EFFECTIVE INTEREST METHOD – Amortized
cost, FVOCI, FVPL
TECHINCAL KNOWLEDGE
1. To apply the effective interest method of amortizing bond discount and premium.
2. To apply the measurement of bond investment at fair value through other
comprehensive income.
3. To apply the fair value option of measuring bond investment.
4. To be able to determine the market price of bonds.
Objective 1
Effective interest method
Effective rate - Is the yield rate or market rate which is the actual or true rate of
interest which the bondholder earns on the bond investment.
Interest earned or interest income is computed by multiplying the effective
rate by the carrying amount of the bond investment.
Nominal rate – Is the coupon rate or stated rate appearing on the face of the bond.
Interest received is computed by multiplying the nominal rate by the face
amount of the bond.
Effective rate versus nominal rate
1. The effective rate and nominal rate are the same if the cost of the bond
investment is equal to the face amount.
2. Bond premium – effective rate < nominal rate.
3. Bond discount – effective rate > nominal rate.
Illustration 1 – Discount
On January 1, 2024, an investor acquired P1,000,000 face amount bonds dated
January 1, 2024. The bonds mature on December 31, 2025. 8% interest is payable
semiannually on June 30 and December 31. The cost of the bonds is P964,540 a price
which yield a 10% effective rate per year.
Required:
1. Schedule of amortization.
Illustration 2 – Premium
On January 1, 2024, an investor acquired P1,000,000 face amount bonds dated
January 1, 2024. The bonds mature on December 31, 2026. 12% interest is payable
annually every December 31. The cost of the bonds is P1,049,740 a price which yield a
10% effective rate per year.
Required:
1. Schedule of amortization.
Illustration 3 – Serial Bond
Face amount of bonds 4,000,000
Acquisition of bonds 4,171,810
Annual installment on December 31, 2024
And every December 31, thereafter 1,000,000
Date of issue January 1, 2024
Nominal interest rate payable annually
Every December 31 10%
Effective interest rate 8%
Required:
1. Schedule of amortization.
Objective 2 – Bond investments – FVOCI
The business model includes selling or trading the financial asset in addition
to collecting contractual cash flows.
The derecognition of the bond investment at FVOCI, the cumulative gain or
loss previously recognized in other comprehensive income shall be recognized
as gain or loss in the income statement.
Illustration 4 – FVOCI
On January 1, 2024, an entity purchased bonds with face amount of P5,000,000 for
P4,760,000 including transaction cost P160,000.
The business model is to collect contractual cash flows and to sell the financial assets.
The bond mature on December 31, 2026 and pay 10% interest annually on December
with a 12% effective yield.
The bonds are quoted at 102 on December 31, 2024.
The bonds are quoted at 105 on December 31, 2025.
The bonds are sold on June 30, 2026 at 110 plus accrued interest.
Required:
1. Amortization table.
2. Journal entries year 2024 – 2026.
1/1/24
12/31/24
12/31/25
6/30/26
3. How much is the carrying amount per table December 31, 2024?
4. How much is the interest income December 31, 2024?
5. How much is the carrying amount per book December 31, 2025?
6. How much is the gain or loss on sale of financial asset June 30, 2026?
7. How much is the interest income June 30, 2026?
Objective 3 – fair value option
Investment in bonds can be designated irrevocably as measured at fair value
through profit or loss even if the bonds are held for collection as a business
model or even if the bonds are held for collection and for trading (FVOCI).
Interest income is based on nominal interest.
All changes in fair value are recognized in profit or loss.
Any transaction cost incurred in acquisition is an outright expense.
Objective 4 – market price of bonds
The market price of bonds is equal to the present value of the principal plus the
present value of future interest payments using effective rate.
Illustration 5 – bond discount
Face amount of bonds 3,000,000
Date of issue of bonds January 1, 2024
Nominal rate 6%
Effective rate 8%
Interest payable annually December 31
Date of maturity December 31, 2026
Required:
1. Compute the Market value of bonds January 1, 2024.
2. Compute the bond discount.
Illustration 5 – bond premium
Face amount of bonds 3,000,000
Date of issue of bonds January 1, 2024
Nominal rate 8%
Effective rate 6%
Semiannual Interest June 30 and December 31
Date of maturity December 31, 2025
Required:
1. Compute the Market value of bonds January 1, 2024.
2. Compute the bond discount.
Illustration 5 – Serial bond - discount
Face amount of bonds 6,000,000
Annual installment every December 31 2,000,000
Date of issue of bonds January 1, 2024
Nominal rate 12%
Effective rate 14%
Interest payable annually December 31
Required:
1. Compute the Market value of bonds January 1, 2024.
2. Compute the bond discount.