FINANCIAL ACCOUNTING AND REPORTING

INVESTMENT IN DEBT SECURITIES

Bonds

• Bonds are long-term debt instruments similar to term loans except that they are usually offered
to the public and sold to many investors.

• 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.

Types of bonds

• Term bonds – bonds that mature on a single date.

• Serial bonds – bonds that mature in a series of maturity dates.

• Registered bonds – bonds issued in the name of the holder (owner). Interest payments are sent
directly to the holder.

• Coupon (bearer) bonds – bonds that can be freely transferred and have a detachable coupon for
each interest payment.

• Zero-coupon bonds (strip bonds) – bonds that do not pay periodic interests. Principal and
compounded interest are due only at maturity date.

• Callable bonds – bonds containing call provisions giving the issuer thereof the right to redeem
the bonds prior to their maturity date.

• Convertible bonds – bonds giving the holder thereof the option of exchanging the bonds for
shares of stocks of the issuer.

Accounting for investments measured at amortized cost

• The accounting for investments in bonds that are measured at amortized cost is similar to the
accounting for notes and loans receivables, in the sense that it also involves the following:

a. Present value computations

b. Preparation of amortization table (Effective interest method)

Discount vs. Premium

• If the carrying amount is less than the face amount, the difference represents a discount.

• If the carrying amount is more than the face amount, the difference represents a premium.

• If there is a discount, the EIR is higher than the NIR.

• If there is a premium, the EIR is lower than the NIR.

 • Discount or premium is amortized using the effective interest method.

Effect of discount amortization

You have acquired a bond with face amount of ₱5,000 for ₱4,000.

 Would this be favorable or an unfavorable on your part?

 Favorable. Why? --- You will be collecting ₱5,000 (excluding interest) while your cash outflow is
only ₱4,000.

 On acquisition date, it seems you have earned a “gain” of ₱1,000, right?

 Yes; however, the PFRSs prohibit you from recognizing this “gain” outright. You need to
amortize it over the term of the bond.

 The “gain” represents the discount (Carrying amount less than Face amount).

 The effect of the amortization is an increase in interest income.

 Over the term of the bonds, total interest income will be greater than total collections of
interests by ₱1,000.

Transaction costs

• Transaction costs incurred in the acquisition of bonds to be measured at amortized cost are
included as part of the cost of the investment.

Sale of bonds prior to maturity

• When bonds are sold prior to maturity, the difference between the net disposal proceeds and
the carrying amount of the bonds, adjusted for any discount or premium amortization up to
date of disposal, is recognized as gain or loss in profit or loss.

Serial bonds

• Serial bonds are bonds with series of maturity dates. Serial bonds are accounted for similar to
term bonds. However, the periodic collections on serial bonds include not only collections for
interests but also collections for principal.

Zero-coupon bonds

• Zero-coupon bonds are bonds that do not pay periodic interests. Both principal and interest are
due only at maturity date.

Financial assets measured at FVOCI (mandatory)

• Initial measurement: Fair value + Transaction costs.

• Subsequent measurement: Fair value

o Changes in fair value are recognized in OCI.

o Impairment losses and gains are recognized in profit or loss.

 o Interest revenue is computed using the effective interest method and is recognized in
profit or loss.

• Derecognition: When the asset is derecognized, the cumulative balance of gains and losses in
equity are transferred to profit or loss as a reclassification adjustment.

• The amounts recognized in profit or loss for a debt instrument measured at FVOCI are the same
as the amounts that would have been recognized in profit or loss if the debt instrument had
been measured at amortized cost.

Regular way purchase or sale of financial assets

• A regular way purchase or sale is a purchase or sale of a financial asset under a contract whose
terms require delivery of the asset within the time frame established generally by regulation or
convention in the marketplace concerned.

• Trade date accounting vs. Settlement date accounting

a. Under trade date accounting, the financial asset purchased (s0ld) is recognized
(derecognized) at the trade date (i.e., the date the entity commits to purchase or sell the
financial asset).

b. Under settlement date accounting, the financial asset purchased (s0ld) is recognized
(derecognized) at the settlement date (i.e., the date the ownership of the financial asset is
transferred).

Fair value change between trade date & settlement date

• For purchases of FVPL and FVOCI assets (but not amortized cost), the buyer recognizes the
change in fair value between the trade date and the settlement date.

• For sale transactions, the seller does not recognize the change in fair value between the trade
date and the settlement date.

Reclassification

• After initial recognition, financial assets are reclassified only when the entity changes its
business model for managing financial assets.

• Reclassification date is the first day of the first reporting period following the change in business
model that results in an entity reclassifying financial assets.
Reclassification of debt-type financial assets
Notes on reclassification

• Only debt instruments can be reclassified. Equity instruments (e.g., investments in shares of
stocks) cannot be reclassified.

• Financial assets cannot be reclassified into or out of the “designated at FVPL” and “FVOCI -
election” classifications.

• The initial measurement is fair value at reclassification date, except for a reclassification from
FVOCI to Amortized cost where the fair value on reclassification date is adjusted for the
cumulative balance of gains and losses previously recognized in OCI.

Impairment

• The impairment requirements of PFRS 9 apply equally to debt-type financial assets that are
measured either at amortized cost or at FVOCI.

• Impairment gains or losses on debt instruments measured at FVOCI are recognized in profit or
loss. However, the loss allowance is recognized in OCI and does not reduce the carrying amount
of the financial asset in the statement of financial position.

Dividends

• Only cash and property dividends received from equity securities may be recognized as dividend
revenue.

Stock rights

• Stock rights, being equity instruments, are measured at fair value.

Disclosure of Risks on financial instruments

1. Credit risk - The risk that one party to a financial instrument will cause a financial loss for the
other party by failing to discharge an obligation.

2. Liquidity risk - The risk that an entity will encounter difficulty in meeting obligations associated
with financial liabilities that are settled by delivering cash or another financial asset.

3. Market risk - The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market prices. Market risk comprises the following.

a) Interest rate risk

b) Currency risk

c) Other price risk

Other long-term investments

Other long-term investments include investments in funds set aside for specific and long-term purpose
and cash surrender value.

Examples of other long-term investments

a. Sinking fund

b. Preference share redemption fund

c. Asset replacement fund

d. Expansion fund

e. Contingency fund

f. Insurance fund

g. Cash surrender value

Cash surrender value

• A cash surrender value accumulates when premiums and interest paid on a whole life insurance
exceed the cost of insurance.

Accounting for cash surrender value

INITIAL RECOGNITION:

• On initial recognition, the cash surrender value is allocated over the required holding period
necessary for it to accumulate (e.g., 3 years). The amount allocated to the current year is
recognized as a deduction from insurance expense while the amount allocated to prior years is
credited to retained earnings. The cash surrender value is classified as noncurrent investment.

• Pro-forma entry:

Cash surrender value xx

Retained earnings xx
Insurance expense xx

SUBSEQUENT PERIODS:

• Subsequent to initial recognition, increases in cash surrender value are treated as deduction
from the insurance expense recognized during the period.

• Pro-forma entry:

Cash surrender value xx

Insurance expense xx

• Cash dividends received from the insurance are not recognized as income but rather as
deduction from the insurance expense recognized during the period.
 • Pro-forma entry:
Cash xx
Insurance expense xx

SETTLEMENT:

• When the insured key employee dies during the year, the increase in cash surrender value is
recognized up to the date of death. The difference between (a) the insurance proceeds received
or receivable and (b) the sum of cash surrender value and any unexpired portion of prepaid
insurance is recognized as gain on life insurance settlement.

• Pro-forma entry:
Cash xx
Cash surrender value xx
Insurance expense/ Prepaid insurance xx
Gain on settlement xx
 INVESTMENT IN ASSOCIATE

Definition of terms

• Associate – an entity, including an unincorporated entity such as a partnership, over which the
investor has significant influence.

• Significant influence – the power to participate in the financial and operating policy decisions of
the investee but is not control or joint control over those policies. (PAS 28)

Significant influence

• Significant influence is presumed to exist if the investor holds, directly or indirectly (e.g. through
subsidiaries), 20% or more of the voting power of the investee, unless it can be clearly
demonstrated that this is not the case.

• For significant influence to exist, the investment should provide the investor voting rights. Thus,
investment in preference shares, regardless of the percentage of ownership, is not accounted
for under PAS 28 because preference shares do not give the investor voting rights.

Evidence of existence of significant influence by an investor

The following may provide evidence of significant influence even if the percentage of ownership interest
is less than 20%.

a) Representation on the board of directors or equivalent governing body of the investee;

b) Participation in policy-making processes, including participation in decisions about dividends or

other distributions;

c) Material transactions between the investor and the investee;

d) Interchange of managerial personnel; or

e) Provision of essential technical information.

Equity method

• Investments in associates or joint ventures are accounted for using the equity method. Under
this method, the investment is initially recognized at cost and subsequently adjusted for the
investor’s share in the changes in the EQUITY of the investee.

T-accounts

Investment in associate Sh. In P/L of associate

beg. xx
Sh. in profit xx xx Sh. in loss Sh. in loss xx xx Sh. in profit
Sh. in (Cr.) OCI xx xx Sh. in (Dr.) OCI
xx Sh. in dividends
Undervaluation Undervaluation
xx of asset of asset xx
xx end. xx
Preference shares issued by an associate

If an associate has outstanding preference shares that are held by parties other than the investor, the
investor computes its share of profits or losses after making the following adjustments.

Discontinuance of the use of equity method

• An investor starts to apply the equity method on the date it obtains significant influence and
ceases to apply the equity method on the date it loses significant influence.

• On the loss of significant influence, the investor shall measure at fair value any investment the
investor retains in the former associate. The investor shall recognize in profit or loss any
difference between:

a. The fair value of any retained investment and any proceeds from disposing of
the part interest in the associate; and

b. The carrying amount of the investment at the date when significant influence is
lost.

Classification of retained interest

Following the discontinuance of equity method, the retained interest shall be classified as follows:
Reclassification of cumulative OCI

• If an investor loses significant influence over an associate, all amounts recognized in other
comprehensive income in relation to the associate shall be accounted on the same basis as
would be required if the associate had directly disposed of the related assets or liabilities.

Change to equity method - Gain of significant influence

• Significant influence may be achieved from additional purchase of shares resulting to an

increase in ownership interest. Although, not specifically addressed in PAS 28, this type of
acquisition may be accounted for by reference to PFRS 3 Business Combinations particularly on
the accounting for business combination achieved in stages.

• “In a business combination achieved in stages, the acquirer shall remeasure its previously held
equity interest in the acquiree at its acquisition-date fair value and recognize the resulting gain
or loss, if any, in profit or loss or other comprehensive income, as appropriate.” (PFRS 3.42 )

Share in losses of associate

If an investor’s share of losses of an associate equals or exceeds its interest in the associate, the
investor discontinues recognizing its share of further losses.

Interest in the associate includes the following:

1. Investment in associate measured under equity method

2. Investment in preference shares of the associate
3. Unsecured long-term receivables or loans

Interest in the associate does not include the following:

1. Trade receivables and payables

2. Secured long-term receivables or loans

After the investor’s interest in the associate is reduced to zero, additional losses are provided for, and a
liability is recognized, only to the extent that the investor has incurred

a. Legal or constructive obligations or

b. Made payments on behalf of the associate.

• Any other losses are not recognized.

• If the associate subsequently reports profits, the investor resumes recognizing its share of
those profits only after its share of the profits equals the share of losses not recognized.