A zero-coupon bond will usually have higher returns than a regular bond with the same maturity because of the shape of the yield curve. Fixed Income Trading Strategy & Education. Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services. Chapter 10: In a Set of Financial Statements, What Information Is Conveyed about Property and Equipment? Meanwhile, if you have specific cash needs at a given time that you don't want to leave to the whims of market fluctuations, then locking in a fixed return by buying a zero coupon bond can be the simplest way to meet your financial goals. However, some of these issues may have call features allowing the issuer to redeem them before maturity. The compounding of this interest raises the principal by $1,068 from $17,800 to $18,868. Read more about Companies issue more zero-coupon bonds to lure FIIs on Business Standard. This is a long-term type of investment that can provide nice yields. The bond is recorded at this principal. 12.1 Accounting for Investments in Trading Securities, 12.2 Accounting for Investments in Securities That Are Available for Sale, 12.3 Accounting for Investments by Means of the Equity Method, 12.4 The Reporting of Consolidated Financial Statements. The interest payments made by regular coupon bonds are due before the date of maturity, so those payments are like small zero-coupon bonds that mature earlier. 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. Pros. If a bond is issued for $37,000 and the company eventually repays the face value of $40,000, the additional $3,000 is interest on the debt. Despite the fact that you don't actually receive an interest payment in cash, the IRS requires you to impute the amount of interest you should have gotten, based on the initial yield. This can be found by table, by formula, or by use of an Excel spreadsheet1. 16.1 Selecting a Legal Form for a Business, 16.3 Issuing and Accounting for Preferred Stock and Treasury Stock, 16.4 The Issuance of Cash and Stock Dividends, 16.5 The Computation of Earnings per Share. Chapter 14: In a Set of Financial Statements, What Information Is Conveyed about Noncurrent Liabilities Such as Bonds? Link to multiple-choice question for practice purposes: http://www.quia.com/quiz/2093003.html, Link to multiple-choice question for practice purposes: http://www.quia.com/quiz/2092980.html. July 5, 2007. Both of the accounting problems have been resolved through use of the effective rate method. Zero coupon bonds are bonds that do not pay interest during the life of the bonds. The price reduction below face value can be so significant that zero-coupon bonds are sometimes referred to as deep discount bonds. Why does any investor choose to purchase a zero-coupon bond if no interest is paid? Why might company managers choose to issue zero-coupon bonds instead of interest-bearing. Subsequently, two problems must be addressed by the accountant. Interest was then recognized periodically by applying the effective rate method. To illustrate, assume that on January 1, Year One, a company offers a $20,000 two-year zero-coupon bond to the public. Please share your supplementary material! The discount serves as a contra account to reduce the net liability balance to its principal amount. Stock Advisor launched in February of 2002. The debt balance is raised gradually to the face value and interest of 6 percent is reported each year over the entire period. The principal is higher in this second year because of the compounding (addition) of the first year interest. Answer: Interest can also be calculated for reporting purposes by a simpler approach known as the straight-line method. Be. sure to consider whether management may choose to repurchase when interest rate is. However, the recipient ultimately receives substantially more than $2,000 after the bond reaches maturity. The straight-line method does not reflect the reality of the transaction. Here are some of the pros and cons of investing in zero-coupon bonds. The straight-line method can also be used to record interest if the resulting numbers are not materially different from the effective rate method. An original issue discount (OID) is the amount of discount or the difference between the original face value and the price paid for the bond. Zero coupon bonds are bonds that do not pay interest during the life of the bonds. And, mathematically, that extra $2,200 is exactly equal to interest at 6 percent per year. A single payment of $20,000 will be made to the bondholder on December 31, Year Two. Municipalities and corporations also issue zero coupon bonds. Is the effective rate method the only acceptable technique that can be used to compute and report interest when the face value of a debt differs from its issue price? The present value of $1 in two years at an annual rate of interest of 6 percent is $0.8900. Most people think of bonds as being appropriate for those who need regular current income without a huge amount of risk. Cumulative Growth of a $10,000 Investment in Stock Advisor, Should I Invest in Zero Coupon Bonds? In the bond market, interest rates are the subject of intense negotiations. Chapter 9: Why Does a Company Need a Cost Flow Assumption in Reporting Inventory? Zero coupon bonds work a bit differently. Chapter 13: In a Set of Financial Statements, What Information Is Conveyed about Current and Contingent Liabilities? Furthermore, the reported interest rate appears to float (6.2 percent to 5.8 percent) as if a different rate was negotiated for each year. They have the same basic feature of being sold at a deep discount and redeemed in the future at full face value. I am 42 years old and interested in zero-coupon bonds … Zero-coupon bonds are also appealing for investors who wish to pass wealth on to their heirs but are concerned about income taxes or gift taxes. The liability should be reported as $20,000 at the end of Year Two. Answer: Determination of the price of a bond is a present value computation in the same manner as that demonstrated previously in the coverage of intangible assets. So for instance, a 10-year zero coupon bond priced when prevailing yields were 3% would typically get auctioned for roughly $750 per $1,000 in face value. The market price of both bonds would have plummeted, with the result that the coupon bonds now pay very high interest relative to their purchase price. present value = $20,000 × $0.8900 Chapter 1: Why Is Financial Accounting Important? Thus, overall reporting of the interest and the liability is not impacted by the method used in recording the issuance of the bond. 13.2 Reporting Current Liabilities Such as Gift Cards. Chapter 17: In a Set of Financial Statements, What Information Is Conveyed by the Statement of Cash Flows? Because all of the return of a zero coupon bond gets incorporated into its price, changes in rates have a more dramatic impact on zero coupon bond prices than with their interest-paying counterparts. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount the investor will receive when the bond "matures" or comes due. Figure 14.8 January 1, Year One—Zero-Coupon Bond Issued at Effective Annual Rate of 6 Percent, Link to multiple-choice question for practice purposes: http://www.quia.com/quiz/2093023.html. That did not happen; there was a single 6 percent interest rate agreed-upon by the debtor and the creditor. The longer the maturity, the greater the price sensitivity. Zero-coupon bonds pay no cash interest. Prepare journal entries for a zero-coupon bond using the effective rate method. Chapter 16: In a Set of Financial Statements, What Information Is Conveyed about Shareholders’ Equity? A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. The Ascent is The Motley Fool's new personal finance brand devoted to helping you live a richer life. Be sure a check what if any those provisions are before you invest. A zero-coupon bond is one that is popular because of its ease. The maturity dates on zero coupon bonds are usually long-term—many don’t mature for ten, fifteen, or more years. Fortunately, you might be able to avoid this issue by holding zero coupon bonds in a tax-favored account like an IRA. Let's conquer your financial goals together...faster. As an alternative, the liability is recorded at its face value of $20,000 with a separate discount of $2,200 also included. For one group, the absolute certainty of receiving a fixed amount on a fixed date in the future is extremely valuable. Unfortunately for zero-coupon bondholders, some taxes can reduce the effectiveness of this strategy. Chapter 8: How Does a Company Gather Information about Its Inventory?
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