AUDITING PROBLEMS
Audit of Liabilities

Submitted by:

Ma. Mikaella D. Bagadiong

Brittney Dianne D. Felin

Submitted to:

Marcial C. Paglinawan, CPA

September 2018
PROBLEM 1:

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

a. P 1,440,000
b. P 1,480,000
c. P 1,500,000
d. P 1,520,000

Solution:

Loan Payable P 1,500,000

Origination Fees (4% x P1.5M). 60,000
P 1,440,000

NOTES:

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

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

PROBLEM 2:

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

a. P 0
b. P 418,250
c. P 468,250
d. P 1,000,000

Solution:
Purchase of annuity P 418,250
Payment of first installment 50,000
Contest prize expense. P 468,250
NOTES:

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

• An annuity is a contract between a purchaser and an insurance company in which the

purchaser makes a lump sum payment or series of payments and in return obtain regular
disbursements beginning immediately or at some point in the future.

• Journal Entries:

Contest pize expense P418,250

Discount on N/P 531,750
N/P- noncurrent P950,000
Contest prize expense P 50,000
N/P - current P 50,000

PROBLEM 3. INTEREST-BEARING NOTE - LUMP SUM

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

Questions:
Based on the above data, answer the following:

1. How much is the cost of the machinery acquired on January 1, 2017?

a. P 3,783,973
b. P 3,796,160
c. P 4,000,000
d. P 4,633,973

Solution:

Present value of 1 for 4 periods @ 10% 0.6830

Present value of an ordinary annuity of 1 for 4 periods @ 10% 3.1699

Present value of principal (4,000,000 x 0.6830) P 2,732,053.821

Present value of annual interest payments (4,000,000 x 15% x 3.1699) 1,901,919.268
Cost of machinery P 4,633,973.089
Schedule of Premium Amortization
Date Interest paid Interest expense Amortization Carrying Amount
Jan 1 2017 4,633,973
Dec 31 2017 600,000 463,397 136,603 4,497,370
Dec 31 2018 600,000 449,737 150,263 4,347,107
Dec 31 2019 600,000 434,711 165,289 4,181,818
Dec 31 2020 600,000 418,182 181,818 4,000,000

NOTES:

• When a property or noncash asset is acquired by issuing a promissory note which is interest
bearing, the property or asset is recorded at the purchase price.

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

2. How much is the interest expense for 2017?

a. P 232,308
b. P 434,711
c. P 463,397
d. P 600,000

Solution:

Carrying amount 2017. P 4,633,973

Effective interest rate 10%
Interest expense P463,397

3. How much is the carrying amount of the note on December 31, 2017?
a. P 4,000,000
b. P 4,347,107
c. P 4,497,370
d. P 4,578,468

Solution:

Carrying amount of note 1/1/2017 P4,633,973

Less: Premium Amortization
Interest paid 600,000
Interest expense (463,397) (136,603)
P4,497,370

4. How much is the current portion of the note on December 31, 2017?

a. Nil
b. P 71,077
c. P 150,263
d. P 4,497,370

NOTE:
• The note is to be paid in full on Dember 31, 2020.
5. How much is the noncurrent portion of the note on December 31, 2017?
a. Nil
b. P 71,077
c. P 4,497,370
d. P 4,347,107

Solution:

Note payable, due December 31, 2020 P 4,000,000

Premium on note payable 633,973
Less: Premium amortization 2017 (136,603)
Carrying amount P 4,497,370

PROBLEM 4. INTEREST-BEARING NOTE - UNIFORM INSTALLMENTS

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

Questions:
Based on the above data, answer the following:
1. How much is the cost of the machinery acquired on January 1, 2017?
a. P 3,783,973
b. P 4,000,000
c. P 4,415,067
d. P 4,633,973

Solution:

Present value of 1 at 10%:

One period 0.9091

Two periods 0.8264
Three periods 0.7513
Four periods 0.6830

Date of Interest Payments Principal Total PV Present Value

payment Payments Payments Factor
Dec 31 2017 4,000,000 x 15% = 1,000,000 1,600,000 0.9091 P
600,000 1,454,545.455
Dec 31 2018 3,000,000 x 15% = 1,000,000 1,450,000 0.8264 1,198,347.107
450,000
Dec 31 2019 2,000,000 x 15% = 1,000,000 1,300,000 0.7513 976,709.2412
300,000
Dec 31 2020 1,000,000 x 15% = 1,000,000 1,150,000 0.6830 785,465.4737
150,000
Total present P 4,415,067.276
value
Schedule of Premium Amortization
Date Interest paid Interest Amortization Principal Carrying
expense Payment Amount
Jan 1 2017 4,415,067
Dec 31 2017 600,000 441,507 158,493 1,000,000 3,256,574
Dec 31 2018 450,000 325,657 124,343 1,000,000 2,132,231
Dec 31 2019 300,000 213,223 86,777 1,000,000 1,045,454
Dec 31 2020 150,000 104,545 45,454 1,000,000 -

2. How much is the interest expense for 2017?

a. P 434,711
b. P 441,507
c. P 463,397
d. P 600,000

Solution:

Carrying amount 2017 P 4,415,067

Effective Rate 10%
P 441,507

3. How much is the carrying amount of the note on December 31, 2017?
a. P 3,000,000
b. P 3,256,574
c. P 3,400,000
d. P 4,578,468

Solution:

Carrying amount, Jan 1 2017 P 4,415,067

Less: Premium Amortization
Interest paid 600,000
Interest expense (441,507) (158,493)
Principal payment (1,000,000)
Carrying amount Dec 31 2017 P 3,256,574

4. How much is the current portion of the note on December 31, 2017?
a. Nil
b. P 124,343
c. P 1,124,343
d. P 2,132,231

Solution:

Note payable P 1,000,000

Premium amortization 124,343
Carrying amount. P 1,124,343
NOTE:

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

5. How much is the noncurrent portion of the note on December 31, 2017?
a. Nil
b. P 124,343
c. P 1,124,343
d. P 2,132,231

Solution:

Note payable, due 2019 P 1,000,000

Premium amortization, due 2019 86,777
Note payable, due 2020 P 1,000,000
Premium amortization, due 2020 45,454
Carrying amount on Dec 31 2018 P 2,132,231

NOTE:

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

PROBLEM 5. Initial Recognition, Subsequent Measurement and Derecognition and

Reclassification of Financial Liabilities at fair value through profit or loss

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

Questions:
Based on the above data, answer the following:

Assume that there are no changes due to credit risk:

1. How much is the interest expense for 2017?

Answer: P600,000

Solution:

Bonds payable 4,000,000

Nominal interest rate 15%
Interest expense. 600,000
2. How much is the unrealized loss (or gain) in 2017 to be recognized in the profit or loss?

Answer: P513,973

Solution:

Bonds payable, Jan 2017 4,633,973

Fair value @103, Dec 2017 4,120,000
Decrease in fair value of bonds payable – gain 513,973

JE:

Jan 1 2017 Cash 4,633,973

Bonds payable 4,4633,973

Dec 31 2017 Interest expense 600,000

Cash 600,000

Bonds payable 513,973

Unrealized gain from change in fair value 513,973

NOTES:

• In accordance with PFRS 9, paragraph 4.2.2, at initial recognition, bonds payable may be
irrevocably designated at fair value through profit or loss.

In other words, under the fair value option, the bonds payable shall be measured initially at
fair value and remeasured at every year-end with any changes in fair value generally
recognized in profit or loss. The carrying amount of the bonds payable is always equal to the
fair value at every year-end.

• There is no more amortization of bond discount and bond premium. Any transaction cost or
bond issue cost should be expensed immediately.

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

3. How much is the realized loss (or gain) on derecognition in 2018 to be recognized in the profit
or loss?

Answer: P32,000

Solution:

Bonds payable retired (4,000,000 x 40% x 103) P 1,648,000

Retirement price (4,000,000 x 40% x 105) 1,680,000
Loss on early retirement of bonds 32,000

JE:
Bonds payable 1,648,000
Loss on early retirement of bonds 32,000
Cash 1,680,000
NOTES:

PFRS 9 Derecognition of a financial liability

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

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

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

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

Answer: Nil

NOTES:

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

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

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

Reclassification from FVPL to amortized cost

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

• The difference between the new carrying amount of the financial instrument at amortized
cost and the face value of the financial instrument shall be amortized through profit or loss
over the remaining life of the financial asset using the effective interest method.
PROBLEM 6. Unrealized Gain or Loss of FVTPL with Change due to Credit Risk
On January 1, 2015, Tubod Co. issues a 6-year bond with a par value of P 2,000,000 and an annual fixed
coupon rate of 10% which is consistent with market rates for bonds with similar characteristics. Tubod uses
observed (benchmark) interest rate. At the date of inception of the bonds, this rate is 7%. At the end of the
first year:
a. Observed (benchmark) interest rate has decreased to 6%.
b. The fair value interest rate of the bonds is 8%.
Tubod is required to present the effects of changes in the liability's credit risk in other comprehensive
income.
 

Questions:
Based on the above data, answer the following:
1. How much is the unrealized gain or loss to be recognized in the OCI during 2015?
a. Nil
b. P 82,000
c. P 77,740
d. P 159,740

2. How much is the unrealized gain or loss to be recognized in the P&L during 2015?
a. Nil
b. P 82,000
c. P 77,740
d. P 159,740

Solution:

The bonds internal rate of return is 10%, because the oberved (benchmark) interest rate is 7%,
the instrument specific component of the internal rate of return is 3%. The discount rate to
calculate the present value of the bond is thus, 9% (6% + 3%).

At the end of 2015:

Present value of 1 for 5 period at 8% 0.6806

Present value of an ordinary annuity of 1 for 5 periods at 8% 3.9927

Present value of principal (2,000,000 x 0.6806) P 1,361,200

Present value of annual interest payments (2,000,000 x 10% x 3.9927) 798,540
Total present value P 2,195,740

Present value of 1 for 5 periods at 9% 0.6499

Present value of an ordinary annuity of 1 for 5 periods at 9% 3.8897

Present value of principal (2,000,000 x 0.6499) P 1,299,800

Present value of annual interest payments (2,000,000 x 10% x 3.8897) 777,940
Total present value P 2,077,740

Fair value at 8% P 2,159,740

Fair value at 9% 2,077,740
Increase in fair value – other comprehensive income 82,000
Increase in the fair value of bonds payable P 159,750
Increase attributable to credit risk 82,000
Increase attributable to change in the market interest rate 77,740

JE:

Dec 31 2015 Unrealized loss on credit risk – OCI 82,000

Unrealized loss from change in fair value 77,740
Bonds payable 159,740

NOTES:

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

• Amounts presented in other comprehensive income should not be subsequently transferred

to profit or loss. However, the cumulative gain or loss may be transferred within the equity.

• This exception does not apply to loan commitments or financial guarantee contracts (PFRS
9 par 5.7.9), nor does it apply if it would create or enlarge an accounting mismatch in profit
or loss. In these cases all changes in fair value of the liability (including the effects of
changes in the credit risks) should be recognized in profit or loss. (PFRS 9. B5.7.8)

Credit risks – the risk that one party to a financial instrument will cause a financial loss for
the other party by failing to discharge an obligation

• Changes in market conditions that give rise to market risk include changes in benchmark
interest rate, the price of another entity’s financial instrument, a commodity price, foreign
excahnge rate or index of prices or rates.
PROBLEM 7. Initial Recognition, Subsequent Measurement and Derecognition and
Reclassification of Financial Liabilities at Amortized Cost

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

Questions:
Based on the above data, answer the following:
1. How much is the interest expense for 2017?

Answer: P463,397

Solution:

Carrying amount 2017. P 4,633,973

Effective interest rate 10%
Interest expenses. P463,397

Schedule of Premium Amortization

Date Interest paid Interest Amortization Carrying
expense Amount
Jan 1 2017 4,633,973
Dec 31 2017 600,000 463,397 136,603 4,497,370
Dec 31 2018 600,000 449,737 150,263 4,347,107
Dec 31 2019 600,000 434,711 165,289 4,181,818
Dec 31 2020 600,000 418,182 181,818 4,000,000

2. How much is the unrealized loss (or gain) in 2017 to be recognized in the profit or loss?

Answer: Nil

NOTE:

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

• PFRS 9, provides that gain and loss on financial instrument measured at amortized cost and
is not part of a hedging relationship shall be recognized in profit or loss when the financial
instrument is derecognized, sold, impaired or reclassified, and through the amortization
process.
3. How much is the realized loss (or gain) on derecognition in 2018 to be recognized in the profit
or loss?

Answer: P7,273

Solution:

Carrying amount of 40% of bonds (4,181,818 x 40%) P 1,672,727

Retirement price (4,000,000 x 40% x 105) 1,680,000
Loss on retirement of bonds 7,273

4. Assuming that on January 1, 2018, the remaining bonds were reclassified to financial
liabilities at fair value through profit or loss, how much is the gain or loss on reclassification?

Answer: P10,909

Solution:

Fair value of remaining 60% bonds (4,000,000 x 60% x 105) P 2,520,000

Carrying amount of remaining 60% bonds (4,181,818 x 60%) 2,509,091
Loss on reclassification of bonds payable 10,909

PROBLEM 8. Financial Liabilities at Amortized Cost - Term Bonds

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

Questions:
Based on the above data, answer the following:

1. How much is the issue price of bonds on January 1, 2015?

a. Nil
b. P 290,302
c. P 1,140,302
d. P 1,051,730

Solution:

Present value of 1 for 3 periods at 10% 0.7513

Present value of an ordinary annuity of 1 for 3 periods at 10% 2.4869

Present value of principal (1,200,000 x 0.7513) P 901,560

Present value of ordinary annuity of interest payments(1,200,000 x 8% x 2.4869) 238,742
Issue price P 1,140,302
2. How much is the interest expense for 2015?
a. P 96,000
b. P 114,030
c. P 117,817
d. P 114,104

Solution:

Carrying amount, Jan 1 2015 P 1,140,302

Effective interest rate 10%
Interest expense P 114,030

PROBLEM 9. Financial Liabilities at Amortized Cost - Serial Bonds

On January 1, 2015, Bukidnon Co. issued 3-year bonds with a face value of P 1,200,000 and stated interest
of 8% per year. The bonds mature in 3 equal annual installments every December 31. The interest is also
payable every December 31. The bonds were acquired to yield 10%. The bonds were appropriately
classified as financial liability at amortized cost.
 
Questions:
Based on the above data, answer the following:
1. How much is the issue price of the bonds on January 1, 2015?
a. P 1,158,925
b. P 907,875
c. P 1,432,125
d. P 896,042

Solution:

Present value of 1 at 10%

One period 0.9091
Two periods 0.8264
Three periods 0.7513

Date of Interest Payments Principal Total PV Present Value

payment Payments Payments Factor
Dec 31 2015 1,200,000 x 8% = 400,000 496,000 0.9091 450,913.6
96,000
Dec 31 2016 800,000 x 8% = 64,000 400,000 464,000 0.8264 383,449.6
Dec 31 2017 400,000 x 8% = 32,000 400,000 432,000 0.7513 324,561.6
Total present P 1,158,924.8
value
Face vale 1,200,000
Discount on 41,075
bonds
payable
2. How much is the interest expense for 2015?
a. P 115,892
b. P 143,212
c. P 107,934
d. P 174,604

Solution:

Carrying amount, Jan 2015 P 1,158,925

Effective interest rate 10%
Interest expense P 115,892

NOTES:

• Term bonds are bonds with a single date of maturity.

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

• Initial measurement of bonds payable PFRS 9, par 5.1.1:

Bonds payable not designated at fair value through profit or loss shall be measured initially
at fair value minus transaction costs that are directly attributable to the issue of the bonds
payable.

The market price or issue price of the bonds payable is equal to the present value of the
principal bond liability plus the present value of future interest payments.

PROBLEM 10. Issuance, Retirement and Conversion of Non-Convertible Bonds

On January 1, 2017, Dumagete Co. issued its, P 4,000, 10%, 5-year bonds at the prevailing rate of
interest of 15%. Interest is payable every December 31.
On December 31, 2017, after payment of interest, 1/2 of the bonds were retired at P 1,900,000 when the
fair value of the securities is P 350. The prevailing rate of interest of the bonds is 12%.
On December 31, 2018, after payment of interest, the remaining bonds were converted into P 100 par
value, 4,000 ordinary shares when the fair value of the securities is P 400. The bonds were converted
because of the equity swap.
 
Questions:
Based on the above data, answer the following:
1. Issue price of the bonds on January 1, 2017.

Answer: P3,329,680

Solution:

Present value of 1 for 5 periods @ 15% 0. 4972

Present value of an ordinary annuity of 1 for 5 periods @ 15% 3.3522

Present value of principal (4,000,000 x 0.4972) P 1,988,800

Present value of annual interest payments (4,000,000 x 10% x 3.3522) 1,340,880
Issue price of bonds P 3,329,680
Schedule of Discount Amortization
Date Interest paid Interest Amortization Carrying
expense Amount
Jan 1 2017 3,329,680
Dec 31 2017 400,000 499,452 99,452 3,429,132
Dec 31 2018 400,000 514,370 114,370 3,543,502
Dec 31 2019 400,000 531,525 131,525 3,675,027
Dec 31 2020 400,000 551,254 151,254 3,826,281
Dec 31 2021 400,000 573,942 173,942 4,000,000

2. The gain or loss on the retirement of the bonds on December 31, 2017.

Answer: P185,434

Solution:

Carrying amount of ½ of bonds, Dec 31, 2017 P 1,714,566

Retirement price 1,900,000
Loss on retirement of bonds 185,434

NOTES:

Retirement of Non-convertible Bonds

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

• No gain or loss on retirement of bonds on maturity.

Conversion of nonconvertible bonds because of equity swap

• Gain or loss on conversion may be recognized:

Fair value of equity instrument ( or if not reliably determinable, fair value of liability) minus
carrying amount of liability

3. The interest expense in 2018.

Answer: P257,185

Solution:

Carrying amount of remaining ½ of bonds P 1,714,566

Effective interest rate 15%
Interest expense 257,185
4. The gain (or loss) on the conversion of the bonds on December 31, 2018.

Answer: P171,751

Solution: .

Carrying amount of the remaining bonds, Dec 2018 (3,543,502 x 50%) P 1,771,751
Fair value of shares ( 4,000 ordinary shares x P 400) 1,600,000
Gain on conversion of bonds 171,751

NOTES:

Equity Swap

• An equity swap is a transaction whereby a debtor and creditor may renegotiate the terms of
a financial liability with the result that the liability is fully or partially extinguished by the
debtor issuing equity instruments to the creditor.

• IFRC 19 provides that an entity shall initially measure equity instruments issued to
extinguish all or part of a financial liability at the fair value of the equity instruments issued or
the fair value of the liability extinguished, whichever is more reliably determinable. If both the
fair value of the equity instruments issued and the fair value of the financial liability
extinguished cannot be measured reliably, the equity instruments issued shall be measured
at the carrying amount of the financial liability extinguished.

Conversion of nonconvertible bonds because of equity swap

• Gain or loss on conversion may be recognized:

Fair value of equity instrument ( or if not reliably determinable, fair value of liability) minus
carrying amount of liability

5. The net increase (or decrease) in the share premium as a result of the conversion of the
bonds on December 31, 2018.

Answer: P1,200,000

Solution:

Fair value of shares issued (4,000 ordinary shares x 400) P 1,600,000

Par value of shares issued (4,000 ordinary shares x 100) 400,000
Share premium 1,200,000
PROBLEM 11. Issuance, Retirement and Conversion of Convertible Bonds

On January 1, 2017, Tagbilaran Co. issued its 10%, 4-year, P4,000,000 convertible bonds for the face
amount of P4,000,000. The bonds are convertible into P200 par ordinary shares at a conversion price of
P250 per share. The prevailing rate of interest of the bonds without the conversion option is 15%. Interest
is payable every December 31.

On December 31, 2017, after payment of interest, 1/2 of the bonds were retired at P 1,900,000 when the
fair value of the securities is P350. The prevailing rate of interest of the bonds is 12%.

On January 1, 2018, to induce the holder to convert the convertible debenture promptly, Tagbilaran
reduces the conversion price to P200 if the debenture is converted before March 1, 2018 (i.e. within 60
days). All the bondholders accepted the offer on January 1, 2018. On the date of conversion, the fair
value of the Tagbilaran Co.'s ordinary share is P240 per share.
 

Questions:

Based on the above data, answer the following:

1. The amount allocated to equity component on January 1, 2017.

Answer: P570,800

Solution:

Present value of 1 for 4 periods at 15%. 0.51718

Present value of an ordinary annuity of 1 for 4 periods at 15%. 2.8550

Issue price P 4,000,000

Less: liability component
Present value of principal (4M x 0.5718) 2,287,200
Present value of interest payment (4M x 2.8550) 1,142,000 3,429,200
Equity Component 570,800

JE:

Cash 4,000,000
Discount on bonds payable 570,800
Bonds payable 4,000,000
Share premium-conversion privilege 570,800
2. The gain or loss on the retirement of the bonds on December 31, 2017.

Answer: P132,170

Solution:

Present value of 1 for 3 periods at 12% 0.7118

Present value of an ordinary annuity of 1 for 3 periods at 12% 2.4018

Carrying amount of bonds retired, Dec 2017 (3,543,580 x 50%) P 1,771,790

Less: Payment applied to liability component

PV of principal (2M x 0.7118) 1,423,600
PV of Interest payments (2M x 10% x 2.4018) 480,360 1,903,960

Loss on Retirement 132,170

Schedule of Discount Amortization

Date Interest paid Interest Amortization Carrying
expense Amount
Jan 1 2017 3,429,200
Dec 31 2017 400,000 514,380 114,380 3,543,580
Dec 31 2018 400,000 531,537 131,537 3,675,117
Dec 31 2019 400,000 551,268 151,268 3,826,385
Dec 31 2020 400,000 573,958 173,958 4,000,000

3. The net increase (or decrease) in equity as a result of the retirement of the bonds on
December 31, 2017.

Answer: P3,960

Solution:

Retirement price P 1,900,000

Less: Payment applied to liability component 1,903,960
Payment allocated to equity component (decrease) 3,960

4. The interest expense in 2017.

Answer: P514,380

Solution:

Carrying amount of bonds, Jan 2017 P 3,429,200

Effective interest rate 15 %
Interest expense 514,800
5. The amount to be recognized in profit or loss as a result of the amendment of the terms on
January 1, 2018.

Answer: P480,000

Solution:
Ordinary shares to be issued (2,000,000 / P 200) 10,000
Ordinary shares to be issued- original terms (2,000,000 / P 250) 8,000
Incremental ordinary shares to be issued 2,000

Value of incremental shares to be issued (2000 x P 240) P 480,000

NOTES:

• PAS 32 paragraph 29 states that an entity recognizes separately the components of a

financial instrument that (a) creates a financial liability of the entity and (b) grants an option
to the holder of the instrument to convert it into an equity instrument of the entity.

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

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

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

• On conversion of a convertible instrument at maturity, the entity derecognizes the liability

component and recognizes it as equity. The original equity component remains as equity
(although it may be transferred from one line item within equity to another). There is no gain
or loss on conversion at maturity. (PAS 32 AG32)

• When an entity extinguishes a convertible instrument before maturity through an early

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

• Once the allocation of the consideration is made, any resulting gain or loss is treated in
accordance with accounting principles applicable to the related component, as follows:
 a. The amount of gain or loss relating to the liability component is recognized in profit or
loss; and

b. The amount of consideration relating to the equity component is recognized in equity.

(PAS 32 AG34)

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