Intermediate Accounting — Financial Liabilities and Bonds: Premiums, Issues Between Interest Dates and Early Redemption

Principles of Accounting chapter 10 covered the basics of bonds issued at a discount. This chapter sets out financial liabilities within the framework of K-IFRS 1109 and 1032 (IFRS 9 and IAS 32) and calculates three practical issues with bonds. Instruments mixing liability and equity components, such as convertible bonds, are covered in chapter 11.

1. Definition and classification of financial liabilities

A financial liability is a contractual obligation to deliver cash or another financial asset to another entity, or to exchange financial instruments under potentially unfavourable conditions. Trade payables, borrowings and bonds are typical. Obligations settled by delivering goods or services, such as advances received or warranty provisions, and obligations arising from law rather than contract, such as income taxes, are not financial liabilities.

Most financial liabilities are measured at amortized cost. Only liabilities held for trading (including derivative liabilities) and liabilities designated at FVPL on initial recognition are measured at fair value.

2. Amortizing a bond issued at a premium

At the beginning of 20X1, company V issued a three-year bond with a face amount of ₩10 million and a coupon of 8% (paid at year-end) when the market rate was 6%.

At a premium, the carrying amount falls each year and so does interest expense. At a discount the opposite holds: the carrying amount and interest expense rise each year. Either way, interest expense stays a constant proportion, opening carrying amount × effective rate. Bond issue costs are deducted from the issue price, so the effective rate ends up higher than the market rate.

3. Bonds issued between interest dates

If a bond’s stated issue date is 1 January but it is actually sold on 1 April, investors pay the accrued interest for January to March up front and receive twelve months’ interest at year-end.

Suppose the bond in section 2 (stated issue date 1 January 20X1) is issued on 1 April at a market rate of 6%. The issue price is found as follows.

1. Present value at 1 January: 1,053.5
2. Effective interest accrued to 1 April: $1{,}053.5 \times 6\% \times 3/12 ≈ 15.8$ → present value at 1 April 1,069.3 (including accrued interest)
3. Accrued coupon interest: $1{,}000 \times 8\% \times 3/12 = 20$
4. Net issue amount of the bond: $1{,}069.3 - 20 = 1{,}049.3$

Cash received is ₩10.693 million, recognized as a bond of ₩10.493 million and interest payable of ₩200,000. Interest expense for 20X1 is nine months, April to December: $1{,}053.5 \times 6\% \times 9/12 ≈ 47.4$, i.e. ₩474,000.

4. Early redemption

When bonds are bought back before maturity, the difference between the carrying amount at the redemption date and the amount paid is a gain or loss on redemption (profit or loss).

If the bond in section 2 is redeemed in full for ₩10.2 million immediately after paying interest at the end of 20X1, the ₩167,000 difference from the carrying amount of ₩10.367 million is a gain on redemption. The market rate rose after issue and the bond’s fair value fell, so it could be bought back cheaply.

5. Liabilities designated at FVPL and own credit risk

For financial liabilities designated at FVPL, the part of the change in fair value arising from changes in the entity’s own credit risk is recognized in other comprehensive income and never reclassified to profit or loss. The rule prevents the paradox of reporting a gain when the entity’s credit deteriorates and the fair value of its liabilities falls. If this treatment would create or enlarge an accounting mismatch, the whole change goes to profit or loss.

Check your understanding

At the beginning of 20X1, company W issued a three-year bond with a face amount of ₩20 million and a coupon of 4% (paid at year-end) at an effective rate of 6% (three-year factors: single sum 0.8396, annuity 2.6730). At the beginning of 20X2 (after paying interest at the end of 20X1) it redeemed half of the bond for ₩9.6 million. What are the issue price, interest expense for 20X1 and the gain or loss on redemption?

The issue price is $80 \times 2.6730 + 2{,}000 \times 0.8396 = 213.8 + 1{,}679.2 = 1{,}893.0$ (₩10,000). Interest expense for 20X1 is $1{,}893.0 \times 6\% ≈ 113.6$, and adding discount amortization of 33.6 gives a carrying amount of 1,926.6 at the end of 20X1. Half the carrying amount is 963.3, so redeeming it for 960 gives a gain of 3.3, i.e. ₩33,000.

References

• Korea Accounting Standards Board, K-IFRS 1109 Financial Instruments (classification and measurement of financial liabilities, derecognition, own credit risk)
• Korea Accounting Standards Board, K-IFRS 1032 Financial Instruments: Presentation
• Donald Kieso, Jerry Weygandt and Terry Warfield, Intermediate Accounting: IFRS Edition, ch. 14