Accounting of a zero-coupon bond

A company sells a long-term, zero-coupon bond. The company’s cash flow from operations in subsequent years, compared to what it would have been if the company had issued debt at par for the same proceeds, will be: A) overstated. B) understated. C) properly stated

If a company issues a proper coupon bond - e.g. 1000$ bond, 5% Coupon, bought at 990 because Market rate = 6% Assume annual: Coupon = 1000*.05 = 50 Interest Expense=990*.06=59.4 -59.4 would go on the Interest Expense on the Income Statement +9.4 would be recognized as Amortization Expense. Net Interest on Income statement = -50 ================================================== for a zero coupon bond (Assuming the same numbers – remember zero coupon bond is also a deep discount bond.) Coupon=0 Interest Expense=-59.4 Amortization=+59.4 Net Interest on Income statement = 0 So based on this - CFO would be overstated - because 50$ would have been reduced for the regular bond - but nothing is reduced for the Zero Coupon bond. Choice A…

It is answer C but the explanation says: Cash interest is only part of the interest expense. The amortization of the bond discount at maturity is charged to financing cash flow when in fact it should be charged against cash flow from operations, so CFO will be overstated. I guess I don’t understand why “in fact it should be charged against CFO”

do not understand… in your choices Choice C is “Properly stated”, but you seem to be saying “overstated” in your answer as well.

I’m sorry, the answer is A, overstated, as you said, and the explanation is what I copied in my previous post. I understand that it is overstated but because there is no income expense for zero-coupon bonds, and since the int payment goes to CFO, then when compared to a coupon issued at par, which does have int payments, its CFO will be overstated (bigger than the CFO of the other bond). This is how I understand it (which is actually what your numeric example is saying, thanks for that, by the way), I do not understand Schweser’s explanation.

What Schweser is saying is this: Amortization of the Bond discount is actually a “change in the Principal value” – in this case the move of the Principal Value towards Par (for a discount bond). The 9.4$ in my example would get added to the 990 (example number) to make the new principal 999.4. Since it is a return of Principal - it will actually be “reclassified” as a CFF Outflow - instead of the CFO outflow it actually is…

ahhhhhhhhhhhhhhh! got it now! thanks so much. :slight_smile: One more SS in order to finish FSA…it’s been interesting, useful and all but I sooooo want to be done with FSA and move on… Thanks again.