CHAPTER 2

Non-Current Liabilities
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Learning Objectives

After reading this chapter, you should be able to

1. Understand the nature of non-current liability.

2. Compare debt financing with equity financing

3. Identify the different classes of bonds
4. Prepare entries for bond issuance, payment of bond interest and
amortization of bond premium or discount.
5. Compute carrying amount of bonds to be presented on the
statement of financial position.
6. Record the derecognition of bond liabilities.
7. Prepare entries to account for long-term notes.
8. Account for different forms of troubled-debt restructuring.
9. Identify required disclosures for non-current liabilities.
 All liabilities not classified as current liabilities are classified as non-current liabilities.
Non-current liabilities include

1. Portion of long-term obligations expected to be settled beyond 12 months from the

end of the reporting period
2. Obligations where the enterprise has an unconditional right to defer settlement for
more than 12 months after the reporting date.
3. Not mainly held for trading purposes

The most common types of non-current liabilities include:

long-term bank borrowings
notes and mortgages

And similar obligations which are related to the general financial condition of the enterprise
rather than to the operating cycle and are due beyond 12 months from the end of the reporting
period. Liabilities arising from finance lease that are not due within 12 months from the end of
the reporting period and deferred income tax liabilities are also classified as non-current
liabilities.

DEBT FINANCING AND EQUITY FINANCING

When a corporation desired to raise additional funds for long-term purposes, it may
borrow by issuing bonds and notes (debt financing) or it may obtain funds by issuing additional
share capital to shareholders (equity financing). Each source of funds has its particular
advantages and disadvantages to the issuing corporation.

In many cases, management and shareholders favor debt financing over equity financing
for the following reasons:

I. Since there will be no issuance of new ordinary shares, the present owners remain in
control of the corporation. By issuing bonds, therefore, a corporation does not spread or
dilute control of management over a larger number of owners.

II. The interest incurred in debt financing is a deductible expense in arriving at taxable
income while dividends o share capital are not.

III. The charge for interest on the debt may be less than the amount of dividends that might
be expected by shareholders.

Debt financing, however, has also its disadvantages. Apparently, an enterprise can avail of
debt financing only if it has adequate security offered to creditors. Moreover, interests on debt
are required to be paid periodically regardless of the enterprises financial performance and
financial position. If the interest is not paid on the dates specified by the contract, the creditors
may bring legal action and there is the possibility of takeover by the creditors.
BONDS PAYABLE

A bond is a formal unconditional promise, made under seal, to pay a specified sum of
money at a determinable future date, and to make periodic interest payment at a stated rate until
the principal sum is paid.

In simple language, a bond is a contract of debt whereby one party is called the issuer
borrows funds from another party called the investor.

A bond is evidenced by a certificate and the contractual agreement between the issuer and
investor is contained in another document known as bond indenture.

TYPES OF BONDS
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Term bonds bonds with a single date of maturity.

Serial bonds bonds that mature by installments.
Mortgage bonds bonds secured by mortgage of real properties.
Collateral trust bonds bonds secured by investments in stocks and bonds.
Debenture bonds bonds without collateral security.
Registered bonds requires the registration of the name of the bondholder on the
books of the corporation.
Coupon or bearer bonds the name of the bondholder is not registered.
Convertible bonds bonds that can be exchanged for equity shares of the issuing
company.
Callable bonds bonds that can be called in for payment before the date of maturity.
Guaranteed bonds bonds issued whereby another party promises to make payment if
the borrower fails to do so.
Junk bonds these are high risk and high yield bonds issued by entities that are
heavily indebted or otherwise in weak financial position.
Commodity-backed bonds bonds which are redeemable in terms of commodities
such as oil or precious metals.

INITIAL MEASUREMENT OF BONDS PAYABLE

In accordance with PFRS 9, 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 fair value of the bonds payable is equal to the present value of the future cash
payments to be settled the bond liability.

Bond issue costs shall be deducted from the fair value or issue price of the bonds payable
in measuring initially the bond payable.

However, if the bonds are designated and accounted for at fair value through profit or
loss, the bond issue costs are treated as expense immediately.

Actually, the fair value of the bonds payable is the same as the issue price or net proceeds
from the issue of the bonds, excluding accrued interest.

SUBSEQUENT MEASUREMENT OF BONDS PAYABLE

In accordance with PFRS 9, after initial recognition, bonds payable shall be measured
either:

a. At amortized cost, using the effective interest method.

b. At fair value through profit or loss.

AMORTIZED COST OF BONDS PAYABLE

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The amortized cost of bonds payable is the amount at which the bond liability is
measured initially minus principal repayment, plus or minus the cumulative amortization
using the effective interest method of any difference between the initial amount and the
maturity amount.

Simply stated, the difference between the face amount and present value of the bonds
payable is amortized using the effective interest method.

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

Accordingly, discount on bonds payable and bond issue cost are presented as deduction
from the bonds payable and premium bonds payable is an addition to bonds payable.

ACCOUNTING FOR ISSUANCE OF BONDS

There are two approaches in accounting for the authorization and issuance of bonds,
namely:

Memorandum approach In this Journal entry approach In this

approach, NO ENTRY is made upon approach, as the title suggests, a
the authorization of the entity to journal entry is made to record the
issue bonds. authorized bonds payable.

PREMIUM ON BONDS PAYABLE

If the sales price of the bonds is more than face value of the bonds, the bonds are said to
be sold at a premium.

The premium on bonds payable is in effect gain on the part of the issuing entity,
because it receives more than what it is obligated to pay under the bond issue.

The obligation of the issuing entity is limited only to the face value of the bonds.

The premium on bonds payable, however, is not treated as an outright gain but amortized
over the life of the bond by

Premium on bonds payable XX

Interest expense XX
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DISCOUNT ON BONDS PAYABLE

If the sales price of the bonds is less than face value of the bonds, the bonds are said to
be sold at a discount.

The discount in bonds payable is in effect a loss to the issuing entity, because it
receives less than what it is obligated to pay which is equal to the face value.

However, the discount on bonds payable is not treated as outright loss but amortized over
the life of the bonds by

Interest expense XX
Discount on bonds payable XX

ACCRUED INTEREST ON BONDS ISSUED

Bonds are often issued at any time between the interest payment dates. Since the
issuing corporation will pay the full periodic interest on all bonds outstanding at an
interest date, the bondholder is usually required to purchase the interest that has accrued
from the most previous interest date to the date of sale. This accrued interest is added to
the issue price of the bond to determine the total cash proceeds from the bond issuance.

TRANSACTION COSTS ON ISSUE OF BONDS

Bond issue costs or transaction costs are incremental costs that are directly attributable
to the issue of bonds payable.

Bond issue costs are not treated as outright expense but amortized over the life of the
bond issue in a manner similar to that used for discount on bonds payable.

Bond issue costs are conceived as cost of borrowing and therefore will increase interest
expense. The amortization of bond issue costs is recorded by

Interest expense XX
Bond issue cost XX

PREMIUM AND DISCOUNT AMORTIZATION

When bonds are issued at a premium or discount, the periodic interest payments
made by the issuer to the investors over the bond life do not represent the complete
interest expense for the periods involved.

In order to reflect the total interest cost of the bonds, bond premium or discount should be
allocated over the life of the bonds using the effective interest method. This allocation,
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called amortization, is a deduction from or addition to the interest expense. Amortization

results in a gradual adjustment of the nominal interest to the effective interest.

EFFECTIVE INTEREST METHOD

Using the effective interest method, a constant interest rate based the carrying
(book) value of the bonds is recognized as interest expense each period, resulting in
unequal recorded amounts of interest expense. The interest method provides an
increasing premium or discount amortization each period.

To obtain a periods interest expense under this method, the bonds carrying value at the
beginning of each period is multiplied by the effective interest rate. The difference
between this amount and the amount of interest paid or accrued (nominal interest rate x
face value of the bonds) is the amount of discount or premium amortization.

Bonds Sold at Premium Discount

Interest expense DECREASES INCREASES
Carrying value DECREASES INCREASES
Amortization INCREASES INCREASES

The effective interest method or simply interest method or scientific method recognizes
two kinds of interest rate nominal rate and effective rate.

The nominal rate is the rate appearing on the face of the bonds while the effective rate is
the actual interest incurred on the bond issue.

The effective rate is the rate that exactly discounts estimated cash future payments
through the expected life of the bonds payable or when appropriate, a shorter period to
the net carrying amount of the bonds payable.

The nominal rate is also known as coupon or stated rate.

The effective rate is also known as yield or market rate.

If the bonds are sold at face value, the nominal rate and effective rate are the same.

If the bonds are sold at a discount, the effective rate is higher than nominal rate.

If the bonds are sold at a premium, the effective rate is lower than nominal rate.

FAIR VALUE OPTION OF BONDS PAYABLE

In accordance with PFRS 9, at initial recognition, bonds payable may be irrevocably

designated as at fair value through profit or loss.
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In other words, under the fair value option, the bonds payable shall be measured initially
at fair value and remeasured at every year-end at fair value and any changes in fair value
are recognized in profit or loss.

There is no more amortization of bond issue cost, bond discount or bond premium.

As a matter of fact, interest expense is recognized using the nominal or stated interest rate
and not the effective interest rate.

RETIREMENT OF BONDS

The issuing corporation may retire bonds at maturity date or before the maturity date
either by redeeming the bonds or repurchasing them in the open market. If bonds retire at
their maturity date, any premium or discount will have been completely amortized. The
retirement is recorded as an ordinary payment of debt, and no gain or loss is recognized
upon the retirement on maturity date. Hence, the entry for the settlement of the bonds on
maturity date is:

Bonds payable XX
Cash XX

The amount of cash paid to the bondholders equals the face value of the bonds.

If the bonds retired prior to their maturity and retirement price is less than the carrying
amount of the bonds, the corporation realizes a gain on the retirement. The carrying value
is equal to the face value of the bonds plus any unamortized premium or less any
unamortized discount on the date of retirement. Similarly, if the retirement price is
greater than the carrying value, a loss is incurred on the retirement of the debt. Gain or
loss on the retirement of bonds is reported in profit or loss as an operating gain or loss.

If bonds are retired before maturity date, the following must be observed:

I. The amortization of premium or discount must be updated to determine the

carrying amount of the bonds at the date of retirement.
II. Any accrued interest on the retired bonds from the most recent interest payment
date up to date of retirement must be recorded and paid.

TREASURY BONDS
Treasury bonds are an entitys own bonds originally issued and reacquired but not
canceled.

When treasury bonds are acquired, the treasury bonds account is debited at face value
and any related unamortized premium or discount or issue cost is canceled.
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The difference between the acquisition cost and the carrying amount of the treasury
bonds is treated as gain or loss on acquisition of treasury bonds.

Any accrued interest paid is charged to interest expense.

Treasury bonds are reported in the statement of financial position as a deduction from
bonds payable.

BOND REFUNDING
Bond refunding is the floating of new bonds payable the proceeds from which are used
in paying the original bonds payable.

Simply stated, bond refunding is the premature retirement of the old bonds payable
through the issuance of new bonds payable.

The refunding charges include the unamortized bond discount or premium, unamortized
bond issue cost and redemption premium on the bonds being refunded.

PFRS 9, provides that bond refunding is an extinguishment of a financial liability.

Further provides that the difference between the carrying amount of the financial liability
extinguished and the consideration paid shall be included in profit or loss.

Accordingly, the refunding charges shall be accounted for as loss on early extinguish of
debt.

BONDS WITH EQUITY CHARACTERISTICS

Corporations may issue bonds that allow creditors to ultimately become shareholders by
either attaching share warrants to the bonds or including a conversion feature in the bond
indenture. In either case, the investor has acquired a dual set of rights, namely: the right
to receive interest and principal payment on the bonds and the right to acquire ordinary
shares and participate in the potential appreciation of the market value of the shares.

Usually, bonds of this nature are attractive to investors and will generally result in either a
relatively lower interest rate or greater proceed when compared with other bond issue
with similar risk but without such rights.

CONVERTIBLE BONDS
Another example of a compound financial instrument is convertible bond. Convertible
bonds give the holders thereof the right to exchange their bondholding into ordinary
shares or other securities of the issuing company within a specified period of time.
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The principle of splitting the issue price of a compound financial instrument to its debt
component and equity component is applied. The issue price of the convertible
component is comprised of two components: a financial liability and an equity
instrument. The total issue price to bifurcated using the residual approach.

TROUBLED DEBT RESTRUCTURING

During periods of depressed economic conditions, some debtors experience difficulty in
meeting their maturing obligations. For this reason, the creditor may grant concession to
the debtor that it would not otherwise grant under normal conditions. This is referred to
as troubled debt restructuring.

Under IAS 39, an entity shall remove a financial liability from its statement of financial
position when, and only when, it is extinguished.

A troubled debt restructuring involves one of three forms:

Asset swap
Equity swap
Modification of debt terms

DISCLOSURE REQUIREMENTS

An entity shall disclose the following in its financial statements:

1. For each class of provision, an entity should disclose:

a. Information about the extent and nature of the financial instruments, including
significant terms and conditions that may affect the amount, timing and certainty
of future cash flows;

b. The accounting policies and methods adopted, including the criteria for
recognition and the basis of measurement applied.
2. When the financial instruments issued by an entity, either individually or as a class,
create a potentially significant exposure to either market risk, credit risk, liquidity risk
or cash flow interest rate risk, terms and conditions that warrant disclosure include

a. Principal, stated face or either similar amount;

b. Date of maturity, expiry, or execution;

c. Early settlement options;

d. Collateral pledged;
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3. For each class of financial liabilities, an entity shall disclose information about its
exposure to interest rate risk.

4. For each class of financial liabilities, an entity shall disclose the fair value of that
class of financial liabilities in a way that permits it to be compared with the
corresponding carrying amount in the balance sheet.

5. An entity shall disclose the carrying amount of financial assets pledged as collateral
for liabilities, the carrying amount of financial assets pledged as collateral for
contingent liabilities, and any material terms and conditions relating to assets pledged
as collateral.

6. If any entity has issued an instrument that contains both a liability and an equity
component and the instrument has multiple embedded derivative features whose
values are interdependent, it shall disclose the existence of those features and the
effective interest rate on the liability component.

7. An entity shall disclose material items of income, expense or gains and losses
resulting from financial liabilities.

QUESTION - THEORY

1. When an entity issued bonds payable for working capital needs, the proceeds from the sale of
the bonds payable

a. Will always be equal to the face amount.

b. Will always be less than to the face amount.
c. Will always be more than to the face amount.
d. May be equal, more or less than the face amount depending on market interest rate.
2. Which of the following statements concerning discount on note payable is incorrect?

a. Discount on note payable may be debited when an entity discounts its own note with the
bank.
b. The discount on note payable is a contra liability account which is shown as a deduction
from note payable.
c. The discount on note payable represents interest charges applicable to future periods.
 CHAPTER 2: NON-CURRENT LIABILITIES

d. Amortizing the discount on note payable causes the carrying amount of the liability to
gradually decrease over the life of the note.

3. In a debt restructuring that is considered an asset swap, the gain on extinguishment is equal to
the

a. Excess of the fair value of the asset over its carrying amount
b. Excess of the carrying amount of the debt over the fair value of the asset.
c. Excess of the fair value of the asset over the carrying amount of the debt.
d. Excess of the carrying amount of the debt over the carrying amount of the asset.

4. The discount resulting from the determination of the present value of a note payable shall be
reported in the statement of financial position as

a. Deferred credit separate from the note.

b. Direct deduction from the face amount of the note.
c. Deferred charged separate from the note.
d. Addition to the face amount of the note.

5. On September 1, 2012, an entity borrowed cash and signed a 2-year interest-bearing note on
which both the principal and interest are payable on September 1, 2014. How many months
of accrued interest would be included in the liability for accrued interest on December 31,
2012 and December 31, 2013?

December 31, 2012 December 31, 2013

a. 4 months 16 months
b. 4 months 4 months
c. 12 months 24 months
d. 20 months 8 months

6. The difference between the carrying amount of a financial liability extinguished and the
consideration given shall

a. Be recognized in profit or loss

b. Be included in equity
c. Be included in retained earnings
d. Not be recognized

7. Costs incurred in connection with the issuance of 10-year bonds which is sold at a slight
premium shall be

a. Charged to retained earnings when the bonds are issued

b. Expensed in the year in which incurred
c. Capitalized as organization cost
d. Reported in the statement of financial position as a deduction from bonds payable and
amortized over the 10-year bond term
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8. Which of the following statements is true in relation to the fair value option of measuring a
bond payable?

I. At initial recognition, an entity may revocably designate a bond payable at fair value
through profit or loss.

II. The bond payable is remeasured at every year-end at fair value and any changes in fair
value are recognized in other comprehensive income

a. I only
b. II only
c. Both I and II
d. Neither I nor II

9. After initial recognition, bonds payable shall be measured at

I. Amortized cost using the effective interest method.

II. Fair value through profit or loss

a. I only
b. II only
c. Either I or II
d. Neither I nor II

10. An entity shall measure initially a note payable not designated at fair value through profit or
loss at

a. Face amount
b. Fair value
c. Fair value plus transaction cost
d. Fair value minus transaction cost

ANSWER THEORY

1. D 6. B
2. D 7. D
3. D 8. D
4. D 9. D
5. D 10. C

QUESTION - PROBLEM

1. HAPPY Company had the following long-term debt:

Bonds maturing in installments, secured by machinery 1,000,000

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Bonds maturing on a single date, secured by realty 1,800,000

Collateral trust bonds 2,000,000

What is the total amount of debenture bonds?

a. 2,000,000
b. 1,000,000
c. 1,800,000
d. 0

2. ACE Company incurred costs of P6,600 when it issued, on August 31, 2012, five-
year debenture bonds dated April 1, 2012. What amount of bond issue expense should
ACE report in its income statement for the year ended December 31, 2012?

a. P440
b. P480
c. P990
d. P6,600

3. OBAMA Companys liability account balances at June 30, 2011, included a 10% note
payable in the amount of P3,600,000. The note is dated October 1, 2010, and is
payable in three equal annual payments of P1,200,000 plus interest. The first interest
and principal payment was made on October 1, 2011.

On June 30, 2012, what amount should be reported as accrued interest payable?

a. 270,000
b. 180,000
c. 90,000
d. 60,000

4. PANADO Company is experiencing financial difficulty and negotiating debt restructuring

with its creditor to relieve it financial stress. The company has a P2,500,000 note payable to
the bank. The bank accepted an equity interest in PANADO Company in the form of
P200,000 ordinary shares quoted at P12 per share. The par value is P10 per share.

The fair value of the note payable on the date of restructuring is P2,200,000.

What amount should be recognized as gain from debt extinguishment as a result of the
equity swap?

a. 400,000
b. 100,000
c. 500,000
d. 200,000
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5. (Refer to no. 4) What amount should be recognized as share premium from the issuance of
the shares?

a. 500,000
b. 100,000
c. 400,000
d. 200,000

6. The following information pertains to Hike Tours, Inc., issuance of bonds on July 1.
2012:

Face amount P400.000

Term 10 years
Stated interest rate 6%
Interest payment dates Annually on July 1
Yield 9%

What is the issue price for each P1,000 bond?

a. P1,000
b. P864
c. P807
d. P700

7. MIAMI Company issued P2,000,000 face value of 10-year bonds on January1. The bonds
pay interest on January and July a and have a stated rate of 10%. If the market rate of interest
is 8%, what will be the issue price of the bonds?

a. 2,262,000
b. 2,113,000
c. 2,159,000
d. 2,279,000
8. On July 1, 2011, HE Company obtained P2,000,0000, 180-day bank loan at an annual rate of
12%. The loan agreement requires HE to maintain a P400,000 compensating balance in its
checking account at the lending bank. HE would otherwise maintain a balance of only
P200,000 in this account. The checking account earns interest at an annual rate of 6%.

Based on a 360-day year, what is the effective interest rate on the borrowing?

a. 12.00%
b. 12.67%
c. 13.33%
d. 13.50%

ANSWERS PROBLEM
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1. Debenture bonds are unsecured bonds or bonds without collateral security. Collateral
trust bonds are bonds secured by investments in shares and bonds.

2. Incurred costs P6,600

x 4 yrs.
P26, 400

Amortization of issue costs in 2009: (26,400/55) P480

The bond term is 4 years, seven months, or 55 months. Bonds were outstanding 4 months
in 2012.

3. Note payable - October 1, 2010 3,600,000

Payment on October 1, 2011 (1,200,000)

Balance, October 1, 2011 P2,400,000

Accrued interest payable from October 1, 2011 to

June 30, 2012 (2,400,000 x 10% x ) P180,000

4. Note payable 2,500,000

Fair value of shares (200,000 x 12) 2,400,000

Gain on debt extinguishment P100,000

5. Fair value of shares 2,400,000

Par value of shares (200,000 x 10) 2,000,000

Share premium P400,000

6. Total issue price = P1,000 (PV1, 9%, 10) + .06 (P1,000)(PVA, 9%, 10)
=P1,000 (.42241) + P60 (6.41766)
= P807.

7. PV of 1 at 4% for 20periods .46

PV of an ordinary annuity of 1 at 4% for 20 periods 13.59

PV of principal (2,000,000 x .46) 920,000

PV of semiannual interest payments (100,000 x 13.59) 1,359,000

Issue price of bonds P2,279,000

8. Interest expense(2,000,000 x 12% x 180/360) 120,000

Interest income on compensating balance
in excess of the normal checking account
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balance (200,000 x 6% x 180/360) ( 6,000)

Net interest expense P114,000

Loan 2,000,000
Less: Compensating balance in excess of the
Normal checking account balance ( 200,000)

Net proceeds P1,800,000

Effective amount (1,800,000 x 180/360) 900,000

Effective interest rate (114,000/900,000) 12.67%

REFERENCES:

Intermediate Accounting; Volume 2; 2012 edition;

By: Nenita S. Robles and Patricia M. Empleo

Financial Accounting; Volume 2; 2012 edition;

By: Conrado T. Valix, Jose F. Peralta and Christian Aris M. Valix

Practical Accounting; Volume 1; 2011 edition;

By: Conrado T. Valix and Christian Aris M. Valix

Theory of Accounts; Volume 2; 2012 edition;

By: Conrado T. Valix and Christian Aris M. Valix

1.
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