CHAPTER 23

FINANCIAL ASSET AT AMORTIZED COST

QUESTION 23-1

Explain the measurement of a financial asset at amortized cost.

ANSWER 23-1

PFRS 9, paragraph 4.2, provides that a financial asset shall be measured at amortized
cost if both of the following conditions are met:

a. The business model is to hold the financial set in order to collect contractual cash
flows on specified dates.

b. The contractual cash flows are solely payments of principal and interest on the
principal amount outstanding.

In other words, the business model is to collect, contractual cash flows if the contractual
cash flows are solely payments of principal interest. In such a case, the financial asset
shall be measured at amortized cost.

Financial assets measured at amortized cost include investment in bonds and other
debt instruments.

Financial assets at amortized cost are classified as noncurrent assets.

PFRS 9, paragraph 4.4, further provides that by residual definition or by default,

financial assets that do not meet the conditions for amortized cost measurement
shall be measured at fair value.

QUESTION 23-2

What is a bond?

ANSWER 23-2

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 payments at a stated
rate until the principal sum is paid.

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

Thus, a bond is a debt security because the bondholder is a creditor and the issuer is a
debtor.
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 ”.

QUESTION 23-3

What is the purpose of acquiring bond investment?

ANSWER 23-3

An investor acquires a bond either as a temporary or permanent investment and derives

regular income in the form of interest.

The investment is usually paid semiannually or every six months as follows:

a. January 1 and July 1

b. February 1 and August 1
c. March 1 and September 1
d. April 1 and October 1
e. May 1 and November 1
f. June 1 and December 1

Of course, there are certain bonds that pay interest annually or at the end of the bond
year.

QUESTION 23-4

Discuss a bond premium and bond discount.

ANSWER 23-4

If the acquisition cost of the bonds is different from the face value, the bonds are said to
be acquired at a premium or discount.

If the acquisition cost is more than the face value, the difference is a bond premium. If
the acquisition cost is less than the face value, the difference is a bond discount.

When the bond investment is held for “trading”, it is not necessary to amortize the
premium or discount.

PAS 39 mandates that interest income for available for sale bond investment must be
calculated using the effective interest method.

Accordingly, this would require amortization of any discount or premium on available

for sale bond investment.

PAS 39 further requires that held to maturity securities shall be measured at amortized
cost. This means that any premium or discount on the acquisition of held to maturity
bond investment must be amortized.
Bond premium or discount is amortized over the life of the bonds. On the part of the
bondholder, the life of the bonds is from the date of acquisition to the date of maturity.

QUESTION 23-5

Why amortize bond premium or bond discount?

ANSWER 23-5

Conceptually, bond premium is a loss on the part of the investor because the investor
paid more than what can be collected on the date of maturity which is equal to the face
value.

Such loss is not recognized outright but allocated or amortized over the life of the bond
to be deducted from the interest income derived from the bond investment. Thus, the
periodic amortization of bond premium is recorded by debiting interest income and
crediting the investment account.

Conceptually, bond discount is a gain on the part of the investor paid less than what can
be collected on the date of maturity.

Such gain is not recognized outright but allocated or amortized over the life of the bond
to be added to the interest income derived from the bond investment. Thus, the periodic
amortization of the bond discount is recorded by debiting the investment account and
crediting interest income.

QUESTION 23-6

What are callable bonds?

ANSWER 23-6

Callable bonds are those which may be called in or redeemed by the issuer prior to the
date of maturity.

Usually, the call price or redemption price is at premium or more than the face value of
the bonds.

The difference between the redemption price and the carrying amount of the bonds on
the date of redemption is recognized on profit or loss.

QUESTION 23-7

What are convertible bonds?

ANSWER 23-7

Convertible bonds are those which give the bondholders the right to exchange their
bonds for share capital of the issuing entity at any time prior to maturity.
This subject matter will be discussed more in detail in a later chapter because
convertible bonds involve an embedded derivative. The equity conversion option is the
embedded derivative.

The existence of the conversion feature generally precludes classification of the

convertible bonds as financial assets at amortized cost because that would be
inconsistent with paying for the conversion feature, meaning the right to convert into
equity shares before maturity.

Accordingly, investment in convertible bonds can be classified as financial asset at fair

value.

QUESTION 23-8

What are serial bonds?

ANSWER 23-8

Serial bonds are those which have a series of maturity dates or those bonds which are
payable in installments.

For instance, a 1,000,000 bond issued on January 1, 2010 may provide that the bond
will mature as follows:

December 31, 2010 200,000

December 31, 2011 200,000
December 31, 2012 200,000
December 31, 2013 200,000
December 31, 2014 200,000

QUESTION 23-9

What are term bonds?

ANSWER 23-9

Term bonds are those bonds that mature on a single date.

Callable and convertible bonds can be classified as term bonds despite their special
features.

QUESTION 23-10

What are the three methods of amortizing bond premium or bond discount?

ANSWER 23-10
1. Straight line method - This method provides for an equal or uniform amount of
premium or discount amortization each accounting period.

2. Bond outstanding method - This method is applicable to serial bonds.

3. Effective interest method or simply “interest method” or scientific method - This

provides or an increasing amount of amortization.

In accordance with PFRS 9, bond investments shall be classified as financial assets

measured at amortized cost using the effective interest method. This means that any
discount or premium must be amortized using the effective interest method.

The straight line method and bond outstanding method are acceptable only when the
computation will result in periodic interest income that is not materially different from
the amount that would be computed using the effective interest method.

QUESTION 23-11

What is the market price of bonds?

ANSWER 23-11

The market price of the bonds is equal to the sum of the following:

a. Present value of principal = principal multiplied by the “PV of 1 factor” for the
number of interest periods using the “effective rate”.

b. Present value of interest payments = Periodic interest payment multiplied by the

“PV of an ordinary of 1 factor” for the number of interest periods using the “effective
rate”.

QUESTION 23-12

Distinguish effective rate and nominal rate.

ANSWER 23-12

Nominal or coupon or stated rate is the rate of interest appearing on the face of the
bonds.

The nominal rate multiplied by the face of the bonds gives the periodic interest received
by the bondholder.

Effective or yield or market rate is the true or actual rate of interest which bondholder
earns on the investment.

The effective rate multiplied by the carrying mount of the bond investment gives the
actual interest earned.
The carrying amount of the bonds is the initial cost gradually increased by periodic
amortization of premium.

The effective rate and the nominal rate are the same if the cost of the bond investment
is equal to the face value.

When the bonds are acquired at a premium, the effective rate is lower than the nominal
rate.

The reason is that the premium is a loss on the part of the bondholder.

On the other hand, when the bonds are acquired at a discount, the effective rate is
higher than the nominal rate.

The reason is that the discount is a gain on the part of the bondholder.

QUESTION 23-13 Multiple choice (IAA)

1. The contractual agreement between an investor and the bond issuer is contained in a
formal document known as

a. Contract of debt
b. Bond indenture
c. Bond certificate
d. Bond agreement

2. Accrued interest on bonds that are purchased between interest dates

a. I ignored by both seller and the buyer.

b. Increases the amount a buyer must pay to acquire the bonds.
c. Is recorded s a loss on the sale of the bonds.
d. Deceases the amount a buyer must pay to acquire the bonds.

3. If a 5-year bond matures on October 1, 2011 and interest is payable semiannually,

the interest dates are

a. April 1 and October 1

b. January 1 and July 1
c. May 1 and November 1
d. Not determinable

4. The effective interest method of amortizing bond discount provides for

a. Increasing amortization and increasing interest income.

b. Increasing amortization and decreasing interest income.
c. Decreasing amortization and increasing interest income.
d. Decreasing amortization and decreasing interest income.

5. The interest written on the face of bond is known as

 a. Nominal rate
b. Coupon rate
c. Stated rate
d. Nominal rate, coupon rate or stated rate

6. To compute the price to pay for a bond, what present value concept is used?

a. Only the present value of 1 concept

b. Only the present value of an annuity 1 concept
c. Both the present value of 1 concept and present value of an annuity 1 concept
d. Neither the present value of 1 concept on the present value of annuity of 1 concept

7. Bonds usually sell at a discount when

a. Investors are willing to invest in the bonds at the stated interest rate.
b. Investors are willing to invest in the bonds at rates that are lower than the stated
interest rate.
c. Investors are willing to invest in the bonds at rates higher than the stated interest
rate.
d. A capital gain is expected.

8. Bonds usually sell at a premium

a. When the market rate of interest is greater than the stated rate of interest on the
bonds.
b. When the stated rate of interest on the bonds is greater than the market rate of
interest.
c. When the price of the bonds is greater than their maturity value.
d. In none of the above cases.

9. The effective interest rate on the bond is lower than the stated rate when bonds sell

a. At maturity value
b. Above face value
c. Below face value
d. At face value

10. The effective interest rate on the bond is higher than the stated rate when bonds
sell

a. At maturity value
b. Above face value
c. Below face value
d. At maturity value

ANSWER 23-13

1. b 6. c
2. b 7. c
3. a 8. b
4. a 9. b
5. d 10. c

QUESTION 23-14 Multiple choice (AICPA Adapted)

1. How is the premium or discount on bonds purchased s a “trading ” investment

reported financial statements?
a. As an integral part of the cost of the asset acquired and amortized over the
remaining life of the bond issue.
b. As an integral part of the cost of the asset acquired until such time as the
investment is sold.
c. As expense or revenue in the period the bonds are purchased.
d. As an integral part of the cost of the asset acquired and amortized over the period
the bonds are expected to be held.

2. An entity did not amortize the discount on its “trading ” bond investment. What effect
would this have on the carrying amount of the investment and on net income,
respectively?

a. Overstated, overstated
b. Understated, overstated
c. understated, understated
d. No effect, no effect

3. An investor purchased a bond classified as a long-term investment between interest

dates at a premium. At the purchase date, the carrying amount of the bond is more
than the

I. Cash paid to seller

II. Face value of bond

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

4. An investor purchased a bond as a long term investment between interest dates at a

premium. At the purchase date, the cash paid to the seller is

a. The same as the face amount of the bond

b. The same as the face amount of the bond plus accrued interest
c. More than the face amount of the bond
d. Less than the face amount of the bond

5. An investor purchased a bond as a long-term investment on January 1. Annual

interest was received on December 31. The investor’s interest income for the year would
be lower if the bond was purchased at
 a. A discount
b. A premium
c. Par
d. Face value

6. An investor purchased a bond as a long-term investment on January 1. Annual

interest was received on December 31. The investor’s interest income for the year would
be higher if the bond was purchased at

a. Par
b. Face value
c. A discount
d. A premium

7. When the interest payment dates of a bond are May 1 and November 1, and a bond
purchased on June 1, the amount of cash paid by the investor would be

a. Decreased by accrued interest from June 1 to November 1.

b. Decreased by accrued interest from May 1 to June 1.
c. Increased by accrued interest from June 1 to November 1.
d. Increased by accrued interest from May 1 to June 1.

8. In the prior year, an entity acquired at a premium 10-year bond s a long-term

investment. At the end of the current year, the bond is quoted at a small discount.
Which of the following situations is the most likely cause of the decline in the bond ’s
market value?

a. The bond issuer issued a stock dividend.

b. The bond issuer is expected to call the bond at a premium, which is less than the
investor’s carrying amount.
c. Interest rates have declined since the investor purchased the bond.
d. Interest rates have increased since the investor purchased the bond.

9. A bond purchased on June 1 of the current year has interest payment dates of April 1
and October 1. Bond interest income for the current year ended December 31 is for

a. 3 months
b. 4 months
c. 6 months
d. 7 months

10. The effective interest method of amortizing bond premium

a. Is too complicated for practical use.

b. Uses constant rate of interest.
c. Is another name for the straight line method.
d. I needed to determine the amount of cash to be paid to bondholders at each interest
date.
ANSWER 23-14

1. b 6. c
2. d 7. d
3. c 8. d
4. c 9. d
5. b 10. b