Compounding Interest

Question: This $20,000 zero-coupon bond is issued for $17,800 so that a 6 percent annual interest rate will be

earned. 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. First, the company will actually have to pay $20,000. The

$17,800 principal balance must be raised to that figure. The liability should be reported as $20,000 at the end of

Year Two. Second, the $2,200 difference between the amount received and the eventual repayment ($20,000 less

$17,800) has to be recognized as interest for these two years. 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?

Answer: “In a Set of Financial Statements, What Information Is Conveyed about Intangible

Assets?”, the effective rate method of reporting a present value figure over time was demonstrated. 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.

Interest for Year One should be the $17,800 principal balance multiplied by the effective interest rate of 6

percent to arrive at interest expense for the period of $1,068. 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.

The compounding of this interest raises the principal by $1,068 from $17,800 to $18,868. The balances to be

reported in the financial statements at the end of Year One are as follows:

Year One—Interest Expense (Income Statement) $1,068

December 31, Year One—Bond Payable (Balance Sheet) $18,868

Interest for Year Two is 6 percent of the new liability balance of $18,868 or $1,132 (rounded). 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.