Cash Flows

Question: This bond was sold at the present value of its future cash flows based on a rate of interest negotiated

by the parties involved. Interest was then recognized periodically by applying the effective rate method. Is the

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effective rate method the only acceptable technique that can be used to compute and report interest when the face

value of a debt differs from its issue price?

Answer: Interest can also be calculated for reporting purposes by a simpler approach known as the straight-line

method. Using this technique, an equal amount of the discount is assigned to interest each period over the life of

the bond. This zero-coupon bond was sold for $2,200 below face value to provide interest to the buyer. Payment

will be made in two years. The straight-line method simply recognizes interest of $1,100 per year ($2,200/2 years).