal rate to the face amount. Interest expense is computed by multiplying the effective interest rate to the present value. ✓ The discount amortization increases the interest expense recognized each period. Total interest expense over the life of the note is greater than the actual payments for interest. ✓ The total interest expense recognized over the life of a note with unreasonable interest rate is equal to the sum of the discount on note payable on initial recognition and the subsequent payments for interest. (216,165 discount on initial recognition + 90k total payments for interest = 306,165 total interest expense; (94,060 + 101,747 + 110,358 = 306,165 total interest expense on the note). The following other present value scenarios are discussed in Intermediate Accounting 1A, under ‘Notes Receivable’: • Note with below-market interest (simple interest) – Principal due at maturity, interests due in semi-annual installments • Note with below market interest (simple interest) – Principal and interest due in installments • Note with below market interest (compounded interest) – Principal and interests due at maturity • On-interest bearing note with deferred payments

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Based on the illustrations above. Kindly discussed your learnings per illustration and relate it to the standards that has been discussed in relation to recording of notes payable.

Summary of the Lesson: • Notes payable are initially recognized at fair value minus transaction costs • Short term notes are initially measured either at face amount or present value • Long term notes with reasonable interest rate are initially recognized at face amount • Long-term noninterest bearing notes and Long-term notes with unreasonable interest rate are initially measured at present value • Notes are initially measured at the cash price equivalent of the noncash consideration received if this amount is determinable. • Stated interest rate (nominal rate, coupon rate, or face rate) is the rate appearing on the face of an interest bearing note. • Effective interest rate (imputed rate of interest, current market rate or yield rate) is the rate used in present value computations • A non-interest bearing note has an unspecified principal and an unspecified interest. These elements are separated through present value computations • Total interest expense recognized over the life of a non-interest bearing note is equal to the discount on note payable on initial recognition. • Interest payable = face amount x Nominal rate • Interest expense = Present value x Effective interest rate

Enrichment Activity: 1. On May 1, 2018, the DCM issued a 9% promissory note with a face value of ₱8,339,760 for a piece of land. The principal and interest, compounded annually, are due on April 30, 2021. How much will the Notes payable will be shown on December 31, 2020 statement of financial position? __________________________ Answer: P 9,544,856 2. Trisha Company had a ₱2,400,000 note payable due June 30, 2021. On December 31, 2020, the entity signed an agreement to borrow up to ₱2,400,000 to refinance the note payable on a long-term basis. The financing agreement called for borrowing not to exceed 80% of the value of the collateral the entity was providing. On December 31, 2020, the value of the collateral was ₱1,800,000. On December 31, 2020, what amount of the note payable should be reported as current liability? ______________________ Answer: P 960,000 3. On April 1, 2020, Dei Delivery Service issued a ₱10,800,000 non-interest bearing note due March 31, 2023 for a price of land with a cash price of ₱8,339,760. How much is the interest expense for the year ended December 31, 2020 (round to nearest peso)? ___________________________

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Answer: P 250,193 4. On September 1, 2019, Arriane Company issued a note payable to National Bank in the amount of ₱2,160,000 bearing interest at 12% and payable in three equal annual principal payments of ₱720,000. On this date, the bank’s 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? __________________________________ Answer: P 57,600

5. Michael Company had the following loans at 12% interest payable at maturity. Michael repaid each loan on scheduled maturity date. Date Amount Maturity date Term 11/1/2019 ₱550,000 10/31/2020 1 year 2/1/2020 1,650,000 7/31/2020 6 months 5/1/2020 880,000 1/31/2020 9 months The entity recorded interest expense when the loans are repaid. As a result, interest expense of ₱165,000 was recorded in 2020. If no correction is made, by what amount would 2020 interest expense be understated? Answer: P 59,400

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Assessment Lesson 2 - NOTES PAYABLE Name: ___________________________________________

Section: _____________ Score: __________

1. On January 1, 2020, Victoria Company borrowed ₱600,000 8%, noninterest-bearing note due in four years. The present value of the note on January 1, 2020 was ₱441,000. The entity elects the fair value method for reporting financial liabilities. On December 31, 2020, the fair value of the note is ₱489,780. At what amount should the discount on note payable be presented on December 31, 2020? _________________________ 2. On January 1, 2020, Sarah Company sold land to Grace Company. There was no established market price for the land. Grace gave Sarah a ₱2,880,000 noninterest bearing note payable in three equal annual installments of ₱960,000 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 ₱2,880,000 note payable in three equal annual installments of ₱960,000 at a 10% rate of interest is ₱2,387,520. What is the carrying amount of the note payable on December 31, 2020? _____________________

3. On December 31, 2020, Vittorio Company purchased a machine from Stefano Company in exchange for a noninterest bearing note requiring eight payments of ₱240,000. The first payment was made on December 31, 2020 and the others are due annually on December 31. At date of issuance, the prevailing rate of interest for this type of note was 11%. The PV of an ordinary annuity of 1 at 11% for 8 period is 5.146 and the PV of an annuity of 1 in advance at 11% for 8 periods is 5.712. On December 31, 2020, what is the carrying amount of the note payable? _________________________________ 4. On January 1, 2017, Gabriel Company signed a ₱120,000 noninterest bearing note due in three years at a discount rate of 10%. The entity elects the fair value option for reporting financial liabilities. On December 31, 2017, the credit rating and risk factors indicated that the rate of interest applicable to its borrowing was 9%. The present value factors at 10% and 9% are as follows: PV Factor 10% 9% 1 period .909 .917 2 periods .826 .842 3 periods .751 .772 What is the carrying amount of the note payable on December 31, 2017? ________________________________ 5. Genesis Company reported liabilities on December 31, 2020 as follows: Accounts payable and accrued interest 1,200,000 12% note payable issued November 1, 2019 maturing July 1, 2021 2,400,000 10% debentures payable, next annual principal installment of ₱600,000 due February 1, 2021 8,400,000 On December 31, 2020, the entity consummated a noncancelable agreement with the lender to refinance the 12% note payable on a long term-basis. The December 31, 2020 financial statements was issued on March 31, 2021. In the December 31, 2020 statements of financial position, what total amount should be reported as current liabilities?

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6. On January 1, 2020, Nicholas Company borrowed ₱4,680,000 from 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 lower than market price. At the 12% imputed interest rate for this type of loan, the present value of the note is ₱3,315,000 on January 1, 2020. What amount of interest expense should be reported in 2020?

Suggested Links: https://www.cliffsnotes.com/study-guides/accounting/accounting-principles-ii/current-liabilities/understanding-notespayable References: Millan, Z.V. (2019). Intermediate Accounting 2 Valix,(2019). Intermediate Accounting 2 Uberita, (2013) Practical Accounting 1

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Lesson 3: BONDS PAYABLE AND OTHER CONCEPTS Lesson Objectives: 1. State the initial and subsequent measurements of bonds payable 2. Account for compound financial statement 3. Explain the accounting for derecognition of liabilities 4. State the requirements for the offsetting of financial assets and financial liabilities Discussion and Application: Standards that are related to BONDS PAYABLE are PAS 32: Financial Instruments: Presentation PFRS 7: Financial Instruments: Disclosures PFRS 9: Financial Instruments Bonds Payable Bonds are long-term debt instruments similar to notes and loans except that bonds are usually offered to the public and sold to many investors. A bond is intended to be broken up into various subunits (e.g., ₱1,000 each) which can be issued to a variety of investors. Debt Instrument is any contract that represents a right upon the holder to receive cash from the issuer thereof or any obligation upon the issuer to pay cash to the holder thereof. A debt instrument represents a debtor-creditor relationship between entities (e.g., accounts, notes, loans, bonds, redeemable preference shares issued and other payables). Bond Indenture is the contractual arrangement between the issuer and the bondholders. It contains restrictive covenants intended to prevent the issuer from taking actions contrary to the interests of the bondholders. A trustee, often a bank, is appointed to ensure compliance. A covenant is agreement inside an agreement, these are the restriction

There are two ways that the entity can raise fund for their operation

Investors Instrument issued Ways of earning Accounting treatment in the part of issuing corporation

Stocks Co-owners Stock Certificate Dividends / Stock appreciation Shareholder’s equity

Bonds creditors Bond Certificate Interest Liability

Bonds payable are form of long-term debt usually issued by corporations, hospitals, and governments. The issuer of bonds makes a formal promise/agreement to pay interest usually every six months (semi annually) and to pay the principal or maturity amount at a specified date some years in the future. The agreement containing the details of the bonds payable is known as the bond indenture.

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US corporations issue bonds instead of common stock for the following reasons: • Debt is less costly than common stock • The interest on bonds is deductible for income tax purposes • Bondholders are not owners and therefore the ownership interest of the existing stockholders will not be diluted.

Before you proceed in reading the specification of bond indenture, please look for the example of bond indenture and read it. A bond indenture may specify, among other things, the following: a. Rights and duties of bondholders and issuer which may include the following: 1. Call provision – the issuer’s right to call the bonds below the scheduled maturity. If interest rates decline, the issuer can call high-interest bonds and replace them with low interest bonds. 2. Redemption rights – the holder’s right to redeem the bonds before the scheduled maturity. This option is usually available of the issuer takes a stated action, for example, when the issuer greatly increased its debt or is being acquired by another entity. b. Restrictions and requirements on the issuer which may include the following: 1. Sinking fund that the issuer is required to establish for the protection of the bondholders. 2. Financial ratios that the issuer is required to maintain. 3. Restriction on dividends available to the issuer’s shareholders. The issuer may be required to appropriate a portion of its retained earnings for the protection of the bondholders. 4. Restriction on incurrence of additional obligations. The issuer may be restricted from issuing new bonds unless the currently issued bonds are settled first or restricted from issuing new bonds in excess of a percentage of bondable property (fixed assets). 5. Appointment of independent trustee whose qualifications are stated in the bond indenture. 6. Authorized amount of bonds that can be issued. c. Interest rate, payment date(s), and maturity date(s) Please answer the statement below Please explain the content of bond indentures. Bond Certificate is issued to the bondholder representing the amount of bonds he has purchased. Bonds are normally issued in denomination, such as ₱1,000 and ₱10,000). These small denominations increase the affordability of bonds enabling the issuer to obtain financing from a wider market. (look for the example of the bond certificate for you to be familiarized with the bond certificate) Even you as individual can purchase a bond. Issuance of bonds Bonds can be issued in several ways, for example, through underwriting, auction, or direct placement with investors. Often, bonds are issued through an underwriter (e.g., investment banker) who agrees on the price of the bonds, pays the issuer, and then resells the bonds to other investors at a higher price. The underwriter is paid a fee for this service and may agree to purchase any unsold bonds at a specified price. Please explain here how the bonds is being issued, in accordance with the one that was being discussed.

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Accounting for bonds Bonds are accounted for in much the same way as notes and loans payable. However, bonds normally are long-term, bear interest, issued at a premium or discount, and entail transaction (issue) costs. Bond premium and discount To reiterate the concepts of premium and discount, an outline is provided below: Cash proceeds (Carrying Effective interest rate amount) compared to Face compared to Nominal amount interest rate

Effect of amortization on interest expense

Discount

Cash proceeds (Carrying amount) is less than face amount

Effective interest rate is higher than Nominal interest rate

Interest expense is greater than Interest paid

Premium

Cash proceeds (Carrying amount) is greater than face amount

Effective interest rate is lower than Nominal interest rate

Interest expense is less than Interest paid

There is no premium or discount if bonds are issued at face amount (except when transaction costs are incurred). When there is no premium or discount, the effective interest rate is equal to the nominal interest rate. Consequently, interest expense equal interest paid. Illustration At a discount When the bonds is issued at a discount this is usually a junk bond, the entity is in financial trouble and he needs funding that is why he is willing to pay higher amount aside from the interest. Therefore, the interest expense here is higher. At a premium This bonds issuance is said to be issued at a premium, usually this types of bonds are good type of bonds, meaning the company is in good credit standing and doing good, that is why the creditor is willing to pay less than the face value. In here the interest expense that will be recognized by the entity will be lowered by the premium amortization.

Borrower (Issuer) The borrower will issue a P1,000,000 face value bonds

Creditor (Investor) Creditor will pay an amount less than 1,000,000.

The borrower issue a P1,000,000 face value bonds

The creditor will pay more than P1,000,000

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Illustration 1: Bonds issued at a discount On January 1, 20x1, ABC Co., issued 1,000 ₱1,000, 10%, 3-year bonds for ₱951,963. Principal is due at maturity but interest is due annually every year-end. The effective interest rate is 12%. Initial measurement The issuance of the bonds is recorded as follows: Jan. 1 , 20x1 Cash Discount on bonds payable (1M – 951,963) Bonds payable (1,000 x ₱1,000)

951,963 48,037 1,000,000

❖ Notes: ✓ There is discount because the issue price (₱951,963) is less than the face amount (₱1M). Consequently, the effective interest rate (12%) is higher than the nominal interest rate (10%). ✓ The "Bonds payable" account is credited at face amount. The discount is recorded separately. ✓ The "Discount on bonds payable" account has a normal debit balance and is a contra account (deduction) to the "Bonds payable" account when determining the carrying amount of the bonds. Bonds payable ₱1,000,000 Discount on bonds payable, Jan. 1, 20x1 (48,037) Carrying amount of bonds payable, Jan. 1, 20x1 ₱ 951,963 ❖ Subsequent measurement: Amortization table Date Interest payments Jan. I, 20xI Dec. 31, 20x1 100,000 Dec. 31, 20x2 100,000 Dec. 31, 20x3 100,000

Interest expense

Amortization

114,236 115,944 117,857

14,236 15,944 17,857

Present Value 951,963 966,199 982,143 1,000,000

Notice that the amortization of the discount increases the periodic interest expense. When bonds are issued at a discount, the cash received is less than the obligation incurred. In effect, there is loss; however, this is not recognized immediately but rather deferred and amortized as an addition to periodic- interest expense. At maturity date, the carrying amount of the bonds is equal to the face amount because, by then, the discount is fully amortized. The other pertinent entries are as follows: Dec. 31, 20x1 Interest expense 114,236 Cash 100,000 Discount on bonds payable 14,236 to record interest expense Dec. 31, 20x2 Interest expense 115,944 Cash 100,000 Discount on bonds payable 15,944 to record interest expense

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Dec. 31, 20x3

Interest expense Cash Discount on bonds payable to record interest expense Bonds payable Cash to record the retirement of bonds

117,857 100,000 17,857

1,000,000 1,000,000

Please answer the following 1. Based on the illustration above, discuss how the Discount on bonds is computed 2. What are the pertinent entries for the initial recognition of bonds?’ 3. You just read and tried to compute for the amortization of the discount? Why is it necessary to do amortization table? 4. What are the subsequent entries for the bonds payable? Why is that necessary? Unamortized balance of discount or premium The unamortized balance of discount or premium as at a certain date is the difference between the face amount and the carrying amount of the bonds at that date. For example, the unamortized discount on the bonds as 01 Dec. 31, 20x1 is computed as follows: Face amount ₱ 1,000,000 Carrying amount - Dec. 31, 20x1 (see table above) (966,199) Discount on bond payable. Dec. 31, 20x1 ₱ 33,801 Based on the illustration above, what is that unamortized balance? Illustration 2: Bonds issued at a premium On January 1, 20x1 ABC Co. issued 1,000, ₱1,000, ₱1,049,737. Principal is due at maturity but interest rate is 10%. ❖ Initial measurement Jan. 1, 20x1 Cash Bonds payable Premium on bonds payable

1,049,737 1,000,000 49,737

❖ Notes: ✓ There is premium because the issue price is greater than the face amount. Consequently, the effective interest rate is lower than the nominal interest rate. ✓ Whether bonds are issued at a discount or premium, “Bonds payable” account is always credited at face amount. ✓ The “Premium on bonds payable” account has a normal credit balance and is an adjunct account (addition) to the “Bonds payable” account when determining the carrying amount of the bonds. Bonds payable ₱1,000,000 Premium on bonds payable, Jan. 1, 20x1 49,737 Carrying amount of bonds payable, Jan. 1, 20x1 ₱1,049,737

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Subsequent measurement - Amortization table Date Interest payments Jan. 1, 20x1 Dec. 31, 20x1 120,000 Dec. 31, 20x2 120,000 Dec. 31, 20x3 120,000

Interest expense

Amortization

104,974 103,471 101,818

15,026 16,529 18,182

Present value 1,049,737 1,034,711 1,018,182 1,000,000

Notice that the amortization of premium decreases the periodic interest expense. When bonds are issued at a premium, thee cash received is more than the obligation incurred. In effect there is gain, however, this is not recognized immediately but Date Jan. 1, 20x1 Apr. 1, 20x1

Interest payment

Interest expense

amortization

30,000

26,243

3,757

Present value 1,049,737 1,045.980

The issue price pertaining only to the bonds is ₱1,045,980. However, since the bonds are issued between interest payment dates, the total proceeds from the issuance will necessarily include the accrued interest sold. The total issue price is computed as follows: Issue price pertaining to bonds only ₱1,045,980 Accrued interest sold (1M x 12% x 3/12) 30,000 Total issue price or total proceeds ₱1,075,980 Actually, you can add back the ₱30,000 from the “Interest payment” column on the amortization table to the PV of bonds on April, 20x1 to compute for the total issue price: (30,000 from interest payment* column + 1,045,980 from ‘present value’ column = 1,075,980).

Jan. 1, 20x1

Cash Bonds payable Premium on bonds payable (1,045,980 – 1M) Interest expense (or Interest payable)

1,075,980 1,000,000 45,980 30,000

An alternative solution is by computing the full-year’s amortization and then allocating it to the period prior to the issued date: Date Interest payment Interest expense amortization Present value Jan. 1, 20x1 1,049,737 Dec. 31, 20x1 120,000 104,974 15,026 1,034,711 Carrying amount as of January 1, 20x1 Premium amortization up to April 1, 20x1 (15,026 x 3/12) Issue price pertaining to bonds only, April 1, 20x1 Accrued interest sold (1M x 12% x 3/12) Total issue price or cash proceeds

₱ 1,049,737 (3,757) 1,045,980 30,000 ₱ 1,075,980

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Based on the illustration above, please answer the following questions 1. What is the difference in computation and recording between bonds issued at a premium and bonds issued at a discount? 2. What is the effect of premium amortization in the interest expense? 3. What is the formula in obtaining the carrying value of the bonds payable when there is a premium?

The illustrations above are the bonds without transaction costs. If we remember in the initial recording you have to deduct the transaction cost from the fair value. In this case there will be an accounting problem in here since you deducted it from the fair value therefore the interest expense will increase. Please see below for the transaction. Accounting for transaction costs Financial liabilities are initially measured at fair value minus transaction costs. Accordingly, transaction costs on issuing bonds (bond issue costs) are deducted when determining the carrying amount of the bonds. Subsequently, the transaction costs amortized using the effective interest method. Transaction costs may require an adjustment to the effective interest rate. Illustration 1: Bonds issued at face amount On January 1, 20x1, ABC Co. issued 10%, ₱1,000,000 bonds at face amount, Principal is due on Dec. 31, 20x3 but interest is due annually every year-end. Case 1: No transaction costs The carrying amount is equal to the face amount because the ponds were issued at face amount and no transaction costs were incurred. Accordingly, there is no premium or discount. The effective interest rate is equal to the 10% nominal rate. The accounting is straightforward — interest expense equals interest paid. Journal entries: Jan. 1, 20x1 Dec. 31, 20x1 Dec. 31, 20x2 Dec. 31, 20x3

Cash Bonds payable (1,000 x ₱1,000) Interest expense (1Mx 10%) Cash Interest expense (1M x 10%) Cash Interest expense (1M x 10%) Cash

1,000,000

Bonds payable Cash

1,000,000

Case 2: With transaction costs ABC Co. paid commission of ₱48,037 to underwriters. ❖ Initial measurement Jan. 1, 20x1 Cash (1M – 48,037) Bond issue cost Bonds payable

1,000,000 100,000 100,000 100,000 100,000 100,000 100,000 1,000,000

951,963 48,037 1,000,000

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Notes: ✓ The transaction costs are recorded separately and will be subsequently amortized using the effective interest method FMV (similar to discount on bonds payable). The carrying amount of the bonds is determined as follows: Bonds payable ₱1,000,000 Bond issue costs (48,037) Carrying amount of bonds payable, Jan. 1, 20x1 ₱ 951,963 ✓ Notice that the bonds are initially measured equal to the net issuance proceeds (₱IM cash receipt – ₱48,037 cash payment). ✓ The transaction costs decreased the carrying amount of the bonds below the face amount. Accordingly, the effective interest rate would be different from the 10% nominal interest rate. We will compute for the effective interest rate using the “trial and error” approach. Trial and error approach 𝐹𝑢𝑡𝑢𝑟𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 × 𝑃𝑉 𝑓𝑎𝑐𝑡𝑜𝑟 𝑎𝑡 𝑥% = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 ➢ Future cash flows: Since the bonds pay interest, the future cash flows consist of payment for the (1) principal and (2) interest. ➢ PV factors: We will use PV of ₱1 for the principal because it is due only at maturity. We will use PV of ordinary annuity of ₱1 for the interest because it is due annually. ➢ Present value: The present value of the bonds on Jan. 1, 20x1 is equal to the carrying amount of ₱951,963 (see computation above). Our working equation is as follows:

Principal: (1M. x PV of P1 @ x%, n=3) + interest: [(1M. x 10%) x PV of an ordinary annuity of P1 @ x%, n=3] = ₱951,963 The carrying amount of the bonds of ₱951,963 is less than the face amount. In effect, there is a discount. Therefore, the effective interest Fate would be higher than the 10% nominal rate First trial: (using 12%) ➢ (1M x PV of ₱1 @ 12%, n=3) + [(1M x 10%) x PV of an ordinary annuity of P1 @ 12%,] = 951,963 ➢ (1M x 0.71178) + (100,000 x 2.40183) = 951,963 ➢ (711,780 + 240,183) = 951,963 is equal to 951,963, The effective interest rate is 12%, i.e., the rate that exactly discounts the future cash flows to the initial carrying amount of the bonds. ❖ Subsequent measurement: Amortization table Date Interest payments Interest expense Jan. 1, 20x1 Dec.31,20x1 100,000 114,236

Amortization 14,236

Present value 951,963 966,199

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Dec. 31,20x2 Dec.31,20x3

100,000 100,000

115,944 117,857

15,944 17,857

The other pertinent entries are as follows: Dec.31,20x1 Interest expense Bond issue cost Cash Dec. 31,20x2 Interest expense Bond issue cost Cash Dec.31,20x3 Interest expense Bond issue cost Cash

982,143 1,000,000

114,236 14,236 100,000 115,944 15,944 100,000 117,857 17,857 100,000

Bonds payable Cash

1,000,000 1,000,000

Illustration 2: Bonds issued at a discount — with transaction costs On January 1, 20x1, ABC Co. issued 1,000, ₱1,000. 10%, 3-year bonds for ₱951,963. Principal is due Dec. 31, 20%3 but interest is due annually every year-end: In addition ABC incurred bond issue costs of ₱44,829. The rate is 12% before adjustment for bond issue costs and after adjustment for bond issue costs. ❖ Initial measurement The initial carrying amount of the bonds is computed as follows: Issue price before transaction costs Transaction costs (Bond issue costs) Carrying amount – Jan. 1, 20x1 (net issue price) The entry to record the issuance of bonds is as follows: Jan. 1, 20x1 Cash Discount on Bonds payable Bonds payable

951,963 (44,829) 907,134

907,134 92,866

Notes: ✓ The bond issue costs are included in the discount on bonds payable so that both will be amortized altogether. This simplifies recording by eliminating the need to allocate the amortization between the bond issue costs and the discount. ✓ The effective interest rate to be used is 14% - the rate adjusted for the bond issue costs. ❖ Subsequent measurement: Amortization table Date Interest payments Interest expense Jan. 1, 20x1

Amortization

Present value 907,134

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Dec.31,20x1 Dec. 31,20x2 Dec.31,20x3

100,000 100,000 100,000

126,999 130,779 135,088

The entry on Dec. 31, 20x1 is as follows: Dec.31,20x1 Interest expense Cash Discount on bonds payable

26.999 30,779 35,088

934,133 964,912 1,000,000

126,999 100,000 26,999

If the bond issue costs are not added to the bond discount, the amortization shall be allocated to the bond issue costs and the discount based on their outstanding balances as shown below: Allocation of Outstanding balance Fraction amortization Discount on bonds payable 48,037 a 48,037/92,866 13,966 Bond issue cost 44,829 44,829/92,866 13,033 92,866 26,999 a (1,000,000 face amount - 951,963 issue price) 48,037 discount on bouts payable. The entries would have been as follows: Jan. 1, 20x1 Cash(951,963 – 44,829) Discount on bonds payable (I M – 951,963) Bond issue costs Bonds payable (1,000 x ₱1,000) Dec.31,20x1 Interest expense Cash Discount on bonds payable Bond issue cost

907,134 48,037 44,829 1,000,000 126,999 100,000 13,966 13,033

For simplicity, we will follow the previous accounting treatment of combining bond issue costs with bond discount (or premium). Please answer the following questions 1. What is a transaction costs? 2. What is the effect of transaction cost in the issuance of bonds? 3. How are you going to get the new effective interest rate? Issuance of bonds between interest payment dates When bonds are issued between interest payment dates, the accrued interest prior to the issuance date is not included in the initial measurement of the bonds, but rather credited to interest payable or interest expense. Moreover, the interest expense recognized for the period represents only the post-issuance interest expense (i.e., interest incurred after issuance date). The pre-issuance interest is not recognized as interest expense.

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There are times that you are going to issue bonds in between interest dates. Meaning let say the bond date is Jan and June, this is the date were interest is to be paid, and the entity shall issue this on March, therefore this is called issuance between interest date. According to standard, this interest on the bonds is not included in the initial recognition, you have to separate it and put it in the interest payable account or interest expense.

Illustration: On April 1, 20x1, ABC Co. issued 12%, ₱1,000,000 bonds dated January 1, 20x1. Case 1: The bonds were issued at 97 including accrued interest. Requirement: Compute for the initial carrying amount of the bonds. Solution: Cash proceeds Less: Accrued interest sold Carrying amount of the bonds, April 1, 20x1

970,000 (30,000) 940,000

The initial carrying amount of the bonds is equal to the cash proceeds excluding the accrued interest. The entry to record the issuance of the bonds is as follows: April 1, 20x1

Cash (1M x 7%) Discount on bonds payable (1M – 940K) Bonds payable Interest expense (or Interest payable) (1M x 12% x 312)

970,000 60,000 1,000,000 30,000

Whether ‘interest expense’ or ‘interest payable’ is credited the total interest expense in 20x1 (disregarding the amortization of discount) post-issuance interest expense of ₱90,000 (1M x 12% x 9/12). Analyze the entries below: “Interest expense” account was initially credited: Interest expense 120K (1M x 12%) Cash 120K to record payment of interest Interest expense = 120K debit – 30K credit on Apr. 1, 20x1 = 90,000

“Interest payable” account was initially credited: Interest expense 90K (1M x 12% x 9/12) Interest payable 30K Cash 120K to record payment of interest Interest expense = 90,000 debit on Dec. 31, 20x1

Requirement: Compute for the initial carrying amount of the bonds.

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Solution: Cash proceeds excluding accrued interest (1M x 97%) Carrying amount of the bonds, April 1, 20x1 April 1, 20x1

970,000 970,000

Cash (1M x 7%) Discount on bonds payable (1M – 940K) Bonds payable Interest expense (or Interest payable) (1M x 12% x 312)

1,000,000 30,000 1,000,000 30,000

Based on the illustration above please answer the following 1. What is your observation regarding the issuance of the bonds? 2. How the interest between issuance date is being resolved in the following illustrations?

Since you are already familiar with the time value of money and the present value factor it will be easier for you to understand it. If you are having a hard time go back to your IA1 module. Issue price of bonds The issue price of bonds can be estimated by discounting the future cash flows of the bonds at a specified effective interest rate. Illustration: ABC Co. plans to issue 12%, 3-year, ₱1,000,000 bonds, dated January 1, 20x1. Principal is due at maturity but interest is due annually. The current market rate is 10%. Case 1: ABC issues the bonds on January 1, 20x1. How much is the estimated issue price? Solution: Issue price of bonds = Present value of future cash flows; or Issue price of bonds = Future cash flows x PV factor

Future cash flows Principal 1M Interest 120K

PV @ 10%, n=3 PV of P1 PV of ordinary annuity of P1

PV factors 0.751315 2.986852

Present value 751,315 298,422 1,049,737

➢ The issue price of the bonds on Jan. 1, 20x1 is ₱1,049,737. Jan. 1, 20x1

Cash Bonds payable

1,049,737 1,000,000

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Premium on bonds payable

49,737

Case 2: ABC issues the bonds on April 1, 20xl. How much is the total proceeds from the issuance? Solution: The issue price on April 1, 20x1 is computed by simply amortizing the Jan. 1, 20x1 issue price up to April 1, 20x1.

Date Jan. 1, 20x1 Apr. 1, 20x1

Interest payment 30,000

Interest expense 26,243

Amortization 3,757

Present value 1,049,737 1,045,980

The issue price pertaining only to the bonds is ₱1,045,980. However, since the bonds are issued between interest payment dates, the total proceeds from the issuance will necessarily include the accrued interest sold. The total issue price is computed as follows: Issue price pertaining to bonds only Accrued interest sold (1M x 12% x 3/12) Total issue price or total proceeds

1,045,980 30,000 1,075,980

Actually, you can add back the ₱30,000 from the “Interest payment” column on the amortization table for the PV of bonds on April 1, 20x1 to compute for the total issue price: (30,000 from Interest payment per column + 1,045,980 from ‘present value column = 1,075,980),

Jan. 1, 20x1

Cash Bonds payable Premium on bonds payable (1,045,980 – 1M) Interest expense (or Interest payable)

1,075,980 1,000,000 45,980 30,000

An alternative solution is by computing the full-year’s and then allocating it to the period prior to the issued date:

Date Jan. 1, 20x1 Dec. 31, 20x1

Interest payment

Interest expense

Amortization

120,000

104,974

15,026

Carrying amount as of January 1, 20x1 Premium amortization up to April 1, 20x1 (15,026 x 3/12) Issue price pertaining to bonds only, April 1, 20x1 Accrued interest sold (1M x 12% x 3/12) Total issue price or cash proceeds

Present value 1,049,737 1,034,711

1,049,737 (3,757) 1,045,980 30,000 1,075,980

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Summarize your learnings here based on the illustrations above.

Bond refunding Bond refunding refers to the issuance of new bonds, the proceeds from which are used to retire existing outstanding bonds. The new bonds usually have lower interest than the replaced bonds. The issuance of the new bonds is recorded in the regular manner (like in the previous illustrations), while the old bonds are extinguished or retired. Retirement of bonds prior to maturity When bonds are retired, any difference between the retirement price and the carrying amount (updated for any discount or premium amortization up to the date of retirement) is recognized as gain or loss in profit or loss. In bond refunding there are two events that is going to happen, that is the issuance of the new bond and the retirement of the existing bonds. For the issuance of new bonds, the same standard shall apply. For the retirement, you just have to update the discount or premium amortization up the date of retirement by updating this, you can deduct or add this to the face value of the retiring bond by then you can get the carrying amount of the bond and compare it with the retirement price, any difference will go to gain or loss in profit or loss. Illustration 1: Retirement of bonds — Bond refunding On January 1, 20x1, ABC Co. issued new bonds with face amount of ₱10M for ₱10,800,000. ABC used the proceeds to retire an existing 10-year, 12%, ₱8,000,000 bonds issued five years earlier. The unamortized discount on the existing bonds is ₱340,000. ABC retired the bonds at a call premium of ₱400,000. ABC incurred ₱50,000 direct costs of retirement. ABC's income tax rate is 30%. Requirement: Compute for the gain or loss on the retirement, Solution: ➢ The issuance of the new bonds is recorded as follows: Jan. 1, 20x1 Cash Bonds payable – new Premium on bonds payable – new ➢ The retirement of the old bonds is recorded as follows: Jan. 1, 20x1 Bonds payable – old Loss on extinguishment of bonds (squeeze) Discount on bonds payable Cash Alternative solution: Carrying amount of bonds retired: Face amount of bonds retired Unamortized discount, Jan. 1, 20x1

8,000,000 (340,000)

10,800,000 110,000,000 800,000

8,000,000 790,000 340,000 8,450,000

7.960.000

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Retirement price (Call price): Face amount of bonds retired Call premium Expense of reacquisition Loss on extinguishment of bonds

8,000,000 400,000 50,000

8,450,000 (790,000)

Notice that the loss is gross of tax. Netting of tax is normally permitted only for results of discontinued operations, items of other comprehensive income, and retrospective adjustments to the beginning balance of retained earnings. Illustration 2: Retirement - between interest payment dates On Jan. 1, 20x1, ABC Co. issued 5-year, 12%, ₱1,000,000 bonds for ₱1,075,816. Principal is due at maturity but interest is due annually. The effective interest rate is 10%. On July 1, 20x3, ABC retired the bonds at 102. The retirement price includes payment for accrued interest. Requirement: Compute for the gain or loss on the retirement. Solution: ➢ An amortization table is prepared up to the date of retirement. Date Interest payments Interest expense Jan. 1, 20x1 Dec. 31, 20x1 120,000 107,582 Dec. 31, 20x2 120,000 106,340 July 1, 20x3 60,000 52,487 ➢ The gain or loss is computed as follows: Carrying amount of bonds retired (from table above) Retirement price (Call price): Retirement price including payment for Accrued interest (IM x 102%) Less: Accrued interest (1M x12% x 6/12) Gain on extinguishment of bonds

Amortization

Present value 1,075,816 1,063,398 1,049,738 1,042,225

12,418 13,6600 7,513

1,042,295

1,020,000 960,000

(60,000)

82,225

Since the bonds are retired between interest payment dates, the retirement price necessarily includes payment for the accrued interest. The interest payment is excluded when computing for the gain or loss on the retirement. Journal entries: July 1, 20x3

July 1, 20x3

Interest expense Premium on bonds payable Interest payable to record the premium amortization up to the date of retirement Bonds payable Premium on bonds payable (1,042,225 – 1M) Interest payable (1M x 12% x 6/12)

52,487 7,513 60,000 1,000,000 42,225 60,000

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Cash (1M x 102%) Gain on extinguishment of bonds to record the retirement of the bonds

1,020,000 82,225

As you studied the illustrations above. 1. How does the refunding of bonds took place? 2. What are the important points that you need to consider in bond refunding?

Serial bonds Serial bonds are bonds in which the principal matures in installments. The periodic payments on serial bonds consist of payments for both interest and principal. Illustration: On January 1, 20x1, ABC Co. issued 10%, ₱3,000,000 bonds for ₱2,900,305. The principal matures in three equal annual installments, payable at each year-end, plus interest on the outstanding principal balance. The effective interest rate is 12%. ❖ Initial measurements 7,900,305 Jan. 1, 20x1 Cash Discount on bonds payable (3M~2,,900,305) Bonds payable ❖ Subsequent measurement: The future payments on the serial bonds are computed as follows: Interest on outstanding Date Principal principal balance Dec. 31, 20x1 1,000,000 3,000,000x10% Dec. 31, 20x2 1,000,000 2,000,000x10% Dec. 31, 20x3 1,000,000 1,000,000x 10%

2,900,305 99,695 3,000,000

Interest payments 300,000 200,000 100,000

Total payments 1,300,000 1,200,000 1,100,000

Amortization table: Date Jan, 1, 20x1 Dec. 31, 20x1 Dec. 31, 20x2 Dec. 31, 20x3

Total payments

Interest expense

Amortization

1,300,000 1,200,000 1,100,000

348,037 233,801 117,857

951,963 966,199 983,143

Tre other pertinent entries are as follows: Dec. 31, 20x1 Interest expense Bonds payable Cash

Present value 2,900,305 1,948,342 982,143 0

348,037 1,000,000 1,300,000

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Dec. 31, 20x2

Dec. 31, 20x3

Discount on bonds payable (squeeze) Interest expense Bonds payable Cash Discount on bonds payable (squeeze) Interest expense Bonds payable Cash Discount on bonds payable (squeeze)

48,,037 233,801 1,000,000 1,200,000 33,801 117,857 1,000,000 1,100,000 17,857

Alternatively, we can modify the amortization table so that we can derive directly the discount amortization: Interest Discount Principal Date payments Interest expense amortization payments Present value (𝑏) = (𝑐) × 12% (𝑐) = (𝑏) − (𝑎) (𝑑) (𝑐) = 𝑃𝑉 + (c) – (d) (𝑎) 1/1/x1 2,900,305 12/31/x1 300,000 348,037 48,037 1,000,000 1,948,342 12/31/x2 200,000 233,801 33,801 1,000,000 982,143 12/31/x3 100,000 117,857 17,857 1,000,000 0 Notice that the discount amortization is simply the difference between the interest payment and interest expense. Zero-coupon bonds Zero-coupon bonds are bonds that do not pay periodic interests. Both principal and compounded interests are due only at maturity date. Illustration: On January 1, 20x1, ABC Co. issued 10%, ₱3,000,000 bonds at a yield to maturity interest of 18%. Principal and interest are due on December 31, 20x3. (Future Value ’FV’ of PL @10%, ‘n=3 is 1331) ❖ Initial measurement Face amount 3,000,000 FV of an ordinary annuity of PL @10%, n=3, 1.331 Maturity value of the bonds (Future cash flow) 3,993,000 Future cash flows PV of ₱1 @ 18, n=3 Present value of bonds (issue price)

3,993,000 0.6086309 2,403,263

Alternative solution: 3M x 110% x 110% x 110% = 3,993,000 x PV of 1 @18%, n=3 = 2,430,263. Jan. 1, 20x1

Cash Discount on bonds payable (3M – 2,430,264) Bonds payable

2,430,263 569,737 3,000,000

❖ Subsequent measurement: Amortization table (Lump sum)

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Date

437,447 516,188 609,102

Discount on bonds payable IGNNO RED

1/1/x1 12/31/x2 12/31/x3 12/31/x3

Interest expense 𝑎 = 𝑏 𝑥 18%

Present value of cash flow * 𝑏 = 𝑝𝑟𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑏𝑎𝑙. +𝑎 2,430,263 2,867,710 3,383,898 3,993,000

* The “present value of cash flow” subsequent to Jan. 1, 20x1 includes amount in interest payable. The other pertinent entries are as follows: Dec. 31, 20x1 Interest expense 437,447 Discount on bonds payable (squeeze) Interest payable (3M x 10%) Dec. 31, 20x2 Interest expense 516,188 Discount on bonds payable (squeeze) Interest payable [(3M + 300K) x 10%] Dec. 31, 20x3 Interest expense 609,102 Discount on bonds payable (squeeze) Interest payable [(3M + 300K + 330K) x 10%] Dec. 31, 20x3 Bonds payable 3,000,000 Interest payable (300K + 330K + 363K) 993,000 Cash

137,447 300,000 186,188 330,000 246,102 363,000

3,993,000

Alternatively, we can modify the amortization table to include columns for “interest payable,” “amortization,” and “present value pertaining only too be the bonds.” Interest Date Interest expense PV of cash flows payable Amortization PV of bonds (a) = 18% x (b) (b) = previous © = 10% x (d) = (a) – (c) (c) = previous balance + (a) (principal + bal. + (d) accrued interest 1/1/x1 2,430,263 2,430,263 12/31/x1 437,447 2,867,710 300,000 137,447 2,567,710 12/31/x2 516,188 3,383,898 330,000 186,188 2,753,898 12/31/x3 609,102 3,993,000 363,000 246,102 3,000,000 Compound financial instruments A compound financial instrument is a financial instrument that, from the issuer’s perspective, contains both a liability and an equity component. These components are classified and accounted for separately. An example of a compound instrument is convertible bonds. Convertible bonds are bonds that can be converted into shares of the issuer. When an entity issues convertible bonds, in effect, it is issuing two instruments – (1) a debt instrument for the payable and (2) an equity instrument for the equity conversion feature. These two components are presented the statement of financial position.

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Equity is defined as a residual amount. Therefore, to separate the debt and equity components of a compound instrument, the entity simply deducts from the cash proceeds of the debt the fair value of the debt component without the equity feature, the remaining amount represents the equity component. This procedure follows the basic accounting equation. Assets Cash proceeds from issuance of compound instrument

– Less

Liabilities Fair value of debt component without the equity feature

=

Equity

equals

Equity component

The sum of the carrying amounts allocated to the liability and equity components is always equal to the fair value of the whole instrument. No gain or loss is recognized on the initial recognition of the components. The separate classifications of the components are not revised for subsequent changes in the likelihood that the conversion option will be exercised. What is the meaning of compound financial Instrument? It is a transaction which involves more than one type of financial instrument. It can be a financial instrument or an equity instrument that is being issued at one time. Yes, it is possible to issue bonds with a privilege of conversion, meaning you can convert the bonds into shares. How are you going to record this? First is separate the debt and equity components of the compound instrument, by deducting from the cash proceeds / the amount fair value of the debt component then the rest will go to equity component. If there is a transaction costs these transaction costs must be allocated to the equity and debt component, As per standard your transaction cost must be deducted from the bonds payable thru the discount or premium if there is and the share premium conversion feature.

Convertible bonds Illustration 1: Issuance of convertible bonds On January 1, 20x1, ABC Co. issued 10%, year, ₱1,000,000 convertible bonds at face amount. Each ₱1,000 bond is convertible into 8 shares with par value of ₱100 per share. On issuance date, the bonds were selling at 98 without conversion option. ABC incurred 50,000 transaction costs on the issuance. ❖ Initial measurement: The issue price is allocated to the liability and equity components as follows: Issue price Fair value of debt instrument w/o equity feature (1M x 98%) (980,000) Equity component 20,000

1,000,000

The transaction cost are allocated to the liability and equity components in proportion to the allocated issue price. Allocated amounts from Allocation of transaction Component issue price Fraction costs Debt component 980,000 980/1,000 49,000 Equity component 20,000 20/1,000 1,000

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1,000,000

1,000/1,000

50,000

The carrying amounts of the liability and equity components are as follows: Equity Debt component component Totals Allocation of issue price 980,000 20,000 1,000,000 Allocation of transaction cost (49,000) (1,000) (50,000) Carrying amounts 931,000 19,000 950,000 Notice that the sum of the carrying amount is equal to the net proceeds from the issuance (1M issue price – 50K transaction costs = 950,000) ➢ Simple entries: Jan. 1, 20x1

Cash 1,000,000 Discount on bonds payable (1M – 980K) 20,000 Bonds payable 1,000,000 Share premium – conversion feature 20,000 To record the issuance of convertible bonds Jan. 1, 20x1 Discount on bonds payable (a) 49,000 Share premium –conversion feature (a) 1,000 Cash 50,000 To record the transaction costs (a) The transaction cost allocated to the equity component is deducted from share premium, while that of the debt component is included in the discount on bonds payable to simplify the subsequent recording of amortization.

➢ Compound entry: Jan. 1, 20x1

Cash Discount on bonds payable (1M – 980K) Bonds payable Share premium – conversion feature To record the issuance of convertible bonds

950,000 69,000 1,000,000 19,000

Illustration 2: Conversion of convertible bonds On January 1, 20x1, ABC Co. issued 10%, 3-year, ₱1,000,000 convertible bonds at 105. Each ₱1,000 bond is convertible into 8 shares with par value of ₱100 per share. Principal is due at maturity but interest is due annually at each year-end. On issuance date, the bonds were selling at a yield to maturity market rate of 12% without the conversion option. On December 31, 20x2, all of the bonds were converted into equity ABC incurred stock issuance costs of ₱20,000. ❖ Initial measurement ➢ The fair value of the bonds without conversion option is computed as follows: Future cash flows PV of 12, n=3 Principal 1M PV of 1 Interest 100K PV of ordinary annuity of 1 Fair value of debt instrument without conversion feature

PV factors 0.711780 2.401831

Present value 711,780 240,183 951,963

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➢ The equity component is computed as follows: Issue price (1M x 105%) Fair value of debt instrument without equity feature Equity component Jan. 1, 20x1

1,050,000 (951,963) 98,037

Cash (1M x 105%) Discount on bonds payable (1M – 951,963) Bonds payable Share premium – conversion feature

❖ Subsequent measurement: Amortization table: Date Interest payment Interest expense Jan. 1, 20x1 Dec. 31, 20x1 100,000 114,236 Dec. 31, 20x2 100,000 115,944 Dec. 31, 20x3 100,000 117,857

1,050,000 48,037 1,000,000 98,037

Amortization 14,236 15,944 17,857

The other pertinent entries prior to conversion are as follows: Dec. 31, 20x1 Interest expense Discount on bonds payable Cash Dec. 31, 20x2 Interest expense Discount on bonds payable Cash ❖ Conversion: The entries on to record the conversion are as follows: Dec. 31, 20x2 Bonds payable Discount on bonds payable (1M – 982,143) Share capital (a) Share premium (squeeze) To record the conversion of bonds into shares Dec. 31, 20x2 Share premium Cash To record the share issuance costs Dec. 31, 20x2 Share premium – conversion feature Share premium To reclassify the equity component of the compound instrument within equity (a) (1M face amount ÷ ₱1,000) x 8 shares x ₱100 par value = 800,000

Present value 951,963 966,199 982,143 1,000,000

114,236 14,236 100,000 115,944 15,941 100,000

1,000,000 17,857 800,000 182,148 20,000 20,000 98,037 98,037

Notes:

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✓ The conversion of the bonds is accounted for as equity set-off, meaning, the carrying amount of the bonds is simply derecognized, the aggregate par value of the shares issued is credited to “Share capital” and the difference is credited to “Share premium.” No gain or loss is recognized on the conversion. ✓ The share issuance costs are treated as reduction to share premium. ✓ The “share premium — conversion feature” is closed to the “share premium” general account because all of the conversion privilege has been exercised. ✓ Prior to the conversion of the bonds, the “share premium — conversion feature” is part of share premium but described as pertaining to the conversion feature, When the conversion featured is exercised, such amount is just reclassified within equity (i.e., from one share premium account to another share premium account) ✓ The conversion increased equity by the carrying amount of the bonds on conversion date less transaction costs incurred on the conversion. Carrying amount of bonds on date of conversion Conversion cost Net increase in equity

982,142 (20,000) 962,143

Increase in share capital 800,000 Net increase in “share premium” (280,180 – 20,000) 260,180 Decrease in “share premium – conversion feature” (98,037) Net increase in equity 962,143 Other scenarios: ➢ Partial conversion: when only some, but not all, of the bonds are converted, only the portion of the bonds that were converted is derecognized. Also, only the portion of the “Share premium – conversion feature” pertaining to the converted bonds is transferred within equity. ➢ Conversion between interest payment dates: When bonds are converted between interest payment dates, the accrued interest is usually settled separately in cash. Thus, only the carrying amount off the bonds is accounted for when applying the ‘equity set-off method. Illustration 3: Retirement of convertible bonds On January 1, 20x1, ABC Co. issued 3-year, 10%, ₱1,000,000 convertible bonds for ₱1,100,000. Principal is due at maturity but interest is payable every year-end. The bonds are convertible into 6,000 ordinary shares with par value of ₱100. At issuance date, the prevailing market rate of interest for similar debt without conversion features is 12%. On December 31, 20x2, all the convertible bonds were retired for ₱1,000,000. The prevailing interest rate for a similar debt instrument without conversion feature as of Dec. 31, 20x2 is 11%. ❖ Initial measurement: Future cash flows PV of 12, n=3 Principal 1M PV of 1 Interest 100K PV of ordinary annuity of 1 Fair value of debt instrument without conversion feature Issue price Fair value of debt instrument without equity feature Equity component

PV factors 0.711780 2.401831

Present value 711,780 240,183 951,963

1,100,000 (951,963) 148,037

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Jan. 1, 20x1

Cash Discount on bonds payable (1M – 951,963) Bonds payable Share premium – conversion feature

❖ Subsequent measurement: Amortization table: Date Interest payment Interest expense Jan. 1, 20x1 Dec. 31, 20x1 100,000 114,236 Dec. 31, 20x2 100,000 115,944 Dec. 31, 20x3 100,000 117,857

1,100,000 48,037 1,000,000 148,037

Amortization

Present value 951,963 966,199 982,143 1,000,000

14,236 15,944 17,857

❖ Retirement: On retirement date, the retirement price is allocated to liability and equity component for purposes of determining the gain or loss on extinguishment of debt. The allocation procedure is similar to the allocation of issue price. Total retirement price Less: Retirement price allocated to the bonds (a) Retirement price allocated to the equity component (b)

1,000,000 (990,991) 9,009

(a)

The retirement price allocated to the bonds is equal to the fair value of the bonds without equity feature as of the retirement date: Future cash flows PV of 11, n=3 Principal 1M PV of 1 Interest 100K PV of ordinary annuity of 1 Fair value of debt instrument without conversion feature (b)

PV factors 0.900901 0.900901

Present value 900,901 90,090 990,991

The residual amount is allocated to the equity component.

➢ The gain or loss on extinguishment of bonds is computed as follows: Carrying amount of bonds – Dec. 31, 20x2 Retirement price allocated to the bonds Loss on extinguishment of bonds ➢ Simple entries: Dec. 31, 20x2

Dec. 31, 20x2

Bonds payable Loss on extinguishment of bonds (squeeze) Discount on bonds payable (1M – 982,143) Cash (amount allocated to the bonds) To record the retirement of convertible bonds Share premium – conversion feature Cash

982,143 (990,991) (8,848)

1,000,000 8,848 17,857 990,991 9,009 9,009

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Dec. 31, 20x2

To record the allocation of retirement price to equity component Share premium – conversion feature (148,037 – 9,009) Share premium To record the forfeiture of conversion feature of retired convertible bonds

139,028 139,028

➢ Compound entry: Dec. 31, 20x2

Bonds payable 1,000,000 Loss on extinguishment of bonds 148,037 Share premium – conversion feature 8,848 Discount on bonds payable 17,857 Cash 1,000,000 Share premium (c) 139,028 (c) The net amount closed to the share premium account is the equity component allocated from the issue price Iess the equity component allocated from the retirement price: Equity component allocated from the issue price 148,037 Equity component allocated from the retirement price (9,009) Amount permanently closed to share premium account 139,028 The equity component is closed to the “share premium” general account because the conversion feature is forfeited by the retirement of the bonds. The equity component remains in equity whether the conversion feature is exercised or not. However, it is reduced by any allocated retirement price. Other scenario: ➢ Partial retirement: When only a portion of the bonds is retired, only that portion is derecognized. Accordingly, the gain or loss is computed only on that portion. Also, only a portion of the “Share premium — conversion feature” is transferred within equity. With the three illustrations discussed above pertaining to bonds payable and the conversion privilege, please list down your learnings per illustration, specifically how the items has been computed, and the standards written on it.

Bonds with share warrants To improve salability, bonds are sometimes issued with share warrants. A share warrant entitles the holder to purchase shares of stocks of the issuer at a fixed price. Generally, the life of the warrant is 5 years, ‘occasionally 10 years, and very occasionally an entity may offer perpetual warrants. Share warrants attached to bonds may be “detachable” or “non-detachable. A detachable share warrant can be detached (separated) from the bond and traded as a separate security. A non-detachable warrant cannot be sold separately from the bond. Bonds issued with share warrants, whether detachable or not, are compound financial instruments and are accounted for similar to convertible bonds. However, unlike convertible bonds, the exercise of share warrants does not extinguish the bonds.

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Another way to improve the marketing of bonds is issue it with share warrants. Share warrants are certificates that entitle the holder thereof to acquire shares at a certain price within a stated period, when these warrants is being issued there is also an equity component that is being issued. The difference between the conversion privilege and the share warrants is what will happen to the bonds if the privilege has been practiced. It says that the conversion privilege extinguishes the bonds while the conversion of share warrants does not, therefore, in the issuance of bonds with share warrants, the bonds will still be in tact. The accounting for issuance of bonds with share warrants is same with issuance of bonds with conversion privilege, only the share premium will have a category of share premium – warrants outstanding.

Illustration: On January 1, 20x1, ABC Co. issued a 3-year, 10%, 1,000, ₱1,000 bonds at 97. Each bond has one detachable share warrant entitling the holder to buy 10 shares of ABC Co. with par value of ₱100 at ₱120 per share. Shortly after issuance, the bonds are selling at 95 ex-warrants. ❖ Initial measurement: Issue price (1,000 x ₱1,000 x 97%) Fair value of debt instrument ex-warrants (1,000 x 1,000 x 95%) Equity component Jan. 1, 20x1

Cash Discount on bonds payable (1M – 950,000) Bonds payable Share premium – warrants outstanding

❖ Exercise of warrants: Half of the warrants were exercised on September 21, 20x3 Sept. 21, 20x1 Share premium – warrants outstanding (20,000 x ½) Share premium

970,000 (950,000) 20,000 970,000 50,000 1,000,000 20,000

10,000 10,000

Write down your learnings from the above illustration and relate it on the standards for Accounting of bonds with share warrants. Reclassification PFRS 9 prohibits the reclassification of financial liabilities. Derecognition of a financial liability A financial liability is derecognized* when it is extinguished, i.e., when the obligation is discharged or cancelled or expires. A liability is extinguished or cancelled or expires. A liability is extinguished in many ways, for example trough

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a. b. c. d. e. f.

Repayment in cash Transfer of non-cash assets or rendering of services Issuance of equity securities Replacement of the existing obligation with a new obligation Waiver or cancellation by the creditor Expiration, e.g., a warranty obligations expires after the warranty period.

*Derecognition is the removal of a previously recognized asset or liability from the entity’s statement of financial position. What is a derecognition of financial liability? Financial liability is said to be derecognize if you are going to remove it from the financial statement, how? It is through payment of liabilities thru cash, other property, issuance of equity securities, refinancing, expiration of liability or cancellation by the creditor. Manner of derecognition of a financial liability Transfer of non-cash or rendering of services /asset swap Issuance of equity securities

Modification of terms Check if the modification is substantial (please see below for the discussion)

Carrying amount of liability extinguished – Carrying amount of noncash asset transferred = Gain or loss in profit or loss Carrying amount of the liability extinguished – FV of the securities issued or FV of the financial liability extinguished whichever is clearly determinable = Gain or loss in profit or loss Present value of the new liability - the carrying amount of original liability = gain or loss in profit or loss

Transfer of noncash assets (Asset swap) When a debtor settles an obligation by transferring noncash asset (‘assets swap’) to the creditor, the difference between the carrying amount of the liability extinguished and the carrying amount of the noncash asset transferred is recognized as gain or loss in profit or loss. Illustration: On Jan. 1, 20x1, ABC Co. settled a ₱1,000,000 loan payable with an unamortized discount of ₱20,000 and an accrued interest of ₱90,000 by transferring to the lender old equipment with cost of ₱3,000,000, accumulated depreciation of ₱2,200,000, and fair value of ₱900,000. ❖ Derecognition: Jan. 1, 20x1

Loan payable Interest payable Accumulated depreciation

1,000,000 90,000 2,200,000

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Discount on loan payable Equipment Gain on extinguishment of debt (squeeze)

20,000 3,000,000 270,000

Notice that the fair value of the noncash asset transferred is ignored. The gain or loss can also be computed as follows: Carrying amount of liability (1M loan – 20K disc. + 90K interest) Carrying amount ‘of noncash asset transferred (3M – 2.2M) Gain on extinguishment of debt

1,070,000 (800,000) 270,000

If payment is less than the liability being extinguish, the difference is a gain. If payment is more than the liability being extinguish, the difference is loss. Transfer of equity securities (Equity swap) When the terms of a financial liability are renegotiated such that the debtor settles it by issuing equity securities (‘equity swap’) to the creditor, the difference between the carrying amount of the liability extinguished and the fair value of the securities issued or fair value of the financial liability extinguished, whichever is more clearly determinable, is recognized as gain or loss in profit or loss. (IFRIC 19) Illustration 1: Fair value of securities issued On Jan. 1, 20x1, ABC Co. settled a ₱1,000,000 loan payable by issuing to the lender 10,000 shares with par value of ₱50 per share. Case 1: Fair value of securities issued The shares are selling at ₱120 per share on Jan. 1, 20x1. Requirement: How much is the gain (loss) on extinguishment debt? Solution: Carrying amount of liability Fair value of securities issued (10,000 x ₱120) Loss on extinguishment of debt Jan. 1, 20x1

Loan payable Loss on extinguishment of debt (squeeze) Share capital (10,000 x ₱50) Share premium [(₱120 – 50) x 10,000 sh.]

1,000,000 (1,200,000) (200,000) 1,000,000 200,000 500,000 700,000

Case 2: Fair value of the financial liability extinguished The fair value of the shares is not reliably determinable. The loan pays annual interest of 12% at each year end and has a remaining term of 3 years. ‘The prevailing market rate for similar debt on Jan. 4, 20x1 is 8%.

Requirement: How much is the gain (loss) on extinguishment of debt?

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Solution: Carrying amount of liability Fair value of value of financial liability extinguished (a) Loss on extinguishment of debt Future cash flows Principal 1,000,000 Interest 120,000 Fair value of financial liability extinguished Jan. 1, 20x1

1,000,000 (1,103,084) (103,084) PV factors @8%, n=3 0.793832 2.577097

Loan payable Loss on extinguishment of debt (squeeze) Share capital (10,000 x 50) Share premium (1,103,084 – 500K)

Present value 793,832 309,252 1,103,084 1,000,000 103,084 500,000 603,084

Modifications of terms A borrower and lender may modify the terms of an existing financial liability, such as by changing the stated interest rate, the maturity date or the face amount, or by reducing, deferring or cancelling any accrued interest. If the modification results to substantially different terms. The existing financial liability is considered extinguished and replaced by a new one. A modification is considered substantial if the present value of the cash flows under the new terms, discounted at the original effective interest rate, is at least 10% different from the carrying amount of the original financial liability. In such case the original liability is derecognized and replaced with the new one. The difference between the present value of the new liability and the carrying amount of original liability is recognized as gain or loss. A modification can be substantial regardless of the debtor’s, financial difficulty. If the modification is not substantial (i.e., less than 10% different), the existing financial liability is not consider extinguished. Therefore, it is continued to be recognized but with modified cash flows depending on the modified terms. An adjustment to the effective interest rate may be necessary. The new liability is not recognized. No gain or loss is recognized. Direct costs of modification are accounted for as follows: a. Included in the gain or loss, if the modification is substantial. b. Deducted from the carrying amount of the existing financial liability and subsequently amortized using the effective interest method, if the modification is not substantial. Illustration: On Dec. 31, 20x1, ABC CO.’s loan was modified as follows: • The principal was reduced from ₱5,000,000 to ₱4,000,000. • The lender forgave the accrued interest of ₱600,000. • The maturity date was extended from Dec. 31, 20x2 to Dec. 31, 20x4. • The nominal interest rate was reduced from 12% to 10%. Interest is due annually at each year-end. The original effective interest rate is 12%. The current interest rate on Dec. 31, 20x1 is 11%.

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➢ The modification is analyzed as follows: Old terms Principal Accrued interest Remaining term (‘n’) Nominal rate

New terms 5,000,000 600,000

4,000,000

12%

3 years 10%

➢ The present value of the modified liability is computed as follows: Future cash flows PV factors @12%, n=3 Principal 4,000,000 0.711780 Interest 400,000 2.401831 Present value of the modified liability

Present value 2,847,121 960,733 3,807,853

➢ The modification is tested for substantiality as follows: Present value of modified liability Carrying amount of old liability (5M principal + 600K interest) Difference Divide by: Carrying amount of old liability Percentage change

3,807,853 5,600,000 (1,792,147) 5,600,000 -32%

The modification is substantial because the change is ‘at least 10%’. Accordingly, the original liability is derecognized and the replaced with the modified liability. The difference between the present value of t the modified liability and thee carrying amount of the old liability, including accrued interest, is recognized as gain or loss. Dec. 31, 20x1 Loan payable – old 5,000,000 Interest payable 600,0000 Discount on loan payable – new 192,147 (4M new principal – 3,807,853 present value) 4,000,000 Loan payable – new 1,792,147 Gain on extinguishment of debt Notes: ✓ The modified liability is discounted using the original effective interest rate on the old liability. The current rate on modification date is ignored. This is because the liability is measured at amortized cost and using the current rate would change this measurement too fair value. ✓ There is gain because the old liability is replaced with a new one that has a lower amount. ✓ The debtor's accounting for modification of terms is similar to the lender's accounting for impairment loss, except that there is no ‘10%’ threshold for the lender. Analyze the computation below (assume the lender’ original effective interest rate is also 12%)

Present value of future cash flows (recoverable amount) Carrying amount of receivable (5M principal + 600K interest) Impairment loss by lender Dec. 31, 20x1

Impairment loss

3,807,853 5,600,000 (1,792,147) 1,792,147

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Interest receivable Allowance for impairment loss (or Loan receivable)

600,000 1,192,147

Troubled-debt restructuring In a troubled-debt restructuring, the creditor grants the debtor, who is undergoing financial difficulties, concession that would not otherwise be granted in a normal business relationship. The restructuring usually involves easing or relaxing the terms of the debt in order to accommodate the debtor. Troubled-debt restructuring is accounted for as modification of financial liability. Waiver or cancellation by the creditor If the creditor cancels a financial liability, the debtor derecognize the liability are recognizes gain. Dec. 31, 20x1 Loan payable 5,000,000 Interest payable 600,000 Gain on extinguishment of debt

5,600,000

Summary of the Lesson: • Accrued interest is excluded from the measurement of bonds issued between interest payments dates • Interest is incurred due to passage of time • Issue price of bonds = Future cash flows x PV factor • When bonds are retired, the difference between the carrying amount at retirement date and the retirement price is recognized as gain or loss • The issue price of a compound financial instrument is allocated to the liability and equity components as follows: Cash proceeds less Fair value of debt component without the equity feature equals equity component • The conversion of convertible bonds is accounted for as equity set-off. No gain or loss is recognized • When convertible bonds are retired, the retirement price is allocated to both the liability and equity components. The amount allocated to the liability component is used to determine the gain or loss on extinguishment of debt. • An asset swap is accounted for using the carrying amount of the noncash asset transferred • An equity swap is accounted for using the fair value of the securities issued or fair value of the liability extinguished, whichever is more clearly determinable • A modification of terms is substantial if the percentage change between the old and new liabilities is at least 10%.

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Enrichment Activity: 1. Angel Company’s December 31, 2020 statement of financial position contained the following items in the long-term liabilities section: 9% registered debentures, callable in 2025 and 2030 ₱ 10,500,000 10% collateral trust bonds, convertible into ordinary shares, beginning 2023 and due in 2026 9,000,000 10% subordinated debenture (₱450,000 maturing annually) 4,500,000 What is the total amount of Angel’s term bonds? ___________________________________ Answer: P 19,500,00 2. On January 1, 2020, Jayden Company issued 6,400 of its 8%, ₱1,000 bonds when the prevailing rate of interest was 9%. The bonds are dated January 1, 2020 and mature on January 2025. Interest is payable annually every December 31. The following are the present value factors: PV of 9% for an ordinary annuity of ₱1 after 4 years 3.2397 PV of 9% after 4 years 0.7084 What amount of proceeds did the company receive on the issue of the bonds? ___________________________________ Answer: P 6,192,486 3. On April 1, 2020 Eli Corp. issued at 99, 2,800 of its 8%, ₱1,000 bonds. The bonds are dated April 1, 2020, to mature on April 1, 2030, and pay interest on April 1 and November 1. Eli paid transaction cost of ₱28,000. From the issuance, how much net cash did Eli receive? ___________________________________ Answer: P 2,744,000 4. On July 1, 2020, Bryson Corporation issued 11% bonds in the face amount of ₱2,600,000 that mature on June 30, 2025. The bonds were issued to yield 5% and interest is payable every January 1 and July 1. Bryson Corporation uses the effective interest method of amortizing bond premium or discount. The following are the present value factors: PV of 5% for an ordinary annuity of ₱1 after 8 periods 6.463 PV of 5% after 8 interest periods 0.677 What is the carrying value of the bonds as of December 31, 2020? ___________________________________ Answer: P 2,675,629

5. On March 1, 2020, Yarah Company issued at 103 plus accrued interest 4,800 of 9%, P1,000 face value bonds. The bonds are dated January 1, 2020 and mature on January 1, 2030. Interest is payable semi-annually on January 1 and July 1. The entity paid bond issue cost of P240,000. What is the net cash received from the bond issuance? ___________________________________ Answer: P 4,776,000

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6. In the statement of financial position of MJ, Inc. as of December 31, 2020, the following accounts appear: 18% Bonds Payable, due January 1, 2023 ₱ 1,200,000 Premium on Bonds Payable 84,000 Accrued Interest on Bonds Payable 108,000 Interest is payable semi-annually on January 1 and July 1. On January 1, 2021, MJ, Inc. redeemed the bonds at 96 plus accrued interest. How much is the gain (or loss) on the redemption of the bonds? ___________________________________ Answer: P 132,000 7. On January 1, 2020, Andrea Company issued 5-year bonds with face value of ₱6,000,000 at 110. The entity paid bond issue cost of ₱96,000 on same date. The stated interest rate on the bonds is 8% payable annually every December 31. The bonds are issued to yield 6% per annum. The entity used the effective interest method of amortization. On December 31, 2020, what is the carrying amount of the bonds payable? ___________________________________ Answer: P 6,414,240

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Assessment Lesson 3 - BONDS PAYABLE Name: ___________________________________________

Section: _____________ Score: __________

1. On March 1, 2020, Leonardo Corporation issued at 103 excluding accrued interest, 1500 of its 15%, ₱1,000 bonds. The bonds are dated January 1, 2020 and mature on January 1, 2030. Interest is payable semi-annually on January 1 and July 1. Leonardo paid transaction costs of ₱90,000. Leonardo would realize net cash receipts from the bond issuance of ___________________________________ 2. On January 2, 2020, Jacob Company issued its 9% bonds in the face amount of ₱4,800,000 which mature on January 1, 2030. The bonds were issued for ₱4,504,867 to yield 10%. Jacob uses the interest method of amortizing bonds discount. Interest is payable annually on December 31. At December 31, 2021, how much should be Jacob’s unamortized bond discount? ___________________________________ 3. On October 1, 2020, Kayden Corporation issued, at 99 excluding accrued interest, 3,600 of its 8% ₱1,000 bonds. The bonds are dated January 1, 2020, mature on January 1, 2030 and pay interest on July 1 and January 1. Kayden paid transaction costs of ₱70,000. From the bond issuance, Kayden received net cash of ___________________________________ 4. On April 1, 2020, Isaac, Inc. issued, at 97 including accrued interest 3,000 of its 10% ₱1,000 bonds. The bonds are dated January 1, 2020, to mature on January 1, 2030. Interest is payable semi-annually on January 1 and July 1 from the bond issuance, how much net cash did Isaac receive? ___________________________________ 5. Belle Company is authorized to issue ₱6,000,000 of 6% 10-year bonds dated July 1, 2020 with interest payments on June 30 and December 31. When the bonds are issued on November 1, 2020, the entity received cash of ₱6,180,000 including accrued interest. What is the discount or premium from the issuance of the bonds payable? ___________________________________ 6. Kris Company reported the following long-term debt on December 31, 2020: 9% registered debentures, callable in 2021, due in 2022 ₱ 4,200,000 11% collateral trust bonds, convertible into ordinary Shares beginning in 2021, due in 2022 3,600,000 10% subordinated debentures (₱600,000 maturing Annually beginning in 2021) 1,800,000 What is the total amount of term bonds? ___________________________________ 7. On January 1, 2020, Catalan Company issued ₱4,800,000, 8% serial bonds, to be repaid in the amount of ₱960,000 each year. Interest is payable annually on December 31. The bonds were issued to yield 10% a year. The entity amortized the bond discount by the interest method. The bond proceeds totaled ₱4,566,720 based on the present value on January 1, 2030 of five annual payment as follows: Due date Principal Interest PV at 1/1/2020 12/31/2020 ₱ 960,000 ₱ 384,000 ₱ 1,221,600 12/31/2021 960,000 307,200 1,046,640

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12/31/2022 960,000 230,400 894,000 12/31/2023 960,000 153,600 760,560 12/31/2024 960,000 76,800 643,920 On December 31, 2020, what is the amount of the bonds payable? ________________________ 8. Bretman Company reported on December 31, 2019 9% bonds payable of ₱4,800,000 less unamortized discount of ₱384,000. Further examination revealed that these bonds were issued to yield 10%. The amortization of the bond discount was recorded using the effective interest method. Interest was paid on January 1 and July 1 of each year. On July 1, 2020 the entity retired the bonds at 103 before maturity. What I the loss on retirement of bonds payable on July 1, 2020? ___________________________________ 9. On April 1, 2020, Aerial Company issued at 99 plus accrued interest, 2,400 of 8% ₱1,000 face value bonds. The bonds are date January 1, 2020, mature on January 1, 2030, and pay interest on January and July. The entity paid bond issue cost of ₱84,000. From the bond issuance, what is the net cash received? ___________________________________ Suggested Links: https://www.accountingcoach.com/blog/what-are-bonds-payable https://www.google.com/search?q=note+payable+picture&sxsrf=ALeKk00DF45Q58b6Dx-OYwuDWMp8Rsc1Q:1599623840612&source=lnms&tbm=isch&sa=X&ved=2ahUKEwiKzayWl9vrAhULHaYKHYlUAiUQ_AUoAXoEC BQQAw&biw=1301&bih=626#imgrc=oi927Xl4yyVnnM References: Millan, Z.V. (2019). Intermediate Accounting 2 Valix,(2019). Intermediate Accounting 2 Uberita, (2013) Practical Accounting 1

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LEARNING MODULE INFORMATION I. Course Code II. Course Title

IA201 INTERMEDIATE ACCOUNTING 2

III. Module Number IV. Module Title

2 Provisions and Contingencies, Share Capital, Retained Earnings

V. Overview of the Module

The course is all about the Liabilities, shareholder’s equity and other special topics in intermediate accounting II. Each topic of this module discusses the standards that govern the recognition of each account in liabilities and shareholder’s equity, there will be computations for illustrations, enrichment wherein you will be asked with problems and after that is the discussion of the problem. It is advised that if you are going to study this module focus on understanding the standards, the why and relationships of computation not just the how it is being computed.

VI. Module Outcomes

At the end of this module, the students should be able to: 1. Apply the financial accounting standards relative to the recognition, measurement, financial statement presentation, and disclosure requirements of liability and shareholders’ equity accounts in accordance with the Philippine Accounting Standards (PAS) and Philippine Financial reporting Standards (PFRS). 2. Apply the standards pertaining to Share Capital and Retained earnings 3. Compute for the Provisions and Contingencies and properly recognize it to the Financial Statement

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Lesson 1: PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS Lesson Objectives: 1. State the recognition criteria for provisions 2. Differentiate the accounting requirements of a provision, a contingent liability and a contingent asset. 3. Describe the available measurement bases for a provision 4. Account for provision Discussion and Application: Standards related to Provisions, Contingent Liabilities and Contingent assets is: PAS 37: Provisions, Contingent Liabilities and Contingent assets Provisions A provision is "a liability of uncertain timing or amount."(PAS 37.10) Provisions differ from other liabilities because of the uncertainty in the timing of their settlement or on the amount needed to settle them. Unlike other liabilities, provisions must necessarily be estimated. Although some other liabilities are also estimated, their uncertainty is generally much less compared to provisions. Provision is a non-financial liability, unlike other liability the measurement for this is merely based on estimates but of course with basis, this shall be recorded as part of a liability also, in a separate line item. Examples of provisions are the following with its simple definition a. Warranty obligations – This is present when the entity sells items with warranty, like cp, laptop, etc. Once, there is a commitment in the part of the seller that there is a warranty for that certain item, then once an item is being sold, then warranty obligation will be recognized. Even if this will not be claimed. b. Estimated liabilities on pending lawsuits – These are the cases wherein the entity is being sued by another entity, in here, if there is more than 50% probability that the entity is going to lose a case, then the entity must recognize the liabilities. c. Provisions for environmental damages – If a mining company or any ordinary company, during the conduct of the operation the entity damaged the environment then the government agency or the LGU might come to the entity asking for payment for environmental damages, then there must be provision for that. d. Provisions of decommissioning costs of an item of PPE e. Obligations caused by an entity's policy to make refunds to customers – maybe you are seeing some marketing strategies saying refund will be given if the product is not effective, then this is the entity’s policy wherein you have to record a provision for the refund liability. f.

Obligations arising from guarantees

g. Provisions on onerous contracts (e.g., purchase commitment) - remember the purchase commitment? This is a situation when a buyer entered into a contract with a supplier committing to buy an item with a certain quantity,

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Price in the near period of time. This being done to protect the fluctuation of prices. h. Provisions for restructuring costs

Provisions are presented in the statement of financial position separately from other types of liabilities. Recognition A provision is recognized when all of the following conditions are met: a. The entity has a present obligation (legal or constructive resulting from a past event; b. It is probable that an outflow of resources embodying economic benefits will be required to settle the obligations; and c. The amount of the obligation can be reliably estimated. If any of the conditions is not met, no provision is recognized. (PAS 37.14) Present obligation In rare cases where it is not clear whether there is a present obligation, an entity deems a past event to give rise to a present obligation if available evidence shows that it is more likely than not that a present obligation exists at the end of the reporting period. Past event A past event that creates a present obligation is called an obligating event. An obligating event is one whereby the entity does not have any other recourse but to settle an obligation. This is the case where: a. the obligation is legally enforceable (legal obligation) ; or b. the entity's actions (e.g., past practice or published policies) have created valid expectations from others that the entity will discharge the obligation (constructive obligation) Financial statements deal with past or historical information. Therefore, no provision is recognized for future operating costs. "The only liabilities recognized in an entity' statement of financial position are those that exist at the end of the reporting period." (PAS 37.18) Only those obligations arising from past events existing independently' of an entity’s future actions are recognized as provisions. Thus, possible outflows of resources embodying economic benefits that the entity can avoid by changing its future actions are not recognized as provision. Although an obligation always involve another party too whom, the obligation is owed (i.e., oblige), it is not necessary that the identity of the obligee is known – indeed the obligee may be the public at large. For a constructive obligation to create a valid expectation from others, is necessary that the commitment must have been communicated to thee parties concerned before the end of the reporting period. Probable outflow of resources embodying economic benefits

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Probable means "more likely than not," i.e., there is a higher chance that the event will cause an outflow of future economic benefits than not. We may think of it as a "51% or more" chance that the outflow will occur. If it is '50:50', then it is not probable because there equal chances of occurrence and nonoccurrence. A '50:50' chance is "possible" but not "probable." Reliable estimate of the obligation Provisions necessarily need to be estimated. If a reliable estimate cannot be made, no provision is recognized. Recognition Criteria (All of these criteria should be present before you recognize any provisions. Present Obligation – in other word this is a commitment to transfer economic resources of the entity, you have to pay cash, property or services. Past Events – is an obligating event, wherein the entity does not have any choice but to settle the obligation because of the past events, there is a sale of gadget with warranty, there is an environmental damage. Probable – More likely than not, 51% of chance that the outflow will occur. Answer the following 1. What is the provision? 2. What is the recognition criteria for provision? 3. Give examples of provisions

Contingent liabilities In a general sense, all provisions are contingent because they are of uncertain timing or amount. However, PAS 37 uses the term "contingent" to refer to those liabilities and assets that are not recognized because they do not meet all of the recognition criteria. A provision and a contingent liability are differentiated below: Provision Contingent liability ➢ A liability of an uncertain timing or amount that ➢ A possible obligation whose existence will be meets all of the following conditions: confirmed only by the occurrence of one or more a. present obligation; uncertain future events not wholly with on the b. probable outflow; and control of the entity; or c. reliably estimated ➢ A present obligation i. it is not probable that it will cause an outflow in its settlement; or ii. its amount cannot be reliably estimated. ➢ You have to record a provision for liability ➢ Contingent liability shall be disclosed to notes to financial statement ➢ Contingent assets shall be disclosed also even if there is a probability that it will happen. Remember we have also to apply the principle of conservatism here.

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Contingent liabilities are disclosed only, except when the possibility economic benefits is remote.

of an

outflow of resources embodying

Contingent assets Contingent assets are those that are not recognized because they do not meet all of the asset recognition criteria (i.e., 'resource controlled arising from past events', 'probable inflow', and 'reliable estimation'). Contingent assets include possible inflows of economic benefits from unplanned or unexpected events, such as claims that an entity is seeking through legal processes where the outcome is uncertain (e.g., claims under tax disputes and disputed insurance claims). Contingent assets are disclosed only, if the inflow oi economic benefits is probable. They are not recognized because recognizing them may result to the recognition of income that may never be realized. However, when the realization of income is virtually certain (100% chance of occurrence), the asset is not a contingent asset and therefore it is appropriate to recognize it. Summary:

Contingent ➢ Liability ➢ Asset

Probable Recognize and Disclose Disclose only

Possible Disclose only Ignore

Remote Ignore ignore

Please answer the following 1. What is contingent liability and contingent asset? 2. What is the accounting treatment for liability? 3. What is the accounting treatment for contingent asset? 4. Why does the contingent liability is being treated like that?

Illustration 1: Contingent asset ABC Co. is involved in a tax dispute. ABC has wrongfully paid taxes and claiming for refund of the taxes it has previously paid. As of December 31, 20x1, ABC's legal counsel was very confident that ABC will be able to recover the tax refund amounting to ₱10M in the coming year. What is the entry to recognize the probable receipt of the tax refund? Answer: None. Contingent assets are disclose only when they are deemed probable. If possible or remote, contingent assets are not required to be disclosed. Illustration 2: Virtually certain In 20x1, there was a robbery in one of ABC's branches. There has been a dispute on the ₱100M insurance claim that ABC has presented to its insurance provider. On December 31. 20x1, the insurance company approved the payment of 80% of ABC's claim (i.e., ₱80M). ABC received a letter that the settlement check for that amount had been mailed, but such check was received only on January 5, 20x2. What is the entry to be made by ABC on December 31, 20x1? Answer: Dec. 31, 20x1

Claims receivable (100M x 80%)

80,000,000

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Gain on settlement of insurance

80,000,000

Since the claim is virtually certain, it is not considered as a contingent asset. Thus, recognition of the approved payment is appropriate. Please write your learnings in the illustrations above:

Measurement Provisions are measured at the best estimate of the amount needed to settle them at the end of the reporting period. Making the estimate requires management s judgment, supplemented by experience from similar transactions, and in some cases, reports from independent experts. The estimate also considers events after the reporting period. ✓ If the provision being measured involves a large population of items, the obligation is measured at its "expected value.”

Expected value is computed by weighting all possible outcomes bv their associated probabilities.

✓ If there is a continues range of possible outcomes, and each point in that range is as likely as any other, the mid-point of the range is used. Nature of the outflow 1. Genera l rule (e.g., one-off event) 2. Involves a large population of items 3. Each possible outcome in a range is as likelv as anv other

Measurement basis ➢ Best estimate ➢ Expected value (Probability Weighted Average) ➢ Mid-point

Recording the provision Provisions are normally recognized as a debit expense (or loss) and a credit to an estimated liability account. However, sometimes a provision forms part of the cost of an asset. For example, provisions for restoration and decommissioning of the cost of an asset. It says in the discussion above, that provisions are being measured thru estimate. Please answer the following 1. What are the rules in estimating provisions? 2. What is the entry for recording the provision?

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Illustration 1: Best estimate In 20xl, ABC Co. received a court order requiring the cleanup of environmental damages cause by one pf ABC’s factory. ABC has no other realistic alternative but to comply with the court order. Other entities have incurred around ₱15M for similar cleanup; however, AABC’s best estimate of the cost of cleanup is ₱20M. Analysis: Step 1. Is there a present obligation? – Yes, environmental damages have already been caused. Step 2. Is the outflow probable? – Yes, ABC has no other realistic alternative but to comply with the court order. Step 3. Can the outflow be measured reliably? – Yes, the problem indicates a “best estimate” of ₱20M. Conclusion: a provision must be accrued and disclosed in the amount of ₱20M. Note: Before a provision can be recognized, the answer to all of the questions in “Step 1 to 3” must be “yes.” If any of the questions has a “no” for an answer, no provision is recognize. When a provision is accrued, a disclosure must also be made. The entry to recognize the provision is as follows: Dec. 31, 20x1 Environmental cleanup costs 20,000,000 Estimated liability for cleanup costs 20,000,000 Illustration 2: Expected value In 20x1, ABC Co. recalled a product due to a possible defect caused by malfunctioning factory equipment. The products recalled will be repaired free of charge. ABC is uncertain whether all product recalled will have the possible defect. However, the following estimate was made by ABC's engineers and managerial accountants and approved by the board of directors. Repair cost 20,000,000 15,000,000 10,000,000 5,000,000

Probability 5% 20% 35% 40% 100%

The expected value of the provision is determined as follows: ' Repair cost Probability (a) (b) 20,000,000 5% 15,000,000 20% 10,000,000 35% 5,000,000 40% 100% The entry to recognize the provision is as follows: Dec. 31, 20x1 Repair costs

Expected value (c) = (a) x (b) 1,0000,000 3,000,000 3,500,000 2,000,000 9,,500,000

9,500,000

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Estimated liability for repairs costs

9,500,000

Illustration 3: Mid-point In 20x1, a lawsuit was filed against ABC Co. for patent infringement. The plaintiff is claiming ₱100M in damages. ABC's legal counsel believes that it is probable that ABC will lose the lawsuit and pay damages of not less than 10M but not more than ₱100M. The probability of any amount within the range is as likelv as any other amount also within the range. The plaintiff has offered to settle the lawsuit out of court for ₱90M but ABC did not agree to the settlement. How much is provision to be reported in ABC's year-end financial statements? Answer: ₱55M [(₱10M + ₱100M) ÷ 2]. The mid-point of the range is used because each point in the range is as l ikely as any other. The entry to recognize the provision is as follows: Dec. 31, 20x1 Probable loss on lawsuit 55,000,000 Estimated liability on pending lawsuit 55,000,000 Discuss your observations from the above illustrations: Illustration 1 Illustration 2 Illustration 3

Risk and uncertainties Estimates take into account risks and uncertainties. Thus, estimates may be increased by a risk adjustment factor to provide an allowance for imprecision inherent estimates. This, however, does not mean that the entity can make excessive provisions or can deliberately overstate liabilities. Present value If the effect of time value of money is material, the estimate of a provisions is discounted to its present value using a pretax discount rate. This is usually the case for provisions for restoration and decommissioning costs where cash outflows occur only after a relatively long period of time from the date of initial recognition. In recording Provision, since this is only based on estimate there is a possibility that there is a risk that estimate may not be exactly what is expected to be paid. Risk adjustment factor is being provided for the allowance of imprecision.

Illustration 1: Present value A manufacturer gives warranties at the time of sale to purchasers of its product. Under the term of the contract of sale, the manufacturer undertakes to make good, bv repair or replacement, manufacturing defects that become apparent within one year from the date of sale. On the basis of experience, it is probable (i.e., more likely than not) that there will be some claims under the warranties. Sales of ₱10 million were made evenly throughout 20X1.

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At December 31, 20x1 the expenditures for warranty repairs and replacements for the product sold in 20x1 are expected to be made 50% in 20x1 and 50% in 20x2. Assume for simplicity that all the 20x2 outflows of economic benefits related to the warranty repairs and replacements take place on June 30, 20x2. Experience indicates that 95% of products sold require no warranty repairs; 3% of product sold require minor repairs costing 10% of the sale price; and 2% of products sold require major repairs or replacement costing 90% of sale price. The entity has no reason to believe future warranty claims will be different from its experience. At December 31, 20x1, the appropriate discount factor for cash flows expected to occur on June 30, 20x2 is 0.95238. Furthermore, an appropriate risk adjustment factor to reflect the uncertainties, in the cash flow estimates is an increment of 6 per cent to the probability weighted expected cash flows. Requirement: Compute for the warranty provision at December 31, 20x1. Solution: Analysis: Step 1. Is there a present obligation? – Yes, products have already been sold. The obligating event for warranties is the act of selling. Step 2. Is the outflow probable? – Yes, based on AABC’s past experience, it is probable that there will be some claims under the warranties. Step 3. Can the outflow be measured reliably? – Yes, sufficient information is available to make a reliable estimate. Conclusion: A provision must be accrued and disclosed. The amount of the provision 1s estimated as follows: Minor repair (10M x 3% x 10%) Major repairs (10M x 2% x 90%) Total Multiply by: Present value factor (given) Total Multiply by: Risk adjustment (100% + 6%) Total Multiply by: Amount to be settled in 20x2 Warranty provision – Dec. 31, 20x1

30,000 180,000 210,000 0.95238 200,000 106% 212,000 50% 106,000

Illustration 2.1: Present value An entity is the defendant in a patent infringement lawsuit. The entity's lawyers believe there is a 30% chance that the court will dismiss the case and the entity will incur no outflow of economic benefits. However, if the court rules in favor of the claimant, the lawyers believe that there is a 20% chance that the entity will be required to pay damages of ₱200,000 (the amount sought by the claimant) and an 80% chance that the entity will be required to pay damages of ₱100,000 (the amount that was recently awarded by the same judge in a similar case) Other outcomes are unlikely. The court is expected to rule in late December] 20x2. There is no indication that the claimant will settle out of court. A 7% risk adjustment factor to the probability-weighted expected cash flows is considered appropriate to reflect the uncertainties in the cash flow estimates. An appropriate discount rate is 10% per year. Requirement: Compute for the provision for lawsuit at December 31,20x1.

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Solution: Al twenty per cent chance: (200K x 20%) At eighty per cent chance: (100K x 80%) Total Multiply by: PV of ₱1 @10% n=l Total Multiply by: Risk adjustment (100% + 7%) Total Multiply by: Probability of settlement (100% -30°'•) Provision for lawsuit – Dec. 31,20x1

40,000 80,000 120,000 0.90909 109,091 107% 116,727 70% 81,709

Illustration 2.2: Present value The facts are the same as in the immediately preceding illustration. However, in this question, because of extremely rare circumstances disclosure of some of the information about the case required by PAS 37 can be expected to prejudice seriously the position of the entity in the dispute over the alleged breach of patent. Requirement: How should the entity account for the transaction described in the preceding illustration? Answer: Recognize a provision measured at the amount determined in the preceding illustration and disclose the general nature of the preceding dispute, together with the fact that, and reason why, the information has not been disclosed. Illustration 2.3: Present value The fact are the same as in the previous illustration. However, in this question, the entity’s lawyers believe there is a 60 per cent chance that the court will dismiss the case and the entity will incur no outflow. Requirement. How should the entity account for the transaction described in the preceding illustration?

Answer: Analysis: Step 1. Is there a present obligation? – Yes, ABC is currently a defendant in a patent infringement lawsuit. Step 2. Is the outflow probable? – No, a 40% chance of occurrence (100% minus 60%) Is not probable. Probable means “more likely than not’” it connotes more than 50% chance occurrence. Step 3. Can the outflow be measured reliably? – Yes, sufficient information is available to make a reliable estimate. Conclusion: A provision must not accrued. The entity shall disclose only a contingent liability (possible obligation). Please answer the following questions 1. What did you notice with the illustrations? 2. Is the recognition criteria is still important in recording provisions? 3. How important is the estimates in provisions?

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Future events Future events may affect the amount needed to settle an obligation. However, future events are considered in estimating a provision only if there is objective evidence that supports their anticipation. For example, the penalty for an environmental damage may be affected by legislation. If a new law that will increase the amount of penalty is expected to be enacted, that new law is anticipated only when it is virtually certain that it will be enacted. Otherwise, it would not be appropriate.' to anticipate it. Expected disposal of assets Gains from the expected disposal of assets are not taken into account when measuring a provision. Gains are recognized separately when the disposal occur. Reimbursements If another party is expected to reimburse the settlement amount of a provision, a reimbursement asset is recognized if it is virtually certain that the reimbursement will be received. The reimbursement asset is presented in the statement of financial position separately from the provision. However, in the statement of comprehensive income, the expense related to the provision may be presented net of the reimbursement. The amount recognized for the reimbursement should not exceed the amount of the provision. An example of an instance where a reimbursement asset may be recognized is when the obligating event that caused the recognition of a provision is insured. The reimbursement asset would be the amount that the entity can claim from the insurance company. This are the terms that are also related to provision. Future event - In this scenario, it says that you will only recognize a future event once it is virtually certain that this event will happen. Classic example of this is the enactment of new environmental law that the entity may be affected directly, if this is virtually certain that it will happen then the entity must recognize certain liability for this. If you will remember the case of Gina Lopez in mining company, since the mining companies have many violations in environmental laws and Gina Lopez’s action made that to be enforceable then, it is virtually certain that this will be a loss on mining entity. Gains on expected disposal of assets are simply taken into account separately. Reimbursement – Insurance company’s are the “another party” that was being discussed above, let say the entity had a liability to a worker that had an accident because of construction, and the family of the worker who was affected by this accident are claiming for some benefits because of accident, since the construction and each worker is insured then they will have reimbursement from insurance company. Reimbursement asset should be used in recognizing the reimbursement, and the expense must be a balance of the reimbursement. Illustration 1: Reimbursement ABC Co. is engaged in logistics services. During the year, a warehouse was destroyed by fire. It was estimated that ABC will probably pay around ₱50M in damages caused to the goods owned by customers that were contained in the destroyed warehouse. The contents of the warehouse at any given point of time are insured for ₱20M. ABC's claim for the insurance has been approved for payment by the insurance company.

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The pertinent entries are as follows: Dec. 31, 20x1 Loss on fire Estimated liability on casualty Dec. 31, 20x1 Insurance claim receivable Gain on insurance

50,000,000 50,000,000 20,000,000 20,000,000

Notice that the claim for the reimbursement is recorded as a separate asset because it is virtually certain (i.e., approved for payment) that the reimbursement will be received and it does not exceed the amount of provision. The provision may be presented in the statement of profit or loss and other comprehensive income net of the reimbursement, i.e., net loss of ₱30M (50m loss minus 20M gain). Illustration 2.1: deductible clause On January 1, 20x2, an explosion occurred at ABC Co.’s plant causing extensive property damage to area buildings. Although no claims had yet been asserted against ABC’s as of March 10, 20x2. ABC’s management and counsel concluded that it is likely that claims will be asserted and that it is probable that ABC will be held responsible for damages. ABC’‘s ₱5,000,000 comprehensive public liability policy has a ₱250,000 deductible clause. ABC estimates an outflow equal to its net liability on the comprehensive public liability policy. ABC’s financial statements were authorized for issue on March 30, 20x2. Requirement: How should the event above be reported in ABC’s December 31, 20x1 financial statements? Answer: As a note disclosure only indicating the probable loss of ₱250,000, i.e., the extent of liability under the comprehensive insurance policy (deductible clause. No provision is recognized because there is no present obligation existing as off the end reporting period (i.e., Dec. 31, 20x10). The explosion occurred in 20x2. Illustration 2.2: Deductible clause On December 31, 20x1 an explosion occurred at ABC Co.’s plant causing extensive property damage to area buildings. Although no claims had yet been asserted against ABC as of March 10,20x2, ABC’s management and counsel considered that it is likely that claims will be asserted and that it is probable that ABC will be held responsible for damages. ABC's ₱5,000,000 comprehensive public liability policy has a ₱250,000 deductible clause. ABC estimates, an outflow equal to its net liability on the comprehensive public hab1lity policy. ABC's financial statements were authorized for issue on March 30, 20x2. Requirement: How should the event above be reported in ABC's December 31,20x1 financial statements? Answers: As a note disclosure only indicating the probable loss of ₱250,000, i.e., the extent of liability under the comprehensive insurance policy (deductible clause). No provision is recognized because there is no present obligation existing as of the end of reporting period (i.e., Dec. 31, 20x1). The explosion occurred in 20x2. Illustration 2.2: Deductible clause On December 31, 20x1, an explosion occurred at ABC Co.’s plant causing extensive property damage to area buildings. Although no claims had yet been asserted against ABC as of March 10, 20x2, ABC’s management and counsel concluded that it is likely that claims will be asserted and that it is probable that ABC will be held responsible for damages. ABC's 5,000,000 comprehensive public liability policy. ABC’s financial statements were authorized for issue on March 30, 20x2.

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Requirement: How should the event above be reported in ABC's December 31,20xl financial statements? Answer: As a provision for ₱250,000, i.e., the expected outflow. Enumerate your observations in the illustrations based on the standards written above.

Changes in provisions Provisions are reviewed at the end of each reporting period and adjusted to reflect the current best estimate. Changes in provisions are accounted for prospectively by accruing an additional amount or by reversing a previously recognized amount. When the provision is discounted, the unwinding (amortization) of the related discount which increases the carrying amount of the provision is recognized as interest expense. Use of provisions A provision is used only for the expenditure it was originally intended for. Charging expenditure against a provision that is intended for another purpose is inappropriate as it would conceal the impact of two different events. Illustration: Changes in provisions In 20x1, ABC Co. recognized provision for a probable loss on pending lawsuit of ₱500,000. The entry in 20x1 to record the provision is as follows: Dec. 31, 20x1 Probable loss on lawsuit Estimated liability on pending lawsuit

500,000 500,000

The lawsuit remains unsettled in 20x2 necessitating a reassessment of the provision ABC determined that the probable loss on the pending lawsuit should be ₱700,000. The entry in 20x2 to record the additional provision is as follows: Dec. 31, 20x1 Probable loss on lawsuit Estimated liability on pending lawsuit Assumption #1: The lawsuit was settled for ₱850,000 in 20x3. The entry to record the settlement is: 20x3 Estimated liability on pending lawsuit Loss on lawsuit Cash Assumption # 2: (Disregard assumption #1) The lawsuit was settled for 600,000 in 20x3. The entry to record the settlement is: 20x3 Estimated liability on pending lawsuit Cash Gain on settlement of provision

200,000 200,000

700,000 150,000 850,000

700,000 600,000 100,000

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Assumption #3: (Disregard assumption #’s 1 and 2) In 20x3, ABC won the lawsuit. None was paid on the settlement. The entry to record the settlement is: 20x3 Estimated liability on pending lawsuit 700,000 Gain on reversal provision

700,000

Notice that changes in provisions are treated as changes accounting estimates and accounted for prospectively. Financial statements in prior years are not restated for the previously recognized provisions. Answer the following questions: 1. Discuss the meaning of changes in provision. 2. What is the accounting for changes in provision, based on the illustrations above.

Application of the recognition and measurement rules Future operating losses No provision is recognized for future operating losses because they do not meet the definition of a liability (i.e., “arising from past events”). The expectation of future operating losses may indicate that certain assets may be impaired. Those assets are tested for impairment under PAS 36. Onerous contracts The provision recognized from an onerous contract reflects the least net cost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfill it. Illustration 1: Onerous contract – purchase commitment On January 1, 20x, ABC Co. signed a three-year, non-cancelable purchase contract, which allows ABC Co., to purchase up to 60,000 units of a microphone annual purchase of 15,000 unit. At year-end, it was found out that the goods are obsolete. ABC had 10,000 units of this inventory at December 31, 20x1, and believes these parts can been sold as scrap for 5 per unit. The loss on purchase commitment is computed as follows: Guaranteed minimum annual purchases (in units) Multiply by: Remaining years covered by the product (20x2 and 20x3) Total goods to be accepted in the future Multiply by: Purchase price less salvage value per unit (₱25 –5) Loss on purchase commitment Dec. 31, 20x1

Loss on purchase commitment Estimated liability on pending lawsuit

15,000 2 30,000 ₱20 600,000 600,000 600,000

Loss on purchase commitment is recognized only for guaranteed future purchases. Consequently, impairment loss and not “loss on purchase commitment” is recognized for the 10,000 units on hand on December 31, 20x1. The entry is provided below.

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Dec. 31, 20x1

Loss on decline of value of inventory [10,000 x (25 – 5)] Inventory

200,000 200,000

Please answer the following 1. What is future operating losses? 2. Why there is no provision that shall be recorded in the future operating losses? 3. What is an onerous contract and how does the entity shall recognize provision for this? 4. What is the accounting for onerous contract? Based on the illustrations above Restructuring Restructuring is "a program that is planned and controlled management, and materially a. The scope of a business undertaken by an entity; or b. The manner in which that business is conducted." (PAS 37.10)

changes either:

Examples: a. Sale or termination of a line of business; b. Closure of business locations in a country or region or the relocation of business activities from one country or region to another; c. Changes in management structure, for example, eliminating a layer of management; and d. Fundamental reorganizations that have a material effect on the nature and focus of the entity’s operations. (PAS 37.70) An entity applies the general recognition criteria provided earlier when recognizing provisions for restructuring costs. In addition, the entity considers the following: Sale of operation A legal obligation exists (and therefore a provision is recognized) only if, at the end of the reporting period, a binding sale agreement is obtained. This is because, until a binding sale agreement is obtained, the entity can still change its mind and may withdraw its plan to sell if it cannot find a purchaser under acceptable terms. If the binding sale agreement is obtained only after the end of the reporting period, no provision is recognized because no present obligation exists at the end of the reporting period. This, however, may be disclosed as a non-adjusting event after the reporting period. Timing of recognition of provision. Look at when does the sale agreement is obtained, If obtained at the end of the reporting period – recognize a provision If obtained only after the reporting period – NO provision is recognized.

Closure or Reorganization A constructive obligation exists (and therefore a provision is recognized) only if at the reporting date, the entity has created valid expectations from others that it will discharge certain responsibilities. This would be the case if, at the end of the reporting period, both the following conditions are met:

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a. Detailed formal plan for the restructuring is adopted; and b. The plan is announced to those affected by it. A mere board decision to restructure is not enough. No provision is recognized it the detailed plan is adopted or announced after the f the reporting period. This may also be disclosed ass a non-adjusting event after reporting period. Restructuring is basically changing the structure of the entity trough sale, stopping of line (let say the entity is a manufacturing firm of electric fan, and they decided to stop the specific line that manufacture the motor line), closing of a segment or branch, changing or organizational structure, etc. With this restructuring of course there are people that will be affected by this, the cost that will be incurred in closing a line or stopping a segment, etc. These are the possible obligations / expenses that the entity might face because of restructuring. Measurement of restructuring provision A restructuring provision includes only the direct costs that are necessarily entailed with the restructuring. It does not include costs that relate to the ongoing activities of the entity or the future conduct of its business. A restructuring provision excludes the following costs; a. Retraining or relocating continuing staff b. Marketing c. Investment in new systems and distribution networks (PAS 37.81) Restructuring provisions are recognized as follows: ✓ Accrue provision only if a binding sale agreement is obtained on or before the end of reporting period. ✓ If binding sale agreement is obtained only after the end of the reporting period, no provision shall be recognized. Only a note disclosure shall be made for the non-adjusting event after reporting period, b. Closure or reorganization ✓ Accrue only if a detailed formal plan is adapted and announced publicly on or before end of reporting period. A board decision is not enough. ✓ If detailed plan is adopted or announced after the end of the reporting period, no provision shall be recognize. Only a note disclosure shall be made for the non-adjusting event after reporting period, c. Restructuring provision on acquisition (merger) ✓ Accrue provision for terminating employees, closing facilities, and eliminating product lines only if announced at acquisition and then only if a detailed formal plan is adopted within a short period of time after acquisition (e.g., 3 months). d. Future operating loss ✓ Provisions are not recognized for future operating losses, even in a restructuring a. Sale of operation

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Illustration: Restructuring provision A of December 31, 20x1, ABC Co. has adopted a detailed formal plan to close one of its toys divisions and put up a new division to manufacture warfare weapons. The plan was communicated through a public announcement and all of those affected by the closure were informed. ABC estimates the following costs in relation to the closure of the division: Termination benefits of employees terminated as a result of the closure Costs of retraining and relocating retained employees Payment for unpaid purchases made by the division New systems, and distributions networks for the weapons division Marketing costs for the weapons to be manufactured by the new division Expected losses during the first year of operations of the weapons division

1,000,000 2,000,000 4.000.000 20,000,000 6,000,000 20,000,000

Requirement: Compute for the provision on December 31. 20x1. Answer: ₱1,000,000 – Termination benefits of employees terminated as a result of the closure Dec. 31, 20x1

Employee benefits expense Provision for restructuring costs

1,000,000 1,000,000

Examples of application of the recognition principles 1. ABC Co. engages in transport services. Past experience shows that ABC incurs ₱100M a year in accidentrelated lawsuits. Can ABC accrue a year-end provision for accident-related lawsuits that can happen in the next accounting period? Answer: No there is no present obligation arising past event because the accident has not yet occurred. 2. ABC Co. engages in transport services. As of year-end, there is a pending lawsuit filed against ABC regarding an accident that happened during the year. It is probable that ABC will lose the lawsuit and pay around ₱10M in damages. Should ABC accrue a provision for the estimated probable loss on lawsuit? Answer: Yes. There is present obligation with probable outflow resources because the accident has already occurred and there is a pending lawsuit for which it is probable that ABC will lose. Also the outflow can be reliably estimated. 3. ABC Co. engages in transport services. An accident happened during the year. However, as of year-end, no lawsuit is yet filed against ABC. It is not expected that a lawsuit will be filed against ABC and there is no reliable estimate for a loss on lawsuit that may be incurred. Can ABC recognize a provision? Answer: No. the outflow of resources is both improbable (i.e., no lawsuit is expected to be filed against ABC) and cannot be estimated reliably. 4. ABC Co. has put up a new branch during the year. The branch suffered loss of ₱20M during the year. Past experience shows that newly put up branches incur losses for the first three years of operations. Can ABC recognize a provision for future losses on its new branch?

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Answer: No. there is no present obligation arising from past events. Only obligations arising from past events existing independently of an entity’s future operations (i.e., future conduct of business) are recognized as provisions. No provision should be recognized for future operating losses not yet incurred. 5. ABC Co. engages in the manufacture of plastic wares. During the year, environmental auditors from a government agency issued their findings that ABC is not complaint with existing laws. ABC is t hen directed by the government to rectify damages caused to the environment and to pay penalty for the unlawful environmental damage. ABC estimated that total cost of rectifying the damage and settling the penalty amounts to ₱100M. Should ABC recognize a provision for the environmental damage? Answer: Yes. There is present obligation with probable outflow of resources because damages have already been caused and ABC is being directed by the government to rectify the damages. Also, the outflow can be reliably estimated. 6. ABC Co. engages in the manufacture of plastic wares. During the year, environmental auditors from a government agency noted that the nature of ABC’s production processes may lead to possible damage to the environment. The environmental auditors further recommended that in order to operate in the particular way, ABC should acquire and fit smoke filters in its factory. The cost of acquiring and fitting such smoke filters is estimated at 100M. Should ABC recognize a provision for the smoke filters? Answer: No. there is no present obligation because damages have not yet been caused (i.e., ….may lead to possible damage’) and ABC can avoid the future expenditure by its future actions, for example by changing its method of operation. 7. ABC Co. engages in mining. During the year, ABC acquired a new mining site and started exploring for possible mineral deposits. Under existing laws, ABC is required to restore the site at the end of its useful life. The restoration costs can be measured reliably. Should ABC recognize a provision for the restoration costs? Answer: Yes. There is present obligation with probable outflow because exploration has already commenced and ABC has no other alternative but to comply with the requirements of law. Also, the outflow can be reliably estimated. 8. ABC Co. engages in mining. During the year, ABC acquired rights to mine a specific area. ABC acquired an oil rig to be used t n extracting the mineral resource. Under existing laws, ABC is required to decommission (dismantle) the equipment at the end of its useful life. As of year-end, the oil rig is yet to be installed. Should ABC recognize a provision for the decommissioning costs?

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Answer: No. There is no present obligation because the oi1 rig is not yet installed. A provision will be recognized only when the oil rig is installed. 9. ABC Co. operates an offshore oilfield where its licensing agreement requires it to remove the oil rig at the end of production and restore the seabed. Ninety per cent of the eventual costs relate to the removal of the oil rig and restoration of damage caused by building it, and 10% arise through the extraction of oil. At the end of the reporting period, the rig has been constructed but no oil has been extracted. ABC estimates that the total cost of decommissioning the equipment and restoring the site is ₱100M. Should ABC recognize a provision? Answer: Yes. There is present obligation with probable outflow of resources because the oil rig has already been constructed and the licensing agreement requires the decommissioning (removal of the equipment at the end of its useful life. Also, the outflow can be reliably estimated. ABC should recognize a provision of ₱90M (₱100M x 90%). The construction of the oil rig creates a legal obligation under the terms of the license to remove the rig and restore the seabed and is, thus, an obligating event. However, at the end of the reporting period, there is no obligation to rectify the damage that will be caused by the extraction of the oil because no oil has yet been extracted. The 10% of costs that arise through the extraction of oil will be recognized as liability when the oil is extracted. 10. An entity in the oil industry causes contamination but cleans up only when required to do so under the laws of the particular country in which it operates. One country in which it operate has had no legislation requiring cleaning up and the entity has been contaminating land in that county for several years. On December 31, 20x1, it is virtually certain that a draft law requiring a cleanup of land already contaminated will be enacted shortly after yea-end. The cleanup cost can be estimated reliably. Should the entity recognize a provision? Answer: Yes. There is present obligation with probable outflows of resources because contamination has already been made and a law which will require cleanup is virtually certain to be enacted. Also, the cost of cleanup can be reliably estimated. 11. An entity in the oil industry causes contamination and operates in a country where there is no environmental legislation. However, the entity has a widely published environmental policy in which it undertakes to cleanup all contamination that is causes. The entity has a record of honoring this published policy. The cleanup cost can be estimated reliably. Should the entity recognize a provision?

Answer: Yes. There is present obligation with a probable outflow because contamination has already been made and, although there is no legal obligation. ABC has a constructive obligation because it will clean up the contamination. Also, the outflow can be reliably estimated. 12. ABC Co. manufacture’s pharmaceutical products. During the year, a government agency discovered a sideeffect caused by a newly introduce product. More than 10,000 patients died with symptom similar to the discovered side-effect. ABC is the only manufacturer or such product. As or year-end, a lawsuit for ₱100B has been filed against ABC. ABC's legal counsel believes that ABC will probably lose on the lawsuit for an estimated amount of 80B. Should ABC recognize a provision for a loss on the lawsuit?

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Answer: Yes. All the recognition criteria for a provision are met. A provision equal to the estimate of ₱80B shall be recognized 13. ABC Co. manufactures pharmaceutical products. During the year, after a certain new product was introduced, 10,000 patients died. After a series of investigation, authorities discovered that when the new product is used with another product, the patient would transform into a gorilla and dies eating too much bananas. ABC's financial year ends at December 31, 20x1. On March 31, 20x1 before the financial statements were authorized for issue, a lawsuit for 100M was filed against ABC. Assuming this is all the information gathered, should ABC recognize a provision for loss on lawsuit as of December 31, 20x1? Answer: No. although there is present obligation the problem did not state whether the outflow of resources is provable and can be estimated reliably. Only disclosure should be made if the obligation is possible. If remote, no disclosure is necessary.

14. ABC Co. provides warranty for products sold. Past experience shows that warranty costs can be reliably estimated. However, ABC cannot identify which customers may require ABC to perform its warranty obligation. Should ABC nevertheless recognize a provision? Answer: Yes. An obligation always involves another party to whom the obligation is owed. However, it is not necessary to specifically identify the party to whom the obligation is owed indeed the obligation may be to the public at large. 15. In conjunction with a marketing strategy, ABC Co. made public announcement that it will pay ₱100M to whoever can lick his/her elbow (pls. don't try). Before year-end, ABC received information from its field agents that there are in fact 10 people in the country who can lick their elbows, all of them CPAs! All of these individuals are aware of the public announcement made by ABC. However, only one of them expressed enthusiasm in claiming the prize. The others are shy. ABC's total assets is ₱100M. Should ABC recognize a provision? Answer: Yes. Provisions may arise from constructive obligations such as those that form valid expectations that the entity incurring them will discharge its responsibilities. 16. On December 12, 20x1 the board of an entity decided to close down a division. Before the end of the reporting period (December 31, 20x1) the decision was not communicated to any of those affected and no other steps were taken to implement the decision. Should the entity recognize a provision? Answer: No. there is no obligating event because the decision was not communicated to the affected parties. Therefore, no valid expectation (constructive obligation) has been created that ABC will discharge any liability. Based on the illustrations above, summarized all your learnings about restructuring.

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Other common types of provisions In addition to those discussed earlier, the flowing are also common sources of provisions: a. Product warranties and guarantees b. Premiums c. Guarantee of indebtedness of others becoming probable Product warranties and guarantees Some products like computers, appliances, cellphones, equipment, and the like are often sold under warranty or guarantee to provide post-sale services, such as free repair service, replacement of parts or entire product, during a specified period if the products are proven to be defective. The present obligation for warranties arises at the point of sale. If the cost of discharging the liability is judged to be significant, a provision should be made in order not to understate liabilities and expenses and overstate profit. However, if the cost of discharging the liability is judged to be negligible, non-recognition of provision is permitted. In such case, warranty expense is recognized only when the warranty is actually discharged. In making the judgment on whether warranty costs may be significant or not, PAS 37.24, provides the following guidance "Where there are a number of similar obligations (e.g., product warranties or similar contracts), the probability that an outflow will be required in settlement is determined by considering the class of obligations as a whole. Although the likelihood of outflow for any one item may be small, it may well be probable that some outflow of resources will be needed to settle the class of obligations as a whole. If that is the case, a provision is recognized (if the other recognition criteria are met)." Applicable standard: PAS 37 vs. PFRS 15 ➢ If a customer has the option to purchase a warranty separately (for example, because the warranty is priced or negotiated separately), the warranty is accounted for in accordance with PFRS 15. Revenue from Contracts with Customers ➢ If a customer does not have the option to purchase warranty separately, the warranty is accounted for in accordance with PAS 37 Provisions, Contingent liabilities and Contingent Assets unless the promised warranty provides the customer with a service in addition to the assurance that the product complies with agreed-upon specifications. Please answer these questions based on the above discussions 1. What is a warranty liability? 2. When are you going to recognize warranty liability? 3. How are you going to record a warranty liability? 4. Please explain the PFRS 15 and PAS 37 Illustration 1: Warranty expense ABC Co. provides 3-year warranty for the products it sells ABC estimates that warranty cost ₱100 per unit sold. As of January 1, 20x1, the liability for warranty has a balance of ₱200,000 for units sold in 20x0. During the year ABC sold 5,000 units and actual warranty costs incurred were ₱310,000.

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Requirements: 1. How much is the warranty expense to be recognized in 20x1? 2. How much is the balance of the warranty obligation as of December 31,20xl? Solutions: Requirements (1): Warranty expense in 20x1 Total units sold in 20x1 Multiply by: Estimated warranty cost per unit Warranty expense – 20x1

5,000 100 ₱500,000

The entry to recognize provision for warranty in 20x1 is as follows: 20x1 Warranty expense (5,00 units x 100) Estimated warranty liability

500,000 500,000

Requirement (2): Warranty obligation as of December 31, 20x1 The entry to record warranty costs incurred in actually discharging the warranty obligation in 20x1 is as follows: 20x1 Estimated warranty liability 310,000 Cash (or cost replacement part) 310,000 The warranty obligation aof December 31, 20x1 is determined through the T-account analysis provided below: Estimated warranty liability Actual warranty costs Dec. 31, 20x1

310,000 390,000

200,000 500,000

Jan. 1, 20x1 (given) Warranty expense

Observe the following: ✓ Warranty expense is computed based on estimated costs. ✓ Warranty expense is unaffected by actual warranty costs. ✓ Actual warranty costs are recognized as deduction from the estimated warranty liability. Liability for premiums Premiums refer to goods, services, cash prizes or special rebates which are included in the main product or services, being offered. Premiums are intended to promote sales. Common examples of premiums include: a. Goods such as T-shirts, caps, umbrella, kitchen wares, toys, and CDs which are included in a main product or service purchased. b. Free health spa (or at discounted price), free movie tickets and free load included in a main product or service purchased. c. Cash prize found at the back of bottle crowns or entitlement to an entry to a raffle draw. Customers may be entitled to such premiums for past purchases by presenting proof of purchase (e.g., product scrappers, boxes, bottle crowns, cash register receipts, or coupons included in products).

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Applicable standard: PAS 37 vs. PFRS 15 ➢ A customer option to acquire additional goods or services for free or at a discount is accounted for under PFRS 15 if the option provides the customer a material right that the customer would not receive without entering into that contract. ➢

A customer option that does not provide the customer with a material right is not accounted PFRS 15; and therefore, accounted for in accordance with PAS 37.

for under

1. Upon reading the discussion above, did you ever remember availing a premium? 2. What is a premium? How does the entity recognize a premium? 3. Explain PAS 37 and PFRS 15. Illustration 1: Premium expense ABC Co. launched a sales promotion in 20x1. For every ten empty packs returned to ABC plus ₱50, customer will receive a set of kitchen knives. ABC estimates that 40% of the packs sold will be redeemed. Information on transactions during the year is as follows: Units Sales Sets of kitchen knives purchased (200 per set) Number of packs redeemed

500,000 300,000 45,000

Amount 750,000,000 60,000,000

Requirement: Compute for the premium expense in 20x1. Solution: The premium expense is computed as follows: Sales in units Multiply by: Estimate of wrappers to be redeemed Estimated wrappers to be presented for redemption Divide by: Required number of wrappers for redemption Estimated number of premiums to be distributed Multiply by: Net cost of premium (200 purchase cost less 50 cash requirement from customer) Premium expense The pertinent entries in 20x1 are as follows: 20x1 Cash Sales To record sales 20x1 Premiums (300,000 x 200) Cash To record the purchase of premiums 20x1 Premium expense Estimated liability for premiums

500,000 40% 200,000 10 20,000 150 3,000,000

750,000,000 750,000,000 60,000,000 60,000,000 3,000,000 3,000,000

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20x1

To record premium expense Cash (45,000 packs ÷ 10) x 50 Estimated liability for premiums [(45,000 packs ÷ 10) x 150] Premiums (45,000 packs ÷ 10) x 200 To record the actual redemption during 20x1

225,000 675,000 900,000

Observe the following: ✓ The present obligation for premiums arises from the sale of the main product and the constructive obligation of honoring redemptions. ✓ Premium expense is recognized based on the estimated premiums to be distributed and measured at the net cost of the premium. This is because ABC will recover a portion of the purchase cost of the premium by requiring cash payment from redeeming customers. ✓ Premium expense is unaffected by the actual distribution of premiums. ✓ Actual distribution of premium s is recorded as deduction to estimated liability for premiums. Illustration 2: Premium liability ABC Co. launched a sales promotion in 20x1. For every five bottles returned to ABC, customers will receive a T-shirt. The unit cost of T-shirt. The unit cost of T-shirt is ₱100. ABC estimates that 80% of sales will be redeemed. Additional information is as follows: Units Sales in 20x1 Sales in 20x2 T-shirts distributed in 20x1 T-shirts distributed in 20x2

500,000 900,000 60,000 147,600

Requirement: How much is the liability for premiums as of December 31, 20x2? Solution: Estimated warranty liability Actual cost of premiums distributed – 20x1 (60,000 x 100) Actual cost of premiums distributed – 20x2 (147,600 x 100) Dec. 31, 20x2

6,000,000

8,000,000

14,760,000 420,000

14,400,000

Jan. 1, 20x1 Premium expense – 20x1 (5500,,000 x 80% ÷ 5 x 100) Premium expense – 20x2 (900,000 x 80% ÷ 5 x 100)

Notice that the premium expenses are computed based on the gross purchase cost of the premium (i.e., ₱100) because there is no cash requirement from redeeming customers. Again, premium expenses are unaffected by the actual premium distribution.

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Guarantee for indebtedness of others There are instances where an entity guarantee the indebtedness of another entity (e.g., as a co-maker of a loan). The guarantor does not recognize any liability when the guarantee is made. However, when it becomes probable that the guarantor will be held liable for the guarantee, such as when the original debtor defaults on the loan, a provision is recognized for the estimated amount that the guarantor will be held liable for the guarantee. Illustration: Guarantee for indebtedness of others On January 1, 20xl, ABC Co. guaranteed a ₱1,000,000 loan obtained by XYZ, lnc. from a bank. On December 31, 20x1, XYZ defaulted on its loan and it became probable that ABC will be held liable to the bank for the ₱1,000.000 loan taken by XYZ. The entries are as follows: Jan. 1, 20x1 Dec. 31, 20x1

No entry

Probable loss on guarantee Estimated liability for guarantee

1,000,000 1,000,000

Notes: ✓ No provision is required on a guarantee unless it becomes probable that the guarantor will be held liable. ✓ Before the liability on a guarantee becomes probable, only disclosures is made in the notes. Disclosure is normally made even in cases where the liability for a guarantee is remote.

Summary of the Lesson: • A provision is a liability of uncertain timing or amount. It is distinguished from other liabilities on the basis of the uncertainty in its timing or amount. Provisions necessarily require estimates. • A provision is recognized if there is present obligation requiring outflow of resources embodying economic benefits that is both probable and measured reliably • Provisions are presented separately from other liabilities • When measuring a provision, an entity uses (a) best estimate, (b) expected value or (c) mid-point • Gains from the expected disposal of asset shall not be taken into account in measuring provision • Reimbursements are considered only when their receipt is virtually certain. • Changes of provisions are accounted for prospectively • Future operating losses up to the date of restructuring is NOT included in a provision, unless they relate to an onerous contract.

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Enrichment Activity: 1. On December 31, 2020, an employee filed a ₱4,800,000 lawsuit against Ed Company for damages suffered when one of Ed’s plants will lose the July 20, 2020. Ed’s legal counsel expects the company will lose the lawsuit and estimates the loss to be ₱800,000 and ₱1,600,000. The employee has offered to settle the lawsuit out of court for ₱1,440,000, but Ed will not agree to the settlement. In its December 31, 2020 statement of financial position, what amount should Ed Company report as provision from lawsuit? ___________________________________ Answer: P 1,200,00

2. Wyatt Company issued the 2020 financial statements on March 1, 2021. The following data are provided by the entity for the year ended December 31, 2020: Amount owing to another entity for services rendered during December 2020 450,000 Estimated long service leave owing to employees in respect of past services 1,800,000 Estimated cost of relocating an employee from head office to a branch in another city (employee will physically relocate in January 2021) 150,000 Estimated cost of overhauling machine every 5 years (the machine is 5 years old on December 31, 2020) 225,000 What amount should be recognized as provision on December 31, 2020? ___________________________________ Answer: P 1,800,000 3. On February 5, 2021, an employee filed a ₱2,600,000 lawsuit against Austin Company for damages suffered when one of Austin’s plant exploded on December 29, 2020. The legal counsel believed the entity would probably lose the lawsuit and estimated the loss to be ₱650,000. The employee offered to settle the lawsuit out of court for ₱1,170,000 but the entity did not agree to the settlement. On December 31, 2020, what amount should be reported as liability from lawsuit? ___________________________________ Answer: P 650,000 4. Ariana Company has long owned a manufacturing site that has now been discovered to be contaminated with toxic waste. The entity has acknowledge its responsibility for the contamination. An initial to clean up feasibility study has shown that it will cost at least ₱950,000 to clean up the toxic waste. During the current year, the entity has been sued for patent infringement and lost the case. A preliminary judgment of ₱570,000 was issued and is under appeal. The entity’s attorneys agree that it is probable that the entity will lose this appeal. What amount of provision should be accrued as liability? ___________________________________

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Answer: P 1,520,000 5. During 2020, Asher Company is the defendant in a patent infringement lawsuit. The entity’s lawyers believe there is a 30% chance that the court will dismiss the case and the entity will incur no outflow of economic benefits. However, the court rules in a favor of the claimant, the lawyers believe that there is a 20% chance that the entity will be required to pay damages of ₱320,000 and an 80% chance that the entity will be required to pay damages of ₱160,000. Other outcomes are unlikely. The court is expected to rule in late December 2020. There is no indication that the claimant will settled out of court. A 7% risk adjustment factor to the probability-weighted expected cash flows is considered appropriate to reflect the uncertainties in the cash flow estimates. An appropriate discount rate is 5% per year. The present value of 1 at 5% for one period is 0.95. What measurement of the provision for lawsuit? ___________________________________ Answer: P 136,618 present value of cash flows 6. Shane Company includes in packages of its products coupons that may be presented to retail stocks to obtain discounts on other Shane Company products. Retailers are reimbursed for the face amount of coupons redeemed plus 10% of that amount for handling costs. The company estimated that 70% of all coupons issued will ultimately be redeemed. Information relating to coupons issued by the company during 2020 is as follows: Consumer expiration date December 31, 2020 Total face amount of coupons issued ₱ 840,000 Total payments to retailers as of December 31, 2020 308,000 What amount should Shane Company report as a liability for unredeemed coupons at December 31, 2020? ___________________________________ Answer: P 338,800 7. The Bryan Company embarked on a promotional program whereby a key chain costing ₱30 each is given away for every 10 bottle crowns returned plus ₱5. Bryan Corporation estimates that only 40% of the bottle crows in the hands of consumers will be presented for redemption. The following information is available: Quantity Amount Bottles sold 1,000,000 ₱10,000,000 Key chains brought for 15,000 450,000 giveaways Key chains distributed to 10,000 customers At the close of the first year, how much should Bryan Corporation recognize as estimated liability for promotional items outstanding? ___________________________________ Answer: P 750,000 8. Marie Company started a new promotional program. For every 10 box tops returned, customers receive a basketball. The entity estimated that only 60% of the box tops reaching the market would be redeemed. Additional information follows:

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Units Sales of product Basketball purchased Basketball distributed

Amounts ₱36,000,000 4,950,000

120,000 6,600 4,800

What is the amount of year-end ___________________________________

estimated

liability

associated

with

this

promotion?

Answer: P 1,800,000 9. Kennedy Company a retailer of electrical goods, participates in a customer loyalty program operated by an airline. The entity grants program members one air travel point for every ₱1,000 spent on electrical goods. Program members can redeemed the points for travel with the airline subject to availability. The entity pays the airline ₱90 for each point. During 2020, the entity sold electrical goods for consideration is ₱9,500,000 and granted 9,500 points. The fair value of a point is ₱100. If the entity has collected the consideration allocated to the points on its own account, what is the revenue to be recognized in 2020 in relation to the points? ___________________________________ Answer: P 950,000

10. A new product introduced by Von Promotions carries two-year warranty against defects. The estimated warranty costs related to sales are as follows: Year of sale 3% Year after sale 5% Sales and actual warranty expenditures for the year ended December 31, 2019 and 2020 are as follows: Sales ₱1,200,000 1,500,000

2019 2020 What amount should Von report ___________________________________

as

its

estimated

Actual warranty expenditures ₱30,000 105,000 liability

as

of

December

31,

2020?

Answer: P 81,000

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Assessment Lesson 1 - PROVISION AND CONTINGENT LIABILITY Name: ___________________________________________ Section: _____________ Score: __________ 1. In May 2020, Hanger Company filed suit against Sipit, Inc. seeking ₱1,445,000 damages for patent infringement. A court verdict in November 2020 awarded Hanger ₱960,000 in damages, but Sipit’s appeal is not expected be decided before 2020. Hanger’s counsel believes it is probable but not virtually certain that Hanger will be successful against Sipit for an estimated amount in the range between ₱480,000 and ₱720,000, with ₱640,000 considered the most likely amount. What amount should Hanger record as a contingent asset from lawsuit in the year ended December 31, 2020? ___________________________________ 2. In May 2020, Stella Company relocated an employee from the Manila head office to a branch in Zamboanga City. At the end of reporting period on June 30, 2020, the cost are estimated at ₱455,000 and analyzed as follows: Cost for shipping goods Airfare Temporary accommodation cost of May and June Temporary accommodation cost for July and August Reimbursement for lease break cost paid in July (lease was terminated in May) Reimbursement for cost of living increases for the period May 1, 2020 to May 1, 2021 Total What amount should be recognized ___________________________________

as

provision

₱ 39,000 13,000 104,000 117,000 26,000 156,000 ₱ 455,000 for

relocation

costs

on

June

30,

2020?

3. During 2020, Allison Company guaranteed a supplier’s ₱850,000 loan from a bank. On October 1, 2020, the entity was notified that the supplier had defaulted on the loan and filed for bankruptcy protection. Counsel believed that the entity would probably have to pay ₱425,000 under the guarantee. As a result of the supplier’s bankruptcy, the entity entered into a contract in December 2020 to retool its machines so that the entity could accept parts from other suppliers. Retooling costs are estimated to be ₱510,000. What amount should be reported as liability on December 31, 2020? ___________________________________ 4. During 2020, Marlin Company become involved in a tax dispute with the BIR. On December 31, 2020, the tax advisor believed that an unfavorable outcome was probable and a reasonable estimate of additional taxes was ₱600,000. After the 2020 financial statements were issued, the entity received and accepted a BIR settlement offer of ₱660,000. What amount of accrued liability should have been reported on December 31, 2020? ___________________________________ 5. Colton Company sells motorcycle helmets. In 2020, the entity sold 5,200,000 helmets before discovering a significant defect in their construction. By December 31, 2020 two lawsuits had been filed against the entity. The first lawsuit, which the entity has little chance of winning, is expected to be settled out of the court for ₱1,950,000 in January 2021. The legal

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counsel believed that the entity has a 50-50 chance of winning the second lawsuit, which is for ₱1,300,000. What is the accrued liability on December 31, 2020 as a result of the lawsuits? ___________________________________ 6. On November 5, 2020, Adrian Company truck was in an accident with an auto driven by Willow. Adrian received notice on January 15, 2021 of a lawsuit for ₱980,000 damages for personal injuries suffered by Willow. The entity’s counsel believed it is probable that Willow will be awarded an estimated amount in the range between ₱280,000 and ₱630,000, and no amount is better estimate of potential liability than any other amount because each point in the range is as likely as any other. The 2020 financial statements were issued on March 31, 2021. What amount of loss should be accrued on December 31, 2020? ___________________________________ 7. On January 1, 2020, Elijah Company owned a machine with cost of ₱2,200,000, estimated residual value was ₱132,000 and fair value was ₱3,520,000. On January 3, 2020, this machine was irreparably damaged by Eliana Company and became worthless. In October 2020, a court awarded damages of ₱3,520,000 against Eliana in favor of Elijah. On December 31, 2020, the final outcome of this case was awaiting appeal and was therefore uncertain. However, in the opinion of Elijah, Eliana’s appeal would be denied. On December 31, 2020, what amount of gain should be accrued? ___________________________________ 8. During January 2020, Asher Company won a litigation award for ₱2,550,000 which was tripled to ₱7,650,000 to include punitive damages. The defendant, who is financially stable, has appealed only the ₱5,100,000 punitive damages. The entity was awarded ₱8,500,000 in an unrelated suit it filed, which is being appealed by the defendant. Counsel is unable to estimate the outcome of these appeals. In the 2020, financial statements, what amount should be reported as pretax gain? ___________________________________

9. During 2020, Camila Company is the defendant in a breach of patent lawsuit. The lawyers believe there is 80% chance that the court will not dismiss the case and the entity will incur outflow of benefits. If the court rules in favor of the claimant, the lawyers believe that there is a 60% chance that the entity will be required to pay damages of ₱2,800,000 and a 40% chance that the entity will be required to pay damages of ₱1,400,000. Other amounts of damages are unlikely. The court is expected to rule in late December 2021. There is no indication that he claimant will settle out of court. A 7% risk adjustment factor to the cash flows is considered appropriate to reflect the uncertainties in the cash flow estimates. An appropriate discount rate is 10% per year. The present value of 1 at 10% for one period is 0.91. What is the measurement of the provision on December 31, 2020? ___________________________________

10. Steff Company inaugurated a promotional campaign on January 2, 2020 to promote the salability of their product. Steff Company placed a coupon redeemable for a premium in each package of cereal sold at ₱300. Each premium costs ₱25 and 10 coupons must be presented by a customer to receive a premium. Steff estimated that only 70% of the coupons issued would be redeemed. For the 6 months ended July 31, 2020, the following transactions occurred: Packages of cereal sold Premium purchased Coupons redeemed

180,000 45,000 81,000

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How much should be reported as premium expense and estimated liability for coupons on the fiscal year ended July 31, 2020, respectively? ___________________________________

11. On July 1, 2020, Clarissa Company started a sales promotional campaign. In each box of cereal sold, Clarissa inserted a coupon redeemable for a premium. To receive a premium, each customer must submit five coupons. Clarissa’s cost for each premium is ₱6. Clarissa estimated that 60% of the coupons issued would be redeemed. For the six months ended December 31, 2020, the following information is available: Boxes of cereal sold 1,200,000 Coupons redeemed 300,000 How much should be the estimated liability for premium claims outstanding at December 31, 2020? ___________________________________

12. In packages of the products, Colton Company included coupons that may be presented at retail stores to obtain discounts on other Curran products. Retailers were reimbursed for the face amount of coupons redeemed plus 10% of that amount for handling costs. The entity honored requests for coupon redemption by retailers up to three months after the consumer expiration date. The entity estimated that 70% of all coupons issued would ultimately be redeemed. The consumer expiration date is December 31, 2020. The total face amount of coupons issued was ₱1,020,000 and the total payments to retailers during 2020 amounted to ₱374,000. What amount should be reported as liability for unredeemed coupons on December 31, 2020? ___________________________________ 13. Elizabeth Company offered a cash rebate of ₱10 on ech ₱40 package of batteries sold during 2020. Historically, 10% of customers mail in the rebate form. During 2020, 10,800,000 packages of batteries are sold and 378,000 ₱10 rebates are mailed to customers. What amount of rebate expense and liability for rebates should be reported respectively, on December 31, 2020? ___________________________________

14. Gabriel Company, a grocery retailer operates a customer loyalty program. The entity grants program members loyalty points when they spend a specified amount of groceries. Program members can redeem the points for further groceries. The points have no expiry date. During 2019, the entity granted 14,000 points. Management expects that 11,200 of these points will be redeemed. The fair value of each loyalty point is estimated at ₱100. The sales during 2019 amounted to ₱11,200,000 including the loyalty points. On December 31, 2019, 5,600 points have been redeemed in exchange for groceries. In 2020, the management revised its expectations and now expects 12,600 point to be redeemed altogether. During 2020, the entity redeemed 5,740 points. What is the revenue earned from loyalty points for the year ended December 31, 2020? ___________________________________

15. William Company operates a customer loyalty program. The entity grants loyalty points for goods purchased. The loyalty points can be used by the customers in exchange for goods of the entity. The points have no expiry date. During 2019, the entity issued 75,000 award credits. The fair value of the award credits is reliably measured at ₱3,000,000. In 2019, the entity sold goods to customers for a total consideration of ₱13,500,000 including the fair value of the award credits. The total award credits expected to be redeemed are 80% in 2019 and 85% in 2020. The award credits actually redeemed are

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22,500 in 2019 and 11,925 in 2020. ___________________________________

What

is

the

revenue

earned

from

points

in

2020?

16. The selling price of Royal Star Company’s units is ₱128,000 each. The buyers are provided with a 2-year warranty that is expected to cost the company ₱3,200 per unit in the year of sale and ₱9,600 per unit in the following the sale. The company sold 128 units in 2019 and 160 units in the 2020. Actual payments for warranty claims were ₱128,000 and ₱832,000 in 2019 and 2020, respectively. How much would be the warranty expense for 2019 and 2020, respectively? ___________________________________ 17. Uratex Company sells televisions at an average price of ₱7,500 and also offers to each customer a separate 3-year warranty contract for ₱975 that requires the company to perform periodic services and to replace defective parts. During 2020, the company sold 360 units and 324 warranty contracts for cash. It estimates the 3-year warranty costs as ₱250 for parts and ₱500 for labor and accounts for warranties separately. Assume sales occurred on December 31, 2020, income is recognized on the warranties, and straight line recognition of warranty revenues occurs. What amount of current and noncurrent liability relative to warranty revenue would appear on the December 31, 2020 statement of financial position, respectively? ___________________________________

References: Millan, Z.V. (2019). Intermediate Accounting 2 Valix,(2019). Intermediate Accounting 2 Uberita, (2013) Practical Accounting 1

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Lesson 2: SHAREHOLDER’S EQUITY (PART 1) SHARE CAPITAL Lesson Objectives: 1. State the components of shareholders’ equity 2. Account for the initial issuances of shares of stocks 3. Account for the reacquisition and retirement of shares of stocks 4. Account for stock rights, convertible preference shares and donated capital

Discussion and application: Shareholder’s equity Shareholder’s equity is the residual interest in the assets of a corporation after deducting all its liabilities. This is the equivalent of the “Owner’s equity” in a sole proprietorship and the aggregate of partners’ capital balances in a partnership. The components of the shareholders’ equity include the following: • Share capital (Capital Stock) ➢ Preference share capital (Preferred stock) ➢ Ordinary share capital (Common stock) ➢ Subscribed share capital (Subscribed capital stock) ➢ Subscription receivable (as deduction) ➢ Share dividends distributable (Stocks dividends payable) ➢ Discount on share capital (as deduction) ➢ Capital liquidated (as deduction) ➢ Share premium (Additional paid-in capital) • Retained Earnings (appropriated and unappropriated) • Other components of equity ➢ Revaluation surplus ➢ Cumulative unrealized fair value gains/losses on FVOCI securities ➢ Translation difference of foreign operations ➢ Effective portion of cash flow hedges • Treasury Shares (Treasury stock) The following transactions affect the accounting for corporation’s equity: a. Authorization, subscription, issuance, acquisition, reissuance and retirement of shares. b. Origination of other equity instruments, such as share options, detachable warrants, and equity component of compound financial instruments. c. Distributions to owners (Dividends) d. Transactions giving rise to “other components of equity” e. Recapitalization and Quasi-Reorganization.

Accounting for Share Capital Accounting for share capital definition of terms

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✓ Authorized share capital – represents the maximum number of shares fixed in the entity’s authorized articles of incorporation that can be subscribed and issued to shareholders ✓ Unissued share capital – represents the portion of the authorized share capital not yet issued and is still available for subscription and issuance ✓ Subscription – contract between the purchaser of shares (i.e. investors) and the issuer (i.e. corporation) in which the purchaser promises to buy shares of the issuing company’s stocks ✓ Subscription receivable – represents the unpaid portion of the subscription price. Subscription receivable is presented as a deduction from the related subscribed share capital, i.e. contra equity account. ✓ Subscribed share capital – represents the portion of the authorized share capital that is subscribed but not yet issued. ✓ Share capital – represents the portion of the authorized share capital that is already issued ✓ Share certificate – is a document that evidences the ownership of a share. Note: ❖ “Share Capital” is credited (under memorandum method) and “Unissued share capital” is credited (under journal entry method) only upon the issuance of shares. ❖ Under the Corporation Code, shares (and share certificates) are issued to subscribers only upon full payment of the subscription price. ❖ The Corporation Code prohibits the issuance of shares in exchange for promissory notes or future services. The corporation must received first the full consideration before shares are issued. An entity accounts for its share capital using one of the following: 1. Memorandum method: Only a memorandum is made for the authorized capitalization. Subsequent issuances of shares are credited to the share capital account. (the memorandum entry is the most commonly used in practice) 2. Journal entry method – The authorized capitalization is recorded by crediting “authorized share capital” and debiting “unissued share capital”. Subsequent issuances of shares are credited to “unissued share capital”. The difference between the two accounts represents the issued share capital. Shareholder’s Equity has been discussed in your PARCOR course, but for the sake of review and mastery we are going to discuss it again of course in somehow detailed manner. Asset = Liabilities + Owner’s Equity (Shareholder’s Equity) The owner’s equity account is basically what is being referred to as Shareholder’s equity account, this is the claim of the owner’s (shareholders) in the entity after the deduction of liabilities from the asset. If Asset has its Cash, Accounts receivable, Equipment etc., Liability has Accounts payable, notes payable, bonds payable and other payables, Share holder’s equity account on the other hand has its own composition, these are share capital, retained earnings, other component of shareholder’s equity account and treasury shares. As we go through the lesson you will fully understand how these accounts are considered as being an important component of a shareholder’s equity account. So, based on the discussion above, kindly answer the following

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1. It says that the shareholder’s equity account has it’s component called a share capital, the question is what is the composition of share capital? Kindly explain each. 2. What is retained earnings? 3. What is treasury shares? Based on what is written above, there are transactions that affects the shareholder’s equity. We have authorization, subscription, issuance, acquisition, reissuance and retirement of shares, kindly define each and how does it affect the owner’s equity account. Please answer the following: 1. A contract between the purchaser of shares and the issuer in which the purchaser promises to buy shares of the issuing company’s stocks. 2. This represents the portion of authorized capital that is not yet being issued but already subscribed. 3. This is the maximum number of shares fixed int eh entity that is authorized by the articles of incorporation. 4. This is already issued share capital. 5. A proof of ownership of share. There are two accounting methods that are being used in recording the share capital, what is the commonly used accounting for share capital?

Illustration: Memorandum method vs. Journal entry method Authorized capitalization 1. On January 1, 20x1, ABC Co. received authorization from the SEC to issue share capital of P1,000,000 divided into 10,000 shares with par value of per share of P100. The authorized share capital is recorded under each of the two methods as follows. Memorandum method Journal entry method Memo entry – The authorized capitalization is P1,000,000 Unissued share capital 1,000,000 divided into 10,000 shares with par value per share of Authorized share capital 1,000,000 P100 Subscription 2. Of the total authorized share capital, 25% was subscribed at par value and 25% of the total subscription was paid at subscription date. Memorandum method Journal entry method Cash (1MX25%X25%) 62,500 Cash (1MX25%X25%) 62,500 Subscription receivable 187,500 Subscription receivable 187,500 Subscribed share capital 250,000 Subscribed share capital 250,000 (1,000,000 x25%) (1,000,000 x25%) 3. Collection of subscription receivable and issuance of shares

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On February 1, 20x1, ABC Co. received full payment for 2,000 subscribed shares and issued the related share certificates. Memorandum method Journal entry method Cash 150,000 Cash 150,000 Subscription receivable 150,000 Subscription receivable 150,000 Subscribed share capital 200,000 Subscribed share capital 200,000 Share capital 200,000 Unissued share capital 200,000 • Subscription price of 2,000 shares (2,000 x P100 par) 200,000 Portion already paid (200,000 x 25%) (50,000) Balance collected 150,000 4. Cash subscription On February 28, 20x1, ABC received cash subscription for 1,000 shares at par value. Memorandum method Journal entry method Cash (1,000 xP100) 100,000 Cash (1,000 x 100) Share capital 100,000 Unissued share capital

100,000 100,0000

Notice that “share capital” (“Unissued share capital”) is directly credited (debited) for cash subscriptions. This is the share capital of ABC Co. as of February 28, 20x1 is shown below: please fill up. Memorandum method Journal entry method Share capital Authorized share capital Subscribed share capital Unissued share capital Subscribe receivable Issued share capital Subscribed share capital _______________ Subscription receivable _____________ Total share capital Total Share capital Classes of Share Capital Share capital is basically classified into two, namely: Ordinary shares (commons stock) represent the residual corporate interest that bears the ultimate risk of loss and receives the benefits of success. Ordinary shareholders are guaranteed neither dividends nor assets upon dissolution but they generally control the management of the corporation and tend to profit the most if the corporation did well. If there is only one share in the entity it should be ordinary share. Four basic rights of the ordinary share holders 1. Right to attend and vote in shareholders’ meetings 2. Right to purchase additional shares (Also known as preemptive right or stock right) 3. Right to share in the corporate profits (also known as right to dividends) 4. Right to share in the net assets of the corporation upon liquidation 1. Only the ordinary share has a voting right a right to vote during the general assembly.

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2. The other right of the ordinary shareholder is what do we call pre-emptive right. Whenever, the entity is going to issue a new share, these shares are first offered to the existing ordinary shareholders, so that they will have an opportunity to maintain the percentage of share that they have through the preemptive right.

Preference shares Preference shares (preferred stocks) are shares that give the holders thereof certain preferences over other shareholders. Such preferences may include priority claims over (a) dividends and/or (b) net assets of the corporation in the event of liquidation. Share premium Share premium (Additional paid-in capital) arises from various sources which include the following: a. Excess of subscription price over par value or stated value. b. Excess of reissuance price over cost of treasury shares issued. c. Distribution of “Small” stock dividends. d. and many more, you are going to see more items that will add up to share premium as you read this lesson. So, it is better to just go back to this item once you saw additional entry to share premium aside from the items discussed here. Illustration: 1. ABC Co. started operations on January 1, 20x1. Its authorized capitalization is P1,000,000 dividend into 10,00 shares with par value per share of P100. ABC Co. receives cash subscriptions for 5,000 shares of P120 per share. 2. On January 31, 20x1, ABC receives subscription for 2,000 shares of P160 per share. 1/1/x1

Cash (5,000 x120 subscription price Share capital (5kx100 par value) Share premium (5kx (P120-P100)

600,000 500,000 100,000

Notes: ✓ Share capital and subscribe share capital are credited at par value regardless of the subscription price ✓ Share premium is credited at the subscription date even for subscriptions that are not yet paid; provided that, it is probable that the total subscription price will be allocated. ✓ ABC Co.’s total contributed capital as January 31, 20x1 is computed as follows Share capital 500,000 Subscribed share capital 200,000 Subscription receivable (320,000) Share premium (100k+120k) 220,000 Total contributed capital 600,000 Par value and No-par value shares

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Par value share – one with a peso value fixed in the articles of incorporation, a par value share cannot be issued below its par value. This appears on each share certificate issued. No par value share is one without a peso value fixed in the articles of incorporation. The no par value share has a stated value (issued value) which is also indicated in the articles of incorporation but not in the share certificate. Under the corporation code no par value shares should not be issued for a consideration less than five (P5) pesos per share. The excess of the subscription price over the stated value is credited to share premium. Legal capital – the portion of the contributed capital that cannot be distributed to the owners during the lifetime of the Corporation unless the corporation is dissolved and all its liabilities are settled first. Based on the concept of trust fund doctrine this doctrine protect the creditors. Legal capital is computed as follows: a. For par value shares, legal capital is the aggregate par value of shares issued and subscribed b. For no-par value shares, legal capital is the total consideration received or receivable from shares issued or subscribed. The total consideration refers to the subscription price inclusive of any amount in excess of stated value. Please answer the following 1. This type of share does not have voting rights. 2. Is it okay to issue a treasury shares at less than it’s cost? 3. This is a portion of contributed capital that cannot be distributed to owners 4. What is a trust fund doctrine? 5. In no par value share there is no share premium. True or False? 6. What is the computation of legal capital of a par value shares? 7. What is the computation of legal capital of a no par value shares? Illustration: The equity section of ABC Co.’s statement of financial position shows the following information. 6% Preference share capital, P100 par value Share premium – preference share capital Ordinary share capital Share premium – ordinary share capital Subscribed share capital – ordinary Subscription receivable -ordinary share capital Retained earnings

200,000 50,000 800,000 300,000 100,000 (50,000) 400,000

Requirements: Compute for the legal capital assuming: a. The ordinary shares are par value shares; and b. The ordinary shares are no-par value shares. Solutions: 6% Preference share capital, P100 par value Ordinary share capital

Par 200,000 800,000

No-Par 200,000 800,000

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Share premium – Ordinary share capital Subscribed share capital – ordinary Legal capital

100,000 1,100,000

300,000 100,000 1,400,000

Notes: ✓ In case of no-par value shares, legal capital includes the share premium on ordinary shares ✓ Preference shares can only be issued as par value per shares. Thus, the share premium of the preference shares is not included. Share issuance costs Issuing shares entails expenditures, such as regulatory fees, legal accounting, and other professional fess, commissions and underwriter’s fees, printing costs of certificates, and documentary stamp tax and other transaction taxes. These expenditures, called “share issuance costs”, are deducted from any resulting share premium from the issuance. If share premium is insufficient, the excess is charged to retained earnings. Illustration: On January 1, 20x1, ABC Co. issued 1,000 share with par value of P100 for P120 per share. Share issuance costs amounted to P5,000. The entries are as follows 1/1/20x1 Cash (1,000x120) Share Capital (1,000 x P100) Share Premium (1,000 x (120 -100) 1/1/20x1 Share premium Cash

120,000 100,000 20,000 5,000 5,000

Answer the following 1. What is the share issuance cost? 2. How are you going to recognize share issuance cost? 3. Is share issuance cost will be categorized as expense, will this reflect in an income statement account? Shares issued at a discount A share can be issued lower down its par value or stated value in this case this is what do we call a discount. According to corporation code you cannot issue a share on a discount therefore this is deemed illegal, only in first issuance (for the reissuance it is allowed). The shareholder is liable to the corporation for the discount and it is being entered into the book as discount liability of the shareholder. Example: An entity issues 1,000 share with par value per share of P100 for P80 per share. The entry is as follows. Date Cash (1,000 x 80) 80,000 Discount on share capital 20,000 Share capital (1,000 x P100) 100,000

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This discount is a receivable from the shareholder concerned but presented as deduction from shareholder’s equity account. Watered stocks There is similarities between Shares issued at a discount and watered stock both are issued at less than par value, the only difference is the consideration received in watered stock the shares are being issued also at a discount but received a non cash consideration. When you are going to receive an asset in exchange of your own share and the fair value of the asset is lower than the par value of the stocks that you are going to issue, then that is called a watered stock. If the discount is not recorded and both the land and shares issued are recorded at par value, assets and equity will be overstated. Secret reserve A secret reserve arises when shares are issued for non-cash consideration with fair value that is above par or stated value but the consideration received is recorded at par or stated value. This is opposite of water stocks. It understates assets and equity. Treasury shares Treasury shares (Treasury stocks) are an entity’s own shares that were previously issued but are subsequently reacquired but not retired. Acquisition of previously issued shares are allowed if there is sufficient unrestricted retained earnings. Treasury shares transactions are entered into for various reasons, such as: a. To increase the fair value per share when corporations feel their shares are undervalued, to increase earnings per share, to reduce dividends, or to increase return on equity by reducing outstanding shares. b. As a tax-efficient method of providing cash to shareholders rather than by paying dividends c. AS a result of redemption of previously issued redeemable shares; d. To use shares reacquired to acquire new assets, to issue share dividends, to issue share options, or as reserve for future issuance; e. To buy out one or more specific shareholders as protection against takeover threat f. To settle shares held by a dissenting shareholder (i.e., appraisal right) as provided under the Corporation Code; g. To eliminate fractional shares arising from share dividends ; or h. To settle delinquent subscriptions when there is no highest bidder. Accounting for Treasury Shares Treasury shares are accounted for using the cost method. Under this method, the reacquisition and subsequent reissuance of treasury shares are recorded at cost. Treasury shares presented as deduction in the shareholders’ equity (i.e., contra equity accounts) The automatic appropriation of retained earnings is in the Corporation Code Section 41, treasury shares transaction is permitted only if there is sufficient unrestricted retained earnings to cover the shares to be purchased. This appropriation shall not be available for the distribution of evidence.

1. Is it legal to have original issuance of share below par value? 2. What is the difference between watered shares and secret reserve? 3. Can you please explain what is a treasury shares? Why is it being purchased by the entity?

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4. What is the accounting treatment for treasury shares? 5. Why do you think the treasury shares is deducted from the shareholder’s equity account? 6. Why do you think there is a need to automatically appropriate retained earnings for the treasury shares purchased? Illustration: On January 1, 20x1, the statement of financial position of ABC Co. shows the following information: Share capital (P100 par value Share premium Retained Earnings Total shareholders equity On July 1, 20x1, ABC requires 1,000 shares at P90. 7/1 /20x1 Treasury shares (1,000 x P90) Cash 7/1/20x1 Retained earnings – unrestricted Retained earnings – appropriated

Case # 1 Reissuance Cost On Sept. 1, 20x1, ABC reissues the 1,000 treasury shares at P90. 9/1/20x1 Cash (1,000 x P90) Treasury shares (1,000 x P90) 9/1/20x1 Retained earnings – appropriated Retained earnings – unrestricted

800,000 160,000 540,000 1,500,000

90,000 90,000 90,000 90,000

90,000 90,000 90,000 90,000

When treasury shares are reissued, the related appropriated retained earnings are reverted back to unrestricted retained earnings. Case 2 ON Sept. 1, 20x1, ABC reissues the 1,000 treasury shres at P140. 9/1/20x1 Cash (1,000 x P140) Treasury shares (1,000 x 90) Share premium-treasury shares 9/1/20x1 Retained earnings – appropriated Retained earnings – unrestricted

140,000 90,000 50,000 90,000 90,000

Case 3 – Reissuance at below cost On September 1, 20x1, ABC reissues the 1,000 treasury shares at P60. 9/1/20x1 Cash (1,000 x P60) 60,000 Share premium – treasury shares Retained earnings 30,000 Treasury shares 90,000 9/1/20x1 Retained earnings – appropriated 90,000

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Retained earnings – unrestricted

90,000

When the treasury shares are subsequently reissued at below the acquisition cost, the excess of the cost over the reissuance price is debited to the following in the order of priority. a. Any balance in “share premium -treasury shares” arising from the same class of share capital b. If the balance in “share premium” – treasury shares” is insufficient or if it has no outstanding balance, any excess is debited to retained earnings. The effect of: • Reacquisition of treasury shares is a decrease in total shareholders’ equity equal to the cost of the reacquired treasury shares • Reissuance of treasury shares is an increase in total shareholders’ equity to the reissuance price. Based on the illustration above: There are instances that the treasury cost will be issued below its cost. What is the accounting treatment for that?

Retirement of Shares Shares are considered retired is they have been reacquired and cancelled in accordance with Securities and Exchange Commission (SEC) regulations. Unlike or treasury shares which can be subsequently reissued, retired shares cannot be reissued anymore. When shares retired, the total par value and the related share premium of the retired shares are removed from the books of accounts. Any difference between the total amount removed and the retirement cost is accounted for as follows. 1. IF the par value and related share premium of the retired shares exceed the retirement cost, the difference is credited to share premium – retirement” 2. If the par value and related share premium of the retired shares are less than the retirement cost, the difference is debited to the following in the order of priority a. share premium – treasury shares b. Retained earnings. Please answer the following questions 1. In the retirement of shares, does the total share holder’s equity increase or decrease? 2. What are the items that you are going to remove from shareholder’s equity during the retirement? 3. What if there is a difference between retirement cost and the amount removed? How are you going to recognize the difference?

Illustration: Retirement of shares On January 1, 20x1, the statement of financial position of ABC Co. shows the following information:

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Share capital (P 100 par value) Share premium Share premium-treasury shares Retained earnings Total shareholders’ equity

800,000 160,000 5,000 535,000 1,500,000

Case # 1 – Retirement cost less than Original issuance price ABC reacquires 1,000 shares at P80 per share on July 1, 20x1 and retires them on September 1, 20x1. July 1 – Reacquisition July 1, 20x1 Sept. 1 – Retirement Sept. 1, 20x1

Treasury shares (1,000 x P80) Cash

80,000 80,000

Share capital (1,000 x P100) Share premium – original issuance (1,000 x P20) Treasury shares (1,000 x P80) Share premium – retirement

Total share premium before retirement Divide by: Total issued shares before retirement (800,000 Share capital / P100 per share ) Share premium per share from original issuance

100,000 20,000 80,000 40,000

P160,000 8,000 P 20

Case 2 – Retirement cost greater than Original issuance price ABC reacquires 1,000 shares at P140 on July 1, 20x1 and immediately retires them. July 1, 20x1 Share capital (1,000 x P100) 100,000 Share premium – original issuance (1,000x P20) 20,000 (a) Share premium – treasury shares 5,000 (b) Retained Earnings 15,000 Cash (1,000 x P140)

140,000

In retirement of treasury shares, retained earnings maybe decreased but never increased. Why?

Sale of different classes of Share capital When entity issues more than one class of share capital for a lump sum price (basket sale), the issuance is accounted for in one of the following: 1. Proportional method – if the fair value of all classes of share capital issued are determinable, the lump sum price is allocated to the classes of capital based on their relative fair value. 2. Incremental method – if only one class of shares has a determinable fair value, such class is assigned its fair value and the excess of the lump sum price is assigned to the other class of shares that does not have determinable fair value.

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Answer the following 1. Explain how the proportional method is being done in issuing different classes of capital? 2. How about the incremental method? 3. When the are you going to use proportional method or incremental method in identifying the share capital issuance?

Illustration: ABC Co. Issued 1,000 ordinary shares with par value per share of P100 and 200 preference shares with par value per share of P130 for a lump sum price of P200,000. Case 1 – Proportional method Quoted prices per share are P120 and P150 for the ordinary and preference shares, respectively. The lump sum price is allocated as follows: No. of shares Fair value per share Preference shares 200 150 Ordinary shares 1,000 120 Totals 1,200 The entry to record the issuance is as follows: Date Cash Preference share capital (200 x P130 par) Share premium – ps (40,000 -26,000) Ordinary share capital (1,000 x P100 par) Share Premium – OS (160,000 -100,000)

Total fair value

Fraction

Allocation

30,000

30/150

40,000

120,000 150,000

120/150 150/150

160,000 200,000

200,000 26,000 14,000 100,000 60,000

Case 2 – Incremental method The ordinary shares have quoted price of P120 per share. However, the fair value of the preference shares cannot be determined reliably. The lump sum price is allocated as follows: Lump sum price Allocation to ordinary shares, at fair value (!,000 x P120) Excess allocated to preference shares The lump sum price is allocated as follows: Lump sum price Allocation to ordinary shares, at fair value (1,000 x 120) Excess allocated to preference shares The entry to record the issuance is as follows: Date Cash Preference share capital (200 x P130 par)

200,000 (120,000) 80,000

200,000 (120,000) 80,000 200,000 26,000

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Share premium – ps (40,000 -26,000) Ordinary share capital (1,000 x P100 par) Share Premium – OS (160,000 -100,000)

54,000 100,000 20,000

Equity Instruments vs. Financial liability The issuer classifies a financial instrument, or its component parts, as a financial asset, a financial liability or an equity instrument in accordance with the substance of the contract (rather than its legal form) and the definitions of a financial assets, a financial liability and an equity instruments. To check whether a financial instrument a financial liability or equity instrument, the overriding consideration is whether the instrument meets the definition of a financial liability. Financial Liability ➢ The entity has a contractual obligation to pay cash or another financial asset or to exchange financial instruments under potentially unfavorable condition

Equity Instrument ➢ The entity has no obligation to pay cash or another financial asset or to exchange financial instruments under potentially unfavorable conditions.

Redeemable and Callable Preference shares Basically if you are going to look at the form of these two shares you are going to initially categorized this one as equity instruments but if we are going to look closely in their substance you will see that they have a different substance. Redeemable preference share Are preferred stock which the holder has the right to redeem at a set date

Callable preference share Are preferred stock which the issuer has the right to call at a set date

Are classified as financial liability because when the holder exercises its right to redeem, the issuer is obligated to pay for the redemption price

Are classified as equity instrument because the right to call is at the discretion of the issuer and therefore has no obligation to pay unless it chooses to call on the shares.

We’ve discussed this one in our PARCOR. It says there that there is what do we call substance over form. In form the redeemable preference share is considered as equity instrument, however, if you are going to the substance of the transaction, that the entity has the contractual obligation to pay cash, this is beyond the control of the entity then it is being considered as a financial liability. Therefore any dividend that will be earned by the redeemable preference share shall be considered as interest expense.

Illustration: Callable preference shares

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ABC Co. issued 1,000 callable preference shares with par value of P100 for P120 per share. The entry to record the issuance is as follows. Date Cash (1,000 x120) 120,000 Preference share capital (1,000 x P100 par) 100,000 Share premium – Preference share 20,000 Case 1 The preference shares are subsequently called in for redemption at P130 per share. The entry to record the redemption is as follows: Date Preference share capital (1,000 x P100 ) 100,000 Share premium -preference share 20,000 Retained earnings 10,000 Cash (1,000 x 130) 130,000 The share capital and share premium are arising from the original issuance are derecognized when the shares are called in for redemption. If redemption price exceeds the original issuance price, the excess is debited to retained earnings. Case 2 The preference shares are subsequently called in for redemption at P90 per share. The entry to record the redemption is as follows. Date Preference share capital (1,000 x 100) 100,000 Share premium – Preference share 20,000 Cash (1,000 x 90) 90,000 Share premium – redemption 30,000 If the redemption price is less than the original issuance price the difference is credited to share premium. Origination of other equity instruments Corporations may issue equity instruments other than shares of stocks whether as separate or standalone equity instruments or bundled with other financial instruments, subject to the provisions of the Corporation Cod. Examples of such equity instruments include the following. 1. Stock rights 2. Conversion options included in convertible bonds and convertible preference shares. 3. Detachable warrants issued with bonds and preference shares 4. Stock options Stock rights Are issued to existing ordinary share-holders in relation to their preemptive rights. The stock rights enable the existing shareholders to protect their current ownership interests by acquiring new shares issued by the corporation before such shares are offered to new investors. Stock rights normally enable existing shareholders to purchase new shares at a price lower than the shares’ market value. Stock rights issued are evidenced by share warrants. Share warrants are certificates that entitle the holder thereof to acquire shares at a certain price within a stated period. Share warrants are issued in conjunction of the following

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a. Issuance of stock rights in relation to shareholders’ right of preemption b. Issuance of detachable warrants with other securities as “sweetener” or “equity kicker” to make the principal instrument more attractive to investors. c. Issuance of share options to employees as additional compensation. Share warrants are exercisable only within definite period of time and shall expire thereafter. Accounting for Stock Rights Stock rights are recorded through memo entry because stock rights are issued to existing shareholders without consideration. An entry is made only when the rights are exercised or recalled. If the stock rights are subsequently recalled, any consideration paid is debited to share premium. No entry is made if the stock rights expire but not recalled. Illustration ABC Co. issues 10,000 stock rights to shareholders which entitle them to purchase one ordinary share with par value of P100 for each stock right held at a subscription price of P120. The fair value per share is P150. The issuance of stock rights is recorded through memo entry as follows. Issued 10,000 stock rights to shareholders enabling them to purchase 10,000 ordinary shares with par value of 100 for subscription price of P120 per share. Subsequently, half of the stock rights issued were exercised. The entry is as follows: Date Cash (10,000 x 1/2x120) 600,000 Ordinary share capital (10,000 x 1/2x P100 par) 500,000 Share premium – Ordinary share 100,000 Case 1 Assume that ABC Co. recalls the other half at P1 per stock right The entry is as follows Date Share premium – Ordinary share Cash (10,000 x ½ x P1)

5,000 5,000

Case 2 Assume that the other half expires but not recalled. ABC Co. will make a memo entry indicating that the unexercised stock rights have been cancelled. Please answer the following 1. What are you going to issue to the shareholder if ever you will give them a stock right / preemptive right? 2. Does the stock right can be issued to a new shareholder? 3. Does the stock right have an expiration date? What is the features of share warrants? 3. What other reasons when you are going to issue share warrants? 4. What is the accounting for the share warrants?

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5. What if the share warrant is not used? What will happen to the share warrants? Convertible bonds and convertible preference shares Entities often issue bonds or preference shares with conversion feature in order to improve salability. The conversion feature gives the holder an option of converting the originally purchased instruments into ordinary shares. When a convertible bonds is being issued, there are two types of financial instruments that are being issued the financial liability for the bonds and an equity instrument for the conversion feature. When preference shares convertible to ordinary shares are issued, the entity has issued only one type of financial instrument – equity instruments but different classes. Illustration: Convertible preference shares ABC Co. issued 1,000 convertible preference shares with par value of P100 for P120 per share. The entry to record the issuance is: Date Cash (1,000 x120) 120,000 Preference share capital (1,000 x P100 par) 100,000 Share premium – Preference share 20,000 Case 1 Subsequently, the preference shares are converted into ordinary shares at “1 ordinary share for 1 preference share held” basis. The ordinary shares have par value per share of P50. The entry to record the conversion is as follows: Date Preference share capital (1,000 x P100 par) 100,000 Share premium – Preference share 20,000 Ordinary share (1,000 x 50 par) 50,000 Share premium – Ordinary share (squeeze) 70,000 Case 2 Subsequently, the preference shares are converted into ordinary shares at “3 ordinary shares for 1 preference share held” basis. The ordinary shares have par value per share of P50. The entry to record the conversion is Date Preference share capital 100,000 Share premium – preference share 20,000 Retained earnings (squeeze) 30,000 Ordinary share (1,000 x3xP50 par) 150,000 1. 2. 3. 4.

What is convertible bonds and convertible preference share? Why is it being issued? What is the accounting for the convertible preference share? If the shareholder is going to convert the preference share or bonds? What will be the entry?

Preference shares with detachable warrants

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Similarly with issuance of preference shares convertible to ordinary shares, when preference shares are issued with detachable warrants, the entity has issued only one type of financial instruments – equity instrument, but of different classes. However, in this case, the detachable warrant is not an embedded derivative but a standalone instrument that should be accounted for separately. Detachable warrants are capable of being transferred or sold separately. PFRS 9 provides that “a derivative that is attached to a financial instrument but is contractually transferable independently of that instrument or has a different counterparty from that instrument, is not an embedded derivative, but a separate financial instrument. The issue price should be allocated to the preference shares and the detachable warrants based on their relative fair values on issuance date. When both the preference shares and the warrants do not have available fair values, the allocation of the issue price is based on the intrinsic value of the warrants computed as the difference between the fair value of the ordinary shares and the subscription price. The warrants are assigned an intrinsic value and any excess of the issue price is allocated to the preference shares. Illustration 1 : Preference shares with detachable warrants ABC Co. issued 1,000 preference shares with par value of P100 for P135,000. The preference shares included 1,000 share warrants that entitle the holder to acquired 1,000 share warrants that entitle the holder to acquire 500 ordinary shares with par value of P50 for P70 per share. The fair values are determined as follows: Preference share ex-warrant 110 Warrant 10 The issue price is allocated as follows: Equity instruments Preference share 1,000 Warrants 1,000

FV per share 110 10

Fair values 110,000 10,000 120,000

The entry to record issuance are as follows: Date Cash 135,000 Preference share capital (1,000 x P100 par) Share premium – Preference share (123,750-100k) Share premium – warrants outstanding Case 1 Subsequently, all of the warrants were exercised. The entries are as follows: Date Cash (500 x70) 35,000 Ordinary share capital (500 x P50 par) Share premium – Ordinary share

Fraction 110/120 10/120 120/120

Allocation 123,750 11,250 135,000

100,000 23,750 11,250

25,000 10,000

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Date

Share premium – warrants outstanding Share premium – Ordinary shares

Case 2 All warrants expire unexercised. The entry is as follows: Date Share premium – warrants outstanding Share premium – Ordinary share

11,250 11,250

11,250 11,250

1. What is the preference share with detachable warrants? 2. What is the difference in accounting treatment of a convertible preference share and the preference share with detachable warrant? 3. What is the meaning of stand alone instrument? 4. What will be the accounting for the preference share with detachable warrant, if the price is determinable and the price is not determinable?

Donated Capital Donated capital arises from gifts received by the corporation by a non-reciprocal transactions. Donated capital may arise from the following: 1. Donations from shareholders – these are credited to share premium 2. Donations from the government – these are recognized as government grants 3. Donations from other sources – these are recognized as income when (a) the conditions attached to the donation are fulfilled or are reasonably expected to be fulfilled, (b) the donation becomes receivable and (c) the criteria for asset recognition are met. Donations from shareholders may be in a form of a. Cash – recognized at the amount of cash received or receivable b. Noncash assets – recognized at the fair value of the noncash assets c. Entity’s own shares – initially recorded through memo entry. Donated capital is recognized only when donated shares are subsequently reissued. This is because no asset is generated from the donated shares until they are subsequently reissued. If the donated shares are not to be resold, the entity should effect a formal reduction of its authorized capital by retiring the shares received. Illustration 1: Cash and noncash donations from shareholders ABC Co. received cash of P100,000 and land with fair value of P500,000 and historical cost of P300,00 from a shareholder. No conditions are attached to the donation. Date

Cash Land Share premium – Donated capital

100,000 500,000 600,000

Illustration 2: Donated shares received from shareholders ABC Co. received 1,000 shares with par value of P100 and fair value of P120 per share from a shareholder as donation.

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The receipt of the shares is recorded through memo entry as follows: Received 1,000 shares with par value of P100 from a shareholder as donation. Subsequently, ABC Co. reissues the 1,000 donates shares at P130 per share. Date Cash (1,000 x130) 130,000 Share premium – Preference share

130,000

1. What is donated capital? 2. What are the sources of donated capital and what will be the accounting treatment for this? 3. What are the types of donation that can be received by the entity? Summary of the Lesson: • The authorized capitalization is accounted for using (a) memorandum method or (b) journal entry method. The more commonly used method is the memorandum method. • The excess of issuance price or subscription price over the aggregate par value (stated value) of shares issued or subscribed is credited to the share premium account • For a par value shares, legal capital is the aggregate par value of shares issued and subscribed. For no-par value shares, legal capital is the total consideration received (receivable) from shares issued (subscribed) • Share issuance costs are deducted from share premium • Treasury shares are entity’s own shares that were previously issued by tare subsequently reacquired but not retired. Treasury shares are accounted for at cost. • The lump sum price of different classes of shares issued is allocated based on their relative fair values • The issuing entity classifies redeemable preference shares as financial liability • Stock rights issued without consideration are recorded through memo entry. • The conversion feature of convertible preference shares are not accounted for separately. ON actual conversion, the convertible preference shares are simply retired and the new shares issued are recognized in the usual manner. • Cash and non-cash asset received as donations from shareholders are classified as share premiums.

Enrichment Activity: 1. Beauty Company provided the following information on December 31, 2020. Preference share capital, P100 par Share premium – preference share Ordinary share capital, P10 par Share premium – ordinary share Subscribed ordinary share capital Retained earnings Note payable Subscription receivable – ordinary share

₱ 2,530,000 885,500 5,775,000 3,025,000 55,000 2,090,000 4,400,000 440,000

What is the amount of legal capital? _______________________________________

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Answer: P 8,360,000 2. Alvarez Company issued 1,100 shares with ₱5 par to Pantaleon as compensation for 1,100 hours of legal services performed. Pantaleon usually bills ₱1,600 per hour for legal services. On the date of issuance, the share was trading on a public exchange at ₱140. By what amount should the share premium account increase as a result of the transaction? _______________________________________ Answer: P 148,500 3. Nano Company issued 220,000 ordinary shares when it began operations in 2019 and issued an additional 110,000 shares in 2020. The entity also issued preference shares convertible into 110,000 ordinary shares. In 2020, the entity purchased 82,500 ordinary shares to be held in treasury. On December 31, 2020, how many ordinary shares were outstanding? _______________________________________ Answer: P 247,500 4. Alexa Company issued 22,000 new ₱100 par ordinary shares at fair value of ₱180 each. The entity incurred professional fee of ₱440,000 and internal management time of ₱330,000 in managing the process in relation to the share issue. What is the increase in equity as a result of the issuance of shares? _______________________________________ Answer: P 3,652,000 5.

Fraggle Company had 770,000 ordinary shares authorized and 330,000 shares outstanding on January 1, 2020.

January 31 Declared 10% stock dividends June 30 Purchased 110,000 shares August 1 Reissued 55,000 shares November 30 Declared 2-for-1 stock split On December 31, 2020, how many ordinary shares outstanding? _______________________________________ Answer: P 616,000

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Assessment Lesson 2 - SHAREHOLDER’S EQUITY Name: ___________________________________________

Section: _____________ Score: __________

1. Effective December 31, 2020, the shareholders of Emma Company approved a two-for-one split of the entity’s share capital, and an increase in authorized shares from 110,000 shares with ₱20 par value to 220,000 shares with ₱10 par value. The shareholders’ equity accounts immediately before the split shares were share capital ₱1,100,000, share premium ₱165,000 and retained earnings ₱1,485,000. What should be the balances in the share premium and retained earnings, respectively, after the share split is effected? _______________________________________& ____________________________________ 2.

Irareza Company was organized on January 1, 2020 with authorized capital of 110,000 shares of ₱200 par value.

January 10 March 25 September 30

Issued 27,500 shares at ₱220 a share Issued 1,100 shares for legal services when the fair value was ₱240 a share issued 5,500 shares for a tract of land when the fair value was ₱260 a share

What amount should be reported for share premium? _______________________________________ 3. On January 1, 2020, Vicky Company had 137,500 share issued which included 27,500 shares held as treasury. January 1 through October 31 – 14,300 treasury shares were distributed to officers as part of a share compensation plan November 1 – A 3-for-1 share split took effect December 1 – The entity purchased 5,500 of its own shares to discourage an unfriendly takeover. These shares were not retired. On December 31, 2020, how many shares were issued and outstanding, ______________________________________& ______________________________________

respectively?

4. In 2019, Connie Company issued 55,000 shares of 10 par value for P100 per share. In 2020, the entity reacquired 2,200 shares at ₱150 per share and immediately canceled these 2,200 shares. In connection with the retirement of shares, what amount should be debited to share premium and retained earnings, respectively? _______________________________________& _______________________________________ 5. On December 31, 2020, Rachel Company canceled 5,500 shares of ₱25 par value held in treasury at an average cost of ₱130 per share. Before recording the cancelation of the treasury shares, the entity had the following balances: Share capital issued originally at P30 per share Share premium Retained earnings Treasury shares, at cost

₱ 687,500 825,000 990,000 715,000

On December 31, 2020, what is the share capital outstanding? _______________________________________

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6.

Unciano Company reported the following shareholders’ equity on January 1, 2020:

Share Capital, P10 par, outstanding 247,500 shares Share premium Retained earnings

₱ 2,475,000 990,000 2,409,000

During the current year, the entity had the following share transactions: • Acquired 6,600 treasury shares for ₱297,000 • Sold 3,960 treasury shares at ₱50 a share • Sold the remaining treasury shares at P41 per share What is the total amount of share premium on December 31, 2020? _______________________________________ 7. During 2020, Kris Company issued 5,500 convertible preference shares of ₱100 par value for ₱110 per share. One preference share can be converted into three ordinary shares of ₱25 par value at the option of the preference shareholder. On December 31, 2020, when the market value of the ordinary share was ₱40, all of the preference shares were converted. What amount should be credited to ordinary share capital and share premium as a result of the conversion, respectively? ______________________________________& ______________________________________

References: Millan, Z.V. (2019). Intermediate Accounting 2 Valix,(2019). Intermediate Accounting 2

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Lesson 3: SHAREHOLDERS’ EQUITY (PART 2) RETAINED EARNINGS Lesson Objectives: 1. Account for distributions to owners 2. Account for recapitalization Discussion and Application: Retained earnings Retained earnings represent the cumulative profits (net of loss, distribution to owners, and other adjustments) which are retained in the business and not yet distributed to the shareholders.

Retained Earnings - Appropriated Retained Earnings - Unappropriated

Total retained earnings may consist of: a. Unrestricted – the portion of retained earnings that is available for future distribution to the shareholders. b. Appropriated (Restricted) – the portion of retained earnings that is not available for distribution unless restriction is subsequently reversed. Appropriations are disclosed in the notes. In the absence of such disclosure, the retained earnings are deemed unrestricted. Appropriation may be a result of 1. Legal requirement – such as retained earnings appropriated for the cost of treasury shares reacquired and those transferred to statutory reserves. The automatic appropriation of retained earnings is in the Corporation Code Section 41, treasury shares transaction is permitted only if there is sufficient unrestricted retained earnings to cover the shares to be purchased. This appropriation shall not be available for the distribution of evidence.

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2. Contractual requirement – such as retained earnings appropriated in compliance with loan agreements or bond indentures for the protection of creditors. Usually when the entity issues bonds or enter into a loan agreement, there is a covenant in that loan agreement, a contractual requirement wherein to protect the creditor certain amount of retained earnings must be appropriated. Remember, appropriation of retained earnings means that you cannot distribute the appropriated retained earnings to the shareholders. 3. Voluntary – such as retained earnings appropriated for probable contingencies, business expansion, and the like. The appropriation of retained earnings is recorded as follows Voluntary appropriation is being done when an entity has future plan for expansion or wants to acquire new asset. Retained earnings – unrestricted xx Retained earnings – appropriated xx When the restriction on the retained earnings no longer exists, the entry above is simply reversed as follows: Date Retained earnings – appropriated xx Retained earnings – unrestricted xx Date

How do you appropriate? 1. Just follow above entry. 2. Did you set aside the cash? – No, you just only need to set aside amount that is not available to the owner. 3. When you appropriate is the shareholder’s equity account change? - No, both the retained earnings and shareholder’s equity account does not change since, you just reclassify the retained earnings account. 4. Do you need to disclose the appropriation in the notes to financial statement? - Yes it is necessary.

Negative balances in equity ➢ A negative balance in a retain earnings, it is described in the financial statement as deficit ➢ When total shareholder’s equity has a negative balance (such as when liability exceeds assets), it is described as “capital deficiency”. Dividends There are two ways that an entity can get its financing, first is thru credit or issuance of bonds and second is thru equity financing. If you issue bonds to investors you are called the borrower and you must pay interest on a regular basis or depending on the stipulation in the contract. However, if you are going to issue stocks or share to the investor, then the investor will be co-owner of the company, in this case, if ever you will have retained earnings that will be available for distribution, you shall distribute the retained earnings in the form of dividends. Dividends may be in a form of: 1. Cash dividends – distribution in the form of cash ➢ Liability dividends – dividends are issued by a corporation that has a temporary cash short shortage. Liability dividends may be either o Scrip dividends – short term, may or may not bear interest o Bond dividends – long term and bear dividends. 2. Property dividends – distribution in form of noncash assets.

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3. Share dividends – distributions in the form of the entity’s own shares. Dividends may be declared: a. Out of unrestricted retained earnings (return on capital) or b. Out of capital (return of capital) If the entity is a regular Corporation, and you are going to declare dividends out of unrestricted retained earnings, then that is being called as return of capital (you are going to apply here the Trust Fund Doctrine). Share dividends (Stock dividends), maybe declared out of share premium in excess of par value, this is not part of legal capital. On the other hand, there are Wasting asset corporations, (the mining Corporations), when they declare dividends, the dividends they will declare is Out of Capital or return of capital, it will follow the Wasting Asset Doctrine. This is being called as Liquidating dividends. Dates relevant to the accounting for dividends a. Date of declaration – The date when the board of directors formally announces the distribution of dividends b. Date of record – the date on which the stock and transfer book of the corporation is closed for registration. Only those who are listed as of this date shall be entitled to received dividends. ➢ Ex-dividend date - to provide shareholders ample time to register, they are normally allowed to register about three to five days prior to the date of record. c. Date of distribution – the date when the dividends declared are distributed to the shareholders who are entitled to the dividends.

How the three dates that are being emphasized above is considered important? It will answer the questions below 1. When are you going to record the liability for dividends? - Declaration date. No Declaration, no obligation. What is the declaration date? When it is being declared by the management and approved by the authority or when there is declaration even if there is no approval, because approval is not necessary. 2. How much will be recorded? - Look at the date of record. Only those who are listed in the transfer book on the date of record shall be entitled of the dividend. 3. When are you going to pay the dividends? Date of distribution. Accounting for Cash dividends ➢ Most common form of distribution to owners. ➢ May be declared at a certain amount per share or a certain percentage of the par value of the shares. ➢ Only the outstanding shares are entitled to dividends. Outstanding shares are shares issued plus subscribed shares minus treasury shares. ➢ Under the Corporation Code, cash dividends due on delinquent shares are first applied to the unpaid balance on the subscription plus costs and expenses, while share dividends (stock dividends) are withheld from the delinquent subscriber until his unpaid subscription are fully paid.

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Illustration: Cash dividends On April 1, 20x1, the board of directors of ABC Co. declared P50 dividends per share to shareholders of record as of April 15, 20x1 for distribution on May 1, 20x1. The shareholders’ equity of ABC as of April 1, 20x1 is as follows: Share capital, authorized capital 10,000 shares, P100 par Subscribed share capital Share premium Retained earnings Treasury shares (at cost of P120 per share) Other components of equity Total shareholder’s equity

800,000 220,000 100,000 454,000 (144,000) 70,000 1,500,000

➢ The outstanding shares are computed as follows Shares issued (800,000 /100 par) Shares subscribed (P220,000 / 100 par) Treasury shares (P144,000 / 120 cost) Outstanding shares

8,000 2,200 (1,200) 9,000

➢ The cash dividends payable is computed as follows Outstanding shares Multiply by: Dividends per share Total cash dividends

9,000 P50 450,000

The pertinent entries are as follows: Date April 1, 20x1 (Date of declaration) April 15, 20x1 Date of record May 1, 20x1 (Date of Distribution)

Retained earnings (or Dividends) Cash dividends payable No entry

450,000 450,000

Cash dividend payable Cash

450,00 450,000

Illustration 2: Liability dividends On April 1, 20x1, the board of directors of ABC Co. declared 50% scrip dividends to shareholders of record as of April 15, 20x1 for distribution on September 30, 20x1. The scrip dividends bear 10% interest per annum. The shareholders’ equity of ABC as of April 1, 20x1 is as follows. Share capital, authorized capital 10,000 shares, P100 par Subscribed share capital Share premium Retained earnings Treasury shares (at cost of P120 per share) Other components of equity Total shareholders’ equity

800,000 220,000 100,000 454,000 (144,000) 70,000 1,500,000

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➢ The scrip dividends payable is computed as follows Shares issued (P800,000 / 100 par) Shares subscribed (P220,000/100 par) Treasury shares (P144,000/120 cost) Outstanding shares Multiply by: par value per share Aggregate par value of outstanding shares Multiply by: Dividends as percentage of par value Total scrip dividends declared Date April 1, 20x1 (Date of declaration) April 15, 20x1 Date of record May 1, 20x1 (Date of Distribution)

Retained earnings (or Dividends) Scrip dividends payable

8,000 2,200 (1,200) 9,000 100 900,000 50% 450,000 450,000 450,000

No entry Scrip dividend payable Scrip Payable

450,00 450,000

Based on the illustrations above, what is the difference between the cash dividends and scrip dividends? What are the similarities in the computation? Accounting for property dividends ➢ Property can be declared instead of cash (inventory, investment in shares of stock of another entity (take note that this is not a own stock of the entity but the stock investment of the entity to another entity), and the like) ➢ The accounting of property dividends is affected by the following: 1. Accounting for the resulting property dividends payable, and 2. Accounting for the non-cash assets declared as property dividends. Accounting for the property dividends payable The liability recognized on the declaration of property dividends is accounted for as follows: a. The property dividends payable is initially measures at the fair value of the non-cash asset at the date of declaration b. At the end of each reporting period and also on the settlement date, the property dividends payable is adjusted for changes in fair value. The changes are recognized as gain or loss, directly in retained earnings. c. On settlement (distribution) date, any difference between the carrying amounts of the dividends payable and the asset distributed is recognized in profit or loss. Accounting for non-cash assets declared as property dividends ➢ If the non-cash asset that is being declared as property dividends is a non-current asset you have to consider some standards in their subsequent recognition, if the non-cash asset declared is a current asset it shall be accounted for under previous accounting no reclassification is needed. ➢ Property dividend as non-current asset

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o

Shall be subject to the requirement under PFRS 5 Non-current asset held for sale and discontinued operation, reclassified as “Non-current asset held for distribution to owners. ▪ It is initially and subsequently measured at the lower of its carrying amount and fair value less costs to distribute. ▪ A loss is recognized it the fair value less costs to distribute is below the carrying amount. ▪ A subsequent increase in fair value less costs to distribute is recognized as a gain but only to the extent of the cumulative losses recognized in previous period. ▪ These gains and losses are recognized in profit or loss.

You will notice that there is not much accounting issue is you are going to issue a cash dividend and scrip dividends. However, there will be accounting considerations for the property dividend declaration. As discussed above, there are two accounting considerations that you are going to consider, 1st is the accounting for property dividends and second is Accounting for non-cash assets declared as property dividends. 1st for the accounting for property dividends - please answer the following 1. What amount of dividends payable are you going to recognize? 2. The property being declared as dividends might change its fair value until the distribution date, are you going to update the amount of property dividend? At what account are you going to recognize the difference? 3. How about the difference on carrying value and the fair value of the property on settlement date? What are you going to do with this? 2nd for the accounting for non-cash assets declared as property dividends. – please answer the following 1. Will there be difference in recording if the asset being declared as property dividend is current or non-current? If yes how will it differ? 2. What will be the standard if you are declaring non-current non-cash asset as property dividend?

Illustration 1: Non-current asset declared as property as property dividends On July 1, 20x1, ABC Co. declared as property dividends 10,000 shares held as investment in associate with carrying amount of P1,000,000. Information on fair values is shown below: Date Fair value July 1, 20x1 800,000 Dec. 31, 20x1 1,100,000 Feb. 1, 20x1 950,000 Assume costs to distributed are immaterial The pertinent entries on July 1, 20x1 are as follows: July 1, 20x1 Retained earnings (or Dividends) Property dividends payable To record the declaration of property dividends July 1, 20x1

NCA held for distribution to owners Impairment loss Investment in associate

800,000 800,000

800,000 200,000 1,000,000

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To record the reclassification of investment in shares declared as property dividends

The property dividends are not yet distributed to the owners as of December 3, 20x1. The pertinent entries are as follows: Dec. 31, 20x1

Retained earnings 300,000 Property dividends payable (1.1M-800K) 300,000 To adjust dividends payable for the change in the fair value of the non-cash assets

Dec. 31, 20x1

NCA held for distribution to owners Gain on impairment recovery To recognize gain on impairment recovery

200,000 200,000

The property dividends payable is settled on February 1, 20x2. The pertinent entries are as follows: Feb. 1, Property dividends payable 150,000 20x2 Retained earnings (1.1M -950k) 150,000 To adjust dividends payable for the change in the fair value of the non-cash assets. Feb. 1, 20x3

Property dividends payable Loss on distribution of property dividends NCA held for distribution to owners To record the distribution of property dividends.

950,000 50,000 1,000,000

Analyze the T -account shown below: July 1, 20x1 July 1, 20x1 Dec. 31, 20x1 Feb. 1, 20x2

Retained earnings 800,000 200,000 300,000 200,000 50,000 150,000 1,000,000

Dec. 31, 20x1 Feb. 1, 20x2 Net debit effect

The net debit to retained earnings of P1M is equal to the carrying amount of the investment in associate on declaration date of P1M. Based on the Illustration above discuss how the standards are being applied in recognizing dividends as non-cash asset. Relate your answers to the standards being discussed. Illustration: Current asset declared as property dividends On July 1, 20x1, ABC Co. declared as property dividends inventory with carrying amount of P1,000,000. Information on fair values is shown below. Fair value July 1, 20x1 800,000 July 31, 20x1 1,100,000

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Assume fair value is not materially different from net realizable value The pertinent fair value is not materially different from net realizable value. July 1, Retained earnings 800,000 20x1 Property dividends payable 800,000 To record the declaration of property dividends July 1, 20x1

Impairment loss Inventory To write down the inventory to NRV.

200,000 200,000

Notes: ➢ Retained earnings and property dividends payable are recognized at fair value on declaration date. ➢ No reclassification is made because the non-cash asset declared as property dividend is a current asset. ➢ If the net realizable value of the inventory exceeds the carrying amount, no write down is necessary. The property dividends payable sis settled on July 21, 20x1. The pertinent entries are as follows. July 31, Retained earnings 300,000 20x1 Property dividends payable (1.1M-800K) 300,000 To adjust the dividends payable for the change in the fair value of the non-cash assets July 31, 20x1

Property dividends payable 1,100,000 Inventory 800,000 Gain on distribution of property dividends 300,000

Accounting for share dividends Share dividends are accounted for as follows: a. If the share dividends declared are considered “small meaning less than 20% of the outstanding shares, the share dividends are accounted for at fair value. Retained earnings is debited for the fair value of the share dividends on declaration date. The difference between the fair value and par value is credited to share premium. b. If the share dividends declared are considered “large: meaning 20% or more of the outstanding shares, the shares are accounted for at par value. Retained earnings is debited for the par value of the share dividends. Accordingly, no share premium arises. The reasons for declaring share dividends may include the following: a. To retain profits in the corporation. Share dividends involve only a transfer from retained earnings to share capital. There is no actual outflow of assets b. To make an impression to the public because many consider share dividends as return on capital. c. To decrease the fair value per share. This makes the shares more affordable to potential investors and easier for the corporation to issue them. Actually, this is also one of the reasons for the varying accounting treatments for “small” and large dividends.

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Accounting for share dividends – Answer the following based on the standard discussed above. 1. What is the difference between the share dividends and the property dividends (specifically the share of stock of another entity)? 2. What will be the first thing that you need to look upon when there is a share dividends for declaration? 3. What is large stock dividend and small stock dividends? Is there a difference of recording if you have these kinds of dividends being declared? 4. How are you going to recognized small stock dividend and large stock dividend? Illustration 1: “Small” share dividends On April 1, 20x1, ABC Co. declared share dividends of “1 share for every 10 shares held” to shareholders of record as of April 15, 20x1, for distribution on May 1, 20x1. The fair value per share on declaration date is P140. ABC’s shareholders’ equity immediately before the dividend declaration is shown below. Share capital, P100 par value Subscribed share capital Share premium Retained Earnings Treasury Shares (at cost of P120 per share) Total shareholder’s equity

800,000 220,000 100,000 524,000 (144,000) 1,500,000

➢ The outstanding shares are computed as follows Shares issued (800,000 / 100 par) Shares subscribed (220,000 /100 par) Treasury shares (P144,000 /120 cost) Outstanding shares

8,000 2,200 (1,200) 9,000

➢ The stock dividends payable or share dividends distributable is computed as follows: Outstanding shares Multiply by: Dividends declared Number of shares declared as dividends Multiply by: Fair value per share Total share dividends The pertinent entries are as follows April 1, 20x1 (Date of declaration)

April 15, 20x1 (Date of record) May 1, 20x1 (Date of distribution)

9,000 1/10 900 140 126,000

Retained earnings (900 shares x 140) Stock dividends payable (900x100) Share premium No entry Stock dividends payable Share capital

126,000 90,000 36,000 90,000 90,000

The shareholders’ equity as of April 1, 20x1 immediately before and after the declaration is shown below:

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Before declaration Share capital Subscribed share capital Stock dividends payable Share premium Retained earnings Treasury shares Total shareholders’ equity

800,000 220,000 100,000 524,000 (144,000) 1,500,000

After declaration

Increase/(Decrease)

800,000 220,000 90,000 136,000 298,000 (144,000) 1,500,000

90,000 36,000 (126,000) -

Notes: ➢ The stock dividends payable or share dividends distributable account is an adjunct equity account (i.e. addition to equity) and not a liability account. 1. Does the declaration of the share dividends affect the shareholder’s equity account? Why? 2. How did you know that this is a small stock dividends, aside from the title of the illustration? 3. How was it being recorded? What is the standard in recording small stock dividend?

Illustration 2: Accounting for large share dividends On April 1, 20x1, ABC Co. declared share dividends of “! Share for every 5 shares held t” to shareholders of record as of April 15, 20x1, for distribution on May 1, 20x1. The fair value per share on declaration date is P140. ABC ‘s shareholders’ equity immediately before the dividend declaration is shown below:

Share capital, P100 par value Subscribed share capital Share premium Retained earnings Treasury shares (at cost of P120 per share) Total shareholders’ equity ➢ The outstanding shares are computed as follows: Shares issued (P800,000 /100 par) Shares subscribed (P220,000/100 par) Treasury shares (P144,000/120 cost) Outstanding shares

800,000 220,000 100,000 524,000 (144,000) 1,500,000

8,000 2,200 (1,200) 9,000

➢ The stock dividends payable or share dividends distributable is computed as follows: Outstanding shares 9,000 Multiply by: Dividends declared 1/5 Number of shares declared as dividends 1,800 Multiply by: Par value per share 100

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Total share dividends April 1, 20x1 (Date of declaration) April 15, 20x1 (Date of record) May 1, 20x1 (Date of distribution)

180,000 Retained earnings (1,800 shares x 100) Stock dividends payable No entry Stock dividends payable Share capital

180,000 180,000 180,000 180,000

1. How did you know that this is a large stock dividends? As if the you did not read the illustration. 2. How was it being recorded? What is the standard in recording large stock dividend? Treasury shares declared as dividends The accounting procedures for small or large share dividends do not apply when the treasury shares is being declared as dividends. Instead the cost method is used. “Retained earnings is debited for the cost of the treasury shares declared and there will be no premium arise. Is treasury shares considered as stock dividend? Yes this is considered as stock dividend, however, the accounting treatment for this is different you are just going to debit the cost of the treasury shares to the retained earnings.

Illustration: On April 1, 20x1, ABC Co. declared share dividends of “1 share for every 10 shares held” from its treasury shares, to shareholders of record as of April 15, 20x1, for distribution on May 1, 20x1. The fair value per share on declaration date is P140. ABC’s shareholders’ equity immediately before the dividend declaration is shown below: Share capital, P100 par value Subscribed share capital Share premium Retained earnings Treasury shares (At cost of P120 per share) Total shareholders’ equity ➢ The outstanding shares are computed as follows: Shares issued (800,000 / 100) Shares subscribed (220,000 /100 par) Treasury shares (P144,000 / 120 cost) Outstanding shares ➢ The stock dividends payable is computed as follows Outstanding shares Multiply by: Dividends declared Number of shares declared as dividends Multiply by: Cost per treasury shares Total share dividends

800,000 220,000 100,000 524,000 (144,000) P1,500,000

8,000 2,200 (1,200) 9,000 9,000 1/10 900 120 108,000

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April 1, 20x1 (Date of declaration)

Retained earnings (900 shares x 120) Stock dividends payable

April 15, 20x1 (Date of record) May 1, 20x1 (Date of distribution) May 1, 20x1

No entry Stock dividends payable Share capital Retained earnings – appropriated Retained earnings – unrestricted

108,000 108,000

108,000 108,000 108,000 108,000

1. What did you notice in the illustration above? 2. How the standards is being applied? 3. Why there is additional entry on May 1, 20x1?

Preference shares Preference shares have one or both of the following preferences over ordinary shares. 1. Preference in the distribution of assets in case of corporate liquidation (preferred as to assets) 2. Preference in the distribution of dividends (preferred as to dividends) Preference shares topic has been discussed already in your PARCOR same with what has been discussed above in share capital and dividends. However, more detailed approach is discussed in here. Before we proceed with the standards on recording of Preference share, let us review first what is a preference share, as discussed earlier, preference share is a type of share wherein it has all the preference pertaining to profit distribution and liquidation. But if the company is going to issue only one share of course it is NOT the preference share but the ordinary share.

Preference over dividends When dividends are declared, preference shares that are preferred as to “dividends” are paid first before ordinary shareholders. Preference over dividends may be: 1. Noncumulative – noncumulative preference share is one which the dividend entitlement for a year is forfeited when dividends are not declared in that year. 2. Cumulative – a cumulative preference share is one which the dividend entitlement accumulates each year until paid. Accumulated unpaid dividends are disclosed as dividends in arrears but not accrued as liability unless the dividends are declared. 3. Nonparticipating – a nonparticipating preference share is one which is entitled only to a fixed amount of dividends. 4. Participating – a participating preference share is one which is entitled to an amount in excess of the fixed amount of dividends. The amount of participation is computed after both the preference and ordinary shares are allocated their basic dividends. ➢ The basic dividend of cumulative preferred shares includes dividends in arrears ➢ The basic dividend of noncumulative preferred shares includes the current year dividend entitlement

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➢ The basic dividend of ordinary shareholders is equal to the aggregate par value of the outstanding ordinary shares multiplied by the preference rate. If there is more than one class of preference shares with different preference rates, the lowest preference rate is used to compute for the basic dividend of ordinary shareholders. ➢ Any excess of the dividends declared after deducting the basic dividends is the amount subject to participation which is allocated depending on the nature of participation of the preference shares. Participating preference shares may be either: a. Fully participating – participates on a pro rata basis (base on aggregate par values of outstanding shares) with ordinary shareholders b. Partially participating – participates only up to a certain amount of percentage. Preference shares may have more than one dividend preference. For example, preference shares may be both cumulative and participating. The dividend entitlement of preference shares may be expressed as: a. Percentage of par value (fixed rate based on par value). For example, a 12% preference share with par value of P100 is entitled to a dividend of P12 (12% x P100) when dividends are declared. b. Specific monetary amount per share For example, a P5 preference share. With par value of P100 is entitle dot a dividend of P5 when dividends are declared. Based on what has been discussed above – Answer the following questions 1. This is a preference share in which the dividend entitlement accumulate each year? ________________________ 2. This is a preference share in which the holder is only entitled to a fix amount. _________________________ 3. A preference share in which the holder is entitled with an excess of fixed amount of dividends ________________________ 4. Participating may be classified as this participates only up to certain amount of percentage. ___________________ 5. This is a preference share in which the dividend entitlement for a year is forfeited when not declared. ___________________

Illustration 1: Dividends on preference shares ABC Co. declared P1,800,000 cash dividends to its preference and ordinary shareholders in 20x3. No dividends have been declared since 20x1. ABC’s shareholders’ equity immediately before the dividend declaration is as follows. 10% preference share capital, P200 par 2,000,000 Ordinary share capital, P100 par 8,000,000 Retained earnings 5,000,000 Total shareholder’s equity 15,000,000 Requirements: Compute for the dividends receive by the preference shareholders and ordinary shareholders respectively, under each of the independent cases below. Case #1: Noncumulative and Nonparticipating The preference shares are noncumulative and nonparticipating. Observe the following steps in the allocation of dividends:

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Step 1: Provide the following steps in the allocation of dividends: - If the preferences shares are noncumulative, provide one-year dividends only - If the preference shares are cumulative, provide all dividends in arrears. Step 2: Any excess is paid to the ordinary shareholders. Total dividends declared Allocation 1. Allocation to preference shares (2mx10%x1yr) 2. Excess allocated to ordinary shares (1.8M -200K) As allocated Case #2 Cumulative and Non-Participating The preference shares are cumulative and non-participating Total dividends declared Allocation 1. Allocation to preference shares (2mx10%x3yr) 2. Excess allocated to ordinary shares (1.8M -600K)

1,800,000 200,000 1,600,000

1,800,000

600,000 1,200,000

As allocated

Case #3 Noncumulative and Fully Participating The preference shares are noncumulative and fully participating For participating preference shares; we will observe the following steps in the allocation of dividends: Step 1: Provide the dividends of the preference shares first. - IF the preference shares are noncumulative, provide one-year dividends only - If the preference shares are cumulative, provide all dividends in arrears Step 2: Provide the basic dividends of the ordinary shares using the preference share rate. Step 3: Allocate the excess dividends after deducting the amounts computed in Steps 1 and 2 above to the preference and ordinary shares pro rata based on the aggregate par values of the outstanding shares.

Total dividends declared

1,800,000

Allocation 1. Allocation to preference shares (2mx10%x1yr) 2. Basic Allocation to ordinary shares (8M par x 10%)

200,000 800,000

Excess subject to participation (1.8 M -200K -800K) 3. Participation of preference shares (800kx2M/10M par) 4. Participation of ordinary shares (800kx8M par/10M par) As Allocated

800,000 160,000 640,000 -

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The total dividends received by each class of shares are as follows: Preference shares: 200,000 basic +160,000 participation) Ordinary shares: (800,000 basic +640,000 participation Total dividends Case #4 Cumulative and Fully Participating The preference shares are cumulative and fully participating Total dividends declared Allocation 1. Basic allocation to preference share (2M par x 10% x 3 years) 2. Basic allocation to ordinary shares (8M par x 10%)

360,000 1,440,000 1,800,000

1,800,000

600,000 800,000

Excess subject to participation (1.8M -600k-800k) 400,000 3. Participation of preference share (P400kx 2m /10m par) 80,000 4. Participation of ordinary share (400kx8m /10m par) 320,000 As allocated Notice that the ordinary shares are allocated only one year dividends regardless of dividends in arrears. Case 5: Cumulative and participating up to 16% The preference shares are cumulative and participating up to 16% Total dividends declared Allocation 1. Basic Allocation to preference shares (2mx10%x3yr) 2. Excess allocated to ordinary shares (1.8M x 10%) Excess subject to participation (1.8M-600K-800K) 3. Participation of preference share (16%-10%) x 2M par) 4. Excess allocated to ordinary shares (400k-120k) As allocated

1,800,000 600,000 800,000 400,000 120,000 280,000

When preference shares are participating only up to a certain percentage (i.e. partially participating), the participation is computed as the excess of the participation percentage over the fixed dividend rate multiplied by the aggregate par value of preference shares outstanding. The total dividends received by each class of shares are as follows: Preference shares: (600,000 basic+!20,000 participation Ordinary shares (800,000 basic +280,000 participation) Total dividends

720,000 1,080,000 1,800,000

In solving these types of problems, you have to look first on what type of preference share does the entity have. Once, you identify the type of preference, then proceed to allocation based on standard. It will be hard to allocate if you do not know the rule in allocation.

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From the illustration above kindly enumerate how does the problem arrived with the said solution and why? Case 1 Case 2 Case 3 Case 4 Case 5. Dividends recognized as expense Dividends declared on equity instruments are charged to retained earnings. However, dividends declared on financial liabilities, such as redeemable preference shares are charged to profit or loss as interest expense. The interest expense can be presented together or separately with interest expense account. Liquidating dividends Liquidating dividends are dividends are dividends declared out of capital rather than out of retained earnings. Liquidating dividends are normally declared only upon corporate liquidation. Disclosure of dividends Dividends declared and the related amount per share are disclosed either in the statement of changes in equity or in the notes. Events after the reporting period. Dividends declared after the reporting period but before the financial statements are authorized for issue are not recognized as a liability at the end of the reporting period because no obligation exists at that time. The dividends are disclosed only in the notes. Other components of Equity Other component of equity pertain to non-owner changes in equity which are required by standards to be directly recognized in equity rather than through a profit or loss. Examples include: a. revaluation surplus b. Cumulative unrealized gain/losses on fair value changes in investments in FVOCI equity securities c. Exchange differences on translating foreign operations d. Effective portion of cash flow hedges. Recapitalization Recapitalization refers to the change in the capital structure of an entity brought about by the cancellation of old shares and issuance of new shares as replacement. Recapitalization is accomplished through any of the following: a. Change from par to no-par of vice versa b. Reduction of par value or stated value c. Share splits or reverse splits Recapitalization does not affect assets, liabilities, or total shareholders equity.

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Take away in Recapitalization • Recapitalization is the restructuring of a company's debt and equity ratio. • The purpose of recapitalization is to stabilize a company's capital structure. • Some of the reasons a company may consider recapitalization include a drop in its share price, to defend against a hostile takeover, or bankruptcy.

Illustration 1: Change from par to no-par The shareholders’ equity of ABC Co. before capitalization is as follows: Share capital, P100 par, 10,000 shares 1,000,000 Share premium 200,000 Retained earnings 300,000 1,500,000 Case 1: ABC recalls and cancels the 10,000 shares and replaces them with 20,000 no par shares with stated value of P5 per share. Date Share capital 1,000,000 Share premium 200,000 Share capital (20,000 x P5) 100,000 Share premium – recapitalization 1,100,000 Case 2: ABC recalls and cancels the 10,000 shares and replaces them with 20,000 no par shares with stated value of P65 per shares. Date Share capital 1,000,000 Share premium 200,000 Retained earnings 100,000 Share capital (20,000 x P65) 1,300,000 What happen with these two cases? What happened to the balances of share capital, share premium, and retained earnings, what is that share premium recapitalization? Share split Share splits may be in the form of 1. Split up or share split 2. Split down or reverse share split Split up occurs when old share are cancelled and replaced by number of new shares but with a reduced par value (stated value) per share. Split down is the opposite of split up whereby old shares are cancelled and replaced by a smaller number of new shares but with an increased par value (stated value) per share.

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Share splits affect only the number of outstanding shares and par value per share. They do not affect assets, liabilities, equity, or the aggregate par value of issued shares. Share splits are recorded only through memo entry. Examples: Split up and Split down ABC Co. has 10,000 shares with par value per share of P100. Case 1: Split up ABC Co. declares a “2 for 1” share split The memo entry to record the split up is as follows Issued 20,000 shares with par value of P50 as a result of a “2 for 1” split of 10,000 old shares with par value of P100.

Case 2: Split down ABC declares a “1 for 2” reverse share split. The memo entry to record the split down is Issued 5,000 shares with par value of P200 as a result of a 1 for 2 reverse share split of 10,000 old shares with par value of P100. In both cases above, the aggregate par value of the shares before and after the share split is unaffected. Summary of the Lesson: • The relevant dates in the accounting for dividends are: (a) date of declaration, (b) date of record, and (c) date of distribution. Journal entries are made only on the dates of declaration and distribution • Only outstanding shares are entitled to dividends. Outstanding shares = Issued shares + Subscribed shares – Treasury shares • Stock dividend payable is an adjunct equity account, not a liability account • Treasury shares declared as dividends are accounted for at cost. • Noncumulative preference shares are entitled only to current-year dividends. Cumulative preference shares are entitled to dividends in arrears • Nonparticipating preference shares are entitled only to their basic dividends. After they are paid their basic dividends, any excess dividend is paid to the ordinary shareholders • Fully participating preference shares are entitled to a pro rata share with the ordinary shares, based on aggregate par values, after both the preference shares and ordinary shares receive their basic dividends. If there is more than one class of preference shares, the basic dividend of ordinary shareholders is computed using the lowest preference dividend rate. • The participation of partially participating preference shares is computed based on the excess of the participation rate over the fixed preference dividend rate. • Dividends are disclosed either on the statement of changes in equity or in the notes • Dividends declared after the end of reporting period are not recognized as liabilities current period.

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Enrichment Activity: 1. Acer Company had 11,000 shares issued and outstanding on January 1, 2020. On March 15, the entity declared a 2 for 1 share split when the fair value of share was ₱80. On December 15, the entity declared a ₱5 per share cash dividend. What amount should be reported as dividends? _______________________________________ Answer: 110,000 2. Clara Company, a real estate developer, is owned by five founding shareholders. On December 1, 2020, the entity declared a property dividend of a “one—bedroom flat” for each shareholder. The property dividend is payable in January 31, 2021. On December 1, 2020, the carrying amount of a one-bedroom flat is ₱1,100,000 and the fair value is ₱1,650,000. However, the fair value is ₱1,980,000 on December 31, 2020 and ₱2,090,000 on January 1, 2021. a. What is the dividend payable on December 1, 2020? _______________________________________ b. What is the dividend payable on December 31, 2020? _______________________________________ c. What amount of gain is included in profit or loss as a result of the settlement of the property dividend on January 31, 2020? _______________________________________ Answers: a. 9,900,000 b. 8,250,000 c. 4,950,000 3. On January 1, 2021, Jervi Company declared a cash dividend of ₱880,000 to shareholders of record on January 15, 2021 and payable on February 15, 2021. The entity reported the following information on December 31, 2020: Accumulated depletion Share capital Share premium Retained earnings

₱ 220,000 1,100,000 330,000 660,000

How much is the liquidating dividend? _______________________________________ Answer: 220,000 4. As the beginning of the accounting year 2020, Violet Company has machinery with a historical cost of ₱5,400,000 and accumulated depreciation of ₱1,800,000. On December 31, 2020, Violet Company decided the machinery as dividend which has a carrying amount at that time of ₱3,000,000. Violet’s policy is to measure all depreciable assets at cost. At the time of declaration, the equipment has a fair market value of ₱2,400,000. What total amount should Violet Company charge its Retained Earnings related to the machinery during 2020? _______________________________________ Answer: P 3,600,000

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Assessment Lesson 3 - RETAINED EARNINGS Name: ___________________________________________

Section: _____________ Score: __________

1. Ho Company issued 220,000 shares of ₱5 par value at ₱10 per share. On January 1, 2020 the retained earnings amounted to ₱3,300,000. In March 2020, the entity reacquired 55,000 treasury shares at ₱20 per share. In June 2020, the entity sold 11,000 of these shares to corporate officers for ₱25 per share. The entity used the cost method to record treasury shares. Net income for the year ended December 31, 2020 was ₱660,000. On December 31, 2020, what amount should be reported unappropriated retained earnings? _______________________________________ 2. Yash Company declared and distributed 10% stock dividend with fair value of ₱1,650,000 and par value of ₱1,100,00, and 25% stock dividend with fair value of ₱4,400,000 and par value of ₱3,850,000. What aggregate amount should be debited to retained earnings for the stock dividend? _______________________________________ 3. At the beginning of the current year, Romario Company had retained earnings of ₱4,400,000. During the year, the entity reported net income of ₱2,200,000, sold treasury shares at a “gain” of ₱792,000, declared a cash dividend of ₱1,320,000, and declared and issued a small share dividend of ₱66,000 shares with ₱10 par value when the fair value of the share was ₱20. What is the amount of retained earnings available for dividends at the end of the current year? _______________________________________ 4.

Filomero Company provided the following information on January 1, 2020:

Share capital, 275,000 shares authorized; 110,000 shares issued and outstanding Share premium Retained earnings

₱ 3,300,000 4,400,000 8,800,000

The entity declared a 10% dividend on April 1, 2020 when the market value of the share was ₱70. The stock dividend was issued on July 1, 2020 when the market value of the share was ₱100. The share has a par value of ₱30. The entity sustained a net loss of ₱1,320,000 for 2020. What amount should be reported as retained earnings on December 31, 2020? _______________________________________ 5. Jeremiah Company had the following classes of shares outstanding as of December 31, 2020. Ordinary shares, ₱20 par value, 22,000 outstanding; Preference shares, 6%, ₱100 par value, cumulative and fully participating, 1,100 shares were outstanding. The last payment of reference dividend was on December 31, 2018. On December 31, 2020, a total cash dividend of ₱99,000 was declared. What are the amounts of dividends payable on both the ordinary and preference shares? _______________________________________

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6. On October 31, 2020, Dylan Company declared its non-current asset (land) as a dividend with a carrying value of ₱2,600,000 and has a current fair value of ₱2,405,000. On December 31, 2020, the non-current asset has a fair value of ₱2,730,000. The non-current asset was distributed on March 31, 2021 when its fair value was ₱2,925,000. a. What amount should be charged to _______________________________________

retained

earnings

at

the

time

the

dividend

was

declared?

b. What amount of property dividends payable should the company disclose in their December 31, 2020 statement of financial position? _______________________________________ c. What amount of asset held for disposal should the company disclose in their December 31, 2020 statement of financial position? _______________________________________

7.

The following share dividends were declared and distributed by Ivy Company: % of Ordinary Share Outstanding

Market Value

10 25 How much should be debited to _______________________________________

Par Value

₱ 315,000 840,000 Retained

Earnings

₱ 210,000 630,000 at

the

time

of

declaration?

8. Hazel Company had 64,000 shares of ₱10 par value treasury shares. These shares were reacquired at a cost of ₱1,280,000. During the current year 2020, the company reissued 45,000 shares at ₱25 per share. Hazel Company used the cost method to account for treasury shares. At December 31, 2020, what amount should Hazel Company show in notes to financial statements as a restriction of retained earnings? _______________________________________

Suggested Links: www.investopedia.com References: Millan, Z.V. (2019). Intermediate Accounting 2 Valix,(2019). Intermediate Accounting 2 Uberita, (2013) Practical Accounting 1

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LEARNING MODULE INFORMATION I. Course Code II. Course Title

IA201 INTERMEDIATE ACCOUNTING 2

III. Module Number IV. Module Title

3 Earnings per share, Basic Earnings per share, Share based Compensation, Employees Benefit The course is all about the Liabilities, shareholder’s equity and other special topics in intermediate accounting II. Each topic of this module discusses the standards that govern the recognition of each account in liabilities and shareholder’s equity, there will be computations for illustrations, enrichment wherein you will be asked with problems and after that is the discussion of the problem. It is advised that if you are going to study this module focus on understanding the standards, the why and relationships of computation not just the how it is being computed.

V. Overview of the Module

VI. Module Outcomes

At the end of this module, the students should be able to: 1. Apply the financial accounting standards relative to the recognition, measurement, financial statement presentation, and disclosure requirements of liability and shareholders’ equity accounts in accordance with the Philippine Accounting Standards (PAS) and Philippine Financial reporting Standards (PFRS). 2. Compute Share Based Compensation 3. Apply the concept, types, and accounting for post-employment benefits 4. Compute book value and basic earnings per share for ordinary and various classes of preference shares for publicly traded and entries that are in the process of issuing ordinary shares in the public securities market.

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Lesson 1: BOOK VALUE PER SHARE Lesson Objectives: 1. Define book value per share 2. Compute for book value per share

Discussion and Application: Book value per share measures the amount each share would receive assuming the entity is liquidated and its assets are sold and its liabilities are settled exactly at the amounts reported on the statement of financial position. Where there is only one class of shares, the formula for the computation of book value per share is: Book value per share = Total shareholder’s equity Number of shares outstanding Book value per share is a method to calculate the per share book value of a company based on common shareholder’s equity in the company. The book value of a company is the difference between that company’s total asset and total liabilities, and not its share price in the market. Should the company dissolve, the book value per common share indicates the peso value remaining for common shareholders after all assets are liquidated and all debtors are paid. ✓ Book value per common share (BVPS) calculates the common stock per-share book value of a firm ✓ Since preferred stockholders have a higher claim on assets and earnings than a common shareholders, preferred equity is subtracted from shareholder’s equity to derive the equity available to common shareholders. ✓ If a company’s BVPS is higher than its market value per share, then its stock may be considered undervalued. In this lesson you will notice that you are not going to do have any journal entry, because the book value per share is usually computed once the balance sheet is already finished.

Where there are two or more classes of shares, the total shareholders’ equity is allocated to a class of shares divided by the number of outstanding shares in that class represents the book value per share of that class. The formula are as follows: Book value per share (Preference share)

= Preference shareholder’s equity Number of preference shares outstanding

Book value per share = Ordinary shareholders’ equity (ordinary shares) Number of ordinary shares outstanding When allocating total shareholders’ equity to the different classes of shares, the residual equity theory is applied. Under this theory, the ordinary shareholder’s equity is a residual amount after deducting preference shareholders’ equity from total shareholder’s equity. This is exemplified by the formula shown below.

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Total shareholders’ equity Less: Preference shareholders’ equity Ordinary shareholders’ equity

xx xx xx

Preference shareholder’s equity The following are guidelines when computing for preference shareholders’ equity. 1. Allocate to the preference shareholders’ equity their liquidation value. In the absence of liquidation value, allocate their aggregate par value. 2. If the preference shares are cumulative, allocate all dividends in arrears. 3. IF the preference shares are noncumulative, allocate the current year dividend only, if it is in arrear 4. If there are no dividends in arrears, no dividends shall be allocated to either cumulative or noncumulative preference shares. What if two shares are present in an entity, it says in the standard that the Book value per share for preference share and the book value per share for the common share shall be computed. How? Simply allocate the shareholder’s equity account to preference share and the book value per share through residual equity theory, this is done by deducting the preference shareholder’s equity from the total shareholder’s equity. The next question is how are you going to compute for preference shareholder’s equity? Read the rulings above. Next is compute for the outstanding shares, why are you going to compute for the outstanding shares? It is because this is necessary in computing for the book value per share, that will be your denominator. How are you going to compute for the outstanding shares? Please see below formula, take note that subscription receivable will not be deducted from here.

Outstanding shares Outstanding shares pertain to shares that are entitled to dividends. The number of outstanding shares is computed as follows: Number of shares issued xx Add: Number of shares subscribed xx Total xx Less: Number of treasury shares xx Number of shares outstanding xx Subscription receivable For purpose of book value per share computation, subscription receivable is not deducted from total shareholders’ equity. This is because in case of corporate liquidation, any unpaid subscription must be collected and used to settle the corporation’s obligations to outside creditors (trust fund doctrine) Illustration 1: One class of shares ABC Co.’s year-end shareholders’ equity consists of the following:

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Share capital, P10 par, 100,000 shares issued Subscribed share capital Share premium Subscription receivable Retained earnings Revaluation surplus Cumulative translation losses on foreign operation Treasury shares, at cost, 10,000 shares Total shareholders’ equity

1,000,000 500,000 370,000 (200,000) 660,000 140,000 (100,000) (70,000) 2,300,000

Requirement: Compute for the book value per share Solutions: The number of shares outstanding is computed as follows: Number of shares issued Number of shares subscribed (500,000/10 par) Total Number of treasury shares Number of shares outstanding

100,000 50,000 150,000 (10,000) 140,000

Book value per share = Total shareholders’ equity/ number of shares outstanding Book value per share = 2,500,000/140,000 Book value per share = 17.86 Subscription receivable is not deducted from the total shareholders’ equity used as numerator in the book value per share computation. The subscription receivable is simply added back, (i.e., computing for the total shareholders’ equity. Illustration 2: Two classes of shares – Cumulative preference share ABC Co.’s year-end shareholders’ equity consists of the following: Preference share, 10% cumulative, P100 par, 20,000 shares 2,000,000 Ordinary share, P10 par, 100,000 shares issued 1,000,000 Retained earnings 820,000 Total shareholder’s equity 3,820,000 Dividends are in arrears for three years. Requirement: Compute for the book value per share for each class of shares. Solutions: Total shareholders’ equity Preference shareholders’ equity: Aggregate par value 2,00,000 Dividends in arrears (2Mx10% x3years) 600,000 Ordinary shareholders’ equity

3,820,000

(2,600,000) 1,220,000

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Divide by: Number of ordinary shares outstanding Book value per share (Ordinary shares(

100,000 12.20

Book value per share ( PS) = Preference shareholders’ equity / Number of preference shares outstanding Book value per share (PS) = 2,600,000/20,000 Book value per share (PS) = 130 Illustration 3: Cumulative pref. sh. – with liquidation value ABC Co.’s year end shareholders’ equity consists of the following: Preference share, 10% cumulative, P100 par, 20,000 Shares, liquidation value of P120 per share Ordinary share, P10 par, 100,000 shares issued Retained earnings Total shareholder’s equity

2,000,000 1,000,000 820,000 3,820,000

Dividends in arrears for three years Requirement: Compute for the book value per share for ordinary shares. Solution: Total shareholders’ equity 3,820,000 Preference shareholders’ equity: Liquidation value (20,000 shares x P120)2,400,000 Dividends in arrears (2M x 10% x 3 yrs) 600,000 (3,000,000) Ordinary shareholders’ equity 820,000 Divide by: No. of ordinary shares outstanding 100,000 Book value per share (Ordinary shares) 8.20 Illustration 4: Non-cumulative preference shares ABC Co.’s year end shareholders’ equity consists of the following: Preference share, 10% noncumulative, P100 par, 20,000 shares Ordinary share, P10 par, 100,000 shares issued Retained earnings Total shareholders’ equity

2,000,000 1,000,000 820,000 3,820,000

Dividends are in arrears for three years. Requirement: Compute for the book value per share for ordinary shares. Solution: Total shareholders’ equity Preference shareholders’ equity Aggregate par value Dividend for current year only (2mx10%) Ordinary shareholders’ equity

3,820,000 2,000,000 200,000

(2,200,000) 1,620,000

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Divide by: NO. of ordinary shares outstanding Book value per share (Ordinary shares)

100,000 16.20

Illustration 5: No dividends in arrears ABC Co.’s year end shareholders’ equity consists of the following: Preference share, 10% noncumulative, P100 par , 20,000 shares Ordinary share, P10 par, 1000,000 shares issued Retained earnings Total shareholders’ equity

2,000,000 1,000,000 820,000 3,820,000

Preference dividends were paid up to year-end, thus, there are no dividends in arrears. Requirement: Compute for the book value per share for ordinary shares. Solution: Total shareholders’ equity Preference shareholders’ equity Aggregate par value Dividend Ordinary shareholders’ equity Divide by: No. of ordinary shares outstanding Book value per share (Ordinary shares)

3,820,000 2,000,000 -

(2,000,000 1,820,000 100,000 18.20

No dividends are allocated because there is no dividends in arrears. Participating preference shares When preference shares are participating, the excess of total shareholders’ equity over the allocated amounts to preference shares and ordinary shares is allocated to both participating preference shares and ordinary shres pro rata based on aggregate par values. The following are guidelines when preference shares are participating: 1. Allocate to preference shares their liquidation value or aggregate par value. If preference shares are cumulative, allocate all dividens in arrears. If preference shares are noncumulative, allocate current year dividend only, if it is in arrear. No dividends shall be allocated if there are no dividends in arrears. 2. The ordinary shares are allocated one year dividends by multiplying the aggregate par value of outstanding ordinary shares with preference dividend rate. If there is more than one type of preference shares, the lowest preference dividend rate shall be used. 3. The excess of total shareholder’s equity over the sum of (1)and (2) above are allocated to the participating preference shares and ordinary shares pro rata based on aggregate par values. Illustration1: Participating preference shares ABC Co.’s year – end shareholders’ equity consists of the following: Preference share, 10% cumulative, fully participating, 100 par, 20,000 shares

2,000,000

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Ordinary shares, P10 par, 100,000 shares issued Retained earnings Total shareholders’ equity

1,000,000 820,000 3,820,000

Dividends are in arrears for three years. Requirement: Compute for the book value per shar for each class of shares. 10% PS, cumulative, fully participating Total shareholders’ equity Allocation: Aggregate par values 2,000,000 Dividends PS (2Mx10%x3years) 600,000 OS (1MX10%) Balance for participation PS (120,000 X 2/3) 80,000 OS (120,000 X 1/3) Equity as allocated 2,680,000 Divide by: No. of shares outstanding 20,000 Book values of shares 134.00

Ordinary shares

Totals 3,820,000

1,000,000

3,000,000 600,000 100,000 120,000 80,000 40,000 -

100,000

40,000 1,140,000 100,000 11.40

The allocation ratios are based on the aggregate par values of the classes of shares of outstanding, i.e., “2/3 = P2M par value of preference shares over the total par values of preference and ordinary shares of P3m (2M+1M). Notice that the sum of the amounts allocated to the different classes of shares is equal to the total shareholders’ equity, i.e., PS P2,680,000 +OS P1,140,000-Total shareholders P3,820,000. Illustration 2: Participating PS – Two types of preference shares ABC Co.’s year-end shareholders’ equity consists of the following. 10% Preference share, cumulative, fully participating, P100 par, 20,000 shares 8% Preference shares, noncumulative, fully participating, P80 par, 2,500 shares Ordinary share, P10 par, 100,000 shares issued Retained earnings Total shareholders’ equity

2,000,000 200,000 1,000,000 820,000 4,020,000

Dividends are in arrears for three years. Requirement: Compute for the book values per share for each class of share. Solution 10% PS (C & FP) Total shareholders’ equity

8% PS (NC & FP)

Ordinary Shares

Totals

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Allocation: Aggregate par values Dividends 10% PS (2M x 10% x 3 yrs) 8% PS (200,000 x 8%) OS (1M x 8%) Balance for participation 10% PS (124,000 x/3.2) 8% PS (124,000 X .2/32) OS (124,000 x 1/32) Equity allocated Divide by: Outstanding share Book value per share

2,000,000

200,000

1,000,000

600,000

3,200,000 600,000

16,000 80,000

77,500

16,000 80,000 124,000

77,500 7,750

7,750

2,677,500 20,000

223,750 2,500

38,750 38,750 100,000

133.88

89.50

11.19

38,750

The lower preference dividend rate is used.

Please enumerate all your observations in all the illustrations Write down all the things that you learned.

Summary of the Lesson: • Book value per share = Equity / Number of outstanding shares • Subscription receivable is not deducted from total shareholder’s equity for purposes of book value per share computation • When there are two or more classes of share capital, the total shareholders’ equity is allocated to the various classes of shares using the residual equity theory, i.e., (Total SHE – preference SHE = Ordinary SHE • Preference shareholders’ equity is equal to the sum of the following a. Liquidation value or Aggregate par value b. All dividends in arrears for cumulative PS; 1-year dividend in arrear for noncumulative PS. If no dividends are in arrear, no dividends are allocated c. Amount of participation, if preference shares are participating • If preference shares are participating, ordinary shares are allocated 1-year dividends using the lowest preference dividend rate • The balance for participation is allocated to the various classes of shares pro rata based on aggregate par values.

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Enrichment Activity: 1. Leo Corporation’s current statement of financial position reports the following shareholders’ equity 5%, Cumulative preference share ₱100 par value per share, 8,000 shares issued and outstanding ₱800,000 Ordinary share, ₱10 par value, 80,000 shares issued and outstanding 800,000 Share premium 480,000 Retained earnings 1,120,000 Dividends in arrears on the preference share amount to ₱80,000. If Leo were to be liquidated, the preference shareholders would receive par value plus a premium of ₱10 per share. How much would be the book value per share on ordinary share? Answer: 28 per share 2. Thomas Company reported the following shareholders’ equity at year-end: 5% cumulative preference share capital, par value ₱100 per share, 32,500 shares issued and outstanding ₱3,250,000 Ordinary share capital, par value ₱35 per share; 130,000 shares issued and outstanding 4,550,000 Share premium 1,625,000 Retained earnings 3,900,000 Dividends in arrears on the preference share amounted to ₱325,000. If the entity were to be liquidated, the preference shareholders would receive par value plus a premium of ₱650,000. What is the book value per ordinary share? Answer: 70

3. Kayden Company had outstanding 90,000 8% preference shares with 100 par value and 225,000 30 par value ordinary shares. Dividends have been paid every except last year and the current year. The preference shares are cumulative and nonparticipating. The entity distributed ₱4,500,000 as dividend in the current year. What is the dividend payable to the ordinary shareholders? Answer: 3,060,000 4.

Stella Company provided following data at year-end: 2020 10% cumulative preference 3,200,000 shares, ₱50 par Ordinary shares, ₱10 par 4,000,000 Share premium 2,400,000 Retained earnings 7,680,000 Net income for the year 2,880,000

2019 3,200,000 3,200,000 2,080,000 6,720,000

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On July 1, 2020, 80,000 ordinary shares were issued. The preference dividends were paid in 2019 but not declared during 2020. The market price of the ordinary share was ₱50 on December 31, 2020. What is the book value per ordinary share for 2020? Answer: 34.0

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Assessment Lesson 1 - BOOK VALUE PER SHARE Name: ___________________________________________

1.

Section: _____________ Score: __________

The shareholders’ equity of Brielle Company shows the following balances on December 31, 2020: 10% Preference share, cumulative and nonparticipating, ₱100 par with a liquidation value of ₱110, 34,000 shares 3,400,000 Ordinary share, ₱100 par, 51,000 shares 5,100,000 Subscribed ordinary shares 1,700,000 Subscription receivable 1,020,000 Treasury share, 8,500 ordinary shares, at cost 680,000 Share premium 1,122,000 Retained earnings 2,686,000

What is the book value per share of ordinary shares, assuming preference dividends are in arrears since 2018? 2. Aaron Company had 9,000 shares ₱500 par value ordinary shares outstanding and 900 shares of ₱1,000 par preference shares outstanding. The current market price of the ordinary share is ₱1,200 per share and total shareholders’ equity amounts to ₱6,480,000. The preference shareholders have a liquidation of ₱1,400 per share and no dividends are in arrears. The book value per share of ordinary share is – 3. Scarlett Corporation has an authorized capital of 11,000 shares of ₱100 par. 8% cumulative preference share and 22,000 shares of ₱100 par ordinary share. The equity account balance at December 31, 2020 totaled ₱2,101,000 broken down as follows: Cumulative preference share capital, ₱550,0000; ordinary share capital, ₱1,210,000; share premium, ₱220,000; retained earnings, ₱286,000; and treasury shares, ordinary (1,100 shares at cost), (₱165,000). Dividends on preference share are in arrears for 2019 and 2020. How much would be the book value per share of ordinary share at December 31, 2020? Wyatt Corporation’s shareholders’ equity at December 1, 2020 is shown below: 6% non-cumulative preference share, ₱100 par (Liquidation value ₱105 per share) 1,200,000 Ordinary share, ₱100 par 3,600,000 Retained earnings 1,140,000 Preference dividends have been paid up to December 31, 2020. At December 31, 2020, how much is Wyatt’s book value per ordinary share? 4.

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5. Riley Company paid cash dividends of ₱840,000 and reported net income of ₱2,170,000. The ordinary shareholders’ equity at year-end was ₱7,000,000 and the entity had 280,000 ordinary shares outstanding. What is the book value per ordinary share? 6. Jacob Company provided the following shareholders’ equity on December 31, 2020: Cumulative preference share capital, ₱100 par, 8% ₱750,000 Ordinary share capital, ₱100 par 1,650,000 Share premium 300,000 Retained earnings 390,000 Treasury ordinary shares – 1,500 at cost (225,000) Dividends on preference shares are in arrears for 2019 and 2020. What is the book value of an ordinary share on December 31, 2020? 7. Jayden Company provided the following data on December 31, 2020: Preference share capital, 10% cumulative and nonparticipating, ₱100 par, 34,000 shares 3,400,000 Ordinary share capital, ₱100 par, 68,000 shares 6,800,000 Subscribed ordinary share capital, 34,000 shares 3,400,000 Subscription receivable 850,000 Share premium 1,700,000 Retained earnings 4,080,000 Treasury ordinary shares, 17,000 at cost 1,360,000 Dividends are in arrears for 3 years. What is the book value per ordinary share? 8. Vivian Company had outstanding 570,000 ordinary shares of ₱20 par and 114,000 preference shares no-par 8% with a stated value of ₱50. The preference shares are cumulative and nonparticipating. Dividends have been paid in every year except the past two years and the current year. The entity paid dividend of ₱950,000 in the current year. What is the dividend payable to the preference shareholders in the current year?

9. The directors of Levi Company wish to declare a dividend whereby ordinary shareholders are to receive a total per share dividend of ₱4. The equity on December 31, 2020 as follows: Preference share capital, ₱100 par, 7% participating up to 10% noncumulative, 110,000 shares authorized, 27,500 shares issued ₱2,750,000 Ordinary share capital, ₱25 par, 275,000 shares authorized and issued 6,875,000 Share premium 1,375,000 Retained earnings 5,500,000 What is the total amount of the dividend that must be declared to meet the per share goal of the board of directors?

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10. Ellie Company provided the following shareholders’ equity on December 31, 2020: Preference share capital, ₱100 par, 96,000 shares issued, 12% cumulative and fully participating 9,600,000 Ordinary share capital, ₱50 par, 240,000 shares issued 12,000,000 Share premium 6,000,000 Retained earnings 8,400,000 Dividends on the preference shares are in arrears for two years including the current year. On December 31, 2020, the entity intends to pay cash dividend of ₱10 per share to the ordinary shareholders. What is the total amount of dividends to be declared for the preference and ordinary shareholders?

Suggested Links: https://www.investopedia.com/terms/b/bookvaluepercommon.asp References: Millan, Z.V. (2019). Intermediate Accounting 2 Valix,(2019). Intermediate Accounting 2 Uberita, (2013) Practical Accounting 1

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Lesson 2: Earnings per Share Lesson Objective: 1. Compute for basic earnings per share Discussion and application: Earnings per share Earnings per share (EPS) is a computation made for ordinary shares. It is a form of profitability ratio which provides a measure of how much profit (loss) each ordinary share has earned (incurred) during the period. Normally, no EPS is computed for preference shares because they have a fixed return, as represented by their dividend rate. In some cases, however, EPS may be computed for preference shares when they are also entitled to a variable return in addition to their fixed return (e.g. participating preference shares). Such preference shares are considered special ordinary shares for the purposes of EPS computation. •

Ordinary share – is “an equity instrument that is subordinate to all other classes of equity instruments”. Ordinary shares participate in profit for the period after all other classes of shares (e.g. preference shares) have participated. An entity may have more than one type of ordinary shares often referred to as “alphabet shares.” For example an entity may have “Class A” and “Class B” ordinary shares. One class, called the “super voting shares,” has more voting rights than the other. One purpose of issuing “super voting” shares is to give key company insiders (e.g. founders and executives greater control over the company’s voting rights. This enables them to control corporate policies and management decisions.

•

Preference share – is one that has preference over other classes of shares, such as preference over dividends or preference over net assets in cases of liquidation, but typically does not have voting rights.

Uses of earnings per share. 1. EPS may be used to assess the value of an entity shares. It shows how much profit one share of the entity is producing. Obviously the higher this ratio is, the better, because the value of the share will increase. 2. EPS promotes comparability when measuring performances of different entities with different resources bases different capital structures and different nature of operations. 3. EPS provides a basis for dividend policy. The higher profit share is producing, the more likely that higher dividends will be declared on the share. Earnings per share is a computation for common shareholder’s of its capability to earn. Basic earnings per share (EPS) tells investors how much of a firm’s net income was allotted toe ach share of common stock. It is reported in a company’s income statement and is especially informative for businesses with only common stock in their capital structures.

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One of the first performance measures to check when analyzing a company’s financial health is its ability to turn a profit. Earnings per share (EPS) is the industry standard that investors rely on to see how well a company has done. Basic earnings per share is a rough measurement of the amount of company’s profit that can be allocated to one share of its common stock. As we proceed in discussion, you will notice that this is pure computation only no entries to consider. What are the other uses of EPS?

Types of Earnings per Share PAS 33 requires the following two presentations of EPS 1. Basic earnings per share 2. Diluted earnings per share If the entity does have a dilutive potential ordinary shares, it presents basic earnings per share only. Basic earnings per share Basic earnings is computed as follows Basic Eps – Profit (loss) less preferred dividends/ Weighted average number of outstanding ordinary shares. Earnings 1. Profit (loss) is net of income tax expense. It includes any exceptional, unusual or infrequent gains or losses. 2. Preferred dividends are deducted as follows: a. If the preference shares are cumulative, one year dividend is deducted, whether, declared or not. b. If the preference shares are non-cumulative, only the dividend declared during the period is deducted. Dividends in arrears (i.e. those pertaining to prior periods) are ignored in the computation of EPS. The numerator (or the difference between 1 and 2) represents the profit or loss attributable to ordinary shareholders. This amount is also adjusted for the following, which are treated like preferred dividends. a. Amortizations of discount or premium on increasing rate preference shares. Discount amortization is deducted from, while premium amortization is added to, profit or loss. b. Any gain or loss (that is recognized directly in retained earnings) arising from settling or repurchasing preference shares. Loss is deducted from, while gain is added to, profit or loss. c. In an induced or early conversion of convertible preference shares, the excess of fair value of ordinary shares or other additional consideration paid over the fair value of the ordinary shares issuable under the original conversion terms (‘loss’) is deducted from profit or loss. Conversely, a gain is added to profit or loss. Shares 3 The denominator is the weighted average number of shares outstanding. This is computed by applying a time-weighting factor to the number of ordinary shares at the beginning of the period and to all issuances and reacquisitions during the period.

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The time-weighting factor is the number of days that the shares are outstanding over the total number of days in the period. However, a reasonable approximation of the weighted average (e.g. months outstanding) is allowed. •

Outstanding shares that are entitled to participated in dividends. Outstanding shares are (1);issued shares plus (2) subscribed shares minus (3) treasury shares.

Shares are usually time-weighted from the date consideration is receivable (which is generally the date of their issue). Thus: a. Shares issued outright are averaged from the issuance date. b. Subscribed shares are averaged from the subscription date. c. Treasury shares are averaged i. as reduction to the number of outstanding shares from the reacquisition date; or ii. as addition to the number of outstanding shares from the reissuance date. d. Shares issued in a business combination are averaged from the acquisition date. Please answer the following questions 1. What is the formula in computing the EPS? 2. How are you going to compute for the Numerator? How about the denominator? Any special consideration in computing these? Illustration 1: Basic EPS – Cumulative preference shares. ABC Co. had the following capital structure during 20x1 and 20x2 Preference shares, P10 par, 6% cumulative, 50,000 shares Issued and outstanding Ordinary shares, P10 par, 200,000 shares issued and outstanding

P500,000 2,000,000

ABC reported profit after tax of P1,200,000 for the year ended December 31, 20x2. ABC paid no preferred dividends during 20x1 and paid P15,000 in preferred dividends during 20x2. Requirement: In its December 31, 20x2 statement of profit or loss, what amount should ABC report as basic earnings per share? Solution Basic EPS = Profit or loss less Preferred dividends / Weighted average number of outstanding shares Basic EPS = 1,200,000 – (500,000 X 6%) / 200,000 Basic EPS = (1,200,000 – 30,000) / 200,000 = 5,85 One- year dividend (whether declared or not) is deducted from profit or loss because the preference shares are cumulative. Illustration 2: Basic EPS – Non-cumulative preference shares. ABC Co. reported profit for the year amounting to P1,000,000. ABC Co. has the following equity instruments: a. 10,000, 10% cumulative preference shares issued and outstanding with par value of P100 per share.

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b. 20,000, 5% non-cumulative preference shares issued and outstanding with par value of P20 per share. c. 11,000 ordinary shares issued and outstanding with par value of P5 per share. ABC Co. declared the following dividends during the year: • P150,000 to cumulative preference shares ‘ • P25,000 to non-cumulative shares; and • P27,500 to ordinary shares Dividends in arrears on cumulative preference share as of the beginning of the year amounted to P200,000. There were no issuances or acquisitions of ordinary shares during the period. Requirement: Compute for the basic earnings per share for the period. Solution: Basic EPS = Profit or loss less Preferred dividends / Weighted average number of outstanding ordinary shares Basic EPS = 1,000,000-(10,000 x100x10%)-25,000 / 11,000 Basic EPS – (1,000,000-100,000-25,000)/11,000 = 79.55 Notes: Although the dividend declared on the cumulative preference shares is P150,000, only one-year dividend of P100,000 is deducted from profit or loss. For the non-cumulative preference shares, only the P25,000 dividend declared during the period is deducted from profit or loss ✓ Dividends in arrears are ignored for both cumulative and noncumulative preference shares. ✓ Dividends declared on ordinary shares are ignored because these dividends are properly considered as return to ordinary shareholders. Illustration 3: Profit or loss – Unusual and infrequent items During 20x1, ABC Co. had the following two classes of shares issued and outstanding for the entire year. 1,000 x 12%, preference shares, P100 par 100,000 100,000 ordinary shares, P10 par 1,000,000 ABC’s 20x1 income statement reported profit of P2,500,000. An expropriation loss of P200,000 had been deducted from the profit the year. ABC’s income tax rate is 30%. Requirement: 1. In computing for the basic earnings per share for 20x1, what amount of earnings should be used? 2. How much is the basic EPS for the year? Requirement (a): Profit or loss used for EPS computation Answer: P2,500,000 The reported profit is presumed to be already net of tax because the “bottom line” in an income statement is profit after tax. Unusual and infrequent losses or gains are appropriately included in the profit used for EPS computation.

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Requirement b: Basic EPS Basic EPS = Profit or loss less Preferred dividends / Weighted average number of outstanding ordinary shares Basic EPS = 2,500,000/100,000 =25 Unless otherwise stated, preference shares are presumed as noncumulative. Thus, no deduction is made on profit or loss for preferred dividend because no preferred dividends were declared during the year. Based on the illustrations above What are your key take away with this topic?

Summary of the Lesson: • If preference shares are cumulative, only one-year dividend is deducted, whether declared or not. If noncumulative, only the dividends declared are deducted

Enrichment Activity: 1. Leonardo Company had 650,000 ordinary shares issued and outstanding at December 31, 2019. During 2020, no additional ordinary shares was issued. On January 1, 2020, Leonardo issued 520,000 nonconvertible preference shares. During 2020, Leonardo declares and paid ₱234,000 cash dividends on the ordinary shares and ₱195,000 on the nonconvertible preference shares. Net income for the year ended December 31, 2020 was ₱1,248,000. What should be the 2020 earnings per ordinary share of Leonardo Company? _______________________________________ Answer: 1.62 2.

Victoria Company had the following capital structure during 2019 and 2020:

Preference shares capital, ₱10 par, 4% cumulative, 35,000 shares issued and outstanding Ordinary share capital, ₱5 par, 280,000 shares issued and outstanding

₱

350,000 1,400,000

The entity reported net income of ₱700,000 for the year ended December 31, 2020. The entity paid no preference dividends during 2019 and paid ₱22,400 in preference dividends during 2020. What amount should be reported as basic earnings per share? _______________________________________ Answer: P 2.45

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3. On January 1, 2020, Farafra Company had ordinary share capital outstanding of ₱100 par value, 340,000 shares or total par value of ₱34,000,000. On July 1, 2020, a bonus issue was made in the ratio of one additional ordinary share for each original share. The net income for 2020 was ₱20,400,000. What amount should be reported as basic earnings per share? _______________________________________ Answer: 30

4. Skull Company had one class of ordinary share capital outstanding and no other securities that are potentially convertible into ordinary shares. During 2020, 110,000 shares were outstanding. In 2021, on April 1, 22,000 shares of treasury were sold, and on July 1, a 2-for-1 share split was issued. Net income was ₱451,000 in 2021 and ₱385,000 in 2020. What amount should be reported as basic earnings per share in the comparative income statement? _______________________________________ Answer: 2021 1.78 2020 1.75

5.

Allmeg Company had the following transactions during the year:

1/1 2/1 3/1 7/1 12/31

Ordinary shares outstanding Issued a 10% stock dividend Issued ordinary shares in a “purchase” combination Issued ordinary shares for cash Ordinary shares outstanding

390,000 39,000 117,000 104,000 650,000

What is the weighted average number of shares outstanding? _______________________________________ Answer: 578,500

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Assessment Lesson 2 – BASIC EARNINGS PER SHARE Name: ___________________________________________

Section: _____________ Score: __________

1. Theodore Company had 168,000 of ordinary shares issued and outstanding at January 1, 2020. On January 2 of the same year, the company issued 112,000 preference shares. During the year, the company issued declared and paid ₱588,000 cash dividend on the ordinary shares and ₱336,000 on the preference shares. Net income for the year was ₱2,100,000. What should be the basic earnings per share on 2020? _______________________________________

2. On December 31, 2020 and 2019, Mason Company had 130,000 ordinary shares and 13,000 cumulative preference shares of 5%, ₱100 par value. No dividends were declared on either the preference or ordinary share in 2020 or 2019. Net income for the current year was ₱1,170,000. What amount should be reported as basic earnings per share? _______________________________________

3.

During 2020, Toko Company had the following two classes of share capital issued and outstanding for the entire year:

Ordinary share capital, 300,000 shares, ₱10 par Preference share capital, 3,000 shares, ₱100 par, 12% convertible share into ordinary share

₱ 3,000,000 300,000

The net income for 2020 was ₱2,700,000 and the income tax rate was 30%. In the computation of basic earnings per share, what is the amount to be used as earnings? _______________________________________

4. On January 1, 2020, Ideo Company had 320,000 ordinary shares and 160,000 4% ₱100 par value cumulative preference shares outstanding. No dividends were declared on either the preference or ordinary shares in 2019 or 2020. On February 10, 2021, prior to the issuance of the financial statements for the year ended December 31, 2020, the entity declared a 100% share split on ordinary shares. Net income for 2020 was ₱12,000,000. What amount should be reported as basic earnings per share? _______________________________________

5. Uholisia Company had 1,080,000 ordinary shares outstanding on January 1, 2020. During 2020, the entity issued rights to acquire one ordinary share at ₱10 in the ratio of one new share for every 4 shares outstanding. The market value of the ordinary share immediately prior to the rights issue is ₱35. The rights were exercised on October 1, 2020. The net income for the year is ₱15,390,000. What amount should be reported as basic earnings per share? _______________________________________

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6. Cindry Company had a profit after tax of ₱28,500,000 for 2020. The following appropriations have not been considered in this amount: Arrears of cumulative preference dividend for 2 years Ordinary dividends Preference share premium payable on redemption Exceptional profit, net of tax

₱ 7,600,000 9,500,000 1,900,000 7,600,000

The entity had 5,700,000 ordinary shares of ₱1 par value outstanding on January 1, 2020. The following share transactions occurred during the current year: Issued at ₱5 per share, ₱1 paid to date and entitled to participate in 475,000 dividends to the extent paid up April 1 Full market price ₱3 per share issue 1,140,000 July 1 Purchase of own shares at ₱3.50 per share 760,000 What amount should be reported as basic earnings per share? _______________________________________ Jan.

7.

1

Charlotte Company provided the following information in relation to share capital:

January 1, 2020 April 1, 2020 October 1, 2020 December 1, 2020

Shares outstanding Shares issued Treasury shares purchased Issued a 100% share dividend

1,500,000 240,000 120,000

What is the number of weighted average shares? _______________________________________ 8. Daisy Company had 350,000 ordinary shares outstanding on January 1, 2020. During 2020 and 2021, the following transactions took place. 2020

March 1 July 1 October 1 December 1

Sold 33,600 shares Issued a 20 percent stock dividend Sold 22,400 shares Purchased 21,000 shares to be held in treasury

2021

June 1 September 1

3 for 1 share split Sold 84,000 shares

a. What is the weighted average number of shares for 2020 to be used in the earnings per share computation for comparative financial statements at the end of 2021? _______________________________________ b. What is the weighted number of shares for 2021 used in the earnings per share computation for comparative financial statement at the end of 2021? _______________________________________

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Suggested Links: https://www.investopedia.com/terms/b/basic-earnings-per-share.asp

References: Millan, Z.V. (2019). Intermediate Accounting 2 Valix,(2019). Intermediate Accounting 2 Uberita, (2013) Practical Accounting 1

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Lesson 3: SHARE-BASED PAYMENTS (PART 1) EQUITY-SETTLED SHARE BASED-PAYMENT TRANSACTION

Lesson Objectives: 1. Define a share-based payment transaction 2. State the accounting methods applicable to share-based payment transactions with (a) non-employees and (b) employees 3. Account for share-based compensation plans Discussion and Application: A corporation may issue its own shares in exchange for noncash consideration, such as noncash assets or services. However, the Corporation Code of the Philippines prohibits the issuance of shares in exchange for promissory notes or future services. Meaning, the consideration must be received first, if in the form of services, the services must have been rendered first, before shares are issued. Furthermore, the value of the consideration received must not be less than the par value or issued value of the shares. Transactions involving the issuance of shares in exchange for noncash consideration are accounted for under PFRS 2. Share-based payment transactions Share-based payment transaction is a transaction in which the entity acquires goods or services and pays for them by issuing its own equity instruments or cash based on the value of its own equity instruments. A share based payment transaction can be: 1. Equity settled share-based payment transaction – one in which the entity receives goods or services and pays for them by issuing its shares of stocks or share options; or 2. Cash settled share-based payment transaction – one in which the entity receives goods or services and incurs an obligation to pay cash at an amount that is based on the fair value of its own equity instruments; or 3. Choice between equity settled and cash-settled – one in which the entity receives goods or services and either the entity or the counterparty is given a choice of settlement in the form of equity instruments or cash based on the fair value of equity instruments. Equity instrument is “ a contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. PFRS 2 applies to all entities, including subsidiaries using their parent’s or fellow subsidiary equity instruments as consideration for goods or services, and to all share based payment arrangements except the following: a. Transactions with owners (including employees who are also shareholders) acting in their capacity as owners, e.g. issuance of dividends, granting of stock rights in relation to an owner’s preemptive right and treasury share transactions. b. Business combinations (PFRS 3 Business Combinations) c. Issuance of shares as settlement of forward contracts, futures, and other derivatives instruments (PAS 32 and PFRS 9 Financial Instruments) Recognition

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Goods or services acquired in share-based payment transactions are recognized when the goods are received or as the services are received. Goods or services received that do not qualify as assets are recognized as expenses. The entity recognizes: a. a corresponding increase in equity if the goods or services are received in an equity-settled share based payment transaction, or a b. liability if the goods or services are acquired in a cash settled share-based payment transaction. Equity settled share-based payment transaction Goods or services received from equity settled share-based payment transactions with non-employees are measured at a fair value of the goods or services received, or if this is not determinable, at the fair value of the equity instruments granted. For transactions with employees and others providing similar services, the fair value of the services received is often not possible to estimate reliably. Accordingly, PFRS 2 requires those services to be measures at the fair value of the equity instruments granted, or if this is not determinable, at the intrinsic value of the entity’s shares of stocks. Equity-settled share-based payment transaction with Non-employees Order of priority in measurement 1. Fair value of goods or services received 2. Fair value of equity instruments granted.

Employees and others providing similar services Order of priority in measurement 1. Fair value of equity instruments granted 2. Intrinsic value

A share based payment is a mode of payment wherein instead of paying cash or other goods to the service provider or a supplier, the entity is going to pay a share as a payment to the service provider or supplier. Or another mode is, paying thru cash but the basis is the value of the share or combination of the share based payment or cash settled share based payment. The entry whenever an entity received goods or service is debited to services or goods (asset) or if that is not an asset debited to expense. The corresponding credit account for this entry if share based payment is increase in equity account or liability account if cash settled share based payment. The 3rd question is how much will be recognized as share based payment. Please see the above table for your guidance. Before we proceed to the illustration kindly answer the following question 1. Please explain the share based payment

Other terms to remember ✓ Equity Instrument granted is “ the right (conditional or unconditional) to an equity instrument of the entity conferred by the entity on another party under a share-based payment arrangement,” PFRS 2-Appendix A. ✓ Fair value is measured at the measurement date o For transactions with non-employees, the measurement date is the date when the entity receives the goods or services o For transactions with employees and others providing similar services, the measurement date is the grant date.

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✓ Grant date is the date at which the entity and the counterparty agree to, and have shared understanding of the terms and conditions of, a shared based payment arrangement. If the agreement is subject to further approval, grant date is the date when the approval is obtained. ✓ Intrinsic value is the difference between the fair value of the shares which the counterparty has the right to subscribe or receive and the subscription price (if any) that the counterparty is required to pay. For example, a share option with fair value of P50 and an exercise price of P30 has an intrinsic value of P20 (i.e. 50-30) Illustration 1: Measurement date – transaction/with non-employee On January 1, 20x1, ABC Co. agreed to issue 10,000 shares with par value per share of P100 to XYZ, Inc. in exchange for a building to be constructed by XYZ for ABC. Construction commenced during the year and the building was completed prior to year- end. Ownership over the newly constructed building was transferred to ABC Co. uses the cost model for its property, plant and equipment. The fair values of the newly constructed building were P1,500,000 on December 31, 20x1 and P1,600,000 on January 31, 20x2. The quoted prices of ABC’s share were P110 on December 31, 20x1 and P120 on January 31, 20x2. Requirement: Provide the journal entries on December 31, 20x1 and January 31, 20x2. Solution: Jan. 1, 20x1 Dec. 31, 20x1

Jan. 31, 20x2

No entry Building Subscribed capital (10k x P100) Share premium Subscribed capital Share capital

1,500,000 1,000,000 500,000 1,000,000 1,000,000

Please answer the following questions 1. Why the fair value of the building is being used, not the fair value of the share? 2. Why the fair value that is being used is the fair value on December 31, 20x1? Illustration 2: Measurement date – Transaction with employee On February 1, 20x1, ABC Co. offered its key employees share options that enable them to acquire ABC shares for P80. The shares are selling at P120. On February 5, 20x1, the key employees counter-offered an exercise price of P70 which was accepted by the board on February 6, 20x1. The share options were approved by the shareholders on general meeting on April 1, 20x1. The key employees received the share options on May 1, 20x1 and are to be exercised on before December 31, 20x1. Question: At which date should the fair value of the share options be valued for the purposes of PFRS 2? Answer: April 1, 20x1. For the transaction with employees (and others providing similar services), the equity instruments granted are measured on grant date. The grant date is the date at which all the parties involved have shared understanding of the terms and conditions of the arrangement and such understanding has received the necessary approval.

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Share-based compensation plans Share-based compensation plan is an arrangement whereby, in exchange for services, an employee is compensated in the form of (or based on) the entity’s equity instrument. Example of share-based compensation: a. Employee share options (equity settled) b. Employee share appreciation rights (Cash settled) c. Compensation plans with a choice of settlement between (a) and (b) above. Share based compensation are given to the key employees of the company to encourage the employees to stay longer in the company and for them to be motivated to do their best because they are not just employees but they will be coowner of the company. Employee share option plans Share option is a “contract that gives the holder the right, but not the obligation, to subscribe to the entity’s shares at a fixed or determinable price for a specified period of time. Some share options given to employees do not require any subscription price, meaning the shares will be issued solely in exchange for employee services. This means that if they were given the share option plan, they will have an opportunity to buy the company’s share at a certain price lower than the fair value within a certain period. In this case, the employee shall have a fund also to buy the share. Measurement of compensation Employee share option plans are equity-settled share-based payment transactions with employees. Accordingly, the services received are measured using the following in order of priority: 1. fair value of equity instruments granted at grant date 2. Intrinsic value The compensation expense (salaries expense) on the employee share option plan is recognized as follows 1. If the share options granted vest immediately, meaning the employee is entitled to the shares without the need to satisfy any condition, salaries expense is recognized in full, with a corresponding increase in equity at grant date. 2. If the share options granted do not vest until the employee completes a specified period of service, the entity recognizes salaries expense as the employee renders service over the vesting period. ✓ The vesting period is “the period during which all specified vesting conditions of a share-based payment arrangement are to be satisfied. ✓ In the absence of the evidence to the contrary, it is presumed that share options vest immediately. Before we proceed with the illustrations, you must understand first what will be the basis in measuring compensation expense and since it is the employee who will receive the compensation, the initial basis is the fair value of the equity instrument at the grant date in the absence of this, you must record the equity instrument based on the intrinsic value.

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Second is how much are you going to record as compensation for a certain period. It says that you are going to recognize a compensation depending on whether it is going to vest immediately or it will not vest immediately. What is the meaning of vesting immediately? This means that there is no condition or period to satisfy in availing the share. In here the salaries expense are recorded in full What is the meaning of vesting condition or period? This means that there are condition or period to satisfy to avail the share. Like the employee must serve a certain number of year, or must achieve a certain profit percentage etc. In here the salaries expense is recognized as the employee renders service over a vesting period.

Please answer the following questions 1. What is the share based compensation plan? Why is it given to the employee? 2. How are you going to recognize the share based compensation plan? 3. What is your entry in recognizing this? Illustration: On January 1, 20x1, Entity A grants 10,000 share options to its key employees. The share options entitle the employees to purchase Entity A’s shares at a subscription price of P110 per share. Entity A’s shares have a par value P100 per share and fair value on grant date of P120 per share. The share options have fair value of P15 per share option. Case 1: Share options vest immediately If the share options vest immediately, Entity A will recognize salaries expense of P150,000 (10,000 share options x P15 fair value per share option) on January 1, 20x1. Jan. 1, 20x1

Salaries expense (10,000 x 15) Share premium – Share option outstanding

150,000 150,000

The fair value of the share options is recognized as compensation expense at grant date because the share options vest immediately. The fair value of the shares is ignored. ➢ The key employees exercised the share options on July 1, 20x1. July. 1, 20x1

July 1, 20x1

Cash (10,000 x 110) Share capital(10,000 x 100) Share premium Share premium – Share option outstanding Share premium

1,100,000 1,000,000 100,000 150,000 150,000

✓ Notice that on the exercise date, the share option outstanding is transferred to share premium. This procedure will be done if the share premium was not exercise and the share premium expired. Case 2: Share options do not vest immediately

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If the share options vest in 3 years, Entity A recognizes salaries expense over the 3-year vesting period as follows: Dec. 31, 20x1

Total share options expected to vest Multiply by: Fair value per share option at grant date Fair value of share options at grant date Multiply by: Vesting period passed over total vesting period Cumulative salaries expense to date Less: Salaries expense recognized in previous periods Salaries expense 20x1

10,000 15 150,000 1yr/3yrs 50,000 50,000

Dec. 31, 20x2

Total share options expected to vest Multiply by: Fair value per share option at grant date Fair value of share options at grant date Multiply by: Vesting period passed over total vesting period Cumulative salaries expense to date Less: Salaries expense recognized in previous periods Salaries expense 20x2

10,000 15 150,000 2yr/3yrs 100,000 (50,000) 50,000

Dec. 31, 20x3

Total share options expected to vest Multiply by: Fair value per share option at grant date Fair value of share options at grant date Multiply by: Vesting period passed over total vesting period Cumulative salaries expense to date Less: Salaries expense recognized in previous periods Salaries expense 20x3 ✓ No salaries is being recorded on grant date, since no service is being granted on that time.

Jan. 1, 20x1

Dec. 31, 20x1 Dec. 31, 20x2 Dec. 31, 20x3

10,000 15 150,000 3yr/3yrs 150,000 100,000 50,000

Memo entry “Granted 10,000 share options to 1 key employees on Jan. 1, 20x1. Fair value per share option on Jan. 1 20x1 is P15” Salaries expense – share options 50,000 Share premium -share options outstanding 50,000 Salaries expense – share options 50,000 Share premium -share options outstanding 50,000 Salaries expense – share options 50,000 Share premium -share options outstanding 50,000

With the illustrations above 1. What is your learnings? 2. What is the entry for share premium – share options outstanding stands for? Vesting condition

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Vesting condition is “a condition that determines whether the entity receives the services that entitle the counterparty to receive cash, other assets or equity instruments of the entity under a share-based payment arrangement. A vesting condition is either a service condition or a performance condition. a. Service condition – a condition that requires the employee to render service over a specified period of time in order to be entitled to receive or subscribe to the shares embodied in the share options b. Performance condition – a condition that requires i. the employee to render service over a specified period of time (i.e. service condition); and ii. specified performance target(s) to be met while the employee is rendering the required service. Examples of performance targets: a. achieving a specified growth profit b. attainment of specified increase in the entity’s share price Vesting conditions can also be classified as market and non-market conditions a. Market condition – a performance condition that is related to the market price of the entity’s shares (e.g. attainment of a specified increase in the entity’s share price) b. Non-market condition – a condition other than a market condition (e.g. service condition and achieving, a specified growth in profit) Market conditions are taken into account when estimating the fair value of the shares or share options at the measurement date. Fair value estimates are not be subsequently revised irrespective of the outcome. With this, even if the market condition is not being achieved and the condition is not being met the entity still needs to recognize compensation expense. Non-market conditions are taken into account when estimating the number of equity instruments that are expected to vest. The estimate is subsequently revised in light of new information. Changes in estimates are accounted for prospectively, meaning the compensation expenses recognized in previous years are not restated. Type of condition Non-market condition Market condition

Example Remaining in employ Increase in share price

Non-attainment of vesting condition Discontinue recognizing further compensation expense for the employee who resigned. Ignored, continue to recognize compensation expense for the equity instrument granted.

Please answer the following questions 1. What is the vesting condition? 2. Give examples of vesting conditions and explain. 3. How important is the vesting condition in recognizing compensation expense? Illustration 1: Changes in Service Condition On January 1, 20x1, Entity A grants 100 share options to each of its 100 key employees conditional upon each employee remaining in Entity A’s employ over the next 3 years. The fair value of each share option is P15.

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On the basis of a weighted average probability, Entity A estimates on January 1, 20x1 that about 20 employees (i.e., 20% or 20 out of the 100 employees) will leave during the three year period and therefore forfeit their rights to the share options. During 20x1, 7 employees left. Entity A revises its estimates to a total of 25% employee departure over the vesting period. During 20x2, 9 employees left. Entity A revises its estimates to a total of 28% employee departure over the vesting period. During 20x3, 8 employees left. Therefore the actual employee departure over the past three years is 24% ((7+8+9)/100)) ❖ The entity A recognizes salaries expense over the vesting period as follows: Date Jan. 1, 20x1 Dec. 31, 20x1 Dec. 31, 20x2 Dec. 31, 20x3

Salaries expense (10,000 x75%) x 15 x 1/3 ((10,000 x 72%)x15x2/3)-37,500 ((10,000x76%)x15x3/3)-37,500-34,500))

37,500 34,500 42,000

10,000 total share options granted = 100 employees x 100 share options Journal entries Jan. 1, 20x1 Dec. 31, 20x1 Dec. 31, 20x2 Dec. 31, 20x3

Memo entry Salaries expense – share options Share premium – share options outstanding Salaries expense – share options Share premium – share options outstanding Salaries expense – share options Share premium – share options outstanding

37,500 37,500 34,500 34,500 42,000 42,000

Please answer the following questions 1. What did you notice with the formula? 2. Where does the 75% coming from? 3. Why the Jan. 1, 20x1 estimate is not being considered? Illustration: Performance condition – exercise price varies On January 1, 20x1, ABC Co. grants to a senior executive 10,000 share options, conditional upon the executive’s remaining in the entity’s employ until the end of 20x3. The exercise price is over P40. However, the exercise price drops to P30 if earnings increase by at least an average of 10% per year over the three year period. On grant date, ABC estimates the following: a. If the exercise price is P30, the fair value of the share options is P15 per option. b. If the exercise price is P40, the fair value of the share options is P13 per option

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During 20x1, earning increased by 12%, and ABC expects that earnings will continue to increase at this rate over the next two years. ABC therefore expects that the earnings target will be achieved, and hence the share options will have an exercise price of P30. During 20x2, the entity’s earnings increased by 13%, and ABC continues to expect that the earnings target will be achieved. During 20x3, the entity’s earnings increased by only 3%, and therefore the earnings target was not achieved. The executive completes three year’s service, and therefore satisfies the service condition. Since, the earnings target was not achieved, the 10,000 vested share options have an exercise price of P40. Entries Jan. 1, 20x1 Dec. 31, 20x1

Dec. 31, 20x2

Dec. 31, 20x3

Memo entry Salaries expense – share options (10,000 x P15 x 1/3) Share premium – share options outstanding Salaries expense – share options ((10,000 x 15 x 2/3)-50,000) Share premium – share options outstanding Salaries expense – share options ((10,000 x13 x3/3)-100,000)) Share premium – share options outstanding

50,000 50,000 50,000 50,000 30,000 30,000

Based on the illustration above, 1. State why the amount of the salaries expense is being computed as follows?

Summary of the Lesson: • A share-based payment transaction is either: (a) equity settled, (b) cash settled, or (c) provides a choice of settlement between (a) and (b) • A share-based transaction with non-employee is measured using the following order of priority 1. fair value of the goods or services received 2. Fair value of the equity instrument granted • A share-based payment transaction with an employee or others providing similar services is measured using the following order of priority 1. Fair value of the equity instrument granted 2. Intrinsic value • Measurement date is the date at which the fair value of the equity instruments granted is measured: a. For transactions with non-employees, the measurement date is the date the goods or services are obtained b. For transactions with employees and others providing similar services, the measurement date is the grant date. • The compensation expense on share based compensation plans are recognized a. In full at grant date if they vest immediately; or b. over the vesting period if there are vesting conditions

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Enrichment Activity: 1. Kaku Company granted 19,000 share options to each of its five directors on January 1, 2020. The options vest on January 1, 2025. The fair value of each option on January 1, 2020 is ₱50 and it is anticipated that all of the share options will vest on January 1, 2025. What amount should be reported as increase in expense and equity for the year ended December 31, 2020? ___________________________________ Answer: P 1,187,500

2. On January 1, 2020, Raizo Company granted share options to certain key employees as additional compensation. The options were for 170,000 ordinary shares of ₱10 par value at an option price of ₱15 per share. Market price of this share on January 1, 2020 was ₱20. The fair value of each share option on January 1, 2020 is ₱8. The options were exercisable beginning January 1, 2020 and expire on December 31, 2020. On April 1, 2020, all share options were exercised. What amount of compensation expense should be reported in 2020? ___________________________________ Answer: P 1,360,000

3. On January 1, 2020, Boa Company granted Hancock, the president, compensatory share options to buy 13,000 ordinary shares of ₱10 par value. The options call for a price of ₱ per share and are exercisable in 3 years following the grant date. Hancock exercised the options on December 31, 2020. The market price of the share was ₱60 on January 1, 2020, and ₱70 on December 31, 2020. The fair value of the share option is ₱30 on the date grant. What is the net increase in shareholders’ equity as a result of the grant and exercise of the options? ___________________________________ Answer: P 260,000

4. Fighting Bull Company issued fully paid shares to 260 employees on December 31, 2020. Normally, shares issued to employees vest over a two-year period but these shares have been givens as a bonus to the employees because of their exceptional performance during the year. The shares have a market value of ₱650,000 on December 31, 2020 and an average of ₱780,000 for the year. What amount should be expensed for this share-based payment transaction? ___________________________________ Answer: P 650,000

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Assessment Lesson 3 - SHARE BASED COMPENSATION – EQUITY SETTLED SHARE BASED PAYMENT TRANSACTION Name: ___________________________________________ Section: _____________ Score: __________

1. In connection with a share option plan for the benefit of key employees, Daisy Company intends to distribute treasury shares when the options are exercised. These shares were bought in 2019 at ₱42 per share. On January 1, 2020, the entity granted share options of 180,000 shares at an option price of ₱38 per share as additional compensation for service to be rendered over the next three years. The options are exercisable during a 2-year period beginning January 1, 2023, by grantee still employed by the entity. Market price of share was ₱47 at the grant date. The fair value of the share option is ₱12 on grant date. No share options were terminated during 2020. What amount should be reported as compensation expense for 2020? ___________________________________ 2. On June 30, 2020, Kikyo Company granted compensatory share options for 48,000 ₱20 par value ordinary shares to certain key employees. The market price of the share on that date was ₱36 and the option price was ₱30. The Black-Scholes option pricing model measured the total compensation expense to be ₱8,100,000. The options are exercisable beginning January 1, 2023, provided the key employees are still in entity’s employ at the time the options are exercised. The options expire on June 30, 2024. On January 15, 2023, when the market price of the share was ₱42, all 48,000 options were exercised. What is the compensation expense for 2022? ___________________________________ 3. On January 1, 2020, Garp Company granted an employee an option to buy 28,000 shares for ₱40 per share, the option exercisable for three years from January 1, 2022. Using a fair value option pricing model, total compensation expense is determined to be ₱336,000. The employee exercised the option on September 1, 2022, and sold the 28,000 shares on December 1, 2022. The service period is for two years beginning January 1, 2020. What amount should be recognized as compensation expense for 2020? ___________________________________

4. On January 1, 2020, Pascia Company granted 120 share options each to 500 employees, conditional upon the employee’s remaining in the entity’s employ during the vesting period. The share options vest at the end of a three-year period. On grant date, each share option has a fair value of ₱30. The par value per share is ₱100 and the option price is ₱120. On December 31, 2021, 30 employees have left and it is expected that on the basis of a weighted average probability, a further 30 employees will leave before the end of the three-year period. On December 31, 2022, only 20 employees actually left and all of the share options are exercised on such date. What is the compensation expense for 2022? ___________________________________ 5. On January 1, 2020, Baxcon Company granted to a senior executive 33,000 share options, conditional upon the executive’s remaining in the entity’s employ until December 31, 2022. The par value per share is ₱50. The exercise price is ₱100. However, the exercise price drops to ₱80 if the entity’s earnings increase by at least an average of 10% per year over the three-year period. On grant date, the entity estimated that the fair value of the share option is ₱30 if the exercise price is ₱80. If the exercise price is ₱100, the fair value of the share option is ₱25. During 2020 and 2021, the earnings increased

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by 11% and 12% respectively. However, during 2022, the earnings increased only by 4%. What amount should be recognized as compensation expense in 2022? ___________________________________

6. On January 1, 2020, Kamijiro Company granted share options to each of the 360 employees working in the sales department. The share options vest at the end of a three-year period provided that the employees remain in the entity’s employ and provided the volume of sales will increase by more than 10% per year. The fair value of each share option on grant date is ₱30. If the sales increase by more than 10%, each employee will receive 240 share options. If the sales increase by more than 15%, each employee will receive 360 share options. On December 31, 2020, the sales increased by more than 10% but not more than 15%, and no employees have left the entity. On December 31, 2021, sales increased by more than 15% and no employees have left. On December 31, 2022, the sales increased by more than 15% and 50 employees left the entity. What amount should be recognized as compensation expense for 2022? ___________________________________

7. Mr. 10 Company, an unlisted entity, decided to issue 1,400 share options to an employee in lieu of many years/ service. However, the fair value of the share options cannot be reliably measured as the entity operates in a highly specialized market where there are no comparable entities. The exercise price is ₱100 per share and the options were granted on January 1, 2020 when the value of the shares was also estimated at ₱100 per share. On December 31, 2020, the value of the shares was estimated at ₱150 per share and the options vested on that date. What value should be placed on the same options issued for the year ended December 31, 2020? ___________________________________ 8. The employee stock purchase plan of Bogard Company specifies that for every ₱100 withheld from employee’s wages for the purchase of Bogard’s ordinary shares, Bogard Company contributes ₱300. The stock is purchased from Bogard’s treasury shares at market price on the date of purchase. The following information pertains to the plan’s 2020 transactions: Employee withholding for the year Market value of 225,000 shares issued Carrying amount of treasury shares issued What amount should be recognized as ___________________________________

525,000 1,575,000 1,350,000 expense

in

2020

in

relation

to

the

stock

purchase

plan?

References: Millan, Z.V. (2019). Intermediate Accounting 2 Valix,(2019). Intermediate Accounting Uberita, (2013) Practical Accounting 1

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Lesson 4: EMPLOYEE BENEFITS – Accounting for short term employee benefits and Defined Contribution plans Related standards: PAS 19 Employee Benefits PAS 26 Accounting and Reporting by Retirement Benefits Plans Lesson Objectives: 1. Differentiate the four classifications of employee benefits under PAS 19 2. State the timing of recognition of employee benefits 3. Differentiate between a defined contribution plan and defined benefit plan 4. Account for defined contribution plan

Discussion and Application Employee Benefits Employee benefits are “all forms of consideration given by an entity in exchange for service rendered by employees or for the termination of employment (PAS 19.8) Employee benefits can be in any form, i.e. cash, goods or services, and may be provided to either the employees or their dependents. Employees include all employees whether regular, part time or casual and regardless of position in the entity, i.e. rankand-file, director or other management personnel. Recognition Employee benefits are recognized as expense when employees have rendered service, except to the extent that the employee benefits from part of the cost of another asset (e.g., salaries of factory workers are included in the cost of inventories) Employee benefits already earned by employees but not yet paid are recognized as liabilities. Employee benefits may arise from contractual agreements (e.g., employment contracts), legislation (e.g. Social Security System “SSS” contributions) or informal practices that create constructive obligations. Four categories of employees benefits under PAS 19 a. Short-term employee benefits b. Post-employment benefits. c. Other long-term employee benefits d. Termination benefits. Short term employee benefits Short term employee benefits are those that are due to be settled within 12 months after the end of the period in which the employees have rendered the related services. Examples include:

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a. b. c. d.

Salaries, wages, and SSS, Philhealth and Pag-ibig contributions Paid vacation leaves and sick leaves Profit-sharing bonuses Non-monetary benefits (e.g., free goods or services

Please answer the following questions 1. Based on what you read above what is an employee’s benefit? 2. What is the account title that is related to employees benefit? 3. How are you going to recognize employees benefits? 4. There are four categories of employees benefit. Can you enumerate them and explain each 5. What is a short term employee benefits? Who among your families/friends or relatives experience this type of benefits? 6. What is the accounting requirements for a short term employee benefits?

General accounting requirements The accounting for short-term employee benefits is relatively simple, in the sense that actuarial valuations and discounting are not necessary in measuring the cost. The benefits are recognized as expense (or as part of the cost of another asset) after the employee has rendered service and becomes entitled to payment. An accrued liability is recognized if the benefits are unpaid. A prepaid asset is recognized if there is excess payment. Short term employee benefits are recognized periodically, e.g. salaries are usually paid every 15th and 30th of the month. Illustration: ABC Co. pays salaries twice a month and does not pay salaries in advance. Employees work five days a week and compensation are computed on these working days. In December 20x1, ABC Co. paid the second semi-monthly salaries on December 26 which falls on a Friday. The next non-working holiday is on New Year’s Day. ABC has 100 employees who earn P1,000 per day. ABC’s cost accountant identified that 70% of salaries incurred pertain to the production of goods. Requirement: How much is the accrued salaries as of December 31, 20x1? Solution: Working days after last salary payment (Dec. 29, 30, 31)* Multiply by: Number of employees Total working days Multiply by: Average pay per day Accrued Salaries – December 31, 20x1 • December 27 and 28 shall fall on weekend The entry to record the accrued salaries is as follows: Dec. 31, 20x1 Direct labor (300,000 x 70%) Salaries expense (300,000 x 30%) Accrued salaries payable

3 100 300 1,000 100,000

210,000 90,000 300,000

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1. What is accrued salaries payable? 2. How does the illustration came up with the amount of accrued salaries payable?

Short-term paid absences Short-term paid absences include vacation, holiday (e.g., regular and nonworking holidays), maternity, paternity and sick leaves. Entitlement to paid absences may be either. a. Accumulating – Those that can be carried forward and used in future periods if not used in the current period. Accumulating paid absences may be either: i. Vesting – unused entitlement are paid in cash when the employee leaves the entity (i.e. monetized) ii. Non-vesting – unused entitlement are not monetized. b. Non-accumulating – Those that expire if not used in the current period and are not paid in cash when the employee leaves the entity. Compensated absences are recognized as follows: a. Accumulating and vesting - all unused entitlements are accrued and measured at their expected settlement amount. b. Accumulating and non-vesting – unused entitlements are accrued but taking into account the possibility that the employees may leave before they use those entitlements. c. Non-accumulating – unused entitlements are not accrued but recognized only when the absences occur. An employee can be prone to sickness, wanted to have some travel goals, or if you are a woman and you got pregnant or if you are a soon to be father you might get a paternity leave, in all these cases, you will be absent from your work, this is aside from regular holidays and non-working holidays. In this case this is being categorized as short term paid absences. Paid absences means that the company will still pay you even if you are not working in the office. There are companies who are giving benefits following the minimum standard of the law. Other companies are offering more than what is the minimum standard. In any case there is a proper accounting for that. From the discussion above, kindly discuss what is the meaning of accumulating and non-accumulating? What are the difference among accumulating and vesting, accumulating and non-vesting and non-accumulating? Illustration 1: Vesting vs. Non-vesting ABC Co.’s employees are entitled to 12 days paid vacation leave per year. Employees are require to take a vacation leave each year, but not necessarily for the full entitlement. Unused vacation leaves can be carried over indefinitely. ABC has 500 employees with an average salary of P1,000 per day. The average salary increase is 5% per year. During 20x1, employees took total vacation leaves of 5,400 days. Based on past experience, 90% of unused vacation leaves in a year are taken in the immediately following year. Case 1: Unused vacation leaves vest. How much is the accrued liability on December 31, 20x1? Solution:

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Total entitlement in 20x1 (500 employees x 12 days each) Less: Vacation leaves taken in 20x1 Unused vacation leaves carried over indefinitely Multiply by: Expected pay rate in 20x2 (P1,000 x 105%) Liability for unused vacation leaves December 31, 20x1 Salaries expense Accrued salaries payable

6,000 (5,400) 600 1,050 630,000

630,000 630,000

Case 2: Unused vacation leaves do not vest. How much is the accrued liability on December 31, 20x1? Solution: Total entitlement in 20x1 (500 employees x 12 days each) Less: Vacation leaves taken in 20x1 Unused vacation leaves carried over indefinitely Multiply by: Estimated vacation leaves to be taken in 20x2 Multiply by: Expected pay rate in 20x2 (1,000 x105) Liability for unused vacation leaves Dec. 31, 20x1

Salaries expense Accrued salaries payable

6,000 (5,400) 600 90% 540 1,050 630,000 567,000 567,000

In case 1 all the unused vacation leave are accrued because they are accumulating and vesting, meaning even if not taken, the leaves will eventually be paid in cash when the employee resigns or retires. In Case 2, only the unused vacation leaves expected to be taken are accrued because they are accumulating and nonvesting. If not taken, ABC Co. has no obligation to convert the leaves into cash. If in case the vacation leaves are non-accumulating, only the leaves actually taken during the year are recognized. Any unused leave is forfeited and therefore none is accrued. Please answer the following questions 1. What did you notice with the computation in the illustrations? 2. How the standards are being applied in recording?

Profit sharing and bonus plans Profit sharing and bonuses are additional incentives given to employees for a variety of reasons - the most obvious is to motivate the employees to be more productive. Profit sharing and bonuses are recognized when (a) ;the entity has a present obligation to pay for them and j(b) the cost can be measured reliably. Examples of bonus schemes: a. Bonus before bonus and before tax. b. Bonus after bonus and before tax

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c. Bonus before bonus and after tax d. Bonus after bonus and after tax 1. Bonus before bonus and before tax – the bonus is computed as a percentage of the profit before deducting the bonus and the income tax expense. The formula is: B=P x Br Where: B = bonus P= profit before deducting the bonus and the income tax expense Br = bonus rate or bonus percentage 2. Bonus after bonus and before tax – the bonus is computed as a percentage of the profit after deducting the bonus but before deducting income tax expense. The formula is B=P – (P/1+Br) 3. Bonus before bonus and after tax – The bonus is computed as a percentage of the profit before deducting the bonus but after deducting income tax expense. The formula is: B = Px 1 - Tr 1/Br-Tr Where Tr = Tax rate 4. Bonus after bonus and after tax – bonus is computed as a percentage of the profit after deducting the bonus and the income tax expense. The formula is B = P x 1 – Tr_____ 1/Br – Tr + 1 Illustration 1: Bonus Computation ABC Co. grants its managerial employees bonus in the form of profit sharing. Information on operations in 20x1 is shown below: Profit before tax Bonus rate or percentage Income tax rate

P1,000,000 10% 30%

Scheme # 1 Bonus before bonus and before tax B = P x Br B = 1,000,000 x 10% B = 100,000 Scheme # 2 Bonus after bonus and before tax B = P – (P / 1 +Br) B = 1,000,000 – (1,000,000 /1+10%) B = 1,000,000 – 909,091 B = 90,909 Scheme #3: Bonus before bonus and after tax

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B = Px 1 - Tr 1/Br-Tr B = 1,000,000 x

1 - 30% 1/10% -30% B = 1,000,000 x 70% 10 -30% B = 1,000,000 x 70% / 9.7 B = 72,165 Scheme #4: Bonus after bonus and after tax B = P x 1 – Tr_____ 1/Br – Tr + 1 B = 1,000,000 x ____70%____ 1/10% – 30% + 1 B = 1,000,000 x 70% / 10.7 B = 65,421 This is a bonus computation that can be answered by following formula. What you need to understand here is this bonus is usually given to the key employees of the company because of the good operation of the business. There are four schemes that you have to consider in computing bonus. You just need to look at the formula and follow how it is being computed.

Post-employment benefits Post-employment benefits are employee benefits (other than termination benefits and short-term employee benefits) that are payable after the completion of employment.” (PAS 19.8) Examples: a. Retirement benefits (e.g. lump sum payment and pensions) b. Other post-employment benefits (e.g., post-employment life insurance or medical care). Post-employment benefits are provided to employees through post-employment benefits plans (a.k.a. retirement plans or pension schemes). A post employment benefit plan can be formal (e.g., explicitly stated in employment contract) or informal (i.e., not documented but implied from the employer’s past practice or the minimum requirement of law). A post employment benefit plan can also be: a. Contributory or non-contributory and b. Funded or Unfunded Contributory • Both are employer and employee contribute to the retirement fund of the employee

Non-contributory Only the employer contributes to the retirement fund of the employee

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Funded • The retirement fund is isolated from the employer’s control and is transferred to a trustee (e.g., investment company) who undertakes to manage the fund and pay directly the retiring employees

Unfunded The employer manages any established fund and pays directly the retiring employees.

Post-employment benefit plans are either: a. Defined contribution plans: or b. Defined benefits plans Defined contribution plans Under a defined contribution plan, the employer commits to make fixed contributions to a fund that will be used to pay for the retirement benefits of the employees. The amount of pos-employment benefits to be received by employees depends on the amount of contributions to the fund together with the investment income therefrom. If the fund balance is less than expected, the employer has no obligation to make good the deficiency. Therefore, the risk that retirement benefits may be insufficient rest with the employee. Defined benefits plans Under the defined benefit plan, the employers commits to pay a definite amount of retirement benefits, which can be determined using a plan formula. The amount of promised benefits is independent of any fund balance. Accordingly, if the fund is insufficient to pay for the promised benefits, the employer is obligated to make good the deficiency. Therefore, the risk of fund insufficiency rest with the employers: Defined Contribution plan • The employer commits to make fixed contributions to a fund. The amount of benefits that an employee will receive is dependent on the fund balance • The risk that the fund may be insufficient to meet the expected benefits rest with the employee

Defined benefit plan • The employer commits to pay a definite amount of retirement benefits. Such amount is independent of any fund balance. • The risk that the fund may be insufficient to pay for the promised benefits rests with the employer.

Post-employment benefit This is the benefit of the employee that will be received after the employees term in the company, meaning his retirement age or even early retirement. Sometimes an employee retires and receives a huge amount of money and that is what do we call lump sum payment, then afterwards, the employee will receive a monthly pension. Others have this higher benefit like insurance or medical assistance even after employment, but very few companies are offering this type of retirement benefits.

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Again as discussed above there are two types of post employment fund, the contributory and non-contributory, the contributory post employment fund is a system wherein both the employee and employer have share in his retirement, while the non-contributory it is the employer only who funds the retirement of the employee. Other classification is funded or unfunded, if funded there is a trustee of the fund of employer and the trustee will pay the retiring employee already, if unfunded the fund is under the control of the employer and the employer will directly pay the employee for the retirement benefits. Now it is your turn, Explain what is defined contribution plan and defined benefit plan. How does it differ in recording and giving benefits to the employee?

Illustration Case 1 Entity A agrees to provide post employment benefits to its employees by making monthly contribution equal to 10% of employees monthly salary to a retirement fund. Upon retirement, the employee is entitled to any accumulated contributions to a fund plus any investment income thereon. The employee bears any investment losses. Analysis: This is a defined contribution plan because the benefits to be received by the employee are dependent on the contributions to the retirement fund. The employee bears the risk that benefits will be less than expected. Case # 2 Entity A agrees to provide post-employment benefits to its employees in the form of a lump sum payment of P2M upon retirement plus monthly pension equal to half of the final monthly salary level, for two years after the retirement date. After the first two years, monthly benefits will decrease by 10% every year and will cease upon the death of the retired employee. Analysis: This is a defined benefit plan because the benefits to be received by the employee are definite amounts and not dependent on contributions to a retirement fund. The employer bears the risk that the fund set aside will be deficient of the promised benefits. Case 3 Upon retirement, the employees of Entity A are entitled to a lump sum payment of equal to half of the final monthly salary level multiplied by the number of years of service. The minimum service period is 10 years. Analysis: This is a defined benefit plan – same reason as with Case # 2. What are your learnings and observation in the ill Hybrid plans are retirement benefit plans that have characteristics of both a defined contribution plan and a defined benefit plan. For accounting purposes, hybrid plans are considered as defined benefit plan.

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Multi-employer plans Under a multiemployer plan, various unrelated employers contribute to common fund that is managed by a trustee to provide post-employment benefits to the employees of the participating employers. Contribution and benefit levels are determined without regard to the identities of the employers. A multi-employer plan is classified as either a defined contribution plan or a defined benefit plan. State Plans A state plan is one that is established by law and operated by the government. It is mandatory for all entities within its scope and is not subject to control or influence by the entity. Examples include: Government Service Insurance System (GSIS), which covers government employees; and Social Security System (SSS), which covers those in the private sector. A state plan is accounted for similar to a multiemployer plan, i.e., classified as either a defined contribution plan or a defined benefit plan. Illustration 1: Social Security System (SSS) Entity A pays monthly SSS Contributions as part of its employee retirement benefits. The retirement benefit plan under the SSS law is described below: Qualification for retirement benefit. • The member is 60 years old, separated from employment or ceased to be self employed, and has paid at least 120 monthly contributions prior to retirement . • The member is 65 years old whether employed or not and has paid at least 20 monthly contributions prior to retirement. Types of retirement benefits. • Lifetime monthly pension – for retiree who has paid at least 120 monthly contributions prior to retirement, and • Lump-sum amount – for retiree who has not paid the required 120 monthly contributions. Monthly pension The monthly pension is based on the contributions paid, credited years of service and the number of dependent minor children not to exceed five. The amount of monthly pension is the highest of the following: 1. The sum of P300 plus 20% of the average monthly summary credit plus 2% of the average monthly salary credit for each credited year of service in excess of ten years; or 2. 40% of the average monthly salary credit; or 3. P1,200 provided that the credited years of service (CYS) is at least 10 or more but les than 200 or P2,000, if the CYS is 20 or more. The monthly pension is paid for not less than 60 months. A retiree has the option to receive in advance, upon date of eligibility, the first 18 monthly pension in lump sum discounted at a preferential rate of interest to be determined by the SSS. The member will receive the monthly pension on the 19th month and month thereafter. IF the member retires after age of 60, the monthly pension shall be the higher of the following. 1. The monthly pension computed at the earliest time the member could have retired, had been separated from selfemployment or ceased to be self-employed plus all the adjustments thereto; 2. The monthly pension computed at the time when the member actually retires.

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Lump sum: The lump sum benefit is equal to the total contributions paid by the member and by the employer including interest. Death of retiree: Upon the death of the retiree, the primary beneficiaries are entitled to 100% of the monthly pension, and the dependents to the “dependents” pension. If the retiree dies within 60 months from the commencement of the monthly; pension and has no primary beneficiaries, the secondary beneficiaries are entitled to a lump sum benefit equivalent to the total monthly pensions corresponding to the 5-year guaranteed period excluding the “dependents” pension. Requirement: Identify whether the retirement benefit plan described above is defined contribution plan or defined benefit plan. Analysis: • The retirement plan is a state plan – it is established by law and operated by the government • It is defined contribution plan – Entity A is liable to the employees only for its share in the monthly SSS contributions. Illustration 2: R.A. 7641 Retirement Pay Law Entity A does not have a post-employment benefit for its employees. Accordingly, Entity A is subject to the minimum requirements of the law. Republic Act No. 7641 provides the following: “ In the absence of a retirement plan (or similar) that provides for the employee’s retirement benefits in the establishment, an employee shall be entitled to an employee retirement benefit upon reaching the compulsory retirement age. The age sixty (60) years or more, but not beyond sixty-five (65) years is the considered compulsory retirement age. If the employee has served the least of five (5) years in the said establishment, he/she may retire and enjoy the benefits equivalent of at least once-half (1/2 month salary for his/her every year of service. A fraction of at least six (6 months) is considered as one whole year. Unless acknowledged by both parties otherwise, one-half (1/2) a month salary’ shall represent the fifteen (15) working days in addition to the one-twelfth (1/12) for the mandated 13th month pay. This also includes the cash equivalent of not more than five (5) days of paid leaves. Requirement: Identify whether the retirement benefit plan described above is a defined contribution plan or defined benefit plan. Analysis: • The retirement plan is not a state plan – although it is promulgated by law, it is not operated by the government • If is a defined benefit plan – Entity A is liable to pay retiring employees the minimum amount computed in accordance with the provisions of the law. Write your learnings in the illustrations above pertaining to state plans? Discuss what is state plans. Insured benefits

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An employer may pay insurance premiums to fund a post-employment benefit plan. Such plan is classified as either defined contribution plan or defined benefit plan. It is a defined benefit plan if the employer retains the obligation to either pay directly the benefits to the employee or make good any deficiency if the insurer fails to pay in full the benefits. Accounting for defined contribution plan The accounting for defined contribution plans is straightforward. Since the employer’s obligation is limited to the amount that it has agreed to contribute, it simply recognizes the contribution as expense (unless it forms part o the cost of another asset) and a liability (if unpaid) when employees have rendered service during a period. If the amount contributed exceeds the fixed amount of contribution, the excess is treated as prepaid asset. The amount of contribution is measured at an undiscounted amount if it is due within 12 months; if due beyond 12 months, it is discounted. Actuarial valuations are not necessary; therefore, there are no actuarial gains or losses. Insured benefits is a manner wherein the entity obtain a third party wherein that third party will be the one to manage the fund for a post employment benefit plan/retirement plan. As we discussed in the topic before, it will depend if it is defined contribution or defined benefit plan. If defined contribution, the employer will only be concerned on how much the contribution is he going to contribute to fund the retirement plan, while in defined benefit plan, the employer is going to pay directly the retiring employee. Accounting treatment for the defined contribution plan is record the premium payment as expense and credit to a liability, and if the payment exceeds on the fixed amount of contribution then it should be treated as asset.

Illustration: Under Entity A’s defined contribution plan, it agrees to make fixed annual contributions of P200,000 to a retirement fund for the benefit of its employees. Accounting At each year-end, Entity A recognizes a fixed retirement benefit cost of P200,000, regardless of whether that amount has actually been contributed and regardless of whether an employee has actually retired during the period. If the contribution is not yet made, Entity A recognizes the retirement benefit cost as a liability (e.g.,accrued payable) measured at an undiscounted amount (i.e. P200,000) if it is due within 12 months from year end. IF the actual contribution during the period exceeds the fixed amount (for example, Entity A contributed P230,000) the excess (of 30,000) is accounted for as prepaid asset. The fact that an employee has actually retired and was paid his/he retirement benefits during the period does not affect the accounting above. For example, assume that an employee has retired during the period and was paid 1M for her retirement benefits. The amount of retirement benefit cost that Entity A recognizes for the period is still P200,000, I,e., the agreed amount of contribution. If the plan is funded, the trustee is the one who will pay the retiring employee and not the Entity A.

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Scenario 1: Entity A’s retirement benefits plan is funded. Entity A contributes P200,000 to the fund held by a trustee. Dec. 31, 20x1 Retirement benefits expense 200,000 Cash 200,000 Scenario 2: Because of poor results of operations, Entity A was only able to contribute P80,000 to the fund Dec. 31, 20x1 Retirement benefits expense 200,000 Cash 80,000 Accrued retirement contributions 120,000 Scenario 3: Because of profitable operations, Entity A decided to contribute P230,000 during the period. Dec. 31, 20x1 Retirement benefits expense 200,000 Prepaid retirement contribution 30,000 Accrued retirement contributions 230,000 Notice that the retirement benefits expense is fixed at P200,000 – the agreed contribution. Any deficiency in the contribution is recognized as accrued liability and any excess is recognized as prepaid asset. Scenario 4: An employee retired and was eligible to P30,000 retirement benefits based on the operating efficiency and investment earnings of the fund. Dare No entry No entry is made because the fund is held by the trustee. The trustee assumes the obligation of paying a retiring employee. The employer’s obligation is discharged by its contributions to the fund. Variation 1: Retirement plan is unfunded but with separate fund Entity A’s retirement plan is unfunded (i.e. not held by a trustee). However, Entity A has established a separate fund for the retirement benefit of its employees. Scenario 1: Entity A accrues the retirement benefits expense for the year and segregates P80,000 to the retirement fund maintained internally. Dec. 31, 20x1

Dec. 31, 20x1

Retirement benefits expense 200,000 Accrued retirement benefits payable 200,000 To recognize retirement benefits expense Retirement fund 80,000 Cash 80,000 To record contributions to the retirement fund maintained internally

Scenario 2: An employee retired and was paid P30,000 retirement benefits based on the operating efficiency and investment earnings of the fund. Date

Accrued retirement benefits payable Retirement fund To record payment of retirement benefits.

30,000 30,000

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Since the fund is not transferred to a trustee (i.e. unfunded), Entity A retains the obligation of paying directly the retiring employees. Variation 2: Retirement plan is unfunded with no separate fund. Entity A’s retirement plan is unfunded and no separate fund is established for the retirement benefits of the employees. Scenario 1: Entity A accrues the retirement benefits expense for the year. Dec. 31, 20x1 Retirement benefits expense Accrued retirement benefits payable Scenario 2: An employee retired and was paid P30,000 retirement benefits. Date Accrued retirement benefits payable Cash

200,000 200,000

30,000 30,000

In practice, many entities do not have a retirement fund set aside for their employees. Others do not have a retirement plan. The absence of a retirement plan, entities are subject to the minimum requirement of the law. According to the illustrations above Enumerate your learnings by just studying the illustrations and related it with the standards. Summary of the Lesson: • Employee benefits are all forms of consideration given to employees in exchange for the services they have rendered • Classification of employee benefits are a. Short term b. Post employment c. Other long-term d. Termination • Accumulating paid absences are those that can be carried over to the next period if not used in the current year. Non-accumulating paid absences expire if not used. • Vesting paid absences are those that are monetized if not used. Non-vesting paid absences are not monetized.

Enrichment Activity: 1. Adarna Company’s employees earn two weeks of paid vacation for each year of employment. Unused vacation time can be accumulated and carried forward to succeeding years and will be paid at the salary in effect when the vacation as taken. As of December 31, 2020, when Ibon salary was ₱9,600 per week. Ibon had earned 18 week vacation time and had used 12 weeks of accumulated vacation time. At December 31, 2020, how much should Adarna carry as liability for Ibon’s accumulated vacation time? ___________________________________ Answer: P 57,600

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2. Mars, Inc. distributed annual bonuses to its sales manager and two sales agents. The company reported ₱2,400,000 profit for 2020 before bonuses and income taxes. Income taxes of Mars, Inc. average 30%. How much is the total amount of bonus if bonus of each is computed at 15% of profit after taxes and bonuses? ___________________________________ Answer: P 574,904

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Assessment Lesson 4 - EMPLOYEE BENEFITS PART 1 Name: ___________________________________________

Section: _____________ Score: __________

1. Sun Company pays all employees on a biweekly basis. Overtime pay, however, is paid in the next week biweekly period. Sun Company accrues salaries expenses only at its December 31, year-end. Data relating to salaries earned in December 31, 2020 are as follows: • Last payroll was paid on December 31, 2020 for the 2-week period ended December 26, 2020. • Overtime pay earned in the 2-week period ended December 31, 2020 was ₱12,600. • Remaining work days in 2020 were December 29, 30, and 31, on which days there was no overtime. • The recurring biweekly salaries total ₱225,000. Assuming a five-day workweek, what amount should Sun Company record accrued salaries at December 31, 2020? ___________________________________

2. Ellen Corporation pays its outside salespersons fixed monthly salaries and commissions on net sales. Sales commissions are computed and paid on a monthly basis (in the month following the month of sale), and the fixed salaries are treated as advances against commissions. However, if the fixed salaries for salespersons exceed their sales commissions earned for a month, such excess is not charged back to them. Pertinent data for the month of April for the three salespersons in sales region 3 are as follows: Salesperson Fixed Salary Net Sales Commission Rate A ₱15,000 ₱300,000 4% B 21,000 600,000 6% C 27,000 900,000 6% Totals ₱63,000 ₱1,800,000

For sales region 3, what total amount should Ellen Company accrue for sales commission payable at April 30, 2020? ___________________________________

3. Grace Company reported payroll for the month of January 2020 as follows: Total wages ₱ 700,000 Income tax withheld 84,000 All wages paid were subject to SSS. The SSS tax rates were 7% each employee and employer. Grace remits payroll taxes on the 15th of the following month. In the financial statements for the month ended January 2020, what amount should be reported respectively as total payroll tax liability and payroll tax expense? ___________________________________

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4. Irving, Inc. pays its general manager an annual bonus of 6% of profit after deduction for both bonus and corporate income tax. For the year 2020, the company realized profit of ₱10,800,000 before said deductions. The income tax rate is 30%. What is the corporate income tax liability at December 31, 2020? ___________________________________ 5. Gonzales Company’s salaried employees are paid biweekly, occasionally, advances made to employees are paid back by payroll deductions. Information relating to salaries for the calendar year 2020 is as follows: 12/31/2019 12/31/2020 Employee advances ₱ 28,800 ₱43,200 Accrued salaries payable 156,000 ? Salaries expense during the year 1,956,000 Salaries paid during the year (gross) 1,872,000 On December 31, 2020, what amount ___________________________________

should

Gonzales

report

for

accrued

salaries

payable?

6. After three profitable years, Bacuno Company decided to offer a bonus to the branch manager of 25% of income over ₱1,200,000 earned by the branch. The income for the branch was ₱1,920,000 before tax and bonus for the current year. The bonus is computed on income in excess of ₱1,200,000 after deducting the bonus but before deducting tax. What is the bonus of the branch manager for the current year? ___________________________________

References: Millan, Z.V. (2019). Intermediate Accounting 2 Valix,(2019). Intermediate Accounting 2 Uberita, (2013) Practical Accounting 1

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LEARNING MODULE

IA201 INTERMEDIATE ACCOUNTING 2

FIRST SEMESTER SCHOOL YEAR 2020-2021

CHECKED BY

AUREA B. NATIVIDAD

HAIDEE B. GONZALES

APPROVED BY

ELLEN C. ALMORO Director Department of Business Education

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