When a bond is issued at a premium, the carrying value is higher than the face value of the bond. When a bond is issued at a discount, the carrying value is less than the face value of the bond. When a bond is issued at par, the carrying value is equal to the face value of the bond. The following T-account shows how the balance in the account Premium on Bonds Payable will decrease over the 5-year life of the bonds under the straight-line method of amortization. As an investor, it is crucial to understand how amortized bonds work because the interest paid back counts as income for you. Amortized bonds are loans in which the borrower pays back both the principal and the interest throughout the life of the loan.
Investors think the company is risky, so they demand a 12% yield to maturity for buying these bonds. The second way to amortize the premium is with the effective interest method. The effective interest method is a more accurate method of amortization, but also calls for a more complicated calculation, since it changes in each accounting period.
Bonds Issued at a Discount
In the 10-year bond example above, the yield to maturity is roughly 5%. That is less than the 6% coupon rate stated because you’re paying more than face value for the bond. If you pay a premium to a bond’s face value, you can amortize that premium over the remaining term of the bond.
However, it can still fall under a bond discount due to market fluctuations. Like the premium bond, the bond discount can also relate to bonds trading at lower than face value. Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer. The Motley Fool reaches millions of people every month through our premium investing solutions, free guidance and market analysis on Fool.com, top-rated podcasts, and non-profit The Motley Fool Foundation. An amortizable bond premium is the amount owed that exceeds the actual value of the bond.
Amortization of premium on bonds payable
The premium arises when the bonds are issued at a price higher than their face value due to a lower market interest rate than the stated interest rate on the bond. The bond amortization calculator calculates the total premium or discount over the term of the bond. The straight line method amortization for each period, and produces an effective interest method amortization schedule showing the premium or discount to be amortized each period. Following on from our article that looked at the discount side, in today’s accounting tutorial series we look at the journal entry and calculations required when a premium on a bonds payable issue is paid. In particular, we will look at how a premium arises, how it is calculated, the journal entries and how to amortise the premium over the life of the bond.
We will also look at the journal entry for the repayment of the bond at maturity. Notice that the effect of this journal is to post the interest calculated in the bond amortization schedule (5,338) to the interest expense account. From the bond amortization schedule, we can see that at the end of period 4, the ending book value of the bond is reduced to 120,000, and the premium on bonds payable (2,204) has been amortized to interest expense. The final bond accounting journal would be to repay the par value of the bond with cash. If a bond is issued at a premium or at a discount, the amount will be amortized over the years through to its maturity. On issuance, a premium bond will create a “premium on bonds payable” balance.
Bonds Issued at a Discount Example: Carr
The bond’s interest payment dates are June 30 and December 31 of each year. This means that the corporation will be required to make semiannual interest payments of $4,500 ($100,000 x 9% x 6/12). The debit of $13,563 in the journal entry decreases the premium on bonds payable premium adjunct account balance. Although not normally a good idea, this off-set entry produces a better reflection of the interest expense incurred by ABC for the period.
- This method is required for the amortization of larger premiums, since using the straight-line method would materially skew the company’s results.
- The difference between the price we sell it and the amount we have to pay back is recorded in a liability account called Premium on Bonds Payable.
- The premium of a bond refers to the variance between its current price, often referred to as the carrying value or market price, and its face value.
- For calculating bond premiums or discounts, it is crucial to calculate the present value of its payments.
Notice that the effect of this journal is to post the interest of 4,249 to the interest expense account. When a corporation prepares to issue/sell a bond to investors, the corporation might anticipate that the appropriate interest rate will be 9%. If the investors are willing to accept the 9% interest rate, the bond will sell for its face value. If however, the market interest rate is less than 9% when the bond is issued, the corporation how to calculate premium on bonds payable will receive more than the face amount of the bond. The amount received for the bond (excluding accrued interest) that is in excess of the bond’s face amount is known as the premium on bonds payable, bond premium, or premium. Amortization of premium on bonds payable is the process of gradually reducing the premium on bonds payable over the bond’s life until the bond’s carrying value equals its face value at maturity.
However, bond premiums and discounts do not apply to this scenario often. Instead, it relates to the trading aspect of the bonds in the market. When an issuer charges a lower price for their bond, it falls under a bond discount.
Usually, this party includes a financial institution that acts as an intermediary. This institution facilitates the process between the bond issuer and the holder. Each period the interest expense (5,338) is the interest paid to the bondholders based on the par value of the bond at the bond rate (4,800) plus the discount amortized (538). Each period the interest expense (4,249) is the interest paid to the bondholders based on the par value of the bond at the bond rate (4,800) less the premium amortized (551). The actual cash interest paid was only $5, the coupon multiplied by the bond’s face value. However, interest expense also includes the $558.39 of amortized discount in the first six months.
The bank debit entry reflects the $2,011,251 raised from the issue. While the credit of $1,740,000 (87 bonds x par value of $20,000) recognises the par value liability owed to bondholders on maturity. At the time, the market rate is lower than 8%, so investors pay $1,100 for the bond, rather than its $1,000 face value. The excess $100 is classified as a premium on bonds payable, and is amortized to expense over the remaining 10 year life span of the bond. At that time, the recorded amount of the bond has declined to its $1,000 face value, which is the amount the issuer will pay back to investors. As before, the final bond accounting journal would be to repay the face value of the bond with cash.