Zero Coupon Bonds - Online Tutor, Practice Problems & Exam Prep

Zero coupon bonds are unique as they do not pay periodic interest. Instead, they are sold at a discount, meaning their selling price is less than their face value. For example, if a company issues $50,000 in zero coupon bonds at a market rate of 8% but offers 0% interest, they might sell for $42,500. Over time, the discount is amortized, and upon maturity, the full principal is repaid. This process affects the accounting entries, where the bonds payable reflects the full face value, while the cash received is lower due to the discount.

Issuing Zero Coupon Bonds

Alright, now let's discuss zero-coupon bonds, a special type of bond. So, a 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? Exactly! Let's think about this as a discounted bond. Right? Let's think about this as a discounted bond. When comparing the stated rate and market rate, remember, a stated rate of 10% and a market rate of 10% mean those bonds 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 0, right? It's not going to 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? The price of the bond will be less than the face value. Okay? So, this is going to be a situation where it's a discounted bond. Up here was a face value bond, sometimes called a par value bond. Same thing. And then the last case is a premium situation, right? And that's 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 bond. We're paying 0% interest when the market is paying 10% interest. Okay? So, what we're going to see is that the bonds are going to be heavily discounted. There's going to be a much lower price because the only payment that people are going to get in the future, that the investors get in the future, is going to be that principal payment upon maturity. So, they're going to pay a much lower amount now and then maybe in 5 years, 10 years, well, that's when they're going to receive their money back. And they'll receive the full principal amount but will 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 going to be a heavier discount. On January 1, 2018, ABC company issues $50,000 of zero-coupon bonds maturing in 5 years. So, $50,000 that is our principal amount, right? In 5 years, we're going to have to pay back $50,000. That's the face value. Oops. Face value of the bonds. And what's this 0? The 0 is the stated interest rate. Okay? So, they're maturing in 5 years. So, the maturity date 5 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 going to have to do? We're going to have to issue at a discount, and that's exactly what happens here. They're going to 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, we can figure out the amount of cash received based on this 85 selling price. So, it's going to be $50,000 of principal, sold for 85% of that. So, it comes out to $50,000 times 0.85 equals $42,500. Okay. So, that's the amount of cash we're going to receive. Notice there are $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 going to 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 going to have a discount on bonds payable right here as a debit for the $7,500. Okay. So, our discount in this case was $7,500. So, what did we do? We received cash of $42,500. And how did we receive it? Well, we took out a liability of bonds payable and that was a $50,000 increase in our liabilities minus the discount of $7,500, 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.

Zero Coupon Bonds:Repaying Principal at Maturity

So every period, we're going to keep making that journal entry for interest expense and discount amortization. You can imagine if we looked at our discount T account, whoops, if we look at our discount T account over the 5 years, well, it started with a balance of 7,500 as a debit balance and then each period, we credit it 1,500 like we did in the previous journal entry. So every year for 5 years, we're crediting it 1,500 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, well, we would have our liability section of our balance sheet showing bonds payable for 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 0. So the carrying value would be 50,000 as of this maturity date, right? So now we've done all 5 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. Let's go ahead and make that journal entry. We're going to debit bonds payable because we no longer owe these bonds. We're 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 5 years, we get rid of the discount, we amortize it into interest expense, and then on the maturity date, we pay off the principal balance. So we saw our decreased by 50,000, right? So there we go. We stay balanced. And that's about it for this journal entry. Let's go ahead and do a practice 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:

• A. A credit to Cash of $50,000
• B. A credit to Interest Payable of $50,000
• C. A credit to Discounts on Bonds Payable of $50,000
• D. A credit to Bonds Payable of $50,000
• E. None of the above

Here’s what students ask on this topic:

What is a zero coupon bond and how does it work?

A zero coupon bond is a type of bond that does not pay periodic interest. Instead, it is sold at a discount to its face value. The investor buys the bond at a lower price and receives the full face value at maturity. For example, if a company issues a $50,000 zero coupon bond at a market rate of 8% but offers 0% interest, it might sell for $42,500. Over time, the discount is amortized, and upon maturity, the full principal is repaid. This means the investor's return comes from the difference between the purchase price and the face value at maturity.

Why would an investor buy a zero coupon bond if it pays no interest?

Investors buy zero coupon bonds because they are sold at a significant discount to their face value, offering a guaranteed return at maturity. The difference between the purchase price and the face value represents the investor's profit. Additionally, zero coupon bonds can be attractive for long-term financial planning, such as saving for a future expense, because they provide a lump sum payment at a specific future date. The lack of periodic interest payments also means there is no reinvestment risk, making them a stable investment option.

How is the initial journal entry for issuing a zero coupon bond recorded?

When a zero coupon bond is issued, the initial journal entry records the cash received and the bonds payable. For example, if a company issues $50,000 in zero coupon bonds at 85% of their face value, it receives $42,500 in cash. The journal entry would be a debit to Cash for $42,500, a credit to Bonds Payable for $50,000, and a debit to Discount on Bonds Payable for $7,500. This reflects the discount at which the bonds were sold.

How is the discount on a zero coupon bond amortized over time?

The discount on a zero coupon bond is amortized over the life of the bond, typically using the straight-line method. For example, if the discount is $7,500 and the bond matures in 5 years, the annual amortization would be $1,500. Each year, the journal entry would include a debit to Interest Expense for $1,500 and a credit to Discount on Bonds Payable for $1,500. This process continues until the discount is fully amortized by the maturity date.

What happens at the maturity date of a zero coupon bond?

At the maturity date of a zero coupon bond, the issuer repays the full face value of the bond to the bondholder. For example, if the face value is $50,000, the journal entry would include a debit to Bonds Payable for $50,000 and a credit to Cash for $50,000. This final payment settles the bond obligation, and the bondholder receives the full principal amount, completing the investment cycle.