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 - Video Tutorials & Practice Problems
Issuing Zero Coupon Bonds
Video transcript
Zero Coupon Bonds:Repaying Principal at Maturity
Video transcript
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: