Zero Coupon Bonds - Video Tutorials & Practice Problems
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Issuing Zero Coupon Bonds
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Alright now let's discuss zero coupon bonds. A special type of bond. So zero coupon bond has no interest payments. Okay so you might be thinking why would anyone buy a zero coupon bond if it's paying no interest? The stated rate on these bonds are 0%. Why why would anyone want to buy that? Well let's think about it as a discounted bond. Right let's think about this as a discounted bond. So stated rate and market rate. Let's do our comparison real quick. Remember the stated rate of 10% and the market rate of 10%. Well those were bonds that will be sold at face value so they would be equal to face value. But what about a situation where the stated rate is less than the market rate? You can imagine that the market rate is going to be something above zero, right? It's not gonna be the market rate of 0%. We can imagine let's say the market rate is 10% and our bond is selling with 0% interest. Well our bond is going to be sold at a discount right? We will be sell the price of the bond will be less than the face value. Okay so this is gonna be a situation where it's a discounted bond up here was a face value bond sometimes called a par value bond. Same thing. Um And then the last case is a premium situation right? And that's where we sell where our interest rate is greater than the market interest rate and the price of the bond will be greater Than the face value. Okay. And those were premium bonds. So what we're dealing with here is a special kind of discounted bond. Okay this is like the most discounted bonds were paying 0% interest when the market is paying 10% interest. Okay. So what we're going to see is that the bonds are gonna be heavily discounted, there's gonna be a much lower price because the only payment that people are gonna get in the future that the investors get in the future is going to be that principal payment upon maturity. So they're gonna pay a much lower amount now and then maybe in five years, 10 years. Well that's when they're gonna receive their money back and they will receive the full principle amount. But we'll have received less money now. Okay so let's go ahead and see how these bonds are initially issued. And remember they're basically a discounted bond. Just that they pay no interest. So there's gonna be heavier discount. So on january 1st 2018 abc company issues 50,000 of zero coupon bonds maturing in five years. So 50,000. That is our principal amount Right? In five years we're gonna have to pay back 50,000. That's the face value Oops face value of the bonds. And what's this? 00 is the stated interest rate. Okay so they're maturing in five years. So the maturity date, five years from now, the market interest rate was equal to 8%. Okay so notice 8% is the market rate while we're paying 0%. So who do you think people would rather buy the market rate bonds at 8%? Or our bonds at 0%. 8%. Sounds more enticing than 0% to an investor. Right? So what are we gonna have to do? We're gonna have to issue at a discount and that's what exactly happens here. They're gonna be issued at 85. Okay. So what does that mean? That means they're issued at 85% of their face value. So if we go ahead and Uh we can figure out the amount of cash received based on this 85 selling price. So it's gonna be 50,000 of principle uh sold for 85% of that. So it comes out to 50,000 times .85. So times .85 is Gonna Equal 42,500. Okay. So that's the amount of cash we're gonna receive notice their $50,000 worth of bonds, but we only received 42,500. So the cash in this case is 42,500. But the bonds payable. Remember the bonds payable account? That's going to be a credit balance? How much is going to go into the bonds payable? Is it gonna be 42,500? No, it's the full 50,000 in principle, right? 50,000 of principle goes into the bonds payable account, always the face value goes into the bonds payable account. Okay? Regardless of what type of bond we're dealing with, we always put the principal amount into the bonds payable account. And then how do we balance this journal entry with the discount? Right. We sold them at a discount. So we're gonna have discount On bonds payable right here as a debit for the 7500. Okay, so our discount in this case was 7500. So what did we do? We received cash of 42,500. And how did we receive it? What we took out a liability of bonds payable And that was 50,000 increase in our liabilities less the discount Of 7500. Right, that was a decrease. So we saw a net increase of 42,500 in our liabilities. Let me draw that under. So Right here, 42,500 was an increase to our liabilities. Right? So notice this is very similar to what we dealt with with a discount except now it's just a deeper discount. Cool. Let's go ahead and see how this affects our interest expense. Journal entries.
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Zero Coupon Bonds:Repaying Principal at Maturity
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So every period we're going to keep making that journal entry for interest expense and discount amortization. So you can imagine if we looked at our discount t account, whoops if we look at our discount t account Over the five years. Well it started with a balance of 7500 as a debit balance. And then each period we credited 1500 like we did in the in the previous journal entry. So every year for five years we're crediting it 1500 every year that's each year's journal entry and we're left with nothing in the discount on bonds payable. Right so all that's left in the carrying value of the bond where we would have our liability section of our balance sheet showing bonds payable for um 50,000 right? The principal amount less the discount which at this point we've gotten rid of the whole discount. So this wouldn't even technically be there of zero. So the carrying value would be 50,000 as of this maturity date. Right? So now we've done all five years have passed and it's finally time to pay back the 50,000. Even though we only got 42,500 to start, we got to pay back the full 50,000. So let's go ahead and make that journal entry. We're going to debit bonds payable because we no longer owe these bonds were paying them back right now for 50,000. And we're going to credit cash for 50,000 because we're paying them in cash. Simple as that. Over the five years we get rid of the discount, we advertise it into interest expense, and then on the, on the maturity date, we pay off the principal balance. So we saw a cash decreased by 50,000, And our liabilities decreased by 50,000. Right? So there we go, we stay dollars. And that's about it for this journal entry. Let's go ahead and do a practice problem.
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Problem
Problem
On January 1, ABC Company issues $1,000,000 of zero coupon bonds at 75. The bonds mature in five years. Assuming that ABC uses the straight-line method for amortization of bond premiums and discounts, the journal entry at the end of the first year would include:
