One of the biggest risks of zero coupon bonds is their sensitivity to swings in interest rates. In a rising interest rate environment, their value is likely to fall more than other bonds. For individuals, zero coupon bonds may serve several investment purposes. By placing funds in a U. Treasury zero, a parent can be assured that the funds will be fully intact to meet this liability.
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International funds invest in non-U. How Does It Work? The parties have negotiated an annual interest rate to be earned of 6 percent. How is the price to be paid for a bond determined after an effective rate of interest has been established?
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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. The parties have negotiated an annual 6 percent effective interest rate. In a present value computation, total interest at the designated rate is calculated and subtracted to leave the present value amount. That is the price of the bond, often referred to as the principal.
Interest is computed at 6 percent for two years and removed.
The remainder is the amount paid for the bond. This can be found by table, by formula, or by use of an Excel spreadsheet. Here, i is 0.
Present value can also be determined using an Excel spreadsheet. Bond prices are often stated as a percentage of face value. The price is the future cash payments with the negotiated rate of interest removed. The issuance is recorded through the following entry. The entry shown here can also be recorded in a slightly different manner. The discount serves as a contra account to reduce the net liability balance to its principal amount.
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Figure As shown in the above journal entry, the bond is initially recorded at this principal amount. Subsequently, two problems must be addressed by the accountant. The additional payment is the cost of the debt, the interest. To arrive at fairly presented figures, these two problems must be resolved.
How is a zero-coupon bond reported in the period after its issuance? It solves both of the accounting problems mentioned here. The debt balance is raised gradually to the face value and interest of 6 percent is reported each year over the entire period. However, no payment is made. Thus, this interest is compounded—added to the principal. Interest that is recognized but not paid at that time must be compounded.
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The contra account is reduced so the net liability balance increases. Thus, overall reporting of the interest and the liability is not impacted by the method used in recording the issuance of the bond.
The ABCs of Zero Coupon Bonds | Larry Saffer
The balances to be reported in the financial statements at the end of Year One are as follows:. The principal is higher in this second year because of the compounding addition of the first year interest. If the principal increases, subsequent interest must also go up. That was exactly 6 percent of the principal in each of the two years. Total interest reported for this zero-coupon bond is equal to the difference between the amount received by the debtor and the face value repaid. Both of the accounting problems have been resolved through use of the effective rate method.
If interest is then recognized each period based on this same set of variables, the resulting numbers will reconcile. Question: This bond was sold at the present value of its future cash flows based on a rate of interest negotiated by the parties involved. Interest was then recognized periodically by applying the effective rate method. 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? Answer: Interest can also be calculated for reporting purposes by a simpler approach known as the straight-line method.
Using this technique, an equal amount of the discount is assigned to interest each period over the life of the bond. Payment will be made in two years. However, a question should be raised as to whether the information reported under this method is a fairly presented portrait of the events that took place. Although the bond was sold to earn 6 percent annual interest, this rate is not reported for either period.