Determination of the price of a bond is a present value computation in the same manner as that demonstrated previously in the coverage of intangible assets. Here, a single cash payment of $20,000 is to be made by the debtor to the bondholder in two years. The parties have negotiated an annual 6 percent effective interest rate. Thus, a portion of the future cash ($20,000) serves as interest at an annual rate of 6 percent for this period of time. In a present value computation, total interest at the designated rate is calculated and subtracted to leave the present value amount. That is the price of the bond, often referred to as the principal. Interest is computed at 6 percent for two years and removed. The remainder is the amount paid for the bond.
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Although the bond was sold to earn 6 percent annual interest, this rate is not reported for either period. Year One: $1,100 interest/$17,800 principal = 6.2 percent Compounding of the interest raises the principal by $1,100 to $18,900 Year Two: $1,100 interest/$18,900 principal = 5.8 percent In reality, the parties established an annual rate of 6 percent for the entire two-year period. When applying the straight-line method, this actual rate is not shown for either year. Furthermore, the reported interest rate appears to float (6.2 percent to 5.8 percent) as if a different rate was negotiated for each year. That did not happen; there was a single 6 percent interest rate agreed-upon by the debtor and the creditor. The straight-line method does not reflect the reality of the transaction. However, it can still be applied according to U.S. but only if the reported results are not materially different from those derived using the effective rate method.
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