Problem - Historical cost accounting vs. fair value accounting for held-to-maturity securities
Consider a bank who writes long-term loans to commercial clients with an intention to hold all purchased bonds to maturity. That is, the bank's business model is not to repackage its loan assets and sell them before they mature.
Consider a 3-year loan asset of the bank. The loan is issued with principal amount $1,000 and coupon interest rate 10%.
Required
(1) Assume the market interest rate for a similar risk-profile debt security is 8% throughout all the years from the initiation to the maturity of the loan. Prepare all journal entries related to the loan asset for the bank using the amortized cost method
(2) Assume the market interest rate is 8% for the first year of the loan period, 12% for the second year, and 6% for the third. Prepare all journal entries related to the loan asset for the bank using the amortized cost method.
(3) Based on your attempt of the two questions above, discuss how interest rate fluctuations affect the earnings recognized in relation to the loan asset under the amortized cost method.