Journal entry for zero coupon bond

Introduction

Zero coupon bond is the type of bond that does not give periodic interest or coupon payment to the buyer of the bond. However, this type of bond is always issued at a discount and the discounted amount can be a big amount that it can be referred to as a deep-discount bond. Likewise, when making the journal entry for the zero coupon bond, we need to include the discounted amount to account for the difference between the cash received from issuing the zero coupon bond and its face value.

And later, we also need to amortize the zero coupon bond at each period during the life of the bond in order to record the interest expense that occurs through the passage of time. In other words, we need to amortize the discounted part of the zero coupon bond to transfer this discounted amount to the interest expense while reducing the discounted amount to zero at the end of bond maturity.

Journal entry for zero coupon bond

We can make the journal entry for zero coupon bonds by debiting the cash account and the bond discount account for the difference between the cash we receive from issuing the zero coupon bonds and their face value and crediting the bonds payable account with the face value of bonds.

Issuing zero coupon bonds:

Account Debit Credit
Cash $$$
Bond discount $$$
Bonds payable $$$

In this journal entry, the bond discount account is a contra account to the bonds payable on the balance sheet, and the amount of bonds payable here is the face value of the zero coupon bonds.

Likewise, the carrying value of the bonds payable on the balance sheet is the bonds payable less the bond discount.

Zero coupon bonds on the balance sheet
Bonds payable $$$
Less: bond discount ($$$)
Carrying value of bonds payable $$$

Hence, we will need to amortize the bond discount over the life of the bond in order to have a carrying value of bonds payable equal to the face value of the bonds at the end of the bond maturity.

Amortization of zero coupon bond

If the zero coupon bonds are issued at a deep discount price that results in a significant or a material amount of discount, we need to amortize the bond discount with the effective interest rate method. On the other hand, if the amount of bond discount is immaterial, we can amortize it using the simple straight-line method by dividing the discounted amount over the life of the bond.

The amortization of the zero coupon bond is made in order to reduce the balance of the bond discount throughout the periods until it becomes zero at the end of bond maturity. And at the same time, it is also made to recognize and record the interest expense on the income statement for the period.

Hence, we can make the journal entry for amortization of zero coupon bonds with the debit of interest expense account and the credit of the bond discount.

Amortization of zero coupon bonds:

Account Debit Credit
Interest expense $$$
Bond discount $$$

Although we do not pay the periodic coupon or interest on the zero coupon bond, the interest expense still occurs throughout the periods of the bond. This is because the interest expense occurs through the passage of time even though there is no payment made during the period.

And at the maturity date, we can pay the amount equaling to the face value of the bonds to redeem the zero coupon bonds back from the bondholders.

In this case, we can make the journal entry for the redemption of the zero coupon bonds by debiting the bonds payable account and crediting the cash account.

Redemption of zero coupon bonds:

Account Debit Credit
Bonds payable $$$
Cash $$$

Zero coupon bond example

For example, we issue $500,000, three-year, zero-coupon bonds for $410,000 which is only 82% of the face value of the bonds.

What are the journal entries for the $500,000 zero coupon bonds:

  • the issuance
  • the amortization (using effective interest rate and straight-line method)
  • the redemption

Solution:

Issuance of zero coupon bonds

As the zero coupon bonds have a $500,000 face value, we cand determine that there is a difference of $90,000 ($500,000 – $410,000) which we can record as the bond discount.

In this case, we can make the journal entry for the issuance of $500,000 zero coupon bonds by debiting the $410,000 cash received to the cash account and the $90,000 difference to the bond discount account, and crediting the $500,000 to the bonds payable as below:

Account Debit Credit
Cash 410,000
Bond discount 90,000
Bonds payable 500,000

Likewise, at the time of issuing the zero coupon bonds, the carrying value of bonds payable on the balance sheet is $410,000 ($500,000 – $90,000).

Zero coupon bonds on the balance sheet
Bonds payable $500,000
Less: bond discount (90,000)
Carrying value of bonds payable $410,000

Amortization of zero coupon bonds using effective interest rate

Before we can amortize the discounted amount of the zero coupon bonds here, we need to determine the effective interest rate first.

As we already know the present value (sold for $410,000) and the future value (face value of $500,000) of the bonds, we can determine the effective interest rate for the zero coupon bonds by using the future value formula of “fv = pv x (1+r)^n” as below:

fv = pv x (1+r)^n

(1+r)^n =fv/pv

1+r = (fv/pv)^(1/n)

r = [(fv/pv)^(1/n)] – 1

Then we can replace the $410,000 to pv and the $500,000 to fv to get the result with the 3 years of zero coupon bonds as below:

r = [(500,000/410,000)^(1/3)] -1

r = 6.8387%

Likewise, we can calculate the interest expense as an amortization amount for each year as below:

Year 1: interest expense = $410,000 x 6.8387% = $28,039

Year 2: interest expense = $438,039 x 6.8387% = $29,956

Year 3: interest expense = $467,995 x 6.8387% = $32,005

 Year  Zero coupon bonds  Discount  Carrying value  Interest expense
 0   500,000   90,000   410,000           –
  1   500,000   61,961   438,039   28,039
  2   500,000   32,005   467,995   29,956
  3   500,000            0   500,000   32,005
Total   90,000

Hence, we can make the journal entry for the amortization of zero coupon bonds using the effective interest rate as below:

Year 1:

Account Debit Credit
Interest expense 28,039
Bond discount 28,039

Year 2:

Account Debit Credit
Interest expense 29,956
Bond discount 29,956

Year 3:

Account Debit Credit
Interest expense 32,005
Bond discount 32,005

Likewise, the $90,000 balance of bond discount will become zero ($90,000 – $28,039 – $29,956 – $32,005) at the end of the third year and the carrying value of bonds payable will equal their face value of $500,000.

Amortization of zero coupon bonds using straight-line method

On the other hand, the amortization of zero coupon bonds using straight-line method will be a simple one. We can simply amortize the $90,000 discounted amount of the zero coupon bonds to be $30,000 per year over the three years periods of the bonds.

Hence, we can make the journal entry for the amortization of zero coupon bonds using the straight-line method as below:

Year 1:

Account Debit Credit
Interest expense 30,000
Bond discount 30,000

Year 2:

Account Debit Credit
Interest expense 30,000
Bond discount 30,000

Year 3:

Account Debit Credit
Interest expense 30,000
Bond discount 30,000

Redemption of zero coupon bonds

At the maturity date, we can make the journal entry for the redemption of zero coupon bonds by debiting $500,000 to the bonds payable account and crediting the same amount to the cash account as below:

Account Debit Credit
Bonds payable 500,000
Cash 500,000

This journal entry will reduce both total assets and total liabilities on the balance sheet by $500,000 as a result of the redemption of the $500,000 zero coupon bonds back from the bondholders at maturity.