Cash Flow Reporting Practices for Interest Paid on Zero Coupon Bonds

Abstract

Debt financing, such as bonds and notes payable, comes with an interest cost that is incurred by the borrower and paid to the lender providing compensation for the use of funds. When zero coupon bonds are issued, interest is included in the principal amount or face value of the bonds. Although coupon payments are not made during the life of the bonds, the company accrues interest expense on them, which is paid when the bonds are repurchased or redeemed at maturity. Hence, when a company repurchases or redeems zero coupon bonds, it should classify the cash outflow for the repayment of principal amount received from bondholders as a financing use of cash and the amount paid in excess of the principal as operating use of cash.

This study examines the cash flow reporting practices of companies that repurchase or redeem zero coupon bonds. We also evaluate the impact these practices have on the reported cash flows from operating activities. Our results indicate that most companies classify the cash paid towards interest on zero coupon bonds as a financing use of cash. The mean reduction in reported operating cash flow that would be caused by inclusion of interest paid on zero coupon bonds averaged approximately 11%.