CHAPTER 46 EFFECTIVE INTER) MARKET PRICE OF Bee METHOD QUESTION 46-1 Explain nominal rate and effective rate of interest, ANSWER 46-1 Pate comeing on of ee wi ve rate is fi Pie: ts the actual interest incurred on the bond The nominal rate is also known as coupon or stated rate. The effective rate is the rate that exactly discounts estimated cash future payments through the expected life of the bonds payable or when appropriate, a shorter period tu the net carrying amount of the: bonds payable. The effective rate is also known as yield or market rate. QUESTION 46-2 Explain the relationship between nominal rate and effective rate of interest. ANSWER 46-2 If the bonds are sold at face amount, the nominal rate and effective rate are the same. Tethe bonds are sold at a discount, the than nominal rate. If the bonds are sold at a premium, than nominal rate. effective rate is higher the effective rate is lower 537QUESTION 46-3 Explain the effective interest method of amortizing discouny and premium on bonds payable. ANSWER 46-3 ‘The effective interest method or simply “interest method” op scientific method recognizes two kinds of interest rate - noming] rate and effective rate. The annual amortization of premium or discount is the difference between the effective interest expense and nominal interest expense. The effective interest expense is computed by multiplying the carrying amount of the bonds payable at the beginning of the year by the effective rate The nominal interest expense is computed by multiplying the face amount of the bonds payable by the nominal rate The effective interest method provides for an increasing amount of discount amortization and increasing amount of interest expense. ‘The effective interest method provides for an increasing amount of premium amortization but a decreasing amount of interest expense. QUESTION 46-4 Explain the treatment of bond issue cost under the effective interest method. ANSWER 46-4 The calculation of effective interest rate shall include all: transaction costs, premiums and discounts. Under the effective interest method, bond issue cost must be “lumped” with the discount on bonds payable and “netted” against the premium on bonds payable. Accordingly, bond issue costs will increase discount on bonds payable and will decrease premium on bonds payable. QUESTION 46-5 Explain market price of bonds payable, ANSWER 46.5 ‘The market price or issue priee of b rice of bonds is the present value of the principal bond I haben, Saal to value of future interest payments using the ek present rate of interest. fective or market Simply stated, the market price of bond the sum of the following: rns vayehle i pial 2. Present value of bonds payable b. Present value of the total interest payments present value of the principal bond liability is equal to the amount of the bonds payable multiplied by the present 1 of I factor at the effective rate for a number of interest ds. [he present value of the future interest payments is equal dic nominal interest multiplied by the present e of an ordinary annuity of 1 factor ol the effective a number of interest periods.5. Under the effective int QUESTION 46-6 Multiple choice (LAA) 1. What is the interest rate written on the face of the bond? a, Coupon rate b. Nominal rate ¢. Stated rate _d: Coupon rate, nominal rate or stated rate 2. What is the rate of interest actually incurred? a. Market rate b. Yield rate c. Effective rate d. Market, yield or effective rate 3. When the effective interest method is used, the periodic amortization would Increase if the bonds were issued at a discount. Decrease if the bonds were issued at a premium. Increase if the bonds were issued at a premium. Increase if the bonds were issued at either a discount or a premium. Reoe 4, A discount on bond payable is charged to interest expense a. Equally over the life of the bond b. Only in the year the bond is issued e. Using the effe terest method d. Only in the year the bond matures l rest method of amort interest expense is equal to a. The stated rate of interest multiplied by the face amount of the bonds. b. The market rate of interest multiplied by the face amount of the bonds. c. The stated rate of interest multiplied by the beginning carrying amount of the bonds. 7d. The market rate of interest multiplied by the beginning carrying amount of the bonds. 540 6, When interest expense for the curre interest paid, the nt year is more than onds were issued at, va. A discount b A premium ¢. Face amount d. An indeterminable amount interest paid, the bonds were esued at 22" less than a. A discount b. A premium fc. Face amount d. An indeterminable amount 8, Bond issue cost. a, Is included in the measurement of the measured at amortized cost. a ee b. Is amortized using the interest method over the life of the bonds payable. c. Will effectively increase the market rate of interest, d. All of these relate to bond issue cost. 9. Bonds usually sell at a. Maturity amount b. Face amount c. Present value d. Statistical expected value 10. Which statement is true about bonds payable? a a. The specific provisions of a bond issue are deserit in a document called bond indenture. b. Periodic interest expense is the stated interest rate times the amount of bond outstanding. tp e. Bonds will sell for a peeqaum when the market terest exceeds stated rate. ae ere Bale price of bond represents the sum of all future cash outflows. ANSWER 46-6 Ld ad ea 7 be e 2d 4 Gia Be aQUESTION 46-7 Multiple choice (IAA) 1. When bonds are sold at a premium. at each subse interest payment date, the cash paid is ‘quent a. Less than the effective interest b. Equal to the effective interest -c. Greater than the effective interest d. More than if the bonds had been sold at a discount 2. When bonds are sold at a discount, at each subsequent interest payment date, the cash paid is a. More than the effective interest -b. Less than the effective interest c. Equal to the effective interest d. More than if the bonds had been sold at a premium 3. When bonds are sold at a discount, at each interest payment date, the interest expense a. Increases b. Decreases c. Remains the same d. Is equal to'the change in carrying amount 4, When bonds are sold at a premium, at each interest payment date, the interest expense a. Remains constant b. Is equal to the change in carrying amount c. Increases A. Decreases 5, Interest expense is A. The effective rate times the carrying amount of the bond during the interest period. b. The stated rate times the face amount of the bond. c. The effective rate times the face amount of the bond. d. The stated interest rate times the carrying amount. ANSWER 46-7 le 2b a a 4d 5. a 542 QUESTION 46-8 Multiple choi ice (AICPA Adapted) 1 What is the effective inte 4 amortized cost? =“ est rate of a bond measured at a. The stated rate of the bond. b. The interest rate currently charged by the entity others for similar bond. 7 Some c. The interest rate that exac future cash payments through the expected He of ty bond or when appropriate, a shorter period carrying amount of the bond. bbe d. The basic risk-free interest rate that is deri observable government bond prices, ae tly discounts estimated For a bond issue which sells for less than face amount, market rate of interest is = a. Dependent on rate stated on the bond b. Equal to rate stated on the bond c. Less than rate stated on the bond Higher than rate stated on the bond What is the market rate of interest for a bond issue which sells for more than face amount? a. Less than rate stated on the bond. bb, Equal to rate stated on the bond c. Higher than rate stated on the bond d. Independent of rate stated on the bond If bonds are issued at a premium, this indicates that a. The yield rate of interest exceeds the nominal rate b. ‘The nominal rate of interest exceeds the yield rate c 4. ‘The yield and nominal rates No neccesary relationship exists between the two rates sees a.5. Which statemer > x nt is true for a bond maturing on a ffective interest method of amo able is used? Sin date when the & riage discount on bonds pay: Interest expense as a percentage of the bond carry amount varies from period to period ng pb. Interest expense increases each six-month period c._ Interest expense remains constant each six-month periog d, Nominal interest rate exceeds effective interest rate ‘The market price ofa bond issued at a discount is the present value of the principal amount at the market rate of interest a. Less the present value of all future interest payments at the market rate of interest. b. Less the present value of all future interest payments at the rate of interest stated on the bond. ¢. Plus the present value of all future interest payments at the market rate of interest. . Plus the present value of all future interest payments at the rate of interest stated on the bond. In theory, the proceeds from the sale of a bond would be equal to . ‘The face amount of the bond, a. b. The present value of the principal amount due at the end of the life of the bond plus the present value of the interest payments made during the life of the bond cc. The face amount of the bond plus the present value of the interest payments made during the life of the bond d. ‘The sum of the face amount of the bond and the periodie interest payments. . Under international accounting standard, the valuation method used for bonds payable is a. Historical cost 'b. Discounted cash flow valuation at current yield rate c. Maturity amount A. Discounted cash flow valuation at yield rate at issuance 544 wed rom bos ty calculate the net proceed to be . Di Dae oe eens at the stated rate of interest. c. Discount the Toutes eet rate of nes: deduet bond isouance cose ns 784 Of interest and 4. Discount the bonds . deaduct bond issuance cn TNS Fe of interet and 10. An entity issued a bond with a stated rate of i that is less than the effective interest rate on the date of issuance, The bond was issued on one of the interest payment dates. What should the enti payment dates, Whats ity report on the first a, An interest expense that is less than th made to bondholders. ee b, An interest expense that is greater than the cash payment made to bondholders. c. A debit to discount on bond payable. ANSWER 46-8 le 6. © 2.4 1b 3. a 8d 4. b 9 a 5. b 10. bCHAPTER 47 COMPOUND FINANCIAL INSTRUMENT QUESTION 47-1 Explain a compound financial instrument. ANSWER 47-1 PAS 32, paragraph 28, defines a compound financial instrument ‘asa financial instrument that contains both a liability and an equity element from the perspective of the issuer. If the financial instrument. contains both a li equity component, the Standard mandat components Shall be accounted for separately. In other words; the consideration received from the issuance of the compound financial instrument shall be allocated between the liability and equity components, QUESTION 47-2 Explain accounting for bonds payable issued with share warrants. ANSWER 47-2 Bonds issued with share warrants are considered as compound financial instrument. Accordingly, the proceeds from the issuance of the bonds payable with share warrants shall be accounted for as partly jiability and partly equity. The proceeds shall be allocated between the bonds payable and the share warrants. Whether detachable or nondetachable, share warrants have a value and therefore shall be accounted for separately. ‘The bonds are assigned an amount equal to the market value of the bonds ex-warrant regardless of the market value of the warrants. The residual amount or remainder of the issue price shall then be allocated to the share warrants. If the bonds have no known market value ex-warrant, the amount allocated to the bonds is equal to the present value or market price of the bonds payable using the effective rate. QUESTION 47-3 Explain accounting for ae issuance. Convertible bonds at the time of original ANSWER 47-3 Convertible bonds are conceived ci instrument. Accordingly, tho issuance ofconvertile bene neat be accounted for as partly liability and partly equity. ‘The issue price of the convertible bonds shall b between the bonds payable and the conversion mivilnnss ‘The bonds are assigned an amount equal to the market value the bonds without the conversion privilege. ‘The residual amount or remainder of the issue price shall then bye allocated to the conversion privilege or equity component, In the absence of market value of the bonds payable without ‘on privilege, the amount allocated to the bonds payable to the present value of market price of the bonds payable ‘g the effective or market interest rate for similar bonds payable without conversion privilege. QUESTION 47-4 1 accounting for the conversion of convertible bonds share capital ANSWER 47-4 “Application Guidance 32 of PAS 32 provides that on conversion fa ‘trument at maturity, the entity derecognizes of a convertible inst y the liability component and recognizes it as equity. ‘gain or loss on conversion at maturity. i the bonds payable is the — Accordingly, the carrying amount of a measure ofthe share capital issued because the caring is the effective price for the shares iss conversion. [Any cost incurred in connection with the bond be deducted from share premium, if any ‘There is noQUESTION 47-5 Multiple choice (PRS) 1. What.is the principal accow instrument? a. The issuer shall pa a compound instrument i © either li or equity. “b. Sener eal classify the liability and equity " components of a compound instrument separately 4y liability or equity instrument. ¢, ‘The issuer shall classify a compound instrument as 4 ability in its entirety, until converted into equity, 4. The issuer shall classify 2 compound instrument ay q liability in its entirety. inting for a compound finang; q al 2.How are the proceeds from issuing a compoung instrument allocated between the liability and equity? A The liability component is measured at fair value and the remainder of the proceeds is allocated to the equity component, b. The proceeds are allocated to the liability and equity based on fair val The proceeds are allocated to the liability and equity based on carrying amount. d. The proceeds are not allocated because the compound instrument is accounted for either as liability or equity 3:-The proceeds from an issue of bonds with share warrants should not be allocated between the liability and equity components when + & The fair value of the warrants is not readily available. BL. The exercise of the Warrants within the next reporting period seems remote. c The warrants issued are nondetachable. A. The proceeds should be allocated between liability and equity under all of these circumstances, 4 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 pore Share premium ~ ordinary Retained earnings Liability account Share premium — share warrants 5. When bonds are issued with share warrants, the equity component is equal to a. Zero b. The excess of the proceeds over the face amount 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. ANSWER 47-5 1b 2a 3. a 4d 5. dQUESTION 47-6 Multiple choice (IAA) .d convertible by the holder into a fixed n 1. A Bord'y shares of the issuer is Mme op ‘a. A compound financial instrument BA primary financial instrument ¢. A derivative financial instrument 4 An equity instrument 2. Convertible bonds a. Have priority over other indebtedness. b. Are usually —_ by a mortgage. c. Pay interest only in the event net income is suffic to cover the interest. ficient d. May be exchanged for equity shares. 3. What is the main reason for issuing convertible bond? a. The ease with which convertible bond is sold even it the entity has a poor credit rating. b. The fact that equity capital has issue cost and convertible bond has none c. Entities can obtain financing at lower rate. d. Convertible bond will always sell at a premium. 4. The major difference between converti nds payable and bonds payable issued with share warrants is that upon exercise of the warrants a. The shares are held by the issuer for a certain period before they are issued to the warrant holder. ». 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. 5. Convertible bonds a. Are separated into the liability component and the : expense component. b. Allow an entity to issue debt financing at lower rate. ¢. Are separated into liability and equity components | based on fair value. d. Alll of the choices are correct, 6. What is the accounting for issued eonvertible bond? a. The instrument is recorded solely as bond. b. The instrument in recorded as either bond or equity ¢. The instrument is recorded solely as equity, ¢ _d, The instrument is recorded as part bond and part equity. 7, Issued convertible bonds are fa. Separated into liability and equity componente with the liability component recorded at fair value and the residual assigned to the equity component b. Always recorded using the fair value option ¢c. Recorded at face amount for the liability 4. Recorded at par value of shares 8, The carrying amount of bonds payable was greater than the par value of the shares issued. Which correetly states an effect of the conversion? a. Shareholders’ equity is increased b. Share premium is decreased c. Retained earnings account increased d. A loss is recognized 9. The conversion of bonds payable is recorded by a. Incremental method b. Proportional method c. Fair value method d. Book value or carrying amount method 10, When convertible bond is not converted but paid at maturity or lose is recorded for the difference between ae ee ing amount of the bond and the present vies, b, The amount allocated to oauity 8 recorded m8 65 ©. The amount allocated to equity sede ried wet {The carrying amount of the bond is derecognized. ANSWER 47-6 ‘ loa Bc 5. Ob a ‘ , 2d 4b 6. 4 & 8 10. st