Liberty Company Bond Teaching Resource: Using A Zero-Coupon Bond To Clarify Bond Liability Accounting

Abstract

Accounting for discounted and premium bond liabilities presents challenges for most students. Fortunately, committed educators can do something about the issue. In this teaching resource, the author presents an approach to simplify bond accounting concepts. Reversing the sequence that bond interest rates are introduced and explained can have a favorable effect on student comprehension.

There are two interest rates associated with a bond: 1) a market rate and 2) a contract rate. When explaining bond fundamentals, it is natural to explain the features of a bond, including its contract interest rate, early in the discussion. This approach makes it difficult to explain later that the only effective interest rate on a bond is the market interest rate. Students must realize that the contract rate is not an effective interest rate. It is a percentage that is used to determine periodic cash payments - not interest expense.

The Liberty Company Bond is a zero-coupon bond, similar to a U.S. Savings Bond that some students received as a graduation gift. Because the bond has only one non-zero interest rate, students are able to comprehend the nature and effect of both market and contract interest rates.