Businesses need funds at the time of start-up of their operations, for expansion plans or even to fund their day-to-day operations. When they are unable to generate adequate funds from their operations, they look towards external sources to raise funds. These can be in the form of issuing share capital or taking on debt. Issuing bonds or notes is one such type of debt-based fund generation. Companies can avail loans from institutions or even the general public in exchange of issue of debt instruments termed as notes. These notes generally have a defined term and maturity period at which the company undertakes to repay the funds borrowed.
This article looks at meaning of and differences between two types of notes issued by companies – interest bearing and zero interest bearing notes.
Definitions and meanings
Interest bearing notes:
Interest bearing notes are those debt instruments issued by a company which have a specified coupon rate attached to them. When issuing such notes, the company undertakes to pay interest on the borrowed money at the specified coupon rate, till maturity of the notes. The interest is expressed as a percentage and is paid on the face value of the note. The interest can be paid monthly, quarterly, half yearly or annually depending on the terms of the issued notes.
On the maturity date, the company is obligated to repay the principal amount borrowed (i.e., face value of the bond). Once this is done, the obligation to pay interest ceases.
ABC Inc raises $500,000 by issue of 5000 interest-bearing notes of face value $100 each. These notes are issued at an annual coupon rate of 9% and have a maturity of 10 years.
The accounting entries passed by ABC Inc will be:
Bank a/c…..500,000 [Dr]
Notes payable a/c …..500,000 [Cr]
(Being interest bearing notes of $500,000 issued)
End of Year 1 and every subsequent year till maturity:
Interest expense a/c…..45,000 [Dr]
Bank a/c …..45,000 [Cr]
(Being interest expense recorded)
Notes payable a/c…..500,000 [Dr]
Bank a/c …..500,000 [Cr]
(Being repayment of notes of $500,000 recorded)
Zero interest bearing notes:
Zero interest bearing notes are those debt instruments issued by a company which do not have any coupon rate attached to them. In case of issue of such instruments, the issuing company is not obligated to pay any periodic interest to the investors. These are also called zero coupon bonds.
As zero interest bearing notes are not liable for any periodic interest, they are issued at significant discount to their face value by the company. These instruments also have a fixed maturity period. At the maturity of the notes, the company is obligated to repay the entire face value back to the investors. Thus, the difference between the issue price and face value redeemed becomes the income for the investor and the cost for the issuing company. These notes have an implied in-built interest.
Companies prefer issuing zero interest notes when they do not wish to bear the expense of annual periodic payments. Companies that expect cash inflows from their business to materialize after several years can opt to issue such notes.
XYZ Inc borrows money from a lender by issuing non-interest-bearing notes. It issues 100 notes of face value $1,000 each @ $914.24 each, with a term of 12 months. Thus, each bond is issued at a discount of $85.76.
The accounting entries passed by XYZ Inc will be:
Bank a/c…..91,424 [Dr]
Discount on notes payable a/c* …..8,576 [Dr]
Notes payable a/c …..1,00,000 [Cr]
(Being non-interest-bearing notes of FV $1,00,000 issued at a discount of $8,576)
End of Month 1 and every subsequent month till maturity:
Interest expense a/c…..714.67 [Dr]
Discount on notes payable a/c…..714.67 [Cr]
(Being discount on notes amortized and charged as interest expense)
Notes payable a/c…..100,000 [Dr]
Bank a/c…..100,000 [Cr]
(Being repayment of notes of FV $100,000 recorded)
Difference between interest bearing and zero interest bearing notes
The eight main points of difference between interest bearing and zero interest bearing notes are detailed below:
- Interest bearing notes are debt instruments that require the issuer to pay interest at a predetermined interest rate, periodically till maturity of the note.
- Zero interest-bearing notes are debt instruments that do not require the issuer to make actual periodic interest payments to the investors.
2. Issue price
- Interest bearing notes are generally issued at face value.
- Zero interest-bearing notes are issued at a deep discount to their face value.
3. Obligation of issuer for periodic interest payments
- In the case of interest-bearing notes, the issuing company is obligated to make periodical interest payments to the investors. The interest payments are made at the attached coupon rate, at periodical intervals set out in the issuing terms.
- In the case of zero interest-bearing notes, the issuing company is not obligated to make any periodic interest payments. His obligation is restricted to repayment of the face value at the time of maturity.
4. Accounting for interest expense
- The actual coupon rate multiplied by the face value of notes is calculated and recorded as periodic interest expense by the issuer in the case of interest-bearing notes. Thus, it accounts for actual interest expense.
- The difference between issue price and face value is first recorded as discount on notes payable by the issuer. This discount is amortized across the term of the notes and recorded as notional interest. Thus, it accounts for notional or imputed interest.
5. Impact on cash flow
- Issuers of interest-bearing notes have a high initial cash inflow followed by periodic cash outflow for interest expense. Hence cash flow is impacted each year/month.
- Issuers of zero interest-bearing notes have a lower initial cash inflow but no periodic cash outflow. The entire cash outflow is postponed till the maturity date.
6. Risk for investors
- The risk for investors is generally lower in interest-bearing notes as they will receive periodic interest payments.
- The risk for investors is generally higher as they will receive the entire interest only on maturity of the notes.
7. Suitable issuers
- Interest bearing notes are suitable for issuing companies who can afford periodic interest payments and who thus wish to distribute their cost of raising funds.
- Zero interest-bearing notes are suitable for issuing companies who wish to reduce their yearly interest burden. They can be opted for by entities whose businesses have high gestation period wherein cash inflows are generated after several years.
8. Suitable investors
- Interest bearing notes are suitable for investors who are looking for regular and stable income. For example, retired individuals.
- Zero interest bearing notes are suitable for investors who do not need regular income but prefer receiving lumpsum income after several years. For example, investors looking to accumulate funds for a specific goal such as children’s education, marriage etc.
Conclusion – interest bearing vs zero interest bearing notes:
Both these types of notes are debt-based instruments and put an obligation on the issuing company to honor the redemption at face value. Issuers and investors alike must opt for their choice of note depending on their specific financial circumstances and goals. For example, a conservative investor looking for regular retirement income can opt for interest bearing notes whereas a capital-heavy company whose start-up phase is significant can opt to issue zero interest bearing notes.