CHAPTER 7

COMPOUND FINANCIAL INSTRUMENT

Questions
1. What is a financial instrument?

2. What are the characteristics of a financial instrument?

3. Give examples of financial instrument?

4. What is a financial liability?

5. Give examples of financial liability?

6. What is an equity instrument?

7. Give examples of equity instrument?

8. What is a compound financial instrument?

9. Explain the accounting for a compound financial instrument?

10. What are the common examples of compound financial instrument?

11. What are share warrants?

12. Distinguish between detachable and nondetachable share warrants?

13. Explain the accounting for bonds payable issued with share warrants.

14. What are convertible bonds?

15. Explain the accounting for convertible bonds at the time of original issuance.

16. Explain the accounting for convertible bonds at the time of actual conversion into share
capital.

17. Explain the accounting for full payment of convertible bonds at maturity.

18. Explain the accounting for full payment of convertible bonds before maturity.
PROBLEMS

Problem 7-1 Multiple choice (PAS 32)

1. It is any contract that gives rise to both a financial asset, of one entity and a financial
liability or equity instrument of another entity

a. Financial instrument
b. Equity instrument
c. Debt instrument
d. Derivative instrument

2. A financial liability is a contractual obligation

I. To deliver cash or other financial asset to another entity

II. To exchange financial instruments with another entity under conditions that are
potentially unfavorable.

a. I only
b. II only
c. Both I and II
d. Neither I or II

3. It is any contract that evidences residual interest in the assets of an entity after deducting
all of its liabilities.

a. Equity instrument
b. Debt instrument
c. Loan receivable
d. Financial asset with indeterminable fair value

4. Financial liabilities include all of the following, except

a. Trade accounts payable

b. Notes payable
c. Bonds payable
d. Income taxes payable

5. Equity instruments include all of the following, except

a. Ordinary shares
b. Preference shares
c. Warrants or options that allow the holder to purchase a fixed number of ordinary shares
of the issuing entity in exchange for a fixed amount of cash.
d. Corporate bonds and other debt instruments issued by the entity.
6. Which of the following is not classified as a financial instrument?

a. Convertible bond
b. Foreign currency contract
c. Warranty provision
d. Loan receivable

7. A bond convertible by the holder into a fixed number of ordinary shares of the entity is

a. A compound financial instrument

b. A primary financial instrument
c. A derivative financial instrument
d. An equity instrument

8. Which of the following should be considered a financial liability?

a. Deferred revenue
b. A warranty obligation
c. A constructive obligation
d. Redeemable preference share

9. What is the principal accounting for a compound financial instrument?

a. The issuer shall classify a compound instrument as either liability or equity based on
evaluation of the predominant characteristics of the contractual arrangement.
b. The issuer shall classify the liability an equity components of a compound instrument
separately as financial liability or equity instrument.
c. The issuer shall classify a compound instrument as a liability in its entirely, until
converted into equity, unless the equity component is detachable and separately
transferable, in which case the liability and equity components shall be presented
separately.
d. The issuer shall classify a compound instrument as a liability in its entity, until
converted into equity.

10. How are the proceeds from issuing a compound financial instrument allocated between the
liability and equity components?

a. First, the liability component is measured at fair value, and then the remainder of the
proceeds is allocated to the equity component.
b. First, the liability component is measured at fair value, and then the remainder of the
proceeds is allocated to the liability component.
c. First, the fair values of both the equity component and the liability component are
estimated. Then, the proceeds are allocated to the liability and equity components based
on the relation between estimated fair value.
d. The equity components is measured at its intrinsic value. The liability component is
measured at the face amount less the intrinsic value of the equity component.
PROBLEM 7-2 Multiple choice (ACP)

1. When an entity issued bonds payable that can be converted into ordinary shares, what will
be the effect on liabilities and equity, respectively?

a. Increase and No effect

b. Increase and Increase
c. No effect and Increase
d. Decrease and Increase

2. An entity issued bonds payable with nondetachable share warrants. In computing interest
expense for the first year, the effective interest rate is multiplied by the

a. Proceeds received from sale of the bonds

b. Face value of the bonds
c. Fair value of the bonds only
d. Share warrants outstanding

3. What an entity issued bonds payable with detachable share warrants, how will share
premium be computed if the warrants are exercised by the bondholders?

a. It is the difference between the proceeds received based on the exercise price and the
total par or stated value of the shares issued.
b. It is the difference between the proceeds received based on the exercise price plus the
share warrants outstanding and the total par or stated value of the shares issued.
c. It is the sum of the share warrants outstanding and total par or stated value of the
shares issued.
d. It is the balance of the share warrants outstanding.

4. When an entity issued convertible bonds, how will share premium be computed if the
bonds were converted into ordinary shares?

a. It is the difference between the carrying amount of the bonds and the total par or stated
value of the shares issued.
b. It is the difference between the value of the bonds and the total par or stated value of
the shares issued.
c. It is the difference between the carrying amount of the bonds plus share premium from
conversion privilege and the total par or stated value of the shares issued.
d. It is the difference between the face value of the bonds plus the share premium from
conversion privilege and total par or stated value of the shares issued.

5. The proceeds from a bond issued with share warrants shall be accounted for as

a. Entirely bonds payable

b. Entirely shareholder’s equity
c. Partly bonds payable and partly unearned revenue
d. Partly bonds payable and partly shareholder’s equity
PROBLEM 7-3 Multiple choice (IAA)

1. When the cash proceeds from bonds issued with share warrants exceed the fair value of
the bonds without the warrants, the excess should be credited to

a. Share premium – ordinary

b. Retained earnings
c. Liability account
d. Share premium – share warrants

2. The proceeds from an issue of bonds with share warrants should not be allocated between
the liability and equity components when

a. The pair value of the warrants is not readily available.

b. The exercise of the warrants within the next reporting period seems remote.
c. The warrants issued are nondetachable.
d. The proceeds should be allocated between liability and equity under all of these
circumstances.

3. When bonds are issued with share warrants, a portion of the proceeds should be allocated
to equity when the bonds are issued with

a. Detachable share warrants

b. Nondetachable share warrants
c. Both detachable and nondetacable share warrants
d. Neither detachable nor nondetachable share warrants

4. When bonds are issued with share warrants, the equity component is equal to

a. Zero
b. The excess of the proceeds over the face value of the bonds.
c. The market value of the share warrants
d. The excess of the proceeds over the fair value of the bonds without the share warrants.

5. The major differences between convertible bonds and bonds issued with share warrants is
that upon exercise of the warrants

a. The share are held by the issuer for a certain period before they are issued to the
warrant holder.
b. The holder has to pay a certain amount to obtain the shares.
c. The shares involved are restricted.
d. No share premium can be part of the transaction.
PROBLEM 7-4 Multiple choice (IAA)

1. Convertible bonds

a. Have priority over other indebtedness.

b. Are usually secured by a mortgage.
c. Pay interest only in the event earnings are sufficient.
d. May be exchanged for equity shares.

2. Convertible bonds

a. Are separated into the liability component and the expense component.
b. Allow an entity to issue debt financing at lower rate.
c. Are separated into their components based on relative fair value
d. All of the choices are correct.

3. What is the accounting for issued convertible bonds?

a. The instrument should be presented solely as bond.

b. The instrument should be presented either as bond or equity but not both.
c. The instrument should be presented solely as equity.
d. The instrument should be presented as part bond and part equity.

4. Issued convertible bonds are

a. Separated into debt and equity components with the liability component recorded at fair
value and the residual assigned to the equity component.
b. Always recorded using the fair value options.
c. Recorded at face value for the liability along with the associated premium or discounts.
d. Recorded at face value without consideration of a premium or discounts.

5. The conversion of bonds is usually recorded by

a. Incremental method
b. Proportional method
c. Fair value method
d. Carrying amount method

6. When convertible bond is not converted but paid at maturity

a. A gain or loss is recorded for the difference between the carrying amount of the bond
and the present value of the cash flows
b. The amount allocated to equity is recorded as a gain.
c. The amount allocated to equity is recorded as a loss.
d. The carrying amount of the bond equal to face value is derecognized.
 7. Bondholders exchanged their convertible bonds for ordinary shares. The carrying amount
of these bonds was lower than market value but greater than the par value of the ordinary
shares issued. If the book value or carrying amount method is used, which is following
correctly states an effect of the conversion?

a. Shareholder’s equity is increased.

b. Share premium is decreased.
c. Retained earnings account increased.
d. A loss is recognized.

PROBLEM 7-5 (IAA)

On January 1, 2015 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, 2015.

Required:

Prepare journal entire for 2015 in connection with the bond issuance and the exercise of the
warrants. Use effective interest method of amortization.

PROBLEM 7-6 (IAA)

On January 1, 2015 Kat Company has decided to raise additional capital by issuing P5,000,000
face value 5 – year bonds with interest rate of 12% payable annually on December 31. To help the
sale of the bonds, share warrants are issued – one warrant for each P1,000 bond sold.

The warrant entitles the holder to purchase five shares at P100 per share. The par value of the
share is P50.

It is reliably determined that the value of the warrants is P30 each at the time of the issuance of
the bonds.

The bonds are sold for P5,100,000 with warrants but would have sold only at P4,657, 000 without
the warrants with 14% effective yield.

Required:

Prepare journal entries for 2015 is connection with the bonds including the exercise of the share
warrants. The effective interest method of amortization is used.
PROBLEM 7-7 (IFRS)

On January 1, 2015, 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 valueof the
warrants at the time of issuance was P1,500,000. The market rate of interest for similar bonds
without the warrants is 10%. The PV of 1 at 5% for ten periods is 7.72. All share warrants were
exercised on December 31, 2015.

Required:

Prepare journal entries for 2015 in connection with the bonds. The interest method of amortization
is used.

PROBLEM 7-8 (IFRS)

On January 1, 2015, 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 2,200,
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, 2015. 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 three periods is 0.77 and the present value of an ordinary
annuity of 1 at 9% for three periods is 2.53.

Required:

Prepare journal entry records issuance of the bonds on January 1, 2015 interest payment,
effective amortization and bond conversion on December 31, 2015.

PROBLEM 7-9 (IAA)

Sunshine Company issued 4-year P5,000,000 face value of 12% convertible bonds at 105 on
January 1, 2015, maturing on January 1, 2020 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, 2015 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:

1. Prepare journal entry to record the issuance of the bonds on January 1, 2015.
2. Prepare journal entry to record the interest payment and amortization for 2015. The
effective interest method of amortization is used.
3. Prepare journal entry to record the conversion of bonds on December 31, 2015.
PROBLEM 7-10 (IAA)

Karen Company showed the following accounts on December 31, 2015:

Bonds payable 5,000,000

Premium on bonds payable 250,000
Share capital – 250,000 shares authorized and 200,000 10,000
shares issued, P50 par
Share premium – issuance 2,000,000
Share premium- conversion privilege 500,000
Retained earnings 2,500,000

The bonds are convertible into 10 shares of capital for every P1,000 bond.

On December 31, 2015, the entire bond issue was converted and on this date, the market value of
the share is 120 and the market value of the bonds is 103.

The entity paid P200,000 as a result of the bond conversion.

Required:

Prepare journal entries for the conversion of the bonds on December 31, 2015.

PROBLEM 7-11 (IAA)

On January 1, 2015. 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 three periods is 2.58.

Required:

1. Prepare journal entry to records the original issuance of the convertible bonds.
2. Prepare journal entry to records the full payment of the convertible bonds at maturity on
January 1, 2018.

PROBLEM 7-12 (IAA)

On January 1, 2015, Arlene Company issued convertible bonds with face value of P5, 000, 000 for
P6, 000, 000. The bonds are convertible into 50,000 shares with P100 par value. The bonds have a
5-year life with 10% stated interest rate payable annually every December 31. The fair value of
the convertible bonds without conversion privilege is P5, 400, 000 and the carrying amount is
P5, 178, 300.

Required:

1. Prepare journal entry record the original issuance of the convertible bonds on January 1,
2015.
 2. Prepare entries on December 31, 2017.

PROBLEM 7-13 (AICPA Adapted)

On March 1, 2015 Fence Company issued 12% P5, 000, 000 nonconvertible bonds 103 which are
due on February 28, 2020. 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, pay value P25.
Interest is payable annually every February 28. On March 1, 2015, the market value of the share
was P40 and the market value of the warrant was P4. 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.

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

PROBLEM 7-14 (AICPA Adapted)

On December 31, 2015, Fort Company issued 5, 000 of 8%, 10-year, P1, 000 face value bonds
with share warrants at 110. Each bond carried a warrant for one share of Fort Company at a
specified option price of P25 per share. Immediately after issuance, the market value of the bonds
without the warrants was P5, 400, 000 and the market value of the warrant was P6, 000, 000.

On December 31, 2015, what is the carrying amount of bonds payable?

a. 5, 400, 000
b. 4, 875, 000
c. 4, 500, 000
d. 4, 400, 000

PROBLEM 7-15 (IAA)

On December 31, 2015, Armada Company issued P5, 000, 000 face value, 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
December 31. However, the prevailing market rate of interest for similar bonds without warrants is
12%. The present value of1 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.

On December 31, 2015, what amount should be recorded as increase in shareholder’s equity as a
result of the bond issuance?

a. 620, 000
b. 440, 000
c. 250, 000
d. 0
PROBLEM 7-16 (IAA)

On December 31, 2015, Lancaster Company issued at 103, five thousand 9%, P1, 000 face value
bonds. Attached to each bond was one share warrant entitling the holder to purchase 10 ordinary
shares of the entity. On December 1, 2015, the fair value of the bonds without the share warrants
was 95, and the fair value of each share warrant was P50.

What amount of the proceeds from the bond issuance should be accounted for as the initial
carrying amount of the bonds payable?

a. 4, 892, 500
b. 4, 750, 000
c. 5, 000, 000
d. 5, 150, 000

PROBLEM 7-17 (IAA)

Moriones Company issued P5, 000, 000 face value 12% convertible bonds at 110 on January 1,
2015, maturing on January 1, 2020 and paying interest semiannually 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 increase I shareholder’s equity arising from the original issuance of the convertible bonds?

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

PROBLEM 7-18 (IFRS)

Susan Company issued 5, 000 convertible bonds on January 1, 2015. The bonds have a three-year
term and are issued at 110 with a face value of P1, 000 per bond. Interest is payable annually in
arrears at a nominal 6% interest rate.

Each bond is convertible at any time 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
PROBLEM 7-19 (IAA)

Heritage Company issued convertible bonds payable for P600, 000. At the date of issuance, it is
determined that the fair value of the bonds is P580, 000. How should the issuance of the bonds be
recognized?

a. As a bond liability for P600, 000 and a contra liability of P20, 000.
b. As a bond liability for P580, 000 and an equity component of P20, 000.
c. As a bond liability for P580, 000 and other comprehensive income of P20, 000.
d. As a bond liability for P600, 000.

PROBLEM 7-20 (IAA)

Jim Company issued 2, 000 P1, 000 convertible bonds at par, with an annual interest rate of 5%
when the market rate was 8%. The bonds are due in 5 years and each P1, 000 bond is convertible
into 3 ordinary shares. At what amount should the liability component of the bond be recognized?
Round of PV factor to three decimals.

a. 2, 006, 000
b. 1, 761, 300
c. 2, 000, 000
d. 239, 569

PROBLEM 7-21 (IFRS)

Green Company issued 2, 000 convertible bonds with a nominal interest rate of 7% at P2, 000
each. Each bond can be converted into five equity shares or redeemed for cash, at the option of
the holder, in 5 year’s time. The fair value at the date of issuance of similar bonds without the
convertibility option was estimated at P1, 500 each. What is the amount recognized in equity in
respect of the original issuance of convertible bonds?

a. 4, 000, 000
b. 3, 000, 000
c. 1, 000, 000
d. 0

PROBLEM 7-22 (AICPA Adapted)

On December 31, 2015, Cey Company had outstanding 12%, P5, 000, 000 face amount
convertible bonds maturing on December 31, 2020. 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, 2015, the unamortized balance in the premium on the bonds payable accounts was
P300, 000. No equity component was recognized from the original issuance of the convertible
bonds. On December 31, 2015, 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
PROBLEM 7-23 (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 indenture 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

PROBLEM 7-24 (AICPA Adapted)

Clay Company had P600, 000 convertible 8% bonds payable outstanding on June 30, 2015. Each
P1, 000 bond was convertible into 10 ordinary shares of P50 par value. On July 1, 2015, the
interest was paid to bondholder’s, 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 component was recognized when the bonds were originally issued. What is
the increase in the share capital and share premium, respectively, as a result of the bond
conversion?

a. 300, 000 and 312, 000

b. 306, 000 and 306, 000
c. 450, 000 and 162, 000
d. 600, 000 and 12, 000

PROBLEM 7-25 (IAA)

Young Company issued 5, 000 convertible bonds at the beginning of the current year. The bonds
have a four-year term with a stated rate of interest of 6%, and are issued at par with a face value
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 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 at maturity. What amount should be recorded as gain or loss on the full payment of
the convertible bonds at maturity?

a. 2, 500, 000 gain

b. 485, 000 loss
c. 485, 000 gain
d. 0
PROBLEM 7-26 (IAA)

On December 31, 2015, Tamia Company showed the following balances:

Bonds payable 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, 2015. On such date, the quoted price of the convertible 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. 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