question archive On January 1, 2020, Naruto Company, a financial service firm, purchased P100,000, face value 5-year bond of Wolverine Corporation for P108,660, a price that yields 5% on a stated interest rate of 7%
On January 1, 2020, Naruto Company, a financial service firm, purchased P100,000, face value 5-year bond of Wolverine Corporation for P108,660, a price that yields 5% on a stated interest rate of 7%
Subject:BusinessPrice:5.87 Bought7
On January 1, 2020, Naruto Company, a financial service firm, purchased P100,000, face value 5-year bond of Wolverine Corporation for P108,660, a price that yields 5% on a stated interest rate of 7%. Interest is payable annually at December 31. Fair values at year-end are as follows:
December 31, 2020 106.5
December 31, 2021 107.5
December 31, 2022 105.7
December 31, 2023 106.0
Naruto's business model for managing debt securities of this type is collecting cash flows that are solely payment for principal and interest. Naruto did not exercise its option to measure the investments at fair value.
Towards the end of 2022, after reviewing it strategic direction, Naruto decides to shut down it retail mortgage business and actively markets its debt investments portfolio in response to profit taking opportunities.
Naruto sold the Wolverine Corporation bonds on May 31, 2023 @106 plus accrued interest.
Requirement:
a. how much interest income should Naruto recognize for the year 2020 as a result of this investment?
b. at what amount should the investment be shown on December 31, 2021 statement of financial position?
c. prepare entries in the books of Naruto relating to the foregoing for years 2022 and 2023.
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Answer:
1. 5433
2. 105448
3. Journal entries
| Date | Particulars | Debit | Credit |
| 12/31/2022 | Cash | 7000 | |
| Investment in bonds | 1728 | ||
| Interest income | 5272 | ||
| 01/1/2023 | Financial Asset- FVPL | 105000 | |
| Investment in bonds | 103720 | ||
| Gain on reclassification | 1280 | ||
| 05/31/2023 | Cash (100000 x 106%) + 2917 | 108917 | |
| Financial Asset- FVPL | 105000 | ||
| Interest Income (100000 x 7%) x 5/12 | 2917 | ||
| Gain on sale on bonds | 1000 |
Amortization table
| Date | Interest received (Face value x 7% stated rate) (100000 x 7%) |
Interest income (Carrying Amount x 5% effective rate) |
Premium Amortization | Carrying Amount |
| 1/1/20 | 108660 | |||
| 12/31/20 | 7000 | 5433 | 1567 | 107093 |
| 12/31/21 | 7000 | 5355 | 1645 | 105448 |
| 12/31/22 | 7000 | 5272 | 1728 | 103720 |
Notes
(1) The bonds shall be classified as Amortized cost since the company's business model is collecting cash flows that are solely payment for principal and interest.
(2) The amortized cost ignores the Fair values of the investment but rather amortize the difference between the Face value (100000) and Present value (108660). The difference is either a premium or a discount. It is a premium when the Present value>Face value, meaning the bondholder(Naruto) PAID more than the face value(the amount to be received at the end of the bond terms). With this, the interest received base on 7% shall be decreased by the amount of premium amortization because it is a and AS IF LOSS at the date when the bond is purchased.
On the other hand, if Naruto paid a purchase price lower than 100000 it is AS IF a GAIN because the amount to be received at the end of the bond term is 100000. Therefore, it's interest income shall be increased by the DISCOUNT amortization.
(3) The presentation in the Statement of Financial may be computed in two ways
| First Way | Second way | ||
| Carrying amount per table | 105448 | Face amount | 100000 |
|
Add: Unamortized Premium at Dec 31, 2021 (108660-100000)- 1567-1645 |
5448 | ||
| Carrying Amount | 105448 |
Reclassification from Amortized cost to Fair value Profit or Loss (FVPL)
| Carrying Amount at Dec 31, 2022 | 103720 |
| Fair value at Dec 31, 2022 (100000 x 105%) | 105000 |
| Gain on reclassification | 1280 |
Notes
(1) Since Naruto decides to shut down it retail mortgage business and to ACTIVELY MARKETS its debt investments portfolio means that the investment requires to be reclassified from Amortized cost to Fair value Profit or Loss because the bonds will be TRADED in the market.
(2) The reclassification shall be effective on first day at the end of the year of the entity's decision to reclassify it. In this case, Jan 1, 2023. The fair value to be use should be in the order of priority.
a. Fair value at Jan 1, 2023
b. Fair value at Dec 31, 2022
Since only letter B is given, it shall be used as the fair value. The reason for this is that the one day difference is IMMATERIAL.
(3) The carrying amount PER TABLE needs to be reclassified to Fair value and this will continue to be remeasured to Fair value until disposal.
(4) Since the disposal happened before end of the year of 2023, no adjustment shall be made but a GAIN OR LOSS shall be recognized directly to profit or loss.
(5) The fair value>carrying amount, a gain since the money received is more than the value of the investment. Otherwise, a loss.
(6)Accrued Interest income is based on the stated rate of 7%. This is the TO BE RECEIVED interest from the bond issuer had the bondholder did not sold the bonds. It is being PREPAID by the purchaser of bonds and shall be included in the computation of cash received, Note that accrual is for 5 months only which is until date of sale May 31, 2023.
