Flexible Learning A.Y.

2020-2021
DISTANCE EDUCATION COURSE GUIDE USING OBTL DESIGN v1

MODULE  4:  12  hrs.   Compound  Financial  Instruments,  Notes  Payable  &  Debt  Restructuring  

DISCUSSION

PART 1. COMPOUND FINANCIAL INSTRUMENT

Definition of Financial Instrument

PAS 32 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. Hence, it
encompasses a financial asset, a financial liability, and an equity instrument.
Moreover, we can see from the definition above that the characteristics of a financial
instrument are the following:
a. There must be a contract.
b. There are at least two parties to the contract.
c. The contract shall give rise to a financial asset of one party and financial liability or
equity instrument of another party.
Examples of financial instrument include: cash in the form of notes and coins; cash in the
form of checks; cash in bank; trade accounts; notes and loans; debt securities; and equity
securities.

Definition of Compound Financial Instrument

Compound financial instrument is a financial instrument that contains both a liability and
an equity element from the perspective of the issuer. In other words, 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.
• Financial liability – any liability that is a contractual obligation to deliver cash or other
financial asset to another entity, or to exchange financial instruments with another entity
under conditions that are potentially unfavorable.
• Equity instrument – any contract that evidences a residual interest in the assets of an
entity after deducting all of its liabilities. It includes ordinary share capital, preference
share capital, and warrants or options.

The common examples of compound financial instrument are as follows: bonds payable
issued with share warrants, and convertible bonds payable.

Accounting for Compound Instrument

The issuer of a financial instrument shall evaluate the terms of the instrument whether it
contains both a liability and an equity component. If the financial instrument contains both a
liability and an equity component, PAS 32 mandates that such components shall be accounted
for separately. Meaning, the consideration received from the issuance of the compound financial
instrument shall be allocated between the liability and the equity components. It is to be noted
that the fair value of the liability component is first determined then the residual amount is
allocated to the equity component.

Examples of Compound Financial Instruments

1. Bonds payable issued with share warrants

Share warrants are granted to enable the holders to acquire equity shares at a
specified price during a definite period. When the bonds are sold with share warrants, the
bondholders are given the right to acquire shares of the issuing entity at a specified price at
some future time.
In addition, share warrants attached to a bond may be detachable or non-detachable.
Detachable warrants can be traded separately from the bond and non-detachable warrants
cannot be traded separately. For accounting purposes, whether detachable or non-
detachable, the warrants have a value and therefore shall be accounted for separately.
How do we allocate the issue price? The bonds are assigned an amount equal to the
“market value of the bonds ex-warrants,” regardless of the market value of the warrants.
The residual amount or remainder o the issue price shall then be allocated to the warrants.

This document is a property of the University of St. La Salle Module 4| Page 1

Unauthorized copying and / or editing is prohibited.
 Flexible Learning A.Y. 2020-2021
DISTANCE EDUCATION COURSE GUIDE USING OBTL DESIGN v1

What if the market value of the bonds ex-warrants (without the warrants) is unknown?
In such a case, the amount allocated to the bonds is equal to the present value of the
principal bond liability plus the present value of the future interest payments using the
effective or market interest rate for similar bonds without the warrants.

SAMPLE PROBLEMS

PROBLEM #1

On January 1, 2020, Monic Company decided to issue 5,000, 10-year bonds of 8%

P1,000 face value each with warrants to acquire share capital at P30 per share. The interest on
the bonds is payable annually every December 31.Each bond contains one warrant which can
be used to acquire 4 shares of P25 par value share capital.
It is reliably determined that without warrants, the bonds would sell at 114.7 with a 6% effective
yield. The bond price with warrants is 120. All warrants are exercised on December 31, 2020.

REQUIRED: Prepare journal entries for 2020 in connection with the bond issuance and the
exercise of the warrants.

SOLUTIONS

a.) Issue price with warrants (5,000,000 x 1.20) 6,000,000

Less: Market price of bonds without warrants (5,000,000 x 1.147) 5,735,000
Equity component (Share warrants outstanding) 265,000

Cash 6,000,000
Bonds payable (at face value) 5,000,000
Premium on bonds payable (5,735,000 - 5,000,000) 735,000
Share warrants outstanding 265,000

b.) Interest expense 400,000

Cash (5,000,000 x 8%) 400,000

c.) Premium on bonds payable 55,900

Interest expense (400,000 - (5,735,000 x 6%)) 55,900

d.) Cash (20,000 x 30) 600,000

Share warrants outstanding 265,000
Share capital (20,000 x 25) - at par value 500,000
Share premium (squeeze) 365,000

PROBLEM #2

On January 1, 2020, Zamboanga Company issued P8,000,000 of 12% bonds payable

maturing in 5 years. The bonds pay interest semiannually on June 30 and December 31. The
bonds include share warrants giving the bondholder the right to purchase 16,000 P100 par
value shares for P150 per share within the next three years. The bonds and warrants were
issued at 120. The value of the warrants at the time of issuance was P1,500,000. The market
rate of interest for similar bonds without the warrant is 10%.
The PV of 1 at 5% for 10 periods is 0.61, and the PV of an ordinary annuity of 1 at 5%
for 10 periods is 7.72. All share warrants were exercised on December 31, 2020.

REQUIRED: Prepare journal entries for 2020 in connection with the bonds.

SOLUTIONS
Int. paid Int. exp. Prem.
PV of prinicipal (8,000,000 x 0.61) 4,880,000 Date (6%) (5%) Amort. CA
PV of interest ((8,000,000 x 6%) x 7.72) 3,705,600 1/1/20 8,585,600
PV of bonds payable, 1/1/20 8,585,600 6/30/20 480,000 429,280 50,720 8,534,880
12/31/20 480,000 426,744 53,256 8,481,624

This document is a property of the University of St. La Salle Module 4| Page 2

Unauthorized copying and / or editing is prohibited.
 Flexible Learning A.Y. 2020-2021
DISTANCE EDUCATION COURSE GUIDE USING OBTL DESIGN v1

Jan. 1 Cash (8,000,000 x 1.20) 9,600,000

Bonds payable 8,000,000
Premium on bonds payable 585,600
Share warrants outstanding (squeeze) 1,014,400

June 30 Interest expense 429,280

Premium on bonds payable 50,720
Cash 480,000

Dec. 31 Interest expense 426,744

Premium on bonds payable 53,256
Cash 480,000

Cash (16,000 x 150) 2,400,000

Share warrants outstanding 1,014,400
Share capital (16,000 x 100) 1,600,000
Share premium (squeeze) 1,814,400

2. Convertible bonds payable

Convertible bonds are those which give 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. When the convertible bonds are issued at a premium or discount, amortization
period is up to the maturity date instead of the conversion date because it is impossible to
predict, if at all, that the conversion privilege will be exercised. Accounting problems arise in
two situations, namely:

• When the convertible bonds are issued

The issuance of convertible bonds shall be accounted for as partly liability
and partly equity. Meaning, the issue price shall be allocated between the bonds
payable and the conversion privilege (equity component).
The bonds are assigned an amount equal to the market value of the bonds
without the conversion privilege. The residual amount shall then be allocated to the
conversion privilege or equity component. In the absence of market value of the
bonds without conversion privilege, the amount allocated to the bonds is equal to the
present value of the principal bond liability plus the present value of the future interest
payments using the effective or market interest rate for similar bonds without
conversion privilege.

• When the convertible bonds are converted

When the bonds are converted into share capital of the issuing entity, the
accounting problem is the determination of a value to be assigned to the share capital
issued. Here are some things to remember:
ü The carrying amount of the bonds is the measure of the share capital issued
because the carrying amount is the “effective price” for the shares issued as a
result of the conversion.
ü There is no gain or loss on conversion at maturity.
ü Any cost incurred in connection with the bond conversion shall be deducted from
share premium or debited to “share issue cost.”
ü The carrying amount of the bonds is equal to the face value plus accrued interest
if not paid, plus unamortized premium or minus unamortized discount and bond
issue cost.
ü The amortization of discount and issue cost or premium up to the date of
conversion shall be recorded.
ü The face of the bonds converted shall be canceled together with the related
unamortized premium or discount and issue cost. If only a portion of the bonds is
converted, the unamortized premium or discount and issue cost balance shall be
canceled proportionately.
ü Normally, conversion is at an interest date. When at other dates. The accrued
interest up to the date of conversion is ordinarily paid. If the interest is not paid, it is
added to the face value of the bonds converted to get the carrying amount of the
bonds for conversion purposes. The accrued interest is charged to interest expense.

This document is a property of the University of St. La Salle Module 4| Page 3

Unauthorized copying and / or editing is prohibited.
 Flexible Learning A.Y. 2020-2021
DISTANCE EDUCATION COURSE GUIDE USING OBTL DESIGN v1

SAMPLE PROBLEMS

PROBLEM #1

On January 1, 2020, Silay Company issued 2,000 convertible bonds. The bonds have a
three-year term and are issued at 110 with a face value of P1,000 per bond, giving total
proceeds of P2,200,000. Interest is payable annually in arrears at a nominal annual interest rate
of 6% Each bond is convertible at any time up to maturity into 25 shares of capital with par value
of P20.
The bonds are converted on December 31, 2020. When the bonds are issued, the
prevailing market rate for similar bonds without conversion privilege is 9%. The present value of
1 at 9% for 3 periods is 0.77, and the present value of an ordinary annuity of 1 at 9% for 3
periods is 2.53.

REQUIRED: Prepare journal entries to record issuance of the bonds on January 1, 2020, interest
payment, amortization of discount/premium, and bond conversion on December 31, 2020.

SOLUTIONS

Int. paid Int. exp. Disc.

PV of prinicipal (2,000,000 x 0.77) 1,540,000 Date (6%) (9%) Amort. CA
PV of interest ((2,000,000 x 6%) x 2.53) 303,600 1/1/20 1,843,600
PV of bonds payable, 1/1/20 1,843,600 12/31/20 120,000 165,924 45,924 1,889,524

a.) Cash 2,200,000

Discount on bonds payable (2,000,000 - 1,843,600) 156,400
Bonds payable 2,000,000
Share premium - conversion privilege (squeeze) 356,400

b.) Interest expense 165,924

Discount on bonds payable 45,924
Cash 120,000

c.) Bonds payable (at face) 2,000,000

Share premium - conversion privilege 356,400
Discount on bonds payable (156,400 - 45,924) 110,476
Share capital (50,000 x 20) 1,000,000
Share premium - issuance (squeeze) 1,245,924

PROBLEM #2 (7-9)

Sunshine Company issued 4-year P5,000,000 face value of 12% convertible bonds at
105 on January 1, 2020, maturing on January 1, 2025 and paying interest annually on
December 31. It is reliably ascertained that the bonds would sell at P4,700,000 without the
conversion feature with an effective yield of 14%. Each P1,000 bond is convertible into 8 shares
of P100 par value share capital.
On December 31, 2020, all of the bonds are converted into share capital. At this time,
the share has a market value of P150 and the bonds are quoted at 101.

REQUIRED: Prepare journal entries to record issuance of the bonds on January 1, 2020, interest
payment, amortization of discount/premium, and bond conversion on December 31, 2020.

SOLUTIONS

Date Int. paid (12%) Int. exp. (14%) Disc. Amort. CA

1/1/20 4,700,000
12/31/20 600,000 658,000 58,000 4,758,000

a.) Cash (5,000,000 x 1.05) 5,250,000

Discount on bonds payable (5,000,000 - 4,700,000) 300,000
Bonds payable 5,000,000
Share premium - conversion privilege (squeeze) 550,000

This document is a property of the University of St. La Salle Module 4| Page 4

Unauthorized copying and / or editing is prohibited.
 Flexible Learning A.Y. 2020-2021
DISTANCE EDUCATION COURSE GUIDE USING OBTL DESIGN v1

b.) Interest expense 658,000

Discount on bonds payable 58,000
Cash 600,000

c.) Bonds payable (at face) 5,000,000

Share premium - conversion privilege 550,000
Discount on bonds payable (300,000 - 58,000) 242,000
Share capital (5,000 x 8 x 100) 4,000,000
Share premium - issuance (squeeze) 1,308,000

PROBLEM #3

On January 1, 2020, Andrea Company issued 4,000 convertible bonds with P1,000
face value per bond. The bonds have a three-year life and are issued at 105 or a total proceeds
of P4,200,000. Interest is payable annually at 6% every December 31. Each bond is convertible
into 20 ordinary shares with P50 par value.
When the bonds are issued, the market rate of interest for similar bonds without
conversion option is 8%. The PV of 1 at 8% for 3 periods is 0.79, and the PV of an ordinary
annuity of 1 at 8% for 3 periods is 2.58.

REQUIRED: Prepare journal entry to record the full payment of the convertible bonds at
maturity on January 1, 2023.

SOLUTIONS

PV of prinicipal (4,000,000 x 0.79) 3,160,000

PV of interest ((4,000,000 x 6%) x 2.58) 619,200
Issue price of the bonds without conversion privilege 3,779,200

Issue price of the bonds with conversion privilege (4,000,000 x 1.05) 4,200,000
Issue price of the bonds without conversion privilege 3,779,200
Equity component (Share premium - conversion privilege) 420,800

Bonds payable (at face) 4,000,000

Interest expense (4,000,000 x 6%) 240,000
Cash 4,240,000

Share premium - conversion privilege 420,800

Share premium - issuance 420,800

PART 2. NOTE PAYABLE

Definition of Note Payable

Note payable (promissory note) is an unconditional promise in writing made by one

person to another, signed by the maker, engaging to pay on demand or at a fixed or
determinable future time, a sum certain in money to order or to bearer.

Initial Measurement of Note Payable

A note payable not designated at fair value through profit or loss shall be measured
initially at fair value minus transaction costs that are directly attributable to the issue of the note
payable. This is because transaction costs are included in the measurement of note payable.
However, if the note payable is irrevocably designated at fair value through profit or loss,
the transaction costs are expensed immediately, hence, no need to deduct the transaction
costs. Also, there is no amortization of discount and premium on note payable. Finally, interest
expense is recognized using the nominal or stated interest rate.
The fair value of the note payable is equal to the present value of the future cash
payment to settle the note payable. The term present value is the discounted amount of the
future cash outflow in settling the note payable using the market rate of interest. Below are
some examples of how to measure the note payable.

This document is a property of the University of St. La Salle Module 4| Page 5

Unauthorized copying and / or editing is prohibited.
 Flexible Learning A.Y. 2020-2021
DISTANCE EDUCATION COURSE GUIDE USING OBTL DESIGN v1

a.) Note issued solely for cash • Present value is equal to the cash proceeds
b.) Interest bearing note issued • The property or noncash asset is recorded at the
for property purchase price.
• The purchase price is reasonably assumed to be the
present value of the note, and therefore, the fair value of
the property because the note issued is interest bearing.
c.) Non-interest bearing note • The property is recorded at the cash price of the property.
issued for property • The cash price is assumed to be the present value of the
note issued.
• The difference between the cash price and the face of the
note issued represents the imputed interest.
• If the cash price is not available, the property is recorded
at the present value of the future cash outflow in settling
the note payable using the market rate of interest.
Payment can be lump sum or installment.

Subsequent Measurement of Note Payable

After initial recognition, a note payable shall be measured:

• At amortized cost using the effective interest method;
Amortized cost is the amount at which the note payable is measured initially
minus principal repayment, plus or minus the cumulative amortization using the effective
interest method of any difference between the initial carrying amount and the maturity
amount.
• At fair value through profit or loss if the note payable is designated irrevocably as
measured at fair value through profit or loss.
PFRS 9 provides that the gain or loss on financial liability designated at fair value
through profit or loss shall be accounted for as follows:
ü The change in fair value attributable to the credit risk is recognized in other
comprehensive income (Account: Gain from credit risk – OCI)
v Credit risk is the risk that the issuer of the liability would cause a financial
loss to the other party by failing to discharge the obligation. It does not
include market risk such as interest risk, currency risk, and price risk.
ü The remaining amount of the change in fair value is recognized in profit or loss.
(Account: Gain from change in fair value)

SAMPLE PROBLEMS

PROBLEM #1

On January 1, 2020, West Company acquired a tract of land for P1,000,000. The entity
paid P100,000 down and signed a two-year promissory note for the balance plus 10% interest
compounded annually. The note matures on January 1, 2022.

REQUIRED: Prepare journal entries to record:

1. Purchase of land on January 1, 2020.
2. Accrued interest on December 31, 2020.
3. Accrued interest on December 31, 2021.
4. Full payment of the note on January 1, 2022.

SOLUTIONS

1.) Land 1,000,000

Cash (downpayment) 100,000
Note payable (at face value) 900,000

2.) Interest expense 90,000

Interest payable (900,000 x 10%) 90,000

3.) Interest expense 99,000

Interest payable ((900,000+90,000) x 10%) 99,000

4.) Note payable 900,000

Interest payable 189,000
Cash 1,089,000

This document is a property of the University of St. La Salle Module 4| Page 6

Unauthorized copying and / or editing is prohibited.
 Flexible Learning A.Y. 2020-2021
DISTANCE EDUCATION COURSE GUIDE USING OBTL DESIGN v1

PROBLEM #2

On January 1, 2020, North Company acquired a machinery with cash price of P750,000
for P1,000,000. The entity paid P200,000 and signed a non-interest bearing promissory note for
the balance which is payable in 4 equal installments every December 31 of each year.

REQUIRED: Prepare journal entries for 2020.

SOLUTIONS

Jan. 1 Machinery (cash price) 750,000

Discount on note payable (squeeze) 250,000
Cash (downpayment) 200,000
Note payable 800,000

Dec. 31 Interest expense 100,000

Discount on note payable (use outstanding method) 100,000

Note payable 200,000

Cash 200,000

PROBLEM #3

On January 1, 2020, South Company acquired a building for P5,000,000. The entity paid
P500,000 down and signed a non-interest bearing note for the balance which is payable in 3
equal annual installments every December 31 of each year. The prevailing interest rate for a
note of this type is 12%. The present value of an ordinary annuity of 1 for 3 periods is 2.4018.

REQUIRED: Prepare journal entries to record purchase of building on January 1, 2020, first
installment payment on December 31, 2020, and interest expense for 2020.

SOLUTIONS
Jan. 1 Building (500,000 + 3,602,700*) 4,102,700
Discount on note payable (squeeze) 897,300
Cash (downpayment) 500,000
Note payable (at face value) 4,500,000
* PV of note (4,500,000/3 x 2.4018)

Dec. 31 Interest expense 432,324

Discount on note payable (3,602,700 x 12%) 432,324

Note payable 1,500,000

Cash 1,500,000

PROBLEM #4

On January 1, 2020, Manila Company acquired a tract of land for P5,250,000. The
entity paid P1,250,000 down and signed a non-interest bearing note for the balance which is
due on January 1, 2023. There was no established exchange price for the land and the note
had no ready market. The prevailing interest rate for this type of note was 12%. The present
value of 1 at 12% for 3 periods is 0.7118.

REQUIRED: Prepare journal entries to record purchase of land on January 1, 2020, interest
expense for 2020, and full payment of the note on January 1, 2023.

SOLUTIONS
Jan. 1 Land (1,250,000 + 2,847,200*) 4,097,200
Discount on note payable (squeeze) 1,152,800
Cash (downpayment) 1,250,000
Note payable (at face value) 4,000,000
* PV of note (4,000,000 x 0.7118)

Dec. 31 Interest expense 341,664

Discount on note payable (2,847,200 x 12%) 341,664

Jan. 1 Note payable 4,000,000

Cash 4,000,000

This document is a property of the University of St. La Salle Module 4| Page 7

Unauthorized copying and / or editing is prohibited.
 Flexible Learning A.Y. 2020-2021
DISTANCE EDUCATION COURSE GUIDE USING OBTL DESIGN v1

PART 3. DEBT RESTRUCTURING

Definition of Debt Restructuring

Debt restructuring is a situation where the creditor, for economic or legal reasons related
to the debtor’s financial difficulties, grants to the debtor, concession that would not otherwise be
granted in a normal business relationship. The concession either stems from an agreement
between the creditor and the debtor, or is imposed by law or court.
The objective of the creditor in a debt restructuring is to make the best of a bad situation
or maximize recovery of investment. Hence, the creditor usually sustains accounting loss on
debt restructuring and the debtor usually realizes accounting gain.

Types of Debt Restructuring

1. Asset Swap

It is the transfer by the debtor to the creditor of any asset, such as real estate,
inventory, receivables, and investment, in full payment of an obligation.
Under PFRS 9, asset swap is treated as a derecognition of a financial liability or
extinguishment of an obligation. The difference between the carrying amount of the
financial liability and the consideration given shall be recognized in profit or loss.
On the other hand, under USA GAAP, asset swap is recorded as if two transactions
have taken place, namely, the sale of the asset and the extinguishment of the liability.
Accordingly, two gains or losses are recognized. The difference between the fair value of
the asset and the carrying amount is the gain or loss on exchange, whereas, the difference
between the carrying amount of the liability and the fair value of the asset is gain or loss
from restructuring.
Take note that between PFRS 9 and USA GAAP, PFRS 9 shall be followed.
Sometimes, a mortgaged property is offered by the debtor in full settlement of the
debt. This is called, dacion en pago. The transaction shall be accounted for as an asset
swap form of debt restructuring. This requires recognition of gain or loss based on the
balance of the obligation including accrued interest and other charges.

SAMPLE PROBLEM

Rainbow Company showed the following balances on December 31, 2020:

Note payable – due December 31, 2020 P 1,000,000
Accrued interest payable 200,000
The entity is in financial distress and negotiates with the creditor for the settlement of the
note payable. Consequently, the entity transferred a patent to the creditor in full satisfaction of
the note payable. The patent has a carrying amount of P600,000 and a fair value of P1,100,000.

REQUIRED: Prepare journal entry to record the asset swap on the boos of Rainbow Company.
a. Under IFRS
b. Under USA GAAP

SOLUTIONS
a.) Note payable (at face) 1,000,000
Interest payable 200,000
Patent (at carrying amount) 600,000
Gain on extinguishment of debt (squeeze) 600,000

b.) Note payable (at face) 1,000,000

Interest payable 200,000
Patent (at carrying amount) 600,000
Gain on exchange (1,100,000 - 600,000) 500,000
Gain on debt restructuring (squeeze or (600,000 - 500,000)) 100,000

2. Equity Swap

It is a transaction whereby a debtor and creditor may renegotiate the terms of a

financial liability with the result that the liability is fully or partially extinguished by the debtor
issuing equity instruments to the creditor. In other words, an equity swap is the issuance of
share capital by the debtor to the creditor in full or partial payment of an obligation.

This document is a property of the University of St. La Salle Module 4| Page 8

Unauthorized copying and / or editing is prohibited.
 Flexible Learning A.Y. 2020-2021
DISTANCE EDUCATION COURSE GUIDE USING OBTL DESIGN v1

According to IFRIC 19, the equity instruments issued to extinguish a financial liability
shall be measured at the following amounts in the order of priority:
a. Fair value of equity instruments issued
b. Fair value of liability extinguished
c. Carrying amount of liability extinguished

The difference between the carrying amount of the financial liability and the initial
measurement of the equity instruments issued shall be recognized in profit or loss.
Furthermore, the gain or loss on extinguishment shall be reported as a separate line item in
the income statement.

SAMPLE PROBLEMS

PROBLEM #1

On December 31, 2020, Sunset Company showed the following data with respect to a matured
obligation:
Mortgage payable P 4,000,000
Accrued interest payable 300,000

The entity is threatened with a court suit if it could not pay its maturing debt. Accordingly,
the entity entered into an agreement with the creditor for the issuance of share capital in full
settlement of the mortgage. The agreement provided for the issue of 35,000 shares with par
value of P100. The share is currently quoted at P130. The fair value of the liability is P4,500,000.

REQUIRED: Prepare journal entry to record the equity swap on the books of Sunset Company:
a. If the fair value of the share capital is used for the equity swap.
b. If the fair value of the liability is used for the equity swap.
c. If the carrying amount of the liability is used for the equity swap.

SOLUTIONS

a.) Mortgage payable (at face) 4,000,000

Interest payable 300,000
Loss on extinguishment of debt (squeeze) 250,000
Share capital (at par) 3,500,000
Share premium (35,000 x (130-100)) 1,050,000

b.) Mortgage payable (at face) 4,000,000

Interest payable 300,000
Loss on extinguishment of debt (squeeze) 200,000
Share capital (at par) 3,500,000
Share premium (4,500,000 - 3,500,000) 1,000,000

c.) Mortgage payable (at face) 4,000,000

Interest payable 300,000
Share capital (at par) 3,500,000
Share premium (4,300,000 - 3,500,000) 800,000

PROBLEM #2

Baguio Company is experiencing financial difficulty and is renegotiating debt

restructuring with its creditor to relieve its financial stress. The entity has a P5,000,000 note
payable to First Bank. The bank is considering two alternatives:
i. Acceptance of land owned by the entity valued at P4,000,000 and carried at its
historical cost of P2,800,000.
ii. Acceptance of an equity interest in the entity in the form of 40,000 shares with fair
value of P120 per share. The share capital has a par value of P100 per share.
REQUIRED: Prepare journal entry that Baguio Company would make under each alternative.

SOLUTIONS
a.) Note payable (at face) 5,000,000
Land (at carrying amount) 2,800,000
Gain on extinguishment of debt (squeeze) 2,200,000

This document is a property of the University of St. La Salle Module 4| Page 9

Unauthorized copying and / or editing is prohibited.
 Flexible Learning A.Y. 2020-2021
DISTANCE EDUCATION COURSE GUIDE USING OBTL DESIGN v1

b.) Note payable (at face) 5,000,000

Share capital (at par) 4,000,000
Share premium (40,000 x (120-100)) 800,000
Gain on extinguishment of debt (squeeze) 200,000

3. Modification of terms

This may involve the interest, maturity value, or both. Interest concession may
involve a reduction of interest rate, forgiveness of unpaid interest, or a moratorium on
interest payment. On the other hand, maturity value concession may involve an extension
of the maturity date or a reduction of the amount to be paid at maturity.

PFRS 9 provides that a substantial modification of terms of an existing financial

liability shall be accounted for as an extinguishment of the old financial liability and the
recognition of a new financial liability.
ü There is substantial modification of terms if the gain or loss on extinguishment is at
least 10% or 10% or more of the old financial liability.

The difference between the carrying amount of the old liability and the present value
of new or restructured liability which is discounted using the old effective rate, shall be
accounted for as a gain or loss on extinguishment of debt. Any costs or fees incurred as a
result of the substantial modification of terms shall be recognized as part of gain or loss on
extinguishment.

What if the modification of terms is not substantial? The gain or loss on

extinguishment is not recognized because the modification is not an extinguishment of the
old liability. Moreover, any costs incurred in modifying the terms are adjusted to the carrying
amount of the old liability and amortized over the remaining terms of the modified liability.
The old liability is simply continued but with the modified interest charges. Accordingly, a
new effective rate must be computed.

SAMPLE PROBLEMS

PROBLEM #1

Grey Company has an overdue 8% note payable to City Bank at P8,000,000 and
recorded accrued interest of P640,000. As a result of a settlement on January 1, 2019, City
Bank agreed to the following restructuring arrangement:
a. Reduced the principal obligation to P7,000,000
b. Forgave the P640,000 accrued interest
c. Extended the maturity date to December 31, 2020.
d. Annual interest of 10% is to be paid on December 31, 2019 and 2020

The present value of 1 at 8% for two periods is 0.8573, and the present value of an
ordinary annuity of 1 at 8% for two periods is 1.7833.

REQUIRED: Prepare journal entries for 2019 and 2020 to record the modification of terms.

SOLUTIONS

PV of principal (7,000,000 x 0.8573) 6,001,100 Interest Interest Premium Carrying

PV of interest payments Date
(7,000,000 x 10% x 1.7833) 1,248,310 paid (10%) Exp. (8%) Amort. amount
PV of new liability 7,249,410 01/01/19 7,249,410
12/31/19 700,000 579,953 120,047 7,129,363
Face value of note payable 7,000,000 12/31/20 700,000 570,637 129,363 7,000,000
PV of note 7,249,410
Premium on note payable 249,410

Note payable (face value) 8,000,000

Accrued interest 640,000
Carrying amount of the old liability 8,640,000
Less: PV of new liability 7,249,410
Gain on extinguishment of debt
(more than 10%) 1,390,590

This document is a property of the University of St. La Salle Module 4| Page 10

Unauthorized copying and / or editing is prohibited.
 Flexible Learning A.Y. 2020-2021
DISTANCE EDUCATION COURSE GUIDE USING OBTL DESIGN v1

2019 Jan. 1 Note payable - old 8,000,000

Interest payable 640,000
Note payable - new 7,000,000
Premium on note payable 249,410
Gain on extinguisment of debt (squeeze) 1,390,590

Dec. 31 Interest expense 700,000

Cash 700,000

Premium on note payable 120,047

Interest expense 120,047

2020 Dec. 31 Interest expense 700,000

Cash 700,000

Premium on note payable 129,363

Interest expense 129,363

Note payable 7,000,000

Cash 7,000,000

PROBLEM #2

Due to adverse economic circumstances and poor management, Bontoc Company has
negotiated a restructuring of P8,500,000 note payable to Second Bank. There is no accrued
interest on the note. The bank has agreed to reduce the face value of the note from P8,500,000
to P8,000,000, reduce the interest rate from 14% to 10%, and extend the due date one year
from date of restructuring.
The restructuring was done at the beginning of 2019. There is no unpaid interest on the
restructured note at this time. The present value of 1 at 14% for one period is 0.8772 and the
present value of an ordinary annuity for two periods at 14% is 1.6467.

REQUIRED: Prepare journal entries for the year 2019.

SOLUTIONS

PV of principal (8,000,000 x 0.8722) 7,017,600 Interest Interest Discount Carrying

PV of interest payments Date
(8,000,000 x 10% x 0.8772) 701,760 paid (10%) Exp. (14%) Amort. amount
PV of new liability 7,719,360 01/01/19 7,719,360
12/31/19 800,000 1,080,640 280,640 8,000,000
Face value of note payable 8,000,000
PV of note 7,719,360
Discount on note payable 280,640

Note payable (face value) 8,500,000

Accrued interest -
Carrying amount of the old liability 8,500,000
Less: PV of new liability 7,719,360
Gain on extinguishment of debt
(less than 10%) 780,640

Jan. 1 Note payable - old 8,500,000

Discount on note payable 280,640
Note payable - new 8,000,000
Gain on extinguisment of debt (squeeze) 780,640

Dec. 31 Interest expense 800,000

Cash 800,000

Interest expense 280,640

Discount on note payable 280,640

Note payable 8,000,000

Cash 8,000,000

This document is a property of the University of St. La Salle Module 4| Page 11

Unauthorized copying and / or editing is prohibited.