Question

Watch the following NBC video about interest rates and then answer the following question.

How does a decrease in market interest rates affect the selling price of bonds and the initial accounting of bonds on issuance?

Grading rubric:

General discussion of how a decrease in market interest rates affects the selling price of bonds.	2 points
Reference to the related section / page of the textbook.	0.5 point
Explanation of the initial accounting entry for the issuance of bonds.	2 points
Constructive response to a peer's post	0.5 point

Your post should not exceed 15 lines (about 250 words) and should focus only on the accounting principles relevant to the scenario. Include the following titles in your post:

• Effect of interest rates on the selling price of bonds
• Reference
• Initial accounting entry

VIDEO TRANSCRIPT

Fed Cuts Key Interest Rate to Record Lows

BRIAN WILLIAMS, anchor:

One analyst called what happened today shock and awe. He said the Federal Reserve today threw everything it had at the US economy. While most Americans went about their day and didn't really feel anything special happen at 2:20 PM Eastern time this afternoon, it will be felt far and wide over time. Most regular folks will notice two things, good news and bad. Some interest rates and mortgage rates will come down. And at the same time, the money you put in the bank will earn next to nothing. But today was a big attempt to use the big stick of government to hit back at a big and dangerous and worsening downturn in our economy. We begin our coverage here tonight with CNBC's Trish Regan.

This really was a big day, Trish.

TRISH REGAN reporting:

Definitely a big one, Brian. You know, this recession is not a typical recession and so the Fed's traditional response, cutting rates, is actually having very little affect on the credit markets and this economy. In a last-ditch effort to revive the economy through traditional means, today the Federal Reserve slashed its main interest rate by three quarters of a percent, to its lowest level in the Fed's nearly 100 year history.

TEXT: Interest Rate

(down arrow) .75%

0-.25% Target Range

Mr. MARK ZANDI (Moody's Economy.Com Economist): The Fed made an unprecedented move. It lowered rates effectively to zero in an effort to get banks to lend to each other, and then ultimately to you and I as consumers and business people.

REGAN: But so far, lower rates have not resulted in more lending, nor have banks transferred lower borrowing costs to consumers. Consider this, since September of 2007, though the Fed Funds Rate has moved lower, mortgage rates have remained high. Banks are hoarding their money, unwilling to lend in part because they're no longer able to sell those mortgages off to investors.

Mr. GREG McBRIDE (Bankrate.Com Analyst): They want that higher return as insulation against loans that may potentially go bad. They're lending but they're being dragged kicking and screaming to the closing table to do it.

REGAN: So now the Fed is going on a buying spree. It has already pledged more than $2 trillion to buy up mortgages, credit cards and auto loans in an effort to improve the credit markets.

Mr. ZANDI: The Federal Reserve is now effectively printing money. The Fed would buy a Picasso painting if they thought it would make a difference.

REGAN: It's a race to correct an economy that's deteriorating daily.
Today, fresh evidence of problems. The number of new homes being built in November plunged nearly 19 percent to the lowest level on record.

TEXT: Housing Starts

(down arrow) 18.9% Lowest on record

REGAN: While deflation continues to remain a threat, consumer prices fell 1.7 percent last month. The fastest rate of decline since 1932. Still most of that deflation came from lower energy prices. A 17 percent drop last month. The hope is that a little bit of extra money in everyone's pockets could translate into real spending power. But so far, Brian, all the evidence suggests that people are just hanging on to every dime.
They're not spending that money.

WILLIAMS: And trying to hang on to every shred of good news. Trish Regan, as always, thanks for starting us off.

BRIAN WILLIAMS, anchor:

On Wall Street, the reaction to this historic move today was positive. It went up quickly. The Dow finished the day up nearly 363 points. And with us again tonight to, as he always does, explain what's going on here, senior economics correspondent Steve Liesman.

(Stock figures follow)

WILLIAMS: Steve, I need you to use terms so basic that I will understand this. What happened today? Was it good news and how are most people going to feel this?

STEVE LIESMAN reporting:

Well, people will feel it , as you said, Brian, in lower rates that are tied to things like the Fed Funds, to things like that London Interbank Offered Rate. If you don't know, just look at your documents, things that are tied to the prime rate. They'll see it that way. What happened today is the Fed effectively shot the last bullet in one gun and then picked up effectively the elephant gun today and said it will shoot anything that moves. Effectively go out and buy Treasuries, buy mortgage securities, buy anything it feels it needs to buy to try to get this economy and the credit markets right. Basically, it decided to put down the pea shooter, pick up the elephant gun.

WILLIAMS: All right. Excellent imagery. Steve Liesman with the explanation tonight from CNBC global headquarters. Steve, thanks, as always.

REQUIREMENT

Your post should not exceed 15 lines (about 250 words) and should focus only on the accounting principles relevant to the scenario. Include the following titles in your post:

• Effect of interest rates on the selling price of bonds
• Reference
• Initial accounting entry

Answer 1

Well decreasing the interest rate may help the sinking economy and correcting the deflation prevailing in the market but on the other hand, it also increases the selling price of the bonds in the market.

The selling price of bonds and change in its interest rate are inversely related to each other, like, if a person has a bond of $100 @5% and after a year he wants to sell the bond but the interest rate prevailing in the market is now 4%, its selling price will be increased accordingly as the investor will give an extra sum to get the existing bond, with a greater rate of interest, from the market.

Reference

In the situation given above, Federal Bank has reduced the interest rate. Accordingly, that will shoot up the selling price of the bonds in the market subject to the condition that banks would all pass on the reduced interest rate.

Explanation of the initial accounting entry

if the bond is issued at its value, accounting entry for the same in the books of the issuer will be-

Cash (Dr) xxx

Bonds Payable xxx