Zero Interest Bonds
Zero-interest Bonds/Debenture is bonds that issued without interest payment, they are sold at discount, so investors can get some profit on the maturity date. The issuer will not require to pay the annual interest expense to the bondholders.
It should be good for the issuer because they can borrow money with zero interest. However, the word zero interest refers to annual interest payment. They are not required to pay annual interest to bondholders. But they still need to provide discounts to them, and it is the expense that they need to pay.
They are usually trading at a huge discount on the issued date while offering a full par value on the maturity date. The difference between the par value and the selling price is the investors’ profit.
Bond is the financial instrument which the issuer sells in the capital market and promise to pay annual interest and face value on the maturity date. For the zero-interest bonds, the investors will not receive annual interest income. They purchase bonds at discount and receive the full amount on the maturity date.
This kind of bond will help the issuers to save some cash flow as they do not worry about annual interest payment. However, they need to provide a huge discount to compensate for this. It is the concept of the time value of money where $1 today is more valuable than $ 1 in one year’s time.
Zero Interest Bonds Price
Price = Face Value / (1+r)n
- Face Value: is the future value that will receive on the maturity date.
- r: is the required rate of return
- n: is the number of the year till the maturity date
The difference between price and face value is the discount that issuers give to investors. It means that the company sells bonds at a lower and promises to pay back the full price.
For the issuers, the discount is the interest expense that needs to be spread and recorded over the bond life. Even they do not require to pay the interest to bonds holders, but they must record interest expense in the income statement. The interest paid will be made at the end of bonds term.
For the investors, the discount is the interest income. They will receive the income at the end of the term of the bonds. Even they do not receive annual interest, but their interests are accrued and paid at the maturity date. They must record
Thus, a zero-interest bond means that the issuers do not pay interest annually. In accounting, this type of bond still has an interest which the issuer needs to pay to investors on the maturity date. The word zeroes interest is just the name but does not mean that it has no interest.
Zero Interest Bonds Example
For example, Mr. A purchased zero-interest bonds that have a face value of 10,000 and will be matured in 6 years. The market interest rate is 8% per year.
Price = 10,000 / (1+8%)6 = $ 6,301
It means that Mr. A needs to pay $ 6,301 to purchase the bond which will expect to receive $ 10,000 on the maturity date in the next 6 years. He will not receive any interest payments during the time of holding bonds.
the time of holding bonds.
Example 2
Company ABC issue 1000 bonds of zero interest rate with 5-year term. The par value of bonds is $ 100 each. In order to reduce the annual cash flow, company decides to issue zero-interest bonds rather than the normal bonds. The market interest rate is 6%. Please prepare the journal entry during issuing and the annual interest expense.
As the company issue bonds at zero interest rate, we need to calculate the selling price first.
Selling price = $ 100/(1+6%)^5 = $ 74.72
Company needs to sell bonds at $ 74.72 per bond. So the company will receive the cash of $ 74,270 for selling 1,000 bonds.
The journal entry is debiting cash $ 74,720 and credit bonds payable with the same amount.
| Account | Debit | Credit |
|---|---|---|
| Cash | 74,720 | |
| Bonds Payable | 74,720 |
The transaction will increase cash and credit bonds payable on balance sheet. Bonds payable will be recorded as long-term liability for the company.
At the end of 1st year, the company needs to record the interest expense into income statement. However, they do not pay interest to the holder, so the interest expense will increase the bonds payable.
We need to calculate the interest expense as follows:
Interest expense = 74,720 * 6% = $ 4,483.2
The journal entry should be debiting interest expense and credit bonds payable
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | 4,483.2 | |
| Bonds Payable | 4,483.2 |
The interest expense will appear in the income statement and Bonds payable also increase.
Every year, the company need to record interest expense and increase the bonds payable. At the end of bonds term, the balance will increase to the par value which will be settled.
We can calculate the whole amount as following:
| Year | Beginning Balance | Interest Expense | Ending Balance |
| 1 | 74,720 | 4,483 | 79,203 |
| 2 | 79,203 | 4,752 | 83,955 |
| 3 | 83,955 | 5,037 | 88,993 |
| 4 | 88,993 | 5,340 | 94,332 |
| 5 | 94,332 | 5,660 | 99,992 |
Note: Error rounding $8, the balance should be $ 100,000.
On the maturity date, bonds payable is equal to par value which is the amount that company needs to pay back to bondholders.
When company makes the payment, the journal entry is debiting bonds payable and credit cash.
| Account | Debit | Credit |
|---|---|---|
| Bonds Payable | 100,000 | |
| Cash | 100,000 |
Bonds payable will be removed from balance sheet and cash also decrease.