BOND INVESTMENTS (DEBT SECURITIES) AT FAIR VALUE

➢ What is a Bond?

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. It is a contract of debt evidences by a certificate known as bond indenture.

It is the most common form of debt security. Bonds are used by companies, municipalities, states,
and sovereign governments to finance projects and operations. Owners of bonds are debtholders,
or creditors, of the issuer. Bond details include the end date when the principal of the loan is due
to be paid to the bond owner and usually includes the terms for variable or fixed interest payments
made by the borrower.

KEY TAKEAWAYS

• Bonds are units of corporate debt issued by companies and securitized as tradeable assets.
• A bond is referred to as a fixed income instrument since bonds traditionally paid a fixed
interest rate (coupon) to debtholders. Variable or floating interest rates are also now quite
common.
• Bond prices are inversely correlated with interest rates: when rates go up, bond prices fall
and vice-versa.
• Bonds have maturity dates at which point the principal amount must be paid back in full or
risk default.

➢ Who are the Issuers of Bonds?

Governments (at all levels) and corporations commonly use bonds to borrow money. Governments
need to fund roads, schools, or other infrastructure. The sudden expense of war may also demand
the need to raise funds.

Similarly, corporations will often borrow to grow their business, to buy property and equipment, to
undertake profitable projects, for research and development or to hire employees. The problem
that large organizations run into is that they typically need far more money than the average bank
can provide. Bonds provide a solution by allowing many individual investors to assume the role of
the lender. Indeed, public debt markets let thousands of investors each lend a portion of the capital
needed. Moreover, markets allow lenders to sell their bonds to other investors or to buy bonds
from other individuals—long after the original issuing organization raised capital.

➢ How Bonds Work?

Bonds are commonly referred to as fixed income securities and are one of three asset classes
individual investors are usually familiar with, along with stocks (equities) and cash equivalents.

When companies or other entities need to raise money to finance new projects, maintain ongoing
operations, or refinance existing debts, they may issue bonds directly to investors. The borrower
(issuer) issues a bond that includes the terms of the loan, interest payments that will be made, and
the time at which the loaned funds (bond principal) must be paid back (maturity date). The interest
payment (the coupon) is part of the return that bondholders earn for loaning their funds to the
issuer. The interest rate that determines the payment is called the coupon rate.
 The initial price of most bonds is typically set at their face value. Face value is a financial term used
to describe the nominal or peso value of a security, as stated by its issuer. . For bonds, it is the
amount paid to the holder at maturity, typically in P1,000 denominations. For example, a
P50,000,000 bond issue may be issued in denomination of P1,000. Thus, there shall be 50,000 bonds
with face value of P1,000 each.

The actual market price of a bond depends on a number of factors: the credit quality of the issuer,
the length of time until expiration, and the coupon rate compared to the general interest rate
environment at the time. The face value of the bond is what will be paid back to the borrower once
the bond matures.

Most bonds can be sold by the initial bondholder to other investors after they have been issued. In
other words, a bond investor does not have to hold a bond all the way through to its maturity
date. It is also common for bonds to be repurchased by the borrower if interest rates decline, or if
the borrower’s credit has improved, and it can reissue new bonds at a lower cost.

➢ What are the Advantages and Disadvantages of Bonds?

• Bondholders receive income through the interest payments
• Bondholders can hold the bond to maturity and get all principal back
• There is profit in reselling bond at a higher price
• Bonds pay out lower returns than stocks
• Companies can default on the bonds issued
• Bond yields can fall

➢ What are the Characteristics of Bonds?

Most bonds share some common basic characteristics including:
• Face value is the money amount the bond will be worth at maturity; it is also the reference
amount the bond issuer uses when calculating interest payments. For example, say an
investor purchases a bond at a premium $1,090 and another investor buys the same bond
later when it is trading at a discount for $980. When the bond matures, both investors will
receive the $1,000 face value of the bond.
• Nominal rate or Coupon rate is the rate of interest the bond issuer will pay on the face
value of the bond, expressed as a percentage. For example, a 5% coupon rate means that
bondholders will receive 5% x P1000 face value = P50 every year.
• Coupon dates are the dates on which the bond issuer will make interest payments.
Payments can be made in any interval, but the standard is semiannual payments.
• Maturity date is the date on which the bond will mature and the bond issuer will pay the
bondholder the face value of the bond.
• Issue price is the price at which the bond issuer originally sells the bonds.

➢ What are the Two Features of a Bond?

Credit quality and time to maturity—are the principal determinants of a bond's coupon rate. If the
issuer has a poor credit rating, the risk of default is greater, and these bonds pay more interest.
Bonds that have a very long maturity date also usually pay a higher interest rate. This higher
compensation is because the bondholder is more exposed to interest rate and inflation risks for an
extended period.
 Credit ratings for a company and its bonds are generated by credit rating agencies. The very highest
quality bonds are called “investment grade” and include debt issued by the government and very
stable companies. Bonds that are not considered investment grade, but are not in default, are called
“high yield” or “junk” bonds. These bonds have a higher risk of default in the future and investors
demand a higher coupon payment to compensate them for that risk.
Bonds and bond portfolios will rise or fall in value as interest rates change.

➢ What are the Classifications of Bond Investments?

a.
b.
c.
d.

➢ What are the Initial Measurements of Bond Investments?

Classification Initial Measurement
FA at FV through Profit or Loss
FA at FV through Other Comprehensive Income
FA at Amortized Cost

➢ What are the Subsequent Measurements of Bond Investments?

Classification Subsequent Measurement
FA at FV through Profit or Loss
FA at FV through Other Comprehensive Income
FA at Amortized Cost

➢ How to Account for the Acquisition of Bonds?

A. Acquired on Interest Dates
Journal entry to recognize the acquisition:
Investment in Bonds xxx
Cash xxx

B. Acquired between Interest dates

o Date of acquisition is not any one of the interest dates.
o The purchase price normally includes the Accrued Interest.
o The portion of the purchase price representing accrued interest should not be
reported as part of the cost of investment but should be accounted for separately.
o On the date of acquisition, the accrued interest is charged either to (A) Accrued
Interest Receivable or (B) Interest Income.

ILLUSTRATION 1: ACQUIRED BETWEEN INTEREST DATES

Acquisition
An entity acquired 12% bonds with face amount of P2,000,000 for
P2,200,000 which includes accrued interest of P20,000.
The bonds are held for trading.

Journal entry to recognize the acquisition:

(A) (B)
FA – FVPL (TS) 2,180,000 FA – FVPL (TS) 2,180,000
Accrued Interest Receivable 20,000 Interest Income 20,000
Cash 2,200,000 Cash 2,200,000

First Semiannual Interest

Journal entry to recognize the interest:

(A) (B)
Cash 120,000 Cash 120,000
Accrued Interest Receivable 20,000 Interest Income 120,000
Interest Income 100,000

KEY TAKEAWAYS:

(A) When accrued interest receivable is debited, upon receipt of the first semiannual interest, the accrued
interest receivable account is closed, and interest income is credited for the excess.

(B) When interest income is debited, the receipt of the first semiannual interest is credited entirely to
interest income.

Note: Approach (B) is more convenient and will be followed in the following illustrations.

ILLUSTRATION 2: ACQUIRED BETWEEN INTEREST DATES KEY TAKEAWAYS:

Acquisition and Semiannual Interest 1) Accrued interest is not given

April 1 Purchased P1,000,000 12% bonds at 96 plus accrued interest. explicitly in most of the
problems. It should be computed
Interest is payable January 1 and July 1.1 The bonds are held as
based on the interest dates and
trading investment2. acquisition date.

Journal entry to recognize the acquisition: 2) If financial asset is held for

FA – FVPL (TS)3 960,000 trading, it shall be classified as
4 FA at FVPL by requirement.
Interest Income 30,000
Cash 990,000 3) Classified as FVPL, the amount
to be recognized at initial
acquisition is the fair value
July 1 Received semiannual interest: which is the quoted price.

Journal entry to recognize the receipt of interest: 4) Accrued interest is computed

Cash 60,000 from the previous interest date
up to the date of acquisition.
Interest Income 60,000
Interest = Face Value x
Nominal Rate x Time

I = P1,000,000 x 12% x 3/12

= P30,000
Sale KEY TAKEAWAYS:
Oct. 31 Sold P600,000 face value bonds for 101 plus accrued interest.
5) The value of bonds to be
Journal entry to record the sale: derecognized is the carrying
amount computed by getting the
Cash 630,000 percentage of the bonds being
5
FA – FVPL (TS) 576,000 sold from the total bonds
Interest Income 6 24,000 acquired then multiplying it to
the acquisition cost:
Gain on sale of bonds - FVPL7 30,000 600,000/1,000,000 = 60%
60% x P960,000 acquisition cost
Year End = P576,000
Dec. 31 The bonds are quoted at 120 at the end of the year.
6) If sold between interest dates,
Journal entry to record the accrued interest: compute for the accrued interest
that is to be earned as income.
Accrued Interest Receivable8 24,000
Computed from the previous
Interest Income 24,000 interest date up to the date of
acquisition. (July to October)
Journal entry to record the change in fair value: I = P600,000 x 12% x 4/12
FA – FVPL (TS) 96,000 = P24,000
Unrealized Gain - FVPL9 96,000 7) Gain on sale =
Selling Price – Carrying amount

NOTE: Cash received ≠ SP

Cash received may include
ILLUSTRATION 3: ACQUIRED BETWEEN INTEREST DATES amounts for accrued interest and
On May 31, 2019 Sunny Co. purchased P3,000,000 10% bonds at gain on sale.
P3,015,000 including the accrued interest. Interest is payable March 1 and Selling price is the quoted price

September 1. The bonds are held as trading investment. 8) Accrued interest receivable for
the remaining bonds shall be
Sunny Co. sold P1,000,000 face value bonds for P1,150,000 on November recognized at every year end.
1, 2019. (July to Dec)
I = P400,000 x 12% x 6/12
The bonds are quoted at 105 at December 31, 2019. = P24,000

9) There is a need to account for

Required: Prepare all journal entries to record the transactions.
the change in fair value of the
remaining bonds at every year
JOURNAL ENTRIES: Notes and Computations: end because the financial asset is
measured at FVPL.
Acquisition (May 31, 2019) To compute for the investment in bonds.
FA- FVPL (TS) 2,940,000 Compute first for the accrued interest
Interest Income 75,000 included in the purchase price of NOTE: Unrealized Gain or Loss is
Cash 3,015,000 P3,015,000, and the remaining shall be equal to the difference of Fair
allocated to the bonds. Accrued interest Value and Carrying Amount.
Semiannual Interest (September 1, 2019) from March 1 to May 31 is computed as FV (400,000 x 120%) = 480,000
Cash 150,000 Interest = 3,000,000 x 10% x 3/12. CA (960,000-576,000) = 384,000
Interest Income 150,000 Unrealized Gain 96,000
On the sale of P1,000,000 bonds,
Sale (November 31, 2019) Carrying amount of bonds is computed as
Cash 1,150,000 CA = 2,940,000 x 1/3.
FA- FVPL (TS) 980,000 Accrued interest income attached to the
Interest Income 25,000 bonds is computed from Sept 1 to Nov 31.
Gain on sale of bonds-FVPL 145,000 Interest = 1,000,000 x 10% x 3/12
Year End (December 31, 2019) At year end, recognize the accrued interest
Accrued Int. Rec. 66,667 income on remaining bonds from
Interest Income 66,667 September 1 to December 31.
Interest = 2,000,000 x 10% x 4/12
FA- FVPL (TS) 140,000
Record also the change in fair value:
Unrealized Gain - FVPL 140,000
FV = 2,000,000 x 105% = 2,100,000
CA = 2,940,000 x 2/3 = 1,960,000
Always take into consideration the following items in recording transactions related to bond
investment:
A. Acquisition: (a) Date of acquisition, whether purchased on or between interest dates
(b) Classification and measurement (c) Fair value or the acquisition price (d) If purchase is in
between interest dates, is the accrued interest included in the purchase price?
B. Interest Receipts: (a) Date of interest payments, this is typically semiannual
C. Sale: (a) Percentage of bonds sold based on the original total of bonds acquired, to compute
for the carrying amount (b) Accrued interest attached to the bonds (c) Selling price
D. Year-end: (a) Accrued interest (b) Change in fair value

EXERCISE PROBLEMS:

1. On Jan 1, 2019 Lyrids Corporation acquired P2,500,000

12% bonds at 96 plus accrued interest. Interest is
payable every May 1 and November 1. The bonds are
held as trading investment

The bonds are quoted at 105 at December 31, 2019.

Required: Prepare all journal entries to record the

transactions.

2. Perseids Company purchased P2,000,000 10% bonds at

105 including the accrued interest. Interest is payable
March 1 and September 1. The bonds are held as trading
investment

Perseids Company sold P1,000,000 face value bonds for

P1,200,000 on August 31, 2019.

The bonds are quoted at 120 at December 31, 2019.

Required: Prepare all journal entries to record the

transactions.