The Sammy Stone Trilogy: Three Cases that Simplify Bond Liability Accounting and Bond Pricing

• In Event: Teaching, Learning, and Curriculum 1

Abstract

In the author’s experience, the greatest challenge for most students in introductory financial accounting course is accounting for bond liabilities. While most students have difficulty with bond liability accounting, almost all understand how a bank account works regarding cash flows, interest, and account balances. Three cases comprise the Sammy Stone Trilogy (SST):
• SAMMY STONE TRILOGY (A): THE PLATINUM BANK ACCOUNT presents a simple bank account as a foundation and reference point for understanding bonds. Students make straightforward expense and liability calculations and prepare five journal entries.
• SAMMY STONE TRILOGY(B): THE FIDELITY BANK BOND presents a bond that is the equivalent of the bank deposit in the SST(A) case regarding the timing and amount of cash flows, expenses, and net liabilities.
• SAMMY STONE TRILOGY (C): PRICING THE BOND presents calculations for determining the price of the SST(B) bond using discounted cash flow methods.

The Sammy Stone Trilogy represents an innovative approach to understanding bonds and bond liability accounting. In the conventional approach to teaching bond liability accounting, the contract (coupon) rate of interest is introduced early as one of the basic features of a bond, and market interest rates are covered at a later time. This sequence makes it difficult for many students to comprehend exactly what a bond’s effective interest rate represents.

The approach that is proposed in this paper reverses the sequence that the two rates of interest are covered. The SST(A) case explains the market rate of interest – and students understand that it is the only effective interest rate. In the SST(B) case, the bank issues a discounted bond that is the equivalent of the bank account regarding the timing and amount of cash flows, expenses, and net liabilities. This sequence enables students to realize that the contract "rate" is not an effective interest rate at all. Case tables and journal entries demonstrate the equivalence of the two liabilities:
• The Net Liability Calculations Table in the SST(A) case is the equivalent of the Effective Interest Amortization Table that they prepare in the SST(B) case, and
• SST(B) journal entries correspond directly to the five journal entries in the SST(A) case.

Author

• Daniel J Jones, Assumption College