CHAPTER 7: COMPOUND FINANCIAL INSTRUMENT

Problem 7-9 (AICPA Adapted)

At the beginning of current year, Fence Company issued 12% P5,000,000 nonconvertible bonds
at 103 which are due in 5 years.

In addition, each P1,000 bond was issued 30 share warrants each of which entitled the
bondholder to purchase for P50 one share of Fence Company, par value P25. Interest is payable
annually every end of the year.

On the date of issuance, the market value of the share was P40 and the market value of the
warrant was P4.

The market rate of interest for similar bonds ex-warrants is 14%. The present value of 1 at 14%
for 5 periods is 0.52 and the present value of an ordinary annuity of 1 at 14% for 5 periods is
3.43.

1. What amount should be recognized as discount or premium on the original issuance of the
bonds?

a. 342,000 premium
b. 342,000 discount
c. 450,000 premium
d. 450,000 discount
Solution:
Present value of principal (5,000,000 x 0.52) 2,600,000
Present value of interest payments (5,000,000 x 12% = 600,000 x 3.43) 2,058,000
Total present value of bonds payable 4,658,000
Face value 5,000,000
Discount on bonds payable 342,000

2. What is the equity component arising from the issuance of bonds payable?

a. 150,000
b. 450,000
c. 492,000
d. 0

Solution:
Issue price of bonds with warrants (5,000,000 x 103%) 5,150,000
Present value of bonds payable 4,658,000
Residual amount allocated to warrants - equity component 492,000

Cash 5,150,000
Discount on bonds payable 342,000
Bonds payable 5,000,000
Share warrants outstanding 492,000
To record the issuance of bonds

3. What amount is credited to share premium if all of the share warrants are exercised?

a. 4,242,000
b. 3,500,000
c. 3,600,000
d. 3,950,000

Solution:
Cash received (150,000 x 50) 7,500,000
Share warrants outstanding 492,000
Total consideration 7,992,000
Par value of share capital issued (150,000 x 25) 3,750,000
Share premium 4,242,000

Cash 7,500,000
Share warrants outstanding 492,000
Share capital 3,750,000
Share premium 4,242,000
To record the exercise of all the share warrants
Problem 7-10 (AICPA Adapted)
Moses Company issued P5,000,000 face amount, 5-year bonds at 109. Each P1,000 bond was
issued with 10 share warrants, each of which entitled the bondholder to purchase one share of
P100 par value at P120. Immediately after issuance, the market value of each warrant was P5.

The stated interest rate on the bonds is 11% payable annually every end of the year.

However, the prevailing market rate of interest for similar bonds without warrants is 12%.

The present value of 1 at 12% for 5 periods is 0.57 and the present value of an ordinary annuity
of 1 at 12% for 5 periods is 3.60.

1. What is the carrying amount of the bonds payable on the date of issuance?

a. 5,450,000
b. 4,830,000
c. 5,000,000
d. 4,380,000

2. What amount should be reported initially as discount or premium on bonds payable?

a. 170,000 discount
b. 450,000 premium
c. 450,000 discount
d. 800,000 discount

Solution:
PV of principal (5,000,000 x 0.57) 2,850,000
PV of interest (5,000,000 x 11% = 550,000 x 3.60) 1,980,000
Total present value of bonds payable 4,830,000
Face value 5,000,000
Discount on bonds payable 170,000
.
3. What is the equity component arising from the issuance of bonds payable?

a. 450,000
b. 500,000
c. 620,000
d. 0

Solution:
Issue price of bonds with warrants (5,000,000 x 109%) 5,450,000
Present value of bonds payable 4,830,000
Residual amount allocated to warrants - equity component 620,000
 If the market value of the bonds without warrants is unknown, the amount allocated to the bonds
is equal to the present value of the principal bond liability plus the present value of future interest
payment using the effective or market interest rate for similar bonds without the warrants.

Cash 5,450,000
Discount on bonds payable 170,000
Bonds payable 5,000,000
Share warrants outstanding 620,000
To record the issuance of bonds

4. What amount is credited to share premium if all of the share warrants are exercised?

a. 1,000,000
b. 1,450,000
c. 1,500,000
d. 1,620,000

Solution:
Cash received (50,000 x 120) 6,000,000
Share warrants outstanding 620,000
Total consideration 6,620,000
Par value of share capital issued (50,000 x 100) 5,000,000
Share premium 1,620,000

Cash 6,000,000
Share warrants outstanding 620,000
Share capital 5,000,000
Share premium 1,620,000
To record the exercise of all the share warrants

Problem 7-11 (AICPA Adapted)

At the beginning of current year, Case Company issued P5,000,000 of 12% nonconvertible
bonds payable at 103 which are due in five years.

In addition, each P1,000 bond was issued with 30 detachable share warrants, each of which
entitled the bondholder to purchase, for P50, one ordinary share of Case Company, par value
P25.

On the date of issuance, the quoted market value of each warrant was P4. The market value of
the bonds ex-warrants at the time of issuance is 95.

1. What is the carrying amount of the bonds payable on the date of issuance?

a.5,000,000
b. 4,750,000
c.5,150,000
 d.4,550,000
2. What amount of the proceeds from the bond issue should be recognized as an increase in
shareholders’ equity?

a.600,000
b.300,000
c.200,000
d. 400,000

Solution:
Issue price of bonds with warrants (5,000,000 x 103%) 5,150,000
Market value of bonds ex-warrants (5,000,000 x 95%) 4,750,000
Residual amount allocated to warrants – equity component 400,000

Cash 5,150,000
Discount on bonds payable 250,000
Bonds payable 5,000,000
Share warrants outstanding 400,000
To record the issuance of bonds

3. What amount is credited to share premium if all of the share warrants are exercised?

a.4,350,000
b.3,750,000
c.4,150,000
d. 0

Solution:
Cash received (150,000 x 50) 7,500,000
Share warrants outstanding 400,000
Total consideration 7,900,000
Par value of share capital issued (150,000 x 25) 3,750,000
Share premium 4,150,000

Cash 7,500,000
Share warrants outstanding 400,000
Share capital 3,750,000
Share premium 4,150,000
To record the exercise of all the share warrants

Problem 7-12 (IAA)

Mariones Company issued P5,000,000 face amount 12% 5-year convertible bonds at 110 at the
beginning of current year, paying interest semi-annually on January 1 and July 1.

It is estimated that the bonds would sell only at 103 without the conversion feature. Each P1,000
bond is convertible into 10 ordinary shares with P100 par value.
What is the increase in shareholders’ equity arising from the original issuance of the convertible
bonds?

a. 350,000
b. 500,000
c. 150,000
d. 0

Solution:
Issue price of bonds with conversion privilege (5,000,000 x 110%) 5,500,000
Market value of bonds without conversion privilege (5,000,000 x 103%) 5,150,000
Residual amount allocated to conversion privilege 350,000

Cash 5,500,000
Bonds payable 5,000,000
Premium on bonds payable 150,000
Share premium - conversion privilege 350,000
To record the issuance of the convertible bonds

Problem 7-13 (IFRS)

At the beginning of current year, Susan Company issued 5,000 convertible bonds. The bonds
have a three-year term and are issued at 110 with a face amount of P1,000 par bond.

Interest is payable annually in arrears at a nominal 6% interest rate.

Each bond is convertible at anytime up to maturity into 100 ordinary shares with par value of P5.

When the bonds are issued, the prevailing market interest rate for similar debt instrument without
conversion option is 9%.

The present value of 1 at 9% for 3 periods is .77 and the present value of an ordinary annuity of 1
at 9% for 3 periods is 2.53.

What is the equity component arising from the original issuance of the convertible bonds?

a. 1,150,000
b. 1,650,000
c. 891,000
d. 391,000

Solution:
Present value of principal (5,000,000 x 0.77) 3,850,000
Present value of interest (5,000,0000 x 6% = 300,000 x 2.53) 759,000
Total present value of bonds payable 4,609,000
Issue price of bonds with conversion privilege(5,000,000 x 110%) 5,500,000
Present value of bonds payable 4,609,000
Residual amount allocated to conversion privilege 891,000

If the market value of the bonds without conversion privilege is unknown, the amount allocated
to the bonds is equal to the present value of the principal bond liability plus the present value of
future interest payments using the effective or market interest rate for similar bonds without
conversion privilege.
Cash 5,500,000
Discount on bonds payable 391,000
Bonds payable 5,000,000
Share premium - conversion privilege 891,000
To record the issuance of the convertible bonds

Problem 7-14 (AICPA Adapted)

On December 31, 2020, Cey Company had outstanding 12% P5,000,000 face amount convertible
bonds maturing on December 31, 2025.

Interest is payable on June 30 and December 31. Each P1,000 bond is convertible into 50 shares
of Cey Company with P10 par value.

On December 31, 2020, the unamortized balance in the premium on bonds payable account was
P300,000. No equity component was recognized from the original issuance of the convertible
bonds.

On December 31, 2020, 2,000 bonds were converted when the share had a market price of P24.
The entity incurred P20,000 in connection with the bond conversion.

What is the share premium arising from the bond conversion?

a. 1,400,000
b. 1,100,000
c. 1,380,000
d. 1,120,000

Solution:
Bonds payable 5,000,000
Premium on bonds payable 300,000
Carrying amount of bonds payable 5,300,000

Carrying amount of bonds converted (2,000/5,000 x 5,300,000) 2,120,000

Par value of share capital issued (2,000 x 50 x 10) 1,000,000
Share premium 1,120,000
Conversion expenses 20,000
Net share premium 1,100,000
Problem 7-15 (AICPA Adapted)
Spare Company had an outstanding share capital with par value of P50,000,000 and a 12%
convertible bond issue in the face amount of P10,000,000. Interest payment dates of the bond
issue are June 30 and December 31.

The conversion clause in the bond debenture entitled the bondholders to receive 40 shares of
Spare Company with P20 par value in exchange for each P1,000 bond.

The holder of P5,000,000 face value bonds exercised the conversion privilege at year-end. The
market price of the bonds at year-end was P1,100 per bond and the market price of the share was
P30.

The total unamortized bond discount was P500,000 and the share premium from conversion
privilege has a balance of P2,000,000 at the date of conversion.

What amount of share premium should be recognized by reason of the conversion of bonds
payable into share capital?

a. 2,000,000
b. 2,750,000
c. 3,000,000
d. 1,750,000

Solution:
Bonds payable 10,000,000
Discount on bonds payable (
500,000)
Carrying amount of bonds payable 9,500,000

Carrying amount of bonds converted (5/10 x 9,500,000) 4,750,000

Applicable share premium from conversion privilege (5/10 x 2,000,000) 1,000,000
Total consideration 5,750,000
Par value of share capital issued (5,000 x 40 x 20) 4,000,000
Share premium – issuance 1,750,000

Problem 7-16 (AICPA Adapted)

Clay Company had P600,000 convertible 8% bonds payable outstanding on June 30. Each
P1,000 bond was convertible into 10 ordinary shares of P50 par value.

On July 1, the interest was paid to bondholders and the bonds were converted into ordinary
shares which had a fair value of P75 per share.

The unamortized premium on these bonds was P12,000 at the date of conversion. No equity
components was recognized when the bonds were originally issued.
What is the increase in share premium as a result of the bond conversion?

a. 312,000
b. 306,000
c. 162,000
d. 300,000

Solution:
Bonds payable 600,000
Premium on bonds payable 12,000
Carrying amount 612,000
Par value of ordinary shares issued (6,000 x 50) 300,000
Share premium 312,000

Problem 7-17 (IAA)

Young Company issued 5,000 convertible bonds at the beginning of the current year. The bonds
had a four-year terms with a stated interest of 6% and were issued at par with a face amount of
P1,000 per bond. Interest is payable annually on December 31.

Each bond is convertible into 50 ordinary shares with a par value of P10. The market rate of
interest is payable on similar nonconvertible bond is 9%.

At the issuance date, the amount of P485,000 was credited to share premium from conversion
privilege.

The bonds were not converted and instead, the entity paid off the convertible bondholders as
maturity.
What amount should be recorded as gain or loss on the full payment of the convertible bonds at
maturity.

a. 500,000 gain
b. 485,000 loss
c. 485,000 gain
d. 0

Solution:
Cash 5,000,000
Discount on bonds payable 485,000
Bonds payable 5,000,000
Share premium - conversion privilege 485,000
To record the issuance of the convertible bonds

Bonds payable 5,000,000

Interest expense (5,000,000 x 6%) 300,000
Cash 5,300,000
To record the settlement of the convertible bonds at maturity date
The payment at maturity is equal to the face amount plus interest.

Share premium - conversion privilege 485,000

Share premium - issuance 485,000
To close the share premium from conversion privilege

Problem 7-18
On December 31, 2020, Tamia Company showed the following balances:

Bonds payable – 6% 4,000,000

Discount on bonds payable 500,000
Share premium – issuance 5,000,000
Share premium – conversion privilege 700,000

The interest is payable annually every December 31. The convertible bonds are not converted but
fully paid on December 31, 2020.

On such date, the quoted price of the bonds with conversion option is 105 which is the payment
to the bondholders plus interest.

However, the quoted price of the bonds without the conversion privilege is 95.

1. What is the carrying amount of the bonds payable on December 31, 2020?

a. 4,000,000
b. 4,500,000
c. 3,500,000
d. 4,200,000

Solution:
Fair value of bonds with conversion privilege(4,000,000 x 105%) 4,200,000
Fair value of bonds without conversion privilege (4,000,000 x 95%) 3,800,000
Fair value of equity component 400,000

Bonds payable 4,000,000

Discount on bonds payable
( 500,000)
Carrying amount of bonds payable 3,500,000

2. What is the gain or loss from extinguishment of bonds?

a. 700,000 gain
b. 700,000 loss
c. 300,000 gain
d. 300,000 loss
Solution:
Carrying amount of bonds payable 3,500,000
Payment equal to the fair value of bonds without conversion privilege
(3,800,000)
Loss on extinguishment (
300,000)

Note that the total payment of P4,200,000 to the bondholders is partly liability of P3,800,000 and
partly equity of P400,000.

3. What is the total payment to the bondholders on December 31, 2020?

a. 4,200,000
b. 4,440,000
c. 4,240,000
d. 4,040,000

Solution:
Fair value of bonds with conversion privilege 4,200,000
Interest expense (4,000,000 x 6%) 240,000
Total payment to the bondholders 4,440,000