Principles of Accounting — Basics of Liabilities and Equity: Bonds, Share Issues and Dividends
The money that buys assets comes from creditors or shareholders. Money from creditors is a liability that must be repaid; money from shareholders is equity, the residual interest. This chapter covers the basic accounting for both sources of finance. Amortization of bonds and the classification of financial liabilities continue in Intermediate Accounting chapter 7, and the details of equity transactions in Intermediate Accounting chapter 9.
1. Operating liabilities
A. Trade payables and other payables
Amounts owed on credit from ordinary trading (buying goods and raw materials) are trade payables; amounts owed from other transactions (buying fixtures, advertising and so on) are other payables. Even for the same kind of credit, separating accounts by the nature of the transaction keeps analyses such as payables turnover from being distorted.
B. Accrued expenses and advances received
The salaries payable and interest payable seen in chapter 3 are accrued expenses. Amounts received from customers in advance are advances received (contract liabilities under the revenue standard). Both are obligations already fixed. Obligations uncertain in amount or timing are assessed separately as provisions (Intermediate Accounting chapter 8).
2. Bonds: the gap between promised interest and market interest
When a company issues bonds, it repays the face amount at maturity and pays interest at the coupon rate on face until then. Investors demand the market rate they could earn on other investments of the same risk. When the two rates differ, the issue price differs from face.
- Coupon rate < market rate: issued below face (at a discount).
- Coupon rate = market rate: issued at face.
- Coupon rate > market rate: issued above face (at a premium).
A. Calculating the issue price
A bond with a face amount of ₩10 million, a coupon rate of 5% a year (paid at year-end) and a three-year maturity is issued when the market rate is 8%.
B. The effective interest method
Each year’s interest expense is opening carrying amount × market (effective) rate. The discount is amortized by the difference from the coupon interest paid in cash, bringing the carrying amount toward face.
| Year | Opening carrying amount | Interest expense (8%) | Cash interest (5%) | Discount amortized | Closing carrying amount |
|---|---|---|---|---|---|
| 1 | 922.7 | 73.8 | 50 | 23.8 | 946.5 |
| 2 | 946.5 | 75.7 | 50 | 25.7 | 972.2 |
| 3 | 972.2 | 77.8 | 50 | 27.8 | 1,000.0 |
Total interest expense over three years is ₩2.273 million: cash interest of ₩1.5 million plus the discount of ₩773,000. Issuing at a discount is a deal in which “less is received up front in exchange for paying less interest”, so the discount is in substance interest too.
3. Equity transactions
A. Issuing shares
Issuing 20,000 ordinary shares with a par value of ₩5,000 at ₩7,000 each brings in cash of ₩140 million: share capital of ₩100 million and share premium of ₩40 million. Fees of ₩2 million directly attributable to the issue are not an expense but are deducted from share premium.
B. Treasury shares
When a company buys back its own shares, they are deducted from equity as treasury shares (a capital adjustment). They are not an asset. Buying 1,000 shares at ₩8,000 each reduces equity by ₩8 million. If the shares are later sold at ₩9,000 each, the ₩1 million difference is not profit but a gain on disposal of treasury shares (capital surplus). The logic is that a company cannot earn a profit by dealing with its own shareholders.
C. Dividends and the legal reserve
A cash dividend becomes a liability, dividends payable, on the date of the shareholders’ resolution (or the board’s, where the articles allow), and cash leaves on the payment date. Under Article 458 of the Korean Commercial Act, a company must set aside at least one tenth of each cash dividend as a legal reserve until the reserve reaches half of share capital (stock dividends excluded).
| Item | Amount |
|---|---|
| Unappropriated retained earnings before appropriation | 5,000 |
| Transfer to legal reserve (10% of dividend) | (100) |
| Cash dividend | (1,000) |
| Unappropriated retained earnings carried forward | 3,900 |
The transfer to the legal reserve moves an amount between boxes within retained earnings, so total equity falls only by the ₩10 million dividend.
Check your understanding
At the beginning of 20X1, company E issued bonds with a face amount of ₩20 million, a coupon rate of 6% (paid at year-end) and a two-year maturity when the market rate was 10% (two-year present value factors: single sum 0.8264, annuity 1.7355). What are the issue price and the interest expense for 20X1? If in the same year E bought 500 treasury shares at ₩10,000 each and sold 300 of them at ₩12,000 each, how much does equity change?
The issue price is (₩10,000). Interest expense for 20X1 is , and the ₩661,000 difference from cash interest of ₩1.2 million is amortized discount. Buying treasury shares reduces equity by ₩5 million and selling 300 shares increases it by ₩3.6 million (of which ₩600,000 is a gain on disposal of treasury shares). The net effect is a ₩1.4 million decrease in equity, with the remaining 200 treasury shares (₩2 million) still deducted from equity.
References
- Korea Accounting Standards Board, K-IFRS 1032 Financial Instruments: Presentation (liabilities versus equity, own equity instruments)
- Korea Accounting Standards Board, K-IFRS 1109 Financial Instruments (effective interest method)
- Korean Commercial Act, Article 458 (legal reserve) and Article 462 (dividends) — National Law Information Center
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