CPA Exam - FAR (Financial Accounting and Reporting)Financial ReportingEasy
A company issues 10-year, $1,000,000 face value bonds with a stated interest rate of 6% payable semi-annually. The market interest rate for similar bonds is 8%. Which of the following statements is true regarding the issuance of these bonds?
- AThe bonds will be issued at a discount.
- BThe bonds will be issued at a premium.
- CThe carrying value of the bonds will increase over time if issued at a discount.
- DThe bonds will be issued at face value.
Show answer & explanationAnswer & explanation
Correct answer: A. The bonds will be issued at a discount.
When the stated (coupon) interest rate of a bond is lower than the market (effective) interest rate, the bond will be issued at a discount. Investors demand a higher return (market rate) than what the bond is offering, so they will only purchase the bond for less than its face value.
Why the other options are wrong
- B. A premium occurs when the stated rate is higher than the market rate.
- C. This statement is true, but it's a consequence of issuing at a discount, not the primary statement about the issuance price itself.
- D. Face value issuance occurs when the stated rate equals the market rate.
Bond Issuance Price
The price at which a bond is issued is determined by comparing its stated interest rate to the prevailing market interest rate for similar bonds.
- Stated Rate > Market Rate = Premium
- Stated Rate < Market Rate = Discount
- Stated Rate = Market Rate = Face Value
Memory trick: Market rate's pull decides the bond's value, above or below par will ensue.