Treadway Company issued bonds with a face value of $20,000 on January 1, 2011. The bonds were due to mature in five years and had a stated annual interest rate of 8 percent. The bonds were issued at face value. Interest is paid semiannually.
a. As of December 31, 2011, market interest rates had decreased by 2 percent, and the market price of Treadway bonds reflected the entire change. Compute the present value of Treadway's bond liability as of that date, using the new effective interest rate (6 percent), and determine the economic gain or loss experienced by the company.
b. Assume instead that as of December 31, 2011, market interest rates had increased by 2 percent, and the market price of Treadway's bonds reflected the entire change. Compute the present value of Treadway's bond liability as of that date, using the new effective interest rate (10 percent), and determine the economic gain or loss experienced by the company.
c. What is the intuition underlying such gains and losses, and why are they not reflected on the financial statements? If you were analyzing the financial statements of Treadway, what could you do to improve the reported numbers?