CFA Practice Question

CFA Practice Question

The interest expense on a discount bond ______ over time.
A. decreases
B. increases
C. can increase or decrease, depending on interest rate movements
Explanation: Remember that the book value of the liability of any straight bond equals the face value at maturity. Hence, when the bond is issued at a discount, the discount amount is amortized over the life of the bond. The outstanding liability thus increases steadily toward the face value. The increasing liability increases the interest expense over time.

User Contributed Comments 5

User Comment
steved333 yeah, draw a curve. premium curves down, discount curves up, and par is a straight line.
Kashi2010 I think the answer should be C.

According to the text book (Fin Reporting, 521) interest expense is recorded at the market rate * the book value, with the excess expense (for a discount bond) being reversed through a discount amortisation entry.

If not changes in the market rate occurs, the interest expense does increase, however if the market rate were to decline the interest expense would decrease also..??

Further from pg527..

It appears that generally companies must report liabilities at historic cost (i.e. ignore market rate movements in the interim) unless they enter into an associated swap in which case the gain/loss in the swap should be removed by adjusted the underlying assets carrying value.

However this then becomes a grey area (again!!) when it states that recent changes to various standards generally allow companies to report FINANCIAL assets/liabilities at fair value... So it depends on how the company in question chooses to classify said liabilities.
tiger No Kashi2010. The interest is the market interest rate prevailing at the time of the bond issuance. It does not change (although it is called market rate) through the life of the bond.
farhan92 "Pull to Par"
GBolt93 Yeah, you expense at the market rate that the bond was originally discounted at, not the current market rate, so interest rate movements don't matter.
You need to log in first to add your comment.