The financial concepts known as future value, present value and compound interest are the keys to understanding the economics and the accounting for the proposed zero coupon loan. Let's spend a few moments reviewing these concepts:
Future Value Definition: (quoted from Harvard Business School online course material)
The future value of any amount of money today is the amount that it would be worth if it were invested and grew at the specified compound interest rate over a given time period.
Present Value Definition:
(Quoted from Harvard Business School online course material)
The present value of an amount to be received at a specified future date is the ...view middle of the document...
2), the bond expects to yield 10% interest on the loan. The lender is able to achieve this by paying only $466,507 to Austral at the loan inception and receiving $1,000,000 at the end of the eight years loan term. The difference of $533,493 is implicit interest on the loan. Austral is attracted to the zero coupon loan opportunity because this deferral of interest payments will reduce the cash it needs to pay the creditor in the short-run, plus there is the tax advantage of bond financing.
Notice that the loan terms reflect both the future value and the present value concepts. If we invested $466,507 at 10% for eight years, we would generate $1,000,000, the loan payment. In other words, $1,000,000 is the future value of the initial loan amount of $466,507.
Alternatively, the loan amount of $466,507 is the present value of the loan payment of $1,000,000 in eight years assuming a 10% interest rate. You can check this by referring to the present value tables on Appendix Exhibit B-7 in Financial and Managerial Accounting by WHBC. The present value of $1 to be received in 8 years at 10% is 0.467 (rounded to three 3 decimal places). The present value of the final payment to the creditor is therefore $1,000,000*0.467 or $467,000.
Present Value table:
To do the accounting for Austral's zero coupon loan, we will have to answer two questions:
What amount should be recorded as the liability - the discounted amount received or the higher maturity amount?
Since there is not a periodic cash interest payment, what periodic interest expense, if any, should be recorded?
At first, zero coupon loans are recorded as a liability at the amount received. Then, in each subsequent accounting period, interest is accrued at the rate implied in the provision. The interest expense is recorded as accrued expense and an addition to the loan liability balance. The interest accrued expense recognition reflects...