Interest payments cut down the wait time and the risk, so they also reduce expected returns. If you don't intend to hold your bond to maturity, you have to stay aware of market fluctuations, and extreme volatility for zero coupon bonds can work against you if rates don't move the way you want. As shown in the above journal entry, the bond is initially recorded at this principal amount. Question: This $20,000 zero-coupon bond is issued for $17,800 so that a 6 percent annual interest rate will be earned. sure to consider whether management may choose to repurchase when interest rate is. Figure 14.9 December 31, Year One—Interest on Zero-Coupon Bond at 6 Percent Rate3. At the end of this section, students should be able to meet the following objectives: Question: A wide array of bonds and other types of financial instruments can be purchased from parties seeking money. Chapter 6: Why Should Decision Makers Trust Financial Statements? The zero-coupon bond has no such cushion, faces higher risk, and makes more money if the issuer survives. They have the same basic feature of being sold at a deep discount and redeemed in the future at full face value. Consolidation in the Brokerage Industry: Is Robinhood Next to be Acquired? That creates a phantom income problem for the bondholders. A regular bond pays interest to bondholders, while a zero-coupon bond does not issue such interest payments. Because no cash interest is paid, the entire amount recognized as interest must be compounded (added) to the principal. the pattern of cash flows (a single payment in the future). With most bonds, the issuer accepts an up-front payment from investors in exchange for promising to pay interest payments at regular intervals and then repay the principal at maturity. A zero-coupon bond will usually have higher returns than a regular bond … Payment will be made in two years. All other things being equal, the price of a zero-coupon bond will increase more than the price of a regular coupon bond when interest rates fall. However, it can still be applied according to U.S. GAAP but only if the reported results are not materially different from those derived using the effective rate method. Yet some bonds are structured specifically not to pay income currently. This discount frequently leads to higher returns in the long-run. Interest for Year One should be the $17,800 principal balance multiplied by the effective interest rate of 6 percent to arrive at interest expense for the period of $1,068. Returns as of 10/29/2020. Chapter 13: In a Set of Financial Statements, What Information Is Conveyed about Current and Contingent Liabilities? Dan Caplinger has been a contract writer for the Motley Fool since 2006. Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Why This Restaurant REIT's 4% Dividend Is Safe, Copyright, Trademark and Patent Information. First, the company will actually have to pay $20,000. That was exactly 6 percent of the principal in each of the two years. A zero-coupon bond is a debt security instrument that does not pay interest. However, no payment is made. The debt balance is raised gradually to the face value and interest of 6 percent is reported each year over the entire period. Primary issuances of zero-coupon bonds have increased since the beginning of this year, as issuers target foreign investors who would want to save withholding tax and exhaust … Identify the characteristics of a zero-coupon bond. It is a way to raise capital without a) diluting the equity ownership of the company and b) not imposing an ongoing drain on cash flow in the form of ongoing interest payments. That makes no economic sense. If interest is then recognized each period based on this same set of variables, the resulting numbers will reconcile. Although the bond was sold to earn 6 percent annual interest, this rate is not reported for either period. It can be challenging to come up with the money to pay taxes on income that was not received. 10.1 The Reporting of Property and Equipment, 10.2 Determining Historical Cost and Depreciation Expense, 10.3 Recording Depreciation Expense for a Partial Year, 10.4 Alternative Depreciation Patterns and the Recording of a Wasting Asset, 10.5 Recording Asset Exchanges and Expenditures That Affect Older Assets, 10.6 Reporting Land Improvements and Impairments in the Value of Property and Equipment.