What is Premium on Bonds Payable?

At this point, the remaining balance will be under the current liabilities on the balance sheet. The journal entries to record the reimbursement of bonds payable are as below. 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. The premium account balance represents the difference (excess) between the cash received and the principal amount of the bonds.

• Bonds payable represent a contractual obligation between a bond issuer and a bond purchaser.
• The semiannual interest paid to bondholders on Dec. 31 is $450 ($10,000 maturity amount of bond × 9% coupon interest rate × 6/ 12 for semiannual payment).
• As a result, the carrying amount increases and gets closer and closer to face amount over time.
• We then noted it was an adjunct account and the debits and credits involved.

When we issue a bond at a discount, remember we are selling the bond for less than it is worth or less than we are required to pay back. The difference between the price we sell it and the amount we have to pay back is recorded in a contra-liability account called Discount on Bonds Payable. This discount will be removed over the life of the bond by amortizing (which simply means dividing) it over the life of the bond. The discount will increase bond interest expense when we record the semiannual interest payment. The unamortized premium on bonds payable will have a credit balance that increases the carrying amount (or the book value) of the bonds payable. The unamortized discount on bonds payable will have a debit balance and that decreases the carrying amount (or book value) of the bonds payable.

What is the nature of the premium account?

As with the straight‐line method of amortization, at the maturity of the bonds, the discount account's balance will be zero and the bond's carrying value will be the same as its principal amount. See Table 2 for interest expense and carrying values over the life of the bond calculated using the effective interest method of amortization . 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.

This can lead to a reduction in annual interest payments, effectively resulting in less income. The term bonds issued at a premium is a newly issued debt that is sold at a price above par. When a bond is issued at a premium, the company typically chooses to amortize the premium paid by the straight-line method over the term of the bond. Although on the face of it the journal entry for a bonds payable premium looks straight forward enough, there is actually quite a lot involved. We then noted it was an adjunct account and the debits and credits involved.

Definition of Amortization of Premium on Bonds Payable

Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. Repayment at maturity is guaranteed by the US Government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation. Treasury Inflation-Protected Securities are guaranteed by the US Government, but inflation-protected bond funds do not provide such a guarantee. Credit risk is the risk that a security could default if the issuer fails to make timely interest or principal payments.

What are the risks associated with bonds?

So we have all the information we need to put together the journal entry for the receipt of bondholders money and issuing them the bond payables. A bond is just a promise to pay another party two things; one, a set rate of interest on specific dates; and two, repay them their principal on maturity. Bonds don’t normally have early repayment options for holders, although of course the bond can normally be sold onto another buyer – with no involvement from the issuer. Let’s look at a specific example to illustrate how a premium on bonds payable works and how it is accounted for. If a corporation redeems a bond prior to its maturity date, the carrying amount at the time should be compared to the amount of cash the issuing company must pay to call the bond.

Type of Account

In addition to the six-monthly interest payments the premium on bonds payable is required to be amortised over the the ten year life of the instrument. The purpose of the amortisation is to provide a better reflection of the borrowing costs incurred by ABC for this debt funding. Because of the cash received compared to the liability taken on, the premium, difference between the market rate and the coupon rate, in affect off-sets the interest being paid at the higher rate of 7 per cent. To illustrate the premium on bonds payable, let's assume that in early December 2021, a corporation has prepared a $100,000 bond with a stated interest rate of 9% per annum (9% per year).

Example of the Amortization of a Bond Premium

Issuers usually quote bond prices as percentages of face value—100 means 100% of face value, 97 means a discounted price of  97%of face value, and 103 means a premium price of 103% of face value. For example, one hundred $1,000 face value bonds issued at 103 have a price of $103,000 (100 bonds x $1,000 each x 103%). Regardless of the issue price, at maturity the issuer of the bonds must pay the investor(s) the face value (or principal amount) of the bonds. Computing long-term bond prices involves finding present values using compound interest. Buyers and sellers negotiate a price that yields the going rate of interest for bonds of a particular risk class. The price investors pay for a given bond issue is equal to the present value of the bonds.

Like any other liability on the balance sheet (statement of financial position), a bond is normally classified as non-current as they tend to be issued on five to ten-year maturities. Of course, this is apart from the year before maturity where that classification would change to current. Issuing bonds - A journal entry is recorded when a corporation issues bonds. The second way audit report examples 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. This method is required for the amortization of larger premiums, since using the straight-line method would materially skew the company's results.

Therefore, ABC Co. records the issue of these bonds through the following journal entries. Furthermore, bonds payable issued for a long-term also enter the current portion on the balance sheet. The above definitions help understand whether bonds payable are current or non-current liabilities. For example, companies may offer 3-year, 5-year, 10-year, or longer bonds. When a bond is sold at a premium, the amount of the bond premium must be amortized to interest expense over the life of the bond.

The higher the risk category, the higher the minimum rate of interest that investors accept. The contract rate of interest is also called the stated, coupon, or nominal rate is the rate used to pay interest. Firms state this rate in the bond indenture, print it on the face of each bond, and use it to determine the amount of cash paid each interest period. There are times when the contract rate that your corporation will pay is more than the market rate that other corporations will pay. As a result, your corporation’s semi-annual interest payments will be higher than what investors could receive elsewhere.