EFFECTIVE INTEREST METHOD

• discount on bonds payable, premium on bonds payable, and bond issue cost are amortized using the effective interest method
• effective interest method is also known as scientific method or simply interest method
• the nominal rate is the coupon or stated rate
• the effective rate is the yield or market rate
• the effective rate is the rate that exactly discounts estimated cash future payments through the expected life of the bonds payable to the net carrying amount of the bonds payable
• ER and NR are the same if bonds are sold at face amount
• when bonds are sold at a discount, the effective rate is higher than the nominal rate
• when bonds are sold at premium, the effective rate is lower than the nominal rate
• the market price or issue price of bonds payable is equal to the PV of the principal bond liability plus the PV of future interest payments using the effective or market rate of interest
• the market price of bonds payable is equal to the sum of the following:

  1. PV of bonds payable
  2. PV of total different payments
• PV of principal bond liability is equal to the face amount of the bonds payable multiplied by the present value of 1 factor at the effective rate for a number of interest periods
• PV of future interest payments is equal to the periodic nominal interest multiplied by the present value of an ordinary annuity of 1 factor at the effective rate for a number of interest periods
• IFRS provides that transaction costs that are directly attributable to the issue of a financial liability shall be included in the initial measurement of the financial liability
• Transaction costs are defined as fees and commissions paid to agents, advisers, brokers and dealers, levies by regulatory agencies and securities exchange, and transfer taxes and duties, and bond issue costs
• transactions costs include bond issue costs
• bond issue costs will increase discount on bonds payable and will decrease premium on bonds payable
• under the effective interest method, bond issue cost must be "lumped" with the discount on bonds payable and "netted" against the premium on bonds payable
• the effective rate cannot be computed algebraically but by means of trial and error or the interpolation process
• PAS 32, paragraph 11, defines a financial instrument as any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity.
• Characteristics of a Financial Instrument [CTA]

  1. There must be a contract.
  2. There are at least two parties to the contract.
  3. The contract shall give rise to a financial asset of one party and financial liability or equity instrument of another party.
• A financial liability is a contractual obligation:

  1. To deliver cash or other financial asset to another entity
  2. To exchange financial instrument with another entity under conditions that are potentially unfavorable
• Examples of Financial Liabilities

  1. Trade accounts payable
  2. Notes payable
  3. Loans payable
  4. Bonds payable
• Examples of Nonfinancial Liabilities

  1. Deferred revenue and warranty obligations
  2. Income tax payable
  3. Constructive obligations
• Deferred revenue and warranty obligations are not financial liabilities because the outflow of economic benefit is the delivery of goods and services rather than a contractual obligation to pay cash.
• Income tax payable is not a financial liability because it is statutory or imposed by law and noncontractual.
• Constructive obligations are not financial liabilities because the obligations do not arise from contracts
• An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of the liabilities.
• Equity instruments include ordinary share capital, preference share capital, and warrants or option.
• PAS 32, paragraph 28, defines a compound financial instrument as a financial instrument that contains both a liability and an equity element from the perspective of the issuer.
• one component of the financial instrument meets the definition of a financial liability and another component of the financial instrument meets the definition of an equity instrument

  compound financial instrument
• Examples of compound financial instrument

  1. Bonds payable issued with share warrants
  2. Convertible bonds payable
• If the financial instrument contains both a liability and an equity component, PAS 32 mandates that such components shall be accounted for separately.
• what is the approach in accounting for a compound financial instrument?

  split accounting
• Split accounting means that the consideration received from the issuance of the compound financial instrument shall be allocated between the liability and equity components.
• in accounting for compound instruments, the FV of the liability is first determined; and then, the residual amount allocated to the equity component
• [Bond payable issued with share warrants] two securities are sold in this case - the bonds and share warrants
• share warrants attached to bonds payable may be detachable or nondetachable
• Detachable warrants can be traded separately form the bond and nondetachable warrants cannot be traded separately
• IFRS does not differentiate whether the equity component is detachable or nondetachable.
• Whether a detachable or nondetachable, the share warrants have a value and shall be accounted for separately