Introduction

PFRS 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 of another entity.

Intended Learning Outcomes

After learning this chapter, the students should be able to:
1. Describe a financial liability and an equity instrument
2. Understand the accounting for a compound financial instrument

COMPOUND FINANCIAL INSTRUMENTS

Financial Instrument gives an entity a financial asset and a financial liability or equity
instrument of another entity, thus, the term encompasses financial asset, liability and equity
instrument.

Characteristics: (CTR)
• There must be a contract.
• There are at least two contracting parties.
• It shall give rise to a financial asset for a party and financial liability or equity
instrument of another party.

Financial Liability- is a contractual obligation

(a) to deliver cash or other financial asset to an entity or
(b) to exchange financial instruments with another entity under conditions that are
potentially unfavorable.

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Examples: Accounts payable, Notes payable, Loans payable, Bonds payable

Equity Instrument is any contract that reflects a residual interest in the assets of an entity
after liabilities.

Examples: Ordinary share capital, Preference share capital, Share warrants and Share options

Compound Financial Instruments (CFI) have both a liability and equity component from
the issuer’s perspective.

Examples: Convertible Bonds, Bonds issued with share warrants

How to account for CFI?

Split Accounting, as mandated by PAS 32 CFI’s liability and equity component are to
be accounted for and presented separately in accordance to their nature. It shall be made at
the issuance and cannot be revised for subsequent interest rate, share price or other price
changes.

Proceeds from the issuance of CFI shall be allocated between the debt component and
equity component. The fair value of the debt instrument is determined and any excess in the
proceeds from issuance shall be allocated to the equity component.

1. Bonds Payable with Share Warrants

Share Warrants- enable bondholders to acquire equity shares at a specified price

at a definite period.

Accounting treatment would be the same regardless whether share warrants are
detachable or non-detachable.

Illustration:
Pro forma Entry:
> Cash XX
Discount on Bonds Payable XX
Bonds Payable XX
Share Warrant Outstanding XX
Premium on Bonds Payable XX

Formula:
Issue Price of bonds with warrants xx
Less: Issue Price of bonds ex-warrants (xx)

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Residual amount allocated to warrants xx

Face amount of bonds xx

Less: Issue price of bonds ex-warrants (xx)
Premium or Discount on bonds payable xx

ILLUSTRATION:
On January 1, 2020, ABC, Co. issued, 5,000 of its 8%, 10 year, Php 1,000 face value bonds with
share warrants at 110. Each bond carries a share warrant which permits the holder to purchase 20
ordinary shares, Php 10.00 par value, at Php 12.00 per share. On the same date, the market value
of bonds ex-warrants is 98.
Requirements:
A. Prepare the necessary journal entries to record the issuance of bonds.
B. Journal Entry to record the exercise 80% of Share Warrants
C. Journal Entry to record the expiration of remaining Share Warrants
D. Assuming the market value of bonds ex-warrants is unknown prepare the entry to record the
issuance of the bonds. Market Interest rate for similar bonds at the time of issuance is 12%. The
present value of 1 at 12% for 10 periods is 0.322 and present value of ordinary annuity of 1 at
12% for 10 periods is 5.65.

A.
Issue Price with Warrants (5000 x P1000 x 1.10) 5,500,000
Less: Market Value of Bonds Ex-Warrants (5000 x P1000 x .98) 4,900,000
Amount allocated to Share warrants 600,000

Face amount of bonds 5,000,000

Less: Issue price of bonds ex-warrants 4,900,000
Discount on bonds payable 100,000

Journal Entry:
Cash 5,500,000

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Discount on Bonds Payable 100,000
Bonds Payable 5,000,000
Share Warrant Outstanding 600,000

B. 80% of Share Warrants are exercised

Cash received (5000 bonds x 80% 20 shares x P12) 960,000
Add: Share warrants outstanding (600,000 x 80%) 480,000
Total Consideration 1,440,000
Less Par Value of Shares (5000 bonds x 80% 20 shares x P10) 800,000
Share Premium 640,000

Journal Entry:

Cash 960,000
Share Warrants Outstanding 480,000
Ordinary Share Capital 800,000
Share Premium 640,000

C.
Journal Entry:
Share Warrants Outstanding (600,000 x 20%) 120,000
Share Premium- Unexercised Warrants 120,000

D.
Issue Price with Warrants (5000 x P1000 x 1.10) 5,500,000
Less: * Present Value of Bonds 3,870,000
Amount allocated to Share warrants 1,630,000

*Present Value of Bonds:

Present Value of Principal (Php 5,000,000.00 x 0.322) 1,610,000
Present Value of Interest Payments [(Php 5,000,000.00 x 8%) x 5.65)] 2,260,000
Total Present Value 3,870,000

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Face amount of bonds 5,000,000
Less: Issue price of bonds ex-warrants 3,870,000
Discount on bonds payable 1,130,000

Journal Entry:
Cash 5,500,000
Discount on Bonds Payable 1,130,000
Bonds Payable 5,000,000
Share Warrant Outstanding 1,630,000

2. Convertible bonds
Gives the holders the right to convert their bond holdings into share capital or other securities of
the issuing entity within a specified period of time.

ISSUANCE: Residual approach would still be used in accounting for convertible bonds, thus, the
issue price will be allocated between bonds payable and conversion privilege. The same method
used in accounting for bonds with share warrants will still utilized- the market value of the bonds
without conversion privilege will be compared to the total issue price (proceeds from issuance),
the difference will be allocated to Share Premium- Conversion Privilege. In the absence of
market value of the bonds without conversion privilege, present value of bonds payable and
future interest payments shall be used- effective rate or market interest rate for similar
bonds.

Illustration:
Pro forma Entry:
Cash

Discount on Bonds Payable XX

Bonds Payable XX
Share Premium – Conversion Privilege XX
Premium on Bonds Payable XX

Formula:
Issue Price of bonds with conversion privilege xx
Less: Issue Price of bonds without conversion privilege (xx)
Share Premium – Bonds Conversion Privilege xx

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Face amount of bonds xx
Less: Issue price of bonds without conversion privilege (xx)
Premium or Discount on bonds payable xx

Conversion: (Pro-forma Entry)

Share Premium from Bonds Conversion Privilege XX
Bonds Payable (at face value) XX
Interest Expense XX
Discount on Bonds Payable XX
Ordinary Share Capital XX
Share Premium XX

ILLUSTRATION:
1. Convertible Bonds- Market Values of Bonds with or without conversion privilege are
determinable.
An entity issued 5,000, 5-year bonds, face value of Php 1,000.00 at 110. The bonds contain a
conversion privilege that provides for an exchange of Php 1,000.00 bond for 20 equity securities
with par value of Php 40.00. It is reliably determined that the bonds would be sold at 95 without
conversion privilege.

Issue Price of bonds with conversion privilege (5000 x P1000 x 1.10) 5,500,000
Less: Issue Price of bonds without conversion privilege (5000 x P1000 x .95) 4,750,000
Share Premium – Bonds Conversion Privilege 750,000

Face amount of bonds 5,000,000

Less: Issue price of bonds without conversion privilege 4,750,000
Discount on bonds payable 250,000

Journal Entry:
Cash 5,500,000
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 Discount on Bonds Payable 250,000
Bonds Payable 5,000,000
Share Premium – Conversion Privilege 750,000

2. Market Value of the convertible bonds are unknown.

On January 1, 20X1, Brendon, Co. issued, 5,000 of its 8%, 10-year, Php 1,000.00 face value
convertible bonds with share warrants at 110. Each bond permits the holder to convert each bond
into an ordinary share.
The market value of bonds without the conversion privilege is unknown. Prepare the entry to
record the issuance of the bonds. Market Interest rate for similar bonds at the time of issuance is
12%. The present value of 1 at 12% for 10 periods is 0.322 and present value of ordinary annuity
of 1 at 12% for 10 periods is 5.65.

Issue Price of bonds with conversion privilege (5000 x P1000 x 1.10) 5,500,000
Less: * Present Value of Bonds 3,870,000
Share Premium – Bonds Conversion Privilege 1,630,000

*Present Value of Bonds:

Present Value of Principal (Php 5,000,000.00 x 0.322) 1,610,000
Present Value of Interest Payments [(Php 5,000,000.00 x 8%) x 5.65)] 2,260,000
Total Present Value 3,870,000

Face amount of bonds 5,000,000

Less: Issue Price of bonds without conversion privilege 3,870,000
Discount on bonds payable 1,130,000

3. Payment of Convertible Bonds at Maturity

On December 31, 2020, the following balances show the following balances before payment:
Bonds Payable- due on December 31, 2020 10,000,000
Share Capital 20,000,000
Share Premium – issuance 8,000,0000
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Share Premium from Bonds Conversion Privilege 800,000
The bonds are convertible and originally issued on January 1, 2011. The price of the bonds on
the date of issuance without the conversion privilege was Php 11,200,000. The bonds were
issued at Php 12,000, 000. The stated interest rate is 10% payable annually every December 31.
The bonds already matured, the premium on the issuance of bonds were fully amortized on
December 31, 2020. On the same date, bonds were not converted.
Journal Entries:
Payment on December 31, 2020:

Bonds Payable (at face amount) 10,000,000

Interest Expense 1,000,000
Cash 11,000,000
Closing of Conversion Privilege:
Share Premium from Bonds Conversion Privilege 800,000
Share Premium - Issuance 800,000

-end-

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